Problem Set 2

Hard copies of your answers are due at the beginning of your section, either on
Thursday, October 6, or Friday, October 7. For example, if your section starts
at 10:00am on Friday, you should submit your answers to your TA in your
section classroom at 10:00am on Friday, October 7. Late problems earn zero
points.

Note: you can work on these problems or your own, or in a small group with
other current Econ 1 students. If you choose to work in a group, each student
needs to hand in a separate, individual copy to his/her TA.

1. The meal plan at university A lets students eat as much as they like for a
fixed fee of $500 per semester. The average student there eats 250 pounds of
food per semester. University B charges $500 for a book of meal tickets that
entitles the student to eat 250 pounds of food per semester. If the student eats
more than 250 pounds, he or she pays extra; if the student eats less, he or she
gets a refund. If students are rational, at which university will average
consumption be higher? Why?

2. A price-taking (that is, competitive) firm makes air conditioners. The market
price of one of their new air conditioners is $120. Its total cost information is
given in the following table.

Air conditioners/day Total cost ($/day)

1 100
2 150
3 220
4 310
5 405
6 510
7 650
8 800

How many air conditioners should the firm produce per day if its goal is to
maximize its profits?

3. Tofu was available 30 years ago only from small businesses operating in
Chinese quarters of large cities. Today tofu has become popular as a high-
protein health food and is widely available in supermarkets throughout the
United States. At the same time, production has evolved to become factory-
based using modern food-processing technologies. Draw a diagram with demand
and supply curves depicting the market for tofu 25 years ago and the market
for tofu today. Given the information above, what does the demand-supply
model predict about changes in the volume of tofu sold in the United States
between then and now? What does it predict about changes in the price of
tofu?

4. 1Consider a firm that has a fixed cost of $60. Complete the following table.

Output FC VC TC MC AFC AVC ATC

1 $10
2 $18
3 $30
4 $45
5 $65
6 $90

5. 2You want to know the short-run marginal cost of producing a Chevrolet

Caprice. Comment on the following statement from an analyst in the
production department: “The marginal cost of a Caprice, given our current
volume, is $12,500. Of course, the actual marginal cost depends on the number
of cars produced. The larger the number produced, the lower the unit cost
because we will spread out our design and tooling costs over more cars.”

1
From Economics, Principles and Tools by Arthur O’Sullivan and Steven Sheffrin. Fourth
edition. Pearson/Prentice Hall. 2006.
2
ibid.
Extra practice problems (completely optional; no points awarded)

A. Economists have observed that in times of low unemployment there are

fewer business startups, while in times of high unemployment more people
decide to start their own businesses. Verbally explain this observed behavior in
terms of opportunity costs.

B. On October 7, 2003, CNN reported that British “researchers found that

classical music […] was the most successful in encouraging people to part with
their cash [in restaurants], with diners spending more than 24 pounds (US$40) a
head.” “With no background music, spending [in meals] fell to around 21
pounds (US$35).”
(a) Graphically show the market for restaurant food when no restaurant plays
any music. Make sure you include demand and supply curves, and show the
equilibrium price and quantity.
(b) Now suppose that all restaurants start playing classical music, at no
additional cost to the restaurant. How would the market for restaurant food
look like after this change? Starting from the same diagram you drew in part
(a), make sure you include demand and supply curves after the introduction of
classical music, and show the new equilibrium price and quantity.
(c) After complaints from the Recording Industry Association of America (the
trade group that represents the U.S. recording industry), restaurants have to
start paying for playing classical music during meals. Graphically show the
effects in the market for restaurant dinners, and, separately, in the classical
music market. Make sure you include demand and supply curves, and show the
equilibrium prices and quantities in each market (one graph per market).

C. Madagascar is one of the main producers and exporters of vanilla, the plant
used in food and drink flavoring. In 2000 and 2001, storms destroyed much of
Madagascar’s vanilla production.
(a) Graphically show the world market for vanilla before and after the storms.
Make sure you include demand and supply curves, and show the equilibrium
prices and quantities. You can assume the vanilla market is competitive.
(b) By 2002 most of the effects of the storms on vanilla production were over,
and the market was back to normal. However, later that year Coca Cola
announced its vanilla flavored Coke. Graphically show the world market for
vanilla after the introduction of the vanilla Coke. Make sure you include
demand and supply curves, and show the equilibrium prices and quantities.
(c) Briefly explain how the effects on price and quantity are different in part
(a) and part (b). Would you be able to tell the two initial shifts apart just from
observing prices and quantities? What is the key piece of information?
 Economics 1
HW# 2 Solution Set
1. Consider the demand curve for food by college students. In particular, suppose that
the demand curve is downward sloping (this denotes a decreasing marginal benefit of
food. In the graph that follows, I will assume the demand curve is linear purely for
convenience).

At University A, there is an unlimited supply of food at a price of $500. Students must

pay a fixed fee of $500 regardless of how much they consume. Thus at University A, the
price of an extra pound of food is zero.

On the other hand, students at University B do not face a fixed fee. While they pay $500
at the beginning of the year to eat 250 pounds of food, they will get a refund/bill if they
choose to eat less/more than the 250 pounds, and they actually face a price of $2 per
pound.

Given these prices, students at University A will continue eating until their marginal
benefit is zero while students at University B will stop eating sooner, when their
willingness to pay for an additional pound of food is $2. This can be seen in the
following graph:

2. Recall from class that a firm maximizes profit by producing the largest quantity such
that marginal cost is less than or equal to the price received for each quantity. To answer
this question, I propose adding a marginal cost column to the table given in the question.
Since the price is $120, then the firm will maximize profits by selling 6 air conditioners
per day. One can verify this by calculating the total profits for each unit. Augmenting
the table with columns for Total Revenue and Profit yields:
 Air conditioners/day Total Cost Total Revenue (P*Q) Profit Marginal
Cost
1 100 120 20 ??∗
2 150 240 90 50
3 220 360 140 70
4 310 480 170 90
5 405 600 195 95
6 510 720 210 105
7 650 840 190 140
8 800 960 160 150
*We do not know the fixed cost associated with the production of air conditioners,
therefore we cannot know the marginal cost of producing the first unit.

3. An increase in the popularity of protein as a source of protein is the same as an

increase in the demand for tofu, or an upward shift of the demand curve. Advancement
in technology for producing tofu is the same an increase in the supply of tofu. This is the
same as a rightward shift in supply. Graphically,

Clearly, the quantity of tofu sold in the US has increased. However, it is not clear what
will happen to the price of tofu. The supply expansion is putting downward pressure on
the price while the demand expansion is putting upward pressure is putting pressure on
the price. Whether price goes up, down, or stays the same cannot be determined because
the question does not tell us the size of the demand and supply shifts, which is needed to
determine this.
4. Your table should look like this. Recall that total cost is equal to the FC plus the sum
of variable costs up to each unit.

Output FC VC TC MC AFC AVC ATC

1 60 10 70 10 60 10 70
2 60 18 78 8 30 9 39
3 60 30 90 12 20 10 30
4 60 45 105 15 15 11.25 26.25
5 60 65 125 20 12 13 25
6 60 90 150 25 10 15 25

5. Marginal cost is the change in total costs due to a one unit change in the quantity
produced. In the short run we know that some factors of production are fixed. The
analyst tells us that the given the current production volume, the marginal cost is
$12,500. He adds that if the volume were larger then the marginal cost would be lower
too. This is untrue. Given that the factors involved in producing a Caprice are fixed in
the short run, it is not possible to lower marginal cost because the costs of things like
tooling and design are spread out over a larger quantity. Tooling the machines and
designing the car are fixed costs. It is true that the average total cost would decrease for
the reasons mentioned by the analyst, but marginal cost would remain the same in the
short run. Larger numbers of Caprices reduce the average fixed cost component of the
average total cost.

Extra Problems

A. Opportunity cost is defined as “the value of the next-best forgone alternative that was
not chosen because something else was chosen” (Taylor, p. 5). The question tells us that
in times of low unemployment there are fewer startups than in times of high
unemployment. We are asked to explain this phenomenon in terms of opportunity cost.
From the question we can conclude that it must be that the opportunity cost to starting a
business during times of low unemployment must be higher than in times of high
unemployment (note: higher (opportunity) costs implies fewer startups here). Next we
need to find what these opportunity costs are and compare them. There are many
opportunity costs involved with starting your own business. The money you have to
invest in your business and the foregone income (i.e. wages and fringe benefits) from not
working for an already established firm are two examples of opportunity costs associated
with starting your own business.

To answer the question, we need to know which of these opportunity costs will vary with
the level of unemployment (because any opportunity cost that is the same in both
scenarios will not influence your decision to start a business). If you are unemployed, you
don’t earn any income from an already established firm, which means that this
opportunity cost goes down to zero. Since the amount of money you would need to invest
into your new business should not change much with the level of unemployment we can
assume it to be the same (yes, workers might ask for a lower wage, but that is not an
opportunity cost for you, but a cost to your potential startup).

Hence, during times of high unemployment many people face relatively low opportunity
costs of starting their own businesses. Similarly, during times of low unemployment most
people have jobs and thus face relatively high opportunity costs. The lower the
opportunity cost to starting their own business, the more likely it is that somebody will
actually start one. Thus, we can conclude that there will be more business startups when
there is high unemployment (lower opportunity costs) than when unemployment is low
(higher opportunity costs).

B.
(a) The initial market before classical music looks like this.

Price
(per person)
Restaurant food without classical music

P*=35

Q* Quantity
(number of diners)

(b) The problem states that when restaurants play classical music, spending (in meals)
increased from $35 to $40 per head. So if a restaurant starts playing music at no
additional cost, we can say that the demand for restaurant food increases, as
people spend more time at the restaurant, eat more and end up paying more. The
demand curve shifts up, and there is a movement along the supply curve, resulting
in a higher equilibrium quantity and price ($40).
 Price
(per person)
Restaurant food with classical music

P2=40

P1=35

D’

Q1 Q2 Quantity
(number of diners)

(c) Making restaurants pay for playing classical music during meals is the same as
increasing the cost of one of its production inputs. Thus the restaurant now faces
increased costs and as a result supply shifts up. There is a movement along the
new demand curve, D', resulting in a lower equilibrium quantity and higher price
of food supplied.

Price
(per person)
Restaurant food with costly classical music

S’
S
P3

P2=40

D’

Q3 Q2 Quantity
(number of diners)
 Once restaurants are forced to pay in order to play classical music it means that
new consumers have entered the market. As a result, demand for classical music
increases, shifting the demand curve up. There is a movement along the supply
curve, resulting in increased Q and P.

Market for classical music

Price

P’

D’

Q Q’
Quantity

C.
(a) The storm destroying much of the production leads to a decrease in the amount of
available vanilla at every possible price. This can be represented as a shift left in
the supply curve. This shift leads to a movement along the demand curve to the
new equilibrium. The result is an increase in price and decrease in quantity sold.
 Effects of the storms on the vanilla market
Price

S’

S
P’

Q’ Q Quantity

(b) The introduction of Vanilla Coke will result in a need for more vanilla at every
possible price. This can be represented as a shift right in the demand curve. This
shift leads to a movement along the supply curve to the new equilibrium. The
result is an increase in price and in quantity sold.

Effects of the Vanilla Coke on the vanilla

Price
market after storms have passed

P’

D’

Q Q’ Quantity
(c) In part a, we experienced a shift in the supply curve which led to an increase in
price and a decrease in quantity sold. In part b, we saw a shift in the demand
curve, leading to an increase in both price and quantity sold. Even if one were
only able to observe the changes in price and quantities, it would still be possible
to distinguish between these two shifts because the equilibrium quantity shifts in
opposite directions. An increase in both price and quantity implies a shift right in
demand while an increase in price accompanied by a decrease in quantity implies
a shift left in supply.