Eastwood's ECO284 assignments

Answers to the Review Questions from Chapter 6 of Parkin's Microeconomics

1. The price of a product is what people must pay to acquire a unit of the good. The value of a product is the marginal benefit people get from another unit of the good. The marginal benefit is equal to the maximum amount that someone is willing to pay for another unit of the good. Basically, this maximum amount shows the maximum quantity of other goods and services the person is willing to forego in order to have another unit of the product in question, so this maximum amount is the value the person assigns to the good.

2. The demand curve shows people’s willingness to pay for each unit of output. In particular, for any unit of output, the distance to the demand curve shows the maximum amount that someone is willing to pay for that unit of production.

3. As more of the product is available, the willingness to pay for another unit decreases. Most students will respond that the willingness to pay decreases because the demand curve slopes downward. Alert students will note that, from Chapter 3, the marginal benefit from additional units of a product decreases. In connection with the point that marginal benefit is defined as the maximum that someone is willing to pay for another unit — so that the willingness to pay measures the marginal benefit — these students can then answer that willingness to pay decreases as more units are available because the marginal benefit decreases as more units are available.

4. Consumer surplus is the value of a good minus the price paid for it. As Figure 6.3 on page 111 shows, consumer surplus for a market is the area under the demand curve and above the market price.

5. Price is what the producer receives when a good is sold; cost is what the producer pays to produce the good. Economists measure cost as opportunity cost.

6. The connection is straightforward: For any quantity, the supply curve shows the minimum supply price of the product. Why? For any quantity, the supply curve shows the minimum price suppliers must receive in order to produce the last unit of the good.

7. As more of a good or service is produced, the minimum supply price rises. The minimum supply price rises because the marginal cost (the opportunity cost of producing one more unit of the good) rises as more of the good is produced. The minimum price that producers must receive in order to produce the good is at least equal to the marginal cost because otherwise producing the unit would cost suppliers profit. Because the marginal cost rises as more of a good is produced, the minimum supply price — which equals the marginal cost — rises.

8. Producer surplus is the price of the good minus the opportunity cost of producing it. Figure 6.5 (page 113) demonstrates that producer surplus is the area under the market price and above the supply curve because the supply curve measures the opportunity cost of producing the product. The producer surplus equals the profit.

9. For resources to be used efficiently, production must be such that the marginal benefit of the last unit of the good produced equals its marginal cost. This condition will be met in a competitive market (not a monopoly market) if there are no external costs nor external benefits, if the market is allowed to produce at its equilibrium level of production with no taxes or subsidies, and if the good is not a public good.

10. For a competitive market to be efficient, the product must not be a public good and there must be no external costs nor benefits (so that the marginal cost, or supply, curve takes account of all the costs of producing the product and the marginal benefit, or demand, curve takes account of all the benefits) and the market must be allowed to produce at the equilibrium quantity. This last condition rules out the presence of taxes, subsidies, quotas, price ceilings, and price floors.

11. A deadweight loss is the loss in consumer surplus and producer surplus from an inefficient level of production.

12. No, a deadweight loss also occurs if more than the efficient level of output is produced. Figure 6.7b (page 117) illustrates the deadweight loss when too much output  is produced. The point is that units produced in excess of the efficient level have a marginal cost that exceeds their marginal benefit. Therefore producing such units costs society more than society benefits. This overproduction subtracts from the consumer and producer surplus realized.

13. One impediment to achieving an efficient level of production is monopoly: If a market is controlled by a single firm, a monopoly, the firm has the incentive to exert its control by raising its price and decreasing the quantity it produces. Another impediment is the possibility that the product is a public good. A public good is subject to the "free rider" problem, in which people have the incentive not to pay for the good. Clearly private firms will not be motivated to produce the product if people can use it without paying for it! In competitive markets, producing products that are not public goods, the presence of external costs or external benefits also makes attaining efficiency doubtful. In these cases, the marginal cost curve does not reflect all the costs to society of the good or the marginal benefit curve does not capture all the benefits. As a result, a competitive equilibrium may well be inefficient. Government policies, such as taxes, subsidies, and quotas also have adverse effects because they affect the supply or demand for the product, thereby causing the equilibrium level of production to differ from the efficient level. Finally, government policies such as price ceilings and price floors also cause the equilibrium level of production and/or consumption to differ from the efficient level.

14. Examples of impediments to efficiency are listed below. Your examples may differ.

bulletMonopoly. An example of a monopoly is Microsoft, the sole (major) producer of IBM compatible personal computer operating systems.
bulletPublic good. National defense is the classic example of a public good.
bulletExternal cost. Any good whose production creates pollution is an example of a good with an external cost.
bulletExternal benefit. Education (discussed at length in Chapter 20) is an example of a product with an external benefit.
bulletTax or subsidy. Taxes and subsidies are the "reverses" of each other, so they have been listed together. Virtually every product has a sales tax imposed on it, so almost any product serves as an example.
bulletQuota. The sale of oranges is subject to a quota.
bulletPrice ceiling. Rent ceilings imposed on apartments are an example of a price ceiling.
bulletPrice floor. The minimum wage is an example of a price floor in the labor market.

15. A monopoly can prevent a market from reaching efficiency because it controls the entire market. The monopoly uses its control over the market to boost the price of the product in order to increase its profit. When the firm raises its price, consumers respond by buying less of the product, so the quantity purchased (and hence the quantity produced) is less than the efficient amount.

16. A public good is one that can be consumed by a person even if he or she did not pay for it. Clearly this fact reduces people’s incentives to pay! Hence competitive firms have very little incentive to produce the product because many people will free ride, that is, consume the good without paying for it. As a result, competitive firms will underproduce a public good.

17. Equilibrium in a competitive market equates the quantity supplied to the quantity demanded and also equates the producers’ marginal costs to the demanders’ marginal benefits. External costs are costs from the production of a good that are not paid by the producers. As a result, the producers’ marginal costs do not include all the costs of producing the product. Hence the equilibrium is inefficient because it does not set the social marginal cost (which includes the external cost) equal to the marginal benefit.

18. As noted in the answer to the previous question, equilibrium in a competitive market equates the quantity supplied to the quantity demanded and also equates the producers’ marginal costs to the demanders’ marginal benefits. External benefits are benefits from the consumption of a good that are not enjoyed by the purchaser. As a result, the demanders’ marginal benefits do not include all the benefits from the product. Therefore the equilibrium is inefficient because it does not set the marginal cost equal to the social marginal benefit, which includes the external benefit.

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