EC101 Problem Set 3

Chapter 10
1. Externality Public Policy Firm A and Firm B are both producers of steel. Steel
is made in factories, and therefore the production of steel generates pollution. Suppose
that Firm A and Firm B are each currently producing 1000 units of pollution every
month.

(i.) Draw a demand and supply diagram for the market for steel. Show the private -

value, private cost, social value, and social cost curves, as well as the externality.
-
-
-

Price ? social cost Private cost

S
Y

Social Value
~
private value
↓
D
>
G

Quantity
Steel
(ii.) Suppose the government implements a command and control policy that requires
every firm to limit pollution generation to 650 units. If Firm A’s opportunity cost
of reducing pollution by 1 unit is $1.50 and Firm B’s opportunity cost of reducing
pollution by 1 unit is $1.80, how expensive is it for each firm to adhere to the
government’s policy?
Lest
$525
$1 So/unit
=

*
·

350 units
Firm A :

. do units
3 x $1 80/unit
. =
$630
Firm B :

(iii.) Now imagine that instead of dictating a universal maximum level of pollution gen-
eration, the government allocates 650 pollution permits (each of which allows 1
unit of pollution production) to each firm. If they wish, firms can engage in trade.
What is the market outcome of this policy? Will firms trade? If yes, at what price
and what are the savings to each firm? If no, why not?

1
 $1 so/unit $1 65/ unit
Eg
.

Firm A cost : .
price =

Firm B : $1 .
80 Neit

firm the permit

If A is
selling
(350 + x)
=
1 080 (350 -

x)
At equilibrium
.

:
1 50.

X = 87 5 .

permits
at $1 05 each
permits
.

87
Firm A sells 5
·

(1 65-1 50) =
$13 .
125
Firm A Saves 87 3 x
. . .

$13 125
(1 69)
.

B 87 80 =
-

Firm Saves 3 1
x
.

: .
.

(iv.) Suppose the demand curve for pollution rights is given by QD = 78 P + 2000. P
represents the price of access to pollution. The government chooses this price in
the form of a corrective tax. What price should the corrective tax equal in order
to achieve the same quantity outcome from parts (ii.) and (iii.)?
QD =
p + 2000

1300 4/p + 2000

-

=p =
700

p = $800

$800
The corrective fax should be

Chapter 13
2. Marginal Product & Cost Curves Suppose you are studying linear algebra for fun.
You observe the following relationship between the hours you invest in learning and the
units of mathematical knowledge you acquire:

Hours Knowledge Units

0 hours 0 k.u.
1 15
2 25
3 33
4 39
5 44

(i.) What is the marginal product of each hour you invest in learning? Graph the pro-
duction function and explain its shape.

Page 2
 cost
Mariginal knowledge S
*
-

Unit
1st V :
15-0 =
15 -

2nd hu
:
25-15 = 10
-

3rd hr :
33-25 : 8
-

4 hr :
39 -

33 = 6
-

g
+
"hr : 44-39 =
5
I S I I

Litt
(ii.) Suppose you experience a predetermined level of growing/learning pain when you
decide to study, regardless of the duration of your session. This pain costs you $80.
Also, the opportunity cost of your time is given by OC = $5 ⇥ h1.5 , where h is the
number of hours you invest in learning. Graph your total cost curve and explain
its shape. F2 $80 oC 15 xh's =
Total cost $80 + 5hls
=
=

Total cost
Hour F T cre

g(0)"5
- - - --

& 80 + = 80 130
-
↑ &

15
I 80 + S(!) E85 120 -
-

-
-
&
S

2 80 + g(2)
15
~
= 94 .
2 110
-

- D
" S

15 los-
g(3)
:

i
↑

3 80 + 1
=
~ 105 98
.

-
-

----
↑

15
g(4) E120
98
"i
x
↑

34
80 +
---
---

i
80 + g(5)"5 = 135 9 .

$ 80 I 7 >
hus

(iii.) In general, what is the relationship between the production function and the total
cost curve?
production function total cost
the and the
the riship blu
related because as more resources are used
is
inversly becomes more costly to produce
each additional veit of output
.

3. Marginal Cost & Average Total Cost Peter produces protein pancakes. Here is
his cost schedule:

Quantity Total Cost

0 pounds $15
1 $20
2 $27
3 $37
4 $50
5 $65

(i.) Calculate variable costs, average variable costs, average fixed costs, marginal costs,
-
-
&
and average total costs. I recommend displaying these values in a table.

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Quantity
V TC VC
C
AFC MC ATC
-
-

O 15 O -

20 5 20
I 5 5 15

12 7 13 5 .

27 6 7 5 .

2
37 22 7 33 .
5 10 12 33.

3
So 35 8 75
.

3 .

75 13 12 5 .

4
5 65 So 10 3 15
13

(ii.) Graph marginal cost, average total cost, average fixed cost, and average variable
cost. Clearly label your axes.

(iii.) What is the efficient scale?

3 pounds because ATC is the lowest (12
.

33)

(iv.) What is the relationship between marginal cost and average total cost? Why is
this the case? What is going on when M C > AT C? What is going on when
M C < AT C?
bi cost of additional
When MCCATC
: ATC is
decreasing &

producing
less the cost
unit is than
average
cost is more than
When Mc > ATC : ATC is
increasing bic production
cost
average
When Mc = Atc : Atc is the lowest Jefficient scale)
Chapter 14
4. Profit Maximization & Perfect Competition Suppose that a profit-maximizing
firm in a perfectly competitive market is currently producing 1000 units.

(i.) If the firm is currently generating $12000 in revenue, what is its marginal cost?
Why?

Revenue =
$12, 000
$12
& Mc at 1000 units is
Quantity = 1000

Price
000=$12/it
-

Page 4
(ii.) If the firm’s fixed costs equal $2500 and total costs equal $10000, is the efficient
scale greater than, equal to, or less than 1000 units?

$10,000
VC = TC -
FC = -

$2 , 500 =

$7 500
,

Atc = TQ
=
$10, 000/1000 =
$10 unit
Price =
$12/eit ·

units
Scale >1000
Efficient
Price
> ATC = Profit
Efficient Scale = minimum ATC

(iii.) If the firm’s fixed costs equal $2500 and total costs equal $10000, what is the aver-
age variable cost?

AVC $7
1
50 unit
$ per
= .

=
=

1000

(iv.) Should the firm shut down in the short-run? If yes, provide an argument as to why.
If no, explain why not.

No because the point

shot down is when price Arc

Price ($12) > Ava ($7 90) so .

the form should
not shot down .

(v.) What is the firm’s current profit or loss? Draw possible marginal cost, average vari-
able cost, average total cost, and marginal revenue curves for this firm to illustrate
your answer. Show the profit/loss on the graph and clearly indicate what is going
on at a quantity equal to 1000 units.

P= TR -

TC

=
$12, 000
- $10, 000 =
$2000

Page 5 -
5. Market Supply with Entry and Exit Suppose firms A, B, and C are considering
joining a perfectly competitive market. Consider the following cost curves for each firm:

Loss
·

Page 6
 -
ROFIT

&

(i.) On each graph, mark the quantity that each firm would choose to produce.

(ii.) On each graph, show the profit/loss of each firm. Which firm(s) will choose to enter
the market?

Page 7