Transcript ECON 1001 AB Introduction to Economics I Dr. Ka

ECON 1001 AB
Introduction to Economics I
Dr. Ka-fu WONG
Eighth week of tutorial sessions
KKL 925, KKL 1010, K812, KKL 106
Clifford CHAN
KKL 1109
[email protected]
Covered and to be covered

Covered last week




Dr. Wong finished up to kf008.ppt and slide #7 of kf010.ppt
You should have at least read up to Chapter 8 The Quest for Profit
and the Invisible Hand
If not, please press hard on it. Start reading Chapter 10 Monopoly
and Other Forms of Imperfect Competition
To be covered in the tutorial sessions this week



Problems in chapter 8: #1, #3, #5, #7 and #9
An extra question relevant to Chapter 8
You are advised to work on the even ones as well
Problem #1, Chapter 8






Explain why the following statements are true or false
A) The economic maxim: “There’s no cash on the table.”
That means there are never any unexploited economic
opportunities
False
This statement is kind of tricky
It is wrong that there are never any unexploited
economic opportunity
In the short run, there are normal unexploited economic
opportunities to be drawn from so new entries are
attracted by a positive economic profit
Solution to Problem #1 (1)




However, as the number of suppliers grows in the long
run, all participating firms will earn a zero economic profit
However, as the number of suppliers grows in the long
run, the market price will be driven down and all the
participating firms will eventually earn a zero economic
profit
Only in the long run, there are no unexploited economic
opportunities
But there are exploited economic opportunities in the
short run so that new suppliers are encouraged to enter
the market!
Solution to Problem #1 (2)




B) Firms in competitive environments making no
accounting profit when the market is in long-run
equilibrium
False
Firms in competitive environments make a positive
accounting profit in the long-run equilibrium so that it
can be used to cover the opportunity cost of resources
supplied
However, firms in competitive environments make no
economic profit in the long-run equilibrium!
Solution to Problem #1 (3)





C) Firms that can introduce cost-saving innovations can
make an economic profit in the short run
True
In the short run, market price of a good has not yet been
adjusted, but firms experience a reduction in production
cost due to the innovations, and thus they enjoy a higher
economic profit
The supply curve will shift to the right due to the
replication of innovation and the increasing number of
suppliers in the market
The market price will be driven down until the economic
profit gets down to zero
Problem #3, Chapter 8
Labour
Food and drink
$2000
$500
Electricity
Vehicle lease
Rent
Interest on loan for equipment
$100
$150
$500
$1,000

John Jones owns and manages a café in Collegetown
whose annual revenue is $5,000. Annual expenses are
as above
Solution to Problem #3 (1)


A) Calculate John’s annual accounting profit
Recall the difference between accounting profit and
economic profit







Accounting profit = Total revenue – Total explicit cost
Economic profit = Total revenue – Total explicit and implicit costs
Economic profit is always less than accounting profit
In this question, the total annual revenue is $5,000
The total explicit cost is the sum of the annual expenses
Total explicit cost = Labour + Food and drink + Electricity
+ Vehicle lease + Rent + Interest on loan for equipment
Total explicit cost = $4250
Solution to Problem #3 (2)




Annual accounting profit = $5000 - $4250 = $750
B) John could earn $1000 per year as a recycler of
aluminum cans. However, he prefers to run the café. In
fact, he would be willing to pay up to $275 per year to
run the café rather than to recycle. Is the café making an
economic profit? Should John stay in the café business?
Explain.
Considers the two options for John: Running a café or
Being a recycler
If he runs the café, he will forgone the annual income
($1000) that he can potentially earn from being a
recycler
Solution to Problem #3 (3)






In addition, if he runs the café, he will receive benefit
which is equivalent to $275 per year
Therefore, if he runs the café, he will forgo the potential
income earned from recycling minus the benefits he
receives from the café
His true opportunity cost is $1000 - $275 = $725
Economic profit = Accounting profit – Implicit cost (OC)
Economic profit = $750 - $725 = $25
Since John’s annual economic profit is greater than 0, he
should run the business
Solution to Problem #3 (4)





Suppose the café revenues and expenses remain the
same, but the recyclers’ earnings rise to $1,100 per year.
Is the café still making an economic profit? Explain.
If the earnings from recycling increases to $1,100, that
means the true opportunity cost becomes $1100 - $275
= $825
Again, economic profit = accounting profit – opportunity
cost
New economic profit = $750 - $825 = -$75
Since the new economic profit is less than zero, John will
suffer from an annual economic loss of $75 from running
the cafe
Solution to Problem #3 (5)




D) Suppose John had not had to get a $10,000 loan at
an annual interest rate of 10 percent to buy equipment,
but instead had invested $10,000 of his own money in
equipment. How would your answer to parts a and b
change?
If John did not borrow a loan to finance the equipment,
he could save the interest on loan for equipment
As a result, the total explicit cost would be decreased by
$1000 to $3250
Therefore, the new annual accounting profit = $5000 $3250 = $1750
Solution to Problem #3 (6)






However, the economic profit in part b would not change
(assuming that the interest rate one has to pay on bank
loan is the same as that one gets from bank deposits.)
There would be a new opportunity cost for the interest
income of $1000 that John would forgo by investing his
money in the equipment
The increase in the accounting profit in part a would be
offset by the new opportunity cost when we calculate the
new economic profit for part b
New economic profit = new accounting profit – new
opportunity cost
New economic profit = $1750 – ($1000 - $275 +$1000)
New economic profit = $1750 - $1725 = $25 (No change!)
Solution to Problem #3 (7)






E) If John can earn $1000 a year as a recycler, and he
likes recycling just as well as running the café, how
much additional revenue would the café have to collect
each year to earn a normal profit?
Normal profit refers to the opportunity cost of the
resources owned by the firm
To earn a normal profit, the café would have to cover all
its implicit and explicit costs
After all explicit costs are taken into account, the
opportunity cost of running the café is $1000
The accounting profit of running the café is $750
Therefore, the café would have to earn an additional
annual revenue of $250 to earn a normal profit of zero
Problem #5, Chapter 8

Explain carefully why, in the absence of a patent, a
technical innovation invented and pioneered in one tofu
factory will cause the supply curve for the entire tofu
industry to shift to the right. What will finally halt the
rightward shift?
Solution to Problem #5 (1)



Since the question does not specific for the market
structure, we assume that the tofu industry is a perfectly
competitive industry in which participating firms are
earning a zero economic profit in the long run
If one of the firms introduces an innovation on the
production technology, its cost (average cost and
marginal cost, etc.) at each production level will be
reduced
In the short run where price has not yet been adjusted,
the innovating firm will earn a positive economic profit
Solution to Problem #5 (2)




As the innovation is not patented, other participating
firms or potential firms will try to reap the positive
economic profit by replicating the innovation and
produce more to the market
As a result, the market supply will increase because of
the non-patented innovation
When the market supply increases, the supply curve will
continue shifting to the right (driving down the price)
The fall in price of tofu will finally halt when the price falls
to a level which generate zero economic profit to the
participating firms
Problem #7, Chapter 8

Unskilled workers in a poor cotton-growing region must
choose between working in a factory for $6000 a year
and being tenant cotton farmer. One farmer can work at
a 120-acre farm, which rents for $10000 a year. Such
farms yield $20,000 worth of cotton each year. The total
non-labour cost of producing and marketing the cotton is
$4000 a year. A local politician whose motto is “working
people come first” has promised that if he is elected, his
administration will fund a fertilizer, irrigation, and
marketing scheme that will triple cotton yields on tenant
farms at no charge to tenant farmers
Solution to Problem #7 (1)





A) If the market price of cotton would be unaffected by
this policy and no new jobs would be created in the
cotton-growing industry, how would the project affect the
incomes of tenant farmers in the short run? In the long
run?
In the short run, a cotton farmer will make an economic
profit as follows
Recall economic profit = total revenue – total explicit and
implicit costs
Note: in the question, it says the marketing scheme will
triple the cotton yields on tenant farms
Hence, new total revenue = $20000 * 3 = $60000
Solution to Problem #7 (2)





Economic profit = $60000 total revenue - $10000 rent $4000 marketing cost - $6000 opportunity cost
Economic profit = $40000 per year
Since the economic profit is greater than zero, factory
workers will switch to being a cotton farmer in the long run
As the number of cotton farmers increases, the rent of
cotton farmland will increase
Once the rent of cotton farmland reaches to $50000 per
year, cotton farmers will earn an economic profit of zero in
the long run
Solution to Problem #7 (3)





Who would reap the benefit of the scheme in the long
run? How much would they gain each year?
Landowner
In the last part, we have shown that in the long run, the
rent on cotton farmland will increase
There will be no new cotton farmers when the rent of on
cotton farmland reaches $50000 for which it was $10000
before the scheme
Thus, landowners in the long run earn an additional rent
of $40000 per 120-acre farmland
Problem #9, Chapter 8

You have an opportunity to buy an apple orchard that
produces $25,000 per year in total revenue. To run the
orchard, you would have to give up your current job,
which pays $10,000 per year. If you would find both jobs
equally satisfying, and the annual interest rate is 10
percent, what is the highest price you would be willing to
pay for the orchard?
Solution to Problem #9 (1)





If you buy the apple orchard, you will incur an opportunity
cost of forgoing the alternative use of money like
investment
Given in the question, the annual interest rate is 10%
That means if you buy the apple orchard, you will incur an
opportunity cost that is equivalent to 10% of the price of
the apple orchard
In addition, you will have to forgo the potential income you
earn from your current job, which is $10,000 per year
Recall economic profit = total revenue – total explicit and
implicit costs
Solution to Problem #9 (2)





Total revenue = $25,000 per year
Total cost = $10,000 forgone income + (Priceappleorchard *
10% annual interest rate)
You are willing to pay for the apple orchard up to a value
that makes a zero economic profit
$25,000 = $10,000 + (0.10*Priceappleorchard)
Priceappleorchard = $150,000
Extra question #1, Chapter 8


Is the following statement true or false? Explain.
Even if there is a non-patented cost-saving technology
introduced, all firms will eventually earn a zero economic
profit in the long run. The economy in the long run is thus
just as well off as in the past
Solution to Extra #1 (1)






False
The technology will generate a positive economic profit
for existing firms in the short run, and it will also attract
new entries to the industry to reap that positive profit
The supply curve will then shift to the right until the
positive economic profit is once again dissipated
All the participating firms will eventually receive a zero
economic profit in the long run
Even so, the economy is still better off than in the past
The technology does create a larger pie for both
consumers and producers in the market
Solution to Extra #1 (2)






Consumers benefit from a new lower price because of
the new technology
Consumers capture a larger consumer surplus as the
supply curve shifts to the right
Though producers earns a lower market price, they
enjoy a higher volume because of the new technology
Producers capture a larger producer surplus as the
supply curve shifts to the right
As a result, the total economic surplus in the long run is
increased
Hence the economy in the long run is actually better off
than in the past!
Solution to Extra #1 (3)
S
S
P
S’ w/ new
technology
P
CS
P*
P*
PS
P*’
CS’
PS’
D
D
0
Q
Q*
0
Q
Q* Q*’
CS’ > CS and PS’ > PS; total economic surplus increases
The end
Thanks for coming!
See you next week!!!