Upcoming SlideShare
×

# Me11e 12

1,753

Published on

0 Likes
Statistics
Notes
• Full Name
Comment goes here.

Are you sure you want to Yes No
• Be the first to comment

• Be the first to like this

Views
Total Views
1,753
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
32
0
Likes
0
Embeds 0
No embeds

No notes for slide

### Me11e 12

1. 1. CHAPTER 9—MONOPOLY AND MONOPSONY MULTIPLE CHOICE1. In long-run equilibrium, monopoly prices are set a level where: a. price exceeds marginal revenue.b.industry demand equals industry supply.c.industry demand is less than industry supply.d.price exceeds average revenue. ANS: A For a monopoly in equilibrium: a.MR = MCb.MC ≤ ACc.MR ≤ ACd.P ≥ AC ANS: A The level of competition in a given market tends to increase if: a.minimum efficient scale of firms increases.b.the number of substitutes increase.c.significant barriers to exit are imposed.d.the number of potential entrants decreases. ANS: B A monopsony is a market with: a.many sellers.b.one buyer.c.many buyers.d.one seller. ANS: B Government-mandated wage arbitration for employers can enhance efficiency when the labor market involves: a.monopoly.b.excess seller power.c.perfect competition.d.monopsony. ANS: D In monopoly competitive markets, profits are maximized when: a.MC = ACb.P > ACc.MR = MCd.MR = P ANS: C A market with one buyer is called: a.monopsony.b.monopoly.c.perfect competition.d.oligopsony. ANS: A The demand curve for a unique product without substitutes is: a.upward sloping.b.downward sloping.c.horizontal.d.vertical. ANS: D A monopolist maximizes profits by producing a level of output where: a.P = ACb.P > MCc.P < MCd.P = MC ANS: B In the short run, a monopolist will: a.shut down if price equals average total cost.b.shut down if price is less than average total cost.c.shut down if price is less than average variable cost.d.never shut down.
2. 2. ANS: CAt the profit maximizing level of output for a monopolist:a.P = AR and AR = ACb.P = MC and MR > MCc.P > MC and MR = MCd.P = MR andAC = MCANS: CEconomic agents that have countervailing power in transactions with monopolists are:a.other monopolists.b.perfect competitors.c.monopsonists.d.individual consumers.ANS: CHolding supply conditions constant, the costs of regulation fall wholly on producers when:a.εP = b.εP ≥ 1c.εP = 1d.εP = 0ANS: AUtility price and profit regulation is based on the perception of:a.externalities.b.diseconomies of scale.c.natural monopoly.d.consumers surplus.ANS: CA natural monopoly exists if:a.marginal revenue is falling as output expands.b.price equals average cost.c.average costfalls as output expands.d.marginal revenue equals marginal cost.ANS: CGovernment seeks to aid economic efficiency in the case of natural monopoly through:a.creating government-financed corporations to compete with the naturalmonopolist.b.subsidizing competitors.c.price regulation.d.breaking the natural monopolistup into smaller competitors.ANS: CWindfall profit is economic profit due to:a.superior operating efficiency.b.innovation.c.economies of scale.d.unexpected orunwarranted good fortune.ANS: DThe Sherman Act specifically prohibits:a.monopolizing.b.asset acquisitions that reduce competition.c.pricediscrimination.d.mergers that reduce competition.ANS: AThe Clayton Act specifically prohibits:a.monopolies.b.asset acquisitions that reduce competition.c.pricediscrimination.d.conspiracies in restraint of trade.ANS: CThe Celler-Kefauver Act specifically prohibits:a.mergers that reduce competition.b.asset acquisitions that reduce competition.c.tyingcontracts that reduce competition.d.conspiracies in restraint of trade.
3. 3. ANS: BThe F.T.C. enforces antitrust laws by:a.sentencing individuals up to three years imprisonment.b.awarding tripledamages.c.issuing cease and desist orders.d.imposing fines on corporations up to \$1million.ANS: CThe capture theory states that:a.certain industries must be captured by government regulators to promote economicefficiency.b.some industries actively seek regulation to limit competition and obtaingovernment subsidies.c.monopoly profits can be captured by society through governmentregulation.d.natural monopolists tend to capture the entire market.ANS: BTo the extent that costs exceed benefits, a given mode of regulation is:a.inequitable.b.efficient.c.inefficient.d.fair.ANS: CThe view of regulation as a government-imposed means of private-market control iscalled:a.capture theory.b.public choice theory.c.public interest theory.d.none of these.ANS: CIn monopoly markets, market demand is:a.perfectly inelastic with respect to price.b.perfectly elastic with respect to price.c.elasticwith respect to price.d.inelastic with respect to price.ANS: CPROBLEMPrice/Output Determination. Sun City, Arizona, a retirement community that featuresfull-service living arrangements, is considering two proposals to provide lawn-care toelderly residents. First, a national lawn-care firm has offered to purchase the citys lawn-care equipment at an attractive price in return for an exclusive franchise on residentialservice. A second proposal would allow several small companies to enter the businesswithout any exclusive franchise agreement or competitive restrictions. Under this plan,individual companies would bid for the right to provide service in a given neighborhood.The city would then allocate business to the lowest bidder.The city has conducted a survey of Sun City residents to estimate the amount they wouldbe willing to pay for various amounts of lawn service. The city has also estimated the totalcost of service per resident. Service costs are expected to be the same whether or not anexclusive franchise is granted. A.Use the indicated price and total cost data to complete the following table.Hours of Lawn Care per MonthPrice per Hour
4. 4. Total Revenue Marginal Revenue Total Cost MarginalCost0\$22.50\$ 0.00121.7521.00221.0040.50320.2558.50419.5075.75518.7592.25618.00107.25717.25120.75816.50132.00915.75150.001015.00180.00B.Determine price and thelevel of service if competitive bidding results in a perfectly competitive price/outputcombination.C.Determine price and the level of service if the city grants a monopolyfranchise.ANS: A.Hours of Lawn Care per MonthPrice per Hour Total Revenue Marginal Revenue Total Cost MarginalCost0\$22.500.00----\$ 0.00----121.75\$ 21.75\$21.7521.0021.00221.0042.0020.2540.5019.50320.2560.7518.7558.5018.00419.5078.0017.2575.7517.25518.7593.7515.7592.2516.50618.00108.0014.25107.2515.00717.25120.7512.75120.7513.50816.50132.0011.25132.0011.25915.75141.759.75150.0018.001015.00150.008.25180.0030.00B.In a perfectlycompetitive industry, MR = MC and P = AC so the optimal activity level occurs at Q = 8hours of lawn care per month and MR = MC = \$11.25 and P = AC = \$16.50. Note for Q >8, P = MR < MC and losses would be incurred.C.A monopoly will maximize profits bysetting MR = MC. Here, MR = MC = \$5.75 at Q = 4 hours of lawn care per month and P =\$19.50 per hour.Price/Output Determination. Tallahassee Cars Unlimited, Inc., a rapidly expanding newentrant to this metropolitan area, is considering two proposals for the provision of itscosmetic detailing of cars (washing, waxing, polishing, engine cleaning, etc.). First, alarge janitorial agency with some experience in the detailing of cars has offered topurchase the business detailing equipment in return for an exclusive franchise. A secondproposal would allow several small contractors to enter the business without any exclusivefranchise agreement or competitive restrictions. Under this plan, individuals would bid forthe right to provide service on groups of cars as they were delivered to the lot, presumablybased on how busy they were at the time. The car lot would then allocate business to thelowest bidder.TCU has conducted a study of its past sales records and the amount of detailing spent oneach car, and the premium over book value recouped in the sale to estimate the amountthey would be willing to pay for various amounts of detailing. The car lot has alsoestimated the total cost of service per car. Service costs are expected to be the samewhether or not an exclusive franchise is granted. To instigate bidding, TCU guarantees thewinner of any bid a minimum per car, whether or not the service is used.
5. 5. A.Use the indicated price and cost data to complete the following table.Hours of Detailing per CarPrice per Hour Total Revenue Marginal Revenue Total Cost MarginalCost0\$24.00\$ 0.00123.4018.00222.8036.00322.2054.00421.6072.00521.0090.00620.40108.00719.80126.00819.20144.00918.60162.001018.00180.00B.Determine price and thelevel of service if competitive bidding results in a perfectly competitive price/outputcombination.C.Determine price and the level of service if the car lot grants a monopolyfranchise.ANS: A.Hours of Detailing per CarPrice per Hour Total Revenue Marginal Revenue Total Cost MarginalCost0\$24.00\$ 0.00--\$ 0.00--123.4023.40\$23.4018.00\$18.00222.8045.6022.2036.0018.00322.2066.6021.0054.0018.00421.6086.4019.8072.0018.00521.00105.0018.6090.0018.00620.40122.4017.40108.0018.00719.80138.6016.20126.0018.00819.20153.6015.00144.0018.00918.60167.4013.80162.0018.001018.00180.0012.60180.0018.00B.In a perfectly competitive industry, P = MR sothe optimal activity level occurs where P = MC. Here, P = MC = \$18 at Q = 10 hours ofdetailing per car, and profits equal zero.C.A monopoly will maximize profits by settingMR = MC. Here, MR = MC = \$18.60 > \$18 at Q = 5 hours of detailing per car and P =\$21 per hour. Note that MR < MC when Q > 5.Price/Output Determination. The City of Ithaca, New York is considering two proposalsto provide its city government the service of computer maintenance. First, a nationalcomputer maintenance and sales franchise has offered to purchase the citys computerequipment at an attractive price in return for an exclusive franchise on computermaintenance. A second proposal would allow several small companies to provide theservice without any exclusive franchise agreement or competitive restrictions. Under thisplan, individual companies would bid for the right to provide service in a givendepartment. The city would then allocate business to the lowest bidder.The city has conducted a survey of its department to estimate the amount they would bewilling to pay for various amounts of computer maintenance. The city has also estimated
6. 6. the total cost of service per department. Service costs are expected to be the same whetheror not an exclusive franchise is granted. A.Use the indicated price and cost data to complete the following table.Hours of Computer Maintenance per Month Price per Hour Total Revenue Marginal Revenue Total Cost MarginalCost0\$75.00\$0--172.50\$50.00270.0050.00367.5050.00465.0050.00562.5050.00660.0050.00757.5050.00855.0050.00952.5050.001050.0050.00B.Determine price and the level of service ifcompetitive bidding results in a perfectly competitive price/outputcombination.C.Determine price and the level of service if the city grants a monopolyfranchise.ANS: A.Hours of Computer Maintenance per Month Price per Hour Total Revenue Marginal Revenue Total Cost MarginalCost0\$75.00\$ 0--\$ 0--172.5072.5072.5050.00\$50.00270.00140.0067.50100.0050.00367.50202.5062.50150.0050.00465.00260.0057.50200.0050.00562.50312.5052.50250.0050.00660.00360.0047.50300.0050.00757.50402.5042.50350.0050.00855.00440.0037.50400.0050.00952.50472.5032.50450.0050.001050.00500.0027.50500.0050.00B.In a perfectly competitive industry, P =MR so the optimal activity level occurs where P = MC. Here, P = MC = \$50.00 at Q = 10
7. 7. hours of computer maintenance per month, and profits equal zero.C.A monopoly willmaximize profits by setting MR = MC. Here, MR = \$52.50 > \$50 = MC at Q = 5 hours ofcomputer maintenance per month and P = \$62.50 per hour. Note that Q = 6 could not bejustified because MRQ=6 = \$47.50 < \$50 = MCQ=6.Price/Output Determination. Orange Freight, Inc., an over-the-road common carrier, isconsidering two proposals for truck maintenance service. First, a national diesel servicefranchise has offered to purchase the business overhaul facilities at an attractive price inreturn for an exclusive franchise on diesel service. A second proposal would allow severalsmall companies to enter the business without any exclusive franchise agreement orcompetitive restrictions. Under this plan, individual companies would bid for the right toprovide service in a given region. Orange Freight would then allocate business to thelowest bidder.Orange Freight has conducted a survey of regional service hubs to estimate the amountthey would be willing to pay for various amounts of diesel service. Orange Freight hasalso estimated the total cost of service per truck. Service costs are expected to be the samewhether or not an exclusive franchise is granted. A.Use the indicated price and cost data to complete the following table.Hours for each Diesel Truck Service per Month Price per Hour Total Revenue Marginal Revenue Total Cost MarginalCost0\$80\$0----1787227672374704726857066668607665486468962901060130B.Determine price andthe level of service if competitive bidding results in a perfectly competitive price/outputcombination.C.Determine price and the level of service if Orange Freight grants amonopoly franchise.ANS: A.Hours for each Diesel Truck Service per Month Price per Hour
8. 8. Total Revenue Marginal Revenue Total Cost MarginalCost0\$80\$ 0--\$ 0--17878\$78727227615274144723742227021470472288662826857035062348666684085840860766462544625486451250530689625584662090106060042750130B.In a perfectlycompetitive industry, P = MR so the optimal activity level occurs where P = MC. Here,equilibrium occurs at Q = 7 hours of diesel truck service per month. Where P = \$66 justcovers MC = \$54. Note that Q = 8 could not be justified because P = MR < MC at thatlevel and beyond. Profits also equal zero at the Q = 7 level.C.A monopoly will maximizeprofits by setting MR = MC. Here, MR = \$70 = MC at Q = 3 hours of diesel truck serviceper month and P = \$74 per hour. Note that MR < MC for Q > 3 (except at Q = 7).Monopoly Equilibrium. Quick Tax, Inc., enjoys pricing power in the Daytona Beachmarket for tax preparation services. Total and marginal revenue relations for smallbusiness customers are:TR = \$280Q - \$0.005Q2MR = ∂TR/∂Q = \$280 - \$0.01QMarginal costs are stable at \$100 per unit. All other costs have been fully amortized.A.As a monopoly, calculate Quick Taxs output, price, and profits at the profit-maximizingactivity level.B.What price and profit levels would prevail based on the assumption thatperfectly competitive pricing emerges in the local market?ANS:A.Set MR = MC to find the profit-maximizing activity level:MR = MC\$280 - \$0.01Q =\$1000.01Q = 180Q = 18,000P = TR/Q = (\$280Q - \$0.005Q2)/Q = \$280 - \$0.005Q =\$280 - \$0.005(18,000) = \$190π = TR - TC = \$190(18,000) - \$100(18,000) =\$1,620,000B.In a perfectly competitive industry, P = MR = MC in equilibrium. Thus, afterthe emergence of competitive market pricing, P = MC = \$100 would result. Because MC =AC, P = MC implies that π = 0.Monopoly Equilibrium. Paradox Dental, Ltd., enjoys a local monopoly in the provisionof oral examination services in Tuskegee, Alabama. Total and marginal revenue relationsfor the standard procedure are:TR = \$250Q - \$0.001Q2MR = ∂TR/∂Q = \$250 - \$0.002QMarginal costs for the process are stable at \$150 per unit. Fixed costs are nil.
9. 9. A.As a monopoly, calculate Paradox Dentals output, price, and profits at the profit-maximizing activity level.B.What price and profit levels would prevail based on theassumption that new entry into the local market results in competitive market pricing?ANS:A.Set MR = MC to find the profit-maximizing activity level:MR = MC\$250 - \$0.002Q =\$1500.002Q = 100Q = 50,000P = TR/Q = (\$250Q - \$0.001Q2)/Q = \$250 - \$0.001Q =\$250 - \$0.001(50,000) = \$200π = TR - TC = \$200(50,000) - \$150(50,000) =\$2,500,000B.In a perfectly competitive industry, P = MR = MC in equilibrium. Thus, afterthe emergence of competitive market pricing, P = MC = \$150 would result. Because MC =AC, P = MC implies that π = 0.Monopoly Equilibrium. The Athletic Medicine Center in Madison, Wisconsin, enjoyspricing power in the practice of medicine. Market demand and marginal revenue relationsfor a standard medical procedure to repair damaged knee cartilage are:P = \$5,000 - \$0.05QMR = ∂TR/∂Q = \$5,000 - \$0.1QFixed costs are nil, and average variable costs are constant at \$4,000 per unit.A.Calculate the profit-maximizing price/output combination and economic profits if theAthletic Medicine Center enjoys an effective monopoly.B.Calculate the price/outputcombination and total economic profits that would result if new entrants create a perfectlycompetitive market.ANS:A.The profit-maximizing price/output combination is found by setting MR = MC. BecauseAVC is constant, MC = AVC = \$4,000. Therefore:MR = MC\$5,000 - \$0.1Q = \$4,0000.1Q= 1,000Q = 10,000P = \$5,000 - \$0.05(10,000) = \$4,500Economic Profits = PQ - AVC ×Q = \$4,500(10,000) - \$4,000(10,000) = \$5,000,000(Note: As a monopolist, the AthleticMedicine Center is the industry.)B.In a perfectly competitive market P = MC. In this instance where AVC is constant and,therefore, MC = AVC, perfectly competitive equilibrium will occur when:P = MC =AVC\$5,000 - \$0.05Q = \$4,0000.05Q = 1,000Q = 20,000P = \$5,000 - \$0.05(20,000) =\$4,000Economic Profits = PQ - AVC × Q = \$4,000(20,000) - \$4,000(20,000) = \$0Inwords, the transformation of the industry from a monopoly to perfect competition hasbrought a \$500 reduction in price and a 10,000 unit expansion in output. At the same time,economic profits have been eliminated.Monopoly Equilibrium. Just CDs, Inc., has developed a booming business in thepurchase and sale of used CDs and used DVDs. Demand and marginal revenue relationsfor the local college student market are:P = \$6 - \$0.00005QMR = ∂TR/∂Q = \$6 - \$0.0001QFixed costs are nil, and average variable costs are constant at \$4 per unit.
10. 10. A.Calculate the profit-maximizing price/output combination and economic profits if JustCDs enjoys an effective monopoly in the local market.B.Calculate the price/outputcombination and total economic profits that would result if Internet competition makes theused CD and used DVD market perfectly competitive.ANS:A.The profit-maximizing price/output combination is found by setting MR = MC. BecauseAVC is constant, MC = AVC = \$4. Therefore:MR = MC\$6 - \$0.0001Q = \$40.0001Q =2Q = 20,000P = \$6 - \$0.00005(20,000) = \$5Economic Profits = PQ - AVC × Q =\$5(20,000) - \$4(20,000) = \$20,000(Note: As a monopolist, Just CDs, Inc., is theindustry.)B.In a perfectly competitive market P = MC. In this instance where AVC is constant and,therefore, MC = AVC, perfectly competitive equilibrium will occur when:P = MC =AVC\$6 - \$0.00005Q = \$40.00005Q = 2Q = 40,000P = \$6 - \$0.00005(40,000) =\$4Economic Profits = PQ - AVC × Q = \$4(40,000) - \$4(40,000) = \$0In words, thetransformation of the industry from a monopoly to perfect competition has brought a \$1reduction in price and a 20,000 unit expansion in output. At the same time, economicprofits have been eliminated.Price Fixing. From 1989 through 1991, the Department of Justice (DOJ) investigated anumber of private, selective colleges for price fixing. The investigation eventually settledon an "overlap group," comprised of about one-half of the most selective private collegesin the United States. The group included 23 colleges, from small liberal arts schools likeColby, Vassar, and Middlebury to larger universities like Princeton and MIT. Somestudents applied to more than one of the 23 schools and, each spring, officials from theseinstitutions met to coordinate the exact calculation of such students financial need. Thecase broke new ground in antitrust theory.The DOJ alleged that the meetings enabled the colleges to collude on higher tuition and toincrease their tuition revenue. The colleges defended their meetings by saying that theyhad to have some coordination in order to successfully implement their commitment tofully cover the need of any student they admitted. The colleges wanted to pull needy, ablestudents into the pool of students who applied to selective private colleges because theysaw such students as a "public good" for all their students. Yet, no college wanted to endup with a disproportionate share of the needy students simply because it hadunintentionally made more generous need calculations than the other colleges. (All of thecolleges attempted to use the same formula for need, but varying and difficult-to-interpretinformation from parents introduced some actual variation in their calculations.)Although the colleges denied the price-fixing allegation, they discontinued their annualmeetings in 1991. Nor did they resume, even after a federal Court of Appeals rendered adecision in their favor.A.How would you determine if the "financial-aid overlap" meeting is an example of pricefixing?B.If price fixing did indeed occur at these meetings, which laws in particular mightbe violated?ANS:A.According to The Wall Street Journal (5/12/91, p. B1);Lewis Kaplow, an antitrust-lawspecialist and Harvard Law School professor, says such activity would be illegal if theparties involved agree to concur on the same family contribution in each case, even if their
12. 12. Price Discrimination. During recent years, national hotel and restaurant chains in theUnited States have charged lower lodging and meal prices to senior citizens in an effort toprofitably segment the market for their services. Thus, senior citizens have come to enjoydiscounts of 10-25% off the prices paid by other (younger) full-price customers. This two-tier pricing scheme has raised the ire of some consumers who view it as discriminatoryand a violation of antitrust laws.A.Is this pricing scheme discriminatory in the economic sense? What conditions would benecessary for it to be profitable to the hotel and restaurant industry?B.Carefully describehow price discrimination could violate U.S. antitrust laws and be sure to mention whichlaws in particular might be violated.ANS:A.Price discrimination exists if the relative prices charged do not reflect relativeproduction and distribution (including transportation) costs. Thus, with pricediscrimination, markups will vary from one market subgroup to another. In order for pricediscrimination to be profitable, markets must be separable (no reselling), and havediffering elasticities of demand. Both conditions would seem to be met in this case. Firstlower senior citizen incomes will cause their demand to be more elastic than demand byyounger and employed consumers. Second, price differentials can be enforced on the basisof verifiable age information (driver licenses or other sources).B.Price discrimination isunlawful under the Robinson-Patman Act only if it results in a substantial lessening ofcompetition. However, this prohibition relates only to firm-firm transactions. Pricediscrimination between firms and final consumers is perfectly legal, and widely practiced.Price Discrimination. Metropolitan bus service companies in the United States havecharged lower fares to senior citizens in an effort to profitably segment the market fortheir services. Thus, senior citizens have come to enjoy discounts of 25-50% off the pricespaid by other (younger) full-price customers. This two-tier pricing scheme has raised theire of some consumers who view it as discriminatory and a violation of antitrust laws.A.Is this pricing scheme discriminatory in the economic sense? What conditions would benecessary for it to be profitable to the bus service industry?B.Carefully describe how pricediscrimination could violate U.S. antitrust laws and be sure to mention which laws inparticular might be violated.ANS:A.Price discrimination exists if the relative prices charged do not reflect relativetransportation costs. Thus, with price discrimination, markets will vary from one marketsubgroup to another. In order for price discrimination to be profitable, markets must beseparable (no reselling), and have differing elasticities of demand. Both conditions wouldseem to be met in this case. First lower senior citizen incomes will cause their demand tobe more elastic than demand by younger and employed consumers. Second, pricedifferentials can be enforced on the basis of verifiable age information (driver licenses orother sources).B.Price discrimination is unlawful under the Robinson-Patman Act only ifit results in a substantial lessening of competition. However, this prohibition relates onlyto firm-firm transactions. Price discrimination between firms and final consumers isperfectly legal, and widely practiced.Price Fixing. Three leading toxic waste disposal companies have entered into a secretcartel to fix prices and allocate business in the upper Midwest. The marginal costs per unit
13. 13. for toxic waste disposal services are as follows: Toxic Waste (000)Ann Arbor Services, Inc. (A)BIG Environmental, Ltd. (B)Chicagoland Disposal, Inc. (C)1\$10\$10\$ 52151010320151542520205302525A.Determine the cartels optimal allocation of output and maximum profit contribution if itsets Q = 8(000) and P = \$20.B.Calculate the perfectly competitive industry price for Q =8.C.How much output would a perfectly competitive industry supply at P = \$20?D.Describe the value to society of breaking up the cartel.ANS:A.The cartel would allocate output so as to minimized total production costs. For Q = 8,the cost minimizing output allocation is:FirmOutputAnn Arbor Services, Inc. (A)2BIGEnvironmental, Ltd. (B)3Chicagoland Disposal, Inc. (C)3Total8(000)The maximum totalprofit contribution would be:π = TR - TCA - TCB - TCC = 8(\$20) - \$25 - \$35 - \$30 =\$70(000)B.In a perfectly competitive industry P = MR and MR = MC in equilibrium. Thus, pricealso equals marginal cost, P = MC. At Q = 8, MC = \$15. Therefore, the perfectlycompetitive industry price for Q = 8 is P = \$15.C.Because P = MC in perfectly competitive equilibrium, firms will continue to supplyoutput up until the point where MC = \$20 when P = \$20. From the table, we see thatoutput would expand from Q = 8(000) to Q = 11(000) if a perfectly competitive industrywere in place:FirmOutputAnn Arbor Services, Inc. (A) 3BIG Environmental, Ltd.(B) 4Chicagoland Disposal, Inc. (C) 4Total11(000)D.If the cartel were abolished, prices would fall from P = \$20 to P = \$15 at an activitylevel of Q = 8(000). This \$5 price difference implies a \$40(000)(= \$5 × 8) cost to societyarising in the form of excess profits to cartel members. Alternatively, if prices remainedstable at P = \$20, output would expand from Q = 8(000) to Q = 11(000). This represents a\$60(000)(= \$20 × 3) increase in the value of output.Generally speaking, the benefits toabolishing cartels consist of social improvement in terms of both equity and efficiencyconsiderations. Efficiency is improved when output expands and price converges tomarginal cost. Equity is improved when unwarranted excess profits are eliminated.Price Fixing. Three leading CATV companies have entered into a secret cartel to fixprices and allocate business in rural southeastern markets. The marginal costs per unit forCATV service (basic hook-up) are as follows: Hook-ups (000)Able Cable, Ltd. (A)Buckeye Cable, Inc. (B)Crimson Tide Cable, Inc. (C)1\$ 4\$ 6\$ 8281210312201242429245314037
14. 14. A.Determine the cartels optimal allocation of output and maximum profit contribution if itsets Q = 8(000) and P = \$36 per month.B.Calculate the perfectly competitive industryprice for Q = 8.C.How much output would a perfectly competitive industry supply at P =\$24 per month?D.Describe the value to society of breaking up the cartel.ANS:A.The cartel would allocate output so as to minimized total production costs. For Q = 8,the cost minimizing output allocation is:FirmOutputAble Cable, Ltd. (A)3BuckeyeCable, Inc. (B)2Crimson Tide Cable, Inc. (C)3Total8(000)The maximum total profitcontribution would be:π = TR - TCA - TCB - TCC = 8(\$36) - \$24 - \$18 - \$30 = \$216(000)B.In a perfectly competitive industry P = MR and MR = MC in equilibrium. Thus, pricealso equals marginal cost, P = MC. At Q = 8, MC = \$12. Therefore, the perfectlycompetitive industry price for Q = 8 is P = \$12 per month.C.Because P = MC in perfectly competitive equilibrium, firms will continue to supplyoutput up until the point where MC = \$24 when P = \$24. From the table, we see thatoutput would expand from Q = 8(000) to Q = 11(000) if a perfectly competitive industrywere in place:FirmOutputAble Cable, Ltd. (A) 3Buckeye Cable, Inc. (B) 4CrimsonTide Cable, Inc. (C) 4Total11(000)D.If the cartel were abolished, prices would fall from P = \$36 to P = \$12 at an activitylevel of Q = 8(000). This \$24 price difference implies a \$192(000)(= \$24 × 8) cost tosociety arising in the form of excess profits to cartel members. Alternatively, if pricesremained stable at P = \$24, output would expand from Q = 8(000) to Q = 11(000). Thisrepresents a significant increase in output.Generally speaking, the benefits to abolishingcartels consist of social improvement in terms of both equity and efficiencyconsiderations. Efficiency is improved when output expands and price converges tomarginal cost. Equity is improved when unwarranted excess profits are eliminated.Costs of Regulation. Glove-Box, Inc., produces glove boxes designed to allow workers tosafely handle hazardous materials used in a wide variety of products. Market demand andmarginal revenue relations for the Glove-Box units are:P = \$500,000 - \$250QMR = ∂TR/∂Q = \$500,000 - \$500QAssume the Occupational Health and Safety Administration (OSHA) has recently ruledthat Glove-Box must install expensive new shielding equipment to further guard againstworker injuries. This will increase the \$200,000 marginal cost of manufacturing by\$250,000 per unit. Glove-Boxs fixed expenses of \$50 million per year, which include arequired return on investment, will be unaffected.A.Calculate Glove-Boxs profit-maximizing price/output combination and economic profitlevel before installation of the OSHA-mandated shielding equipment.B.Calculate theprofit-maximizing price/output combination and economic profit level after Glove-Boxhas met OSHA guidelines.C.Compare your answers to parts A and B. Who pays theeconomic burden of meeting OSHA guidelines?ANS:A.Glove-Box will maximize profits by setting MR = MC. Before the OSHA-mandatedincrease in costs, MC = \$200,000. Therefore,MR = MC\$500,000 - \$500Q =\$200,000500Q = 300,000Q = 600P = \$500,000 - \$250(600) = \$350,000Total Economic
15. 15. Profits = PQ - TC = \$350,000(600) - \$200,000(600) - \$50,000,000 = \$40,000,000B.After the OSHA-mandated increase in costs, MC = \$250,000. Therefore, Glove-Boxsoptimal activity level changes as follows:MR = MC + \$50,000\$500,000 - \$500Q =\$250,000500Q = 250,000Q = 500P = \$500,000 - \$250(500) = \$375,000Total EconomicProfits = PQ - TC = \$375,000(500) - \$250,000(500) - \$50,000,000 = \$12,500,000C.In this instance, Glove-Box and its customers share the costs of meeting OSHAguidelines. The number of units sold falls by 16.7% from 600 to 500 in response to the\$25,000 price increase from \$350,000 to \$375,000. Therefore, customers bear some of theregulatory burden due to higher prices and fewer units of output being available. The restof the burden of this regulation has fallen on Glove-Box stockholders in terms of losteconomic profits, and Glove-Box employees in terms of lost employment opportunitiesdue to reduced levels of production.Costs of Regulation. Biosystems Technology, Inc., manufacturers equipment used by thebiotechnology industry in the analysis of protein and DNA. Market demand and marginalrevenue relations for the Biosystems units are:P = \$50,000 - \$25QMR = ∂TR/∂Q = \$50,000 - \$50QSuppose the Occupational Health and Safety Administration (OSHA) has recently ruledthat Biosystems must install expensive new shielding equipment to further guard againstworker injuries. This will increase the \$10,000 marginal cost of manufacturing by \$15,000per unit. Biosystems fixed expenses of \$15 million per year, which include a requiredreturn on investment, will be unaffected.A.Calculate Biosystems profit-maximizing price/output combination and economic profitlevel before installation of the OSHA-mandated shielding equipment.B.Calculate theprofit-maximizing price/output combination and economic profit level after Biosystemshas met OSHA guidelines.C.Compare your answers to parts A and B. Who pays theeconomic burden of meeting OSHA guidelines?ANS:A.Biosystems will maximize profits by setting MR = MC. Before the OSHA-mandatedincrease in costs, MC = \$10,000. Therefore,MR = MC\$50,000 - \$50Q = \$10,00050Q =40,000Q = 800P = \$50,000 - \$25(800) = \$30,000Total Economic Profits = PQ - TC =\$30,000(800) - \$10,000(800) - \$15,000,000 = \$1,000,000B.After the OSHA-mandated increase in costs, MC = \$15,000. Therefore, Biosystemsoptimal activity level changes as follows:MR = MC + \$5,000\$50,000 - \$50Q =\$15,00050Q = 35,000Q = 700P = \$50,000 - \$25(700) = \$32,500Total Economic Profits =PQ - TC = \$32,500(700) - \$15,000(700) - \$15,000,000 = -\$2,750,000 (a loss)C.In this instance, Biosystems and its customers share the costs of meeting OSHAguidelines. The number of units sold falls by 12.5% from 800 to 700 in response to the\$2,500 price increase from \$30,000 to \$32,500. Therefore, customers bear some of theregulatory burden due to higher prices and fewer units of output being available. The restof the burden of this regulation has fallen on Biosystems stockholders in terms of losteconomic profits, and Biosystems employees in terms of lost employment opportunitiesdue to reduced levels of production. Although the company will continue to operate in theshort-run, its long-run survival is threatened given that it is unable to generate a post-regulation required rate of return.
16. 16. Tariffs. The Nippon Switch Corporation is an importer and distributor of Japanese-madepacket switches, special routing devices that direct data traffic to various computers on alarge private telecommunications network for companies like GM, Sears and 3M. TheU.S. Commerce Department recently informed the company that it will be subject to anew 35% tariff on the import cost of computer switch devices. The company is concernedthat the tariff will slow its sales growth, given the highly competitive nature of the packetswitch market. Relevant market demand and marginal revenue relations are:P = \$400 - \$0.035QMR = ∂TR/∂Q = \$400 - \$0.07QThe companys marginal cost equals import costs of \$100 per unit, plus \$20 to covertransportation, insurance, and related selling expenses. In addition these costs, thecompanys fixed costs, including a normal rate of return, come to \$250,000 per year onthis product.A.Calculate the optimal price/output combination and economic profits prior to impositionof the tariff.B.Calculate the optimal price/output combination and economic profits afterimposition of the tariff.C.Compare your answers to parts A and B. Who pays theeconomic burden of the import tariff?ANS:A.The company will maximize profits by setting MR = MC. Prior to imposition of thetariff, marginal cost reflects import costs plus selling expenses only:MR = MC\$400 -\$0.07Q = \$100 + \$200.07Q = 280Q = 4,000P = \$400 - \$0.035(4,000) = \$260TotalEconomic Profits = PQ - TC = \$260(4,000) - \$100(4,000) - \$20(4,000) - \$250,000 =\$310,000B.After imposition of the tariff, marginal cost reflects import costs, plus selling costs, plusthe import fee:MR = MC + Import fee\$400 - \$0.07Q = \$100 + \$20 + 0.35(\$100)0.07Q =245Q = 3,500P = \$400 - \$0.035(3,500) = \$277.50Total Economic Profits = PQ - TC =\$277.50(3,500) - \$100(3,500) - \$20(3,500)- \$35(3,500) - \$250,000 = \$178,750C.The company and its customers share the costs of the import tariff. The number ofswitches sold falls from 4,000 to 3,500 units in response to the \$17.50 price increase from\$260 to \$277.50. In addition to this burden borne by its customers, the company and itsemployees suffer due to lost profits and employment opportunities.Tariffs. The Northern Lights Company is an importer and distributor of Scandinavianwool sweaters. The U.S. Commerce Department recently informed the company that itwill be subject to a new 20% tariff on the import cost of woolen clothing. The company isconcerned that the tariff will slow its sales growth, given the highly competitive nature ofthe clothing market. Relevant market demand and marginal revenue relations are:P = \$240 - \$0.002QMR = ∂TR/∂Q = \$240 - \$0.004QThe companys marginal cost equals import costs of \$50 per unit, plus \$10 to covertransportation, insurance, and related selling expenses. In addition these costs, thecompanys fixed costs, including a normal rate of return, come to \$4 million per year onthis product.
17. 17. A.Calculate the optimal price/output combination and economic profits prior to impositionof the tariff.B.Calculate the optimal price/output combination and economic profits afterimposition of the tariff.C.Compare your answers to parts A and B. Who pays theeconomic burden of the import tariff?ANS:A.The company will maximize profits by setting MR = MC. Prior to imposition of thetariff, marginal cost reflects import costs plus selling expenses only:MR = MC\$240 -\$0.004Q = \$50 + \$100.004Q = 180Q = 45,000P = \$240 - \$0.002(45,000) = \$150TotalEconomic Profits = PQ - TC = \$150(45,000) - \$50(45,000) - \$10(45,000) - \$4,000,000 =\$50,000B.After imposition of the tariff, marginal cost reflects import costs, plus selling costs, plusthe import fee:MR = MC + Import fee\$240 - \$0.004Q = \$50 + \$10 + 0.2(\$50)0.004Q =170Q = 42,500P = \$240 - \$0.002(42,500) = \$155Total Economic Profits = PQ - TC =\$155(42,500) - \$50(42,500) - \$10(42,500)- \$10(42,500) - \$4,000,000 = -\$387,500 (a loss)C.The company and its customers share the costs of the import tariff. The number of woolsweaters sold falls from 45,000 to 42,500 units in response to the \$5 price increase from\$150 to \$155. In addition to this burden borne by its customers, the company and itsemployees suffer due to lost profits and employment opportunities. Although the companywill continue to operate in the short-run, it is not earning a required rate of return on thisproduct, and will discontinue operation in the long-run.Tariffs. The Steel Supply Corporation is an importer and distributor of Taiwanese-made,96 piece hand-tool sets (screw drivers, wrenches, and the like). The U.S. CommerceDepartment recently informed the company that it will be subject to a new 25% tariff onthe import cost of fabricated steel. The company is concerned that the tariff will slow itssales growth, given the highly competitive nature of the hand-tool market. Relevantmarket demand and marginal revenue relations are:P = \$80 - \$0.0001QMR = ∂TR/∂Q = \$80 - \$0.0002QThe companys marginal cost equals import costs of \$32 per unit, plus \$8 to covertransportation, insurance, and related selling expenses. In addition to these costs, thecompanys fixed costs, including a normal rate of return, come to \$2,500,000 per year onthis product.A.Calculate the optimal price/output combination and economic profits prior to impositionof the tariff.B.Calculate the optimal price/output combination and economic profits afterimposition of the tariff.C.Compare your answers to parts A and B. Who pays theeconomic burden of the import tariff?ANS:A.The company will maximize profits by setting MR = MC. Prior to imposition of thetariff, marginal cost reflects import costs plus selling expenses only:MR = MC\$80 -\$0.0002Q = \$32 + \$80.0002Q = 40Q = 200,000P = \$80 - \$0.0001(200,000) = \$60TotalEconomic Profits = PQ - TC = \$60(200,000) - \$32(200,000) - \$8(200,000) - \$2,500,000= \$1,500,000B.After imposition of the tariff, marginal cost reflects import costs, plus selling costs, plusthe import fee:MR = MC + Import fee\$80 - \$0.0002Q = \$32 + \$8 + 0.25(\$32)0.0002Q =
18. 18. 32Q = 160,000P = \$80 - \$0.0001(160,000) = \$64Total Economic Profits = PQ - TC=\$64(160,000) - \$32(160,000) - \$8(160,000)- \$8(160,000) - \$2,500,000 = \$60,000C.The company and its customers share the costs of the import tariff. The number of hand-tool sets sold falls from 200,000 to 160,000 units in response to the \$4 price increase from\$60 to \$64. In addition to this burden borne by its customers, the company and itsemployees suffer due to lost profits and employment opportunities.Monopoly Regulation. The Woebegone Telephone Company, a utility serving ruralcustomers in Minnesota, is currently engaged in a rate case with the regulatorycommission under whose jurisdiction it operates. At issue is the monthly rate the companywill charge for basic hookup service. The demand curve for monthly service is P = \$50 -\$0.005Q. This implies annual demand and marginal revenue curves of:P = \$600 - \$0.06QMR = ∂TR/∂Q = \$600 - \$0.12Qwhere P is service price in dollars and Q is the number of customers served. Total andmarginal costs per year (before investment return) are described by the function:TC = \$100,000 + \$100Q + \$0.04Q2MC = ∂TC/∂Q = \$100 + \$0.08QThe company has assets of \$4 million and the utility commission has authorized a 12.5%return on investment.A.Calculate Woebegones profit-maximizing price (monthly and annually), output, andrate-of-return levels.B.What monthly price should the commission grant to limitWoebegone to a 12.5% rate of return?ANS:A.To find the profit-maximizing level of output, set MR = MC where:MR = MC\$600 -\$0.12Q = \$100 + \$0.08Q0.2Q = 500Q = 2,500P = \$50 - \$0.005(2,500) = \$37.50(Monthlyprice)P = \$600 - \$0.06(2,500) = \$450(Annual price)π = TR - TC = \$450(2,500) -\$100,000 - \$100(2,500) - \$0.04(2,5002) = \$525,000If the company has \$4 millioninvested in plant and equipment, its optimal rate of return on investment is:Return oninvestment = = 0.13125 or 13.125%(Note: Profit is falling Q > 2,500.)B.With a 12.5% return on total assets, Woebegone would earn profits of:π = Allowedreturn × Total assets = 0.125(\$4,000,000) = \$500,000To determine the level of outputthat would be consistent with this level of total profits, consider the profit relation:π = TR- TC\$500,000 = \$600Q - \$0.06Q2 - \$100,000 - \$100Q - \$0.04Q2500,000 = -0.1Q2 + 500Q- 100,0000 = -0.1Q2 + 500Q - 600,000which is a function of the form aQ2 + bQ + c = 0where a = -0.1, b = 500 and c = -600,000, and can be solved using the quadraticequation.Q = = = = 2,000 or 3,000 customersBecause public utility commissions
19. 19. generally want utilities to provide service to the greatest possible number of customers atthe lowest possible price, the "upper" Q = 3,000 is the appropriate output level. Thisoutput level will result in a monthly service price of:P = \$50 - \$0.005(3,000) = \$35This\$35 per month price will provide Woebegone with a fair rate of return on total investment,while ensuring service to a broad customer base.Monopoly Regulation. The Black Hills Telephone Company, a utility serving ruralcustomers in South Dakota is currently engaged in a rate case with the regulatorycommission under whose jurisdiction it operates. At issue is the monthly rate the companywill charge for call waiting service. The demand curve for this monthly service is P =\$6.25 - \$0.00025Q. This implies annual demand and marginal revenue curves of:P = \$75 - \$0.003QMR = ∂TR/∂Q = \$75 - \$0.006Qwhere P is service price in dollars and Q is the number of customers served. Total andmarginal costs per year (before investment return) are described by the function:TC = \$108,000 + \$25Q + \$0.002Q2MC = ∂TC/∂Q = \$25 + \$0.004QThe company has assets of \$100,000 used for call waiting services and the utilitycommission has authorized a 12% return on investment.A.Calculate Black Hills profit-maximizing price (monthly and annually), output, and rate-of-return levels.B.What monthly price should the commission grant to limit Black Hills toan 12% rate of return?ANS:A.To find the profit-maximizing level of output, we must set MR = MC where:MR =MC\$75 - \$0.006Q = \$25 + \$0.004Q0.01Q = 50Q = 5,000P = \$6.25 - \$0.00025(5,000) =\$5(Monthly price)P = \$75 - \$0.003(5,000) = \$60(Annual price)π = TR - TC = \$60(5,000)- \$108,000 - \$25(5,000) - \$0.002(5,0002) = \$17,000If the company has \$100,000 investedin plant and equipment, its optimal rate of return on investment is:Return on investment = = 0.17 or 17%(Note: Profit is falling Q > 5,000.)B.With a 12% return on total assets, Black Hills would earn profits of:π = Allowed return× Total assets = 0.120(\$100,000) = \$12,000To determine the level of output that wouldbe consistent with this level of total profits, consider the profit relation:π = TR -TC\$12,000 = \$75Q - \$0.003Q2 - \$108,000 - \$25Q - \$0.002Q212,000 = -0.005Q2 + 50Q -108,0000 = -0.005Q2 + 50Q - 120,000which is a function of the form aQ 2 + bQ + c = 0where a = -0.005, b = 50 and c = -120,000, and can be solved using the quadraticequation.Q = = = =4,000 or 6,000 customersBecause public utility commissions generally want utilities toprovide service to the greatest possible number of customers at the lowest possible price,the "upper" Q = 6,000 is the appropriate output level. This output level will result in amonthly service price of:P = \$6.25 - \$0.00025(6,000) = \$4.75This \$4.75 per month price
20. 20. for call waiting service will provide Black Hills with a fair rate of return on totalinvestment, while ensuring service to a broad customer base.Monopoly Regulation. The Hoosier Gas Company, a utility serving customers inBloomington, Indiana, is currently engaged in a rate case with the regulatory commissionunder whose jurisdiction it operates. At issue is the rate the company will charge per mcfusage of natural gas. The demand curve for monthly service is P = \$6.75 - \$0.000375Q.This implies annual demand and marginal revenue curves of:P = \$81 - \$0.0045QMR = ∂TR/∂Q = \$81 - \$0.009Qwhere P is mcf price in dollars and Q is the units of mcf used, in thousands. Total andmarginal costs per year (before investment return) are described by the function:TC = \$36,200 + \$21Q + \$0.0005Q2MC = ∂TC/∂Q = \$21 + \$0.001QThe company has assets of \$1 million and the utility commission has authorized an 11%return on investment.A.Calculate Hoosiers profit-maximizing price (monthly and annually), output, and rate-of-return levels.B.What monthly price should the commission grant to limit Hoosier to an11% rate of return?ANS:A.To find the profit-maximizing level of output, we must set MR = MC where:MR =MC\$81 - \$0.009Q = \$21 + \$0.001Q0.01Q = 60Q = 6,000P = \$6.75 - \$0.000375(6,000) =\$4.50(Monthly price)P = \$81 - \$0.0045(6,000) = \$54(Annual price)π = TR - TC =\$54(6,000) - \$36,200 - \$21(6,000) - \$0.0005(6,0002) = \$143,800If the company has \$1million invested in plant and equipment, its optimal rate of return on investment is:Returnon investment = = 0.1438 or 14.38%(Note: Profit is falling for Q > 6,000.)B.With an 11% return on total assets, Hoosier would earn profits of:π = Allowed return ×Total assets = 0.11(\$1,000,000) = \$110,000To determine the level of output that wouldbe consistent with this level of total profits, we consider the profit relation:π = TR -TC\$110,000 = \$81Q - \$0.0045Q2 - \$36,200 - \$21Q - \$0.0005Q2110,000 = -0.005Q2 + 60Q- 36,2000 = -0.005Q2 + 60Q - 146,200Which is a function of the form aQ2 + bQ + c = 0where a = -0.005, b = 60 and c = -146,200, and can be solved using the quadraticequation.Q = = = =3,400 or 8,600 customersBecause public utility commissions generally want utilities toprovide service to the greatest possible number of customers at the lowest possible price,the "upper" Q = 8,600 is the appropriate output level. This output level will result in amonthly service price of:P = \$6.75 - \$0.000375(8,600) = \$3.525This \$3.525 per mcf pricewill provide Hoosier with a fair rate of return on total investment, while ensuring serviceto a broad customer base.
21. 21. Monopoly Regulation. The Redwood Cable Company, a CATV utility serving customersin Eugene, Oregon, is currently engaged in a rate case with the regulatory commissionunder whose jurisdiction it operates. At issue is the monthly rate the company will chargefor basic hookup service. The demand curve for monthly service is P = \$37.50 -\$0.0005Q. This implies annual demand and marginal revenue curves of:P = \$450 - \$0.006QMR = ∂TR/∂Q = \$450 - \$0.012Qwhere P is service price in dollars and Q is the number of customers served. Total andmarginal costs per year (before investment return) are described by the function:TC = \$4,275,000 + \$75Q + \$0.0015Q2MC = ∂TC/∂Q = \$75 + \$0.003QThe company has assets of \$1.5 million and the utility commission has authorized a 15%return on investment.A.Calculate Redwoods profit-maximizing price (monthly and annually), output, and rate-of-return levels.B.What monthly price should the commission grant to limit Redwood to a15% rate of return?ANS:A.To find the profit-maximizing level of output, we must set MR = MC where:MR =MC\$450 - \$0.012Q = \$75 + \$0.003Q0.015Q = 375Q = 25,000P = \$37.50 -\$0.0005(25,000) = \$25(Monthly price)P = \$450 - \$0.006(25,000) = \$300(Annual price)π= TR - TC = \$300(25,000) - \$4,275,000 - \$75(25,000) - \$0.0015(25,0002) = \$412,500Ifthe company has \$1.5 million invested in plant and equipment, its optimal rate of return oninvestment is:Return on investment = = 0.275 or 27.50%(Note: Profit isfalling for Q > 25,000.)B.With a 15% return on total assets, Redwood would earn profits of:π = Allowed return ×Total assets = 0.15(\$1,500,000) = \$225,000To determine the level of output that wouldbe consistent with this level of total profits, we consider the profit relation:π = TR -TC\$225,000 = 450Q - \$0.006Q2 - \$4,275,000 - \$75Q - \$0.0015Q2225,000 = -0.0075Q2 +375Q - 4,275,0000 = -0.0075Q2 + 375Q - 4,500,000Which is a function of the form aQ2 +bQ + c = 0 where a = -0.0075, b = 375 and c = -4,500,000, and can be solved using thequadratic equation.Q = = = = 20,000 or 30,000 customersBecause public utility commissionsgenerally want utilities to provide service to the greatest possible number of customers atthe lowest possible price, the "upper" Q = 30,000 is the appropriate output level. Thisoutput level will result in a monthly service price of:P = \$37.50 - \$0.0005(30,000) =\$22.50This \$22.50 per month price will provide Redwood with a fair rate of return ontotal investment, while ensuring service to a broad customer base.Pollution Regulation. Porky Pig, Inc., processes hogs at a large facility in Iowa City,
22. 22. Iowa. Each hog processed yields both pork and a render by-product in a fixed 1:1 ratio.Although the render by-product is unfit for human consumption, some can be sold to alocal pet food company for further processing. Relevant annual demand and cost relationsare:PP = \$125 - \$0.0005QP(Demand for pork)MRP = \$125 - \$0.001QP(Marginal revenue frompork)PB = \$25 - \$0.001QB(Demand for render by-product)MRB = \$25 -\$0.002QB(Marginal revenue from render by-product)TC = \$1,156,250 + \$75Q(Totalcost)MC = \$75(Marginal cost)Here P is price in dollars, Q is the number of hogs processed (with an average weight of100 pounds), QP and QB are pork and rendered by-product per hog, respectively; both totaland marginal costs are in dollars. Total costs include a risk-adjusted normal return of 15%on a \$2 million investment in plant and equipment.Currently, the city allows the company to dump excess by-product into its sewagetreatment facility at no charge, viewing the service as an attractive means of keeping avalued employer in the area. However, the sewage treatment facility is quicklyapproaching peak capacity and must be expanded at an expected operating cost of\$500,000 per year. This is an impossible burden on an already strained city budget.A.Calculate the profit-maximizing price/output combination and optimal total profit levelfor Porky.B.How much by-product will the company dump into the Iowa City sewagetreatment facility at the profit-maximizing activity level?C.Calculate output and totalprofits if the city imposes a \$25 per unit charge on the amount of B Porkydumps.D.Calculate output and total profits if the city imposes a fixed \$500,000-per-yeartax on Porky to pay for the sewage treatment facility expansion.E.Will either taxalternative permit Porky to survive in the long-run? In your opinion, what should IowaCity do about its sewage treatment problem?ANS:A.Solution to this problem requires that we look at several production and sales optionsavailable to the firm. One option is to produce and sell equal quantities of pork (P) and by-product (B). In this case, the firm sets relevant MC = MR.MC = MR P + MRB = MR\$75 =\$125 - \$0.001Q + \$25 - \$0.002Q0.003Q = 75Q = 25,000 hogsThus, the profit maximizingoutput level for production and sale of equal quantities of P and B would be 25,000 hogs.However, we must check to determine that the marginal revenues of both products arepositive at this sales level before claiming that this is an optimal activity pattern.Evaluated at 25,000 hogs:MRP = \$125 - \$0.001(25,000) = \$100MRB = \$25 -\$0.002(25,000) = -\$25Because the marginal revenue for B is negative, and because Porkycan costlessly dump excess production, the sale of 25,000 units of B is suboptimal. Thisinvalidates the entire solution developed above because output of P is being held down bythe negative marginal revenue associated with B. The problem must be set up in a fashionthat recognizes that Porky will stop selling B at the point where its marginal revenuebecomes zero because, given production for P, the marginal cost of B is zero.Set:MRB = MCB\$25 - \$0.002QB = \$00.002QB = 25QB = 12,500 unitsThus, 12,500 units ofB is the maximum that would be sold. Any excess units will be dumped into the cityssewage treatment facility. The price for B at 12,500 units is:P B = \$25 - \$0.001QB = \$25 -\$0.001(12,500) = \$12.50To determine the optimal production of P (pork), set the marginal revenue of P equal tothe marginal cost of producing another unit of the output package:MR P = MCP = MCQ\$125- \$0.001QP = \$750.001QP = 50QP = 50,000 units(Remember QP = Q)AndPP = \$125 -
23. 23. \$0.0005QP = \$125 - \$0.0005(50,000) = \$100Excess profits at the optimal activity level for Porky will be:Excess profits = π = TRP +TRB - TC = PP × QP + PB × QB - TCQ = \$100(50,000) + \$12.50(12,500) - \$1,156,250 -\$75(50,000) = \$250,000Because total costs include a normal return of 15% on a \$2million investmentTotal profits = Required return + Excess profits = 0.15(\$2,000,000) +\$250,000 = \$550,000B.With 50,000 hogs being processed, but only 12,500 units of B sold, dumping of Bis:Units B dumped = Units produced - Units sold = 50,000 - 12,500 = 37,500 unitsC.Part A shows that if all P and B produced is sold, an activity level of Q = 25,000 willresult in MRB = -\$25. A dumping charge of \$25 per unit of B will cause Porky to prefer tosell the last unit of B produced (and lose \$25) rather than pay a \$25 fine. Therefore, thisfine, as will any fine greater than \$25, eliminates dumping and causes Porky to reduceprocessing to 25,000 hogs per year. This fine structure would undoubtedly reduce oreliminate the need for a new sewage treatment facility.Although eliminating dumping isobviously attractive in the sense of reducing sewage treatment costs, the \$25 fine has theunfortunate consequence of cutting output substantially. Pork prices will rise to P P = \$125- \$0.0005(25,000) = \$112.50, and by-product prices will fall to PB = \$25 - \$0.001(25,000)= \$0. (This means Porky will give the pet food company all of its by-product sludge.)Employment will undoubtedly fall as well. In addition to these obvious short-run effects,long-run implications may be especially serious. At Q = 25,000, Porkys excess profitswill beExcess profits = TRP + TRB - TC = \$112.5(25,000) + \$0(25,000) - \$1,156,250 -\$75(25,000) = -\$218,750 (a loss)This means that total profits will be:Total profits =Required return + Excess profits = 0.15(\$2,000,000) + (-\$218,750) = -\$81,250 (aloss)This level of profit is insufficient to maintain the investment. Thus, although a \$25dumping charge will eliminate dumping, it is likely to cause the firm to close down ormove to some other location. The effect on employment in Iowa City could be disastrous.D.In the short-run, a \$500,000 tax on Porky will have no effect on dumping, output oremployment. However, at the Q = 50,000 activity level, a \$500,000 tax would reducePorkys total profits to \$50,000 (=\$550,000 - \$500,000) or \$250,000 below the requiredreturn on investment. Following imposition of a \$500,000 tax, the firms survival and totalemployment would be imperiled in the long-run.E.No, Porky will not be able to bear the burden of either tax alternative. Obviously, thereis no single best alternative here. The highest fixed tax the company can bear in the long-run is \$250,000, the full amount of excess profits. If the city places an extremely highpriority on maintaining employment, perhaps a \$250,000 tax on Porky plus \$250,000 ingeneral city tax revenues could be used to pay for the new sewage system treatmentfacility.Pollution Regulation. Blue Gem, Inc., processes almonds at a large facility in Redding,California. Each pound of almonds processed yields both shelled almonds and shell by-product in a fixed 1:1 ratio. Although the by-product is unfit for human consumption,some can be sold to a regional manufacturer of stone-washed denim garments (the shellsare crushed and used as abrasives). Relevant annual demand and cost relations are:PA = \$14.25 - \$0.000005QA(Demand for shelled almonds)MRA = \$14.25 -\$0.00001QA(Marginal revenue from shelled almonds)P B = \$4 - \$0.00001QB(Demand forshell by-product)MRB = \$4 - \$0.00002QB(Marginal revenue from shell by-product)TC =\$3,000,000 + \$6.25Q(Total cost)MC = \$6.25(Marginal cost)Here P is price in dollars, Q is the number of pounds of almonds processed, Q A and QB areshelled almonds and shell by-product per pound of almonds, respectively; both total andmarginal costs are in dollars. Total costs include a risk-adjusted normal return of 15% on a
24. 24. \$10 million investment in plant and equipment.Currently, the city allows the company to dump excess by-product into its landfill at nocharge, viewing the service as an attractive means of keeping a valued employer in thearea. However, the landfill is quickly approaching peak capacity and must be expanded atan expected operating cost of \$750,000 per year. This is an impossible burden on analready strained city budget.A.Calculate the profit-maximizing price/output combination and optimal total profit levelfor Blue Gem.B.How much by-product will the company dump into the Redding,California landfill at the profit-maximizing activity level?C.Calculate output and totalprofits if the city imposes a \$4 per unit charge on the amount of shell by-product BlueGem dumps.D.Calculate output and total profits if the city imposes a fixed \$750,000-per-year tax on Blue Gem to pay for the landfill expansion.E.Will either tax alternative permitBlue Gem to survive in the long-run? In your opinion, what should Redding do about itslandfill problem?ANS:A.Solution to this problem requires that we look at several production and sales optionsavailable to the firm. One option is to produce and sell equal quantities of shelled almonds(A) and shell by-product (B). In this case, the firm sets relevant MC = MR.MC = MR A +MRB = MR\$6.25 = \$14.25 - \$0.00001Q + \$4 - \$0.00002Q0.00003Q = 12Q = 400,000pounds of almondsThus, the profit maximizing output level for production and sale ofequal quantities of A and B would be 400,000 pounds of almonds. However, we mustcheck to determine that the marginal revenues of both products are positive at this saleslevel before claiming that this is an optimal activity pattern.Evaluated at 400,000 pounds of almonds:MRA = \$14.25 - \$0.00001(400,000) =\$10.25MRB = \$4 - \$0.00002(400,000) = -\$4Because the marginal revenue for B isnegative, and because Blue Gem can costlessly dump excess production, the sale of400,000 units of B is suboptimal. This invalidates the entire solution developed abovebecause output of A is being held down by the negative marginal revenue associated withB. The problem must be set up in a fashion that recognizes that Blue Gem will stop sellingB at the point where its marginal revenue becomes zero because, given production for P,the marginal cost of B is zero.Set:MRB = MCB\$4 - \$0.00002QB = \$00.00002QB = 4Q B = 200,000 unitsThus, 200,000units of B is the maximum that would be sold. Any excess units will be dumped into thecitys landfill. The price for B at 200,000 units is:PB = \$4 - \$0.00001QB = \$4 -\$0.00001(200,000) = \$2To determine the optimal production of A (shelled almonds), set the marginal revenue ofA equal to the marginal cost of producing another unit of the output package:MR A = MCA= MCQ\$14.25 - \$0.00001QA = \$6.250.00001QA = 8QA = 800,000 units(Remember QP =Q)AndPA = \$14.25 - \$0.000005QA = \$14.25 - \$0.000005(800,000) = \$10.25Excess profits at the optimal activity level for Blue Gem will be:Excess profits = π = TRP+ TRB - TC = PA × QA + PB × QB - TCQ = \$10.25(800,000) + \$2(200,000) - \$3,000,000 -\$6.25(800,000) = \$600,000Because total costs include a normal return of 15% on a \$10million investmentTotal profits = Required return + Excess profits = 0.15(\$10,000,000) +\$600,000 = \$2,100,000B.With 800,000 pounds of almonds being processed, but only 200,000 units of B sold,dumping of B is:Units B dumped = Units produced - Units sold = 800,000 - 200,000 =600,000 units
25. 25. C.Part A shows that if all A and B produced is sold, an activity level of Q = 400,000 willresult in MRB = -\$4. A dumping charge of \$4 per unit of B will cause Blue Gem to preferto sell the last unit of B produced (and lose \$4) rather than pay a \$4 fine. Therefore, thisfine, as will any fine greater than \$4, eliminates dumping and causes Blue Gem to reduceprocessing to 400,000 pounds of almonds per year. This fine structure would undoubtedlyreduce or eliminate the need for a new landfill.Although eliminating dumping is obviouslyattractive in the sense of reducing landfill costs, the \$4 fine has the unfortunateconsequence of cutting output substantially. Almond prices will rise to P A = \$14.25 -\$0.000005(400,000) = \$12.25, and by-product prices will fall to PB = \$4 -\$0.00001(400,000) = \$0. Employment will undoubtedly fall as well. In addition to theseobvious short-run effects, long-run implications may be especially serious. At Q =400,000, Blue Gems excess profits will be:Excess profits = TRP + TRB - TC =\$12.25(400,000) + \$0(400,000) - \$3,000,000 - \$6.25(400,000) = -600,000 (a loss)Thismeans that total profits will be:Total profits = Required return + Excess profits =0.15(\$10,000,000) + (-\$600,000) = \$900,000This level of profit is insufficient to maintaininvestment. Thus, although a \$4 dumping charge will eliminate dumping, it is likely tocause the firm to close down or move to some other location. The effect on employment inRedding could be disastrous.D.In the short-run, a \$750,000 tax on Blue Gem will have no effect on dumping, output oremployment. At the Q = 800,000 activity level, a \$750,000 tax would reduce Blue Gemstotal profits to \$1,350,000, or \$150,000 below the \$1,500,000 required return oninvestment. Following imposition of a \$750,000 tax, the firms survival and totalemployment would be imperiled in the long-run.E.No, Blue Gem will not be able to bear the burden of either tax alternative. Obviously,there is no single best alternative here. The highest fixed tax the company can bear in thelong-run is \$600,000 the full amount of excess profits. If the city places an extremely highpriority on maintaining employment, perhaps a \$600,000 tax on Blue Gem plus \$150,000in general city tax revenues could be used to pay for the new landfill.