FACTS AND TOOLS

Question 11.11

3. In Figure 11.8, you saw what happens in the long run when demand rises in a constant cost industry. Let’s see what happens when demand falls in such an industry: For instance, think about the market for gasoline or pizza in a small city after the city’s biggest textile mill shuts down. In the following figure, indicate the price and quantity of output at three points in time:

1. In the long run, before demand falls

2. In the short run, after demand falls

3. In the long run, after demand falls

Also, answer the following questions about the market’s response to this fall in demand.

1. When will the marginal cost of production be lowest: At stage I, II, or III?

2. When firms cut prices, they often do so in dramatic ways. During which stage will the local pizza shops offer “Buy one, get one free” offers? During which stage will the local gas station be more likely to offer “Free car wash with fill-up?”

3. When is P > AC? P < AC? P = AC?

4. Restating the previous question: When are profits positive? Negative? Zero?

5. Roughly speaking, will the long-run response mostly involve firms leaving the industry, or will it mostly involve individual firms shrinking? The Firm column of Figure 11.8 should help you with the answer.

1. Suppose Sam sells apples, picked from his apple tree, in a competitive market. Assume all apples are equal in quality, but grow at different heights on the tree. Sam, being fearful of heights, demands greater compensation the higher he goes: So for him, the cost of grabbing an apple rises higher and higher, the higher he must climb, as shown in the Total Cost column in the following table. The market price of an apple is $0.50.

2. How long is the “long run?” It will vary from industry to industry. How long would you estimate the long run is in the following industries?

3. In this chapter, we discussed the story of Dalton, Georgia, and its role as the carpet capital of the world. A similar story can be used to explain why some 60% of the motels in the United States are owned by people of Indian origin or why, as of 1995, 80% of doughnut shops in California were owned by Cambodian immigrants. Let’s look at the latter case. In the 1970s, Cambodian immigrant Ted Ngoy began working at a doughnut shop. He then opened his own store (and later stores).*

Ngoy was drawn to the doughnut industry because it required little English, startup capital, or special skills. Speaking the same language as your workers, however, helps a lot.

4. Ralph opened a small shop selling bags of trail mix. The price of the mix is $5, and the market for trail mix is very competitive. Ralph’s cost curves are shown in the figure below.

5. In the competitive children’s pajama industry, a new government safety regulation raises the average cost of children’s pajamas by $2 per pair.

217

6. In the ancient Western world, incense was one of the first commodities transported long distances. It grew only in the south of the Arabian Peninsula (modern-day Yemen, known then as Arabia Felix), which was transported by camel to Alexandria and the Mediterranean civilizations, notably the Roman Republic. As the republic expanded into a richer and larger empire, the demand for incense grew and planters in Arabia added a second and then a third annual crop (though this incense was not as high in quality). Cultivation also crossed to the Horn of Africa (modern-day Oman) even though such fields were farther away from Rome.2

7. You run a small firm. Two management consultants are offering you advice. The first says that your firm is losing money on every unit that you produce. To reduce your losses, the consultant recommends that you cut back production. The second consultant says that if your firm sells another unit, the price will more than cover your increase in costs. In order to reduce losses, the second consultant recommends that you should increase production.

8. Paulette, Camille, and Hortense each own wineries in France. They produce inexpensive, mass-market wines. Over the last few years, such wines sold for 7 euros per bottle; but with a global recession, the price has fallen to 5 euros per bottle. Given the information below, let’s find out which of these three winemakers (if any) should shut down temporarily until times get better. Remember: Whether or not they shut down, they still have to keep paying fixed costs for at least some time (that’s what makes them “fixed”).

To keep things simple, let’s assume that each winemaker has calculated the optimal quantity to produce if they decide to stay in business; your job is simply to figure out if she should produce that amount or just shut down.

9. Suppose Carrie decides to lease a photocopier and open up a black-and-white photocopying service in her dorm room for use by faculty and students. Her total cost, as a function of the number of copies she produces per month, is given in the table:

218

10. Let’s explore the relationship between marginal and average a little more. Suppose your grade in your economics class is composed of 10 quizzes of equal weight. You start off the semester well, then your grades start to slip a little, but then you get back into the swing of things, your grades pick up, and you finish off the semester with a bang. Your 10 quiz grades, in order, are: 82, 74, 68, 72, 77, 83, 86, 88, 90, and 100. Graph your marginal grades, along with your average grade, after each quiz. What do you notice about the relationship between marginal and averages? Your grades start improving with your fourth quiz grade; does your average also start increasing with your fourth quiz grade? Why or why not?

11. Given the cost function in the following table for Simon, a housepainter in a competitive local market, answer the questions that follow. (You may want to calculate average cost.)

What is the minimum price per room at which Simon would be earning positive economic profit? At prices below this price, what will Simon’s long run plan be?

12. Sandy owns a firm with annual revenues of $1,000,000. Wages, rent, and other costs are $900,000.

13. You and your roommate are up one night studying microeconomics, and your roommate looks puzzled. You ask what is wrong, and you get this response: “The book says that in the short run fixed costs are an expense but not a cost—but that doesn’t make any sense. How can something be an expense but not a cost?” How do you respond?

14. Use the variable cost information in the following table to calculate average variable cost and average cost (assume fixed cost is $350), and then use this data to answer the questions that follow. One of them might not have an answer.

219

15. Look carefully at Figure 11.6. What is represented by the space in between the average cost (AC) and average variable cost (AVC) curves? Why do they get closer together as quantity increases? Will they ever meet?

1. The demand for most metals tends to increase over time. Moreover, as we discussed in this chapter and also in Chapter 5, these types of natural resource industries tend to be increasing cost industries. And yet the price of metals compared with other goods has tended to fall slowly over time (albeit with many spikes in between). The following figure, for example, shows an index of prices for aluminum, copper, lead, silver, tin, and zinc from 1900 to 2003 (adjusted for inflation). The trend is downward. Why do you think this is the case?

2. Frequent moviegoers often note that movies are rarely based on original ideas. Most of them are based on a television series, a video game, or, most commonly, a book. Why? To help you answer this question, start with the following.

4. In Kolkata, India, it is very common to see beggars on the streets. Imagine that the visitors and residents of Kolkata become more generous in their donations; what will be the effect on the standard of living of beggars in Kolkata? Answer this question using supply and demand, making assumptions as necessary.

5. Just to make sure you’ve gotten enough practice using the different formulas in this chapter, let’s try a challenging exercise with them. Very little information is given in the following table, but surprisingly, there’s enough information for you to fill in all of the missing values—if you remember all of the relationships and can think of creative ways to use them.

!launch! WORK IT OUT

1. Fill in the missing numbers in the table, assuming that Margie can charge 6 cents per black-and-white copy.

2. How many copies per month should Margie sell?

3. If the lease rate on the copier were to increase by $50 per month, how would that impact Margie’s profit-maximizing level of output? How would this $50 increase in the lease rate affect Margie’s profit? What will she do when it is time to renew her lease?