Problem Set 5 Answer Key

1. If, by monopoly, we are talking about a single-price monopolist (as opposed to one that practices price discrimination), then there is reason to believe that the monopolist is bad for the economy. Such a monopoly will cause dead-weight loss: the gain in producer surplus is less than the loss in consumer surplus. (See the answer to #8 also.)

3. The development of the railroads brought geographically-isolated markets closer together. In essence, barriers to entry were reduced due to lower transporation costs. The reduced transportaton costs allowed firms in one part of the country to compete against those in far away parts.

4. If you treat the Mafia as a crime monopolist, then we would predict that the Mafia has incentives to restrict the amount of crime in order secure greater profits. In other words, the Mafia may be able to erect entry barriers to prevent small-time hoods from engaging in too much criminal behavior.

6. TR = $2000; TC = $1200; Profit = $800; The monopolist should not change its price and output because of the imposition of the lump sum tax--it's a fixed cost. Profits are simply reduced to $500.

7. Since MC > MR, the monopolist should cut output (and thereby raise its price).

8. Price discrimination could be beneficial to the economy in the sense that it encourages the monopolist to eliminate dead weight loss by selling to more customers. The three conditions are in your notes.

9. Price discrimination:
a) those who do not own a boat
b) adults
c) business travelers
d) rich

Q	P	TR	MR	MC	FC	VC	TC	PROFIT
1	50000	50000	50000	10000	50000	10000	60000	-10000
2	40000	80000	30000	10000	50000	20000	70000	10000
3	30000	90000	10000	10000	50000	30000	80000	10000
4	20000	80000	-10000	10000	50000	40000	90000	-10000
5	10000	50000	-30000	10000	50000	50000	100000	-50000

b) A single-price monopolist maximizes profit by selling Q = 3 (where MR = MC) at a P = $30,000. Profits are $10,000.
c) A price discriminating monopolist has an incentive to sell to all those who are willing to pay above the MC. Thus, the firm will sell to all 5 buyers (that last buyer will be indifferent) at the maximum price each is willing to pay. Thus TR=$150,000 and profits will be $50,000.

11. Market failure is the inability of a private unregulated market to attain efficiency, where efficiency is defined as marginal social benefits = marginal social cost. Three broad problems can lead to market failure: monopoly, public goods, and externalities.

12. Rational ignorance suggests that people will not spend a lot of time and money worrying about every piece of legislation debated by governments. Special interest groups, however, will attempt to manipulate the political process to their advantage in order to secure concentrated benefits at taxpayer expense.

16. Median voter model:
a) Kramer is the median voter and the parties will propose a tax rate to appeal to him, namely, 30%.
b) Jerry is now the median voter and the parties will propose a tax rate to appeal to him, namely, 40%.
c) Kramer becomes the median voter again, and a tax rate of 30% will be proposed.

18. Mosquito abatement program.
a) Under majority rule, only Charlie would vote in favor of the abatement program (since he values the program at $100, which is more than the cost to each owner of $35). Thus, the abatement program would not be approved. From society's point-of-view this would be inefficient since the total value of the program to the three guys ($120) is greater than the total cost ($105).
b) Unanimity could be reached by having Charlie subsidize Art and Bob's "tax bill." Assuming Art and Bob are willing to pay their values, Charlie could pay $34 on behalf of Art and $16 on behalf of Bob in order to pay for the abatement program. All parties would thus benefit.

19. The class in which students earn their own grades will have the higher class average. The class in which students earn the class average as their grade will attract a lot of free riders. The free riders are likely to be (how should I say) academically-challenged, thereby ensuring an overall lower class average.

21. Private costs = $10,000
External costs = $5000 + 4000 + 1000 = $10,000
Social costs = private + external = $20,000

22. On the one hand, a monopolist is inefficient because it tends to underproduce. On the other hand, a firm that generates a negative externality tends to overproduce its product. Combining these two yields an uncertain outcome since the two effects may tend to offset each other to some degree.

23. Does it matter whether the people living around the airport came after the airport was built? Why or why not?

24. Fishermen and sludge.
a) The fishermen will buy the nets at a cost of $2750.
b) The factory will buy the nets for the fishermen at a cost of $2750.
c) The tax is likely to be set equal to the damage done by the sludge to the fishermen, namely, $4000. Given this potential tax liability, the factory will try to minimize its costs by avoiding the tax. Since the factory is precluded from bargaining with the fishermen as in part (b), they will be unable to buy the net system. The next best option is to install the water filter system at a cost of $3500 (which is better than paying $4000 in taxes).
d) As Coase would argue, the outcomes in parts (a) and (b) are identical: as long as property rights are well-defined and transaction costs are low, private bargaining will result in the most efficient outcome. In this case, efficiency requires that the nets be used. However, in part (c), transactions costs were high enough to prevent bargaining so that only a "second best" outcome prevailed.

25. Tuna.
a) Free market price is $3.00 and output is 6,000,000 tuna where (private MB = private MC)
b) Socially optimal price is $4.50 and output is 3,000,000 tuna (where MSB = MSC)
c) Tax would be equal to the marginal external cost of tuna at the optimal output, namely, $2.25. Consumers would end up paying $1.50 of the tax (the change in market price from part (a) to part (b)).