CHP 11 Econ

Chapter 11
PERFORMANCE AND STRATEGY IN COMPETITIVE MARKETS

QUESTIONS AND ANSWERS
Q11.1
Your best income-earning opportunity appears to be an offer to work for a local

developer during the month of June and earn $2,000. However, before taking the job,
you accept a surprise offer from a competitor. If you actually earn $2,600 during the
month, how much producer surplus have you earned? Explain.
Q11.1
ANSWER
$600. Producer surplus is the amount a seller is paid minus the sellers marginal cost
of production. In this case, the opportunity cost of $2,000 is the relevant marginal cost
of deciding to work for the competitor, and producer surplus is the amount received
above and beyond that amount. The amount received, $2,600, represents a $600
premium over the amount that would have been received from your next-best
employment opportunity and represents the value of your producer surplus.
Q11.2
Assume that you are willing to pay $1,100 for a new personal computer that has all the
bells and whistles. On the Internet, you buy one for the bargain price of $900.
Unbeknownst to you, the Internet retailers marginal cost was only $750. How much
consumer surplus, producer surplus, and net addition to social welfare stems from
your purchase? Explain.
Q11.2
ANSWER
Consumer surplus is the amount that consumers are willing to pay for a good or service
minus the amount that they are required to pay. Consumer surplus represents value
derived from consumption that consumers are able to enjoy at zero cost. It also
describes the net benefit derived by consumers from consumption, where net benefit is
measured in the eyes of the consumer. If you are in the market for a new personal
computer and willing to pay up to $1,100, but you buy one for the bargain price of
$900, you realize consumer surplus of $200. Consumer surplus represents the
difference between the price you were willing to pay and the price paid.
Whereas consumer surplus is closely related to the demand curve for a product,
producer surplus is closely related to the supply curve for a product. Producer surplus
is the amount paid to sellers minus the cost of production. It represents the amount
paid to sellers above and beyond the required minimum and is the net benefit derived
by producers from production. If you paid $900 and the Internet retailers marginal
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Chapter 11
cost was $750, the amount of producer surplus is $150, or the difference between the
minimum price a seller would be willing to accept and the price received.
In competitive market equilibrium, social welfare is measured by the sum of net
benefits derived from trade by consumers and producers. Social welfare is the sum of
consumer surplus and producer surplus. In this case, the total gains from trade are
$350. The gain from trade realized by the consumer is $200; the gain from trade
realized by the producer is $150.
Q11.3
After having declined during the 1970s and 1980s, the proportion of teenage smokers
in the United States has risen sharply since the early-1990s. To reverse this trend,
advertising programs have been launched to discourage teenage smoking, penalties
for selling cigarettes to teenagers have been toughened, and the excise tax on
cigarettes has been increased. Explain how each of these public policies affects
demand for cigarettes by teenagers.
Q11.3
ANSWER
Like any drug interdiction program, advertising programs designed to discourage
teenage smoking can have a favorable effect by causing an inward shift in the demand
curve for cigarettes. Similarly, to the extent that penalties for selling cigarettes to
teenagers preclude some underage smokers, the demand curve for cigarettes will shift
inward. In both cases, a reduction in demand for cigarettes by teenagers will be noted.
Following a excise (per unit) tax increase, the price of cigarettes will rise and cause a
decrease in the quantity demanded as shown by an upward movement along the
demand curve.
Significant evidence suggests that teenage smoking is in fact susceptible to
economic considerations. Economists Jonathan Gruber and Jonathan Zinman find that
a major explanation for the rise in youth smoking over the 1990s was a sharp decline in
cigarette prices in the early 1990s, caused by a price war among the tobacco
companies. Gruber and Zinman find that young people are very sensitive to the price
of cigarettes in their smoking decisions. The authors estimate that for every 10 percent
decline in the price, youth smoking rises by almost 7 percent, a much stronger price
sensitivity than is typically found for adult smokers. The price decline of the early
1990s can explain about a quarter of the rise in smoking from 1992 through 1997.
Similarly, the significant decline in youth smoking observed in 1998 is at least partially
explainable by the first steep rise in cigarette prices since the early 1990s. However,
price does not appear to be an important determinant of smoking by younger teens who
are experimental smokers. Restrictions on access to cigarette purchases can lower the
quantity that younger teens smoke, but the most influential tool that policymakers have
to reduce youth smoking is clearly excise taxes that raise the price of cigarettes. (See:
Jonathan Gruber and Jonathan Zinman, Youth Smoking in the U.S.:Evidence and
Implications, NBER Working Paper No. 7780).
Performance and Strategy in Competitive Markets
65
Q11.4
In 2004, OPEC reduced the quantity of oil it was willing to supply to world markets.
Explain why the resulting price increase was much larger in the short run than in the
long run.
Q11.4
ANSWER
The supply and demand for oil are relatively inelastic in the short run, but fairly elastic
in the long run. In the short run, oil supply is quite inelastic because it takes time to
drill new wells, build additional pipelines, and arrange for ship cargo transportation.
Similarly, in the short run, the demand for oil is quite inelastic because consumers have
fixed needs for gasoline to power their cars, fuel to heat their homes, and so on. In the
long run, supply conditions in the oil market can be rather elastic because OPEC
members tend to cheat on their cartel agreements to restrict output, and because nonOPEC producers respond to higher oil prices by expanding production. Oil demand
also tends to be more elastic in the long run because consumers respond to higher oil
prices by buying high-mileage automobiles, increasing home insulation, and so on.
Q11.5
The demand for basic foodstuffs, like feed grains, tends to be inelastic with respect to
price. Use this fact to explain why highly fertile farmland will fetch a relatively high
price at any point in time, but that rising farm productivity over time has a negative
overall influence on farmland prices.
Q11.5
ANSWER
At any point in time, farmers with especially fertile farmland earn economic rents
because of the superior productivity of their soil. Even in competitive long-run
equilibrium, especially fertile soil has the potential to generate durable economic rents.
With an ability to generate durable above-normal profits, especially fertile land will
generate an above-normal price in the real estate market. In fact, especially fertile soil
will attract a sufficiently high market price as to afford the buyer nothing more than a
risk-adjusted normal rate of return on the buyers investment.
However, the long-term profit-making potential of farmland is limited by the fact
that the demand for basic foodstuffs, like feed grains, tends to be inelastic with respect
to price. With rising farm productivity over time, the supply of basic foodstuffs tends
to rise faster than stagnant demand causing stagnant to declining prices for farm
products. Over time, increasing farm productivity in the United States has had an
adverse effect on farm prices and farmer incomes in the United States.
Q11.6
In 1990, Congress adopted a luxury tax to be paid by buyers of high-price cars,

yachts, private airplanes, and jewelry. Proponents saw the levy as an effective means
of taxing the rich. Critics pointed out that those bearing the hardship of a tax may or
may not be the same as those who pay the tax (the point of tax incidence). Explain
how the elasticities of supply and demand in competitive markets can have direct
implications for the ability of buyers and sellers to shift the burden of taxes imposed
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Chapter 11
upon them. Also explain how elasticity information has implications for the amount of
social welfare lost due to the deadweight loss of taxation.
Q11.6
ANSWER
When Congress passed the luxury tax, the goal was to raise revenues from those who
could most easily afford to pay for government services, the rich. Unfortunately,
because the demand for new luxury items produced and sold in the United States is
relatively elastic, buyers of such luxury items can choose to postpone such purchases,
or buy them from producers not subject to tax, in order to minimize their discretionary
tax payments. When demand is elastic and supply is inelastic, as in the case of yacht
production, for example, the largest share of tax burden falls on producers rather than
buyers. In the case of yachts, the luxury tax caused a steep decline in domestic
production. Producer profits plummeted and workers got laid off. They, rather than
rich customers, tended to suffer. It is important to keep in mind that the economic
hardship of a tax (tax burden) can seldom be inferred by simply referencing the party
responsible for paying the tax (tax incidence).
In general, the burden of a tax tends to fall on that side of the market that tends
to be relatively less elastic. Elasticity also has implications for the amount of social
welfare lost due to the deadweight loss of taxation. Holding the elasticity of demand
constant, the deadweight loss of a tax is small when supply is relatively inelastic.
When supply is relatively elastic, the deadweight loss of a tax is large. Similarly,
holding supply elasticity constant, the deadweight loss of a tax is small when demand
is relatively inelastic. When demand is relatively elastic, the deadweight loss of a tax
is large.
Q11.7
Both employers and employees pay Social Security (FICA) on wage income. While the
burden of this tax is designed to be borne equally by employers and employees, is a
straight 50/50 sharing of the FICA tax burden likely? Explain.
Q11.7
ANSWER
No. Social security (FICA) taxes were designed so that employers and employees
would share the burden of the tax. This type of payroll tax drives a wedge between the
wage paid by the employer and the wage received by the employee. In most
circumstances, it is reasonable to expect that employers and employees share in paying
the economic burden of the tax. However, it is not reasonable to assume that
employers and employees equally share responsibility for paying the economic
hardship imposed by FICA taxes just because the incidence of the tax is 50/50. Some
tax burden shifting can be expected, depending upon demand and supply conditions in
the labor market.
For example, if the demand for labor is highly elastic, employees will find it
difficult to pass along the burden of payroll taxes to employers. In this case,
employees will be forced to bear a large share of the economic burden of FICA taxes.
67
If labor demand is inelastic, employees will find it easy to pass along the burden of
payroll taxes to employers. In this case, employers will be forced to bear a large share
of the economic burden of FICA taxes. If labor demand were perfectly elastic,
employees would bear the entire economic burden of FICA taxes. If labor demand
were perfectly inelastic, employers would bear the entire economic burden of FICA
taxes.
On the other hand, holding the elasticity of labor demand constant, the economic
burden of payroll taxes tends to shift from employees towards employers as the
elasticity of supply increases. If labor supply were perfectly elastic, employers would
bear the entire economic burden of FICA taxes. If labor supply were perfectly
inelastic, employees would bear the entire economic burden of FICA taxes. None of
these circumstances are likely, however, and some sharing in the economic burden of
FICA taxes is to be expected between employers and employees. In general, tax
burdens fall more heavily on the side of the market that is less elastic.
Q11.8
The Fair Labor Standards Act establishes a federal minimum wage of $7.25 per hour
effective July 24, 2009. Use your knowledge of market equilibrium and the elasticity
of demand to explain how an increase in the minimum wage could have no effect on
unskilled worker income. When will increasing the minimum wage have an incomeincreasing effect versus an income-decreasing effect. Which influence is more likely?
Q11.8
ANSWER
Federal minimum wage policy is an important economic and social concern. As such,
it is a special focus of the economic analysis of markets for labor and other inputs.
Federal minimum wage policy is also an interesting application for considering the
effects of public policy in competitive markets.
An increase in the federal minimum wage will have no effect on the income of
unskilled workers if the minimum wage lies below the market equilibrium wage for
unskilled workers both before and after the increase. This appears to be the case in
many markets where the going rate for unskilled labor is as much as $8 to $10 per
hour, or significantly above the federal minimum. When the minimum wage is
increased to a level above the equilibrium wage rate for unskilled labor, income effects
of an increase in the minimum wage can be measured using information about the
elasticity of labor demand.
If the demand for labor has an elasticity with an absolute value of one, | P | = 1,
an increase in the minimum wage will have no effect on worker incomes. The amount
of income lost due to layoffs will be exactly offset by the increased income of retained
unskilled workers. If labor demand is elastic,| P | > 1, an increase in the minimum
wage will decrease worker incomes. The amount of income lost due to layoffs will be
more than the amount of increased income for retained unskilled workers. If labor
demand is inelastic, | P | < 1, an increase in the minimum wage will increase worker
incomes. The amount of income lost due to layoffs will be more than offset by the
increased income of retained unskilled workers.
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Chapter 11
The income effect of an increase in the minimum wage is an empirical question.
Dozens of economic studies confirm that unskilled labor demand is elastic, and suggest
that an increase in the minimum wage will decrease worker incomes.
Q11.9
The New York City Rent Stabilization Law of 1969 established maximum rental rates
for apartments in New York City. Explain how such controls can lead to shortages,
especially in the long run, and other economic costs. Despite obvious disadvantages,
why does rent control remain popular?
Q11.9
ANSWER
Ostensibly, the goal of rent control is to make housing more affordable, especially for
the elderly and the poor. Since the supply of apartments is fixed (perfectly inelastic) in
the short run, imposition of rent controls has little effect on short-run supply. In the
long run, however, landlords can decided whether or not to exit the rental business.
This gives rise to an upward sloping long-run supply curve for apartments.
If
controlled rental rates are below the equilibrium market price, as is true in New York
City, then short-run shortages in apartment availability will tend to be exacerbated in
the long run. Without sufficient financial incentives, landlords can simply refuse to
expand the supply of apartments to meet growing demand over time. Rent control
leads to costly nonmarket solutions, like long waiting lists or clumsy to administer
apartment allocation schemes, and black market under-the-table payments to
landlords. Critics of the New York City rent control system contend that the wealthy
disproportionately occupy rent controlled units, politicians and other bureaucrats
unfairly benefit from the system, and that landlord bankruptcies cost State and urban
taxpayers million of dollars.
Despite obvious economic costs, rent control remains popular with certain
constituents. Obviously, anyone who continues to live in a rent-controlled apartment
has the potential to benefit from squatters rights. Similarly, rent control programs
tend to be very popular with politicians and other bureaucrats who enjoy enormous
power and related benefits under such systems.
Q11.10
Wal-Mart founder Sam Walton amassed an enormous fortune in discount retailing,

one of the most viciously competitive markets imaginable. How is this possible?
Q11.10
ANSWER
In long-run equilibrium, the typical firm in a competitive market is only able to earn a
risk-adjusted normal rate of return on investment. However, in the short run,
unanticipated changes in industry demand and supply conditions can result in
disequilibrium profits and losses. After risk adjustment, and after correcting reported
business profits to account for the effects of accounting error and bias, many
competitive firms earn large disequilibrium profits or suffer large disequilibrium losses
at any given point in time. If information about future revenues and costs were perfect
69
and adjustment costs were immaterial, instantaneous adjustments to competitive firm

and industry capacity would insure that disequilibrium profits were minimal and
fleeting. Disequilibrium profits are sustainable for the typical firm only when
information is imperfect and adjustment costs are significant. Wal-Mart has sustained
a superior rate of profitability in a cut-throat business for more than 30 years. While
the company has clearly benefited from rapid change in discount retailing technology,
and thereby earned some disequilibrium profits, 30 years is a very long time, and
something more than just disequilibrium profits are at work.
During the last quarter of the twentieth century, Wal-Mart grew to dominate the
discount retailing business and became one of the most enormous success stories in
corporate America. Wal-Mart is clearly much more efficient than the typical retailer,
and earns superior profits (economic rents) in recognition of this superior productivity.
For example, Wal-Mart was among the first to establish an Intranet to link its retail
stores with suppliers to better meet customer demand and minimize inventory costs.
The efficiency of Wal-Marts management information system is legendary. WalMart also closely links employee pay with performance. The manager of Pet Supplies,
for example, earns a bonus depending upon the sales and profit performance of that
square footage. Pet Supply managers watch inventory closely, and both shoplifting
and employee theft at Wal-Mart is far below industry norms. So long as Wal-Mart can
maintain such advantages, it will earn superior rates of return in a savagely competitive
business.
SELF-TEST PROBLEMS AND SOLUTIONS
ST11.1
Social Welfare. A number of domestic and foreign manufacturers produce

replacement parts and components for personal computer systems. With exacting user
specifications, products are standardized and price competition is brutal. To illustrate
the net amount of social welfare generated in this hotly competitive market, assume
that market supply and demand conditions for replacement tower cases can be
described as:
QS
= -175+ 12.5P
(Market Supply)
QD
= 125 - 2.5P
(Market Demand)
where Q is output in thousands of units and P is price per unit.
ST11.1
A.
Graph and calculate the equilibrium price/output solution.
B.
Use this graph to help you algebraically determine the amount of consumer
surplus, producer surplus and net social welfare generated in this market.
SOLUTION
70
A.
Chapter 11
The market supply curve is given by the equation
QS = -175 + 12.5P
or, solving for price,
12.5P = 175 + QS
P = $14 + $0.08QS
The market demand curve is given by the equation
QD = 125 - 2.5P
2.5P = 125 - QD
P = $50 - $0.4QD
Graphically, demand and supply curves appear as follows:
71
Replacement Computer Tower Equilibrium

$60
$50
Price
$40
Supply
P = $14 + $0.08QS
$30
$20
Demand
P = $50 - $0.4QD
$10
$0
0
10
20
30
40
50
60
70
80
90
100
110
120
Quantity (000)
Algebraically, to find the market equilibrium levels for price and quantity, simply set
the market supply and market demand curves equal to one another so that QS = QD. To
find the market equilibrium price, equate the market demand and market supply curves
where quantity is expressed as a function of price:
Supply = Demand
-175 + 12.5P = 125 - 2.5P
15P = 300
P = $20
To find the market equilibrium quantity, set equal the market supply and market
demand curves where price is expressed as a function of quantity, and QS = QD:
Supply = Demand
$14 + $0.08Q = $50 - $0.4Q
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Chapter 11
0.48Q = 36
Q = 75(000)
The equilibrium price-output combination is a market price of $20 with an
equilibrium output of 75 (000) units, as shown in the figure.
B.
The value of consumer surplus is equal to the region under the market demand curve
that lies above the market equilibrium price of $20. Because the area of such a triangle
is one-half the value of the base times the height, the value of consumer surplus equals:
Consumer Surplus = [75 ($50 - $20)]
= $1,125 (000)
In words, this means that at a unit price of $20, the quantity demanded is 75 (000)
units, resulting in total revenues of $1,500 (000). The fact that consumer surplus
equals $1,125 (000) means that customers as a group would have been willing to pay
an additional $1,125 (000) for this level of market output. This is an amount above and
beyond the $1,500 (000) paid. Customers received a real bargain.
The value of producer surplus is equal to the region above the market supply
curve at the market equilibrium price of $20. Because the area of such a triangle is
one-half the value of the base times the height, the value of producer surplus equals:
Producer Surplus = [75 ($20 - $14)]
= $225 (000)
At a unit price of $20, producer surplus equals $225 (000). Producers as a group
received $225 (000) more than the absolute minimum required for them to produce the
market equilibrium output of 75 (000) units. Producers received a real bargain.
benefits derived by consumers and producers. Social welfare is the sum of consumer
surplus and producer surplus:
Social Welfare = Consumer Surplus + Producer Surplus

= $1,125 + $225
= $1,350 (000)
ST11.2
Price Ceilings. The local government in a West Coast college town is concerned
about a recent explosion in apartment rental rates for students and other low-income
renters. To combat the problem, a proposal has been made to institute rent control
that would place a $900 per month ceiling on apartment rental rates. Apartment
supply and demand conditions in the local market are:
QS
= -400+ 2P
(Market Supply)
QD
= 5,600 - 4P
(Market Demand)
where Q is the number of apartments and P is monthly rent.

A.
Graph and calculate the equilibrium price/output solution. How much consumer
surplus, producer surplus, and social welfare is produced at this activity level?
B.
Use the graph to help you algebraically determine the quantity demanded,
quantity supplied, and shortage with a $900 per month ceiling on apartment
rental rates.
C.
Use the graph to help you algebraically determine the amount of consumer and
producer surplus with rent control.
D.
Use the graph to help you algebraically determine the change in social welfare
and deadweight loss in consumer surplus due to rent control.
ST11.2
SOLUTION
A.
The competitive market supply curve is given by the equation

QS = -400 + 2P
2P = 400 + QS
P = $200 + $0.5QS
The competitive market demand curve is given by the equation
QD = 5,600 - 4P
4P = 5,600 - QD
P = $1,400 - $0.25QD
To find the competitive market equilibrium price, equate the market demand and
market supply curves where quantity is expressed as a function of price:
Supply = Demand
-400 + 2P = 5,600 - 4P
6P = 6,000
P = $1,000
To find the competitive market equilibrium quantity, set equal the market supply
and market demand curves where price is expressed as a function of quantity, and QS =
QD:
Supply = Demand
$200 + $0.5Q = $1,400 - $0.25Q
0.75Q = 1,200
Q = 1,600
Therefore, the competitive market equilibrium price-output combination is a
market price of $1,000 with an equilibrium output of 1,600 units.
A p a rtm en t R en ta l Eq u ilib riu m

$1,6 00
S up ply
P = $2 0 0 + $ 0.5
S Q
D em an d
P = $ 1 ,40 0 - $0.2D 5Q
$1,4 00
$1,2 00
Monthly rental price
$1,0 00
$8 00
$6 00
$4 00
$2 00
$0
0
2 00
4 00
60 0
80 0
1 ,000
1, 20 0
1 ,4 00
1 ,60 0
1,8 00
2,000
A partm e n t u n it s
The value of consumer surplus is equal to the region under the market demand
curve that lies above the market equilibrium price of $1,000. Because the area of such
a triangle is one-half the value of the base times the height, the value of consumer
surplus equals:
Consumer Surplus = [1,600 ($1,400 - $1,000)]
= $320,000
In words, this means that at a unit price of $1,000, the quantity demanded is 1,600
units, resulting in total revenues of $1,600,000. The fact that consumer surplus equals
$320,000 means that customers as a group would have been willing to pay an
additional $320,000 for this level of market output. This is an amount above and
beyond the $1,600,000 paid. Customers received a real bargain.
curve at the market equilibrium price of $1,000. Because the area of such a triangle is
Producer Surplus = [1,600 ($1,000 - $200)]
= $640,000
At a rental price of $1,000 per month, producer surplus equals $640,000. Producers as
a group received $640,000 more than the absolute minimum required for them to
produce the market equilibrium output of 1,600 units. Producers received a real
bargain.
= $320,000 + $640,000
= $960,000
B.
The market demand at the $900 price ceiling is

QD = 5,600 - 4(900)
= 2,000 units
The market supply at the $900 price ceiling is
QS = -400 + 2(900)
= 1,400 units
The market shortage created by the $900 price ceiling is
Shortage = QD - QS
= 2,000 - 1,400
= 600 units
C.
Under rent control, the maximum amount of apartment supply that landlords are
willing to offer at a rent of $900 per month is 1,400 units. From the market demand
curve, it is clear that renters as a group are willing to pay as much as (or have a
reservation price of) $1,050 per month to rent 1,400 apartments:
P = $1,400 - $0.25(1,400)
= $1,050
Under rent control, the value of consumer surplus has two components. A first
component of consumer surplus is equal to the region under the market demand curve
that lies above the price of $1,050 per month. This amount corresponds to
uncompensated value obtained by renters willing to pay above the market price all the
way up to $1,400 per month. As in the case of an uncontrolled market, the area of such
a triangle is one-half the value of the base times the height. A second component of
consumer surplus under rent control is the uncompensated value obtained by renters
willing to pay as much as $1,050 per month to rent 1,400 apartments, and who are
delighted to rent for the controlled price of $900 per month. This amount corresponds
to the amount of revenue represented by the rectangle defined by the prices of $1,050
and $900 and the quantity of 1,400 units. Notice that this second component of
consumer surplus includes some value privately measured as producer surplus. Under
rent control, the total amount of consumer surplus is:
Rent-Controlled Consumer Surplus = [1,400 ($1,400 - $1,050)]
+ [1,400 ($1,050 - $900)]
= $245,000 + $210,000
= $455,000
In this case, consumer surplus rises from $320,000 to $455,000, a gain of $135,000 as
a result of rent control.
curve at the rent-controlled price of $900. Because the area of such a triangle is onehalf the value of the base times the height, the value of producer surplus equals:
Producer Surplus = [1,400 ($900 - $200)]
= $490,000
At a rent-controlled price of $900 per month, producer surplus falls from $640,000 to
$490,000, a loss of $150,000.
D.
The change in social welfare caused by rent control is measured by the change in net
benefits derived by consumers and producers. The change in social welfare is the
change in the sum of consumer surplus and producer surplus:
Social Welfare Change = Consumer Surplus Change
+ Producer Surplus Change
= $135,000 - $150,000
= -$15,000 (a loss)
This $15,000 deadweight loss in social welfare due to rent control has two
components. First, there is a deadweight loss of consumer surplus from consumers
unable to find a rent-controlled apartment but willing to pay upwards from the prior
market equilibrium price of $1,000 per month up to $1,050 per month. This amount is
equal to the area shown in the graph as ABD. Because the area of such a triangle is
one-half the value of the base times the height, the first component of deadweight loss
in consumer surplus equals:
Deadweight Loss in Consumer Surplus = [(1,600 -1,400) ($1,050 - $1,000)]
= $5,000
Second, there is a deadweight loss of producer surplus from landlords forced to rent at
the rent-controlled price of $900 per month rather than the market equilibrium price of
$1,000 per month. This amount is equal to the area shown in the graph as BCD.
Because the area of such a triangle is one-half the value of the base times the height,
the second component of deadweight loss in consumer surplus equals:
Deadweight Loss in Producer Surplus = [(1,600 -1,400) ($1,000 - $900)]
= $10,000
PROBLEMS AND SOLUTIONS
P11.1
P11.1
Social Welfare Concepts. Indicate whether each of the following statements is true or
false, and explain why.
A.
In competitive market equilibrium, social welfare is measured by the net benefits

derived from consumption and production as measured by the difference
between consumer surplus and producer surplus.
B.
The market supply curve indicates the minimum price required by sellers as a
group to bring forth production.
C.
Consumer surplus is the amount that consumers are willing to pay for a given
good or service minus the amount that they are required to pay.
D.
Whereas consumer surplus is closely related to the supply curve for a product,
producer surplus is closely related to the demand curve for a product.
E.
Producer surplus is the net benefit derived by producers from production.
SOLUTION
A.
False. In competitive market equilibrium, social welfare is measured by the sum of net
surplus and producer surplus.
B.
True. The market supply curve indicates the minimum price required by sellers as a
group to bring forth production. The height of the market supply curve measures
minimum production cost at each and every activity level.
C.
True. Consumer surplus is the area under the demand curve that lies above the market
price. It represents the amount that consumers are willing to pay for a given good or
service minus the amount that they are required to pay. Consumer surplus represents
value derived from consumption that consumers are able to enjoy at zero cost. It also
describes the net benefit derived by consumers from consumption, where net benefit is
measured in the eyes of the consumer. From the standpoint of society as a whole,
consumer surplus is an attractive measure of the economic well-being of consumers.
D.
False. Whereas consumer surplus is closely related to the demand curve for a product,
producer surplus is closely related to the supply curve for a product.
E.
True. Producer surplus is the amount paid to sellers minus the cost of production. It
represents the amount paid to sellers above and beyond the required minimum.
Producer surplus is the net benefit derived by producers from production. Just as
consumer surplus is an appealing measure of consumer well-being, producer surplus is
an attractive measure of the economic well-being of producers.
P11.2
Labor Policy. People of many different age groups and circumstances take advantage
of part-time employment opportunities provided by the fast-food industry. Given the
wide variety of different fast-food vendors, the industry is fiercely competitive, as is the
unskilled labor market. In each of the following circumstances, indicate whether the
proposed changes in government policy are likely to have an increasing, a decreasing,
or an uncertain effect on employment in this industry.
A.
Elimination of minimum wage law coverage for those working less than 20
hours per week.
B.
An increase in spending for education that raises basic worker skills.
C.
An increase in the employer portion of federally-mandated FICA insurance

costs.
D.
A requirement that employers install expensive new worker-safety equipment.
E.
A state requirement that employers pay 8% of wages to fund a new national

health-care program.
P11.2
SOLUTION
A.
Uncertain. Elimination of minimum wage coverage for those working less than 20
hours per week will either increase or have no effect on employment opportunities in
the industry. If the minimum wage is above the current market equilibrium wage rate,
elimination of the minimum wage for some workers will have the effect of increasing
employment opportunities. However, if the minimum wage rate is below the current
market equilibrium wage rate, as has been true in many parts of the U.S., eliminating
the minimum wage for some workers will have no effect.
B.
Increase. An increase in spending for education that raises basic worker skills has the
effect of increasing the marginal productivity of workers, and the marginal revenue
product generated for employers. A favorable impact on job opportunities can be
expected as a result of such an enhancement in worker efficiency.
C.
Decrease. An increase in the employer portion of federally-mandated FICA insurance

costs has the effect of increasing the costs of worker employment. Without any similar
enhancement in worker productivity, a negative impact on employment opportunities
can be anticipated.
D.
Uncertain. A requirement that employers install expensive new worker-safety

equipment has an uncertain effect on employment opportunities. Generally speaking, a
reduction in employment opportunities can be expected following an increase in such
costs. However, if the mandated increase results in a rise in fixed costs only, and if the
industry earned above-normal rates of return on investment, then employers might pay
such costs with no reduction in employment.
E.
Decrease. Like an increase in the employer portion of federally-mandated FICA

insurance costs, a state requirement that employers pay 8% of wages to fund a new
national health care program has the effect of increasing the costs of worker
employment. Without any offsetting enhancement in worker productivity, a negative
impact on employment opportunities can be anticipated.
P11.3
Social Welfare. Natural gas is in high demand as a clean-burning energy source for
home heating and air conditioning, especially in major metropolitan areas where air
quality is a prime concern. The domestic supply of natural gas is also plentiful.
Government reports predict that gas recoverable with current technology from
domestic sources is sufficient to satisfy production needs for more than 50 years.
Plentiful imports from Canada are also readily available to supplement domestic
production. To illustrate the net amount of social welfare generated in this vigorously
competitive market, assume that market supply and demand conditions are
QS
= -2,000 + 800P
(Market Supply)
QD
= 4,500 - 500P
(Market Demand)
where Q is output in million Btus (in millions), and P is price per unit. A British
thermal unit (Btu) is an English standard unit of energy. One Btu is the amount of
thermal energy necessary to raise the temperature of one pound of pure liquid water
by one degree Fahrenheit at the temperature at which water has its greatest density
(39 degrees Fahrenheit).
A.
Graph and calculate the equilibrium price/output solution.
B.
surplus, producer surplus and net social welfare generated in this market.
P11.3
SOLUTION
A.

QS = -2,000 + 800P
800P = 2,000 + QS
P = $2.5 + $0.00125QS
QD = 4,500 - 500P
500P = 4,500 - QD
P = $9 - $0.002QD
To find the market equilibrium levels for price and quantity, simply set the market
supply and market demand curves equal to one another so that QS = QD. To find the
market equilibrium price, equate the market demand and market supply curves where
quantity is expressed as a function of price:
Supply = Demand
-2,000 + 800P = 4,500 - 500P
1,300P = 6,500
P = $5
Supply = Demand
$2.5 + $0.00125Q = $9 - $0.002Q
0.00325Q = 6.5
Q = 2,000 (million)
Therefore, the equilibrium price-output combination is a market price of $5 with
an equilibrium output of 2,000 (million) units.
Natural Gas Equilibrium

$10
$9
Supply
P = $2.5 + $0.00125QS
$8
$7
Price
$6
$5
$4
$3
$2
Demand
P = $9 - $0.002QD
$1
$0
0
500
1000
1500
2000
2500
3000
Quantity (000)
B.
The value of consumer surplus is equal to the region under the market demand curve
that lies above the market equilibrium price of $5. Because the area of such a triangle
Consumer Surplus = [2,000 ($9 - $5)]
= $4,000 (million)
In words, this means that at a unit price of $5, the quantity demanded is 2,000 (million)
units, resulting in total revenues of $10,000 (million). The fact that consumer surplus
equals $4,000 (million) means that customers as a group would have been willing to
pay an additional $4,000 (million) for this level of market output. This is an amount
above and beyond the $10,000 (million) paid. Customers received a real bargain.
curve at the market equilibrium price of $5. Because the area of such a triangle is onehalf the value of the base times the height, the value of producer surplus equals:
Producer Surplus = [2,000 ($5 - $2.5)]
= $2,500 (million)
At a unit price of $5, producer surplus equals $2,500 (million). Producers as a group received
$2,500 (million) more than the absolute minimum required for them to produce the market
equilibrium output of 2,000 (million) units. Producers received a real bargain.
3500

= $4,000 + $2,500
= $6,500 (million)
P11.4
Deadweight Loss of Taxation. To many upscale homeowners, no other flooring

offers the warmth, beauty, and value of wood. New technology in stains and finishes
call for regular cleaning that takes little more than sweeping and/or vacuuming, with
occasional use of a professional wood floor cleaning product. Wood floors are also
ecologically friendly because wood is both renewable and recyclable. Buyers looking
for traditional oak, rustic pine, trendy mahogany, or bamboo can choose from a wide
assortment.
At the wholesale level, wood flooring is a commodity-like product sold with rigid
product specifications. Price competition is ferocious among hundreds of domestic
manufacturers and importers. Assume that market supply and demand conditions for
mahogany wood flooring are:
QS
= -10 + 2P
(Market Supply)
QD
= 320 - 4P
(Market Demand)
where Q is output in square yards of floor covering (000), and P is the market price
per square yard.
A.
Graph and calculate the equilibrium price/output solution before and after
imposition of a $9 per unit tax.
B.
Calculate the deadweight loss to taxation caused by imposition of the $9 per unit
tax. How much of this deadweight loss was suffered by consumers versus
producers? Explain.
P11.4
SOLUTION
A.

QS = -10 + 2P
2P = 10 + QS
P = $5 + $0.5QS
QD = 320 - 4P
4P = 320 - QD
P = $80 - $0.25QD
supply and market demand curves equal to one another so that QS = QD. For example,
to find the market equilibrium price, equate the market demand and market supply
curves where quantity is expressed as a function of price:
Supply = Demand
-10 + 2P = 320 - 4P
6P = 330
P = $55
Supply = Demand
$5 + $0.5Q = $80 - $0.25Q
0.75Q = 75
Q = 100 (000)
Therefore, the equilibrium price-output combination is a market price of $55
with an equilibrium output of 100 (000) units.
Following imposition of a $9 per unit tax, the new market supply curve is given
by the equation
P = $5 + $0.5QS + tax
= $5 + $0.5QS + $9
= $14 + $0.5QS
or, solving for quantity,
P = $14 + $0.5QS
0.5QS = -14 + P
QS = -28 + 2P
QD = 320 - 4P
4P = 320 - QD
P = $80 - $0.25QD
To find the market equilibrium price, equate the market demand and market
supply curves where quantity is expressed as a function of price:
Supply = Demand
-28 + 2P = 320 - 4P
6P = 348
P = $58
Supply = Demand
$14 + $0.5Q = $80 - $0.25Q
0.75Q = 66
Q = 88 (000)
Therefore, the equilibrium price-output combination with a $9 per unit tax is a
market price of $58 with an equilibrium output of 88 (000) units.
W o o d F lo o rin g E q u ilib riu m

$90
$80
$70
S u p p ly
P = $5 + $ 0.5Q
S
$60
S u p p ly + t a x
P = $ 1 4 + $ 0S .5 Q
$50
Price
D
D em and
P = $ 8 0 - $ 0 .2
D 5Q
$40
$30
$20
$10
$0
0
10
20
30
40
50
60
70
80
90
100
110
Q u an ti ty (0 0 0 s q. yd.)
B.
The amount of deadweight loss due to taxation suffered by consumers is given by the
triangle bounded by ABD. Because the area of such a triangle is one-half the value of
the base times the height, the value of lost consumer surplus equals:
Consumer Deadweight Loss = [(100 - 88) ($58 - $55)]
= $18 (000)
In the absence of a tax, a supply price of $49 [= $5 + $0.5(88)] would be associated
with a quantity supplied of 88 (000) units. Therefore, amount of deadweight loss due
to taxation suffered by producers is given by the triangle bounded by BCD. Because
the area of such a triangle is one-half the value of the base times the height, the value
of lost producer surplus equals:
Producer Deadweight Loss = [(100 - 88) ($55 - $49)]
= $36 (000)
The total amount of deadweight loss due to taxation suffered by consumers and
producers is given by the triangle bounded by ACD. The area of such a triangle is
simply the amount of consumer deadweight loss plus producer deadweight loss:
Total Deadweight Loss = Consumer Loss + Producer Loss
120
= $18 (000) + $36 (000)

= $54 (000)
P11.5
Lump Sum Taxes. In 1998, Californias newly deregulated power market began
operation. The large power utilities in the state turned over control of their electric
transmission facilities to the new Independent System Operator (ISO) to assure fair
access to transmission by all generators. The new California Power Exchange
(CalPX) opened to provide a competitive marketplace for the purchase and sale of
electric generation. The deregulation required electric utilities to split their business
into generation, transmission, and distribution businesses. The utilities continue to
own all of the transmission and distribution facilities, but the ISO controls all of the
transmission facilities. Utilities provide all distribution services, but customers are
allowed to choose their energy supplier. The utilities were required to sell off 50% of
their generating facilities. In addition, utilities have to sell all their electric generation
to the Power Exchange and purchase all power for their customers through the Power
Exchange. To illustrate the net amount of social welfare generated by a competitive
power market, assume that market supply and demand conditions for electric energy in
California are:
QS
= -87,500+ 1,250P
(Market Supply)
QD
= 250,000 - 1,000P
(Market Demand)
where Q is output in megawatt hours per month (in thousands), and P is the market
price per megawatt hour. A megawatt hour is one million watt-hours, where watthours is a common measurement of energy produced in a given amount of time,
arrived at by multiplying voltage by amp hours. The typical California home uses one
megawatt hour of electricity per month.
A.
Graph and calculate the equilibrium price/output solution. Use this graph to
help you algebraically determine the amount of producer surplus generated in
this market.
B.
Calculate the maximum lump-sum tax that could be imposed on producers

without affecting the short-run supply of electricity. Is such a tax apt to affect
the long-run supply of electricity? Explain.
P11.5
SOLUTION
A.

QS = -87,500 + 1,250P

1,250P = 87,500 + QS
P = $70 + $0.0008QS
QD = 250,000 - 1,000P
1,000P = 250,000 - QD
P = $250 - $0.001QD
supply and market demand curves equal to one another so that QS = QD. For example,
to find the market equilibrium price, equate the market demand and market supply
curves where quantity is expressed as a function of price:
Supply = Demand
-87,500 + 1,250P = 250,000 - 1,000P
2,250P = 337,500
P = $150
Supply = Demand
$70 + $0.0008Q = $250 - $0.001Q
0.0018Q = 180
Q = 100,000 (000)
with an equilibrium output of 100,000 (000) units.
curve at the market equilibrium price of $150. Because the area of such a triangle is
Producer Surplus = [100,000 ($150 - $70)]
= $4,000,000 (000)
At a unit price of $150, producer surplus equals $4,000,000 (000). Producers as a
group received $4,000,000 (000) more than the absolute minimum required for them to
produce the market equilibrium output of 100,000 (000) units. Producers received a
real bargain.
Electricity Market Equilibrium
$250
$225
$200
Price
Supply
P = $70 + $0.0008Q
S
C onsumer S urplus
$175
$150
Producer Surplus
$125
$100
Demand
P = $250 - $0.001Q
D
$75
$50
$25
$0
0
25,000
50,000
75,000
100,000
125,000
150,000
175,000
Quantity (000 me gawatt hours pe r month)
B.
The maximum lump-sum tax that could be imposed on producers without affecting the
short-run supply of electricity is $4,000,000 (000), or the total amount of producer
surplus. This stems from the fact that the market supply curve indicates the minimum
price required by sellers as a group to bring forth production. In the short run, the
market supply curve equals the marginal cost of production, so long as marginal cost
exceeds average variable cost. In the long run, the market supply curve equals the
marginal cost of production, so long as marginal cost exceeds average total cost.
Taxing away all producer surplus with a lump sum tax will leave long-run supply
unaffected only if producers are still able to earn a risk-adjusted rate of return on
investment. If the lump-sum tax makes it impossible for the typical competitor to earn
a normal profit, then some exit is to be expected and industry output will fall in the
long run.
P11.6
Demand v. Supply Subsidy. In Africa, the continent where the polio epidemic has
been most difficult to control, international relief efforts aimed at disease eradication
often work against a backdrop of civil unrest and war. In some countries, temporary
cease-fire agreements must be negotiated to allow vaccination and prevent serious
outbreaks from occurring. During peacetime and during war, low incomes make
paying for the vaccine a real problem among the poor. To make the oral polio vaccine
more affordable, either consumer purchases (demand) or production (supply) can be

subsidized. Consider the following market demand and market supply curves for a
generic oral polio vaccine:
QD
= 24,000 - 1,600P
(Market Demand)
QS
= -2,000 + 1,000P
(Market Supply)
where Q is output measured in doses of oral vaccine (in thousands), and P is the
market price in dollars.
A.
Vouchers have a demand-increasing effect. Graph and calculate the equilibrium

price/output solution before and after the institution of a voucher system
whereby consumers can use a $3.25 voucher to supplement cash payments.
B.
Per-unit producer subsidies have a marginal cost-decreasing effect. Show and

calculate the equilibrium price/output solution after the institution of a $3.25 per
unit subsidy for providers of the oral polio vaccine. Discuss any differences
between answers to parts A and B.
P11.6
SOLUTION
A.

QD = 24,000 - 1,600P
1,600P = 24,000 - QD
P = $15 - $0.000625QD
QS = -2,000 + 1,000P
1,000P = 2,000 + QS
P = $2 + $0.001QS
supply and market demand curves equal to one another so that QS = QD. To find the
market equilibrium price, equate the market demand and market supply curves where
quantity is expressed as a function of price:
Supply = Demand
-2,000 + 1,000P = 24,000 - 1,600P
2,600P = 26,000
P = $10
Supply = Demand
$2 + $0.001Q = $15 - $0.000625Q
0.001625Q = 13
Q = 8,000 (000)
with an equilibrium output of 8,000 (000) units.
Following the institution of a $3.25 per unit demand voucher, the new voucheraided market demand curve is given by the equation
P = $15 - $0.000625QD + voucher
= $15 - $0.000625QD + $3.25
= $18.25 - $0.000625QD
P = $18.25 - $0.000625QD
0.000625QD = 18.25 - P
QD = 29,200 - 1,600P
To find the new market equilibrium price, equate the new voucher-aided market
demand and market supply curves where quantity is expressed as a function of price
and QS = QD:
Supply = Demand
-2,000 + 1,000P = 29,200 - 1,600P
2,600P = 31,200
P = $12
Supply = Demand
$2 + $0.001Q = $18.25 - $0.000625Q
0.001625Q = 16.25
Q = 10,000 (000)
Therefore, the equilibrium price-output combination with a $3.25 per unit
voucher is a market price of $12 with an equilibrium output of 10,000 (000) units.
Polio Vaccine Equilibrium

$20
Supply
P = $2 + $0.001Q
$18
Price
$16
$14
MC - $3.25
$12
$10
Demand + $3.25
$8
$6
Demand
P = $15 $0.000625Q
$4
$2
$0
0
2,500 5,000 7,500 10,000 12,500 15,000 17,500
Doses of Oral Vaccine (000)
B.
Following the institution of a $3.25 per unit producer subsidy, the new subsidy-aided
market supply curve is given by the equation
P = $2 + $0.001QS - subsidy
= $2 + $0.001QS - $3.25
= -$1.25 + $0.001QS
P = -$1.25 + $0.001QS
0.001QS = $1.25 + P
QS = 1,250 + 1,000P
To find the new market equilibrium price, equate the market demand and
subsidy-aided market supply curves where quantity is expressed as a function of price
and QS = QD:
Supply = Demand
1,250 + 1,000P = 24,000 - 1,600P
2,600P = 22,750
P = $8.75
Supply = Demand
-$1.25 + $0.001Q = $15 - $0.000625Q
0.001625Q = 16.25
Q = 10,000 (000)
Therefore, the equilibrium price-output combination with a $3.25 per-unit
subsidy is a market price of $8.75 with an equilibrium output of 10,000 (000) units.
Notice that this is the exact same level of output as was achieved with the demand
voucher of $3.25 in part A. Also notice that the market price of $12 in part A results in
an effective price to consumers of $8.75 (=$12 - $3.25), the exact same price as in part
B. Holding demand and supply elasticities constant, there is no economic difference
between an identical per unit subsidy (or tax) for buyers or seller.
P11.7
Price Floors. Each year, about 9 billion bushels of corn are harvested in the United
States. The average market price of corn is a little over $2 per bushel, but costs
farmers about $3 per bushel. Tax payers make up the difference. Under the 2002
$190 billion, 10-year farm bill, American taxpayers will pay farmers $4 billion a year
to grow even more corn, despite the fact that every year the United States is faced with
a corn surplus. Growing surplus corn also has unmeasured environmental costs. The
production of corn requires more nitrogen fertilizer and pesticides than any other
agricultural crop. Runoff from these chemicals seeps down into the groundwater
supply, and into rivers and streams. Ag chemicals have been blamed for a 12,000square-mile dead zone in the Gulf of Mexico. Overproduction of corn also increases
U.S. reliance on foreign oil.
To illustrate some of the cost in social welfare from agricultural price supports,
assume the following market supply and demand conditions for corn:
QS
= -5,000+ 5,000P
(Market Supply)
QD
= 10,000 - 2,500P
(Market Demand)
where Q is output in bushels of corn (in millions), and P is the market price per
bushel.
A.
Graph and calculate the equilibrium price/output solution. Use this graph to
help you algebraically determine the amount of surplus production the
government will be forced to buy if it imposes a support price of $2.50 per
bushel.
B.
Use this graph to help you algebraically determine the gain in producer surplus
due to the support price program. Explain.
P11.7
SOLUTION
A.

QS = -5,000 + 5,000P
5,000P = 5,000 + QS
P = $1 + $0.0002QS
QD = 10,000 - 2,500P
2,500P = 10,000 - QD
P = $4 - $0.0004QD
To find the market equilibrium levels for price and quantity, simply set the
market supply and market demand curves equal to one another so that QS = QD. To
Supply = Demand
-5,000 + 5,000P = 10,000 - 2,500P
7,500P = 15,000
P = $2
Supply = Demand
$1 + $0.0002Q = $4 - $0.0004Q
0.0006Q = 3
Q = 5,000 (million)
Therefore, the equilibrium price-output combination is a market price of $2 with
an equilibrium output of 5,000 (million) bushels.
The effects of a $2.50 government price support can be seen by noting that at
that price market supply will equal
QS = -5,000 + 5,000P
= -5,000 + 5,000(2.50)
= 7,500 (million)
At the $2.50 price support, market demand will equal
QD = 10,000 - 2,500P
= 10,000 - 2,500(2.50)
= 3,750 (million)
Therefore, with a $2.50 price support, surplus production is
Surplus Production = QS - QD
= 7,500 - 3,750
= 3,750 (million)
B.
With a $2.50 government price support, the value of producer surplus is equal to the
region above the market supply curve at the market price of $2.50. Because the area of
such a triangle is one-half the value of the base times the height, the value of consumer
surplus equals:
Corn Market Equilibrium

$5.00
$4.50
$4.00
Supply
P = $1 + $0.0002QS
Price
$3.50
$3.00
Consumer Surplus
$2.50
Producer Surplus
$2.00
$1.50
Demand
P = $4 - $0.0004QD
$1.00
$0.50
$0.00
0
1,250
2,500
3,750
5,000
6,250
7,500
8,750
Bushels of Corn (millions)
Producer SurplusPS = [7,500 ($2.50 - $1)]

= $5,625 (million)
In a free market, the value of producer surplus is equal to the region above the market
supply curve at the market equilibrium price of $2. Because the area of such a triangle
Producer SurplusFM = [5,000 ($2 - $1)]
= $2,500 (million)
Therefore, the gain in producer surplus caused by the $2.50 government price support
program is:
Gain in Producer Surplus = Producer SurplusPS - Producer SurplusFM
= $5,625 - $2,500
= $3,125 (million)
This gain in producer surplus caused by the $2.50 government price support program is
shown in the graph by the region $2$2.50AB.
P11.8
Import Controls. Critics argue that if Congress wants to make the tax code more
equitable, a good place to start would be removing unfair tariffs and quotas. Today,
there are more than eight thousand import tariffs, quotas, so-called voluntary import
restraints, and other import restrictions. Tariffs and quotas cost consumers roughly
$80 billion per year, or about $800 for every American family. Some of the tightest
restrictions are reserved for food and clothing that make up a large share of lowincome family budgets.
The domestic shoe market shows the effects of import controls on a large
competitive market. Assume market supply and demand conditions for shoes are:
QUS
= -50+ 2.5P
(Supply from U. S. Producers)
QF
= -25+ 2.5P
(Supply from Foreign Producers)
QD
= 375 - 2.5P
(Market Demand)
where Q is output (in millions), and P is the market price per unit.
A.
Graph and calculate the equilibrium price/output solution assuming there are no
import restrictions, and under the assumption that foreign countries prohibit
imports.
B.
surplus transferred to producer surplus and the deadweight loss in consumer
surplus due to a ban on foreign imports. Explain.
P11.8
SOLUTION
A.
In the absence of import restrictions, the market supply curve is determined by adding
supply from domestic plus foreign producers
QS = QUS + QF
= -50 + 2.5P - 25 + 2.5P

= -75 + 5P
5P = 75 + QS
P = $15 + $0.2QS
QD = 375 - 2.5P
2.5P = 375 - QD
P = $150 - $0.4QD
To find the market equilibrium levels for price and quantity, simply set the
market supply and market demand curves equal to one another so that QS = QD. To
Supply = Demand
-75 + 5P = 375 - 2.5P
7.5P = 450
P = $60
Supply = Demand
$15 + $0.2Q = $150 - $0.4Q
0.6Q = 135
Q = 225 (million)

with an equilibrium output of 225 (million) units.
On the other hand, if foreign goods are kept off the market, the domestic
producer supply curve becomes the market supply curve
QS = -50 + 2.5P
2.5P = 50 + QS
P = $20 + $0.4QS
To find the market equilibrium levels for price and quantity in the face of import
supply restrictions, simply set the market supply and market demand curves equal to
one another so that QS = QD. To find the market equilibrium price, equate the market
demand and market supply curves where quantity is expressed as a function of price:
Supply = Demand
-50 + 2.5P = 375 - 2.5P
5P = 425
P = $85
Supply = Demand
$20 + $0.4Q = $150 - $0.4Q
0.8Q = 130
Q = 162.5 (million)
Therefore, the equilibrium price-output combination with import supply
restriction is a market price of $85 with an equilibrium output of 162.5 (million)
bushels.
B.
In a free market, the value of consumer surplus is equal to the region under the market
Price
Shoe Market Equilibrium

$160
$150
$140
$130
$120
$110
$100
$90
$80
$70
$60
$50
$40
$30
$20
$10
$0
Supply US
P = $20 + $0.4Q
Consumer Surplus
A
B
Supply US+F
P = $15 + $0.2Q
Producer Surplus
25
50
75
Demand
$150 - $0.4Q
100
125
150
175
200
225
250
275
300
325
Quantity (millions)
demand curve that lies above the market equilibrium price of $60. Because the area of
such a triangle is one-half the value of the base times the height, the value of consumer
surplus equals:
Consumer SurplusUS+F = [225 ($150 - $60)]
= $10,125 (million)
With a ban on foreign goods, the value of consumer surplus is equal to the region
under the market demand curve that lies above the market price of $85. Because the
area of such a triangle is one-half the value of the base times the height, the value of
consumer surplus equals:
Consumer SurplusUS = [162.5 ($150 - $85)]

= $5,281.25 (million)
Therefore, the loss in consumer surplus caused by foreign supply restriction is:
Loss in Consumer Surplus = Consumer SurplusUS+F - Consumer SurplusUS
= $10,125 - $5,281.25
= $4,843. 75 (million)
The $4,843.75 (million) loss in consumer surplus due to the foreign supply
restriction has two components. First, there is a transfer of consumer surplus to
producer surplus. This amount is shown as the area in the rectangle bordered by
$60$85AB:
Transfer to Producer Surplus = 162.5 ($85 - $60)
= $4,062.5 (million)
Second, there is a deadweight loss of consumer surplus equal to the area shown as
ABC. Because the area of such a triangle is one-half the value of the base times the
height, the value of consumer surplus equals:
Deadweight Loss in Consumer Surplus = [(225 - 162.5) ($85 - $60)]
= $781.25 (million)
P11.9
Protective Tariffs. In the United States, steel production has remained constant since
the 1970s at about 100 million tons per year. Large integrated companies, like U.S.
Steel remain important in the industry, but roughly 50% of domestic production is now
produced by newer, nimble and highly efficient mini-mill companies. Foreign imports
account for roughly 30% of domestic steel use. In order to stem the tide of rising
imports, President George W. Bush announced in 2002 that the United States would
introduce up to thirty per cent tariffs on most imported steel products. These measures
were to remain in place for three years. To show how protective tariffs can help
domestic producers, consider the following cost relations for a typical competitor in
this vigorously competitive market:
TC = $150,000 + $100Q + $0.15Q2
MC = TC/ Q = $100 + $0.3Q
Where TC is total cost, MC is marginal cost, and Q is output measured by tons of Hot
Dipped Galvanized Steel. Cost figures and output are in thousands.
A.
Assume prices are stable in the market, and P = MR = $400. Calculate the profitmaximizing price/output combination and economic profits for a typical producer in
competitive market equilibrium.
B.
Calculate the profit-maximizing price/output combination and economic profits for a

typical producer if domestic market prices rise by 30% following introduction of
Bushs protective tariff.
P11.9
SOLUTION
A.
The profit-maximizing price/output combination is found by setting MR = MC:

MR = MC
$400 = $100 + $0.3Q
0.3Q = 300
Q = 1,000 (000)
Economic Profits = P Q - TC
= $400(1,000) - $150,000 - $100(1,000) - $0.15(1,0002)
= $0 (000)
In this competitive market, there are no economic profits in long-run equilibrium for a
typical competitor.
B.
Following introduction of the Bush protective tariff, the domestic market price can be
expected to rise 30% and P = MR = $520 (= 1.3 $400). The profit-maximizing
price/output combination is found by setting MR = MC:
MR = MC
$520 = $100 + $0.3Q
0.3Q = 420
Q = 1,400 (000)
Economic Profits = P Q - TC
= $520(1,400) - $150,000 - $100(1,400) - $0.15(1,4002)
= $144,000 (000)
Introduction of a protective tariff in this competitive market has the effect of raising
prices and creating above-normal returns for producers. Of course, the forgotten
consumer is the one forced to pick up the tab.
P11.10
Generic Competition. The Federal Trade Commission seeks to ensure that the
process of bringing new low-cost generic alternatives to the marketplace and into the
hands of consumers is not impeded in ways that are anti-competitive. To illustrate the
potential for economic profits from delaying generic drug competition for one year,
consider cost and demand relationships for an important brand-name drug set to lose
patent protection:
TR
= $10.25Q - $0.01Q2
MR
= TR/Q = $10.25 - $0.02Q
TC
= $625 + $0.25Q + $0.0025Q2
MC
= TC/Q = $0.25 + $0.005Q
where TR is total revenue, Q is output, MR is marginal revenue, TC is total cost,

including a risk-adjusted normal rate of return on investment, and MC is marginal
cost. All figures are in thousands.
A.
B.
Set MR = MC to determine the profit-maximizing price/output solution and economic

profits prior to the expiration of patent protection.
Calculate the firms competitive market equilibrium price/output solution and
economic profits following the expiration of patent protection and onset of generic
competition.
P11.10
SOLUTION
A.
The profit-maximizing monopoly price/output combination is found by setting MR =

MC and solving for Q:
MR
$10.25 - $0.02Q
0.025Q
= MC
= $0.25 + $0.005Q,
= 10
= 400 (000)
= TR/Q = $10.25 - $0.01Q

= $10.25 - $0.01(400)
= $6.25
= TR - TC
= $10.25Q - $0.01Q2 - $625 - $0.25Q - $0.0025Q2
= $10Q - $0.0125Q2 - $625
= $10(400) - $0.0125(4002) - $625
= $1,375 (000)
(Note: Profit is falling for Q > 400 (000).)

B.
If the onset of generic competition forces a competitive market solution, P = MR =

MC at the average cost-minimizing output level. To find the output level where
average cost is minimized, set MC = AC and solve for Q:
MC
= AC
$0.25 + $0.005Q
= ($625 + $0.25Q + $0.0025Q2)/Q
$0.25 + $0.005Q
= $625Q-1 + $0.25 + $0.0025Q
625Q-1
= 0.0025Q
625Q-2
= 0.0025
625
2
Q
= 0.0025
625
0.0025
= 500 (000)
AC
= $625/500 + $0.25 + $0.0025(500)

= $2.75
At the average-cost minimizing output level, MC = AC = $2.75. Because P = MR in a

competitive market equilibrium:
P = MR = MC = AC = $2.75
= TR - TC
= $2.75Q - $625 - $0.25Q - $0.0025Q2
= $2.75(500) - $625 - $0.25(500) - $0.0025(5002)
= $0 (000)
(Note: Average cost is rising for Q > 500 (000).)
CASE STUDY FOR CHAPTER 11

The Most Profitable S&P 500 Companies
While net income is an obviously useful indicator of a firms profit-generating ability, it has
equally obvious limitations. Net income will grow with a simple increase in the scale of the
operation. A 2% savings account will display growing interest income over time, but would
scarcely represent a good long-term investment. Similarly, a company that generates profit
growth of only 2% per year would seldom turn out to be a good investment. In the same way,
investors must be careful in their interpretation of earnings per share numbers. These numbers
are artificially affected by the number of outstanding shares. Following a 2:1 stock split, for
example, the number of shares outstanding will double, while share price and earnings per share
will fall by one-half. However, such a stock split neither enhances nor detracts from the economic
appeal of a company. Because the number of outstanding shares is wholly determined by vote of
the companys stockholders, the specific earnings per share number for any given company at any
point in time is somewhat arbitrary. Earnings per share numbers are only significant on a relative
basis. At any point in time, the earnings per share number for a firm is relatively meaningless, but
the rate of growth in earnings per share over time is a fundamentally important determinant of
future share prices.
Because absolute measures, like net income, paint only an incomplete picture of corporate
profitability, various relative measures of profitability are typically relied upon by investors. First
among these is the accounting rate of return on stockholders equity (ROE) measure. Simply
referred to as ROE, the return on stockholders equity measure is defined as net income divided by
the book value of stockholders equity, where stockholders equity is the book value of total assets
minus total liabilities. ROE tells how profitable a company is in terms of each dollar invested by
shareholders, and reflects the effects of both operating and financial leverage. A limitation of
ROE is that it can sometimes be unduly influenced by share buybacks and other types of corporate
restructuring. According to Generally Accepted Accounting Principals (GAAP), the book value of
stockholders equity is simply the amount of money committed to the enterprise by stockholders. It
is calculated as the sum of paid in capital and retained earnings, minus any amount paid for share
repurchases. When extraordinary or unusual charges are significant, the book value of
stockholders equity is reduced, and ROE can become inflated. Similarly, when share repurchases
are at market prices that exceed the book value per share, book value per share falls and ROE
rises. Given the difficulty of interpreting ROE for companies that have undergone significant
restructuring, and for highly leveraged companies, some investors focus on the return on assets, or
net income divided by the book value of total assets. Like ROE, return on assets (ROA) captures
the effects of managerial operating decisions. ROA also tends to be less affected than ROE by the
amount of financial leverage employed. As such, ROE has some advantages over ROA as a
fundamental measure of business profits. Irrespective of whether net income, profit margin, ROE,
ROA, or some other measure of business profits is employed, consistency requires using a common
basis for between-firm comparisons.
Table 11.2 shows ROE data for 30 of the most consistently profitable companies found
within the Standard and Poors 500 stock index. Beer titan Anheuser-Busch Companies, Inc.;
personal products and drug manufacturer Johnson & Johnson, and consumer goods goliath
Procter & Gamble Co. are enormously profitable when profits are measured using ROE. To get
some useful perspective on the source of these enormous profits, it is worth considering the
individual economic factors that contribute to high levels of ROE: profit margin, total asset
turnover, and financial leverage. Among these three potential sources of high ROE, high profit
margins are the most attractive contributing factor because high profit margins usually mean that
high rates of ROE are sustainable for an extended period. Profit margins show the amount of
profit earned per dollar of sales revenue. On a per unit basis, profit margins can be expressed as
/Sales = P-AC/P. When profit margins are high, the company is operating at a high level of
efficiency, competitive pressure is modest, or both. In a competitive market, P = MC=AC, so
profit margins converge toward zero as competitive pressures increase. Conversely, P > MC in
monopoly markets, so profit margins can be expected to rise as competitive pressures decrease.
High profit margins are clear evidence that the firm is selling distinctive products.
Considering the effects of profit margins on the market value of the firm is a simple means
for getting some interesting perspective on the importance of profit margins as an indicator of the
firms ability to sustain superior profitability. The market value of the firm represents the stock
markets assessment of the firms future earnings power. If high profit margins suggest attractive
profit rates in the future, then profit margins should have a statistically significant impact on the
current market value of the firm. An attractive way to measure the stock markets assessment of
profit margin data is to study the link between profit margins and the firms P/E ratio. In the P/E
ratio, P stands for the companys stock price, and E stands for company earnings, both
measured on a per share basis. P/E ratios are high when investors see current profits as high,
durable, and/or rapidly growing; P/E ratios are low when investors see current profits as
insufficient, vulnerable, or shrinking.
The P/E ratio effects of ROE, profit margin, total asset turnover, and financial leverage for
consistently profitable corporate giants found within the S&P 500 are shown in Table 11.3.
A.
Describe some of the advantages and disadvantages of ROE as a measure of corporate

profitability. What is a typical level of ROE, and how does one know if the ROE
reported by a given company reflects an adequate return on investment?
B.
Define the profit margin, total asset turnover, and financial leverage components of
ROE. Discuss the advantages and disadvantages of each of these potential sources of
high ROE.
C.
Based upon the findings reported in Table 11.3, discuss the relation between P/E
ratios and profit margins, total asset turnover, and financial leverage. In general,
which component of ROE is the most useful indicator of the firms ability to sustain
high profit rates in the future?
CASE STUDY SOLUTION

A.
For successful large and small firms in the United States and Canada, ROE averages
roughly 10 to 15% during a typical year. This average ROE is comprised of a typical
profit margin on sales revenue of roughly 5-10%, a standard total asset turnover ratio
of 1.0 times, and a common leverage ratio of roughly 2:1. ROE is an attractive
measure of firm performance because it shows the rate of profit earned on funds
committed to the enterprise by its owners, the stockholders. When ROE is at or above
15% per year, the rate of profit is generally sufficient to compensate investors for the
risk involved with a typical business enterprise. When ROE consistently falls far
below 10% per year, profit rates are generally insufficient to compensate investors for
the risks undertaken. Of course, when business risk is substantially higher than
average, a commensurately higher return is required. When business risk is somewhat
lower than average, a somewhat below-average profit rate is adequate.
This naturally suggests an important question: How is it possible to know if
business profit rates in any given circumstance are sufficient to compensate investors
for the risks undertaken? The answer to this difficult question turns out to be rather
simple: just ask current and potential shareholders and bondholders. While it is
difficult to accurately assess business risk, and the problem of accurately measuring
profit rates is always vexing, shareholders and bondholders implicitly inform
management of their risk/return assessment of the firms performance on a daily basis.
If performance is above the minimum required, the firms bond and stock prices will
rise; if performance is below the minimum required, bond and stock prices will fall.
For privately held companies, the markets risk/return assessment comes at infrequent
intervals, such as when new bank financing is required. If performance is above the
minimum required, bank financing will be easy to obtain; if performance is below the
minimum required, bank financing will be difficult or impossible to procure.
Therefore, as a practical matter, firms must consistently earn a business profit rate or
ROE of at least 15% per year in order to grow and prosper. If ROE consistently falls
below this level, sources of financing tend to dry up and the firm withers and dies. If
ROE consistently exceeds this level, new debt and equity financing is easy to obtain,
and growth by new and established competitors is rapid.
Finally, while ROE may indeed be the most useful accounting indicator of
business profits, other accounting data should also be used to compare profit rates
across different lines of business, companies, and industries. In particular, investors
must be cautious in evaluating companies that report lofty ROE, but only moderate
profit margins and low ROA.
B.
When profit margins are high, robust demand or stringent cost controls, or both, allow
the firm to earn a significant profit contribution. Holding capital requirements
constant, the firms profit margin is a useful indicator of managerial efficiency in
responding to rapidly growing demand and/or effective measures of cost containment.
However, rich profit margins do not necessarily guarantee a high rate of return on
stockholders equity. Despite high profit margins, firms in mining, construction, heavy
equipment manufacturing, cable TV, and motion picture production often earn only
modest rates of return on equity because significant capital expenditures are required
before meaningful sales revenues can be generated. Thus, it is vitally important to
consider the magnitude of capital requirements when interpreting the size of profit
margins for a firm or an industry.
Total asset turnover is sales revenue divided by the book value of total assets.
When total asset turnover is high, the firm makes its investments work hard in the
sense of generating a large amount of sales volume. Grocery and apparel retailing are
good examples of industries where high rates of total asset turnover can allow efficient
firms to earn attractive rates of return on stockholders equity despite modest profit
margins.
Leverage is often defined as the ratio of the book value of total assets divided by
stockholders equity. It reflects the extent to which debt and preferred stock are used
in addition to common stock financing. Leverage is used to amplify firm profit rates
over the business cycle. During economic booms, leverage can dramatically increase
the firms profit rate; during recessions and other economic contractions, leverage can
just as dramatically decrease realized rates of return, if not lead to losses. Despite
ordinary profit margins and modest rates of total asset turnover, ROE in the
automobile, financial services and telecommunications industries can sometimes
benefit through use of a risky financial strategy that employs significant leverage.
However, it is worth remembering that a risky financial structure can lead to aweinspiring profit rates during economic expansions, such as that experienced during the
mid-1990s, but it can also lead to huge losses during economic contractions or
recessions, such as that experienced during 2003. In the financial services sector, high
rates of financial leverage can boost profits during periods of declining interest rates,
but cause extreme financial distress during period of rapidly fluctuating interest rates.
C.
Using a simple ordinary least squares regression approach to investigating the P/Eprofit ability relation, there is no simple and obvious positive effect of ROE on P/E
ratios. These results are perhaps surprising because it is commonly perceived that
ROE is the most attractive accounting measure of the firms wise use of operating and
financial leverage. Perhaps the distortions to ROE numbers caused by significant
corporate restructuring in recent years have reduced the utility of those numbers for
investors.
A high degree of correlation between P/E ratios and profit margins is clearly
evident for this sample of consistently profitable corporate giants found within the
S&P 500. The statistically-significant slope coefficient in the simple P/E = f (profit
margin) relation suggests that investors more highly capitalize reported earnings for
high profit margin firms. Neither total asset turnover nor financial leverage has a
similarly consistent and positive effect on P/E ratios. Similarly, profit margins are the
only component of ROE with a statistically significant effect on P/E ratios in a

multiple regression model approach. Apparently, investors tend to rely upon high
profit margins as useful indicators of the firms ability to sustain above-average profits
in the future.

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Chapter 11

PERFORMANCE AND STRATEGY IN COMPETITIVE MARKETS

Your best income-earning opportunity appears to be an offer to work for a local

Performance and Strategy in Competitive Markets

In 1990, Congress adopted a luxury tax to be paid by buyers of high-price cars,

Performance and Strategy in Competitive Markets

Wal-Mart founder Sam Walton amassed an enormous fortune in discount retailing,

Performance and Strategy in Competitive Markets

and adjustment costs were immaterial, instantaneous adjustments to competitive firm

Social Welfare. A number of domestic and foreign manufacturers produce

where Q is output in thousands of units and P is price per unit.

Graph and calculate the equilibrium price/output solution.

Performance and Strategy in Competitive Markets

Replacement Computer Tower Equilibrium

Social Welfare = Consumer Surplus + Producer Surplus

where Q is the number of apartments and P is monthly rent.

The competitive market supply curve is given by the equation

A p a rtm en t R en ta l Eq u ilib riu m

Monthly rental price

The market demand at the $900 price ceiling is

In competitive market equilibrium, social welfare is measured by the net benefits

Producer surplus is the net benefit derived by producers from production.

An increase in spending for education that raises basic worker skills.

An increase in the employer portion of federally-mandated FICA insurance

A requirement that employers install expensive new worker-safety equipment.

A state requirement that employers pay 8% of wages to fund a new national

Decrease. An increase in the employer portion of federally-mandated FICA insurance

Uncertain. A requirement that employers install expensive new worker-safety

Decrease. Like an increase in the employer portion of federally-mandated FICA

Graph and calculate the equilibrium price/output solution.

The market supply curve is given by the equation

Natural Gas Equilibrium

In competitive market equilibrium, social welfare is measured by the sum of net

Deadweight Loss of Taxation. To many upscale homeowners, no other flooring

The market supply curve is given by the equation

W o o d F lo o rin g E q u ilib riu m

= $18 (000) + $36 (000)

Calculate the maximum lump-sum tax that could be imposed on producers

The market supply curve is given by the equation

or, solving for price,

Electricity Market Equilibrium

Quantity (000 me gawatt hours pe r month)

more affordable, either consumer purchases (demand) or production (supply) can be

Vouchers have a demand-increasing effect. Graph and calculate the equilibrium

Per-unit producer subsidies have a marginal cost-decreasing effect. Show and

The market demand curve is given by the equation

Polio Vaccine Equilibrium

2,500 5,000 7,500 10,000 12,500 15,000 17,500

Doses of Oral Vaccine (000)

The market supply curve is given by the equation

Corn Market Equilibrium

Bushels of Corn (millions)

Producer SurplusPS = [7,500 ($2.50 - $1)]

(Supply from U. S. Producers)

(Supply from Foreign Producers)

= -50 + 2.5P - 25 + 2.5P

Therefore, the equilibrium price-output combination is a market price of $60

Shoe Market Equilibrium

Consumer SurplusUS = [162.5 ($150 - $85)]

Calculate the profit-maximizing price/output combination and economic profits for a

The profit-maximizing price/output combination is found by setting MR = MC:

= TR/Q = $10.25 - $0.02Q

= $625 + $0.25Q + $0.0025Q2