Economics Homework 5 - Model

1. Suppose the cross elasticity of demand for goods A and B is +3.8, and for goods X and Y is -2.7. What can you conclude about the relationship of the goods A and B, and of X and Y (i.e., are they substitutes or complements)?

The positive cross-elasticity for goods A and B mean that as the price of one good increases (and thus its demand decreases), then the demand for the other good increases. A and B must be substitutes because the demand for one good increases as the demand for the other good decreases. The negative cross-elasticity for goods X and Y mean that as the price of one good increases (and thus its demand decreases), then the demand for the other good decreases. X and Y must be complements because the demand for one good increases as the demand for the other good increases.

2. Suppose it costs you $500 to make each of your first 5 units, then$200 to make each of your next 5 units, and then $100 to make each of your next 5 units. Costs do not decrease further for you. What is the marginal cost for you to make another unit, after you have made 15 units? What is your overall average cost per unit after you make your 16th unit? Compare the two and comment on how whether they are equal, and why. The marginal cost for each of units 11 through 15 is$100. The marginal cost for the next unit, the 16th unit, is the same: $100. The average cost is the total cost ($500x5 plus $200x5 plus$100x5 plus $100) divided by the total number of units (16), which equals$4100/16 = $256.25 . Marginal cost is usually lower than average cost because average cost includes fixed costs, like building a factory, while marginal cost includes only the extra expenses for one more unit. 3. Suppose your annual income increases from$20,000 to \$25,000. Suppose your demand for steak increases by 10% and your demand for fast food hamburgers decreases by 5%. Which type of goods are steak, and which type are hamburgers?

Because the demand for steak increases when the consumers' income increases, steak must be a normal good. The opposite is true for hamburgers in this question: the demand for hamburgers decreased when the buyers' income increased, so hamburger must be an inferior good. This makes sense: as people make more income, they substitute steak for hamburger.

4. What does an owner do when his marginal revenue exceeds his marginal cost? Explain, including what will eventually happen to the marginal revenue compared with the marginal cost for the owner.

An owner increases his output and keeps selling more and more, as long as his marginal revenue exceeds his marginal cost. Eventually his marginal revenue will decrease as his goods become less scarce (because he made so many of them). When his marginal revenue declines to the amount of his marginal cost, then the owner stops making additional product because he is not earning a profit on any additional units. He wants to avoid losing money from an oversupply of his own good.

5. What does the Coase theorem say about the desirability, and the effect, of government regulations that increase transaction costs?

The Coase theorem says that transaction costs interfere with efficient levels of activity. When there are no transaction costs, then the free market attains the optimal use of a resource no matter who owns it. If transaction costs exist, then they impede the ability of people to deal with each other for the optimal result. Government regulations increase transaction costs, and thus are bad for the economy.