INSTRUCTOR’S MANUAL
Nora Underwood
University of Central Florida
, CONTENTS
P A R T 1: Introduction: Markets and Prices
Chapter 1 Preliminaries 1
Chapter 2 The Basics Of Supply And Demand
5
P A R T 2: Producers, Consumers, and Competitive Markets
Chapter 3 Consumer Behavior
23
,Chapter 4 Individual And Market Demand 41
Chapter 4 Appendix 58
Chapter 5 Uncertainty and Consumer Behavior 64
Chapter 6 Production 74
Chapter 7 The Cost Of Production 84
Chapter 7 Appendix 98
Chapter 8 Profit Maximization And Competitive Supply 102
Chapter 9 The Analysis Of Competitive Markets 117
P A R T 3: Market Structure and Competitive Strategy
Chapter 10 Market Power: Monopoly and Monopsony
138
Chapter 11 Pricing With Market Power
160
Chapter 11 Appendix 185
Chapter 12 Monopolistic Competition And Oligopoly
191
Chapter 13 Game Theory And Competitive Strategy
217
Chapter 14 Markets For Factor Inputs 232
Chapter 15 Investment, Time, And Capital Markets 242
P A R T 4: Information, Market Failure, and the Role of Government
Chapter 16 General Equilibrium And Economic Efficiency 255
Chapter 17 Markets With Asymmetric Information 267
Chapter 18 Externalities And Public Goods 278
PART I
INTRODUCTION:
MARKETS AND PRICES
CHAPTER 1
PRELIMINARIES
TEACHING NOTES
The first two chapters reacquaint students with the microeconomics
that they learned in their introductory course: Chapter 1 focuses on the
general subject of economics, while Chapter 2 develops supply and demand
analysis. The use of examples in Chapter 1 facilitates students’ complete
,understanding of abstract economic concepts. Examples in this chapter
discuss markets for prescription drugs (Section 1.2), introduction of a new
automobile (Section 1.4), design of automobile emission standards (Section
1.4), the minimum wage (Section 1.3), the market for sweeteners (Section
1.3), and real and nominal prices of eggs and education (Section 1.3).
Discussing some of these, or another, example is a useful way to review
some important economic concepts such as scarcity, making tradeoffs,
building economic models to explain how consumers and firms make
decisions, and the distinction between competitive and non-competitive
markets. Parts I and II of the text assume competitive markets, market
power is discussed in Part III, and some consequences of market power are
discussed in Part IV of the text.
Review Question (2) illustrates the difference between positive and
normative economics and provides for a productive class discussion. Other
examples for discussion are available in Kearl, Pope, Whiting, and Wimmer, “A
Confusion of Economists,” American Economic Review (May 1979).
The chapter concludes with a discussion of real and nominal prices.
Given our reliance on dollar prices in the chapters that follow, students should
understand that we are concerned with prices relative to a standard, which in
this case is dollars for a particular year.
QUESTIONS FOR REVIEW
1. It is often said that a good theory is one that can be refuted by an
empirical, data-oriented study. Explain why a theory that cannot be
evaluated empirically is not a good theory.
There are two steps to consider when evaluating a theory: first,
you should examine the reasonability of the theory’s
assumptions; second, you should test the theory’s predictions by
comparing them with facts. If a theory cannot be tested, it
cannot be accepted or rejected. Therefore, it contributes little to
our understanding of reality.
2. Which of the following two statements involves positive economic
analysis and which normative? How do the two kinds of analysis
differ?
a. Gasoline rationing (allocating to each individual a maximum
amount of gasoline that can be purchased each year) is a poor
social policy because it interferes with the workings of the
competitive market system.
Positive economic analysis describes what is. Normative
economic analysis describes what ought to be. Statement (a)
merges both types of analysis. First, statement (a) makes a
positive statement that gasoline rationing “interferes with the
workings of the competitive market system.” We know from
economic analysis that a constraint placed on supply will change
the market equilibrium. Second, statement (a) makes the
normative statement (i.e., a value judgment) that gasoline
rationing is a “poor social policy.” Thus, statement (a) makes a
, normative comment based on a conclusion derived from positive
economic analysis of the policy.
b. Gasoline rationing is a policy under which more people are
made worse off than are made better off.
Statement (b) is positive because it states what the effect of
gasoline rationing is without making a value judgment about the
desirability of the rationing policy.
3. Suppose the price of unleaded regular octane gasoline were 20
cents per gallon higher in New Jersey than in Oklahoma. Do you think
there would be an opportunity for arbitrage (i.e., that firms could buy
gas in Oklahoma and then sell it at a profit in New Jersey)? Why or
why not?
Oklahoma and New Jersey represent separate geographic
markets for gasoline because of high transportation costs. If
transportation costs were zero, a price increase in New Jersey
would prompt arbitrageurs to buy gasoline in Oklahoma and sell it
in New Jersey. It is unlikely in this case that the 20 cents per
gallon difference in costs would be high enough to create a
profitable opportunity for arbitrage, given both transactions costs
and transportation costs.
4. In Example 1.3, what economic forces explain why the real price of
eggs has fallen while the real price of a college education has
increased? How have these changes affected consumer choices?
The price and quantity of goods (e.g., eggs) and services (e.g., a
college education) are determined by the interaction of supply
and demand. The real price of eggs fell from 1970 to 1985
because of either a reduction in demand (consumers switched to
lower-cholesterol food), a reduction in production costs
(improvements in egg production technology), or both. In
response, the price of eggs relative to other foods decreased.
The real price of a college education rose because of either an
increase in demand (e.g., more people recognized the value of an
education), an increase in the cost of education (e.g., increase in
staff salaries), or both.
5. Suppose that the Japanese yen rises against the U.S. dollar- that
is, it will take more dollars to buy any given amount of Japanese yen.
Explain why this increase simultaneously increases the real price of
Japanese cars for U.S. consumers and lowers the real price of U.S.
automobiles for Japanese consumers.
As the value of the yen grows relative to the dollar, more dollars
exchange for fewer yen. Assume that the costs of production for
both Japanese and U.S. automobiles remain unchanged. Then
using the new exchange rate, the purchase of a Japanese
automobile priced in yen requires more dollars. Similarly, the
, purchase of a U.S. automobile priced in dollars requires fewer
yen.
6. The price of long-distance telephone service fell from 40 cents per
minute in 1996 to 22 cents per minute in 1999, a 45-percent (18
cents/40 cents) decrease. The Consumer Price Index increased by 10-
percent over this period. What happened to the real price of
telephone service?
Let the CPI for 1996 equal 1 and the CPI for 1999 equal 1.1, which
reflects a 10% increase in the overall price level. To find the real
price of telephone service in each period, divide the nominal price
by the CPI for that year. For 1996, we have 40/1 or 40 cents, and
for 1999, we have 22/1.1 or 20 cents. The real price therefore fell
from 40 to 20 cents, a 50% decline.
EXERCISES
1. Decide whether each of the following statements is true or false
and explain why:
a. Fast food chains like McDonald’s, Burger King, and Wendy’s
operate all over the United States. Therefore the market for fast food
is a national market.
This statement is false. People generally buy fast food within
their current location and do not travel large distances across the
United States just to buy a cheaper fast food meal. Given there is
little potential for arbitrage between fast food restaurants that
are located some distance from each other, there are likely to be
multiple fast food markets across the country.
b. People generally buy clothing in the city in which they live.
Therefore there is a clothing market in, say, Atlanta that is distinct
from the clothing market in Los Angeles.
This statement is false. Although consumers are unlikely to travel
across the country to buy clothing, suppliers can easily move
clothing from one part of the country to another. Thus, if clothing
is more expensive in Atlanta than Los Angeles, clothing
companies could shift supplies to Atlanta, which would reduce the
price in Atlanta. Occasionally, there may be a market for a
specific clothing item in a faraway market that results in a great
opportunity for arbitrage, such as the market for blue jeans in the
old Soviet Union.
, c. Some consumers strongly prefer Pepsi and some strongly prefer
Coke. Therefore there is no single market for colas.
This statement is false. Although some people have strong
preferences for a particular brand of cola, the different brands are
similar enough that they constitute one market. There are
consumers who do not have strong preferences for one type of
cola, and there are consumers who may have a preference, but
who will also be influenced by price. Given these possibilities, the
price of cola drinks will not tend to differ by very much,
particularly for Coke and Pepsi.
2. The following table shows the average retail price of butter and
the Consumer Price Index from 1980 to 2001.
ˇ 1980 1985 1990 1995 2000 2001
CPI 100 130.58 158.62 184.95 208.98 214.93
Retail Price of $1.88 $2.12 $1.99 $1.61 $2.52 $3.30
butter
(salted, grade AA,
per lb.)
a. Calculate the real price of butter in 1980 dollars. Has the real
price increased/decreased/stayed the same since 1980?
CPI1980
Real price of butter in year X = * nominal price in year X.
CPI year X
1980 1985 1990 1995 2000 2001
$1.88 $1.62 $1.25 $0.87 $1.21 $1.54
Since 1980 the real price of butter has decreased.
b. What is the percentage change in the real price (1980 dollars)
from 1980 to 2001?
Percentage change in real price from 1980 to 2001 =
1.54 − 1.88
= −0.18 = −18% .
1.88
c. Convert the CPI into 1990 = 100 and determine the real price of
butter in 1990 dollars.
To convert the CPI into 1990=100, divide the CPI for each year by
the CPI for 1990. Use the formula from part (a) and the new CPI
numbers below to find the real price of milk.
New CPI 1980 63.1 Real price of milk 1980 $2.98
