Problem Set 2

CONSUMER SURPLUS, PRODUCER SURPLUS AND THE EFFICIENCY OF MARKETS

Suppose that in reviewing the material of this chapter you were sitting in the Pavilion sipping coffee for two or three hours. Suppose you have the following marginal benefit schedule for your coffee consumption:

Cup number:	1	2	3	4	5	6	7
Marginal benefit:	$2.00	1.00	0.50	0.25	0.10	0.05	0.00

Suppose the Pavilion charges $0.50 per cup. If you follow the benefit-cost rule, how many cups of coffee will you purchase?

Calculate the magnitude of your consumer surplus at that price, and illustrate this amount in a diagram of your demand curve for coffee.

Would your consumer surplus rise of fall if you purchased the fourth cup of coffee for $0.50? By how much?

What quantity of coffee would you demand at $0.10 per cup? Does a drop in price make consumer surplus rise or fall? Illustrate the change in your diagram.

The Pavilion changes its pricing policy. Instead of charging $.50 per cup, you can now have as many cups of coffee as you want (free refills) for $1.75.

(1)

How many cups will you drink with free refills, and how large will your consumer surplus be?

(2)

Given the information in this problem, which pricing policy would you prefer, $.50 per cup or $1.75 with free refills? Explain briefly.

2.	Suppose you have the opportunity to sell used books for $15 each and can sell 1 book per hour. The only cost to you is the opportunity cost of your time. For the first 5 hours you value your time at $10 per hour, but you value additional hours at $20 per hour because they cut into your study time.
	a.	In a supply diagram, draw the marginal cost to you of supplying books and also draw in the price you receive for books.
	b.	Indicate how many books you will sell, and calculate your producer surplus.

5.	The following questions concern the online Java application, The characteristics of a market equilibrium <http://faculty.oxy.edu/whitney/java/stepview/ec250/d021_Equilibrium.html>
	a.	Click the 'First' button, and then click the 'Draw' button. What are values for the equilibrium price and quantity?
	b.	Click 'Next' until you reach step 7, then click 'Draw': Is there an excess supply or excess demand for pay phone calls? How many units?
	c.	Click 'Next' until you reach step 9, then click 'Draw': Is there an excess supply or excess demand for pay phone calls? How many units?
	d.	Click 'Next' until you reach step 13, then click 'Draw': Is there a net gain or a net loss from producing call number 3,000? How large?
	e.	Click 'Next' until you reach step 16, then click 'Draw': Is there a net gain or a net loss from producing call number 8,000? How large?
	f.	Click 'Next' until you reach step 17, then click 'Stop.' Draw the results shown at step 17, and calculate the sizes of the welfare losses for the illustrated cases of underproduction and overproduction.

6.	Answer the following questions based on the supplementary reading, "Why Calls Should Cost a Quarter":
	a.	Based on the editorial, what appears to be the efficient price for local calls from a public phone? Depict your answer in a supply and demand diagram.
	b.	According to the editorial, what was the actual price for pay phone calls in New York City? Label that price in your diagram and then use Qs' to label the quantity supplied and Qd' to label the quantity demanded at that price.
		(1)	In your diagram, indicate the welfare loss compared to the equilibrium if the phone company reduces quantity to Qs' because of the artificially low price.
		(2)	In practice, regulated phone companies are required to provide public phone service to all who want it at the regulated price (in this case, Qd'). In your diagram, indicate the welfare loss if Qd' is produced.
	c.	Briefly describe why each of the areas you indicated in part b are considered welfare losses compared to the market equilibrium.

PRICE ELASTICITY OF DEMAND

8.	What will happen to total expenditure in each of the following cases?
	a.	The price of gasoline rises, and the price elasticity of demand equals 0.3.
	b.	The price of peas rises, the price elasticity of demand equals 3.5.
	c.	The price of baseball tickets rises, and the price elasticity of demand equals 1.0

11.	Answer the following questions based on the supplementary reading, "Price Hike: Coming Soon to a Theater Near You?"
	a.	Consider passage B. Use the information from Tuesday's and Wednesday's receipts to calculate the quantity of tickets sold when the price is (1) $6.00 and (2) $6.50.
	b.	Define consumer surplus.
	c.	Based on the information from part a, diagram the demand curve for "Willow" and indicate in your diagram the change in consumer surplus that resulted from Wednesday's price increase.
	d.	Calculate a numerical value for the change in consumer surplus.
	e.	Given what happened to ticket receipts from Tuesday and Wednesday, is the demand for "Willow" elastic or inelastic over the $6.00 to $6.50 price range? Explain briefly.

A CLOSER LOOK AT COSTS AND DECISION MAKING

13.	Answer the following questions (there are several good similar examples in the supplementary reading, "Marginal Values and Economic Decisions.")
	a.	Distinguish between the concepts of sunk costs and variable costs.
	b.	Suppose that you own a car. Insurance and depreciation cost you $2,000 per year no matter how many miles your drive. Your only other expense is $.04 per mile for gasoline.
		(1)	If you drive 10,000 miles per year, what is your total cost? Your average cost per mile?
		(2)	This weekend, you have to go to San Diego for an Ultimate Frisbee tournament. The round-trip distance is 200 miles. You could drive or take the train, which costs $35 round-trip. Everything else the same, should you drive or take the train? Explain.

14.	Suppose that when you first entered college, you considered that your expected benefits of a college education (B) barely exceeded your expected costs (C). Suppose that halfway through college, you realize that your expected benefits are only about two-thirds of what you had originally estimated. Should you drop out of college or go ahead and finish? Explain your reasoning. [Hint: consider starting out by making up some hypothetical values to work with for benefits and costs.]

3.	Mankiw, Chapter 7, Problems and Applications number 6. Include with your answers a supply and demand diagram which plots the data from problems 4 and 5 in Mankiw.

4.	Based on the diagram to the right, calculate the dollar size of the welfare loss compared to the equilibrium level of output if: a. 2 units get produced. b. 7 units get produced.

12.	Answer the questions that accompany the supplementary reading, "Despite Fare Rise, Taxi Fleets Report New Losses Again."