Chapter 5 - Answer

Solutions Manual

CHAPTER 5 APPLICATIONS OF MICROECONOMICS THEORYAS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS SUGGESTED ANSWERS TO THE REVIEW QUESTIONS I. Questions 1. The amount of a commodity purchased per unit of time is a function of or depends on the price of the commodity, money incomes, the prices of other (related) commodities, tastes and the number of buyers of the commodity in the market. A change in any of the above factors will cause a change in the amount of the commodity purchased per unit of time. The elasticity of demand measures the relative responsiveness in the amount purchased per unit of time to a change in any one of the above factors, while keeping the others constant. 2. The price elasticity of demand measures the relative responsiveness in the quantity of a commodity demanded to changes in its price. The income elasticity of demand measures the relative responsiveness in the amount purchased to changes in money income. Similarly, the cross elasticity of demand measures the relative responsiveness in the amount purchased to changes in the price of a related commodity. The above elasticity concepts apply as much to the individual consumer’s response as to the market response. However, we are primarily interested in the market responses. 3. The factors governing the size of the coefficient of price elasticity of demand are as follows: a) Number and closeness of substitutes for the commodity. The more and better the available substitutes for a commodity, the greater its price elasticity of demand is likely to be. Thus, when the price of tea rises, consumers readily switch to good substitutes such as coffee and cocoa, so the coefficient of price elasticity of demand for tea is likely to be high. On the other

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hand, since there are no good substitutes for salt, its elasticity is likely to be very low. b) Number of uses of the commodity. The greater the number of uses of a commodity, the greater is its price elasticity. For instance, the elasticity of aluminum is likely to be much greater than that of butter since butter can be used only as food while aluminum has hundreds of uses (e.g., aircraft, electrical wiring, appliances and so on). c) Expenditures on the commodity. The greater the percentage of income spent on a commodity, the greater its elasticity is likely to be. Thus the demand for cars is likely to be much more price elastic than that for shoes. d) Adjustment time. The longer the allowed period of adjustment in the quantity of a commodity demanded, the more elastic its demand is likely to be. This is so because it takes time for consumers to learn of new prices and new products. In addition, even after a decision is made to switch to other products, some time may pass before the switch is actually made. e) Level of price. If the ruling price is toward the upper end of the demand curve, demand is likely to be more elastic than if it were toward the lower end. This is always true for a negatively sloped straight-line demand curve and is usually true for curvilinear demand curves. 4. The price elasticity of supply (es) measures the relative responsiveness or sensitivity in the quantity of a commodity supplied to changes in its price only. Thus es, as e, measures movements along the same supply curve. 5. The longer the period of adjustment allowed for a change in the price of a commodity, the more elastic the supply curve of the commodity is likely to be. This is so because it takes time for producers to respond to price changes. 6. The answer depends on the price elasticity of demand for taxi rides in Metro Manila. If the demand for taxi rides is price inelastic, the decision was correct. If demand is elastic, then increasing taxi fares reduces the total revenue of taxi owners. In order to see what happened to the total profits of taxi owners, we must compare this decrease in total revenue 5-2

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with the change in total costs (higher wages for taxi drivers but fewer taxis and fewer taxi drivers). Unfortunately, in the real world we often do not have (and it might be difficult) to get estimates of the elasticities necessary to reach correct decisions. 7. A bad harvest is reflected in a decrease in supply (i.e., an upward shift in the market supply curve of agricultural commodities). Given the market demand for agricultural commodities, this decrease in supply causes the equilibrium price to rise. Since the demand is price inelastic, the total receipts of farmers as a group increase. When the demand for an agricultural commodity is price inelastic, the same result can be achieved by reducing the amount of land under cultivation for the commodity. This is done in some farm-aid programs. 8. a. An entrepreneur running his firm must include as part of his costs of production not only what he actually pays out to hire labor, purchase raw and semi-finished materials, borrow money and rent land and buildings (the explicit costs), but also the maximum salary that the entrepreneur could have earned working in a similar capacity for someone else (say, as a manager of another firm). Similarly, the entrepreneur must include as part of his costs of production the return in the best alternative use from the capital, land and on any other factor of production that he owns and that he uses in his own enterprise. These resources owned and used by the firm itself are not “free” resources. The implicit cost to the firm involved in using them is equal to the best alternative foregone (i.e., what these same resources would have earned in their best alternative use). Whenever we speak of costs in economics or draw cost curves, we always include both explicit and implicit costs. b. For the inputs which the firm purchases or hires, the firm must pay a price at least equal to what these same inputs could earn in their best alternative use. Otherwise, the firm could not purchase them or retain them for its use. Thus the cost to the firm involved in the use of any input, whether owned by the firm (implicit cost) or purchased (explicit cost), is equal to what the same input could earn in its best alternative use. This is the alternative or opportunity cost doctrine. We assume that factor prices remain constant regardless of the quantity of each factor demanded by the firm per unit of time. That is, we assume that the firm is a perfect competitor in the factor market. 5-3

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9. A firm should combine inputs in order to minimize the cost of producing various level of output. The production function of a firm together with the prices that the firm must pay for its factors of production or inputs determine the firm’s cost curves. 10. Prices reflect marginal value, not total value. The marginal value of a good is the maximum amount a consumer would be willing to pay for a specific unit. The height of the demand curve reflects the value consumers place on each unit. The total value is the total benefit consumers derive from all units consumed. The area under the demand curve for the number of units consumed reflects the total value. Water provides an example of a good with high total value but low marginal value. With regard to the last question, are there more nurses or professional wrestlers? 11. Neither markets nor the political process leaves the determination of winners and losers to chance. Under market organization, business winners and losers are determined by the decentralized choices of millions of consumers who use their million votes to reward firms that provide preferred goods at a low cost and penalize others who fail to do so. Under political decision making, the winners and losers are determined by political officials who use taxes, subsidies, regulations and mandates to favor some businesses and penalize others. 12. a. Profitable production increases the value of resources owned by people and leads to mutual gain for resource suppliers, consumers and entrepreneurs. b. Losses reduce the value of resources, which reduces the well-being of at least some people. There is no conflict. 13. Business firms do have strong incentive to serve the interest of consumers, but this is not what motivates them. Instead, they are motivated by self-interest and the pursuit of income, but they must provide consumers with a quality product if they are going to be successful. Good intentions are not required for people to engage in actions that are helpful to others.

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II. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

A D C B A D C B A A C

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

D C C D D B D B D C D

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