applied econ Answers to Review Quizzes & Problems - CH 05.pdf

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A n s w e r s t o t h e R e v i e w Q u i z z e s

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1. Why do we need methods of allocating scarce resources?Because resources are scare, it is not possible to fulfill everyone’s wants. As a result, some method ofdeciding which wants will be fulfilled and which will not—that is, some method of allocatingresources—must be utilized.

2. Describe the alternative methods of allocating scarce resources.

Resources can be allocated using:

• Market price: People who are willing and able to pay the price get the resource.• Command: Someone in command decides who gets the resource.

• Majority rule: The majority vote decides how resources are allocated.

• Contest: Winners receive the resource.

• First-come, first-served: People first in line get the resource.

• Lottery: Randomly selected winners receive the resource.

• Personal characteristics: People with the “right” characteristics get the resource.

• Force: The stronger person or group gets the resource.

3. Provide an example of each allocation method that illustrates when it works well.

Below are examples of when each allocation scheme works well:

• Market price: Generally works well in competitive markets and for most goods and services.

An example is the allocation of cat food.• Command: Generally works well in organizations where lines of authority are clear and it is

easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tellsa worker to clean the tables.

• Majority rule: Generally works well when large numbers of people are affected by theallocation. An example is an election in which people vote whether or not to support a tax tobuild more parks.

• Contest: Generally works well when the efforts of the participates are hard to monitor. Anexample is the contest run by Pfizer in which three top managers competed to see who wouldbe appointed CEO.

• First-come, first-served: Generally works well when a resource can be used by only one user ata time. An example is a line at a movie ticket booth.

• Lottery: Generally works well when there is no way to easily distinguish which user of aresource would use it most effectively. An example is the lottery used to allocate cell phonefrequencies.

• Personal characteristics: Generally works well when resource use is tied between differentpeople. An example is the decision whom to marry.

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• Force: Generally works well when used to uphold the rule of law. An example is the stateimprisoning thieves.

4. Provide an example of each allocation method that illustrates when it works badly.Below are examples of when each allocation scheme would work poorly:

• Market price: Deciding court cases on the basis of who will pay the most for the decision.

• Command: Running an economy.

• Majority rule: Deciding how many acres of wheat to plant.• Contest: Allocating food in a winner-take-all contest.• First-come, first-served: Admitting students to college based on who applied first.

• Lottery: Assigning grades based on random chance.

• Personal characteristics: Renting only to married couples.

• Force: Stealing by threat of physical harm.

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1. How do we measure the value or marginal benefit of a good or service?The value, or marginal benefit, of a good or service is measured by the maximum amount thatconsumers are willing to pay for one more unit of a good or service.

2. What is consumer surplus? How is it measured?Consumer surplus is the value or marginal benefit of a good minus the price paid, summed over thequantity of the good purchased. The price per unit of a good is assumed to be equal for all units of thegood purchased. The quantity purchased is determined by equating the marginal benefit to the pricepaid. This means that the consumer surplus can be measured as the area under the demand curve andabove the price paid, summed over the entire quantity purchased.

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1. What is the relationship between the marginal cost, minimum supply-price, and supply?The minimum supply-price of producing one more unit of a good or service is its marginal cost, and themarginal cost is the minimum price that producers must receive to induce them to offer one more unitof a good or service for sale.

2. What is producer surplus? How is it measured?Producer surplus is the price received for each unit of a good minus the cost of producing it, summed overall units produced. The price per unit of a good is assumed to be the same for all units of the good sold.The quantity purchased is that quantity where the marginal cost is equal to the price received. Thismeans that the producer surplus can be measured as the area under the price and above the supply curve,summed over the entire quantity sold.

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1. Do competitive markets use resources efficiently? Explain why or why not.In the absence of the obstacles mentioned earlier in the chapter, competitive markets use society’sresources efficiently. For resources to be used efficiently they must be allocated to produce the quantityof a good or service where the marginal cost of the last unit produced in the market is equal to the

marginal benefit. This condition will be met in a competitive market because equilibrium quantityoccurs where the demand curve (which equals the marginal social benefit curve) intersects the supplycurve (which equals the marginal social cost curve).




EFF ICIENCY AND EQUITY 75

2. What is deadweight loss and under what conditions does it occur?The deadweight loss is the is the decrease in total surplus that results from an inefficient level ofproduction. This is the decrease in consumer surplus plus the decrease in producer surplus that occurs

when the market either overproduces or underproduces relative to the efficient quantity..

3. What are the obstacles to achieving an efficient allocation of resources in the market

economy?Markets with price or quantity regulations, taxes or subsidies, externalities, public goods or commonresources, monopoly power, or high transactions costs will not produce the efficient quantity of a goodor service. In each of these situations, the market prices charged or quantities produced and sold will notresult in the efficient allocation of resources. Efficiency requires that the marginal social benefit of thelast unit produced be equal to the marginal social cost. The equilibrium at the intersection of thedemand and supply curves in the competitive market creates this result. When the market price orquantity is pulled away from the market equilibrium, the marginal social benefit of the last unitproduced does not equal its marginal social cost.

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1. What are the two big approaches to thinking about fairness?The two big approaches to thinking about fairness are:

• “It’s not fair if the result isn’t fair,” or utilitarianism.

• “It’s not fair if the rules aren’t fair,” or equality of opportunity .

2. What is the utilitarian idea of fairness and what is wrong with it?The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resourcesto be “fair.” There should be income transfers from the rich to the poor until equality is achieved,because the marginal benefit of the last dollar of income is the same for everybody. There are twoproblem with utilitarianism:

• It ignores the cost of implementing the income transfers, which will decrease the total goods andservices that the finite resources of society can produce. The size of the economic pie will be smaller.

• It assumes that the existence of decreasing marginal benefits allows us to make inter-personalcomparisons about value gained and lost at different levels of consumption of a good or service.

While one can compare the marginal benefits from consuming different levels of a good or servicefor an individual, this is not the same as comparing the marginal benefits from consuming differentlevels of a good or service across individuals.

3. Explain the big tradeoff. What idea of fairness has been developed to deal with it?The big tradeoff is the tradeoff between equality and efficiency . Redistributing incomes changes theincentives facing producers and consumers. Taxing income decreases producer surplus and taxingpurchases decreases consumer surplus. Producers produce less and consumers consume less, and totaleconomic activity declines, such that the size of the economic pie decreases. The big tradeoff has led tothe idea that the fairest distribution is that which makes the poorest person as well off as possible.

4. What is the idea of fairness based on fair rules?The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation ofresources to be “fair.” This is the economic application of the symmetry principle , that people in similar

situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed:• The government must enforce laws that establish and protect rights to private property that are held

by individuals in society, and

• Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.




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A n s w e r s t o t h e P r o b l e m s a n d A p p l i c a t i o n s

1. At West, recognized as the “jewel of Vancouver’s culinary crown,” reservations are essential. At Le Bistro Chez Michel, a restaurant in North Vancouver, reservations are recommended. At Viji’s, a restaurant not far from the University of British Columbia, reservations are not

accepted.a. Describe the method of allocating scarce table resources at these three restaurants.

All these restaurants use a first-come, first-serve system. Viji’s uses this system directly. West uses a first-come, first-serve because the first person to call to make a reservation at a particular time is allocated thetable at that time. Le Bistro Chez Michel uses a combination of the immediate first-come, first servesystem and the reservation based first-come, first-serve system.

b. Why do you think restaurants have different reservations policies?The speed with which tables turn over at the different restaurants probably is quite different and thecustomers probably have quite different values of time. West has a low turnover rate—only 1 or 2groups of customers can use a table each night—and its customers have a high value of time. If Westrefused to take reservations, its customers would need to wait an inefficiently long time and would goelsewhere, so West’s profits would fall. At Viji’s, the tables have a high turnover rate and the customers

have a lower value of time. Allowing reservations would be costly for Viji’s and would spare itscustomers only a slight wait at most, so allowing reservations would decrease Viji’s profits. At Le BistroChez Michel, the turnover rate of the tables is between that at West and Viji’s, so it uses a combinationof phone reservation first-come, first-serve and appear in person first-come, first serve.

c. Why might each restaurant be using an efficient allocation method?Each restaurant is using a different allocation method because of the relative costs. Each uses the methodthat has the lowest cost for the restaurant.

d. Why do you think restaurants don’t use the market price to allocate their tables?Market allocation requires that customers pay for a table and the price would fluctuate from one hour tothe next depending on the number of customers who arrive. Customers would be highly uncertain aboutthe price they would need to pay and such uncertainty decreases the demand for meals from therestaurant. The decreased demand lowers the restaurant’s profit.

2. The table providesinformation on the demandschedules for train travel for Ann, Beth, and Cy, who arethe only buyers in themarket.

Quantity demanded(kilometre)

Price(dollars perkilometre) Ann Beth Cy

3 30 25 204 25 20 155 20 15 106 15 10 57 10 5 08 5 0 09 0 0 0





b. What are the minimum prices that Xavier, Yasmin, and Zack are willing to accept tosupply 20 rides? Why?

The minimum supply-price equals the lowest price at which a producer is willing to produce the givenquantity. The supply schedule tells us the minimum supply-price. Xavier’s minimum supply-price for 20rides is $80; Yasmin’s minimum supply-price is $90; and, Zack’s minimum supply-price is $100.

c. What is the marginal social cost when the total number of rides is 30?

The quantity of rides is supplied is 30 when the price is $70 per ride. The marginal social cost of anyquantity is equal to the price for which that quantity will be supplied, so when the total number of ridesis 30, the marginal social cost equals $70 per ride.

d. What is the marginal cost for each supplier when the total number of rides is 30 and howmany rides does each of the firms supply?

When the total number of rides is 30, Xavier supplies 15 rides, Yasmin supplies 10 rides, and Zacksupplies 5 rides. The marginal cost for each firm is $70.

e. What is each firm’s producer surplus when the price is $70 a ride? Xavier’s producer surplus is $225; Yasmin’s producer surplus is $100; and, Zack’s producer surplus is$25.

When the price is $70 per ride, Xavier supplies 15 rides. Xavier’s producer surplus is the triangular areaunder the price and above his supply curve. The supply curve is linear, so Xavier’s producer surplus is

1/2 × ($70 − $40) × 15, which equals $225. When the price is $70 per ride, Yasmin supplies 10 rides. Yasmin’s producer surplus is the triangulararea under the price and above his supply curve. The supply curve is linear, so Yasmin’s producer surplus

is 1/2 × ($70 − $50) × 10, which equals $100. When the price is $70 per ride, Zack supplies 5 rides. Zack’s producer surplus is the triangular areaunder the price and above his supply curve. The supply curve is linear, so Zack’s producer surplus is 1/2

× ($70 − $60) × 5, which equals $25.

f. What is the market producer surplus when the price is $70 a ride?The market producer surplus is equal to the sum of Xavier’s producer surplus plus Yasmin’s producersurplus plus Zack’s producer surplus, which is $225 + $100 + $25 or $350.

5. Based on the information provided in the news clip in problem 3,

a. Can an eBay auction give the seller a surplus?

Yes, an eBay auction can give a seller a surplus. The seller has a minimum supply price for which theitem will be sold. If the price established in the auction exceeds that minimum supply price, the sellerhas a surplus.

b. Draw a graph to illustrate an eBay auctionand show the consumer surplus andproducer surplus that it generates.

Figure 5.1 illustrates an eBay auction. The figureassumes that there are many suppliers of thisgood, each with a different minimum supply priceso that the supply curve is upward sloping. Theconsumer surplus is area A, the area under thedemand curve and above the (auction-

determined) market price. The producer surplus isarea B , the area under the market price and abovethe supply curve.




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6. The figure illustrates the market for cellphones.

a. What are the equilibrium price andequilibrium quantity of cell phones?

The equilibrium price is $30 per cell phone andthe equilibrium quantity is 100 cell phones permonth.

b. Shade in and label the consumer surplus andthe producer surplus.

In Figure 5.3 (on the next page) the consumersurplus is the shaded area A and the producersurplus is the shaded area B .

c. Shade in and label the cost of producing thecell phones sold.

In Figure 5.3 (on the next page) the cost ofproducing the cell phones sold is equal to area C .

d. Calculate total surplus.The total surplus is equal to the sum of theconsumer surplus plus the producer surplus, orthe triangle with area A + area B . The amount ofthe total surplus equals ½ × ($60 per cell phone − $15 per cell phone) × 100 cell phones, which is$2,250.

e. What is the efficient quantity of cellphones?

The efficient quantity of cell phones is 100 cell

phones per month.





7. The table gives the demand and supplyschedules for sunscreen. Sunscreenfactories are required to limitproduction to 100 bottles a day.

a. What is the maximum price thatconsumers are willing to pay for the100th bottle?

Consumers are willing to pay amaximum price of $15 for the 100th bottle of sunscreen. The demand schedule shows the maximumprice that consumers will pay for each bottle of sunscreen. The maximum price that consumers will payfor the 100th bottle is $15.

b. What is the minimum price that producers are willing to accept for the 100th bottle?Producers are willing to accept a minimum price of $5 for the 100th bottle of sunscreen. The supplyschedule shows the minimum price that producers will accept for each bottle of sunscreen. Theminimum price that produces will accept for the 100th bottle is $5.

c. Describe the situation in this market.There is less than the efficient quantity being produced. The efficient quantity is the equilibrium

quantity, 200 bottles.d. How can the 100 bottles be allocated to beachgoers? Which possible methods would be fair

and which would be unfair?The bottles can be allocated using a contest (a raffle for the bottles, perhaps), first-come, first-served (aline until all 100 bottles are distributed), personal characteristics (perhaps all fair-haired people areallocated the sun screen), or force (a fight). Using the “fair results” criteria, none of the allocationschemes are necessarily fair because there is no guarantee that poorer people will receive the sun screen.Using the “fair rules” criteria, the force method is definitely unfair and the others are fair.

8. Wii Sells Out Across Japan… Japan finally came in for its share of Wii madness this weekend. … However, given thelarge amount of interest in the console — which Nintendo has flogged with a TV-ad blitz forthe past two months — demand is expected to be much higher than supply. … Yodobashi

Camera was selling Wii games on a first-come, first-served basis, so eager customers showedup early so as not to miss out on their favorite titles. [But] customers who tried to get in the… line after 6 or 7 a.m. were turned away. … [and] many could be spotted rushing off tothe smaller Akihabara stores that were holding raffles to decide who got a Wii.

Gamespot News , Dec 1, 2006

a. Why was the quantity demanded of Wii expected to exceed the quantity supplied? At the price of a Wii set by Nintendo, the quantity demanded was forecast to exceed the quantitysupplied. Stores could run surveys to determine how many customers were likely to buy a Wii from thestore. The survey could be as informal as clerks reporting how many people asked about a Wii duringthe clerk’s shift to more formal by asking customers to sign up in advance to buy a Wii. Given thesesurveys, the quantity demanded was expected to exceed the quantity Nintendo released for sale.

b. Did Nintendo produce the efficient quantity of Wii? Explain

At the price Nintendo set, Nintendo did not produce the efficient quantity of Wii. There was a shortageof Wii consoles. The MSB of a Wii exceeds the MSC so the market is inefficient.

PriceQuantitydemanded

Quantitysupplied

(dollars per bottle) (bottles per day)0 400 05 300 100

10 200 20015 100 30020 0 400




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c. Can you think of reasons why Nintendo might want to underproduce and leave the market with fewer Wii than people want to buy?

Nintendo might have wanted to create a shortage to gain more publicity for its Wii. If news reportershad story after story about the shortage, then Nintendo would gain free publicity. Additionally, giventhe very high initial demand for a Wii, if the price was set so that the quantity supplied equaled theinitial (very high) quantity demanded, then the price would be high. After the initial adopters were

satisfied, the price would then fall and Nintendo would get a reputation for price gouging.d. What are the two methods of resource allocation described in the news clip?

The first store was using a first-come, first serve method of allocation. The second, smaller stores wereallocating Wii using a lottery so that winners would obtain a Wii.

e. Is either method of allocating Wii efficient?Neither method is likely efficient. But given that the price was not going to charge to allocate the Wii,some other method or methods had to be used to allocate the Wii.

f. What do you think some of the people who managed to buy a Wii did with it?Some of the people who acquired a Wii resold it to other people.

g. Explain which is the fairer method of allocating the Wii: the market price or the twomethods described in the news clip.

Allocating Wii according to the market price is not necessarily fair using the “fair results” approach but

is fair using the “fair rules” approach. The other two methods of allocation are fair according to either offairness measures only by random chance.

9. New Zealand’s Private Forests

In the late 1980s, New Zealand decided it was time to quit cold turkey. Its addiction wasgovernment. … By the early 1990s, New Zealand had [sold] half of the country’s totalplantation forests to the highest bidder, introducing an era of privately-owned forests. “We want [timber companies] to behave like farmers. Farmers make sure they don’t destroy thesoil or run down its fertility. Farmers look after their farms to make them continuouslyproductive.” … The argument right from the start was … [i]t’s a commercial decision. Theseare supposedly commercial forests planted to make a profit. …

Reuters , September 7, 2007

a. In the late 1980s, was the New Zealand timber industry efficient? Did logging companies

operate in the social interest or self-interest?In the late 1980s, the logging companies were operating in their self-interest. They were producingmore than the efficient quantity. Marginal cost exceeded marginal benefit. The logging companies werenot considering all of the costs of production because they did not own the land on which they were

working. They had no incentive to preserve forestland or to cut timber in a way that would makefuture harvesting of trees profitable.

b. Since the early 1990s, has the New Zealand timber industry been efficient? Have loggingcompanies operated in the social interest or self-interest?

Since the early 1990s, the logging companies have been operating in the self-interest and the socialinterest. They are producing the efficient quantity. Marginal social cost equals marginal social benefitbecause the private forest owners charge the logging companies for the use of the land.The logging companies now must consider all of the costs of producing.

c. What incentive do private timber companies have to ensure that they “operate likefarmers”?

The incentive that private companies have to ensure that they "operate like farmers" is profit.If loggers deplete the forests this year, they will have no profit in the years to come. The private timbercompany has the incentive to maximize its profit over the long term. This incentive means that the




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d. If sandwich makers produce 200 a day, what is the deadweight loss?The deadweight loss is $50. Deadweight loss is the sum of the consumer surplus and producer surplusthat is lost because the quantity produced is not the efficient quantity. The deadweight loss equals the

quantity (200 − 150) multiplied by ($4 − $2)/2, which is $50.

e. If the sandwich market is efficient, what is the consumer surplus, what is the producersurplus, and what is the total surplus?

150 sandwiches is the efficient quantity and the equilibrium price is $3. The consumer surplus is thearea of the triangle under the demand curve above the price. The area of the consumer surplus triangle is

½ × ($6 − $3) × 150, which is $225. The producer surplus is the area of the triangle above the supplycurve below the price. The price is $3 and the quantity is 150. The area of the triangle is 1.2 × ($3 −

$0) × 150, which is $225. The total surplus is the sum of the consumer surplus plus the producersurplus, which is $450.

f. If the demand for sandwiches increases and sandwich makers produce the efficientquantity, what happens to consumer surplus and producer surplus?

If the demand for sandwiches increases, the price and quantity of sandwiches both rise. The producersurplus definitely increases. The effect on consumer surplus is ambiguous. It rises if the quantityincreases by a larger percentage than does the price but it falls if the price rises by a larger percentagethan does the quantity.

12. The Right Price for Digital Music: Why 99 Cents per Song is Too Much, and Too Little. Apple’s 99-cents-for-everything model isn’t perfect. Isn’t 99 cents too much to pay for musicthat appeals to just a few people? What we need is a system that will continue to pack thecorporate coffers yet be fair to music lovers. The solution: a real-time commodities marketthat combines aspects of Apple’s iTunes, Nasdaq, the Chicago Mercantile Exchange,Priceline, and eBay. ... Songs would be priced strictly on demand. The more people whodownload [a particular song] ... the higher the price [of that song] will go. ... The fewerpeople who buy a [particular] song, the lower the price [of that song] goes. ... In essence,this is a pure free-market solution—the market alone would determine price.

Slate , December 5, 2005

Assume that the marginal social cost of downloading a song from the iTunes store is zero.(This assumption means that the cost of operating the iTunes store doesn’t change if peopledownload more songs.)

a. Draw a graph of the market for downloadable music with a price of 99 cents foreverything. On your graph, show consumer surplus and producer surplus.

Figure 5.4 shows this market. The marginal socialcost curve runs along the horizontal axis. Theconsumer surplus is area A and the producersurplus is area B .

b. With a price of 99 cents for everything, isthe market efficient or inefficient? If it isinefficient, show the deadweight loss on your graph.

The market is inefficient. Efficiency requires that

the amount be the quantity for which themarginal social benefit equals the marginal socialcost, which in this case is the quantity at whichthe marginal social benefit curve intersects the





horizontal axis. The deadweight loss is area C in Figure 5.4.

c. If the pricing scheme described in the news clip were adopted, how would consumersurplus, producer surplus, and the deadweight loss change?

The price of popular songs rises, so the consumer surplus for popular songs decreases and the producersurplus increases. A larger deadweight loss is created. The price of unpopular songs falls, so the consumersurplus for unpopular songs increases and the producer surplus decreases. A smaller deadweight loss is

created.d. If the pricing scheme described in the news clip were adopted would the market be

efficient or inefficient? Explain.The market would likely become more inefficient because the inefficiency of the popular songs—thesongs most people want—increases. The price exceeds the marginal social cost.

e. Is the pricing scheme described in the news clip a “pure free-market solution”? Explain. With a pure free-market solution the price is determined by supply and demand. The pricing methoddiscussed in the clip uses only demand and so it is not the same as a pure free-market solution. A purefree market solution produces the efficient quantity of 200 downloads and the price is zero.

13. A winter storm cuts the power supply and isolates a small town in the mountains. Thepeople rush to buy candles from the town store, which is the only source of candles. Thestore owner decides to ration the candles to one per family but to keep the price of a candle

unchanged .

a. Who gets to use the candles? Who receives the consumer surplus and who receives theproducer surplus on candles?

The people who buy candles from the town store are not necessarily the people who use the candles. Abuyer from the town store can sell a candle and will do so if he or she can get a price that exceeds his orher marginal benefit. The people who value the candles most—who are willing to pay the most—willuse the candles.Only the people who are willing to pay the most for candles receive the consumer surplus on candles,and the store owner receives the same producer surplus as normal. People who sell the candles they buyfrom the store receive additional producer surplus.

b. Is the allocation efficient? Is the allocation fair?The allocation is efficient because the people who value the candles most use them. Two views of

fairness: The rules view is that if the rule of one candle per family is followed and exchange is voluntary,then the outcome is fair. But the results view is that if the candles are allocated unequally, then theallocation is unfair.

14. Ticketmaster Accused of “Price-Gouging” in Canada

As if the imminent Live Nation ticketing venture wasn’t enough for Ticketmaster, thecompany now has to deal with accusations of “price gouging” by angry Elton John fans inSaskatchewan. When tickets for Elton John’s performance in the capital city of Saskatoon went on sale, fans discovered that Ticketmaster had already sold out of their allotment, andinstead recommended fans try to buy tickets at Tickets Now, a secondary ticketing siteowned by Ticketmaster. Not only did Tickets Now already have tickets for sale, but they were also demanding much higher prices than originally posted on Ticketmaster, leadingfans to accuse the company of scalping. ... Ticketmaster said they were not aware they were

shuffling fans to Tickets Now and has since removed the link. The company’s head ofticketing in Saskatchewan said, “The inventory belongs to the promoter and artist, and theartist determines who has what privileges in advance of the public on sale or not, like fanclubs for instance.”

Rolling Stone , July 14, 2008




86 CHAPTER 5

a. What is “price-gouging”? Is price gouging in the social interest or self-interest?"Price gouging" is a term used to describe a situation in which a seller sells a good at a price that ishigher than what is considered reasonable or fair. In common usage, "price gouging" also refers toprices that are set by practices inconsistent with a competitive market. Choices made in self-interest are the choices that you think are the best ones available for you. Choicesin the social interest are choices that are the best ones for society as a whole. If the higher price arises

because of an increase in demand or a decrease in supply or a combination of both, then the higher priceis the equilibrium price, the market is efficient, and the higher price is in the social interest. Totalsurplus is maximized.The higher price is also in the self-interest of Ticketmaster. It is setting theprice to maximize profit.

b. Explain the effect of the company’s “scalping” on consumer surplus and producer surplus. A person who buys a ticket from a scalper and attends the concert receives a smaller consumer surplusthan he or she would have received if he or she had paid the original price for the ticket. The scalper sellsthe ticket for more than he paid for it, so he receives a producer surplus. The scalper converts someconsumer surplus to producer surplus. Total surplus, the sum of consumer surplus and producer surplus,does not change. So “scalping” reduces the consumer surplus and increases the producer surplus butdoes not change total surplus.

c. Evaluation the “fairness” of Ticketmaster “shuffling fans to Tickets Now” when the

concert tickets went on sale to the public.Ticketmaster's actions were unfair by the fair results view because the tickets did not necessarily go to thepoorest people. The tickets went to the richer people who could afford the higher priced tickets on saleat “Tickets Now”. Ticketmaster' actions were fair by the fair rules view because the ticket transactionsinvolved voluntary exchange.

d. Describe the allocation method used when the “artist determines who has what privilegesin advance of the public on sale or not, like fan clubs for instance.”

A command system allocates resources by the order (command) of someone in authority. When "theartist determines who has what privileges in advance of the public on sale or not, like fan clubs forinstance", the artist orders or commands who will get the tickets.

15. Fight Over Water Rates; Escondido Farmers Say Increase Would Put Them Out of BusinessThe city is considering significant increases in water rates for agriculture, which historically

has paid less than residential and business users. . . . [S]ince 1993, water rates have gone upmore than 90 percent for residential customers while agricultural users. . .have seenincreases of only about 50 percent, . . .

The San Diego Union-Tribune , June 14, 2006

a. Do you think that the allocation of water among San Diego agricultural and residentialusers is likely to be efficient? Explain your answer.

The allocation of water is almost surely inefficient. If the marginal social cost curve of distributing wateris the same for agricultural and residential users, as is probably the case, the only way that the allocationscheme can be efficient is if the marginal social benefit curve of agricultural lies below the marginalsocial benefit curve of residential users. Such a situation seems unlikely because water is necessary foragricultural users to grow their crops so the marginal social benefit of water to farmers probably exceedsthat for residential users.

b. If agricultural users pay a higher price for water, will the allocation of resources becomemore efficient?If agricultural users pay a higher rate for water, probably the allocation of resources will be moreefficient. Efficiency requires that marginal social benefit equals marginal social cost. Currently it is likelythe case that the marginal social benefit of the last unit of water for agricultural users is less than themarginal social cost of producing the last unit of water.





c. If agricultural users pay a higher price for water, what will happen to consumer surplusand producer surplus from water?

If the price paid by agricultural users rises, the consumer surplus of agricultural users decreases and theproducer surplus increases.

d. Is the difference in price paid by agricultural and residential users fair? According to the “fair results” approach, the difference in price is fair only if agricultural users are poorer

than residential users. If, however, agricultural users are wealthier than or comparable to residentialusers, the difference in price is not fair. The difference in price is not fair according to the “fair rules”approach because the price of water is not determined in competitive markets.

15. After you have studied Reading Between the Lines on pp. 122–123, answer the followingquestions:

a. What is the major problem in achieving an efficient use of the world’s water? Water needs to be transported from where it is available to where it is needed. This basic issue leads totwo major problems: Overproduction in some areas and underproduction in other areas. Oftenoverproduction in an area leads to underproduction later in the same area. In particular, markets in

water are not competitive. In many areas, water is “free” to whomever digs a deep enough well. As aresult, too many people dig wells and water is overproduced. If the overproduction is bad enough, thelevel of groundwater can be reduced so far that it becomes literally impossible to extract any water. Then

water needs to be transported to the now arid area. In this case, often the government transports the water and sells it at a very low price or gives it away. But because the government does not sell the waterat an equilibrium price (and because the government is not motivated by seeking profit) less water istransported than the efficient quantity.

b. If there were a global market in water, like there is in oil, how do you think the market would work?

The market for water would be more efficient than the current situation. Areas with a great deal of water, say Canada, could export water to areas with less water, say Mexico. If water was purchased andsold in markets, there would be greater incentive to build desalination plants where they are practical as

well as greater incentive to conserve water where it is in abundance.

c. Would a free world market in water achieve an efficient use of the world’s water resources?Explain why or why not.

A free world market in water likely would (eventually) bring an efficient use of resources as the necessaryinfrastructure was constructed. Of the factors that can lead to inefficiency (government price andquantity regulations, monopoly power, and so forth) the only issue that could possibly lead toinefficiency is the point that water is a common resource in some situations.

d. Would a free world market in water achieve a fair use of the world’s water resources?Explain why or why not and be clear about the concept of fairness that you are using.

A “fair results” approach to fairness would argue that in third world countries, very poor inhabitants (forexample, nomads) would not be able to afford “enough” water and so some redistribution is needed forthe sake of fairness. A “fair rules” approach to fairness asserts that a competitive market is enough toinsure fairness.




88 CHAPTER 5

17. Use the link on MyEconLab (Chapter Resources, Chapter 5, Web links) to visit the Web siteof Health Action International and read the article by Catrin Schulte-Hillen entitled “Studyconcerning the availability and price of AZT.” Then answer the following questions andexplain your answers using the concepts of marginal benefit, marginal cost, price, consumersurplus, and producer surplus.

a. What is the range of retail prices of AZT across the countries covered by the study?The retail (pharmacy) prices range from $0.67 in Thailand to $2.80 in Germany.

b. What, if anything, do you think could be done to increase the quantity of AZT and decreaseits price?

The article states that “The major determining factor is the existence of alternative products on themarket, i.e. competition.” So one factor that will lead to lower prices and increased quantities is eitherdisregard the patent or wait until the patent expires. In either case, the increased competition will lead tolower prices and increased quantities. If the government does not want to disregard the patent, it couldtry to negotiate lower prices by perhaps arranging purchases of larger quantities. Or the governmentcould simply lower the allowable legal price for AZT in the nation. The drawback with this last policy isthat it might lead to a decrease in the quantity of AZT available.

c. Canadian online pharmacies sell AZT to Americans for a price below the U.S. price. Doesthis practice increase or decrease consumer surplus, producer surplus, and deadweight lossfrom AZT in the United States?

The practice of Canadian on-line pharmacies selling AZT in the United States at a price below the U.S.price increases consumer surplus in the United States. U.S. producers sell AZT to Canadian pharmacies,but at a lower price than they can sell the drug in the United States. To the extent that the Canadiansales replace sales of U.S.-sold products, producer surplus in the Untied States decreases. However, tothe extent that the product is manufactured in the United States and to the extent that these sales are“new,” that is, would not have been made except for the lower price, the sales increase U.S. producersurplus. Producer surplus in Canada increases.

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