1 PRODUCTION POSSIBILITIES

CURVES
Purpose: To use the production possibilities curve (PPC) model to understand scarcity and constrained choice. To emphasize the distinction between movements along a PPC and shifts the PPC. To show the concept of opportunity cost using the PPC model. Computer file: ppc98.xls Instructions and background information: Open the Excel file ppc98.xls, and choose whether you want to do the problems as practice, or whether you want to do the problems to hand in for credit. A production possibilities curve (PPC) shows the maximum amount of one good that can be produced given a production level for some other good, and given the total amounts of inputs available for production of both goods, and given the technology of production. The PPC shows the limits on outputs of goods because society does not have unlimited resources. And it shows the trade-off society must bear if more of a good is to be produced. Attainable levels of output are those that can be produced with the current resources (inputs) and technology. Unattainable levels of output cannot be produced with current resources and technological know-how. Efficient levels of output occur when the maximum output of one good is being produced, given the output level of the other. Efficient output levels must lie on the production possibilities curve. Output levels are inefficient if it possible to s produce more of everything using only your current resources and know-how. The production possibilities curve for these problems shows the quantities of pizza and pasta that can be produced given the amount of labor input available for production, and given the current technology for producing the goods. (There may be other inputs than labor, such as wheat or tomatoes, but they are being held constant for the problems you will have to work out here.) Examine carefully the parts of the screen that show data. There are baseline and current values for all of the variables: labor, pizza and pasta output, and technical efficiency. You will be able to change the current values (within limits), and the graph will show the results of your choices. You can change the amounts of pizza and pasta produced by choosing different amounts of pizza. The spreadsheet will automatically compute the corresponding maximum amount of pasta. Labor is the amount of labor available for the production of both of the goods. Labor will be allocated to pasta and pizza depending on how much of each of the goods you want to produce. 1-1

Near the bottom of the spreadsheet you will see some baseline and current values for efficiency. These values are indices that measure how productive labor is in producing each of the goods. For example, the baseline value for labor efficiency in producing pizza is .50. This means that, for pizza, an increase in labor of 1 percent will increase the output of pizza by .50 percent. Correspondingly, an increase in labor by 10 percent would increase pizza production by 5 percent. Increasing an efficiency value makes labor more efficient in the production of a good; it is just like having a technological improvement. Experiment with the worksheet by changing the current values of labor, pizza, and the technology of production and seeing the effects on the production possibilities curve. Be sure you have a good enough grasp of what happens so that you can predict the general consequences for the position of the production possibilities curve of each kind of change. The (marginal) opportunity cost of a good is the value of what must be given up to get one more unit of the good. For example, in a world that has only pizza and pasta, the marginal opportunity cost of pizza is the amount of pasta that must be given up to get one more unit of pizza. For example, if pizza output is 10, the opportunity cost of one more pizza is the amount of pasta you must give up in order to produce 11 units of pizza. For the PPC you work with the cost of an extra pizza is higher the more pizza you ll produce. Marginal opportunity cost of pizza is the numerical value of the slope of the PPC. It is the bowing out of the curve from the origin that shows the property of increasing opportunity cost. Some of the questions ask you to find the amount of labor it would take to produce a particular level of output. The worksheet contains a special version of Goal Seek to help you solve this problem. But remember, you can always find the answer using trial and error -- it just takes a little longer. Suppose the problem is to figure out how much labor you would need to get pasta production of 115.00 units, given your output level for pizza. To solve this problem using Goal Seek proceed this way: (i) Click on the button that says Click here to use Goal Seek. (ii) A dialog box appears asking you what value of pasta you need to produce. Enter the number 115 (the target value of pasta) in the text area and click on OK, or hit Return. (iii) Another dialog box appears asking you for the cell address of the variable you want to change to make pasta equal to 115. Since you want to change labor, you must enter the cell address of the labor value . That value is in cell I20 of the worksheet. Enter I20 in the text area of the dialog box and click on OK or hit Return. If you chose OK, and everything worked as planned, the new value for labor is displayed, and the graph is updated. If in entering information you get an error box or message, simply choose OK in the error box and continue entering information. Here are some things to watch for and learn as you do the problems: 1-2

1) 2) 3) 4)

Changing the value of pizza moves you along the production possibilities curve. Changing the labor or the input efficiencies makes the production possibilities curve shift. Provided you are on the PPC (not inside it), getting more of one good is costly. There is no free pizza! The only way to get more of everything is to increase your inputs or improve your technology.

Here are some hints to help you get the answers quicker: 1) Always be sure to set variables to their baseline values when asked to do so in the questions. 2) If the answer is a word instead of a number, always use lower case letters. Check the Answer Bin for alternatives, and Copy items from the Bin and Paste them on the Answer Sheet if you want. ___________________________ MATH MAVEN'S CORNER: The equation for the PPC in this problem set is given by Y = A( L ( X / B ) (1/ E X ) ) EY , where Y is the quantity of pasta, X is the quantity of pizza, L is total labor, and EX and EY are the efficiency indexes for pizza and pasta, respectively. The values of A and B are randomly assigned when you open the workbook. You can use this function to answer all the questions above instead of using the worksheet. One thing that is easy to do with this function is to compute the end points of the PPC, which will tell you the maximum amount of either good that can be produced.

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PRODUCTION POSSIBILITIES CURVES Questions Set all variables to their baseline values. Set pizza production to 30. 1) What's the most pasta that can be produced? Set all variables to their baseline values and set pizza production to 35. Enter values for pasta that satisfy each of the following conditions: 2) Attainable and inefficient. 3) Attainable and efficient. 4) Unattainable. Set all variables to their baseline values and set pizza production to 20. Enter values for pasta that satisfy each of the following conditions: 5) Attainable and inefficient. 6) Attainable and efficient. 7) Unattainable. Set all variables to their baseline values. Set Pizza production to 30. 8) Are 100 units of pasta attainable or unattainable? 9) Are 115 units of pasta attainable or unattainble? Set all variables to their baseline values, and set pizza production to 40. 10) Enter a value of pasta that is unattainable. Set all variables to their baseline values and set pizza production to 35. 11) What would total labor input have to be to have maximum pasta production of 105? Set all variables to their baseline values and set pizza production to 35. 12) What's the cost (in pasta) of one more unit of pizza? Set all variables to their baseline values. What's the (marginal) opportunity cost of pizza 13) when pizza is 10? 14) when pizza is 30? 15) when pizza if 40? 16) Based on your answers to questions 13) to 15), when more pizza is produced, does the cost of one more pizza increase or decrease? Set all variables to their baseline values, and set pizza production to 40. The government must admit (or deport) enough workers to get 140 units of pasta. 17) What's the size of the new workforce? 1-4

2 DEMAND FUNCTIONS AND

DEMAND CURVES
Purpose: To emphasize the distinction between movements along demand curves and shifts of demand curves. To show using graphs how to compute quantities demanded. Computer file: demand98.xls Instructions and background information: Open the Excel file demand98.xls, and choose whether you want to do the problems as practice, or whether you want to take the test to hand in for credit. If you choose the test option, you will be prompted to enter your name and student number. The demand for any good is the amount consumers want to buy and are able to buy in a particular period of time. The basic model of demand says that the amount demanded of any good depends on the good own price, consumer income, the prices of substitutes and s complements, consumer preferences, and perhaps other factors. In this example, the spreadsheet shows a hypothetical demand curve for spaghetti in San Francisco, measured in plates per day. Demand depends on the price of spaghetti, average annual money income of consumers, the price of tacos, and the price of wine. You can change all of the prices and income and the spaghetti demand will be updated. The graph of the demand curve will be redrawn to show the effects of your changes. Economists make an important distinction between the effects on the amount demanded of changing a good own price, and the effects on the amount demanded when one of the other s determinants of demand varies, such as income. When a good own price changes, consumers s move along a particular demand curve. When any other determinant changes, the demand curve shifts. Changes in a good own price are said to cause a change in quantity demanded, while s changes in other factors are said to cause a change in demand. Experiment with the worksheet by changing the current values of prices and income and seeing the effect on demand and on the graph of the demand curve. Your task in doing these problems is to figure out and record the effects of the variables that affect demand.

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All of the questions can be answered using trial and error. A shortcut is available in Excel that will make finding the answers a lot quicker. Goal Seek is a computer program that can be found as an item under the Tools menu in Excel. You can tell Goal Seek to find the value of a variable that will make a function (or equation) equal to a particular value. For example, you could get Goal Seek to find the price of spaghetti that would make the demand for spaghetti equal to 3,000 plates per day. For help in using Goal Seek, check the introductory section of these problems. Here are some important results to watch for: 1) Only changes in a good own price move consumers along their demand curve for s the good. Changes in all of the other factors affecting demand cause the demand curve to shift. Changes in prices of related goods can cause demand to increase or decrease depending on whether the related goods are substitutes or complements. Changes in income can either increase or decrease demand, depending on whether the good is normal or inferior.

2)

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__________________________ MATH MAVEN'S CORNER: The demand function for spaghetti is given by e Q ( D ) = (a )( p sb )( I c )( ptd )( p w ) , where ps is the price of spaghetti, pt is the price of tacos, pw is the price of wine, and I is income. The numbers a, b, c, d, and e are randomly assigned parameters that vary from one user to another.

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DEMAND FUNCTIONS AND DEMAND CURVES Questions Set all variables to their baseline values. 1) How much spaghetti is demanded when its price is $25 per plate? 2) How much is demanded when price is $15 per plate? Set all variables to their baseline values. 3) When the price of spaghetti is $25 per plate, how much do consumers want to spend on spaghetti? Set all variables at their baseline values. 4) When the price of spaghetti is $15 per plate, how much do consumers want to spend on spaghetti? [Compare your answer to the answer to 3).] Set all variables to their baseline values. 5) With the price of spaghetti at $12, how much does demand increase when income rises to $25,000? 6) Set all variables to their baseline values and set the price of spaghetti to $12. Increase the price of wine to $35 per bottle. Does the demand for spaghetti increase or decrease? Based on the analysis of the previous question, by how much did the demand for spaghetti change when the price of wine increased from $20 to $35 per bottle? Set all variables to their baseline values, and set the price of spaghetti to $12. What would income have to be to make demand increase to 5000? Set all variables to their baseline values, and set the price of spaghetti to $12. What would the price of wine have to be to make demand equal to 2,000? Set income to $30,000, and all other variables at their baseline values. What would the price of spaghetti have to be to make demand equal to 4,000? Set income to $30,000, and all other variables to their baseline values. What would the price of spaghetti have to be to make demand equal to 5,000? Are tacos and spaghetti substitutes or complements in this problem?

7)

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SUPPLY FUNCTIONS AND SUPPLY CURVES

Purpose: To emphasize the distinction between movements along supply curves and shifts of supply curves. To show, using graphs, how to compute quantities supplied. To show the effects of a per unit tax on supply. Computer file: supply98.xls Instructions and background information: Open the Excel file supply98.xls, and choose whether you want to do the problems as practice, or whether you want to do the problems to hand in for credit. The supply of any good is the amount producers or firms want to sell and are able to sell in a time period. The basic model of supply assumes that the amount supplied depends on the good own price, the prices of inputs used in its production, the technology of production, s certain kinds of taxes, and perhaps other factors. In this example, the spreadsheet shows a hypothetical supply curve for spaghetti in San Francisco, measured in plates served per day. Supply depends on the price of spaghetti, the prices of two inputs, labor and sauce, and the amount of a per unit tax placed on production and sale. A per unit tax is an amount producers must pay the government for each unit of output sold. The producer total tax bill is found by multiplying the tax per unit times the number of units sold. s You can change all of the variables and spaghetti supply will be updated. The graph of the supply curve will be redrawn to show the effects of your changes. Experiment with the worksheet by changing the current values of prices, and the tax rate and seeing the effects on quantity supplied and on the graph of the supply curve. The answers to all of the questions can be found by using trial and error. Excel, however, provides you with a shortcut that can make finding the answers a lot quicker and easier -- Goal Seek. The Goal Seek program can be found under the Tools menu in Excel. You can use it here, for example, to find the value of a per unit tax that will make the amount of spaghetti supplied equal to a prespecified amount. Or you can use it to find the price of spaghetti that will make the amount supplied equal to a given amount, say 4,000 plates per day. You can find help in using Goal Seek in the introductory section to these problems. Here are some things to watch for and learn as you do the problems: 3-1

1)

Only changes in a good own price move firms along the supply curve for s spaghetti. Changes in all of the other factors affecting supply (price of sauce, the per unit tax, etc.) make the supply curve shift. Changes in input prices change supply more at higher spaghetti prices. The supply curve seems to pivot at the origin. Changes in the per unit tax shift the supply curve up by the amount of the tax along the entire length of the curve. Negative taxes are called subsidies, and shift the supply curve down by the amount of the subsidy. Government can manipulate the amount of spaghetti offered for sale by changing the amount of the tax or subsidy.

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Here are some hints to help you get the answers quicker: 1) Always be sure to set variables such as input prices and the tax rate to their baseline values when you are asked to do so. When the spreadsheet computes its own version of the answers it assumes you have done this. Be sensitive to the signs (+ or -) on you answers when you asked for the change re in a variable. Decreases must carry the minus sign to be recognized as correct.

2)

If the answer is a word instead of a number, always use lower case letters. Check the Answer Bin for alternatives, and Copy items from the Bin and Paste them on the Answer Sheet it you want. __________________________ MATH MAVEN'S CORNER: The supply function for spaghetti is given by q Q ( S ) = M ( ps t ) n psauce w r , where ps is the price of spaghetti, psauce is the price of sauce, w is the price of labor (the wage rate), and t is the tax per unit of spaghetti. The parameters M, n, q, and r vary randomly from problem to problem.

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SUPPLY FUNCTIONS AND SUPPLY CURVES Questions Set all variables to their baseline values. 1) How much spaghetti is supplied when its price is $20 per plate? 2) How much is supplied when price is $10 per plate? Set all variables to their baseline values. 3) When the price of spaghetti is $10 per plate, how much total revenue from sales do producers expect? Set all variables at their baseline values. 4) When the price of spaghetti is $15 per plate, how much total revenue from sales do producers expect? [Compare your answer to the answer to 3).] 5) Set all variables to their baseline values. With the price of spaghetti at $12, how much does supply change when the wage rate (price of labor) rises to $8.00? Set all variables to their baseline values and set the price of spaghetti to $12. Increase the price of sauce to $7 per unit. Does the supply of spaghetti increase or decrease? Based on the analysis of the previous question, by how much did the supply of spaghetti change when the price of sauce increased from $3 to $7 per unit? Set all variables to their baseline values, and set the price of spaghetti to $12. If a tax of $5 per unit is placed on all spaghetti sales, how much does supply change? Set all variables to their baseline values, and set the price of spaghetti to $6. If a tax of $5 per unit is placed on all spaghetti sales, how much does supply change? Set all variables to their baseline values, and set the price of spaghetti to $12. If a subsidy of $2 per plate is paid to sellers, how much does supply change? Set all variables to their baseline values. With a subsidy of $5 per plate, what would the price of spaghetti have to be to make supply equal to 4,000? Set all variables to their baseline values, and set the price of spaghetti to $8. What would the price of labor (wage rate) have to be to make supply equal to 2,500?"

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Set all variables to their baseline values, and set the price of spaghetti to $10. Now set to tax to $5. 13) By how much must the price of spaghetti rise to keep spaghetti supply at its pre-tax level? 3-3

EQUILIBRIUM PRICES

Purpose: The purpose of this problem set is to show that markets will be in equilibrium when excess demand is zero. You will explore how variations in price can put a market in equilibrium. You will examine the effects of taxes on market equilibrium price and quantity. Computer file: eq98.xls Background information. This problem set deals with the workings of a hypothetical market for spaghetti. It is concerned with how the market price changes when the amount consumers want to buy is different from the amount suppliers want to sell. Excess demand for a good is quantity demanded minus quantity supplied at the current market price. If at the current market price of a good the amount demanded by consumers is greater than the amount supplied by sellers, there is excess demand, and market price will tend to rise. On the other hand, if the amount demanded by consumers is less than the amount supplied by sellers, excess demand is negative, and market price will fall. A market is in equilibrium if excess demand is zero, that is, if consumers want to buy exactly the amount the suppliers want to sell. Open the Excel file eq98.xls. You will be asked whether you want to do practice problems or take the test for this problem set. Choose one option, and enter any requested information. A student number should have at least four digits at the end. What you then see are supply and demand curves for a hypothetical market for spaghetti in San Francisco, as well as some data on the market, including the market price of spaghetti, average annual income of consumers, quantity supplied, quantity demanded, and excess demand at the current market price. Quantities demanded and supplied are measured in plates of spaghetti per day. You can change the price of spaghetti by clicking on its current value, entering a new value, and hitting Enter. New values for the variables in the model are computed automatically, and the graph is updated to show the current market price. You can also change demand factors such as income, and the prices of tacos and wine. Finally, you can change the prices of two inputs into spaghetti, and adjust the amount of a per unit tax, all determinants of supply.

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Play with the worksheet by changing the price of spaghetti, and seeing what happens to excess demand. Then change some of the demand data and supply data values (incomes and prices) that underlie the demand and supply curves. Be sure you understand what happens when you change each of the "policy" variables. Finding the equilibrium price of spaghetti using Goal Seek is easy. (It easier than using s trial and error, though that not a bad strategy for getting a feel for how the market works.) s 1) 2) Select the cell that contains the value for excess demand by clicking on it. Select Goal Seek from the Tools menu. The Set Cell box should contain the cell address of the value for excess demand. If it doesn click on the cell that t, contains the current value for excess demand. Click on the To Value box. Use the keyboard to enter the number zero (0), but don't hit the Enter key. Click on the By Changing Cell box. Because you want to change price to get excess demand equal to zero, click on the current value for the price. Click on the OK button. Excel displays another dialog box showing the status of goal seeking. To incorporate the results into the worksheet, click on OK. To return to the values you started with choose Cancel.

3) 4) e) f)

If you chose OK, and everything worked as planned, the equilibrium values for the market are displayed. If in entering information you get an error box or message, simply choose OK in the error box and continue entering information. Now you ready to tackle the questions for this problem set. re __________________________ MATH MAVEN'S CORNER: The demand function for spaghetti is given by d Q ( D ) = ( A) p sa I b ptc p w , where ps is the price of spaghetti, pt is the price of tacos, pw is the price of wine, and I is income. The values of A, a, b, c, and d are set by the program. The supply g function for spaghetti is given by Q ( S ) = B( p s t ) f p sauce w h , where ps is the price of spaghetti, psauce is the price of sauce, w is the price of labor (the wage rate), and t is the tax per unit of spaghetti. The program sets the values of B, f, g, and h.

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EQUILIBRIUM PRICES Questions With all variables at their baseline values:_ 1) What's the equilibrium price of spaghetti? 2) What's the equilibrium quantity of spaghetti? Change the level of income to $27,000. 3) What's the new equilibrium price of spaghetti? 4) What's the new equilibrium quantity of spaghetti? 5) Is spaghetti normal or inferior here?"

Set all variables to their baseline values. Set the price of spaghetti to its equilibrium level. Now the price of tacos falls to $3. 6) At the current price of spaghetti, supply changes by 7) At the current price of spaghetti, demand changes by When the price of tacos falls to $3 (as in the last question), 8) What's the new equilibrium price of spaghetti? 9) What's the new equilibrium quantity of spaghetti? Set all variables to their baseline values. Set the price of spaghetti to its equilibrium level. The wage rises to $7.50 an hour. 10) At the current price of spaghetti, supply changes by... 11) At the current price of spaghetti, demand changes by When the wage rises to $7.50 (as in the last question), 12) What's the new equilibrium price of spaghetti? 13) What's the new equilibrium quantity of spaghetti? Set all variables to their baseline values. A tax of $4.00 per plate is put on all spaghetti sales. 14) What's the new equilibrium price of spaghetti? 15) What's the new equilibrium quantity of spaghetti? For the $4.00 tax per plate in the last question: 16) The tax of $4.00 caused an increase in price of how much? 17) What is the government's total tax revenue from its spaghetti tax? Set all variables to their baseline values. Set the price of spaghetti to its equilibrium level. Government grants a subsidy of $3 per plate. 18) What's the change in price due to the subsidy? 19) Continuing on from the last question, what's the change in quantity due to the subsidy?

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20)

Continuing on from the last question, what's the total cost of the subsidy to the government?

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5 LABOR MARKETS
Purpose: To show the determinants of wages in a simple market for labor. To show the effects of imposing an effective minimum wage in a labor market. To show how equilibrium wages change in response to changes in output prices, and labor productivity. Computer file: labor98.xls Instructions and background information: The previous exercise showed how equilibrium price was determined in the market for a good. Economists claim that the markets for labor can also be described using a model of supply and demand. In particular, the equilibrium wage rate, which is the price of labor services, is determined in a labor market. But there are important differences between the markets for goods, such as spaghetti, and the markets for inputs, such as labor. One is that the roles of consumers and firms in input markets are reversed from what we saw in goods markets. This is because consumers are at the same time both the suppliers of labor and the demanders of goods, while firms have the dual role of suppliers of goods and demanders of labor. Open the Excel file labor98.xls. What you see are some data on the market for unskilled labor in Flint, Michigan, including the wage rate for that labor, the price of bread (the food of the working classes), the price firms must pay for capital inputs, an index of labor productivity, quantity supplied, quantity demanded, and excess demand at the currently selected wage. Quantities of labor are measured as the number of workers employed, assuming each worker labors for 8 hours a day. The wage rate is the hourly wage. To find the daily wage just multiply the wage rate by 8. Firms produce automobiles that sell for $18,000 each. On the labor supply side, the workers have the chance to be employed either in the automobile industry at the going wage, or join the army and receive, on average, the wage of a corporal. You should experiment by trying some different values for the selected wage, and each of the demand and supply variables. The factors listed under DEMAND DATA and SUPPLY DATA cause the respective curve to shift. Be sure you understand the reasoning behind the shifts. For example, an increase in the index of labor productivity (perhaps because workers get extra training) results in an increase in labor demand. Be sure you can explain why labor demand changes at all in this case, and why the change in demand for labor is an increase and not a decrease. Why does it cause the demand curve to shift, compared to moving along the curve? 5-1

In questions 7-10 you asked to explore the effects on labor markets of increases in the re prices of goods that consumers buy. To understand these questions you need to know the difference between the money wage and the real wage workers are paid. The money wage is simply the number of dollars per hour that workers get paid. The real wage is the wage in terms of goods -- the amount of goods workers earn per hour. For example, the real wage of unskilled workers in terms of bread is the number of loaves of bread the worker earns per hour. You compute the real wage by dividing the money wage by the price of goods. In this example the real wage is the money wage divided by the price of bread. Here are some things to watch for and learn as you do the problems: 1) 2) Labor markets can achieve equilibrium through changes in the money wage. An effective minimum wage will cause some unemployment, but may also raise the incomes of employed workers as a group. The effect on incomes depends on the elasticity of demand for labor. An increase in the price of the output sold by the firm will ultimately increase the money and real wages of workers. Higher wages in other occupations such as the army have effects on the wages of unskilled labor.

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Here are some hints: 1) The spreadsheet is not sensitive to the units of measurement, such a dollars, when you enter answers. You can always omit dollar signs ($), for example, and still get the right answer. But the spreadsheet is sensitive to sign (+ or -), so be careful on that account. If you use trial and error, rather than Goal Seek, to get an answer, remember that you usually have to be accurate to within about one-tenth of one percent of the exact answer. Sometimes, however, being accurate within five percent (plus or minus) will be ok.

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__________________________ c MATH MAVEN'S CORNER: The demand function for labor is given by D ( L) = ( A) w aT b pc , where w is the money wage for unskilled labor, pc is the price of capital, and T is the technology f index for labor. The supply function for labor is given by S ( L) = ( M )( w t ) n pbread w cf , where w is the wage rate, pbread is the price of bread, wc is the corporal wage, and t is a tax per hour of s labor. The values of all of the parameters are randomly assigned.

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LABOR MARKETS Questions Set all variables to their baseline values. 1) What is the equilibrium hourly wage for unskilled labor in this market? 2) What is the equilibrium level of employment? Set all variables to their baseline values, and set the wage to its equilibrium level. The price of output (automobiles) rises to $23,000. 3) 4) What's the new equilibrium wage? What's the new level of equilibrium employment level?

Set all variables at their baseline values, including the price of automobiles. You are a consultant to the auto industry in Flint, Michigan, and have been asked by your bosses to advise them on the effects of a recent Pentagon proposal. The proposal is to change the military pay scale so the average wage for a corporal in the army will rise to $12 per hour. 5) What's the new equilibrium wage in the unskilled labor market? For the proposal in the last question to raise corporals' wages to $12 per hour, 6) What's the new level of employment in the market for unskilled labor? Set all variables to their baseline values. The price of bread rises to $4.00 per loaf. 7) What's the new equilibrium wage rate? 8) What's the new equilibrium level of employment? Set all variables to their baseline values. 9) What's the real wage (in terms of bread) of unskilled labor in the baseline equilibrium? When the price of bread rises to $4 per loaf, and the market for unskilled labor adjusts to its new equilibrium, 10) What's the new real wage of unskilled labor? 11) With all variables at their baseline values, and the labor market in equilibrium, what's the TOTAL HOURLY INCOME FROM WAGES of unskilled workers as a group? Set all variables to their baseline values. Your task is to pick a value for an effective minimum wage. [Choose a wage less than $20, so it shows on the graph.] 12) What wage rate do you choose? 13) For the minimum wage you chose in the last question, did the incomes of unskilled workers increase or decrease compared to the market equilibrium wage 5-3

Set all variables to their baseline values, and set the wage to its equilibrium level. The government imposes a tax of $2 per hour worked. 14) What's the new hourly take-home wage of workers?

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ELASTICITY OF DEMAND

Purpose: To provide practice in computing and understanding price elasticity of demand. Computer file: elas98.xls Instructions and background information: Elasticity of demand is the economists way of talking about how responsive consumers are to price changes. For some goods, like salt, even a big increase in price will not cause consumers to cut back very much on consumption. For other goods, like vanilla ice cream cones, even a modest price increase will cause consumers to cut back a lot on consumption. [Think for a minute about why this is so. For example, there are few substitutes for salt, but many substitutes for vanilla ice cream cones. Moreover, most people dont spend very much of their income on salt, so they wont feel the pinch so much when its price rises.] Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in a goods price. Take any pair of prices and quantities on a demand curve. Call these points (p0, Q0) and (p1, Q1). The formula for price elasticity of demand is The first term in brackets is the percentage change in quantity, Q. The second term in [(Q1 Q0 / Qbase ) 100] /[( p1 p0 / pbase ) 100] brackets is the percentage change in price, p. Qbase and pbase are the base values of quantity and price for which the percentage change is to be computed. Most economists set Qbase equal to the average quantity, rather than either of the two points. The same convention holds for pbase. While arbitrary, this convention at least assures that the percentage changes you get will be the same no matter whether price and quantity are increasing or decreasing. . When Qbase and pbase are the average values, then elasticity is being computed using the midpoint method. Notice that if you apply the formula above exactly then the number you get for elasticity will be negative. This is because demand curves are negatively sloped -- an increase in price always causes a decrease in quantity. Often, economists will change the formula a bit by putting a minus sign in front of it so the number for elasticity will be positive. While sometimes confusing to non-economists, this convention is widely used and you should be aware of it. In the problems you will do here, the computer has been programmed to allow both positive and negative values of elasticity to be correct. There is a neat way of classifying values of elasticity. When the numerical value of elasticity is less than one, demand is said to be inelastic. When the numerical value of elasticity is greater than one, demand is elastic. So elastic demand means that people are 6-1

relatively responsive to price changes (remember the vanilla ice cream cone). Inelastic demand means that people are relatively unresponsive to price changes (remember salt). An important relationship exists between the elasticity of demand for a good and the amount of money consumers want to spend on it at different prices. Spending is price times quantity, p times Q. In general, a decrease in price leads to an increase in quantity, so if price falls spending may either increase or decrease, depending on how much quantity increases. If demand is elastic, then a drop in price will increase spending, because the percent increase in quantity is larger than the percent decrease in price. On the other hand, if demand is inelastic a drop in price will decrease spending because the percent increase in quantity is smaller than the percent decrease in price. In the graph of a demand curve, spending is a rectangular area (p times Q), and it is often easy to see whether demand is elastic or inelastic just by inspecting the spending rectangles at different prices. Here are some things to watch for and learn as you do the problems: 1) 2) Notice that elasticity is a pure number. It has no units of measurement attached to it. This makes it easy to compare elasticity between different goods. The linear demand curve here has constant slope (by definition). Notice that the elasticity is not constant as you choose different price/quantity pairs. Demand is more elastic at higher prices than lower prices. Elasticity is not slope. Despite the rather mechanical nature of these problems remember that its more important to understand the idea of elasticity than it is to compute it. One path to understanding is to remove some of the mystery of the concept by being able to compute it.

3)

Here are some hints to help you get the answers quicker: 1) 2) Use a hand calculator to do the computations. Or use the calculator that is built in to the computer you are using. Carry two decimal places (at least) for the values you compute for elasticity.

___________________________ MATH MAVEN'S CORNER: The demand function for spaghetti is linear in all variables in this problem set. The parameters of the function are chosen randomly when a person begins using the computer file.

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ELASTICITY OF DEMAND Questions Set all variables to their baseline values. 1) What's the percent change in the price of spaghetti between prices of $18 and $20? [Hint: Use the midpoint method.] Set all variables to their baseline values. 2) What's the percent change in the QUANTITY of spaghetti when the price changes from $18 to $20? Set all variables at their baseline values. 3) What's the elasticity of demand for spaghetti between the prices of $18 and $20? 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) Set all variables to their baseline values. Based on your answer to the last question, is the demand for spaghetti elastic or inelastic between prices of $18 and $20? Set all variables to their baseline values. What's the percent change in the price of spaghetti between prices of $10 and $12? What's the percent change in the QUANTITY of spaghetti when the price changes from $10 to $12? What's the elasticity of demand for spaghetti between the prices of $10 and $12? Set all variables to their baseline values. Based on your answer to the last question, is the demand for spaghetti elastic or inelastic between prices of $10 and $12? Set all variables to their baseline values. Is the demand for spaghetti elastic or inelastic between prices of $8 and $10? Set all variables to their baseline values. How much money do consumers want to spend on spaghetti when the price is $25? Set all variables to their baseline values. The price drops to $23. How much money do consumers want to spend on spaghetti now? When the price falls from $25 to $23 (as in the last two questions), does spending on spaghetti increase or decrease? What's the elasticity of demand between these prices? 6-3

14) 15) 16) 17) 18) 19)

Is demand elastic or inelastic? Set all variables to their baseline values. How much money do consumers want to spend on spaghetti when the price is $7? Set all variables to their baseline values. The price drops to $5. How much money do consumers want to spend on spaghetti now? When the price falls from $7 to $5 (as in the last two questions), does spending on spaghetti increase or decrease? What's the elasticity of demand between these prices? Is demand elastic or inelastic?

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7 CONSUMER & PRODUCER SURPLUS

Purpose: To provide practice in computing and understanding producer and consumer surplus. Computer file: csps98.xls Instructions and background information: The concepts of producer and consumer surplus help economists make welfare (normative) judgments about different ways of producing and distributing goods. For example, we might want to know whether the current level of production of pizzas is the best one from society point of view, or whether social welfare might be improved by having more or less s pizza. If current pizza production is socially optimal, then the amount of society resources s being devoted to pizza is about right. Analyzing consumer and producer surplus allows us to say whether current production is optimal or not. Consumer surplus is the difference between the value to buyers of a level of consumption of a good and the amount the buyers must pay to get that amount. Consumer surplus is the price welfare consumers get from the good. Consumer surplus can be estimated from the demand curve for a good. Graph a) shows the demand curve for pizza, and Q* pizzas are being consumed. Suppose that pizzas sell for P*, the highest price that could be charged for Q*. The value consumers place on consuming Q* is the area A+B. But consumers pay only P* for each pizza, paying P* times Q* in all. Consumers get a value A+B at a cost of B. The area A is the consumer surplus.
A a) P*

A
B Q* D Q

price S b) P

A
C D Q Q

Producer surplus is the difference between the revenue sellers take in from sale of a good and the minimum amount they would accept to produce it. Producer surplus is the welfare sellers get from selling a good. In a competitive market, producer surplus can be estimated from a good supply curve. s The graph b) shows the supply curve for pizza, and Qpizzas are being sold. Suppose pizzas sell for P the lowest price that would induce sellers to sell Q Pizza firms have receipts of Qtimes , . P(area C + D), but would be willing to sell Qfor an amount equal to area D. The producer surplus is area C. It the welfare sellers get from the good. s 7-1

Graph c) shows the total producer and consumer surplus in a pizza market where Q is sold at a price P. Consumer surplus is A, and producer surplus is B. The total welfare from the good is A+B. This is the value of the good to buyers minus the cost to sellers. The total surplus will be maximized (under most conditions) if the free market equilibrium prevails. In graph d) the sum of producer and consumer surplus is A+B, and total welfare is a maximum.

price c) P" A B

D price A d) P* B D Q* Q Q" S Q

Open the file csps98.xls. What you see are demand and supply curves for pizza in a hypothetical market. You asked to compute the values of the concepts just introduced: The re value of the good to buyers, the cost to sellers, and the producer and consumer surplus. As with elasticity, it more important to understand the concept than to know how to compute it. But s being able to compute the values will give you confidence in using the concepts when you need them, and also illustrate the practical importance of the ideas for public policy. Here are some things to watch for and learn as you do the problems: 1) Notice that you need to know quantity and price to compute the surplus. A lower price will always increase the consumer surplus. A higher price will increase the producer surplus. In a competitive market, equilibrium price and quantity will also be the price and quantity that maximize the total surplus. This is one reason economists seem to have a love affair with competitive markets.

2)

Here are some hints to help you get the answers quicker: 1) You need a calculator to do the computations. The area of a right triangle is ll (1/2)baseheight. Draw a sketch of the graphs on a piece of scrap paper, and label the crucial points by referring to the worksheet display of the graph. You need to know where the ll supply and demand curves intersect the price axis. Set quantity to zero to find these numbers. At one point you need to find the equilibrium price and quantity in the market. ll Use Goal Seek (or experimentation) to find the value of quantity that makes the difference between the buyer price and seller price equal to zero. s s

2)

3)

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PRODUCER AND CONSUMER SURPLUS Questions Set all variables to their baseline values, and set quantity to 20. 1) What must price be to have consumers want to purchase this quantity? [Hint: It's the Buyer's Price (BP).] Set all variables to their baseline values, and set quantity to 20. 2) What's the total value to consumers of 20 units of output? Set all variables at their baseline values, and set quantity to 20. 3) If the price consumers must pay is the buyer's price, how much must they spend on the good? 4) Based on your answer to the last question, what is the amount of Consumer Surplus when 20 units are sold at the buyer's price? Set all variables to their baseline values and increase the output to 25. 5) What's the new buyer's price of the good? 6) What's the amount of Consumer Surplus when quantity is 25, and the good sells at the buyer's price? 7) What's the change in Consumer Surplus compared to what you found in question 4? Set all variables to their baseline values, and set the quantity to 20. 8) What must price be to induce producers to sell exactly 20 units of output? [Hint: It's the seller's price (SP).] Set all variables to their baseline values, and set quantity to 20. 9) If the price producers receive is the seller's price, how much are the producers' receipts? 10) With quantity still at 20, what are the total costs of producers? 11) If quantity is 20, and if producers receive the seller's price for that output, what is the amount of Producer Surplus? Set all variables to their baseline values and increase the output to 25. 12) What's the new seller's price of the good? 13) What's the amount of Producer Surplus when quantity is 25, and the good sells at the buyer's price? 7-3

[Warning: Be sure to compute at the BUYER'S price.] Set all variables to their baseline values, and. set quantity to 25. 14) If the good sells at the buyer's price, what is the sum of consumer and producer surplus? 15) With quantity at 25, print the graph. On your printout, shade in the area that shows the total surplus (consumer plus producer). TURN IN THE PRINTOUT WITH YOUR ANSWER SHEET! (If you save your answer sheet as a file, and submit it electronically, you should turn in the printout as requested by your instructor.) 16) At what quantity is the sum of producer and consumer surplus maximized? 17) What is the maximum amount of consumer surplus plus producer surplus? [NOTE: This is the total welfare from the good when the free market output is produced.] 18) With quantity at the level where the total surplus is maximized, print the graph. On your printout, shade in the area that shows the total surplus. TURN IN THE PRINTOUT AS REQUESTED BY YOUR INSTRUCTOR.

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8 TAXES AND WELFARE

Purpose: To show the effects of an excise tax on social welfare. Computer file: taxwelf98.xls Instructions and background information: In the previous problem set you showed that competitive markets ordinarily maximize the welfare from a good or service. The reason markets have this remarkable and desirable characteristic is that in the market equilibrium the sum of consumer and producer surplus is as large as possible. A corollary to this result is that interference with the operation of a free market, if it changes price and quantity, must reduce welfare as measured by the sum of producer and consumer surplus. In this problem set you will explore the effects of an excise tax on welfare in a market for pizza. The result is that the tax causes welfare to decrease, even taking into account the gain in revenue the government gets from the tax. This decrease in welfare is usually referred to a the deadweight loss due to the tax. The deadweight loss due to an excise tax is a form of economic inefficiency. It a s reduction in consumer and producer surplus, and the result is that less than the socially best amount of the good is produced, and it is sold at too high a price. Another way economists describe this result is to say that excise taxes distort the allocation of resources. This is just another way of saying that when the excise tax is imposed, too little of society resources will be s devoted to the good. This is not to say that government should never use excise taxes to raise revenue. In many cases people are prepared to accept the deadweight loss due to taxes if the government can provide services that the market would otherwise fail to provide. These services may include things such as defense, income redistribution, some kinds of education, and legal protection. Open the file taxwelf98.xls. What you see are demand and supply curves for pizza in a hypothetical market. You asked to compute the total surplus in the market for pizza in the re absence of any tax or subsidy. Then you change the tax, and explore the consequences for consumer surplus, producer surplus, and total welfare. The tax is presumed to be collected by pizza firms in this case, so the imposition of the tax shows up as a shift in the supply curve for pizza. Here are some things to watch for and learn as you do the problems: 8-1

1)

Total welfare (consumer plus producer surplus) is maximized in the market equilibrium. The tax raises the market price of pizza to consumers. Because sellers collect the tax, their after-tax price is lower than if there were no tax. Both buyers and sellers lose surplus as a result of the tax. The tax revenue of the government is less than the loss of surplus. Consumers and producers lose more than the government gains. Therefore there is a deadweight loss in welfare from the tax.

2)

3) 4)

Here are some hints to help you get the answers quicker: 1) You need a calculator to do the computations. The area of a right triangle is ll (1/2)baseheight. Drawing a sketch of the graphs on a piece of scrap paper will help. Label the crucial points in your sketch by referring to the worksheet display of the graph. You need to know where the supply and demand curves intersect the price axis. ll Set quantity to zero to find these numbers. You need to find the equilibrium price and quantity in the market. Use Goal ll Seek (or experimentation) to find the quantity of pizza that makes the difference between the buyer price and seller price equal to zero. s s You'll need to find the loss in welfare due to an excise tax. In the diagram at the right, the loss due to the tax is the triangle k. The easiest way to find k is to notice that it is onehalf of the area k+n+m. The area k+n+m is easy to compute. It's just the rectangle that is (Q0 - Q1) wide by (p0 - (p0-T)) wide.
price p0 k p0 - T Q0 m Q1 D Q n S+T S

2)

3)

4)

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TAXES AND WELFARE Questions Set all variables to their baseline values. 1) What is the market equilibrium quantity? 2) What is the market equilibrium price? Set all variables to their baseline values. 3) What's the amount of consumer surplus at the market equilibrium? 4) What's the amount of producer surplus at the market equilibrium? Set all variables at their baseline values. 5) At the market equilibrium, what's the total surplus (consumer plus producer)? With variables starting from their baseline values, set the excise tax to $5 per pizza. 6) What's the new equilibrium price of pizza? 7) What's the new equilibrium quantity of pizza? 8) After the tax, what's the new buyer's price? 9) After the tax, what's the new consumer surplus? 10) After sellers pay the tax, what's their new amount of producer surplus? 11) What's the total tax amount paid to the government? 12) With the tax at $5, and the market in equilibrium, PRINT THE WORKSHEET. Shade in and label the consumer surplus, producer surplus, and total tax. TURN IN THE PRINTOUT WITH YOUR OTHER ANSWERS. (If you save your answer sheet as a file, and submit it electronically, you should turn in the printout as requested by your instructor.) Put the tax at $5, and the market in equilibrium. 13) What's the deadweight loss in welfare due to the tax? 14) Print out the worksheet one more time. Shade in the area showing the deadweight loss in welfare due to the tax. TURN IN THE PRINTOUT WITH YOUR OTHER ANSWERS. (If you save your answer sheet as a file, and submit it electronically, you should turn in the printout as requested by your instructor.) 8-3

9 TRADE AND WELFARE

Purpose: To show the effects of international trade on social welfare. Computer file: tradewlf98.xls Instructions and background information: Once again we get to explore the implications for social welfare of an important policy issue in economics, namely, the effects of allowing international trade in a good. The tools to answer this question are the now familiar ones of producer and consumer surplus. The spreadsheet for this problem shows supply and demand curves for wine in a small country. We first consider this country in isolation when there is no trade. In the absence of trade, price and quantity are determined by domestic supply and demand. The social welfare from domestic production and consumption of wine is the sum of producer and consumer surplus at the home equilibrium price. When international trade is possible, consumers and producers can buy and sell wine at the world price. If the world price is greater than the no-trade price, then the country will be an exporter of wine. On the other hand, if the world price is less than the no-trade price, then the country will be an importer of wine. Introducing international trading in wine affects producer and consumer surplus, as well as the total surplus for the country. Allowing trade always increases the total surplus in the market for the traded good. Consumers and producers are affected differently, however. If trade results in exports of wine, then domestic consumers are hurt because they must pay a higher price than before. Producers will gain surplus as a result of the higher price. By comparison, if trade results in imports of wine, then domestic consumers are better off because they pay a lower price for wine. But producers are hurt because they get a lower price. The spreadsheet shows supply and demand curves for wine. You can change the world price and the graph shows the resulting quantities supplied and demanded at that price. If you set the world price above the no-trade equilibrium, which is shown as a faint dotted line in the chart, the amount of wine exported is the difference between supply and domestic demand. If the world price is less than the no-trade equilibrium, then imports are the difference between domestic demand and domestic supply. In this problem you cannot change either the tax rate or the level of consumer income. 9-1

Here are some things to watch for and learn as you do the problems: 1) Total welfare, measured by the sum of consumer and producer surplus is always increased when trade can take place. Compared to the no-trade situation, if a good is exported there will be an increase producer surplus, and a decrease consumer surplus. Domestic producers gain from trade, and domestic consumers lose. Compared to the no-trade situation, if a good is imported there will be a decrease in producer surplus, and an increase in consumer surplus. Domestic producers lose from trade, and domestic consumers gain. World prices, based on the principle of comparative advantage, determine whether a good will be imported or exported.

2)

3)

4)

Here are some hints to help you get the answers quicker: 1) You need a calculator to do the computations. The area of a right triangle is ll (1/2)baseheight. For each group of questions, drawing a sketch of the graphs on a piece of scrap paper will help. Label the crucial points in your sketch by referring to the worksheet display of the graph. You need to know where the supply and demand curves intersect the price axis. ll You can do this by trial and error changing the world price. Or you can use Goal Seek, once to find the world price for which quantity demanded equals zero, and again to find the world price for which quantity supplied equals zero. On the way to computing values for consumer and producer surplus, you need to ll find the no-trade equilibrium quantity in the market. Use Goal Seek (or experimentation) to find the world price that makes the excess demand for wine equal to zero.

2)

3)

4)

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TRADE AND WELFARE Questions The sheet shows the market for wine in a small country. 1) If there is no trade in wine, what is the domestic price? 2) What is the domestic quantity? Assume there is no trade in wine. 3) What's the amount of consumer surplus. 4) What's the amount of producer surplus. 5) What's the total surplus? Suppose the world price of wine is $20, and that importing and exporting wine is allowed. 6) Will the small country be an importer or exporter? With the world price at $20, 7) What's the quantity demanded of wine? 8) What's the new amount of consumer surplus? 9) Did consumers gain or lose from trade? With the world price at $20, 10) What's the quantity supplied of wine? 11) What's the new amount of producer surplus? 12) Did producers gain or lose from trade? 13) With free trade in wine at a world price of $20, how much is the gain in total surplus? Now suppose the world price of wine is $7, and that importing and exporting wine is allowed. 14) Will the small country be an importer or exporter? With the world price at $7, 15) What's the quantity demanded of wine? 16) What's the new amount of consumer surplus? 17) Compared to no trade, did consumers gain or lose from trade? With the world price at $7, 18) What's the quantity supplied of wine? 19) What's the new amount of producer surplus? 20) Compared to no trade, did producers gain or lose from trade? 21) With free trade in wine at a world price of $7, how much is the gain in total surplus?

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22) With the world price at $20, print the graph and shade in the GAIN in surplus due to trade. TURN IN THE PRINTOUT WITH THE REST OF YOUR ANSWERS. (If you save your answer sheet as a file, and submit it electronically, you should turn in the printout as requested by your instructor.)

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10

EXTERNALITIES

Purpose: This problem set illustrates the effect of a negative production externality on social welfare, and shows how a tax can be used to regulate the amount of the external effect created. Computer file: ext98.xls Instructions and background information: The spreadsheet shows a hypothetical market for paper. Paper firms, when they produce paper, also create pollution. In this case they cause water pollution because they dump the byproducts of paper making into nearby streams and rivers. The marginal external cost (MEC) of papermaking is constant in this problem. That is, each extra unit of paper produced also adds a fixed amount of pollution costs to the environment. For example, if the MEC is $15.00, then each extra unit of paper produced causes an extra $15.00 of environmental damage. The spreadsheet shows the marginal private costs (MPC) of paper production, which is just the supply curve of the firms in the industry. The (marginal) social cost of paper production (MSC) is the sum of the marginal private cost and the marginal external cost. The demand for paper is designated as the marginal private benefit (MPB) from paper consumption. Because there are no external effects on the demand side of the market, this is the same as the marginal social benefit (MSB). So that you can see what happens when market conditions change, the spreadsheet allows you to change consumer income, a demand factor, and an input price, a supply factor. Finally, you can change the size of a per unit tax on paper production. The spreadsheet will show, when the tax is greater than zero, the marginal costs to firms of producing more paper, including the tax. By adjusting the tax, you can control how much paper, and therefore, how much pollution is produced. Your task in the problems is to figure out what the private market does under a variety of conditions, and to figure out what the socially best outcome is in these cases. You are also asked to suggest optimal tax policies that will make the paper firms operate in societys interest. Here are some important results to watch for: 1) When there is a harmful externality, even a competitive market will produce too much of a good from societys point of view. 2) But even at the socially best output of the good, there will still be some pollution and pollution cost.

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3) If pollution is taxed correctly then changes in the underlying demand and supply conditions in the market will not require adjusting the pollution tax to get the socially best output. HINTS: Competitive markets will produce where MPC = MPB. Society wants an output where MSC = MSB. An appropriate tax can raise MPC to equal MSC. Goal Seek can be used to solve all of these problems, but experimentation, especially with changing the tax, is likely to be helpful.

_________________________ MATH MAVENS CORNER: All of the functions in this problem set are linear, but the parameters will vary from one students problem to another.

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EXTERNALITIES Questions Set all variables to their baseline values. If the market for output (paper) is competitive, then 1) What is the equilibrium quantity that will be traded? 2) What is the market price of paper in a free market? Set all variables to their baseline values. 3) When one more unit of output is produced, what is the increase in the cost of pollution (the marginal external cost)? Set all variables at their baseline values. 4) At the free market price and quantity, what is the total cost of the pollution created? 5) With all variables at their baseline values, what is the socially best output of paper? 6) What is the socially best price? That is, what price SHOULD paper sell for? 7) At the socially best price and quantity, what is the total cost of pollution created? [Compare your answer to that for question 4).] 8) Set all variables to their baseline values. What tax per unit of output should be imposed on paper firms to get them to produce the socially best output? Set all variables to their baseline values. Now suppose consumer income rises to $40,000. 9) What's the new free market quantity of paper? 10) What's the new free market price of paper? For the quantity and price you found for the last two questions, 11) What are the total pollution costs? 12) With income still at $40,000., what is the socially best output of paper? With income still at $40,000 13) What is the socially best price of paper? 14) What is the socially best amount of pollution? 15) With income still at $40,000, what tax per unit of output should be imposed on the paper firms to get them to produce the socially best output? [Compare your answer to that for question 8).] Set all variables to their baseline values. Now suppose that input prices fall to $10.00. 16) What's the new free market quantity of paper? 17) What are the total pollution costs at this quantity? With input prices still at $10.00,

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18) What is the socially best quantity of paper? 19) What tax per unit of output will get the market to the socially best quantity of paper? [Compare the tax to the answers to Questions 8) and 15).

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11 PRODUCTION FUNCTIONS
AND ISOQUANTS
Purpose: To illlustrate production functions, isoquants, and total product curves. Computer file: cdprod98.xls Background information: The production function is the economist's description of the technology of production. It defines for every combination of inputs to the production process the maximum output that can be produced. If you did the exercise on utility functions and indifference curves, it may help you to know that the function representing the production function here is of the same general form as the first utility function in that problem set. The difference in meaning here is that the dependent variable is the output of a good per unit time, and the independent variables are inputs into the production process. Isoquants, or constant quantity curves, show all values of inputs for which output is constant. Isoquants are formally similar to the indifference curves in the utility function problems. The numerical value of the slope of an isoquant is the marginal rate of technical substitution. It is analogous to the marginal rate of substitution in the model of utility and choice, and shows the extent of substitutability between a pair of inputs. A total product curve shows the relationship between output and a single variable input, holding all other inputs constant. There will, in general, be a different total product curve for each value of the fixed input(s). The marginal product of an input is the change output per unit change in a variable input, holding all other inputs constant. The marginal product is the slope of a total product curve. The Law of Diminishing Returns says that the marginal product of an input will eventually decline as more of a variable input is used. Most of the questions in this problem set entail manipulating the graph of the production function to show the isoquants and total product curves. To maneuver the graph, click on any of the vertices. Small black dots appear on all of the vertices. You can drag any black dot to change the orientation of the grpah. [To do this, put the mouse pointer on the black dot, and depress the left mouse button. If you hold the button down and move the mouse, the graph will change form and move with the pointer. Releasing the mouse button redraws the graph, showing the new orientation.] Experiment by moving the graph of the production surface to different orientations, then proceed to answer the questions.

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Economists generally impose fewer theoretical restrictions on production processes than on preferences. For example, it is commonly allowed that marginal products of some inputs be negative. And the marginal rate of technical substitution is not always assumed to be increasing as inputs are gradually substituted for each other. In fact, a good deal of economic analysis is devoted to production processes in which the inputs are used in fixed proportions the isoquants appear as right-angles. __________________________________ MATH MAVEN'S CORNER: The production function used to generate the graph in this problem set is given by Q = AL K where L is the amount of labor used and K is the amount of capital used. Exponential functions of this sort are commonly used by economists to describe production functions. They are called Cobb-Douglas functions, though the termis sometimes reserved for the special case in which the exponents sum to one. An isoquant is the implicit function relating L and K for a given Q. The marginal product of an input is the partial derivative of output with respect to that input. For example, the marginal product of labor in this case is AL-1K , or Q/L.

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PRODUCTION FUNCTIONS AND ISOQUANTS Questions 1) For the part of the function shown in the graph, is the marginal product of labor always positive? (yes or no) 2) For the part of the production function shown in the graph, is the marginal product of capital always positive? (yes or no) 3) Reorient the graph so that it shows the isoquants between labor and capital. Print the graph (or save it as a file) and turn it in with your other answers. 4) For the part of the production function shown in the graph, are the isoquants <convex>? (yes or no) 5) For the part of the production function shown in the graph, do isoquants intersect? (yes or no) 6) Reorient the graph so it shows the total product curves as a function of capital. Print the graph (or save it as a file) and turn it in with your other answers. [If you save it as a file, be sure to change the file name to end in a <2> so you don't overwrite the file saved in question 3.] 7) Do the total product curves obey the Law of Diminishing Returns so long as some of each input is employed? (yes or no)

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12 COST MINIMIZATION
Purposes: To show how a cost minimizing firm chooses inputs in the long-run. To show how to derive a firm's long-run total cost curve. Computer file: costmin198.xls. Background information: Consider a firm, say a university, that produces an output, for example, the number of student credit hours, from two inputs, labor, L, and capital, K. The university's provost (chief academic officer) can buy any amounts of the two inputs used in production at fixed, known prices. The problem she faces is to choose the amounts of labor and capital that will minimize the total cost of producing a specified output. In other words, this is the standard cost minimization problem in the theory of the firm. The production function for the university gives the current technology of production. Given the technology of production, the cost minimizing amounts of the inputs are those for which (i) the firm can produce the required output, and (ii) the marginal rate of technical substitution of labor for capital equals the ratio of the price of labor to the price of capital. Another way to say this is that the university should be on a cost constraint (isocost line) where the constraint is just tangent to the given isoquant. Once you find the cost minimizing amounts of inputs, you will examine the effects of changing input prices on the university's minimum cost of production, and you will derive the school's long-run total cost curve. The spreadsheet shows a few of the university's isoquants, and a cost constraint for the current level of output and input use. The baseline value for output is 30, and the baseline values of labor and capital are $9 and $4, respectively. You can return to these values by clicking on the appropriate button on the spreadsheet. Excel computes the amount of capital needed to produce the current output of 30 units of instruction. Get a feel for how the model works by setting output to 30, and choosing some different values for labor. Notice how the cost of production changes every time you choose a different amount of labor to produce the given output. Notice also that the isocost line (cost constraint) changes every time you change labor to show the effects on total cost. The central question here is how to produce the required output at minimum total cost. The answer is to choose input amounts that make the Marginal Rate of Technical Substitution of L for K equal to P(L)/P(K). Here's how to use Goal Seek to find the answer. 12-1

Set output to its required amount, and make sure input prices are at the amounts you want. (i) Select the cell containing the current value for the MRTS. (ii) Enter Goal Seek from the Formula menu. (iii) Click on the To Value box, and enter the numerical value of the price ratio of the inputs using the keyboard. (iv) Click on the By Changing Cell box, then click on the cell containing the current value of labor. The cell address should appear in the By Changing Cell box. (v) Click on OK, and, if everything goes well, Excel will find a solution. To update the worksheet with the solution, click on OK. The firm's long-run total cost curve shows the minimum cost of producing any output, given input prices and the technology of production, when all inputs are variable. You can find points on the LRTC by solving the firm's cost minimization problem for a succession of output levels, holding input prices constant. That's just what you're asked to do in the problems, and you will plot the LRTC from the points you find. Here are some things to watch for and learn as you do the problems. 1) At the cost minimizing input choices, the ratio of the input prices (PL/PK) is equal to the MRTS (L for K). The isoquant and cost constraint are tangent to each other. Lowering an input price will lead the firm to use more of the input whose price has fallen. Note the similarity between the cost minimization problem firm's face and the utility maximization problem consumers face. Note that the MRTS of labor for capital is equal to the ratio of marginal product of labor to the marginal product of capital (MPL/MPK)

2)

3)

4)

_________________________________________ MATH MAVEN'S CORNER: The production function used to generate the graph is given by Q = AL. K where L is the amount of labor and K is the amount of capital. The cost constraint is given by C = PL L + PK K , where C is total cost, and PL and PK are the prices of L and K, respectively. The values of A, a, and are chosen randomly, but can be seen in the Answer Bin. The math problem is to minimize C subject to the production function with output set to the required output. It can be solved either of two ways: substitute the constraint into the definition of total costs so only one of the inputs is a variable and then minimize, or use the Lagrangian 12-2

Theorem. Satisfy yourself, if you wish, that the marginal rate of technical substitution of L for K is (a/)(K/L) in this case. The MRSL for K in general is -dK/dLdQ=0 = ( L)/( K). Q/ Q/

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COST MINIMIZATION Questions Set output and input prices to their baseline values. Set labor use to 50. 1) What is the total cost of 30 units of output when labor is 50? 2) How much capital is used in this case? Continuing on from the last question: 3) What is the marginal product of labor? 4) What is the marginal product of capital? 5) What is the MRTS of labor for capital? Be sure output and input prices are at their baseline values. 6) What is the minimum cost of producing 30 units of output? 7) How much labor is used at the cost minimizing solution? 8) How much capital is used at the cost minimizing solution? Continuing on from the last question: 9) At the cost minimizing solution, what is the ratio of the price of labor to the price of capital? 10) At the cost minimizing solution, what is the MRTS of L for K? Set all variables to their baseline values. Questions 11-16 generate the data to find the firm's longrun total cost curve. 11) What's the minimum cost of producing zero units of output? 12) What's the minimum cost of producing 10 units of output? 13) 14) 15) 16) What's the minimum cost of producing 20 units of output? What's the minimum cost of producing 35 units of output? What's the minimum cost of producing 40 units of output? What's the minimum cost of producing 45 units of output

17) Print out the Graph Paper sheet by selecting it (by clicking on its tab at the bottom of the screen), and clicking on the button to print. Graph the firm's total cost curve using the points you found in questions 6 and 11 to 16. Set all variables to their baseline values. Now raise the price of labor to $12/unit.

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18) What's the new minimum cost of producing 30 units of output? (Compare to question 6.) 19) Following on from the last question, what's the new best level of labor use? (Compare to question 7.)

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13 MORE COST MINIMIZATION

Purposes: To illustrate cost minimization by emphasizing input marginal products. To show how to derive the firm's total product curves for a single variable input. Computer file: costmin298.xls. Background information: Consider again a university that produces student credit hours from two inputs, labor, L, and capital, K. Just as in the previous problem set, the provost faces the standard cost minimization problem for given technology and input prices, how can total cost be minimized for a given level of production. The difference here is in the form of the information the provost has about the technology of production, the university's production function. In this problem set she knows directly the marginal products (MP) of the two inputs. She can compute the marginal rate of technical substitution from the marginal productivities, but those data are not displayed on the spreadsheet. Indeed, the MRTS(L for K) is equal to the marginal product of labor (MPL) divided by the marginal product of capital (MPK). This gives us a different, and, to many people, more intuitive explanation of the decision rule for minimizing the cost of production. The decision rule for minimizing cost is to choose inputs so that MPL/PL = MPK/PK. MPL/PL, labor's marginal product divided by it's price, is the extra output due to spending another dollar on labor. Costs are minimized when the marginal product per dollar spent on all inputs is the same. If the marginal product per dollar differs between any two inputs, output can be increased (or cost lowered), buy shifting resources in favor of the input with the higher MP per dollar. In the spreadsheet, you are asked to find the minimum cost following this rule. Use Goal Seek to do this. First set output to the desired amount. Then use Goal Seek to set the difference between the marginal products per dollar to zero by changing the amount of labor. One new exercise here is showing how to find the short-run total product curve for a single variable input, given some amount of a fixed input. You're asked to set the capital amount to 60, and find the relationship between output and the single variable input, labor. Doing this for several amounts of labor allows you to find and plot the total product curve. In a subsequent exercise you will learn about the relationship between these short-run total product curves and a firm's short-run cost curves. 13-1

Here are some things to watch for and learn as you do the problems. 1) At the cost minimizing input choices, the marginal product per dollar spent on labor equals the marginal product per dollar spent on capital. The isoquant and cost constraint are tangent to each other, just as in the previous problem set. You should be able to manage the cost minimization problem both in terms of marginal products, and in terms of the marginal rate of technical substitution. The firm's total product curve is the relationship between output and a single variable input. Be sure you can tell by looking at your graph of the total product curve whether or not the technology obeys the Law of Diminishing Returns.

2)

3)

Here is a trick to help you get answers to questions 9 to 15: Finding the values of labor and output for a given level of capital can be tricky, because you cannot change the capital amount directly on the spreadsheet. Here's how to proceed: (i) Set the value for labor to the value called for in the problem. (ii) Select the cell containing the current value of capital. (iii) Enter Goal Seek from the Tools menu. (iii) Click on the To Value box, and enter the numerical value of the capital. (iv) Click on the By Changing Cell box, then click on the cell containing the current value of output. The cell address should appear in the By Changing Cell box. (v) Click on OK, and, if everything goes well, Excel will find a solution. To update the worksheet with the solution, click on OK. _________________________________________ MATH MAVEN'S CORNER: The production function used to generate the graph is given by Q = AL. K where L is the amount of labor and K is the amount of capital. The cost constraint is given by C = PL L + PK K , where C is total cost, and PL and PK are the prices of L and K, respectively. The values of A, a, and are chosen randomly, but can be seen in the Answer Bin. The math problem is to minimize C subject to the production function with output set to the required output. It can be solved either of two ways: substitute the constraint into the definition of total costs so only one of the inputs is a variable and then minimize, or use the Lagrangian Theorem. Satisfy yourself, if you wish, that the marginal rate of technical substitution of L for K is (a/)(K/L) in this case. The MRSL for K in general is -dK/dLdQ=0 = ( L)/( K). Q/ Q/

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COST MINIMIZATION Questions Set output and input prices to their baseline values. Set labor use to 40. 1) 2) 3) 4) What is the total cost of 27 units of output when labor is 40? What is the marginal product of labor when output is 27 and labor is 40? Continuing on from the last question, what is the marginal product of capital when labor is 40 and output is 27? Continuing on from the last question, if the firm buys another dollar's worth of labor, by how much does output increase? Continuing on from the last question, if the firm buys another dollar's worth of capital, by how much does output increase? If the firm wants to minimize total cost, should it be using more labor or more capital? (enter labor or capital). Continuing on from the last question, what's the best level of labor to use to produce 27 units of output? What are total costs at the best amount of labor (and capital)?

5) 6)

7) 8)

Set all variables to their baseline values. Now suppose the firm is operating in the short-run with fixed capital of 60 units. 9) For capital equal 60, and labor equal to 1, what is output?

Continuing on from the last question: 10) 11) 12) For capital equal to 60, and labor equal to 5, what is output? For capital equal to 60, and labor equal to 10, what is output? For capital equal to 60, and labor equal to 20, what is output?

Continuing on from the last question: 13) 14) 15) For capital equal to 60, and labor equal to 30, what is output? For capital equal to 60, and labor equal to 40, what is output? For capital equal to 60, and labor equal to 50, what is output?

Print out the Graph Paper sheet by selecting it clicking on the print button. 16) Use the data you generated answering questions 9 through 15 to plot the total product curve for the firm as a function of labor. 13-3

14 MARGINAL PRODUCTS AND

MINIMIZING COST
Purpose: To illustrate cost minimization using marginal products directly, rather than the idea of marginal rate of technical substitution. Computer file: costmin398.xls Background information: This problem set takes a different tack to understanding cost minimization for a given level of output. Instead of relying on the diffficult idea (at least for people who don't know calculus) of the marginal rate of technical substitution, we consider the rule for cost minimization rewritten so that it emphasizes the marginal products of inputs, and the notion of marginal product per dollar. Regardless of one's technical background, many people find the intuition in the approach taken in this problem set to be more accessible. Again take a typical firm that wants to minimize the total cost of producing a particular level of output. The firm uses two inputs, labor and capital, that can be bought at fixed prices P(L) and P(K). We can find (for any amounts of the inputs) the marginal product of, say, L as the increase in output achieved from employing an extra unit of labor, holding capital constant. The marginal product per dollar spent on labor is therefore MP(L)/P(L). This is the increase in output the firm can achieve from spending another dollar on labor. Similar definitions hold for capital. A firm wanting to minimize cost should always seek a mix of inputs, L and K, such the the marginal products per dollar spent on each should be equal. That is, we want MP(L)/P(L) = MP(K)/P(K). Why? Suppose the firm is producing the desired output with MP(L)/P(L) > MP(K)/P(K). Spending one dollar less on capital will reduce output by capital's marginal product per dollar. But because the marginal product per dollar for labor is greater than that for capital, less than a dollar's worth of labor must be bought to achieve the desired output. Costs are reduced by buying more of the input whose marginal product is higher. The graph in this problem set displays directly the marginal products per dollar for each input. You can determine by simple inspection of the height of the graphs whether cost if minimized, and if not, which input should be more intensively employed.

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To find the cost minimizing amounts of labor and capital, use Goal Seek to make the difference between their marginal products per dollar equal to zero by changing the amount of labor. __________________________________ MATH MAVEN'S CORNER: The production function used to generate the graph in this problem set is the same exponential form given by Q = AL K where L is the amount of labor used and K is the amount of capital used. Once again the actual values for the parameters appear in the Answer Bin, and you can use them to answer the questions by more conventional means pencil, paper, and a hand calculator.

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MARGINAL PRODUCTS AND MINIMIZING COST Questions Set output and input prices to their baseline values. Set labor use to 12. 1) What is the total cost of 23 units of output when labor is 12? 2) What is the marginal product of labor when output is 23 and labor is 12? 3) Continuing on from the last question, what is the marginal product of capital when labor is 12 and output is 23? 4) Continuing on from the last question, if the firm buys another dollar's worth of labor, by how much would output increase? 5) Continuing on from the last question, if the firm buys another dollar's worth of capital, by how much does output increase? 6) If the firm wants to minimize total cost, should it be using more labor or more capital? (enter labor or capital). 7) Continuing on from the last question, what's the best level of labor to use to produce 23 units of output? 8) What are total costs at the best amount of labor (and capital)? Set all variables to their baseline values, and find the best amounts of labor and capital to produce 20 units of output. 9) What is the cost minimizing amount of labor? Continuing on from the last question, now lower the price of labor to $5. 10) Which input now has the higher marginal product per dollar? (labor or capital) 11) What's the new cost minimizing amount of labor?

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15 PRODUCTION AND COST

IN THE SHORT-RUN
Purpose: To illustrate the relationship between total product curves and total cost curves. To show the relationship between changes in input prices and a firm's cost of production in the shortrun. Computer file: tptc198.xls Instructions and background information: You own and operate an apartment cleaning service firm in Detroit. Your business is to clean and repair apartments for landlords whose tenants have recently moved out. The left graph in the computer display shows the total product curve for your firm. The input is the number of workers you hire per day, and the output is the number of apartments cleaned per day. There are two baseline variables in this problem. One is the wage rate you must pay your workers, and the other is something called "labor efficiency". Labor efficiency is an index of how efficiently labor services are used to clean apartments, and is an aspect of the technology of production. It doesn't have anything to do with whether you are a good manager, or whether your workers goof off on the job. The relationship between the numbers of employees you hire and the output produced is purely technical. Labor efficiency is .50 in this problem, and you cannot change it -- that is reserved for the next problem set. In the real world, the labor efficiency index might go up if you provide your workers with more equipment -- mops and brooms, for example. Workers for your business do not come free. In fact, you must hire workers and pay them at a rate of $10 per worker per day. $10/day is the market wage. If you try to pay less than that, workers simply will not work for you. The data on the total product curve (see the left graph) shows the output you get for any amount of labor input you choose. The data on the total cost curve show total cost for any output you choose, given the wage rate. You can pick any values you want for output and the wage rate, and the total cost curve on the right displays the results. The table also shows the amount of labor required for the output you choose. The left and right graphs operate independently. The input and output you see in the total product curve can be different from the output and cost you see on the total cost curve. 15-1

Here are some things to watch for and learn as you do the problems: 1) Given the technology of production, you can get more output without using t more labor input. 2) Given the wage rate and the technology of production, higher output is possible only with increased costs. 3) Raising the wage rate (the price of a variable input) increases total, average, and marginal costs. An increase in the wage causes total cost to increase more at higher outputs than lower outputs. 4) In the short-run, fixed costs are the firm costs when output is zero. s

Here are some hints to help you get the answers quicker: 1) Average cost is total cost divided by output.

2) Marginal cost is the change in total cost per unit change in output. C/Q. Marginal cost is the cost of one more, the extra cost of increasing output by one unit. The marginal cost of the 25th unit of output is the difference in total cost at 25 minus the total cost at 24 units of output. ___________________________ MATH MAVEN'S CORNER: The total product curve for the computer problems is Q = ALe, where the exponent e is the efficiency index, and A is a constant. e in this case is also the elasticity of output with respect to changes in L. The marginal product is the derivative of total product with respect to L, or AeLe-1. The total cost curve is TC = FC + (pL)(Q/A)1/e, where pL is the wage rate, $10.00 a day to start off with.

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PRODUCTION AND COST IN THE SHORT-RUN Questions Set all variables to their baseline values, and set labor input to 10. 1) How many apartments are cleaned per day with this amount of labor? Set all variables to their baseline values, and set labor input to 20. 2) How many apartments are cleaned per day with this amount of labor? Set all variables to their baseline values, and set labor input to 20. Increase the wage rate to $12/day. 3) With labor at 20, what is the change in output? Set the wage is $10/day. 4) If 15 apartments must be cleaned, how many workers must be hired to get the job done? Make sure the wage is set to $10/day, and set output at 15 apartments per day. 5) What's the TOTAL COST of cleaning 15 apartments? Now set the wage to $12/day. 6) What's the TOTAL COST of cleaning 15 apartments? 7) When the wage rose from $10 to $12 per day, did total cost INCREASE or DECREASE? Set all variables to their baseline values and set output at 15 apartments per day. 8) What's the AVERAGE COST of cleaning 15 apartments? Now set the wage to $12/day. 9) What's the AVERAGE COST of cleaning 15 apartments? 10) When the wage rose from $10 to $12 per day, did average cost INCREASE or DECREASE? Set the wage back to $10/day, its baseline value. 11) What's the MARGINAL COST of cleaning the 15th apartment? [Hint: What's the total cost of cleaning 15compared to 14?] Now set the wage to $12 per day. 12) What's the MARGINAL COST of cleaning the 15th apartment at the higher wage?

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13) When the wage rose from $10 to $12 per day, did marginal cost INCREASE or DECREASE? 14) What's the amount of fixed cost for the firm?

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16 MORE PRODUCTION AND COST

IN THE SHORT-RUN
Purpose: To illustrate the relationship between changes in technology and a firm's cost of production in the short-run. Computer file: tptc298.xls Instructions and background information: You own and operate an apartment cleaning service firm in Detroit. Your business is to clean and repair apartments for landlords whose tenants have recently moved out. The left graph shows the total product curve for your firm. The input is the number of workers you hire per day, and the output is the number of apartments cleaned per day. Just as in the last problem set, the value called "Labor efficiency (new)" is an index of how efficiently labor services are used to clean apartments. Labor efficiency here is part of the technology of production. The baseline value for "labor efficiency" is .50. You can experiment with what happens to the total product curve for different values for the index. Technological improvements mean an increase in the labor efficiency index, as you can verify with a little experimentation. Notice that an improvement in technology allows you to get more output from the same amount of inputs, and allows you to produce the same level of output at lower cost because you need fewer ll workers. The figure at the right of the screen shows the short-run total cost curve for your apartment cleaning business. The daily wage you must pay is $10.00, and there are fixed costs, mostly in the form of rental contracts on machinery, and insurance. Under the "TOTAL COST CURVE" information you can select a value for output, and Excel computes the total cost needed to produce that output in the short-run. Notice that under the "TOTAL COST CURVE" information Excel also computes the labor required to produce the output you desire. You can change the labor use in the left diagram and the level of output in the right diagram independently. Experiment with changing output and the efficiency index until you understand how each kind of change affects the display. Here are some things to watch for and learn as you do the problems:

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1) A change in technology changes the total product curve and and the total cost curve. An improvement in technology increases the output you get from a given amount of labor, and decreases the cost of producing a given level of output. 2) It is no accident that the total product curves and total cost curves are logically linked. In this example, the total product curve increases at a decreasing rate (the marginal product of labor diminishes as more labor is used), and the total cost curve increases at an increasing rate (the marginal cost rises as more output is produced). Here are some hints to help you get the answers quicker: 1) 2) Word answers (as opposed to numbers) must be entered as lower case. Average cost is total cost divided by output.

3) Marginal cost is the change in total cost per unit change in output. In economists jargon, the marginal cost of the 10th unit of output is the increase in total cost in going from 9 to 10 units of output. __________________________ MATH MAVEN'S CORNER: The total product curve in this problem is the same functional form as the previous problem set.

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MORE PRODUCTION AND COST IN THE SHORT-RUN Questions Set efficiency to the baseline value of .50. 1) How many apartments can you clean per day with 20 workers? Keep efficiency at its baseline value. 2) Does the production function (total product curve) have the property of diminishing marginal product? [yes or no] Increase efficiency to .60. 3) How many apartments can you now clean per day with 20 workers? Keep the efficiency index at .60. 4) Does the production function (total product curve) still have the property of diminishing marginal product? [yes or no] Set the efficiency index to its baseline value. 5) What's the TOTAL COST of cleaning 15 apartments? 6) What are the labor requirements for cleaning 15 apartments per day? Now set the efficiency index to .60. 7) What's the TOTAL COST of cleaning 15 apartments? 8) What are the labor requirements for cleaning 15 apartments per day? Set efficiency to its baseline value of .50. 9) What's the AVERAGE COST of cleaning 15 apartments? Increase the efficiency index to .60. 10) What's the AVERAGE COST of cleaning 15 apartments? Set the efficiency index to its baseline value. 11) What's the MARGINAL COST of cleaning the 15th apartment? Now set the efficiency index to .60. 12) What's the MARGINAL COST of cleaning the 15th apartment? You can summarize your results now. For each cost concept listed, does an improvement in efficiency cause an INCREASE or a DECREASE in cost? 13) Total cost. 14) Average cost. 15) Marginal cost. 16-3

17 TOTAL, AVERAGE, AND

MARGINAL COSTS
Purpose: To illustrate the relationship between total, average and marginal costs. To show the effects of changes in fixed costs and of per unit (excise) taxes. Computer file: tamc98.xls Instructions and background information: You operate the Smiling Dog Vineyard and Winery in Paw Paw, Michigan. The top graph shows the short-run total cost curve for the production of wine. Quantity is the number of cases you produce each year. Total costs are measured on the vertical axis. The base value for fixed cost is $25,000, and the amount of tax on your output is zero. When you change either fixed cost or the tax the new total cost curve is drawn in the upper diagram. The bottom graph shows the average and marginal cost curves that correspond to the base case. When you change the level of fixed costs or the tax, Excel draws the new corresponding average and marginal cost curves. When you choose an output level Excel computes and shows the corresponding levels of total, average, and marginal cost. In both diagrams, output is the independent variable and costs are the dependent variables. You choose a value for output, and the corresponding cost curve shows the value for costs. In the spreadsheet, you can choose Output, Fixed Cost, and the Tax per unit of output. Excel then computes the new total, average, and marginal costs, and redraws the cost curves. Here are some things to watch for and learn as you do the problems: 1) The shape and position of the average and marginal cost curves is completely determined by the total cost curve. All information relating output to costs is contained either in the total cost curve or in the companion set of average and marginal cost curves. Which representation of costs economists use depends on the particular questions that must be answered. Average and marginal cost curves have a special geometric relationship that is clearly shown in this problem set. When average cost is declining as output increases, marginal cost is less than average cost. When average cost is rising, marginal cost is greater than average cost. When average cost is neither rising nor falling (at a minimum or maximum), marginal cost equals average cost. 17-1

2)

3)

Marginal cost can be thought of as the cost of one more unit of output. It is the slope of the total cost curve (TC/Q). It is easy to deduce the general shape of the marginal cost curve by inspecting the total cost curve. In this problem set the total cost curve increases at an increasing rate, so marginal cost rises with output. An excise (per unit) tax raises both average and marginal costs by exactly the amount of the tax per unit. Total cost increases by the output times the tax per unit. One consequence of this is that the output at which average cost is minimized is unchanged if an excise tax is imposed. An increase in fixed costs raises total cost by precisely the amount of the increase. An increase in fixed costs raises average costs, but leaves marginal costs unchanged. This last result follows directly from the nature of an increase in fixed costs. The increase shifts the total cost curve upward, but leaves its slope the same at each output.

4)

5)

Here are some hints to help you get the answers quicker: 1) At the minimum average cost, marginal cost equals average cost. The spreadsheet shows a value for the difference between average and marginal costs. You can use Goal Seek or experimentation to find the output that makes this difference equal to zero, that is, the output where average cost is minimized.

For letter or word answers to some of the questions, be sure to use lower case letters only. Or search the Answer Bin for correct options. __________________________ MATH MAVEN'S CORNER: The total cost curve in the problem is given by TC = FC + a (Q ) + b(Q 2 ) + t (Q ) where TC is total cost, FC is fixed cost, Q is output, and t is the tax per unit of output. The values of the parameters a and b are chosen randomly. The average cost is TC/Q, and marginal cost is (TC)/ Q.

2)

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TOTAL, AVERAGE, AND MARGINAL COSTS Questions Set all variables to their baseline values. 1) When average cost is declining, is marginal cost GREATER than, LESS than, or EQUAL to average cost? Set all variables to their baseline values. 2) When average cost is increasing, is marginal cost GREATER than, LESS than, or EQUAL to average cost? Set all variables to their baseline values, and set output 4,000. 3) What's the value of average cost? 4) Is AC rising at that output? [yes or no] 5) What is marginal cost when output is 4,000? Set all variables to their baseline values, and set output to 1500. 6) What's the value of average cost? 7) Is AC rising at that output? [yes or no] 8) What is marginal cost when output is 1500? Set all variables to their baseline values. 9) At what level of output is average cost a minimum? 10) What is average cost (AC) at that output? 11) What is marginal cost (MC) at that output? Set the value of the per unit tax to $10. 12) If output is 4,000, how much did AC increase? 13) If output is 4,000, how much did MC increase? 14) If output is 4,000, how much did total cost increase? Set the tax at $10 per unit of output. 15) At what output is the value for the new AC at its minimum? Set all variables to their baseline values. Now increase the level of fixed cost to $50,000. 16) If output is 4,000, how much did AC increase? 17) If output is 4,000, how much did MC increase? 18) If output is 4,000, how much did total cost increase? Set the level of fixed cost to $50,000. 19) At what output is the value for the new AC at its minimum?

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20) Which option best describes the effect of increasing a per unit tax? [enter a, b, or c] a) AC rises by the amount of the tax per unit. b) TC rises by the amount of the tax per unit. c) MC is unchanged. 21) Which option best describes the effect of increasing fixed cost? [enter a, b, or c] a) TC increases by FC times output. b) AC increases by the amount of FC. c) MC is unchanged.

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18 PROFIT MAXIMIZATION FOR

THE COMPETITIVE FIRM
Purpose: To practice application of the rule for a competitive firm to maximize profits: MR = MC. Computer file: pcmax98.xls Instructions and questions: You are a management consultant to the CLEAN CREW SERVICE CO., a small provider of apartment cleaning services in a large market with many competitors. The graph shows the short-run average cost curve for the production of CLEAN CREW's services. Quantity is the number of apartments cleaned per day. Average and marginal costs, as well as market price, are measured on the vertical axis. The base value for fixed cost is $250, and the amount of tax on the firm's output is zero. Market price is determined in the market for apartment cleaning services, but you can adjust it to any value you want for experimental purposes, and to formulate sensible management policies. Your job as a consultant is to recommend an output level to CLEAN CREW s management under a variety of economic conditions. When you choose an output level, Excel computes and shows the corresponding levels of total, average, and marginal cost, as well as the amount of total revenue. You need a hand calculator to compute total profit (total revenue ll minus total cost) at each output level you choose. Total profits are maximized at the output level where marginal revenue equals marginal cost. Marginal revenue equals price for a competitive firm. Another way to say the rule is that marginal revenue minus marginal cost must be zero for total profit to be a maximum. The value of MR-MC for any output you choose is displayed on the worksheet. As you experiment with different output levels you can see MR-MC change. For profit to be a maximum, MR-MC must be zero. An easy way to find the output where profit is zero is to use Goal Seek. Within Goal Seek you want MR-MC to be zero by changing output. Here are some things to watch for and learn as you do the problems: 1) THE PROFIT MAXIMIZING OUTPUT IS THE ONE WHERE MR = MC. SO WHEN MR MINUS MC EQUALS ZERO, PROFIT IS MAXIMIZED. 18-1

2)

The most common error that people make in thinking about profit maximization is that profit is maximized at the bottom of the average cost curve. Total profit is not maximized at the bottom of the average cost curve. If MR is greater than MC, increasing output will add more to revenue than to costs, and so increase profit.

3)

Here are some hints to help you get the answers quicker: 1) Use Goal Seek this way to find the output where profit is maximized. (a) Select the cell that contains the current value for MR-MC(NEW) by clicking on it. Choose Goal Seek from the Tools menu. The dialog box provides space to enter the three pieces of information: MR-MC, zero, and output. b) The value in the Set Cell box is $F$18. If the Set Cell box does not contain $F$18 (or F218), edit the box until it does. c) Click on the To Value box. Use the keyboard to enter the number zero (0), but don't hit the Enter key. d) Click on the By Changing Cell box. Because you want to change output to get MRMC equal to zero, click on the current value for output, cell F29. $F$29 is displayed. e) Click on the OK button. f) Excel displays another dialog box showing the status of goal seeking. To incorporate the results into the worksheet, click on OK. To return to the values you started with choose Cancel. 2) Use the Answer Bin to get the word answers if necessary. __________________________ MATH MAVEN'S CORNER: The total cost curve when there is no tax is given by TC = 250 + aQ + bQ 2 , where Q is output. Total revenue is pQ, where p is the price of output. Profit = TR - TC. To maximize profit, take the derivative of profit with respect to output and set the derivative equal to zero. By definition, MR is the derivative of TR with respect to Q, and MC is the derivative of TC with respect to Q. Maximizing profit therefore requires MR = MC. Note that for a competitive firm MR always turns out to be equal to price.

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PROFIT MAXIMIZATION FOR THE COMPETITIVE FIRM Questions Set fixed cost and the tax to their baseline values. 1) At what level of output is average cost minimized? Set all variables to their baseline values. 2) If price is $60 per apartment, and the firm tries to minimize average cost, what are total costs of the firm? Set price to $60, as in question 2), and set output where AC is minimized. 3) What's the firm's total revenue? 4) What's the firm's total profit? Set all variables to their baseline values, and set price to $60. 5) At what output is total profit maximized? 6) What's total revenue at that output? 7) What's total cost at that output? With variables at baseline values, set the price to $60. 8) What's total profit when profit is maximized? [Compare to answer 4.] With fixed cost and tax at their baseline values, set output to the level where profit is maximized. 9) What is marginal cost at that output? Following on from question 9: 10) What is marginal revenue at the profit maximizing output? 11) What is profit per unit of output (average profit) at that output? Set all variables to baseline values. Set price to $20. 12) How much should the firm produce to maximize profit? 13) How much should the firm supply? Now raise price to $30. 14) How much should the firm produce to maximize profit? 15) How much should the firm supply? Now raise price to $40. 16) How much should the firm produce to maximize profit? 17) How much should the firm supply? 18) Given the price of output, which curve shows the amount the firm wants to supply? [Enter mc or ac.] 18-3

19) Set price back to $60, and set output to the profit maximizing amount. Print out the sheet, construct, and shade in the area that shows total profit. TURN IN THE PRINTOUT AS REQUESTED BY YOUR INSTRUCTOR.

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19 MORE PROFIT MAXIMIZATION

FOR THE COMPETITIVE FIRM
Purpose: To examine the effects of taxes, subsidies, and changes in fixed cost on the choices made by a competitive firm Computer file: pcmax298.xls Instructions and background information: This problem set is a follow-up on the previous one. You are still a management consultant to the CLEAN CREW SERVICE CO., a small provider of apartment cleaning services in a large market with many competitors. The set up of the spreadsheet is the same as before. The only difference is that now you will advise the firm on the probable results of changes in the taxes the firm must pay, and on the results of changes in fixed cost. You learned earlier that a per unit tax of t dollars per unit of output raises both average costs and marginal costs of the firm by exactly t dollars. Both average and marginal cost curves shift up by exactly the amount of the tax per unit. A per unit subsidy (a negative tax) has exactly the opposite effect. A competitive firm that wants to maximize profit will want to produce the output where marginal revenue equals marginal cost. If a tax causes marginal cost to rise, then the firm will make appropriate adjustments to the tax by reducing output. The spreadsheet shows costs both before and after a tax is imposed. The graph shows the marginal and average cost curves only after the tax. A change in fixed cost does not change marginal cost. You will see that when fixed cost is changed there is no incentive for the firm to change output. It maximizes profits at the same output both before and after the change in fixed cost. Here are some things to watch for and learn as you do the problems: 1) THE PROFIT MAXIMIZING OUTPUT IS THE ONE WHERE MR = MC. SO WHEN MR MINUS MC EQUALS ZERO, PROFIT IS MAXIMIZED. A per unit tax on output will cause the firm to reduce output in order to maximize profits. Total profits fall as a result of the tax.

2)

19-1

3)

A per unit subsidy will lower marginal costs. The firm will respond to the subsidy by increasing output. Maximum profits will be larger with the subsidy than without it.

A change in fixed cost will change the firm profits by the amount of the change in s fixed costs. But the profit maximizing output will be unchanged, and the same amount of resources will be devoted to production of the good in the firm. __________________________ MATH MAVEN'S CORNER: The total cost curve when there is a per unit tax is given by TC = 250 + aQ + bQ 2 + tQ , where Q is output, and t is the tax per unit. Total revenue is pQ, where p is the price of output. Profit = TR - TC. To maximize profit, take the derivative of profit with respect to output and set the derivative equal to zero. By definition, MR is the derivative of TR with respect to Q, and MC is the derivative of TC with respect to Q. Maximizing profit therefore requires MR = MC. Note that for a competitive firm MR always turns out to be equal to price. Note also that the tax raises the MC curve by exactly t.

4)

19-2

MORE PROFIT MAXIMIZATION FOR THE COMPETITIVE FIRM Questions Set fixed cost and the tax to their baseline values. 1) If price is $65 per apartment, what is the profit maximizing output for the firm? 2) What are total profits at this output? Increase the per unit tax to $10 per apartment, and keep output at the level you found in question 1. 3) If price is at $65 per apartment, what is marginal revenue 4) What is the value of marginal cost? Keep the tax at $10 per apartment, and price at $65. 5) What's the profit maximizing output? 6) What are total profits at this output? 7) What's the firm's tax bill at this output? Set all variables to their baseline values, and set price to $65. Now raise fixed cost to $500. 8) What's the new profit maximizing output? [Compare to 1 and 5.] Following on from question 8: 9) What's total profit when fixed cost is $500? 10) By how much did profit fall when fixed cost increased by $250? Set price to $65, and FC and TAX to their baseline values. Government now sets a subsidy of $8 per apartment cleaned. 11) What's the new profit maximizing output? [Compare to question 1.] Following on from question 11: 12) What are total profits including the subsidy 13) What's the total subsidy paid to the firm? Set all variables to baseline values and set price to $60. 14) How large a per unit tax must the government impose to get the firm to produce 20 units of output?

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20 COMPETITIVE MARKETS IN
THE SHORT-RUN
Purpose: To illustrate price determination in the short-run in a competitive market, and to relate price determination to the choices made by competitive firms. Computer file: srmkt198.xls Instructions and background information: You are a government economist studying the wine industry with an eye to commenting on some proposed policies that may affect the industry. On the spreadsheet for this problem set the graph at the left shows the short-run average and marginal cost curves for a typical wine producing firm. The graph at the right shows the market supply and demand curves for wine when there are 500 firms in the industry, and consumer incomes are $55,000 per family. Market price is $40 per case. At this price the market is probably not in equilibrium, nor is the typical firm maximizing total profit. The variables you can choose here are market price, the firm's output, income, a tax rate, and the number of firms. Excel automatically computes all the other values in the tables. The wine industry is assumed to be perfectly competitive. The price of wine is determined in the market by supply and demand. In equilibrium excess demand for wine must be zero. Firms in the industry take the market price as a constant, and try to maximize profits by choosing an output level. In equilibrium for the firm, marginal revenue must equal marginal cost. Firms in the industry must adjust their outputs in response to changes in the market equilibrium price. Your report about the wine industry must contain information about the industry likely s responses to changes in underlying economic conditions, as well as changes in government policies. To this end, you will conduct a series of hypothetical experiments using the model in this problem set. You will first explore a change in income that affects the market demand for wine. Then you will explore the effects of government imposing a per unit tax on wine, including effects on price, quantity, profits, and social welfare measured by consumer and producer surplus. Here are some things to watch for and learn as you do the problems:

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1) Competitive markets adjust to equilibrium through changes in price. If a good is produced in perfect competition, it is supply and demand in the market that determine the price. 2) A competitive firm takes market price as given, and tries to maximize profit by choosing output so that marginal cost equals marginal revenue. Because price is constant for the typical competitive firm, marginal revenue and price (average revenue) are equal. 3) An increase in market demand raises equilibrium price, induces firms to sell more, and increases economic profit. 4) An increase in a per unit (excise) tax raises the market supply curve and firms marginal and average cost curves by the amount of the tax per unit. The decrease in market supply raises price, but by less than the tax, and reduces quantity. Firms reduce output because marginal cost rises by more than price. Profits fall. 5) The excise tax causes a loss in total welfare as measured by consumer and producer surplus. Here are some hints to help you get the answers more quickly: 1) Use Goal Seek to find the market equilibrium price. After you find the price, use Goal Seek again to find the firm output that will make MR-MC equal to zero. s 2) You need a calculator to figure out total profits. The quickest way to do that is ll to find the profit per unit (P-AC) and multiply by output. 3) To find the loss in welfare from the tax, sketch the supply and demand curves before and after the tax on a piece of scrap paper. Previously computed market quantities will give you the important information you need to find the deadweight loss. ll ___________________________ MATH MAVEN CORNER: For this problem the market demand curve is given by S Q ( D ) = aI b( P ) , where I is income, P is price, and a and b are randomly picked constants. The market supply curve is given by Q ( S ) = N ( P t d ) / c , where N is the number of firms in the industry, t is the tax per unit of output placed on all firms, and d and c are constants. The cost curves of the typical firm are AC = d + (c / 2)( q ) + ( FC / q) + t , and MC = d + c ( q) + t . FC is fixed cost.

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COMPETITIVE MARKETS IN THE SHORT-RUN Questions Set income, the tax, and the number of firms to their baseline values. 1) What's the market equilibrium price of wine? 2) What's the market equilibrium quantity of wine? Set income, the tax, and the number of firms to their baseline values. 3) With the market in equilibrium, what output should the firm produce to maximize profit? 4) How much is maximum total profit? With the tax still at zero, reduce income to $45,000. 5) Is wine normal or inferior? Continuing on from question 5, 6) What's the new market equilibrium price? 7) What's the new market equilibrium quantity? With income still at $45,000, and the market in equilibrium, 8) What output should the typical firm produce? 9) What are the maximum profits of the typical firm? 10A) Return all variables to their baseline values, and make sure the number of firms is 500. Make sure the market is in equilibrium, and that the typical firm is maximizing profit. Go on to question 10B). The government imposes a tax of $10 per case on all wine produced and sold. 10B) What's the new equilibrium market price of wine? Continuing on from the last question, 11) What's the new equilibrium market quantity of wine? 12) For the $10 tax on wine, how much did the price of wine rise? 13) At the new equilibrium price of wine, what is the profit maximizing output of the typical firm? 14) What are the firm's maximum profits after the tax? 15) For the $10 tax on wine, how much total tax is paid by the typical firm? 16) What are the total tax collections of the government? 17) For the $10 tax on wine, with the market and firm in the new equilibrium, what is the deadweight loss to society in consumer and producer surplus due to the tax?

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21 MORE COMPETITIVE MARKETS

IN THE SHORT-RUN
Purpose: To provide more practice working with price and output determination in competitive markets in the short-run. Computer file: srmkt298.xls Instructions and background information: You are still operating in the role of a government economist studying the wine industry. Emphasis here is mostly on the effects of subsidies to the wine industry. The exercises here will help generate data that you can use to prepare your report on the consequences of government intervention in the industry. The wine industry is assumed to be perfectly competitive. The price of wine is determined in the market by supply and demand. In equilibrium excess demand for wine must be zero. Firms in the industry take the market price as a constant, and try to maximize profits by choosing an output level. In equilibrium for the firm, marginal revenue must equal marginal cost. Firms in the industry must adjust their outputs in response to changes in the market equilibrium price. The graphical setup for this problem is the same as for the previous one. The variables you can choose here are market price, the firm's output, income, a tax rate, and the number of firms. Excel automatically computes all the other values in the tables. Here are some things to watch for and learn as you do the problems: 1) As in the previous problem set, competitive markets adjust to equilibrium through changes in price. If a good is produced in perfect competition, it is supply and demand in the market that determine the price. 2) A competitive firm takes market price as given, and tries to maximize profit by choosing output so that marginal cost equals marginal revenue. Because price is constant for the typical competitive firm, marginal revenue and price (average revenue) are equal. 3) A subsidy is just a negative tax. A per unit subsidy lowers the market supply curve and firmsmarginal and average cost curves by the amount of the subsidy per unit. The increase in market supply lowers price, but by less than the subsidy, and increases quantity. Firms increase output because marginal cost falls by less than price falls. Profits rise. 21-1

Here are some hints to help you get the answers more quickly: 1) Use Goal Seek to find the market equilibrium price. After you find the price, use Goal Seek again to find the firm output that will make MR-MC equal to zero. s 2) You need a calculator to figure out total profits. The quickest way to do that is ll to find the profit per unit (P-AC) and multiply by output. 3) You asked at one point to compute the elasticity of demand for wine. Use the re midpoint formula to determine whether demand is elastic or inelastic. ___________________________ MATH MAVEN CORNER: For this problem the market demand curve is given by S Q ( D ) = aI b( P ) , where I is income, P is price, and a and b are randomly picked constants. The market supply curve is given by Q ( S ) = N ( P t d ) / c , where N is the number of firms in the industry, t is the tax per unit of output placed on all firms, and d and c are constants. The cost curves of the typical firm are AC = d + (c / 2)( q ) + ( FC / q) + t , and MC = d + c ( q) + t . FC is fixed cost.

21-2

MORE COMPETITIVE MARKETS IN THE SHORT-RUN Questions Set income, the tax, and the number of firms to their baseline values. 1) What's the market equilibrium price of wine? 2) What's the market equilibrium quantity of wine? Start from the equilibrium you found in questions 1) and 2). 3) What output should the firm produce in order to maximize profit? 4) How much is maximum total profit? The government decides to help the wine industry by paying a subsidy of $10 per case. 5) What's the new short-run equilibrium price of wine? Continuing on from question 5, 6) What's the new market equilibrium quantity? 7) What's the total cost of the subsidy to the government? With the subsidy still at $10 per case, and the market in equilibrium, 8) What output should the typical firm produce? 9) What are the maximum profits of the typical firm? 10) When the typical firm maximizes profits after receiving the subsidy, what are the total subsidy payments to the firm per time period? 11) How much did market price of wine change in response to the $10 per case subsidy? [Hint: Decreases must carry a minus sign.] 12) Before the subsidy, how much do consumers spend on wine? 13) After the subsidy, how much do consumers spend on wine? 14) Between the before-subsidy and after-subsidy prices of wine, is demand elastic or inelastic? Set all variables to their baseline values, and make sure the market is in equilibrium. Increase income to $60,000. 15) What's the new market equilibrium price? 16) Continuing on from the last question, what's the new market equilibrium quantity? 17) Continuing on from the last question, what's the new profit maximizing quantity for the typical firm? 21-3

18) Continuing on from the last question, what are the profits of the typical firm? 19) What are the total profits of the industry?

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22 COMPETITIVE MARKETS IN
THE LONG-RUN
Purpose: To illustrate price determination in the long-run in a competitive market. Computer file: lrmkt198.xls Instructions and background information: You are a consultant to the wine industry with the objective of assessing the future course of prices and profits in the face of a changing economic climate. The industry faces the prospect of some new taxes, and rather large changes in consumer incomes. Your job will be to advise the industry on what they might expect in the short-run and long-run if these changes actually happen. The wine industry is a constant cost industry. This means that as firms enter and leave the industry the prices of inputs are unchanged. This fact will make your investigations easier. The wine industry is perfectly competitive, and the model you use to analyze change is ll in the computer file lrmkt198.xls. The graph at the left side of the screen shows the long-run average cost curve of a typical firm producing wine. Also included in the left-hand graph is the marginal cost curve that goes with the LRAC curve. The only difference from the problem sets on competitive markets in the short-run is that here the cost curve should be interpreted as a longrun average cost curve. The graph at the right shows the market supply and demand curves for wine when there are 500 firms in the industry, and consumer incomes are $55,000 per family. Market price is $40 per case. At this price the market for wine is probably not in equilibrium, nor is the typical firm maximizing profit. The supply curve shown at the right should be interpreted as a short-run supply curve because as you move up it the number of firms is fixed. This problem set is mostly about long-run adjustments, however, so you will be able to change the number of firms in the industry to see what happens to market supply. The variables you can choose here are price, a firm's output, income, a tax rate, and the number of firms. Excel automatically computes all the other values in the tables. As an economist you know that entry of new firms will occur in response the positive economic profits. You must predict the final level of equilibrium price, which you know must be at the bottom of the long-run average cost curve. Because LRAC and MC must be equal when LRAC is at its minimum point, you can use the Goal Seek facility in Excel to solve the problem. You want MC-AC to be zero by changing the firm output. Once you do this, the long-run price s must be at the level of AC. 22-1

Entry of new firms will make price approach its long-run equilibrium level. You need to find out how many firms will eventually enter the industry. To do this set price at its long-run equilibrium level. (See the hint below on how best to do this.) The market will be in equilibrium in the long-run only when enough firms have entered to make excess demand in the market equal to zero. You can solve the problem by trial and error, or use Goal Seek to get excess demand equal to zero by change the number of firms. Of course, in the long-run profits for the typical winery, and for the industry will be zero. You will have to break this sad news to the Wine Marketing Board! Separate analyses prepared by the economists predict that very soon family income will fall to $45,000 per year. Starting from the long-run equilibrium you just found you asked to re predict the short-run effects of the decrease in income on the wine industry. Assume in this case that short-run means only that firms can't enter or leave the industry, but that firms can move along the marginal cost curve shown for the typical firm. You then asked to predict the new long-run equilibrium position of the firm and re industry after the effects of the change in demand have occurred. In calculating this, remember that the long-run equilibrium price must leave the firm with zero profits. Here are some things to watch for and learn as you do the problems: 1) If the typical firm in a competitive industry can earn positive economic profits, new firms will enter the industry. In the long-run, entry and exit of firms assures that price settles down at the minimum point of the long-run average cost curve. In the long-run equilibrium the typical firm earns zero economic profit.

2)

Here are some hints to help you get the answers quicker: 1) In some questions you asked to find the level of long-run equilibrium price by re finding minimum average cost. You then enter that level of price in the market data. To make your price entry as accurate as possible, try this: Select the cell that has the minimum value of AC. From the Edit menu, Copy the minimum value. Select the cell that has the value of price. Choose Paste Special from the Edit menu. Then, from the dialog box that appears select Values, and hit OK. This will keep as many digits as possible in the value for long-run equilibrium price. You can use Goal Seek to find the number of firms in the long-run equilibrium. First set price to its long-run equilibrium level. (See hint 1).) Then use Goal Seek to make excess demand equal to zero by changing the number of firms. 22-2

2)

3)

Remember that in the long-run equilibrium the firm must still maximize profit by choosing MR = MC. But in the long-run the best the firm can do is earn a zero economic profit.

__________________________ MATH MAVEN CORNER: The underlying equations here are the same as for the previous S problem set. Here there is only a difference in interpretation: The cost curves are assumed to be long-run instead of short-run cost curves. Notice also that the industry is assumed to be a constant cost industry.

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COMPETITIVE MARKETS IN THE LONG-RUN Questions Reset all variables to their baseline values. Record the SHORT-RUN EQUILIBRIUM values of the following variables: 1) Market price. 2) Market quantity. 3) Firm's quantity. 4) Firm's profits. 5) Industry profits. Start from the equilibrium you found in questions 1) to 5). For long-run equilibrium price must be at minimum LRAC. 6) At what output for the firm is LRAC minimized? 7) What is the long-run equilibrium price? In the long-run, entry and exit of firms is a crucial market price adjustment factor. Find the longrun equilibrium for the firm and industry. Then go on to question 8B. Enter the long-run equilibrium values for the following variables: 8) Market quantity. 9) Market price 10) Number of firms. 11) Firm quantity. 12) Firm profits. Economic studies predict a drop in income to $45,000 per year. Starting from the long-run equilibrium you just found, what are the SHORT-RUN values of these variables? 13) New short-run equilibrium price. 14) New short-run equilibrium market quantity. Continuing on from the last problem, what are the SHORT-RUN values of these variables? 15) New short-run equilibrium firm quantity. 16) New short-run equilibrium firm profits. Now find the new LONG-RUN equilibrium for the wine industry, and for the typical firm. Record the new long-run equilibrium values for these variables: 17) New long-run price. 18) New long-run market quantity. 19) Number of firms.

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Continuing on from the last questions, record the new values of these variables: 20) New long-run equilibrium firm quantity. 21) New long-run equilibrium firm profits.

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23 MORE COMPETITIVE MARKETS

IN THE LONG-RUN
Purpose: To illustrate price determination in the long-run in a competitive market. Computer file: lrmkt298.xls Instructions and background information: You are continuing on with your job as a consultant to the wine industry. In this problem set you will focus on predicting the long-run effects of a proposed tax on the industry. At the end you be asked to analyze the effects of a price fixing scheme that the government has in mind ll that will operate through a system of taxes or subsidies. The graphical setup for this problem is the same as in the previous problem. The variables you can choose here are price, a firm's output, income, a tax rate, and the number of firms. Excel automatically computes all the other values in the tables. The first proposal you asked to consider is a tax of $10 per case on all wine produced re and sold. Starting from a long-run equilibrium for the firm and industry, you first find the shortrun consequences of the tax. The number of firms is fixed in the short-run, so market adjustments take place through changes in price. You then asked to predict the new long-run equilibrium position of the firm and re industry after the effects of the tax have worked their way through the market. In calculating this, remember that the long-run equilibrium price must leave the firm with zero profits. Here are some things to watch for and learn as you do the problems: 1) If the typical firm in a competitive industry earns losses (negative economic profits), firms will leave the industry. In the long-run, entry and exit of firms assures that price settles down at the minimum point of the long-run average cost curve. In the long-run equilibrium the typical firm earns zero economic profit.

2)

Here are some hints to help you get the answers quicker:

23-1

1)

You can use Goal Seek to find the number of firms in the long-run equilibrium. First set price to its long-run equilibrium level. Then use Goal Seek to make excess demand equal to zero by changing the number of firms. Remember that in the long-run equilibrium the firm must still maximize profit by choosing MR = MC. But in the long-run the best the firm can do is earn a zero economic profit.

3)

__________________________ MATH MAVEN CORNER: The underlying equations here are the same as for the previous S problem set. Notice also that the industry is assumed to be a constant cost industry.

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MORE COMPETITIVE MARKETS IN THE LONG-RUN Questions Reset all variables to their baseline values. Record the LONG-RUN EQUILIBRIUM values of the following variables: 1) Market price. 2) Market quantity. 3) Number of firms. 4) Industry profits. Continue from the LONG-RUN equilibrium you found in questions 1) to 4). 5) What is the best output for the typical firm? 6) What are the firm's profits in the LONG-RUN equilibrium? The government decides to put a tax of $10 per case on all wine produced and sold. Start from the long-run equilibrium for the firm and industry. 7) What's the new SHORT-RUN equilibrium price? 8) What's the new SHORT-RUN market quantity? Continuing on from question 8), what are the SHORT-RUN equilibrium values of the following variables? 9) Firm's output. 10) Firm's profit. Now we turn to the long-run impact of the tax. What are the new (after-tax) LONG-RUN equilibrium values of the following variables? 11) Market price. 12) Market quantity. 13) Number of firms. Continuing on from the last problem, what are the LONG-RUN values of these variables? 14) New LONG-RUN equilibrium firm quantity. 15) New LONG-RUN equilibrium firm profits. Set all variables back to their baseline values, and put the market and firm in long-run equilibrium. Income now rises to $60,000. 16) How many firms will there be in the new long-run equilibrium?

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Continuing on from the last question, what are the new long-run equilibrium values of these variables? 17) Market price. 18) Market quantity. 19) Quantity for the firm.

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24 MONOPOLY
Purpose: To illustrate price determination in monopoly. Computer file: monop98.xls Instructions and background information: The RipOff Cable TV Company is a monopoly operating in a medium size mid-western city. The company hires you as a consultant to help them try to improve their profits. The company has provided you with all of the demand and cost data that they possess. These data are summarized in the graphs and tables that are contained in the accompanying spreadsheet. Current output is 20,000 homes hooked up to the system. Average family income in the market area for the monopolist is $55,000 per year. The price is the monthly fee per home hooked up to the system. In experimenting with different pricing and output scenarios you can change the current output, the tax (or subsidy) to the industry, and the average income per family. Excel automatically computes price, marginal revenue, average and marginal cost, and some other handy values such as the difference between marginal revenue and marginal cost, and the difference between price (average revenue) and marginal cost. As an economic consultant you are aware of the rules that can achieve several of the company objectives. For maximum profit the company should choose an output level at which s marginal revenue equals marginal cost. Once that output is determined, price is set according to the demand curve. A problem with the profit maximizing output is that it is too small from society point of s view. Society ordinarily wants output to be where marginal cost is equal to price, because then the sum of producer and consumer surplus will be maximized. Monopolists when left to their own devices will produce too little of a good from society point of view, and sell it at too high a s price. The loss of surplus when a monopolist maximizes profits is called the deadweight loss due to monopoly. Governments often regulate monopolies to try to eliminate the deadweight loss. One method sometimes used is a system of taxes or subsidies, and you are asked to formulate a subsidy plan for the Cable TV Company that will make it choose a pricing and output policy that is in the public interest. Here are some things to watch for and learn as you do the problems:

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1)

The demand curve the monopolist sees for its product is the same as the market demand curve. In fact the market demand curve is the monopolist average s revenue curve. Average revenue is price! The monopolist own policy variable is output. To maximize total profit, it s should choose the output at which MC = MR. Price is then set according to the demand curve. Monopolists are inefficient in the sense that they do not produce the socially best output, nor set the socially best price. Monopolists produce too little and charge too high a price from society point of view. The socially best output is the one at s which MC = P. The monopolist may still earn profits at this output.

2)

3)

Here are some hints to help you get the answers quicker: 1) Use Goal Seek to find the profit maximizing output. You want to have MR-MC ll equal to zero by changing output. Use Goal Seek to find the socially best output. The objective is to make AR-MC equal to zero by changing output.

2)

In a difficult problem, you asked to find the subsidy that would make the re monopolist produce the socially best output. The trick is to start at the socially best output you found by making price equal to marginal cost. Then use Goal Seek to make MR-MC equal to zero by changing the tax. Be sure you understand why this works! __________________________ MATH MAVEN CORNER: For the worksheet monopoly, the average revenue curve is S given by AR = aI b(Q ) , where I is income in dollars, and a and b are randomly chosen parameters. You might want to show that the marginal revenue curve is therefore MR = aI 2b(Q ) . The average cost curve is given by AC = c + d (Q ) + eQ 2 + t , where t is the tax per unit of output, and c, d, and e are randomly chosen parameters. The marginal cost curve is given by MC = c + 2d (Q ) + 3eQ 2 + t .

3)

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MONOPOLY Questions Set all variables to their baseline values. Make sure output is set to 20,000 hookups. Record the values of these variables: 1) Market price. 2) Average cost. 3) Profit per unit of output. 4) Total profit. Keep output at 20,000 hookups. 5) What is the increase in cost due to one more hookup (MC)? 6) What's the added revenue from one more hookup (MR)? 7) If one more hookup is added, what's the change in profits? 8) At an output of 20,000, should the firm be producing more or less output? [Enter more or less.] Cable company management wants to know how to maximize total profit, and what price to set. 9) What's the profit maximizing output? 10) What's the profit maximizing price? 11) Continuing on from the last problem, what are total profits when profits are maximized? Cable company management expects consumer incomes to rise to $60,000. You must advise them on what output to sell if the increase occurs. 12) What's the new profit maximizing output? Continuing on from the last question, record the values of these variables after income rises: 13) Market price. 14) Total profits. 15A) Set all variables to their baseline values. You are visited by staff members from the cable TV regulator's office. These are government officials and you must tell them the truth about the firm's operation. Go on to 15B. The government officials want to know what output will result in the socially best amount of cable TV services. 15B) What's the socially best output? 16) What's the socially best price? 17) What are total profits when the socially best output and price are set? 24-3

The government regulators thank you for your help, but would like you to tell them how large a subsidy the firm would need to produce the socially best output. 18) What per unit subsidy will be required? 19) What price would the firm WANT to charge if they actually received the subsidy?

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25 MORE MONOPOLY
Purpose: To illustrate price determination in monopoly. Computer file: monop298.xls Instructions and background information: This problem set continues with the analysis of the behavior of the RipOff Cable TV Company, a monopolist in the provision of cable services. The company has provided you with all of the demand and cost data that they possess. These data are summarized in the graphs and tables that are contained in the accompanying spreadsheet. Starting from profit maximizing levels of output and price, which you must determine, you work out the implications of some hypothetical government policies. The first one is a per unit tax on cable TV services. You need to find the effects of the tax on price and output. ll The second policy is a proposal to regulate the cable company by forcing them to produce the output where total profits are zero. This is an often-used policy in the real world when regulators allow firms to earn so-called normal profits. This is just a scheme in which economic profits are forced to be zero. The firm is allowed to earn what it could earn in its next best alternative business. An important point of this exercise is to show that the zero-profit output is actually too large from society point of view. Recall that the socially best output is where s marginal cost equals price, not where profits are zero! Here are some things to watch for and learn as you do the problems: 1) A per unit tax will cause a monopolist to reduce output and raise price, just as would happen in a competitive industry. A policy that will force the monopolist to produce at a price equal to average cost (zero profit) will result in too much output from society point of view in this s problem.

2)

Here are some hints to help you get the answers quicker: 1) Finding the output where price equals average cost (AR-AC = 0) can be tricky and requires some care. This is because the average cost curve is U-shaped, and therefore may cross the demand curve at two different outputs. You want to find the largest output where price equals average cost. If you use Goal Seek to do this you have to be careful, as the program will usually find the solution that is 25-1

closest to the starting value, not necessarily the one you want. To help Goal Seek get the right answer, look at the graph and set output close to the value you re looking for at the start. If the output Goal Seek gives you is negative, you know you got the wrong answer. ve Use Goal Seek to find the socially best output. The objective is to make AR-MC equal to zero by changing output. __________________________ MATH MAVEN CORNER: For the worksheet on monopoly, the average revenue curve is S given by AR = aI b(Q ) , where I is income in dollars, and a and b are randomly chosen parameters. You might want to show that the marginal revenue curve is therefore MR = aI 2b(Q ) . The average cost curve is given by AC = c + d (Q ) + eQ 2 + t , where t is the tax per unit of output, and c, d, and e are randomly chosen parameters. The marginal cost curve is given by MC = c + 2d (Q ) + 3eQ 2 + t . 2)

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MORE MONOPOLY Questions Set all variables to their baseline values. Record the profit maximizing values of the following variables for the cable TV company: 1) Output. 2) Price. 3) Total profit. The local government, in its effort to balance its budget, decides to levy a tax of $5 per hookup on the cable company. 4) What's the new profit maximizing output for the company? 5) What's the new price the company will charge it's customers? 6) How much does the government take in in tax revenues? 7A) Government regulators, unable to control the cable TV monopoly any other way, decide to order the company to charge price equal to average cost. They order the company to sell all that is demanded at the regulated price. Go on to 7B. Set all variables to their baseline values. 7B) What output will be sold under regulation? [Hint: Find the output where profit is zero.] 8) What price will be charged under regulation? 9) What will be the cable company's total profit? 10) Does the average cost pricing scheme result in MORE or LESS output than is socially desirable? [Enter MORE or LESS.] Summarize your results by listing the following prices: 11) Price where profit is maximized. 12) Price where social welfare is maximized. 13) Price at which profit is zero.

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26 NATURAL MONOPOLY
Purpose: To illustrate price determination in natural monopoly. Computer file: natmon98.xls Instructions and background information: THE RIDE is a bus transportation system that operates as a monopoly in Boulder, Colorado. The bus company sells monthly passes to its customers who then get to use the bus system by showing their passes, a system not very much different from that used on many college campus bus systems. THE RIDE hires you as a consultant to help them try to improve their profits, and advise them on the best responses to changes in economic conditions. The company has already provided you with all of the demand and cost data contained in the graph and accompanying values in the spreadsheet. Current output is 50,000 passes. Average consumer income in the Boulder area is $55,000 per year. THE RIDE operates with economies of scale. That is, average cost falls as output increases. In experimenting with different pricing and output scenarios you can change the current output, the tax (or subsidy) to the bus system, and the average income per consumer. Excel automatically computes all the other values in the tables. As an economic consultant, you know that the firm's profits will be maximized at the output where marginal cost equals marginal revenue. On the other hand, you know that the socially best price to charge is the one where marginal cost equals price. As with any monopoly, THE RIDE will want to charge too high a price and sell too small a quantity from society point s of view. Marginal cost pricing presents a unique problem in the case of THE RIDE because the firm operates with economies of scale. As output increases, average cost declines, which implies that marginal cost is always less than average cost. This means that setting price equal to marginal cost will result in price less than average cost -- the firm will earn losses. Here are some things to watch for and learn as you do the problems:

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1)

Just as with other monopolies, a natural monopoly maximizes profit by choosing the output where MC = MR. And just as with other monopolies, the firm is inefficient -- it produces less than the socially best output. From society point of view, a firm should produce an output where marginal cost s equals price. In the case of a natural monopoly, that production level will mean losses to the firm. This presents a regulatory dilemma. Either the firm must be subsidized, or some other output must be chosen. Natural monopolies in the real world are often made to set price at the level of average cost. From society point of view, this is inefficient in the sense that it s leads to a deadweight loss. It also gives firms an incentive to keep costs high.

2)

3)

Here are some hints to help you get the answers quicker: 1) Finding the outputs in questions 8, 11, 14, and 17 can be tricky, especially if you use Goal Seek to find the answers. This is because the marginal and average cost curves each cross the demand and marginal revenue curves twice, giving two possible answers to these questions. Take care of this difficulty by starting Goal Seek at an output near the objective. Goal Seek, in trying to find where two curves intersect, looks for the closest intersection.

2) You need a hand calculator to make some of the computations. ll __________________________ MATH MAVEN CORNER: For the worksheet the problems on natural monopoly the S average revenue curve is given by AR = aI b(Q ) , where I is income in dollars, and a and b are randomly chosen parameters. Test yourself by finding the marginal revenue curve. The average cost curve is given by AC = ( c / Q ) + d (Q f ) + t , where t is the tax per unit of output, and c, d, and f are random parameters. Again, see if you can find the marginal cost curve.

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NATURAL MONOPOLY Questions Set all variables to their baseline values. Make sure output is set to 25,000 passes per month. Record the values of these variables: 1) Average cost. 2) Price. 3) Profit per bus pass sold. 4) Total profit. Keep output at 25,000 passes per month. 5) What is the cost of one more pass (MC)? 6) What's the added revenue from one more pass (MR)? 7) If one more pass is sold, what's the change in profits? As a consultant you must advise THE RIDE on how to maximize its total profits. Be sure all variables are at their baseline values. 8) At what output is total profit maximized? 9) What price should be charged to maximize total profit? Continuing on from the previous question: 10) What's total profit when profit is maximized? THE RIDE is predicting that consumer incomes will fall next year to $50,000. The company needs to know what this means for its pricing policies. 11) What's the best output for the firm when income is $50,000? 12) What price should the firm charge? Continuing on from the last question where income was $50,000: 13) What's the amount of maximum profits? Set all values to their baseline values. Find the values of the following variables: 14) Socially best output. 15) Socially best price. 16) Total profits at the socially best output. Government regulators realize they may have to use a system of average cost pricing even if that is not socially optimal. 17) At what output is price equal to AC? 18) What's price at that output?

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Now summarize your results. Enter values for each of the following prices: 19) Profit maximizing price. 20) Socially best price. 21) Price where profit is zero.

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27 PRICE DISCRIMINATION
Purpose: To illustrate price discrimination in monopoly Computer file: prdisc98.xls Instructions and background information: Price discrimination is a device some firms use to increase profits by charging different consumers different prices for the same commodity. Examples are commonplace. A college or university may charge a different tuition rate for first year students than fourth year students for the same course. The local electric company may charge commercial and residential users different rates per kilowatt-hour of service, even though the cost of provision is the same for both. Colleges will often sell tickets to college-sponsored sporting events at lower prices to students than to the general public. For price discrimination to be accomplished, the firm must have some way of keeping speculators from buying up the good or service at the low price, and simply reselling it at the high price. Very often, it is a characteristic of the good that determines whether price discrimination is possible. In the case of electric service, for example, it is simply too costly for commercial users, who usually buy at a lower price, to save up power and then resell it to residential users. When colleges sell tickets to students at reduced prices, they often have to take measures to prevent resale, such as invoking laws against scalping, or requiring identification in addition to a ticket to gain entry. For this problem set, we take the example of a local cable television provider, the RipOff Cable TV Co., who sells to two groups of consumers. One group consists of residential customers, while the other group is composed of commercial users, for example, operators of restaurants, bars, or other business establishments. Output of the firm is the total number of hookups it provides. For any total quantity sold, how does the RipOff Cable TV Co. set prices and sales levels in the two markets in which it operates? We assume the firm wants to maximize the total revenue it receives for any level of total output. We get to the question of how to choose total output, and therefore the level of ll total costs, later on. To maximize total revenue from the sale of hookups the output should be allocated between the two markets so that marginal revenue is the same in each. The reasoning is that if marginal revenue were higher in one market, say the residential market, then total receipts could be increased by moving some output from the commercial to the residential market. Once outputs are chosen to make marginal revenue the same in the two markets, price in each market will be determined by its demand curve. There is a relationship

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between the prices charged and the elasticities of demand in the two markets. The more inelastic the demand, the higher the price charged. To decide on the total output where profits are maximized, the firm should produce where marginal cost equals marginal revenue. Of course, in general there is only one marginal cost curve while there are two marginal revenue curves, so we must be careful to take that into account in comparing MR and MC. In this problem set, marginal cost is assumed to be constant, so determination of total output will be fairly simple. In the spreadsheet there are only two variables you can choose, sales to the residential market, and total sales to both markets together. Sales to the commercial market are automatically computed as the difference between total sales and residential sales. Use the Goal Seek facility in Excel to solve most of the problems. Here are some things to learn and watch for as you do the problems: 1) Price discrimination allows a firm to increase the total revenue from sales compared to charging all customers the same price. A price discriminating firm must have some way to keep the markets separate. If it easy for consumers to buy the good and simply resell it in s the higher priced market, price discrimination will be impossible. Price will be higher in the market with the more inelastic demand, not necessarily the larger demand. Think about this, and try computing elasticity in the two markets when price discrimination takes place.

2)

3)

Here are some hints to help you get the answers quicker: Questions 15) and 16) are difficult. To find the conditions under which profit is maximized, operate on the residential market first, determining the output at which MR = MC. Then, with the residential market in equilibrium, try to set MR = MC in the commercial market by changing the total quantity. _________________________ MATH MAVEN CORNER: S The marginal revenue curve for the residential B market is given by MRr = AQr , where A and B are parameters that are unique to your problem. The marginal revenue curve for the commercial market is the same functional form, but with different parameters. 1)

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PRICE DISCRIMINATION Questions Record the following values when all variables are at their baseline values: 1) Quantity in the residential market. 2) Price in the residential market. 3) Quantity in the commercial market. 4) Price in the commercial market Following on from the previous question: 5) What are RipOff total receipts from both markets together? s The firm's objective is to maximize total revenue. Be sure to set variables to their baseline values. To maximize total revenue 6) What quantity should it sell in the residential market? 7) What price should it charge there? Continuing from the previous question, 8) What quantity will be sold in the commercial market? 9) What price will be charged there? 10) When RipOff is maximizing total revenue, how much are its receipts from both markets together? [Compare to question 5.] With total quantity still at its baseline value, suppose RipOff is ordered to sell to all customers at the same price. 11) What price does it charge? When RipOff must charge everyone the same price (as in the last question), 12) What is the company's total revenue? [Compare to questions 5 and 10.] Increase total sales from 3,000 to 4,000. If RipOff can price discriminate between the residential and commercial customers, 13) What's the new residential price? 14) What's the new commercial price? Suppose that Ripoff's marginal cost is constant at $7.00 per hookup. 15) If the firm can price discriminate, and wants to maximize profit, what price will it charge in the residential market? Continuing on from the last question: 16) What price will it charge in the commercial market? Suppose a tax of $2.00 per hookup is now imposed on all hookups sold by RipOff. This raises MC to $9.00.

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17) How much will price INCREASE in the residential market? 18) How much will price INCREASE in the commercial market?

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28 UTILITY FUNCTIONS AND

INDIFFERENCE CURVES
Purpose: To show the relationship between utility functions, indifference curves, and total utility curves. Computer files: cdutil98.xls and cesutil98.xls Instructions and questions: The utility function defines the level of utility or satisfaction as a function of the quantities of commodities consumed. The function embodies the consumer's preferences. In the utility function the dependent variable is utility, and the independent variables are the amounts consumed of goods or services. An indifference curve shows all of the amounts of goods that give the consumer the same level of satisfaction. (An indifference curve is an implicit function that has the amounts of goods as variables. It doesn't have dependent and independent variables in the sense of there being a cause and effect.) A collection of amounts of goods, say five plates of spaghetti and thirty tacos, is referred to a "consumption bundle" or "market basket of commodities". A total utility curve shows total utility as a function of one good, holding all other goods constant. Economists usually assume that utility functions have several properties or characteristics. For example, the preferences behind the utility function are assumed to be "complete" and transitive. In addition, preferences have the characteristic that "more is better", and that indifference curves are convex. Completeness means that the consumer can decide for any pair of bundles whether she prefers one to the other or is indifferent between them. There are no bundles about which the consumer just throws up her hands and says she can't make up her mind. Transitivity means that the consumer's preferences are consistent in the sense that if she prefers bundle B to A, and prefers bundle C to B, then we know she will prefer C to A without even asking her. The implication of the transitivity assumption is that indifference curves can't cross each other. "More is better", sometimes called the nonsatiety assumption or the "pig principle", is the assumption that more of a good always increases total utility if the amounts of other goods are 28-1

held constant. This means that total utility curves will always be positively sloped, and that socalled "higher" indifference curves lie above and to the right of "lower" indifference curves. Convexity of indifference curves (i.e., "Indifference curves are convex when viewed from the origin.") is sometimes referred to as the assumption of increasing marginal rate of substitution. The marginal rate of substitution of spaghetti for tacos is the number of tacos needed to compensate the consumer for the loss of one unit of spaghetti. It is minus the slope of an indifference curve. If you now open the Excel file cdutil98.xls you will see a three dimensional graph of a utility function for a typical consumer who gets satisfaction from consuming spaghetti (S), and tacos (T). Click on any of the vertices of the graph. Small black dots appear on all vertices. You can drag on any black dot to change the orientation of the graph. [Put the mouse pointer on a dot, and depress the left mouse button. If you hold the button down the graph will change form and move with the pointer as you move the mouse.] If you reorient the graph so that you are, in effect, looking at it from above, you can see the indifference curves for the consumer. If you reorient it so you are viewing it from the side in, say, the tacos direction, you can see the total utility curves for spaghetti. As an extra credit exercise open the file cesutil98.xls. You'll see another utility function that has a different mathematical form. Does this function conform to the assumptions economists usually make about utility functions? __________________________ MATH MAVEN'S CORNER: The utility function used to generate the graph in cdutil98.xls is given by U = (10)S .3 T.5 where S is the amount of spaghetti consumed and T is the amount of tacos consumed. Exponential functions of this sort that are used to describe utility functions and production functions (to be taken up later) are called Cobb-Douglas functions, though the term is sometimes reserved for the special case in which the exponents sum to one. The utility function used to generate the graph in cesutil98.xls is given by U = (S .5 + T .5 ) 2 This is a special case of a class of functions used by economists called Constant Elasticity of Substitution (CES) functions.

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UTILITY FUNCTIONS AND INDIFFERENCE CURVES Questions 1) 2) For the part of the function shown in the graph, are preferences complete? (yes or no) For the part of the utility function shown in the graph, is the nonsatiety assumption true? (yes or no) Reorient the graph so that it shows the indifference curves between spaghetti and tacos. Print the graph (or save it as a file) and turn it in with your other answers. For the part of the utility function shown in the graph, are the indifference curves "convex"? (yes or no) For the part of the utility function shown in the graph, are preferences transitive? (yes or no) Reorient the graph so it shows either the total utility curves for tacos, or the total utility curves for spaghetti. Print the graph (or save it as a file) and turn it in with your other answers. [If you save as a file be sure to change the file name to end in a "2" so you don't overwrite the file saved in question 3.] Do the total utility curves have the property of "diminishing marginal utility" so long as some of each good is consumed? (yes or no)

3)

4)

5)

6)

7)

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29 UTILITY MAXIMIZATION
Purpose: To demonstrate the rule for utility maximization. To show the effects on consumer choice of changes in prices and income. Computer files: utilmax198.xls. Instructions and questions: Sally Jones gets utility from consuming two goods, spaghetti and tacos. She receives a fixed money income each week, and can buy spaghetti and tacos at fixed known prices. The problem she faces is to choosing the amounts of spaghetti and tacos that will maximize her utility. In other words, she has to solve the standard problem in the theory of consumer behavior. The utility maximizing amounts of the goods, the solution to Sally's problem, are those for which (i) she spends all of her income, and (ii) her marginal rate of substitution (MRS) of spaghetti for tacos equals the ratio of the price of spaghetti to the price of tacos. Another way to say this is that she should be on her budget constraint where an indifference curve is just tangent to the constraint. This problem set is the first of three on this subject. Here you are given Sally's preferences as a set of indifference curves, and the income and prices she faces. The task is to find the utility maximizing amounts of the goods to consume. You accomplish this in Excel by using Goal Seek to find the amount of spaghetti that makes the difference between the MRS and price ratio equal to zero. In the problem set after this one you are asked to solve the same problem on the assumption utility is cardinally measurable. One way to state the utility maximizing rule in this case is that the consumer should buy goods so that the marginal utility per dollar spent on all goods is the same. (Marginal utility per dollar spent on a good is simply its marginal utility divided by its price.) In the third problem set you will examine the effects on a consumer's choices of changes in income and the prices of the goods, and derive the demand curve for a good. Open the Excel file utilmax198.xls. What you see are a few of the Sally's indifference curves (in blue), her indifference curve for her current levels of consumption of tacos and spaghetti (in red), and her budget constraint for the current levels of income and prices (in black). You can change consumption by choosing different amounts of spaghetti. Taco consumption is automatically computed to exhaust income for each level of spaghetti you choose. Change money 29-1

income and the prices of the goods so you understand how the changes affect Sally's budget constraint. Get a feel for how the model works by choosing some different values for spaghetti consumption. Notice that taco consumption adjusts so that all income is spent on these two goods. Notice also what happens when spaghetti consumption exceeds 37.5. Set spaghetti consumption equal to 15. Make sure income is $150, the prices of spaghetti and tacos are $4.00 and $1.50, respectively. You should be able to see that the consumer is not maximizing utility at the current consumption amounts. The rule for utility maximization is that Sally should choose goods so that the marginal rate of substitution between them is equal to the ratio of their prices. In this example we want the MRS of spaghetti for tacos to equal P(S)/P(T). When you solve the problem of maximizing utility (use Goal Seek to do it), notice that at the solution to the consumption problem the budget constraint and the red indifference curve are tangent to each other. Notice also that the utility maximizing amounts of the goods are the amounts Sally demands. That is, they are the amounts she wants to buy, and is able to buy. Hints and tips: 1) Use Goal Seek to find the utility maximizing amounts of S and T. Set the MRS equal to the price ratio of the goods by changing the amount of spaghetti. 2) Be sure you understand the different effects of changing income and prices on the budget constraint. 3) Remember that an important purpose of this model is to show that the demand for a good depends only on income, the good's own price, the prices of other goods, and preferences. _________________________ MATH MAVEN'S CORNER: The utility function used to generate the graph in utilmax98.xls is given by

U = AS T
where S is the amount of spaghetti consumed and T is the amount of tacos consumed, and A, , and are randomly chosen. The budget constraint is given by I = PSS + PTT, where I is income, and PS and PT are the prices of S and T, respectively. The math problem is to maximize utility subject to the budget constraint. It can be solved either of two ways: substitute the constraint into the utility function so only one of the goods is a variable and then maximize, or use the Lagrangian Theorem. Satisfy yourself, if you wish, that the marginal rate of substitution of S for T is (T/S) in this case. The MRSS for T in general is -dT/dS|dU=0 = ( S)/( T). U/ U/

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UTILITY MAXIMIZATION Questions 1) With income and prices at their baseline values, what is the largest amount of spaghetti the consumer can buy? Following on from the last question, what is the largest amount of tacos the consumer can buy? Set income and prices to their baseline values. If the consumer buys 10 units of spaghetti, how many tacos can she buy? Set income and prices to their baseline values. Set spaghetti consumption to 15 units. Beginning from this point, what's the utility maximizing amount of spaghetti? When utility is maximized, what is total spending on spaghetti? Continuing on from the last question, what's the utility maximizing amount of tacos? What is spending on tacos? Set income and prices to their baseline values. The consumer wins the lottery, which increases her income to $220. What's the new demand (utility maximizing amount) for spaghetti? Continuing on from the last question, what's the new demand for tacos? Set income and prices to their baseline values, and set consumption at the utility maximizing values. The price of spaghetti now falls to $2.50 per plate. What's the new best amount of spaghetti? (Compare to 4.) Continuing on from the last question, what's the new utility maximizing amount of tacos? (Compare to 6.)

2)

3)

4)

5) 6) 7) 8)

9) 10)

11)

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30 MORE UTILITY MAXIMIZATION

Purpose: To demonstrate the rule for utility maximization when utility is a cardinal measure of satisfaction. To show the effects on consumer choice of changes in prices and incomes. Computer file: utilmax298.xls Instructions and questions: In the previous problem set utility was measured ordinally, which is to say that consumers were only expected to rank bundles of goods in order of preference. In an ordinal ranking, bundles may be first, fifth, or eighth, for example. A stronger assumption about consumers would be to expect them to say things like "I like consuming 6 bicycles four times as much as consuming 2 bicycles,) or "Three tacos gives me 125 utils of satisfaction, and one more taco would add 18 utils to my total satisfaction." In this case utility is a cardinal phenomenon, and can therefore be measured with real numbers, not just a ranking. If utility is cardinal, we can reformulate the rule for utility maximization into one that is, to some folks at least, more intuitive. The more intuitive version of the rule is that the consumer should adjust consumption to make the marginal utility of an extra dollar spent on each good the same for all goods. In the case of spaghetti and tacos, utility will be maximized if MU(S)/PS = MU(T)/PT Just as in the previous problem set, the utility maximizing consumer should spend all income on the goods. The ratio of MU to price, the marginal utility per dollar, is the extra utility a consumer will get from spending one more dollar on the good. Open the Excel file utilmax2.xls. The screen will show a set of indifference curves similar to those in the last problem set. The differences here are that you can see a) the value of the marginal utility for each good (not just the marginal rate of substitution), b) the marginal utility per dollar, and c) the total utility from consuming a bundle of goods. Some of Sally Jones's indifference curves are shown in blue, and her indifference curve for current consumption of spaghetti and tacos is shown in red. You can change her consumption by choosing different amounts of spaghetti. Taco consumption is automatically computed to exhaust income for each level of spaghetti you choose. You can also change income and the prices of the two goods. You're asked in the questions to find the utility maximizing amounts of the goods. You can use Goal Seek to do this by asking it to set the difference between the marginal utilities per

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dollar equal to zero by changing the amount of spaghetti. Notice that the nature of the solution is exactly the same as before -- at the best choice, the slope of an indifference curve is equal to the slope of the budget constraint. Pay particular attention here to the problem in which Sally has to pay income taxes, and then receives in return an amount of goods exactly equal in value to her tax bill. Her utility goes down as a result, even though she receives the same dollar value of goods both before and after the tax. Economists make a big thing out of this result, and it is good if you understand the intuition of the result. Here are some other things to watch for as you do the problems: 1) Consumers maximize utility by choosing amounts of goods so that the marginal utility per dollar spent on all goods is the same. The marginal utility per dollar is a good's marginal utility divided by its price.

Giving a consumer goods is unlikely to raise her utility by as much as giving her an equivalent amount of money. (The exception is the case in which the consumer is given in goods what she would have bought with the money anyway.) _________________________ MATH MAVEN'S CORNER: The utility function used to generate the graph in utilmax298.xls is given by

2)

U = AS T
where S is the amount of spaghetti consumed and T is the amount of tacos consumed, and A, , and are randomly chosen. This is the same utility function as in the last problem set. The budget constraint is given by I = PSS + PTT, where I is income, and PS and PT are the prices of S and T, respectively. The marginal utility of S is given by S, and similarly for T. Therefore U/ there is an easy relationship between the Marginal Rate of Substitution and the marginal utilities. The MRSS for T in general is -dT/dS|dU=0 = ( S)/( T), which is the ratio of the marginal U/ U/ utilities.

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MORE UTILITY MAXIMIZATION Questions Set income and prices to their baseline values, and set spaghetti consumption to 5 plates. 1) 2) How much is taco consumption? How much is total utility?

Following on from the last question: 3) 4) 5) If the consumer spends one more dollar on spaghetti, how much does total utility increase? If the consumer spends one more dollar on tacos, how much does total utility increase? Is total utility maximized when the consumer buys 5 plates" of spaghetti? (yes or no) Following on from the last question, of which good should the consumer buy more? (spaghetti or tacos) What is the utility maximizing amount of spaghetti? What is the utility maximizing amount of tacos? With income and prices to their baseline values, what is total utility when utility is maximized? (Compare to 2)

6) 7) 8) 9)

Disaster strikes the consumer, and she finds she has to pay $51 dollars in income taxes. Her weekly income is now at $99, and prices of spaghetti and tacos are $4 and $1.50, respectively. 10) 11) 12) What's the new utility maximizing amount of spaghetti? What's the new utility maximizing amount of tacos? Continuing on from the last question, what is the consumer's new level of utility? (Compare to 9)

Now suppose the government proposes to give the consumer $51 worth of government benefits in the form of 12 plates of spaghetti and 2 tacos. (The consumer gets the benefits after making the choice in question 12.) 13) What's the consumer's level of utility now (after paying the tax and getting the benefits)?

Set income and prices to their baseline levels, and find the utility maximizing solution. Now set the price of spaghetti to $2 per plate. 14) How much spaghetti is demanded at the lower price? (Compare to question 7.)

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15)

For spaghetti, does Sally obey the Law of Demand? (yes or no)

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31 DEMAND CURVES, AND INCOME

AND SUBSTITUTION EFFECTS
Purpose: To show how to find the demand curve for a good from the standard utility maximization problem. To show how to find income and substitution effects of a price change. Computer file: utilmax398.xls Instructions: Martha Johnson's utility is a function of the quantities of spaghetti and tacos she consumes. The first task in this problem set is to derive and plot Johnson's demand curve for spaghetti. By definition, a consumer's demand curve is the relationship between a good's own price and the quantity demanded, given income, prices of other goods, and preferences. The point being emphasized here is that the quantity demanded is the consumer's utility maximizing amount of the good the amount the consumer wants to buy, and is able to buy. The experiment to find the demand curve is straightforward. Choose a number of prices for spaghetti, and find the corresponding optimal amounts of spaghetti the consumer will choose. Income, prices of other goods, and preferences are held constant. With the price and spaghetti consumption data in hand, plot the demand curve for spaghetti. Demand curves are assumed to be negatively sloped, a proposition usually called the Law of Demand. Can the Law of Demand be "proved" for the standard case of the theory of consumer behavior? Have enough assumptions been loaded on consumer preferences to assure that every time a good's price falls, the quantity that maximizes utility will rise? This question is explored using the concepts of income effects and substitution effects of a change in price. The whole issue arises out of the following observations: When the price of a good falls, that good is now relatively cheaper than other goods, and consumers would tend to substitute in favor of buying more of the cheaper good even if income were unchanged. On the other hand, when the price of a good falls, the consumer can buy more of everything, not only the good whose price fell. Purchasing power rises. So there is a sense in which a decrease in price is similar (but not exactly the same) as an increase in income. Now consider Johnson's choices. When the price of spaghetti falls, we can imagine her moving to a new consumption bundle in two stages. The first is her change in spaghetti consumption due to spaghetti's becoming cheaper, holding her real income constant. This change is called the substitution effect of the change in price. The second is her change in consumption of spaghetti due to her becoming richer as a result of the price change, richer in terms of real income. But what is real income? Economists suggest that a good measure of a consumer's real income is total utility.

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What are we to make of this breaking down of a change in consumption into so-called income and substitution effects? The substitution effect of a price change always works in the direction predicted by the Law of Demand. This is due to the assumption that indifference curves are convex when viewed from the origin. But the change in consumption due to an increase in real income, holding prices constant, may work to either increase or decrease consumption of the good whose price has changed. If the good is normal, we have nothing to worry about, because the income and substitution effects work in the same direction. But if the good is inferior, a negative income effect works against the substitution effect, and which one dominates depends on which is numerically larger. So theoretically at least, it's possible for a good to violate the Law of Demand. If the income effect is larger than the substitution effect, and works in the opposite direction the good is called a Giffen Good. You're asked to find the income and substitution effects of a change in the price of spaghetti. Do this in several steps. It must be done by trial and error, as using Goal Seek is not enough. Start from the baseline values of income and prices of the spaghetti and tacos. When you reduce the price of spaghetti, optimal consumption will rise. Call this change in spaghetti consumption the total change. Now find the substitution effect by gradually decreasing money income, maximizing utility at each step of the way, until the real income (utility) is the same as where you started. The difference between spaghetti consumption at this point, and the original optimal amount is the substitution effect. The income effect is the difference between the total change and the substitution effect.
T

The graph at the right may help you compute the income and substitution effects more easily. Original consumption is S0, and final consumption is S2. The total change is S2 - S0. S1 is consumption at the lower price of spaghetti when utility is at its original value. The substitution effect is S1 - S0, and the income effect is S2 - S1. Here are some other things to watch for as you do the problems: 1)

U0 S0 S1 S2

U2 S

For the utility function used in these problems, both goods are normal so the Law of Demand is always true

Finding the substitution effect is tedious, but you should be able to find it in less than ten tries. _________________________ MATH MAVEN'S CORNER: The utility function used to generate the graph in utilmax398.xls is given by

2)

U = AS T
where S is the amount of spaghetti consumed and T is the amount of tacos consumed, and A, , and are randomly chosen. This is the same utility function as in the last problem set, though

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your parameters will be different here. See if you can find the demand function directly. It's also possible to find the exact income and substitution effects analytically. If you want to try this, the exact values for the parameters in your problem are given in the Answer Bin. Good luck!

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DEMAND CURVES, AND INCOME AND SUBSTITUTION EFFECTS Questions Set income and prices to their baseline values, and find the utility maximizing amounts of the goods. 1) 2) 3) How much is taco consumption? How much is spaghetti consumption? How much is total utility?

With income and the price of tacos at their baseline values: 4) 5) 6) When the price of spaghetti is $2, how much is demanded? When the price of spaghetti is $6, how much is demanded? When the price of spaghetti is $8, how much is demanded?

Continuing on from the last question, with income and the price of tacos at their baseline values: 7) 8) 9) When the price of spaghetti is $10, how much is demanded? When the price of spaghetti is $12, how much is demanded? Print out the Graph Paper sheet by selecting the sheet (by clicking on its tab at the bottom of the screen), and clicking on the button to print. Graph the demand curve for spaghetti using the points you found in questions 2 and 4 to 8.

Set all variables to their baseline values, and find the optimal consumption amounts, and the maximum level of utility. Call these baseline consumption and utility. Now reduce the price of spaghetti to $2 per plate. 10) 11) What's the total change in spaghetti consumption? What would the consumer's money income have to be at the lower price of spaghetti to give her (at best) the baseline level of utility? Following on from the previous question, what is the level of spaghetti consumption at the income level you found? What is the substitution effect of the price change? What is the income effect of the price change?

12)

13) 14)

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32 MARGINAL UTILITY AND

OPTIMIZATION
Purpose: To demonstrate the rule for utility maximization when utility is a cardinal measure of satisfaction. To show the effects on consumer choice of changes in prices and incomes. Computer file: utilmax498.xls Instructions and questions: This problem set is the same as the one preceding it, except in one respect. It is that the accompanying graphical display doesn't use indifference curves, but relies instead on straightforward measures of marginal utility per dollar of the two goods. A simple bar chart shows the values of marginal utility per dollar for each of the goods for any values of income, prices, and consumption. Compared to the use of indifference curves, many people find the approach taken here to be more intuitive in explaining the nature of the optimization problem. The approach taken here is also good for people who like to avoid the discussion of indifference curves entirely in a presentation of consumer choice. If utility is cardinal, we can reformulate the rule for utility maximization into one that is, to some folks at least, more intuitive. The more intuitive version of the rule is that the consumer should adjust consumption to make the marginal utility of an extra dollar spent on each good the same for all goods. In the case of spaghetti and tacos, utility will be maximized if MU(S)/PS = MU(T)/PT The ratio of MU to price, the marginal utility per dollar, is the extra utility a consumer will get from spending one more dollar on the good. In addition to following the marginal rule, the consumer should spend all income on the goods. Open the Excel file utilmax4.xls. The screen will show a bar chart that shows the marginal utilities per dollar for the two goods. You can change Sally Jones's consumption by choosing different amounts of spaghetti. Taco consumption is automatically computed to exhaust income for each level of spaghetti you choose. You can also change income and the prices of the two goods. You're asked in the questions to find the utility maximizing amounts of the goods. You can use Goal Seek to do this by asking it to set the difference between the marginal utilities per dollar equal to zero by changing the amount of spaghetti. Notice that the nature of the solution is exactly the same as before -- the heights of the bars measuring marginal utility per dollar are the same for the two goods.

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_________________________ MATH MAVEN'S CORNER: The utility function used to generate the graph in utilmax498.xls is given by
U = AS T

where S is the amount of spaghetti consumed and T is the amount of tacos consumed, and A, , and are randomly chosen. This is the same utility function as in the last problem set. The budget constraint is given by I = PSS + PTT, where I is income, and PS and PT are the prices of S and T, respectively. The marginal utility of S is given by S, and similarly for T. Therefore U/ there is an easy-to-understand relationship between the Marginal Rate of Substitution and the marginal utilities. The MRSS for T in general is -dT/dS|dU=0 = ( S)/( T), which is the ratio of U/ U/ the marginal utilities.

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MARGINAL UTILITY AND OPTIMIZATION Questions Set income and prices to their baseline values, and set spaghetti consumption to 5 plates. 1) 2) How much is Sally's taco consumption? How much is her total utility?

Following on from the last question: 3) 4) 5) 6) 7) 8) 9) If Sally spends one more dollar on spaghetti, how much does total utility increase? If she spent another dollar on tacos, how much would total utility increase? Is total utility maximized when she buys 5 plates of spaghetti? (yes or no) Following on from the last question, of which good should Sally buy more? (spaghetti or tacos) What is the utility maximizing amount of spaghetti? What is the utility maximizing amount of tacos? With income and prices to their baseline values, what is total utility when utility is maximized? (Compare to 2)

Now increase the Sally's income to $220. 10) What is her new demand for spaghetti? 11) What is her new demand for tacos? 12) 13) Following on from the last question, is spaghetti normal or inferior? Are tacos normal or inferior?

Set income and prices to their baseline levels, and find the utility maximizing solution. Now set the price of spaghetti to $2 per plate. 14) 15) How much spaghetti is demanded at the lower price? (Compare to question 7.) For spaghetti, does Sally obey the Law of Demand? (yes or no)

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33 DISCOUNTED PRESENT VALUE

Purpose: To illustrate the idea of discounted present value with computations of the value of payments to be received in the future at different rates of interest. To use discounted present value to determine the profitability of investments. Computer file: pv98.xls Instructions and background information: The spreadsheet for this problem set is a kind of calculator that will help you compute the discounted present value of a series of payments and costs. The first three spreadsheet columns show information on payments and costs associated with an asset in several years. The relationship upon which all the calculations are based is that the present value of P(t) dollars to be received t years hence is equal to [P(t)/(1+i)t], where i is the rate of interest expressed as a decimal. Column A lists the years payments are to be received or costs incurred. Year 0 is today, year 1 is one year from today (one year hence, in economist's jargon), etc. Column B shows the amounts of payments (in dollars) received by the owner of a hypothetical asset in respective years. On "wake up" this column has $100 in rows 3 through 7. You can enter any numbers you wish in this column. Hitting the Reset to Baseline button will clear the values from this column. Each entry in column C shows the discounted present value (DPV) of the payment just to the left in column B. E.g., the DPV of $100.00 to be received 4 years in the future if the interest rate is 6% is $79.21 [cell C7]. [$79.21 = $100/((1 + .06)2)] In economist's lingo this is called "The present value of $100 four years hence at 6 percent." Cell E3 shows the current interest rate. On "wake up" i = .06 or 6%. To change the interest rate, select cell E3 and enter the rate of interest either as a percent or a decimal. For example, to change the interest rate to 10 percent, enter either .10 or 10%. Many assets, and the one shown is an example, give the owner a series of payments in many years in the future, not just a single payment. Cell F3 shows the discounted present value of the series of payments in column B. That is, it is the sum of the values in column C. The value in cell F3 is the present value of the asset.

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The graph is a bar chart showing the present value of each of the payments in the respective years. You should experiment by choosing some different values for the payments and/or inserting new ones, and seeing what happens to the present values in the graph. You should also experiment by choosing some different values for the rate of interest. Be sure you understand why an increase in the rate of interest must decrease the present value of a payment to be received in the future. Here are some things to watch for and learn as you do the problems: 1) For a payment to be received in the future there is an inverse relationship between the rate of interest and the present value of the payment. Higher interest rates always lead to lower discounted values. You should buy an asset if the discounted present value of the benefits (payments) is greater than the discounted present value of the costs. The DPV of an asset is the amount of money you would have to put on deposit (lend) today at the current interest rate to be able to withdraw (receive) the payments in the future.

2)

3)

Here are some hints to help you get the answers quicker: 1) In these problems all future payments and costs are assumed to take place at the end of the period in question. For example, in question 1, enter the value of the payment in cell B6, next to year 3. In question 5, enter the first interest payment from the bond next to year 1. The payment for year 0 should be blank. In question 5, enter the first interest payment from the bond next to year 1. The payment for year 0 should be blank. In question 7, the first return from owning the machine occurs in year 1, that is, after one year. However, the cost of the machine occurs today, year 0. In all, you get 6 years of returns from owning the machine. Remember to add the scrap value of the machine to the returns in last year. In question 17 you get the payoff from the first year of energy saving in year 1. (Year 0 should be blank or zero.) Then enter $40 through year 10.

2)

3)

4)

Try this exercise to get some insight into the value of your college education. Suppose you are considering buying a college education (majoring in Economics?) which you expect to give you considerably higher incomes in future years than if you had just a high school education. Your income is expected to be 33-2

$15,000 per year higher with the college education. Your working life will start 3 years from now, say, and last for 40 years. What is the value of the returns to the college education if interest rates are 3%, 6%, and 10%? What's your own personal estimate of the cost of your college education? Assume a 4 year college career. Add a) and b) together, discounting the future costs if you wish to get the total cost. a) b) Opportunity cost in lost wages. Out of pocket costs of tuition, books, supplies, etc. (but not housing or meals).

Is the investment going to be worth it?

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DISCOUNTED PRESENT VALUE Questions Note: The values of payments and costs you need to answer the questions are generated randomly by the spreadsheet when you open it. You will need to look at the questions in the spreadsheet to obtain the values. Your Uncle Harry says he will give you $______ three years from now to help you pay for a new car. 1) When the interest rate is 6%, what's the present value of his gift to you? 2) What's the present value if the rate of interest is 3%? 3A) Some people set up trusts or make other financial arrangements to pay for their kid's college education. Martha Klutz knows that when her daughter goes to college the expenses will be $______ per year for four years. [Go on to 3B.] Her daughter is now a high school sophomore, so the first bill will arrive 3 years from now. The rate of interest is 8%. 3B) How large a trust must Klutz set up today so that her daughter's college education is just paid for in the future? 4) How large would the trust have to be if the rate of interest was 3% instead of 8%? 5A) A bond is a promise to pay its holder fixed amounts of money at specified times in the future. Suppose you have a chance to buy a bond that pays the following amounts in interest and principal: [Go on to 5B.] 5B) After one year you will receive a series of annual interest payments of $______ for 10 years. At the time you receive the last interest payment you will receive the principal value of the bond of $20,000. [Go on to 5C.] 5C) If the rate of interest is 7%, what's the maximum amount you would be willing to pay for the bond? 6) If the rate of interest were 10%, what would be the price of the bond? 7A) You are in the pizza business and want to buy a new pizza making machine. The machine costs $______ today. At the end of each year you own the machine it will give you returns of $______ after paying for maintenance and repairs. [Go on to 7B.] After you have owned the machine for 6 years you expect to sell it for scrap for $1,000. (You scrap it at the same time you get the last $______ return.) What is the present value of the RETURNS at 33-4

7B) 8) 9)

3%? 7%? 11%?

What's the present value of the COST of the machine if the interest rate is: 10) 3%? 11) 7%? 12) 11%? Should you buy the machine at each of the following interest rates? [Enter Yes or No.] 13) 3%? 14) 7%? 15) 11%? 16A) You win a big prize in the Super Lottery. You receive $_____ today, and then $_____ for each of the succeeding 9 years. [Go on to 16B.] 16B) How much would the state have to put on deposit today to just pay you off if the state's interest rate is 7%? 17A) You go to Big George's to buy a new refrigerator for your apartment. The store offers two models, regular (costs $______) and energy efficient (costs $______). Both will last for 10 years. [Go on to 17B.] The energy efficient refrigerator will save you $40 per year in electricity bills. 17B) What the difference in the initial purchase price between the energy efficient s model and the regular model? Continuing on from the previous question assume the rate of interest is 12%. 18) What the present value of the energy saving from the energy efficient model? s 19) Should you buy the energy efficient model? [Yes or No]

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34 INTERNAL RATE OF RETURN

Purpose: To illustrate how to compute the internal rate of return on an investment or series of future payments and costs. To show how to use the internal rate of return to make investment decisions. Computer files: irr98.xls Instructions and background information: The first two spreadsheet columns show information on payments and costs associated with an asset in several years. Column A lists the years payments are received or costs incurred. Year 0 is today, year 1 is one year from today, etc. Column B shows the dollar payments received or costs incurred on a hypothetical asset in respective years. On "wake up" this column has -9500, 500, 500, and 10500 in the topmost cells. Costs are entered as negative numbers, so the asset represented is one that costs $9,500 today and pays $500, $500, and $10,500 in each of the next 3 years, successively. Cell D58 shows the internal rate of return (IRR) on the asset whose cash flow values are listed in the cells in column B. The IRR is the interest rate that makes the sum of the present values of the payments equal to zero. If i is a rate of interest, the IRR is the value of i that makes this equation true: 0 = R(0) + R(1)/(1+i) + R(2)/(1+i)2 + ... + R(T)/(1+i)T, where R(t) is the dollar return t years from now. Another way to define the internal rate of return is as the interest rate that makes the net discounted present value of an asset equal to zero. Or, equivalently, as the interest rate that makes the discounted present value of the costs equal to the discounted present value of the returns. All of these ways of saying it come down to the same thing. Of course, solving the equation for the internal rate of return may not be an easy task. In fact, for T larger than 5 there is, in general, no way to do it using the ordinary methods of algebra, so various methods of approximation are used. Excel finds the IRR by trial and error, and the way the computer you are working on is set up, it gives up if it doesn't get close to the answer after 20 tries.

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To help Excel out, you can choose a value in cell F58, labeled BEST GUESS. It is the interest rate Excel starts with as it tries to find the IRR by trial and error. When the spreadsheet wakes up the BEST GUESS for the internal rate of return is 10%. You can change BEST GUESS and all of the values in column B to answer the questions. All other cells in the sheet are locked. The graph shows the net discounted present value of the asset you are working with at interest rates from 0 to 100 percent in 1 percent intervals. The internal rate of return can be estimated by seeing where the graph crosses zero on the vertical axis. You can use the graph to make a good BEST GUESS. Experiment with some different values for returns and costs in different years and see what happens to the internal rate of return. NOTE: The numbers in column B must contain at least one positive value and one negative value for the procedure to work. In addition, Excel has a quirk in the IRR computation that makes it treat blanks and zeros differently. If you want a zero payment or cost in an intermediate year of your asset, be sure to enter "0" in the cell, don't just leave it blank. Here are some things to watch for and learn as you do the problems: 1) The answers to questions 1, 3, 4, and 8 are percentages -- rates of return. Enter your answer in the answer sheet either as a decimal, or with a percent sign (%). For example, if your answer is 7.52 percent, enter either .0752 or 7.52%. The IRR is the average annual rate of return on an asset. Generally, you can profit by buying assets that have an IRR greater than the rate of interest you have to pay to borrow money. The idea is that if IRR exceeds the rate of interest you can use the income from the asset to pay off both principal and interest from the loan and still have something left over. Higher internal rates of return occur when costs go down or returns rise.

2) 3)

4)

Here are some hints to help you get the answers quicker: 1) In question 3, remember to deduct the $3,000 down payment from the cost of the car. Enter the loan amount as a negative number in cell B58. Then enter the 5 payments you must make in succeeding years.

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2)

Question 4 is very much like Question 7 in the problem set on discounted present value. Remember to add the scrap value of the machine to the last return that you enter in year 7. In Question 8 on the lottery, you sell the winning ticket to someone else. That means the buyer return in period zero is a negative amount that is the payment to s you, plus the immediate payment when the ticket is cashed. The remaining 9 payments are entered as positive numbers.

3)

Try this exercise to get an idea how economists use the IRR to measure the value of a college education. Suppose your sister or brother is about to finish high school and is considering buying a college education (majoring in Economics?) which he/she expects to yield considerably higher incomes in future years than if he/she had just a high school education. Income will be $18,000 per year higher with the college education. If your sibling goes to college, his/her working life will start 5 years from now, say, and last for 40 years. Suppose the costs in each of the 4 years of college are $12000. The first year of costs occurs one year from now, so enter it next to Year 1. And remember to put a minus sign in front of the costs. Then enter the remaining costs and benefits next to the correct years. (The last income payment should be entered in year 44.) What is the internal rate of return on a college education for your sibling? In the computer exercise on discounted present value you gave an estimate of your real life estimated costs of your college education. Divide that total cost by 4 to get the estimated annual cost, and enter the costs in the spreadsheet. What is the expected internal rate of return on your investment if the annual income gain estimates of $15,000 per year for 40 years are correct?

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INTERNAL RATE OF RETURN Questions Note: The values of payments and costs you need to answer the questions are generated randomly by the spreadsheet when you open it. You will need to look at the questions in the spreadsheet to obtain the values. 1A) A government bond costs $_____ today, and will pay you $_____ in interest in each of the next 3 years. The first payment occurs one year from now. [Go on to 1B.] At the time you receive the last interest payment you also receive the bond's principal or face value of $10,000. 1B) What's the internal rate of return on the bond? Continuing on from the last question: 2) If you can borrow money at 4% should you buy the bond? [Yes or No.] 3A) You are considering buying a car for $_____, and need to borrow the entire amount less a down payment of $3,000. You take out a loan that you will pay back in five annual installments of $_____. [Go on to 3B.] 3B) The first loan payment is due one year from the time you get the car, the second two years hence, etc. The salesman tells you that the loan payments include both principal and interest. [Go on to 3C.] You will own the car after you make the last payment. 3C) What rate of interest are you paying on the loan? 4A) You are in the pizza business and want to buy a new pizza making machine. The machine costs $_____ today. At the end of each year you own the machine it will give you returns of $_____ after paying for maintenance and repairs. [Go on to 4B.] After you have owned the machine for 6 years you expect to sell it for scrap for $1,000. (You scrap it at the same time you get the last $_____ return.) 4B) What is the internal rate of return on the machine? Consider again the pizza machine in the last question. Would you buy the machine if you could borrow money at the following rates? [Answer Yes or No.] 5) 5% 6) 12% 7) 20%

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8A) You win a big prize in the Super Lottery. You will receive $_____ today, and then $_____ for each of the succeeding 9 years. [Go on to 8B.] 8B) There are private parties who will buy your winning ticket for a lump sum payable today. In fact, one such person offers to pay you one half of your total winnings (10 times $_____). [Go on to 8C.] Suppose you sell your ticket for the offered price. 8C) What rate of return is the buyer receiving on the investment?

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35

COMPARATIVE ADVANTAGE

Purposes: To show the difference between Absolute Advantage and Comparative Advantage in production, and to explain the implications of the Theory of Comparative Advantage for trade and exchange. In particular, you will learn why specialization in production and trade with others leads to greater world production, than if each country tries to be self-sufficient. Computer file: compad198.xls. Discussion: Here is the typical scenario. Consider the simple example of two countries, the U.S. and France, both of which can produce water and flags. We begin by assuming some labor productivities in the two countries displayed in the following table, which shows the daily output per worker in both France and the U.S. in producing the goods. Output of one more worker WATER FLAGS U.S. 10.00 10.00 FRANCE 8.00 5.00 For example, a typical U.S. worker can produce 10 flags per day, or 10 cases of bottled water per day. French workers are less productive (perhaps because they are less educated, or have less capital to work with), producing either 5 flags or 8 cases of water per day. Economists say that the U.S. has an absolute advantage in producing both goods because U.S. workers have greater output per worker, 10 versus 8 for water, and 10 versus 5 for flags. The figure at the right shows these data in graphical form. The vertical axis shows production of a typical worker in the flag industry, and the horizontal axis shows the production of a typical worker in the water industry. The straight line labeled "U.S." shows the output of a typical worker in the U.S. for the various ways that worker can be employed. For example, the point on the line shows the typical U.S. worker producing seven flags and three cases of water. (You can, if you wish, think of the point as the result of 70 percent of the workers in the U.S. being the flag industry, 35-1

and the rest being in the water industry.) You would be correct in thinking of the two straight lines in the figure as being production possibilities curves in the two countries. The line for France has a similar interpretation. A French worker who produces only water can produce 8 cases per day. The point on the line showing production of 4 water and 2.5 flags means that half the worker's effort goes into making water, and half into flags. If she worked exclusively producing flags her output would be 5 flags per day. That the U.S. has an absolute advantage in both goods shows up in the graph as the production possibilities line for the U.S. lying completely "outside" that for France. Now let's look at comparative advantage. A country has a comparative advantage in producing a good if it can produce extra units of a good at lower opportunity cost than the other country. Remember that the opportunity cost of producing of water, say, is the number of flags the country must give up in order to produce one more unit of water. In our example, the U.S. can produce one more unit of water by giving up one more flag. (Look at the figure and see that the slope of the line for U.S. production is minus one.) France, on the other hand must give up only 5/8 of a flag to get one more water. (See that the slope of the line for France is minus 5/8.) France can produce an extra unit of water more cheaply than the U.S. The opportunity cost of water in each country is the numerical value of the slope of the country's production possibilities curve. The ppc for France is flatter, with a slope of 5/8, or 0.625, than the ppc for the U.S., with a slope of 1.0. Producing another unit of water costs less in France than in the U.S. Even though French workers are less efficient than the U.S., they can produce extra water at a lower cost, and we say France has a comparative advantage in water production. And the U.S. has a comparative advantage in flag production. Unless the two production possibilities curves are parallel, a country will always have a comparative advantage in some good. And the other country will have a comparative advantage in the other good. For comparative advantage it is the slopes of the production possibilities curves that matter, not whether they cross or whether one is "outside" the other. The theory of comparative advantage states that a country should specialize in the production of the good in which it has a comparative advantage. So France should try to specialize in water production, and the U.S. in flag production. We would therefore expect France to be an exporter of water, sending some to the U.S. in exchange for flags. The countries will both want to do this it's in their mutual self-interest because doing so will mean more flags and water for everyone. The theory of comparative advantage says that even if a country is better at producing everything it will still benefit from specializing in the production of one of the goods, and engaging in trade to acquire what it desires of the other good. This is because even when one country is better at producing everything, both countries can benefit from specialization and trade because total world production of both goods will be greater. 35-2

This is a truly amazing claim if you stop to think about it. If it is true, and as we shall see, it certainly is, then even the richest country can benefit from trade with the poorest country, and both countries will benefit. Comparative advantage is rife with policy implications. It suggests, among other things, that interfering with free trade, through a system of government tariffs and quotas will reduce the mutual benefits from specialization and exchange. Economists are, for the most part, vigorous advocates of free trade! Recap 1) A country has a comparative advantage in producing a good when the country can produce the good at lower (marginal) opportunity cost. 2) A country should specialize in the production of the good in which it has a comparative advantage, and trade with other countries to achieve the desired consumption levels of goods it doesn't produce. 3) Unless the countries have exactly the same costs (their production possibilities curves are parallel), then specialization and trade will be advantageous. 4) Absolute advantage has nothing to do with whether trade takes place, or with who should specialize in producing which goods. The absolute advantage in the example simply means that the U.S. is a richer country than France. But that has no bearing on whether they can gain from trade. Answering the questions Open the Excel file compad198.xls. What you will see is the same graph and table of input productivities in the U.S. and France we used in the earlier example. In addition, you will see two more tables. The first shows productivity in the two countries in terms of input requirements (workers required per flag or per case of water) instead of the outputs per worker. But these two ways of describing productivity are linked to each other. For example, if daily output per worker in the U.S. is ten flags, then the input requirement for producing one flag is 0.1 workers. The reason for including the table with input requirements is that some instructors prefer to talk about absolute and comparative advantage in those terms. So the data are included here. You won't need the data on input requirements to get the answers in this problem set. You can experiment with the labor productivities by changing the values in the top table, and seeing what happens to the table of input requirements. The remaining table, at the bottom of the spreadsheet, shows production of the goods in the two countries. You can change the amount of water produced in each, and Excel computes the resulting amount of flags. These are the numbers you will change to show what happens to each countries production when they operate in isolation, and when they can specialize and trade with each other. 35-3

To work through the details, we need to make some simple assumptions about how much water and flags the people in France and the U.S. want to consume. Our working assumption is that people in both countries want to consume equal amounts of flags and water. For example, if the U.S. produced flags and water on its own it would want to produce half water and half flags, and be at the point 5 flags and 5 cases of water on the graph. Similarly, if the French had the same tastes, and did not trade or specialize in production, then they would want to be at the point 2.5 flags and 4 water on their production possibilities curve. One consequence of our assumption about demand is that it won't make sense to produce anything other than equal amounts of the two goods in total. This will mean, in turn, that when countries specialize in production the specialization may not be complete. Consult the Hints and tips section below to get help with this problem with this while you are answering the questions. Hints and tips: 1) Keep your eye on the main point: Specialization leads to larger world production of goods than if countries just produced and consumed in isolation. 2) For questions 7 and 8 you can use Goal Seek to make (water flags) equal to zero by changing the amount of water for each country. 3) After you answer question 12, but before you answer question 13, notice that the total number of flags produced is not equal to the number units of water produced. This shows up at the 2.00 in cell F26. So with these production levels it's not possible to meet our requirement that equal amounts of the goods are consumed. For question 13, it's easy to make the appropriate adjustment in production using Goal Seek. You'll want to make cell F26 equal to zero by changing cell D24, the U.S. production of water. Countries specialize, but not completely. The U.S. will want to produce a little bit of water, even though it specialized in the production of flags. 4) This problem set doesn't include the usual randomization of parameters that you'll find in other problem sets. Everyone's questions and answers here are the same. To try your hand at different configurations of absolute and comparative advantage try out the next problem set. _________________________ MATH MAVEN'S CORNER: The equation of the U.S. production possibilities curve is F = 10 W , where F and W are the amounts of flags and water produced, respectively. For France, the curve is F = 5 (5 / 8)W . In the absence of specialization and trade, requiring that consumption of the two goods be the same means finding where F = W crosses the production possibilities curve for a country.

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COMPARATIVE ADVANTAGE Questions For all of the questions in this problem set be sure that U.S. output per worker is 10 for both water and flags, and the French output per worker is 8 for water and 5 for flags. 1. Which country has the absolute advantage in the production of water? (Enter "France" or "U.S.") Which country has the absolute advantage in the production of flags? (Enter "France" or "U.S.") What is the opportunity cost of water (in terms of flags) in France? What is the opportunity cost of water (in terms of flags) in the U.S.? Which country has the comparative advantage in water production? (Enter "France" or "U.S.") Which country has the comparative advantage in flag production? (Enter "France" or "U.S.") The preferences of U.S. residents are to consume equal amounts of water and flags. In the absence of trade, what amount of water (or flags) will be produced in the U.S.? [Be sure this amount of water is entered in cell D24 of the worksheet.] 8. The preferences of the French are also to consume equal amounts of water and flags. In the absence of trade, what amount of water (or flags) will be produced in France? [Again, be sure the amount is entered in cell D25 of the worksheet.] 9. Under the assumptions about preferences in questions 7. and 8., what is the world production of water in the absence of trade? Continuing on from the last question, what is the world production of flags in the absence of trade? If France specializes completely in the good in which it has a comparative advantage, how much water will she produce? (Be sure this value is entered in the correct cell of the COMPAD worksheet.) 35-5

2.

3. 4. 5.

6.

7.

10.

11.

12.

Continuing on from the last question, if the U.S. specializes completely in the good in which it has a comparative advantage, how much water should it produce? (Be sure this value is entered in the correct cell of the COMPAD worksheet.) What level of U.S. water production would allow both specialization and equal flag and water consumption in the world? [Hint: Specialization is not complete here. Use Goal Seek to get total (Water Flags) equal to zero by changing the U.S. production of water.] Given equal production of water and flags for the world, what's the new world production of water after specialization (as in question 13) takes place? Given equal production of water and flags for the world, what's the new world production of flags after specialization takes place? What's the world gain in flag production after specialization? What's the world gain in water production after specialization? Suppose France gets ALL the gains from trade. [I.e., U.S. consumption after trade is 5 water and 5 flags.] What is the French consumption of water after trade? Following on from the last question, what is the French consumption of flags after trade?

13.

14.

15.

16. 17. 18.

19.

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36 MORE COMPARATIVE ADVANTAGE

Purposes: To provide a training ground for learning about the theory of comparative advantage and the gains in output that result from countries specializing in production and trading with each other. Computer file: compad298.xls. Discussion: The model of comparative advantage in this problem set is similar to the model in the last problem set, except that the numbers for labor productivity in the two countries will be different. By "playing" this problem set over and over as practice, you will be able to explore all of the possible variations in absolute and comparative advantage for the two countries. In the last problem set we considered the simple example of two countries, the U.S. and France, both of which can produce water and flags. There, the U.S. has an absolute advantage in producing both water and flags, and France had a comparative advantage in producing water. That the U.S. had an absolute advantage in production of a good showed up in the graph (see the figure at the right) as that country having a larger intercept for its production possibilities curve on that good's axis. That France had a comparative advantage in the good on the horizontal axis showed up as that country's production possibilities curve being "flatter" than the curve for the U.S. Of course, when France had the comparative advantage in water, the U.S. had to have the comparative advantage in flags. Consider now the randomly chosen labor productivities in the following table. Output of one more worker WATER FLAGS U.S. 6.17 8.78 FRANCE 8.62 6.67 Here the absolute advantage in flag production belongs to the U.S. (8.78 versus 6.67 flags per worker), while the absolute advantage in water lies with France (8.62 versus 6.17 water per 36-1

worker. The production possibilities curves for the two countries are shown in the following table. Note that the curves in this case intersect. The easiest way to explore comparative advantage is to look at the graph at the right. The country with the comparative advantage in water, the good on the horizontal axis, must be the one with the flatter production possibilities curve. In this case France has the comparative advantage in water. Therefore, the U.S. must have the comparative advantage in flags. You can compute the opportunity cost of water directly from the table. In France the cost of one more water is (6.67/8.62), or about 0.77 flags. The U.S. cost of one more water is (8.78/6.17), or about 1.42 flags. So France, with the lower opportunity cost of water, has the comparative advantage in that good. The theory of comparative advantage says that the country with the comparative advantage in a good will tend to specialize in the production of that good, and export whatever amount it doesn't want to consume in exchange for some of the other good. In this example, the theory suggests that France will specialize in the production of water, and the U.S. will specialize in the production of flags. France will export water to the U.S. in exchange for flags. Answering the questions In answering the questions in this problem set we will assume, as we did in the previous one, that the people of both France and the U.S. want to consume flags and water in equal proportions. One consequence of this is that, in some cases, specialization in production of a good will not be complete, and a country may end up producing a little bit of a good in which it doesn't have the comparative advantage. The hints below tell you how to handle cases like this. Open the Excel file compad298.xls. If at the prompt you choose "Take test," you can enter your name and an ID number that will give you a randomly selected set of data that will be the same in subsequent "plays" so long as you enter the same ID number. If you choose "Practice" you will get a different randomly selected problem set each time you play. Using the second option will allow you to explore what happens in all possible cases of absolute and comparative advantage. We strongly recommend doing the second option several times to get a feel for how the model works, even if you answer only the first 12 questions as practice.

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Hints and tips: 1) Keep your eye on the main point: A country will specialize in the good in which it has the comparative advantage. Specialization leads to larger world production of goods than if countries just produced and consumed in isolation. 2) For question 7 you can use Goal Seek to make (water flags), the value in cell F24, equal to zero by changing the amount of water (cell D24). 3) For question 8 use Goal Seek again to make (water flags), the value in cell F25, equal to zero by changing the amount of water (cell D25). 4) Questions 9 and 10 are key for understanding comparative advantage: The values asked for here are the total world production of the goods in the absence of trade. These are computed as the benchmark values against which you can measure the benefits of specialization and trade. 5) Question 11 requires some thought. If France has the comparative advantage in flags, then just enter 0 (zero) in cell D25. If she has the comparative advantage in water, enter the maximum amount of water she can produce, the amount in cell D17. 6) Question 12 presents the same difficulty. If the U.S. has the comparative advantage in flags, then just enter 0 (zero) in cell D24. If it has the comparative advantage in water, enter the maximum amount of water it can produce, the amount in cell D16. If you have gotten to this point, you can grasp the importance of the exercise, which is that total production of both goods has gone up as a result of specialization. 7) After you answer question 12 (but before you answer question 13) notice that the total number of flags produced may not equal the number units of water produced. This shows up as cell F26 being non-zero. So with the current production levels it's not possible to meet our requirement that equal amounts of the goods are consumed. You can use Goal Seek to fix this problem. Here's how to proceed. A) If France has the comparative advantage in water, and cell F26 is greater than zero, do Option 1 below. B) If France has the comparative advantage in water, and cell F26 is less than zero, do Option 2 below. C) If the U.S. has the comparative advantage in water, and cell F26 is greater than zero, do Option 2 below. D) If the U.S. has the comparative advantage in water, and cell F26 is less than zero, do Option 1 below. 36-3

Option 1: Use Goal Seek to set cell F26 to zero by changing cell D25. Option 2: Use Goal Seek to set cell F26 to zero by changing cell D24. This complication is an artifact of our assumption that consumption of the two goods is equal. It's not very important to the economics. What is important for the economics is that specialization and trade will increase the total amount of goods produced in the world. _________________________ MATH MAVEN'S CORNER: Here's a table showing productivities for labor in France and the U.S. Output of one more worker WATER FLAGS A B U.S. C D FRANCE The equation of the U.S. production possibilities curve is F = B ( B / A)W , where F and W are the amounts of flags and water produced, respectively. A is the U.S. water productivity, and B is the U.S. flag productivity. For France, the curve is F = D ( D / C )W , where D is the flag productivity and C is the water productivity. The U.S. has the absolute advantage in water if A>C, and the absolute advantage in flags if B>C. The opportunity cost of water in the U.S. is B/A, and the opportunity cost of water in France is D/C. The U.S. has the comparative advantage in water if (B/A)<(D/C). In the absence of specialization and trade, requiring that consumption of the two goods be the same means finding where F = W crosses the production possibilities curve for a country.

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MORE COMPARATIVE ADVANTAGE Questions 1. Which country has the absolute advantage in the production of water? (Enter "France" or "U.S.") Which country has the absolute advantage in the production of flags? (Enter "France" or "U.S.") What is the opportunity cost of water (in terms of flags) in France? What is the opportunity cost of water (in terms of flags) in the U.S.? Which country has the comparative advantage in water production? (Enter "France" or "U.S.") Which country has the comparative advantage in flag production? (Enter "France" or "U.S.") The preferences of U.S. residents are to consume equal amounts of water and flags. In the absence of trade, what amount of water (or flags) will be produced in the U.S.? [Be sure this amount of water is entered in cell D24 of the worksheet.] 8. The preferences of the French are also to consume equal amounts of water and flags. In the absence of trade, what amount of water (or flags) will be produced in France? [Again, be sure the amount is entered in cell D25 of the worksheet.] 9. Under the assumptions about preferences in questions 7 and 8, what is the world production of water in the absence of trade? Continuing on from the last question, what is the world production of flags in the absence of trade? If France specializes completely in the good in which she has a comparative advantage, how much water will she produce? (Be sure this value is entered in cell D25 of the COMPAD worksheet.) Continuing on from the last question, if the U.S. specializes completely in the good in which it has a comparative advantage, how much water should it produce? (Be sure this value is entered in cell D24 of the COMPAD worksheet.) 36-5

2.

3. 4. 5.

6.

7.

10.

11.

12.

13.

What level of U.S. water production would allow both specialization and equal flag and water consumption in the world? [Hint: Be sure to check out the hints and tips section of the write up.] What level of French water production would allow both specialization and equal water and flag consumption in the world? [Hint: Be sure to check out the hints and tips section of the write up.] Given equal production of water and flags for the world, what's the new world production of water after specialization (as in questions 13 and 14) takes place? Given equal production of water and flags for the world, what's the new world production of flags after specialization (as in questions 13 and 14) takes place? What's the world gain in flag production after specialization? What's the world gain in water production after specialization?

14.

15.

16.

17. 18.

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37 LABOR DEMAND FOR THE

COMPETITIVE FIRM
Purposes: To explain the factors determining a firm's demand for labor. Computer file: labcomp198.xls. Discussion: The role of the firm in the standard economics "circular flow" diagram is to be a seller of outputs and a buyer of inputs. Because the firm plays two roles, as a seller of goods and services and as a buyer of inputs, economists can formulate the problem of profit maximization in either of two ways. One is to ask how the firm can choose its quantity of output, and the other is to ask how the firm can chose the amounts of its inputs in order to maximize profits. How the competitive firm solves the problem of output choice was the topic of problem sets dealing with competitive firms in the short- and long-run. Hidden behind the scenes of that problem was the idea that when the firm chooses the best output, it must also be deciding how much of each input to use. Here we strip back the veil that disguised the input choice, and develop explicit rules for choosing inputs. Let's start by using the reasoning that led to the firm's rule for choosing output. To maximize profit the firm should produce where marginal revenue equals marginal cost. There may have been some subsidiary details added to the rule, but the basic idea is that the firm wants to produce where the addition to cost is exactly equal to the addition to revenues from producing one more unit. That marginal way of thinking is carried over here, the only difference being that the focus in on how much of an input to use, rather than on how much output to produce. Consider an apple orchard owner trying to decide what how many workers to hire in order to maximize profits from the sale of apples. The orchard owner calls you in as a consultant to help out in thinking about the issues. Here's what you need to know in order to help: Following the same logic that we developed in analyzing output choice, you should ask the owner whether hiring an additional worker would add more to the firm's receipts than to its costs. If hiring another worker adds more to receipts than costs, then profits would increase, and the worker should be hired. Now consider how you might measure these two concepts, the changes in receipts and costs from hiring another worker. If the firm is in perfect competition, a price taker, then finding 37-1

the extra cost of hiring another worker, or unit of labor, is easy it's just the money wage rate (W) that workers must be paid. For example, if the going market wage rate for orchard workers, is $70 per day, then that is the cost of hiring one more worker. Thinking about the extra revenue the firm gets from hiring another worker is a bit more complicated. When the firm hires one more worker, some addition to output occurs, which is the marginal product of labor (MP). This is not the extra revenue of the firm, however, just the physical output that results. To find the revenue we must compute how much extra revenue results from the sale of the extra output. If the firm is a perfect competitor, extra units of output can be sold at the going market price (P). So the extra receipts from employing one more worker would the marginal product of the worker times the price of output. This amount, MP times P, is called the Value of the Marginal Product (VMP) of labor. If we draw the graph of VMP and the amount of labor, the result is called the Value of Marginal Product curve for labor. It shows at each level of labor use the extra receipts to the firm from hiring another unit of labor. The Law of Diminishing Returns says that the marginal product of labor must eventually decline. This means that at more workers are hired the amount added to output from each one hired becomes less and less. Here's an example. Suppose at the current level of employment of, say, 150 workers, the marginal product of labor is 10 bushels per worker per day. And suppose that apples sell for $8.00 per bushel. Then the Value of the Marginal Product of labor is 10 bushels per worker times $8.00 per bushel, or $80 per worker. If the wage rate is $70 per worker per day, then another worker would add more to the firm's receipts ($80) than it adds to costs ($70), and more workers should be hired. Only if the orchard hires workers to the point at which VMP equals W would it be maximizing profits. We call the profit maximizing level of employment the firm's demand for labor. In the case of perfectly competitive firms, the demand curve for labor corresponds exactly to the firms VMP curve. Neat result! Tip: Notice that, in competition, the rule for hiring workers (VMP = wage), is very much like the rule for choosing output (MC = P). The difference is that the hiring rule is framed in terms of changing labor, while the output rule focuses on just that, output. On careful examination, these rules are actually equivalent ways of looking at the same thing. Since VMP equals MPP, the labor rule can be written as P = W/MP. But W/MP is just the marginal cost of output check out the units of measurement. This analysis gives economists insight into how the demand for labor is determined. On the output side, the technology, through the determination of the marginal products, and the price of output are the crucial factors. On the input side, the wage rate is central. So changes in technology and output price, because they change the Value of Marginal Product, coupled with changes in the money wage, are all you need to know to determine labor demand. 37-2

Tip: The demand for labor is sometimes called a derived demand. This is because labor is not demanded for its own sake, the way you would demand pizza or wine, but because there is an ultimate demand for goods produced with labor. In a sense, the demand for labor is dependent on or derived from the demand for goods. Answering the questions The problem set steps you through the process of understanding the underlying factors in labor demand. It begins with your visit to a hypothetical apple orchard where the owner is trying to figure out how much labor to employ. The answer, of course, is the level of employment where VMP = W. It goes on to examine a couple of very simple policy exercises involving the effects of technical change and labor training programs on labor demand. Hints and tips: 1) Finding labor demand means finding the level of labor use where VMP = W. Use Goal Seek to find the level of labor use where (VMP W) equals zero. 2) The demand for labor curve in this case is the Value of Marginal Product curve.

3) Two things can cause the demand curve for labor to shift, changes in the output price and changes in the technology. 4) Changing the money wage moves you along the demand curve for labor.

5) If perfect competition doesn't hold, for example, because there is monopoly in the output market, then things become somewhat more complicated, and the above choice rule won't apply. Or if there is more than one variable input, perhaps because the firm can also change capital, or there are several different kinds of labor with different productivities and wages, then things also become more complicated, and the VMP curve will not correspond exactly to the firm's demand for labor curve. But these are details that need not detract from the central point that firms have demand curves for labor, and those demand curves depend on technology and prices. _________________________ MATH MAVEN'S CORNER: The marginal product of labor function is MP = ( a bL)T , where L is the level of labor use, T is the technology index, and a and b are parameters that vary randomly for each version of the problem set. The Law of Diminishing Returns requires that b be positive over the relevant range of choice, so that the marginal product function is negatively sloped.

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LABOR DEMAND FOR THE COMPETITIVE FIRM Questions 1. You are visiting the proprietor of a local apple orchard. The owner tells you that he is currently employing 100 workers to maintain the orchard and pick the fruit. When the proprietor hired his one-hundredth worker (as opposed to hiring the 99th), how much was output increased as a result? 2. Make sure all variables are at their baseline values. When the orchard owner hired his one-hundredth worker, by how much did his receipts from sales change? 3) Suppose the money wage of orchard workers is $60 per day. What is the cost of the owner hiring the last (one-hundredth) worker? 4) What was the change in profits to the orchard owner due to hiring that last (onehundredth) worker? 5) The owner then admits to you that he is considering changing the number of people he hires. Should he change the number he hires? (Enter "yes" or "no".) 6) You admit to the owner that you are an economics student, and can actually advise him on the exact number of workers he should be hiring. How many workers should he be employing? 7) And as another way of putting the last question, how many workers should the orchard owner DEMAND? 8) 9) Now suppose the wage rate falls to $50 per day. What's the firm's DEMAND for labor? And finally, if the wage falls to $20 per day, what's the firm's DEMAND for labor?

[THE POINT: The value of marginal product curve IS the firm's demand curve for labor in this case. Changes in the wage rate move you along the demand (VMP) curve.] 10) For this question make sure that all variables are set to their baseline values and the wage rate is $50 per day. Now suppose that the orchard owner discovers that the price of apples rises to $12 per bushel. What is the level of labor demand with the higher price of apples? [THE POINT: An increase in the price of the firm's output causes its demand (VMP) curve to shift.]

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11A) Again, set all variables to their baseline values, and set the wage rate to $50 per day. Now suppose that the orchard owner tells you about a new technology that has become available for orchard management. [Go on to 11B.] 11B) The result of adopting the new methods would be to raise the marginal product of labor for the orchard. To see the effect of the new technology, set the technology index to 1.2. What is the change in labor demand compared to the old technology? [THE POINT: An improvement in technology raises the demand for labor, leading to an increase in employment.] 12A) Set all variables to their baseline values, and set the wage rate to $50 per day. You talk with the orchard owner about his plan to provide on the job training sessions for his workers. He thinks that the training will cause the marginal product of labor in his firm to rise. [Go on to 12B.] 12B) Actually the training program will raise the technology index to 1.1. Make a prediction about the effect of the training program on the firm's employment. How many MORE workers will the owner hire? [THE POINT: Training will increase the demand for labor if it raises the marginal product of labor.]

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