Econ 200H: David Reiley
Due Thursday, 19 October 2006

## Problem Set #4

As before, the following exercises come from "problems" at the end of each chapter of the textbook. Recall that in general, I recommend not spending more than about 20 minutes thinking about any single problem. (The extra-credit problems are an exception - I expect them to take longer, but they are an opportunity for those who are interested in learning more.)

Note that the last two problems are excellent examples of exam questions based on newspaper articles. Expect a similar problem on your second exam. Please ask questions on these if you're stumped.

1. (5 points) Taylor, problem 11.1.
2. (10 points) Taylor, problem 11.4.
3. (10 points) Taylor, problem 11.5.
4. (10 points) Taylor, problem 11.8.
5. (10 points) Taylor, problem 11.9.
6. (20 points) In the beach city of Santa Barbara, California, there are seven bathing-suit stores, each with the same schedule of costs. The stores' products are differentiated by location, so each firm faces its own downward-sloping demand curve. Each firm's downward-sloping demand schedule is identical. Swim With Style is a typical store, with the following demand and cost schedules:

 Quantity of suits sold (per hour) Price Total Cost 1 \$68 \$70 2 66 80 3 64 85 4 62 90 5 60 100 6 58 115 7 56 136 8 54 164 9 52 200 10 50 245

1. Calculate total revenue, marginal revenue, marginal cost, and average cost at each level of sales for the store.
2. If Swim With Style is a profit maximizer, what number of suits will it sell per hour? What will its price and profit be?
3. How can you tell that the bathing-suit market in Santa Barbara is not in long-run equilibrium? What will happen because it is out of equilibrium?
7. (25 points) Now seventeen new bathing-suit stores enter the Santa Barbara market, joining the seven that already existed. As a consequence, the demand schedule facing Swim With Style (and the identical schedules facing all other stores) falls, while the cost schedules remain the same as in the previous problem:

 Quantity of suits sold (per hour) Price Total Cost 1 \$31.50 \$70 2 28.50 80 3 25.50 85 4 22.50 90 5 19.50 100 6 16.50 115 7 13.50 136 8 10.50 164 9 7.50 200 10 4.50 245

1. What number of suits will Swim With Style sell?
2. What price will it charge, and what will its profit be?
3. Is the market in long-run equilibrium now? Why or why not?
4. What is the average cost per swimsuit sold?
5. How many swimsuits are sold in Santa Barbara each hour, and what is the total cost incurred?
6. From your calculations in Problem 1, identify the sales quantity at which Swim With Style's average cost would be a minimum. What is this average cost?
7. Suppose the total number of swimsuits sold in the market remained constant at the level you found in (e), but the number of stores was reduced so that each was operating at its point of minimum average cost. (Assume this is done by order of a central planner; the stores don't get to decide whether to operate or how much to produce. That is, we're temporarily replacing the market outcome with the decision of a benevolent central planner.) How many stores would be in operation? What would be the total costs of all the stores taken together? Compare this to your answer in (e) above.
8. Summarize briefly what you have learned from this problem about the inefficiency of monopolistic competition.
9. Can you think of any efficiency benefits that can occur with monopolistic competition, perhaps making up for the inefficiency identified in part (h)?
8. (15 points) Consider the following statement: "Public education is not a public good, but it does involve externalities."
1. Do you agree or disagree with this statement? Explain.
2. Suppose government were not involved in the provision of education. Why might the level of education provided privately not be optimal? Explain.
3. Given that government provides K-12 education, why might the amount of education not be optimal? Explain.
9. (10 points) Suppose production creates 10 pounds of pollution for every ton of paper manufactured. The demand and supply of paper are described by the following table, where quantities are measured in tons:

 Price Quantity Demanded Quantity Supplied \$100 80 100 \$90 85 95 \$80 90 90 \$70 95 85 \$60 100 80 \$50 105 75

1. What will be the equilibrium price and quantity? How much pollution will be emitted?
2. Suppose that the government imposes a tax of \$20 per ton of paper. What are the new equilibrium price and quantity? By how much does the government policy reduce the quantity of pollution?
10. (10 points) Taylor, problem 15.6.
11. (10 points) Taylor, problem 15.8.
12. (10 points) Taylor, problem 15.10.
13. (10 points) Taylor, problem 15.12.
14. (25 points) For this question, please refer to this October 2002 Wall Street Journal article about university tuition.
1. Do you feel that college education is an example of a public good?  Explain why or why not.
2.  Identify an externality associated with college education.  Is this a positive or a negative externality?  Explain your reasoning.
3. The article points out that state funding accounts for 36% of revenues at public colleges, while tuition accounts for 19% of revenues. Suppose that the rest of the revenues go to support purposes other than education, such as research, but that the entire state subsidy to universities goes towards tuition. Assume also that, as nonprofit enterprises, colleges charge only enough tuition (including any subsidy) to cover their costs. Under these assumptions, what would be the average tuition amount if state subsidies were removed? How does this compare to the average private university tuition? What might account for the difference?
4.  Would you expect state subsidies of college education to increase or decrease overall economic efficiency?   Explain your reasoning.
5. Which of the four market structures discussed in class best applies to the market for private colleges?  Explain your reasoning.
6.  Identify an example of price discrimination described in the article.  In your example, which group of consumers would you expect to have a higher price elasticity of demand, and which group would you expect to have a lower price elasticity of demand?  Explain your reasoning.
7. Which would you expect to be easier to implement, price discrimination for university education, or price discrimination for computers?  Explain your reasoning.
15. (25 points) For this question, please read this October 2001 Wall Street Journal article about Cipro, an antibiotic which has been approved for the treatment of anthrax, among other illnesses.
1. Identify, in the article, an externality generated by the consumption of Cipro. Explain why this is an externality.
2. In a free market, would you expect this externality to lead to too much, too little, or just enough consumption of Cipro? Why?
3. The market for prescription drugs is not exactly a free one. Identify a government regulation, already in place, that might help correct the market failure pointed out in the previous two parts of this question.
4. Which of the four market structures discussed in class best applies to the market for doctors? Explain your reasoning.
5. Do doctors have an incentive to prescribe more ciprofloxacin than would be socially optimal/efficient? Explain why or why not.
6. As of 2001, Bayer AG’s patent on ciprofloxacin hydrochloride prevented other companies from manufacturing this chemical. Which of the four market structures discussed in class would best apply to the market for ciprofloxacin in 2001? Explain your answer.
7. Upon expiration of Bayer’s patent in 2004, other manufacturers would become able to manufacture generic ciprofloxacin. Which of the four market structures would you expect to occur as 2004? How would you expect the market price of ciprofloxacin to change as the result of patent expiration?
8. After generic ciprofloxacin became available, what might you expect to have happened to the total quantity of ciprofloxacin sold? Increase, decrease, or stay the same? Explain your reasoning.
9. (Optional - 10 extra-credit points) Provide some research about the actual prices and quantities of ciprofloxaxin. Compare prices before and after the 2004 patent expiration. If possible, also compare quantities before and after the 2004 patent expiration. Make sure to describe your sources of information.
16. (Optional - 10 extra-credit points) Some people advocate providing vouchers to families and allowing them to redeem these vouchers for their children at either private or public schools. Identify an advantage and a disadvantage of this proposal, from the point of view of economic efficiency.
17. (Optional - 20 extra-credit points). In class, we played an oligopoly game between N different firms with homogeneous goods and identical production technologies. Each firm simultaneously chose its output quantity, and the total output by all N firms determined the market price. (This game is called the Cournot game by economists, as it was first analyzed by a French economist named Cournot in the 1800s.)

For concreteness, let's consider the case with N=5 firms. For each firm, AC=MC=10. The market demand is given by the following inverse demand curve: P = 100 - Q. Recall that in this game, each of the 5 different firms chooses its own quantity (q1, q2, q3, q4, q5), and the total market quantity Q is given by the sum of the five firms' choices: Q = q1+q2+q3+q4+q5.

1. If the firms wish to work as a cartel to maximize their joint profits, what total quantity should be produced? Assume that the firms agree to divide the profits equally by each producing identical levels of output; what quantity should each individual firm produce? What will be the market price, and what will be the amount of profit earned by each firm?
2. Demonstrate that if each other firm produces the quantity prescribed in part (a), then firm 1 can earn more profits by deviating from the prescription. What does this tell us about the stability of the cartel?
3. Find the symmetric Nash equilibrium output for this game. That is, find the level of output for each firm such that, if all the other firms produce the prescribed output, firm 1 will have no incentive to deviate from the prescribed level of output. What will be the level of output for each firm, what will be the market price, and what will be the profit for each firm in this equilibrium?
4. How does the Nash equilibrium compare to the cartel solution in (a)?

18. (Optional - 10 extra-credit points, based on the last portion of Chapter 8) Provide a newspaper or magazine article about a merger between two firms (or a purchase of one firm by another). Describe whether you think there are any cost savings to be had by this merger. Do these cost savings represent economies of scale, or economies of scope? Explain your reasoning.