Chapter 7 Perfect Competition and the Invisible Hand

Active Learning Exercises for Chapter 7: Perfect Competition and the Invisible Hand 1. (Perfect competition and efficiency, Social surplus) Suppose there is a neighborhood on a Friday night where there are three parents looking for a babysitter for one hour (the buyers) and three teenagers willing to babysit (the sellers). The table below shows the reservation values of the buyers and sellers for the one hour of babysitting. A. Use the data in the table below to plot the demand and supply curve for babysitters. B. What will be the equilibrium quantity of babysitters hired? C. What is the social surplus if 2 babysitters are hired? What is the social surplus if 3 babysitters are hired? Buyers Reservation Value ($) Sellers Reservation Value ($) John 15 Ken 14 Marcia 12 Hank 11 Suzanne 10 Greta 8 Solution: See the graph below for Part A. The equilibrium quantity of babysitters hired will be two (we do not know the exact equilibrium price, but we know it will be between $11 and $12). The social surplus if 2 babysitters are hired will be (15-8) + (12-11) or $8. The social surplus if 3 babysitters are hired is (15-8) + (12-11) + (10-14) or $4. 2. (Allocation of resources across firms in an industry) Three tomato farmers have identical agricultural technology, but the land that they farm on differs in quality and therefore in the cost of production. The marginal cost and average total costs for each level of output of tomatoes for each farmer is found in the table below. If the price of a bushel of tomatoes is $13 per bushel: A. How many tomatoes will each farmer choose to produce? B. What will be the marginal cost for each farmer? C. What will be the profit for each farmer? Farmer Katie Farmer Joseph Farmer Dayo Quantity MC ATC MC ATC MC ATC 1 8 12 9 13 6 10 2 5 8.5 7 10 4 7 3 9 8.67 13 11 6 6.67 4 13 9.75 17 12.5 9 7.25 5 19 11.6 23 14.6 13 8.5 6 25 13.83 29 17 19 10.17 Solution: A. Farmer Katie will produce 4; Farmer Joseph will produce 3; Farmer Dayo will produce 5. B. The marginal cost for all 3 farmers will be $13 per bushel C. The profits for Farmer Katie will be Q*(P - ATC) = 4*(13 - 9.75) = $13 The profits for Farmer Joseph will be 3*(13 - 11) = $6 The profits for Farmer Dayo will be 5*(13 - 8.5) = $22.5 3. (Price controls; Deadweight loss) In 2014, the price of gasoline in Iran was artificially low, 22 cents per liter, due to price controls. The government provides subsidies to the oil companies so that the amount traded on the market is equal to the quantity demanded at 22 cents per liter. In a graph of the market for gasoline in Iran, label the area that represents the deadweight loss. Solution: See graph below. The area labeled D represents the deadweight loss. 4. (Prices guide the invisible hand) In the late 2000s, consumers embraced restaurants that provided fast food made with higher quality ingredients such as gourmet hamburgers. Individual firms were making significant economic profits. Assume the market is perfectly competitive. Show a graph of a gourmet hamburger firm making a profit and a graph representing the overall market for gourmet hamburgers. Do you expect firms to enter or exit the market? Show the effect of the firms entering or exiting on both the market and firm graphs. Solution: See the graphs below. With firms making profits, other firms will enter the market. This will shift the supply curve rightward and lower the market price. Firms will continue to enter until the firms are making zero economic profits.