PROBLEM SET

Chapter 1.1 – Ten principles of Economics

1. Describe some of the trade-offs faced by each of the following:
a. a family deciding whether to buy a new car
- A family deciding whether to buy a new car faces a trade-off between the cost of the car and
other things they might want to buy. For example, buying the car might mean they must give
up going on vacation for the next two years. So, the real cost of the car is the family’s
opportunity cost in terms of what they must give up.
b. a member of Congress deciding how much to spend on national parks
- For a member of Congress deciding whether to increase spending on national parks, the trade-
off is between
a bachelor’s degree and the benefits of an increased education (such as higher future earnings
and greater knowledge)
3. You were planning to spend Saturday working at your part-time job, but a friend asked you to
go skiing. What is the true cost of going skiing? Now suppose you had been planning to spend
the day studying at the library. What is the cost of going skiing in this case? Explain.
- If you are thinking of going skiing instead of working at your part-time job, the cost of skiing
includes its monetary parks and other spending items or tax cuts. If more money goaes into the
park system, that may mean less spending on national defense or on the police force. Or instead
of spending more money on the park system, taxes could be reduced.
c. a company president deciding whether to open a new factory
- When a company president decides whether to open a new factory, the decision is based on
whether the new factory will increase the firm’s profits compared to other alternatives. For
example, the company could upgrade existing equipment or expand existing factories. The
bottom line is: Which method of expanding production will increase profit the most?
d. a professor deciding how much to prepare for class
- In deciding how much to prepare for class, a professor faces a trade-off between the value of
improving the quality of the lecture compared to other things she could do with her time, such
as working on additional research or enjoying some leisure time.
e. a recent college graduate deciding whether to go to graduate school
- In deciding whether to go to graduate school, the student faces a trade-off between his
possible earnings with and time costs, which includes the opportunity cost of the wages you are
giving up by not working. If the choice is between skiing and going to the library to study, then
the cost of skiing is its monetary and time costs including the cost of possibly earning lower
grades in your courses.
5. The company that you manage has+ invested$5 million in developing a new product, but the
development is not quite finished. At a recent meeting, your salespeople report that the
introduction of competing products has reduced the expected sales of your new product to $3
million. If it would cost $1 million to finish development and make the product, should you go
ahead and do so? What is the most that you should pay to complete development?
- The fact that you have already sunk $5 million is not relevant to your decision anymore,
because that money is gone. What matters now is the chance to earn profits at the margin. If
you spend another $1 million and can generate sales of $3 million, you’ll earn $2 million in
marginal profit, so you should do so. You are right to think that the project has lost a total of $3
million ($6 million in costs and only $3 million in revenue) and you should not have started it.
However, if you do not spend the additional $1 million, you will not have any sales and your
losses will be $5 million. So what matters here is trying to minimize your loss. In fact, you
would pay up to $3 million to complete development; any more than that, and you will not be
increasing profit at the margin.
Chapter 1.2 – Thinking Like an Economist
1. Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of
goods and services and the flow of dollars for each of the following activities.
a. Selena pays a storekeeper $1 for a
quart of milk.
b. Stuart earns $4.50 per hour working
at a fast food restaurant.
c. Shanna spends $30 to get a haircut.
d. Sally earns $10,000 from her 10
percent owner ship of Acme
Industrial.

5. Classify the following topics as

relating to microeconomics or macroeconomics.
a. a family’s decision about how much income to save  Micro
b. the effect of government regulations on auto emissions  Micro
c. the impact of higher national saving on economic growth  Macro
d. a firm’s decision about how many workers to hire  Micro
e. the relationship between the inflation rate and changes in the quantity of money  Macro
6. Classify each of the following statements as positive or normative. Explain.
a. Society faces a short-run trade-off between inflation and unemployment.
 P-s because it deals with how the economy is, not how it should be.
b. A reduction in the rate of money growth will reduce the rate of inflation.
 P-s, economists have found that money growth and inflation are very closely related.
c. The Federal Reserve should reduce the rate of money growth.
 N-s because it states an opinion about something that should be done, not how the world is.
d. Society ought to require welfare recipients to look for jobs.
 N-s because It does not state a fact about how the world is.
e. Lower tax rates encourage more work and more saving.
 P-s, the statement reflects how the world is.
Chapter 2.1 – Interdepence and the Gains from Trade
Chapter 2.2 – The Market Forces of Supply and Demand
4. Consider the markets for film streaming services, TV screens, and tickets at movie theaters.
a. For each pair, identify whether they are complements or substitutes:
• Film streaming and TV screens
• Film streaming and movie tickets
• TV screens and movie tickets
- DVDs and TV screens are likely to be complements because you cannot watch a DVD without
a television
- DVDs and movie tickets are likely to be substitutes because a movie can be watched at a
theater or at home.
- TV screens and movie tickets are likely to be substitutes
for the same reason.
b. Suppose a technological advance reduces the cost of
manufacturing TV screens. Draw a diagram to show
what happens in the market for TV screens.
- The technological improvement would reduce the cost
of producing a TV screen, shifting the supply curve to
the right. The demand curve would not be affected. The result is that the E P will fall, while the
EQ will rise.
6. Using supply-and-demand diagrams, show the effects of the following events on the market
for sweatshirts.
a. A hurricane in South Carolina damages the cotton crop.
- When a hurricane in South Carolina damages the cotton crop,
it raises input prices for producing sweatshirts. As a result, the
supply of sweatshirts shifts to the left, as shown in Figure 22.
The new equilibrium price is higher and the new equilibrium
quantity of sweatshirts is lower.
b. The price of leather jackets falls
- A decline in the price of
leather jackets leads more
people to buy leather jackets,
reducing the demand for sweatshirts.
The result, shown in Figure 23, is a decline in both the
equilibrium price and quantity of sweatshirts.

c. All colleges require morning exercise in appropriate attire.

- The effects of colleges requiring students to engage in morning
exercise in appropriate attire raises the demand for sweatshirts, as
shown in Figure 24. The result is an increase in both the
equilibrium price and quantity of sweatshirts.

d. New knitting machines are invented.

- The invention of new knitting machines increases the supply of sweatshirts. As Figure 25
shows, the result is a reduction in the equilibrium price and an increase in the equilibrium
quantity of sweatshirts.
10. The market for pizza has the following demand and supply schedules:

a. Graph the demand and supply curves. What are the equilibrium price and quantity in this
market?
- Quantity supplied equals quantity demanded at a price of $6 and quantity of 81 pizzas
b. If the actual price in this market were above the equilibrium price, what would drive the
market toward the equilibrium?
- If the price were greater than $6, quantity supplied would exceed quantity demanded, so
suppliers would reduce the price to gain sales.
c. If the actual price in this market were below the equilibrium price, what would drive the
market toward the equilibrium?
- If the price were less than $6, quantity demanded would exceed quantity supplied, so
suppliers could raise the price without losing sales. In both cases, the price would continue to
adjust until it reached $6, the only price at which there is neither a surplus nor a shortage.
Chapter 2.3 – Elasticity and its Application
2. Suppose that business travelers and vacationers have the following demand for airline tickets
from Chicago to Miami:
a. As P of tickets rises from $200 to $250, what is the P elasticity of D for (i) business travelers
and (ii) vacationers? (Use the midpoint method in your calculations.)
- For business travelers, the P elasticity of D when the price of tickets rises $200  $250 is
(2,000-1,900)/1,950÷(250-200)/225=0.5/0.22=0.23
- For vacationers, the price elasticity of demand when the price of tickets rises $200  $250 is
(800-600)/700÷(250-200)/225=0.29/0.22=1.32
b. Why might vacationers and business travelers have different elasticities?  Price elasticity is
higher when close substitutes are available.
- The P elasticity of D for vacationers is higher than the elasticity for business travelers because
vacationers can choose more easily a different mode of transportation (like driving or taking
the train). They may also choose not to travel at all. Business travelers are less likely to do so
because time is more important to them and their schedules are less adaptable.
8. The New York Times reported (Feb. 17, 1996) that subway ridership declined after a fare
increase: “There were nearly four million fewer riders in December 1995, the first full month
after the price of a token increased 25 cents to $1.50, than in the previous December, a 4.3%
decline.”
a. Use these data to estimate the price elasticity of demand for subway rides.
- %ΔP (using the midpoint formula) is (1.5-0.25)/0.875×100%=142,86%.
Therefore, the P elasticity of D is 4.3/142.86 = 0.03, which is very inelastic.
b. What happens to the Transit Authority’s revenue when the fare rises?
- Because the demand is inelastic, the Transit Authority's revenue rises when the fare rises.
c. Why might your estimate of the elasticity be unreliable?
- The elasticity estimate might be unreliable because it is only the first month after the fare
increase. As time goes by, people may switch to other means of transportation in response to the
price increase. So the elasticity may be larger in the long run than it is in the short run.
10. Consider public policy aimed at smoking.
a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of
cigarettes currently costs $2 and the government wants to reduce smoking by 20 percent, by
how much should it increase the price?
- With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20%
requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes currently $2,
this would require an increase in the price to $3.33 a pack using the midpoint method (note that
($3.33 – $2)/$2.67 = .50).
b. If the government permanently increases the price of cigarettes, will the policy have a larger
effect on smoking one year from now or five years from now?
- The policy will have a larger effect five years from now than it does one year from now. The
elasticity is larger in the long run, because it may take some time for people to reduce their
cigarette usage. The habit of smoking is hard to break in the short run.

c. Studies also find that teenagers have a higher price elasticity of demand than adults. Why
might this be true?
- Because teenagers do not have as much income as adults, they are likely to have a higher price
elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more
difficult to reduce their quantity demanded in response to a higher price.
Chapter 2.4 – Supply, Demand, and Government Policies
2. The government has decided that the free market price of cheese is too low.
a. Suppose the government imposes a binding price
floor in the cheese market. Draw a supply-and-demand
diagram to show the effect of this policy on the price of
cheese and the quantity of cheese sold. Is there a
shortage or surplus of cheese?
- The imposition of a binding price floor in the cheese
market is shown in Figure 4. In the absence of the
price floor, the price would be P1 and the quantity
would be Q1. With the floor set at Pf, which is greater
than P1, the quantity demanded is Q2, while quantity
supplied is Q3, so there is a surplus of cheese in the
amount Q3 – Q2.
b. Farmers complain that the price floor has reduced their total revenue. Is this possible?
Explain.
- The farmers’ complaint that their total revenue has declined is correct if demand is elastic.
With elastic demand, the percentage decline in quantity would exceed the percentage rise in
price, so total revenue would decline quantity demanded
c. In response to farmers’ complaints, the government agrees to purchase all the surplus cheese
at the price floor. Compared to the basic price floor, who benefits from this new policy? Who
loses?
- If the government purchases all the surplus cheese at the price floor, producers benefit and
taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue would
increase substantially. However, consumers would buy only quantity Q2 of cheese, so they are
in the same position as before. Taxpayers lose because they would be financing the purchase of
the surplus cheese through higher taxes.
4. Suppose the federal government requires beer drinkers to pay a $2 tax on each case of beer
purchased. (In fact, both the federal and state governments impose beer taxes of some sort.)
a. Draw a supply-and-demand diagram of the market for beer
without the tax. Show the price paid by consumers, the price
received by producers, and the quantity of beer sold. What is the
difference between the price paid by consumers and the price
received by producers?
- Figure 5 shows the market for beer without the tax. The
equilibrium price is P1 and the equilibrium quantity is Q1. The
price paid by consumers is the same as the price received by
producers.
b. Now draw a supply-and-demand diagram for the beer market with the tax. Show the price
paid by consumers, the price received by producers, and the quantity of beer sold. What is the
difference between the price paid by consumers and the price received by producers? Has the
quantity of beer sold increased or decreased?
- When the tax is imposed, it drives a wedge of $2 between
supply and demand, as shown in Figure 6. The price paid by
consumers is P2, while the price received by producers is P2
– $2. The quantity of beer sold declines to Q2.

9. The U.S. government administers two programs that affect the market for cigarettes. Media
campaigns and labeling requirements are aimed at making the public aware of the dangers of
cigarette smoking. At the same time, the Department of
Agriculture maintains a price-support program for tobacco
farmers, which raises the price of tobacco above the
equilibrium price.
a. How do these two programs affect cigarette consumption?
Use a graph of the cigarette market in your answer.
- Programs aimed at making the public aware of the dangers of smoking reduce the demand for
cigarettes, shown in Figure 10 as a shift from demand curve D1 to D2. The price support
program increases the price of tobacco, which is the main ingredient in cigarettes. As a result,
the supply of cigarettes shifts to the left, from S1 to S2. The effect of both programs is to reduce
the quantity of cigarette consumption from Q1 to Q2.
b. What is the combined effect of these two programs on the price of cigarettes?
- The combined effect of the two programs on the price of cigarettes is ambiguous. The
education campaign reduces demand for cigarettes, which tends to reduce the price. The
tobacco price supports raising the cost of production of cigarettes, which tends to increase the
price. The end result on price depends on the relative sizes of these two effects.
c. Cigarettes are also heavily taxed. What effect does this tax have on cigarette consumption?
- The taxation of cigarettes further reduces cigarette consumption, because it increases the price
to consumers. As shown in the figure, the quantity falls to Q3.
Chapter 2.5 – Consumers, Producers, and the Efficiency of Markets
1. Medusa buys an iPod for $120 and gets a consumer surplus of $80.
a. What is her willingness to pay?
- Consumer surplus is equal to willingness to pay minus the price paid. Therefore, Medusa's
willingness to pay must be $200 ($120 + $80).
b. If she had bought the iPod on sale for $90, what would her consumer surplus have been?
- Her consumer surplus at a price of $90 would be $200 − $90 = $110.
c. If the price of an iPod were $250, what would her consumer surplus have been?
- If the price of an iPod was $250, Medusa would not have purchased one because the price is
greater than her willingness to pay. Therefore, she would receive no consumer surplus.
10. Your friend is considering cell phone ring two service providers. Provider A charges $120
per month for the service regardless of the number of phone calls made. Provider B does not
have a fixed service fee but instead charges $1 per minute for calls. Your friend’s monthly
demand the equation QD =150 - 50 gives minutes of calling. P, where P is the price of a
minute.
a. With each provider, what is the cost to your friend of an extra minute on the phone?
- With Provider A, the cost of an extra minute is $0. With Provider B, the cost of an extra
minute is $1.
b. In light of your answer to (a), how many minutes would your friend talk on the phone
with each provider?
- With Provider A, my friend will purchase 150 minutes [= 150 – (50)(0)]. With Provider B, my
friend would purchase 100 minutes [= 150 – (50)(1)].
c. How much would he end up paying each provider every month?
- With Provider A, he would pay $120. The cost would be $100 with Provider B

d. How much consumer surplus would he obtain with

each provider? (Hint: Graph the demand curve and recall
the formula for the area of a triangle.)
- Figure 17 shows the friend’s demand. With Provider A,
he buys 150 minutes and his consumer surplus is equal
to (1/2)(3)(150) – 120 = 105. With Provider B, his
consumer surplus is equal to (1/2)(2)(100) = 100.
e. Which provider would you recommend that your
friend choose? Why?
- I would recommend Provider A because he receives
greater consumer surplus.
Chapter 3 – The Theory of Consumer Choice
Chapter 4 – The Costs of Production
4. Nimbus, Inc., makes brooms and then sells them
door-to-door. Here is the relationship
between the number of workers and Nimbus’s
output in a given day:
a. Fill in the column of marginal products. What
pattern do you see? How might you
explain it?
- See the table for marginal products. Marginal
product rises at first, then declines because of
diminishing marginal product.
b. A worker costs $100 a day, and the firm has fixed
costs of $200. Use this information to
fill in the column for total cost.  See the table for total cost.
c. Fill in the column for average total cost. (Recall that ATC = TC/Q.) What pattern do
you see?
- See the table for average total cost. Average total cost is U-shaped. When quantity is low,
average total cost declines as quantity rises; when quantity is high, average total cost rises as
quantity rises.
d. Now fill in the column for marginal cost. (Recall that MC = ∆TC/∆Q.) What pattern do
you see?
- See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply as output
increases. This is due to diminishing marginal product.
e. Compare the column for marginal product and the column for marginal cost. Explain
the relationship.  When marginal product is rising, marginal cost is falling, and vice versa.
f. Compare the column for average total cost and the column for marginal cost. Explain
the relationship.
- When marginal cost is less than average total cost, average total cost is falling; the cost of the
last unit produced pulls the average down. When marginal cost is greater than average total
cost, average total cost is rising; the cost of the last unit produced pushes the average up.
The table of costs
Worker Outpu Marginal Product Total Average Total Cost Marginal Cost
t Cost
0 0 --- $200 --- ---
1 20 20 300 $15.00 $5.00
2 50 30 400 8.00 3.33
3 90 40 500 5.56 2.50
4 120 30 600 5.00 3.33
5 140 20 700 5.00 5.00
6 150 10 800 5.33 10.00
7 155 5 900 5.81 20.00

6. Consider the following cost information for a pizzeria:

a. What is the pizzeria’s fixed cost?

- The fixed cost is $300, because fixed cost equals total cost minus variable cost. At an output of
zero, the only costs are fixed cost.
b. Construct a table in which you calculate the marginal cost per dozen pizzas
using the information on total cost. Also, calculate the marginal cost per dozen
pizzas using the information on variable cost. What is the relationship between
these sets of numbers? Comment.
Quantity Total Variable Marginal Cost (using total Marginal Cost
Cost Cost cost)
(using variable
cost)
0 $300 $0 --- ---
1 350 50 $50 $50
2 390 90 40 40
3 420 120 30 30
4 450 150 30 30
5 490 190 40 40
6 540 240 50 50
Marginal cost equals the change in total cost for each additional unit of output. It is also equal to
the change in variable cost for each additional unit of output. This occurs because total cost
equals the sum of variable cost and fixed cost and fixed cost does not change as the quantity
changes. Thus, as quantity increases, the increase in total cost equals the increase in variable
cost.
Chapter 5 – Firms in Competitive Markets
4. Consider total cost and total revenue given in the
following table:

Here is the table showing costs, revenues, and profits:

Quantit Total Cost Marginal Cost Total Marginal Revenue Profit
y Revenue
0 $8 --- $0 --- $-8
1 9 $1 8 $8 -1
2 10 1 16 8 6
3 11 1 24 8 13
 4 13 2 32 8 19
5 19 6 40 8 21
6 27 8 48 8 21
7 37 10 56 8 19

a. Calculate profit for each quantity. How much should the firm produce to maximize profit?
- The firm should produce five or six units to maximize profit.
b. Calculate marginal revenue and marginal cost for each quantity. Graph them. (Hint:
Put the points between whole numbers. For example, the marginal cost between 2 and 3
should be graphed at 21⁄2.) At what quantity do these curves cross? How does this relate
to your answer to part (a)?
- Marginal revenue and marginal cost are graphed in Figure 4. The curves cross at a quantity
between five and six units, yielding the same answer as in Part (a).
c. Can you tell whether this firm is in a competitive industry? If so, can you tell
whether the industry is in a long-run equilibrium?
c. This industry is competitive because marginal
revenue is the same for each quantity. The industry is
not in long-run equilibrium, because profit is not
equal to zero.

8. A profit-maximizing firm in a competitive market is currently producing 100 units of

output. It has average revenue of $10, average total cost of $8, and fixed costs of $200.
a. What is its profit?
- Profit is equal to (P – ATC) × Q. Price is equal to AR. Therefore, profit is ($10 – $8) × 100 =
$200.
b. What is its marginal cost?
- For firms in perfect competition, marginal revenue and average revenue are equal. Since
profit maximization also implies that marginal revenue is equal to marginal cost, marginal cost
must be $10.
c. What is its average variable cost?
- Average fixed cost is equal to AFC /Q which is $200/100 = $2. Since average variable cost is
equal to average total cost minus average fixed cost, AVC = $8 − $2 = $6.
d. Is the efficient scale of the firm more than, less than, or exactly 100 units?
- Since average total cost is less than marginal cost, average total cost must be rising.
Therefore, the efficient scale must occur at an output level less than 100.

Chapter 6 – Monopoly
1. A publisher faces the following demand schedule for the next novel from one of its popular
authors: The author is paid $2 million to write the book, and the marginal cost of publishing the
book is a constant $10 per book.

a. Compute total revenue, total cost, and profit at each quantity. What quantity would a
profit-maximizing publisher choose? What price would it charge?
- A profit-maximizing publisher would choose a quantity of 400,000 at a price of $60 or a
quantity of 500,000 at a price of $50; both combinations would lead to profits of $18 million.
b. Compute marginal revenue. (Recall that MR = ΔTR/ΔQ.) How does marginal
revenue compare to the price? Explain.
- Marginal revenue is always less than price. Price falls when quantity rises because the demand
curve slopes downward, but marginal revenue falls
even more than price because the firm loses
revenue on all the units of the good sold when it
lowers the price.
c. Graph the marginal-revenue, marginal-cost, and
demand curves. At what quantity do the
marginal-revenue and marginal-cost curves cross?
What does this signify.
Figure 2 shows the marginal-revenue, marginal-
cost, and demand curves. The marginal-revenue and
marginal-cost curves cross between quantities of 400,000 and 500,000. This signifies that the
firm maximizes profits in that region.
d. In your graph, shade in the deadweight loss. Explain in words what this means.
- The area of deadweight loss is marked “DWL” in the figure. Deadweight loss means that the
total surplus in the economy is less than it would be if the market were competitive, because the
monopolist produces less than the socially efficient level of output.
e. If the author were paid $3 million instead of $2 million to write the book, how would this
affect the publisher’s decision regarding what price to charge? Explain.
- If the author were paid $3 million instead of $2 million, the publisher would not change the
price, because there would be no change in marginal cost or marginal revenue. The only thing
that would be affected would be the firm’s profit, which would fall.
f. Suppose the publisher was not profit maximizing but was concerned with maximizing
economic efficiency. What price would it charge for the book? How much profit would it make
at this price?
- To maximize economic efficiency, the publisher would set the price at $10 per book, because
that is the marginal cost of the book. At that price, the publisher would have negative profits
equal to the amount paid to the author.
The following table shows revenue, costs, and profits, where quantities are in thousands, and
total revenue, total cost, and profit are in millions of dollars:
Price Quantity Total Revenue Marginal Revenue Total Profit
Cost
(1,000s)
$100 0 $0 ---- $2 $-2
90 100 9 $9 3 6
80 200 16 7 4 12
70 300 21 5 5 16
60 400 24 3 6 18
50 500 25 1 7 18
40 600 24 -1 8 16
30 700 21 -3 9 12
20 800 16 -5 10 6
10 900 9 -7 11 -2
0 1,000 0 -9 12 -12
5. Larry, Curly, and Moe run the only saloon in town. Larry wants to sell as many drinks as
possible without losing money. Curly wants the saloon to bring in as much revenue as possible.
Moe wants to make the largest possible profits. Using a single diagram of the saloon’s demand
curve and its cost curves, show the price and quantity combinations favored by each of the three
partners. Explain.
- Larry wants to sell as many drinks as possible without
losing money, so he wants to set quantity where price
(demand) equals average total cost, which occurs at
quantity QL and price PL in Figure 6. Curly wants to
bring in as much revenue as possible, which occurs
where marginal revenue equals zero, at quantity QC and
price PC. Moe wants to maximize profits, which occurs
where marginal cost equals marginal revenue, at
quantity QM and price PM.

Chapter 7.1 - Monopolistic Competition