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1

Consider a bookstore whose customers are evenly spread in clusters of three per kilometre, along a very long line. All of the consumers are identical, and each one will purchase one copy of the new Parry Hotter book as long as the price of the book plus the cost they incur travelling to the store is not larger than $20. There are three consumers at each location. Travel cost for each consumer is $0.75 per kilometre. The price of the book (at the store) is $12.50.

(a) What is the maximum distance that a consumer will travel to purchase a book from the store? Explain your reasoning.

(b) Using Figure 1.1 (in the text) as a guide, draw a diagram that illustrates your solution from part (a).

(c) Find the firm's market area and calculate the firm's total sales. Explain your reasoning.

(d) Suppose now that the bookstore faces competition from an Internet book seller who can deliver the book to a consumer at any location for $15. How does this change your answers to parts (a), (b), and (c)? Explain your reasoning, and include a diagram showing how the appearance of the Internet book seller affects the firm's market area.

(a) The total price of purchasing a copy from the store (including travel cost) is 12.5 + 0.75
d, where d is the distance that a consumer travels. Only consumers for whom this is less than
or equal to 20 will patronize the store, so 12.5 + 0.75 d

2

Suppose now that the bookseller's customers are evenly spread over a large (2-dimensional) area or region, and that there is one consumer at every location. Maintain the other assumptions given in Question 1: the mill price of a book is $12.50, the cost of travel is $0.75 per kilometre (from any direction), and the reservation price of a consumer is $20. Assume, to begin, that there are no other booksellers.

(a) What is the shape and radius of the firm's market area under these conditions? What is the firm's total sales? Explain your reasoning. Hint: the area of a circle is equal to (radius ). 2

(b) If the region in which the customers live is a square that is 100 kilometres wide, how many firms like this one (with circular market areas) could the region support? Explain your reasoning and illustrate your solution in a diagram.

(c) How many potential customers are not served under your solution to part (b)? Does this seem like a viable long-term solution? Explain your reasoning.

(a) The firm’s market area is a circle, with a radius equal to the maximum distance that a consumer will travel to patronize the firm, 10 kilometres. Since there is one consumer at each location, and since each consumer in the firm’s market area buys one copy, the firms total sales equal the area of the firm’s market area, π(102) . 314.

(b) The area of the region now equals 10,000 square kilometres, and the diameter of each circular market area is 20 kilometres, so one can fit at most 25 firms like this one in the region. Students should include a diagram to illustrate their answer.

(c) Since there is one consumer at each location, there are 10,000 consumers in total, and 25(314) = 7850 fall into the market areas of one of the firms. Thus, 10,000 ! 7,850 = 2,150 potential customers are not served. This doesn’t seem viable — firms will probably try to serve these
customers as well. Perhaps the shapes of the market areas will change so that more of the region is covered.

3

The simple theory of market areas introduced in the text suggests that firms should locate some distance away from their competitors, to avoid overlapping market areas. However, in many cases in the real world, we observe similar but competing firms locating together. For example, auto dealers commonly cluster in certain areas of a city. What economic force or forces, not present in our simple theory of market areas, could explain this phenomenon?

This question asks the student to speculate about the reason for a particular location pattern, and marks
should be awarded for any reasonable effort at providing an explanation for this. The main economic
force that explains this location pattern is comparison shopping. The products of the auto dealers are all slightly different, and by locating together the firms can increase the number of potential consumers who visit their location. This is apparently good for sales. It may also be that this location pattern is encouraged by government regulation: zoning laws may only permit auto dealers to locate in a few areas of a city.

4

The kingdom of Caltrans is considering the construction of a new highway between hamlets A and B. Otto, a commuting serf, travels between A and B. His demand curve for travel is T = 80 - P, where T is the number of trips and P is the cost per trip. If the new highway is built, the cost per trip will decrease from P = 40 to P = 30, and Otto's taxes will increase by 300. Will Otto support the construction of the highway? Explain your reasoning and use a diagram to support your answer. (Hint: how does construction of the highway affect Otto's consumer's surplus?)

When P = 40, Otto takes 40 trips and his consumer’s surplus equals 800. When P = 30, Otto takes 50 trips, and his consumer’s surplus is 1250. Thus, construction of the highway will cause Otto’s consumer’s surplus to increase by 450. Since this is larger than the tax increase, Otto will (or should) support the proposal. Students should include a diagram to illustrate their answer, and this diagram should show the increase in consumer’s surplus.

Diagram on R&D answers Question 4

5

Suppose the demand for housing is given by q D = 90 - 2p and that the supply of housing is given by qs = p Suppose further that the government introduces a rent control policy that states that the price of housing cannot exceed 20.

a) Calculate the effects of this policy on consumers' surplus, producers' surplus, and welfare, and show these effects in a diagram.

b) What is the deadweight loss of the policy, and where does it come from?

c) Landlords often charge very large "key fees", parking fees, and furniture rental charges in rent controlled markets. Use your diagram from part (a) to explain why this occurs.

(a) Before rent control, CS = 225, PS = 450 and so W = 675. After rent control, CS = 400, PS = 200 and W = 600. Thus, consumers are better off, producers are worse off, and
welfare decreases. The diagram should look a lot like Figure 2.15.
Diagram on R&D answers Question 5

(b) The dead weight loss is the reduction in welfare, which equals 75. This loss arises from the
fact that rent control causes the quantity of housing traded to decrease from 30 to 20, since it
causes a reduction in the quantity supplied. These units that are lost were valuable to society
in the sense that people were willing to pay more for them than they cost to supply. Consequently, their loss causes the surplus that society receives from this market to decrease.

(c) Consumers are willing to pay at least 15 per unit more than the controlled rent — this is the vertical distance between the demand curve and the controlled rent. People will be willing to pay up to this amount in key fees or other charges to secure a place to live.

6

Consider a residential builder who is deciding how much open area to include in a suburban condominium development. Individuals who will live in the development are willing to pay more for their suites if the development includes some open space. Suppose that the marginal benefit that the developer receives as a result of this factor is MB = 100 - 0.5S, where S is the amount of open space, measured in square feet. However, open space is costly to the developer, since it restricts the amount of housing that he can build — open space has an opportunity cost. Suppose that the marginal cost of open space to the developer is given by MC = S. Residents outside the development also derive a benefit from having some open space in the development — some space may be provided as a park that they can use, or it may be that including some open space makes the development aesthetically more appealing. Suppose that these marginal external benefits are given by MEB = 50 - 0.25S.

a) Find the equilibrium level of open space, that is, the level that the developer will choose taking only his own interests into account.

b) What is the marginal social benefit (MSB) of open space in this case? Using Figure 2.22 (in the text) as a guide, illustrate MB, MSB, and MC in a diagram.

c) Find the efficient amount of open space, that is, the level that maximizes the welfare of the community. How does the efficient amount of open space compare with the equilibrium amount that you calculated in part (a)? Explain the intuition behind your finding.

d) How can the community induce the developer to incorporate the efficient level of open space into the project? Show a calculation, if possible.

(a) The developer will choose the level of S for which MB = MC, or 100 - 0.5S = S, which implies S = 100/1.5 = 66.67.

(b) Adding the MB and MEB curves gives MSB = 150 - 0.75S. Students should include a diagram to illustrate their answer
Diagram in R&D Lesson 1 Question 6

(c) The efficient amount of open space satisfies MSB = MC, or 150 - 0.75S = S, which implies S = 150/1.75 = 85.7. This is more than the equilibrium amount of open space. The developer provides too little open space because he has no incentive to consider the benefits of open space
to other members of the community.

(d) One solution is to subsidize the provision of open space. The required subsidy equals the level
of MEB at the efficient level of open space, so the efficient subsidy would equal 50 - 0.25(85.7) = 28.6 per unit. With this subsidy, the marginal benefit of open space to the
developer becomes MB + subsidy = 128.6 - 0.5S. Now the developer will choose the level
of S for which 128.6 - 0.5S = S, which implies S = 128.6/1.5 = 85.7, which is, of course, the efficient amount. Of course, there are other alternatives. The community could also
require that the developer include this amount of open space, or (what is most common) allow the developer to build to a higher density if the project includes a certain amount of open space.

7

Suppose that the demand for basement apartments in West Point Grey is given by qD = 1,150 - p + .01E, where E stands for UBC enrollment and p is the monthly price (rent) of basement apartments. The short-run supply is fixed at 800, and the long-run supply is given by qs= 200 + p.

a) Assuming that UBC enrollment is 25,000, calculate the short-run equilibrium price. Is this consistent with the long-run equilibrium?

b) Now assume that UBC enrollment suddenly rises to 30,000. Calculate the new short-run equilibrium price and the long-run equilibrium price and quantity. Illustrate both of these solutions using a single diagram.

c) Suppose that the provincial government imposes rent controls just as UBC enrollment increases to 30,000. The maximum monthly rent allowed is $500. Will this policy cause a housing shortage in the long-run? If yes, provide the amount of the shortage. Explain your reasoning and provide any relevant calculations.

d) Landlords often charge very large "key fees", parking fees, and furniture rental charges in rent controlled markets. Use your answer to part (c) to explain why this occurs.

(a) With E = 25,000, the demand for apartments is qd = 1,400 - p. Since qs = 800 in this case, the short-run equilibrium price is 600 per month. At this price, long-run supply equals qs = 200 + 600 = 800, so the short and long-run equilibria are consistent when enrollment equals 25,000.

(b) With E = 30,000, the demand for apartments is qd = 1,450 - p. Then, in the short-run, qD = qs implies p = 650 per month. Students should include a diagram to illustrate their answer.
To find the long-run quantity, the long-run supply curve must be equated to the demand curve and the intersection of the two curves will mark the long-run equilibrium price and quantity.
qs - 200 = 1150 + 0.01(30000) - qD
2q = 1650
q = 825
p = 825-200
p = 625
Diagram in R&D Lesson 1 Question 7

(c) With a rent ceiling at p = 500, long-run supply is given by qs = 200 + 500 = 700, while demand equals qd = 1,450 - 500 = 950. Thus, there will be shortage of 250 units in the long-run.

(d) Consumers are willing to pay more than the controlled rent — this is the vertical distance
between the demand curve and the controlled rent. People will be willing to pay up to this amount in key fees or other charges to secure a place to live.

8

If consumption increases as a consumer's marginal benefit declines, which of the following statements about the demand curve is TRUE?
1) As we move to the right along the demand curve, quantity demanded increases and the price consumers are willing to pay decreases.
2) As we move to the left along the demand curve, quantity demanded increases and the price consumers are willing to pay increases.
3) As we move to the right along the demand curve, quantity demanded increases and the price consumers are willing to pay increases.
4) As we move to the left along the demand curve, quantity demanded increases and the price consumers are willing to pay decreases.

Answer: (1) A demand curve shows the relationship between the price per unit and the quantity demanded. In this case we know that consumption increases as a consumer’s marginal benefit declines so we know that the demand curve will be downward sloping. In a downward sloping curve as the price falls, the quantity demanded increases.

9

At SuperDuper Grocery, the owners, Larry and Marge, have noticed that the demand for cucumbers has increased at all prices (i.e., the demand curve has shifted to the right). Assuming that cucumbers are a normal good, zucchinis are a substitute, and carrots are a complement, which of the following statements could explain the shift in the demand curve for cucumbers?

A) The price of zucchini has increased by $0.75.
B) The price of carrots has decreased by $1.05.
C) Shopper's income has increased.
D) The price of cucumbers has decreased.

1) Only Statement C is true.
2) Only Statements A, B, and C are true.
3) All of the above statements are true.
4) Only Statements B and D are true.

Answer: (2) Statement D is incorrect because a price change of cucumber causes a movement along the demand curve not a shift of the entire demand curve. From this question, we know that the entire demand curve has shifted out. Statement A causes a shift to the right of the demand curve for zucchinis. Since cucumbers and zucchinis are substitutes, an increase in the price of zucchinis leads to an outward shift in the demand curve for cucumbers. Since cucumbers and carrots are complements, Statement B is correct. If two goods are complements, a decrease in the price of carrots leads to an increase in demand for cucumbers. An increase in income leads to an increase in demand, or a rightward shift in the curve if the good is normal. Since cucumbers are a normal good, Statement C is true.

10

The slope of the supply curve for land would be approximately:
1) 1/2.
2) horizontal.
3) vertical.
4) cannot be determined without more information.

Answer: (3) Since land is a non-reproducible product, the quantity supplied is fixed and cannot be changed. As the price for the product changes, the quantity available will not change. This will result in the supply of land as a vertical line supplying the same quantity at every price.

11

Handy Man Tools has been in the business of manufacturing and selling tools for many years. Some materials are bought from other stores and some are made at the shop. The metal for the hammer is produced in-house and the wood that is required is bought from Troy's Timber. Severe forest fires over the last few years have left Troy's Timber with a smaller supply of wood than usual. What effect does this change in the supply of lumber have on the equilibrium price and quantity of wood between Handy Man Tools and Troy's Timber?
1) The equilibrium quantity of wood increases and the equilibrium price of wood decreases.
2) The equilibrium quantity of wood decreases and the equilibrium price of wood increases.
3) There is no effect on the equilibrium price and quantity of wood.
4) The effect on the equilibrium price and quantity of wood cannot be determined without more information.

Answer: (2) An increase in input prices causes the supply curve to shift up and to the left. This causes the supply curve to now cross the demand curve at a higher price and lower quantity.

12

Molson Miller does not own a cell phone and is not allowed to use the telephone in his office for personal calls. After work he uses the pay phone outside his office to call his Mom for a ride home. The weekly demand curve for public pay phones is qd = 6 - p, where p represents the price per phone call.
If it costs $1 for every phone call made, what is the consumer surplus?
1) $12.50
2) $15.00
3) $5.00
4) $25.00

Answer: (1) At a price of $1 per phone call Molson Miller uses the pay phone 5 times, qd = 6 ! 1, qd = 5. The weekly demand function crosses the qd axis at 6 and the P axis at 6. The consumer surplus is the area above a price of $1 and below the demand curve, (6 ! 1) × 5 × 1/2 = $12.50.

13

Molson Miller does not own a cell phone and is not allowed to use the telephone in his office for personal calls. After work he uses the pay phone outside his office to call his Mom for a ride home. The weekly demand curve for public pay phones is qd = 6 - p, where p represents the price per phone call.

Now assume that Molson Miller can buy a weekly phone card. The weekly phone card costs $5.50 and allows Molson Miller to make as many calls as he wants during the week for free. If Molson Miller buys the phone card by how much does his consumer surplus change?

1) His consumer surplus increases by $3.00.
2) His consumer surplus decreases by $11.00.
3) His consumer surplus increases by $5.50.
4) His consumer surplus does not change.

Answer: (4) At a price of $0 per phone call Molson Miller uses the pay phone 6 times, qd = 6 ! 0, qd = 6. The consumer surplus is the area above a price of $0 and below the demand curve, 6 × 6 × 1/2 = $18. The weekly phone card costs $5.50 and therefore Molson Miller’s total consumer surplus when he buys the weekly phone card is $12.50 ($18 ! $5.50). Molson Miller’s consumer surplus is the same with or without the weekly phone card.

14

If a supply curve is fixed at 100 units and the demand curve is downward sloping, who bears the ENTIRE burden of an increase in consumer taxes?

1) Consumers bear the burden of an increase in consumer taxes because they are paying the tax.
2) Suppliers bear the burden of an increase in consumer taxes because they must lower their price.
3) The burden of an increase in consumer taxes is split equally between the buyers and sellers.
4) The burden of the increase in consumer taxes cannot be determined without more information.

Answer: (2)
Suppliers bear the burden of the consumer taxes because the same amount 100 units is supplied at a
lower price (P ). Consumers still pay exactly the same amount as they did before (P ), but suppliers 0 1
now receive (P ), the price that buyers pay minus the tax.
Diagram located in Lesson 1 MC Question 7 answers

15

In markets with negative externalities, why is a corrective tax required to achieve an efficient market?

1) A corrective tax is required because the marginal external cost curve does not cross the marginal benefit curve at the efficient level. The tax is added to the marginal external cost so the two curves now cross at the point where the net social benefit is maximized.
2) A corrective tax is required because the quantity must be reduced to a point where the marginal benefit curve is equal to the marginal cost curve.
3) A corrective tax is required because the marginal cost curve plus the marginal external cost curve is not equal to the marginal social cost curve. A corrective tax must be added to the marginal benefit curve to make the marginal benefit curve equal to the marginal social cost curve.
4) A corrective tax is required because the quantity must be reduced to a point where the marginal social cost curve is equal to its marginal benefit curve.

Answer: (4)
Efficiency is maximized where the marginal social cost curve crosses the marginal benefit curve.
Producers will produce where the marginal cost curve crosses the marginal benefit curve. A corrective
tax is added to the negative externality so that the company produces where the marginal benefit curve
crosses the marginal social cost curve. Option (1) is incorrect because the net social benefit is not
maximized when the marginal external cost curve crosses the marginal benefit, corrective tax or no
corrective tax. Option (2) is incorrect because a corrective tax does not reduce the quantity to a point
where the marginal benefit curve is equal to the marginal cost curve; it reduces the quantity to a point
where the marginal benefit curve is equal to the marginal social cost curve. Option (3) is incorrect
because the corrective tax is not added to the marginal benefit curve

16

A deadweight loss is a very common economic effect of taxes. The deadweight loss reduces which surplus?

1) Only the consumer surplus area.
2) Only the producer surplus area.
3) The result depends on the slopes of the demand and supply curves.
4) Both the consumer and the producer surplus areas.

Answer: (3)
Option (4) is only correct if both curves are normal (the demand curve has a negative slope and the
supply curve has a positive slope). If either curve is fixed (the demand curve and/or the supply curve
is horizontal or vertical), the deadweight loss falls entirely on either the consumer surplus area or the
producer surplus area. The area lost due to the deadweight loss depends on the slopes of the demand
and supply curves

17

A positive externality exists when the actions of an individual or firm have a direct beneficial impact on others. The market for positive externalities generates too little of the activities that produce positive externalities. Which of the following statements is FALSE?

1) If decision makers take the external benefit into account when deciding how much to produce, they would produce at a level that maximizes net social benefits.
2) If we subtract the marginal external benefit form the marginal social benefit, we see where the marginal cost curve crosses the marginal benefit curve.
3) If the subsidy is equal to the marginal external benefit at the point where the marginal cost curve crosses the marginal social benefit curve, the marginal benefit curve will shift so that the net social benefit of the activity will be maximized.
4) The marginal external benefit is equal to the subsidy that would raise the marginal benefit curve to the level that maximizes the net social benefit at all locations of quantity.

Answer: (4) A per unit subsidy equals the marginal external benefit only at the quantity where the marginal cost and the marginal benefit curves cross. At other quantities, the marginal external benefit is not equal to the subsidy that would raise the marginal benefit curve to the level that maximizes the net social benefit. Option (1) is true because if decision makers take the external benefit into account when making decisions, they would produce at a level that maximizes net social benefits, where the marginal cost curve crosses the marginal social benefit curve. Option (2) is true because MSB = MC + MEB. Using simple algebra if we subtract MEB from both sides of the equation, MSB ! MEB = MC. Option (3) is true because a per unit subsidy equal to MEB at the quantity where the marginal cost curve crosses the marginal social benefit curve will raise the MB curve and cause the decision makers to make efficient choices. In the above explanation, MC represents the marginal cost curve, MB represents the marginal benefit curve, MSB represents the marginal social benefit curve, and MEC represents the marginal external benefit curve.