ANSWERS TO SUGGESTED ADDITIONAL HOMEWORK

CHAPTER 5
5-1. Distinguish between returns to scale and returns to a factor.
Returns to scale refers to the relation between output and a proportional
variation of all inputs taken together. Returns to a factor refers to the relation between
output and the variation in only one input, holding all other inputs fixed.
5-2. Your company currently uses steel and aluminum in a production process. Steel costs
$.50 per pound, and aluminum costs $1.00 per pound. Suppose the government imposes a
tax of $.25 per pound on all metals. What affect will this have on your optimal input mix?
Show using isoquants and isocost lines.
It is likely to shift the optimal mix toward using more aluminum. The $0.25 per pound
tax is a larger percentage tax on steel. Thus, the price of steel has increased relative to
the price of aluminum. The graphic analysis is similar to Figure 5.7. The original
isocost line has a slope of-.5/1 = -.5. The slope of the isocost line after the tax is (.5+.25)/(1+.25) = -.6. The optimal input mix to produce any given quantity of output
now uses more aluminum and less steel. Note: The chapter concentrates on the
substitution effect and does not go into detail about scale effects. In a more in-depth
analysis, one would consider changes in the scale of output that also might accompany
an increase in input prices.
5-3. Your company currently uses steel and aluminum in a production process. Steel costs
$.50 per pound, and aluminum costs $1.00 per pound. Suppose that inflation doubles the
price of both inputs. What affect will this have on your optimal input mix? Show using
isoquants and isocost lines.
If inflation has the same percentage effect on both inputs, there is no change in relative
prices. Thus, there is no change in the optimal input mix to produce any given output.
A graphical picture such as Figure 5.7 remains unchanged.
5-4. Is the "long-run" the same calendar time for all firms? Explain.
No. The short run is the operating period during which at least one input is fixed in
supply. In the long run, no inputs are fixed. These definitions are not based on
calendar time. Rather, the length of each period depends on how long it takes the firm
to vary all inputs. This time can vary across firms.
5-6. Suppose that average cost is minimized at 50 units and equals $1. marginal cost at this
output level?
It is $1. Marginal equals average when the average is at a minimum.
5-7. What is the difference between economies of scale and economies of scope?
Economies of scale involve efficiencies from producing higher volumes of a given product,
while economies of scope involve cost savings that result from joint production.
5-8. What is the difference between economies of scale and learning effects?
Economies of scale imply reductions in average cost as the quantity being produced in the
production period increases. Learning effects imply a shift in the entire average cost curvew
(the average cost for producing a given quantity in a production period decreases with
cumulative volume).

CHAPTER 6
6-1: What four basic conditions characterize a competitive market?

A large number of either actual or potential buyers and sellers.

Product homogeneity.
Rapid dissemination of accurate information at low cost.
Free entry and exit in the market.

6-3. Should a company ever produce an output if the managers know it will lose money
over the period? Explain.
The firm should operate in the short run, as long as it obtains enough revenue to cover
its variable costs. Revenue in excess of variable costs helps to cover fixed costs (which
are incurred even if the firm does not operate).
6-4. What are economic profits? Does a firm in a competitive industry earn long-run
economic profits? Explain.
Economic profits are "abnormal profits" (profits above what it takes to entice
investment in the industry). Firms in a competitive industry can earn economic profits
in the short run. The existence of economic profits will attract entry into the industry.
Thus, firms are unlikely to earn economic profits over a long time period. Even in
relatively competitive industries, however, there are firms that do exceptionally well
over long time periods, for example by being the low-cost producer or having some
particular advantage relative to competitors, such as location. These are inframarginal
rents (not monopoly rents). The excess returns often do not go to the owner of the
enterprise, but rather to the factor input that produces the particular advantage. We
discuss these issues in greater detail in Chapter 8.
6-5. The Johnson Oil Company has just hired the best manager in the industry. Should the
owners of the company anticipate economic profits? Explain.
No. The excess returns are likely to go to the manager. The manager's salary will be
bid up by other firms who want the manager's services.
6-7. The Suji Corporation has a monopoly in a particular chemical market. The industry
demand curve is P = 1,000 - 5Q. Marginal cost is 3Q. What is Suji's profit-maximizing
output and price? Calculate the corresponding profits.
The optimal output of 76.92 is found by setting MR = MC: 1000 - 10Q = 3Q. The
corresponding price of $615.40 is found from the demand curve. The profits are TR TC = $47,336.57 - $8,875.03 = $38,461.54. Note: we are assuming that there are no fixed
costs. Thus, total cost is the area under the marginal cost curve.
6-8. Assume the industry demand for a product is: P = 1,000 - 20Q. Assume that the
marginal cost of product is $10 per unit.
What price and output will occur under pure competition? What price and output will occur
under pure monopoly (assume one price is charged to all customers)?
Price equals marginal cost under pure competition. Thus, price = $10 and quantity =
49.5. The monopolist will set marginal revenue (1000 -40Q) equal to marginal cost.
The corresponding price and quantity are $505 and 24.75.
Draw a graph that shows the lost gains from trade that result from having a monopoly.
The graph is the same as in Figure 6.5 (except that a different demand curve is used).

CHAPTER 7
7-1. Macrosoft is a new producer of word processing software. Recently it announced it is
giving away its product to the first 100,000 customers. Using the concepts from this
chapter, explain why this might be an optimal policy.
There are often network externalities for software products -- demand is
higher when there are more users. Given that people exchange documents, it is
advantageous to use compatible software. Therefore, Macrosoft might be giving the
product away to create a large base of users to increase future demand. With higher
demand it will be able to charge higher prices.
It is also expensive for a person to change software programs (having to learn
new commands, etc.). The company may be trying to encourage people to switch so
that they will be "locked in" when it comes to purchasing new editions. Users will be
willing to pay a somewhat higher price for the new edition rather than switching to a
new product because of the switching costs.
7-2. The local space museum has hired you to assist them in setting admission prices. The
museum's managers recognize that there are two distinct demand curves for admission. One
demand curve applies to people ages 12 to 64, whereas the other is for children and senior
citizens. The two demand curves are:
Pa = 9.6 -- 0.08Qa
Pcs = 4 - 0.05Qcs

where PA is the adult price, Pcs is the child/senior citizen price, Qa is the adult
quantity, and Qcs is the child/senior citizen quantity. Crowding is not a problem at the museum, so managers consider margina
a. What price should they charge to each group to maximize profits?

Adults

Children/Senior Citizens

Set MR = MC

9.6 - .16QA = 0
Qa = 60

4 - .1Qcs = 0
Qcs = 40

Find Price

Pa = " 9.6 Pa = $4.8

Pcs = 4 - 0.05*40
Pcs = $2

0.08*60

b. How many adults will visit the museum? How many children and senior citizens?
60 adults
40 children and senior citizens
c. What are the museum's profits?
Profits = TR - TC
= 4.8*60 + 2*40 - 0
= $368

7-3. Textbook publishers have traditionally produced both United States and international editions of most
leading textbooks. The United States version typically sells at a higher price than the international edition.
(a) Discuss why publishers use this pricing plan. (b) Discuss how the Intemet might affect the ability of
companies to implement this type of policy.
a. The demand for textbooks in certain foreign markets is more elastic than in the Untied States (i.e.,
consumers are more price sensitive). The policy is likely a form of price discrimination (group
pricing).
b. The internet potentially makes it more likely that books sold outside of the United States will be
resold in the United States, thus making it more difficult to sustain price differentials (consider the
example of cigarettes in the text). A necessary condition for price discrimination is the ability to limit
resale among consumers.
7-4. Suppose in Table 7.2 (Product Bundling) that the professional user values Expedia Streets at $15 rather
than $30. Keep all other valuations the same. Discuss how this change affects the optimal pricing strategy.
In this case there are no gains from bundling. The sum of the minimum reservation price is the same
as the minimum reservation price for the bundle. To sell both products to both type of users you can
either set the prices at $15 and $10 for Streets and Planner respectively, or price the bundle at $25.
Profits are the same in either case.
7-5:

Explain why perfect personalized pricing is typically more profitable than menu
pricing. Why then do companies use menu pricing?

In the limit, personalized pricing extracts the maximum profit from each consumer. With menu
pricing, typically some of the consumers obtain surplus. If the firm tries to extract the maximum
surplus from each customer by pricing menu options in a particular way, some of the consumers are
likely to be able to select different options to obtain surplus. This ability to self-select from the menu
typically makes it impossible to extract all consumer surplus.
7-6. In the example in this chapter, the linear approximation method produced the profit-maximizing price,
whereas the markup pricing rule did not. Does this imply that the linear rule is always better than the markup
rule? Explain.
In the example, the underlying demand curve was linear. Thus, the linear approximation method
worked well (perfectly). If the demand curve is highly nonlinear the technique will not work well. If
the demand curve is isoelastic (or if the current elasticity is close to that at the optimal price), the
markup pricing rule will dominate.
7-7: Why do companies grant discounts to senior citizens and students?
Presumably, it is a form of price discrimination. Senior citizens and students are likely to have more
elastic demand for products than the average consumer. Thus, it can be optimal to charge them a
lower price, while charging other customers a higher price. Note that the other customers are not
subsidizing senior citizens and students. All customers are paying at least marginal cost for the
product.
7-8. You own a theater with 200 seats. The demand for seats is Q = 300 - 100P. You are charging $1.25 per
ticket and selling tickets to 175 people. Your costs are fixed and do not depend on the number of people
attending. Should you cut your price to fill the theater? Explain. What other pricing policies might you use
to increase your profits?
Revenue is maximized at the point where marginal revenue equals zero. In this problem, MR = 3 - .
02Q. Thus, it is optimal to sell 150 tickets at a price of $1.50 a ticket. This policy produces $225 in
revenue. The current policy produces $218.75 in revenue. The theater might be able to increase
revenue through price discrimination. For example, it might price tickets to the general public at
$1.50. It could then entice other people who are not willing to pay the $1.50 through policies such as
senior citizen or student discounts.

CHAPTER 11

11-1. Describe the three aspects of organizational architecture?

First is the assignment of decision rights; this assignment indicates who has authority to make
particular decisions within the organization. Second is the performance-evaluation system; this system
specifies the criteria that will be used to judge the performance of agents within the organization (for
example, employees). Third is the reward system; this system specifies how compensation (and other
rewards and punishments) will be distributed among agents within the firm.
11-2. What is a major difference between the architectures of markets and firms?
The architecture in markets is created spontaneously with little conscious thought or human direction.
Through market transactions, property rights are reassigned so that decision making and specific
knowledge are linked. Private property rights provide strong incentives for productive actions --they
create powerful performance-evaluation and reward systems. Within firms, the architecture is created
by management.
11-3. Suppose that a manager decides that a company's decision making is too centralized. Will simply
delegating more decisions to lower-level employees solve the problem? Explain?
No. The other components of architecture (rewards and performance evaluation) probably also have
to be changed to provide incentives to lower-level employees to make productive decisions.
11-4. Traditionally, many public utility companies (such as telephone and electric companies) have been
highly regulated by the government. Thus, they have operated in stable environments, shielded from
competition and rapid change. Recently, deregulation has substantially altered the environments of some of
these companies. For the first time, they are being exposed to intense competition from other companies.
Discuss how this change in the environment is likely to affect the optimal organizational architecture of
utility companies.

Traditionally, public utilities have had relatively centralized decision making and have made limited
use of incentive compensation (especially for lower-level managers and employees). Given the changes
in the business environment, is it likely that local specific knowledge will become more important. For
example, the tastes and preferences of customers can become more important to a company as it faces
increased competition. Also, maintaining state of the art technology can become more important.
These arguments suggests that deregulation might motivate a further decentralization of decision
rights. Correspondingly, to make the three legs of the stool balance, one might expect increased use of
incentive compensation. Empirical studies of deregulated industries tend to support these conjectures.
11-5. In most restaurants, the waiters receive a large portion of their compensation through tips from
customers. Generally the size of the tip is decided by the customer. However, many restaurants require a 15
percent tip for parties of eight or more. Using the concepts from this chapter, discuss (a) why the practice of
tipping has emerged as a major method of compensating the wait staff, (b) why the customer typically
decides on the amount of the tip, and (c) why restaurants require tips from large parties.
a. Tipping provides incentives for waiters to do a better job compared to paying them a straight
salary. Tipping provides incentives to provide high quality service and to sell products (since the tip is
based on a percentage of the bill).
b. The customer has the specific knowledge about whether or not the waiter did a good job.
c. For tipping to work, the customer must follow through on the implicit promise to tip if the quality of
service is good. Individuals in large parties often have incentives to shirk on the tip (free ride). For
instance, if each individual agrees to place his share of the bill in a common pool, the amount collected
is usually less than the bill plus the normal tip. Hence, large parties are less likely to give reasonable
tips unless they are required. Requiring a tip helps to solve this agency problem. The waiter has fewer
incentives to provide good service. However, the waiter still has incentives to sell products.
11-7. Prominent management consultants sometimes argue that decision making in teams is usually more
productive than decision making by individuals (important synergies arise when teams operate that are absent
when individuals work by themselves). These consultants suggest that most companies have long failed to make
proper use of teams. Their advice is that most firms should increase their use of teams significantly. Critique this
advice.

Managers should be skeptical of this type of advice. If firms have not used teams and
continued to survive over a long time period, this suggests that the use of teams is not always
productive. The principle of economic Darwinism suggests that competition long ago would
have driven firms to use more teams if teams were always more productive. After all, teams
are not a new idea. It is possible that the environment has changed in ways that make the use
of teams more valuable for certain 17rms. However, this does not mean that all firms should use
teams (it depends on the environment in which they operate). In the next chapter, we discuss
the economics of teams in more detail.