Economic Instructor Manual

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 seller’s 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 retailer’s 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 retailer’s marginal cost was $750, the amount of producer surplus is $150, or the difference

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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).

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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 non-OPEC 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 buyer’s 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

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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 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. 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 income-increasing 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, | εP | = 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,| εP | > 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

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workers. If labor demand is inelastic, | εP | < 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.

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 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-Mart’s management information system is legendary. Wal-Mart 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.

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.

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ST11.1 SOLUTION

A. 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:


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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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 = ½ [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 = ½ [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.

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

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 = ½ [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.

The value of producer surplus is equal to the region above the market supply curve at 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 producer surplus equals:

Producer Surplus = ½ [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 = ½ [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.

The value of producer surplus is equal to the region above the market supply curve at the rent-controlled price of $900. 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 = ½ [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 = ½ [(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 = ½ [(1,600 -1,400) ×($1,000 - $900)]

= $10,000

PROBLEMS AND SOLUTIONS

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.

P11.1 SOLUTION

A. False. In competitive market equilibrium, social welfare is measured by the sum of net benefits derived by consumers and producers. Social welfare is the sum of consumer 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. Use this graph to help you algebraically determine the amount of consumer surplus, producer surplus and net social welfare generated in this market.

P11.3 SOLUTION


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.

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 is one-half the value of the base times the height, the value of consumer surplus equals:

Consumer Surplus = ½ [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.


Producer Surplus = ½ [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.



= $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. The market supply curve is given by the equationQS = -10 + 2P


2P = 10 + QS

P = $5 + $0.5QS


QD = 320 - 4P


4P = 320 - QD

P = $80 - $0.25QD

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. 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.

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 = ½ [(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 = ½ [(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

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

= $54 (000)

P11.5 Lump Sum Taxes. In 1998, California’s 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 watt-hours 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


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

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. 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)

Therefore, the equilibrium price-output combination is a market price of $150 with an equilibrium output of 100,000 (000) units.


Producer Surplus = ½ [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.

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:


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. The market demand curve is given by the equation

QD = 24,000 - 1,600P


1,600P = 24,000 - QD

P = $15 - $0.000625QD

The market supply curve is given by the equation

QS = -2,000 + 1,000P


1,000P = 2,000 + QS

P = $2 + $0.001QS

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 + 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)

Therefore, the equilibrium price-output combination is a market price of $10 with an equilibrium output of 8,000 (000) units.

Following the institution of a $3.25 per unit demand voucher, the new voucher-aided 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.

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 12,000-square-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)


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


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


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:

Producer SurplusPS = ½ [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 is one-half the value of the base times the height, the value of consumer surplus equals:

Producer SurplusFM = ½ [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 low-income 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. Use this graph to help you algebraically determine the amount of consumer 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


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)

Therefore, the equilibrium price-output combination is a market price of $60 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 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 = ½ [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 = ½ [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 = ½ [(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 profit-maximizing 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 Bush’s 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 = ΔTR/ΔQ = $10.25 - $0.02Q

TC = $625 + $0.25Q + $0.0025Q2

MC = ΔTC/ΔQ = $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. Set MR = MC to determine the profit-maximizing price/output solution and economic profits prior to the expiration of patent protection.

B. Calculate the firm’s 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 = MC

$10.25 - $0.02Q = $0.25 + $0.005Q,

0.025Q = 10

Q = 400 (000)

P = TR/Q = $10.25 - $0.01Q

= $10.25 - $0.01(400)

= $6.25

π = 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

= 0.0025

Q =

= 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

π = 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 firm’s 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 company’s 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 Poor’s 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 π/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 firm’s ability to sustain superior profitability. The market value of the firm represents the stock market’s assessment of the firm’s 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 market’s assessment of profit margin data is to study the link between profit margins and the firm’s P/E ratio. In the P/E ratio, “P” stands for the company’s 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 firm’s 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 firm’s performance on a daily basis. If performance is above the minimum required, the firm’s bond and stock prices will rise; if performance is below the minimum required, bond and stock prices will fall. For privately held companies, the market’s 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 firm’s 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 firm’s 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 awe-inspiring 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/E-profit 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 firm’s 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 firm’s ability to sustain above-average profits in the future.

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