ec1ps3an - Department of Economics University of...

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1 Department of Economics Professor Kenneth Train University of California, Berkeley Fall Semester 2009 ECONOMICS 1 Problem Set 3 – Suggested Answers I. Each of the following statements is misguided. Explain what is wrong with the reasoning: 1. It doesn't hurt an unregulated monopolist to have its cost rise since the monopolist can simply raise its price to cover the extra costs. Remember that the monopolist cares about profits, which are Q M x (P-AC), where Q M is chosen by the monopolist at the point where MR=MC. If marginal costs go up, then Q M will go down because MR and MC will intersect at a lower quantity. The effect of this is to reduce profits, thus hurting the monopolist. At the lower quantity, the monopolist will indeed be able to charge a higher price, as stated above, but it will also face higher AC due to the cost increase. The effect of this on profits depends on which is larger, the change in P or the change in AC. Overall, profits are likely to go down if a monopolist’s costs rise, even though it can increase its price. (You should be able to draw the diagram to illustrate what is happening.) 2. Consider a monopolist that is regulated under price cap regulation and prices at the cap. This regulated monopolist does not benefit from an outward shift in the demand curve since it can't raise its price in response to the higher demand. An outward shift in the demand curve will allow the firm to sell more output at the price that it is charging. The firm can therefore make more profit even without being able to raise its price. (Again, you should be able to draw the graph.) 3. There is no reason to subsidize private universities since their fees are high enough. Higher education, whether public or private, has positive externalities. Since private universities that produce education do not get the benefits of these externalities, they will tend to produce too little education (relative to the social optimum). The reason for the subsidy is, therefore, to give universities an incentive to produce more education and thus to achieve the social optimum. 4. In a high fire-risk area like the Berkeley-Oakland hills, there would be no problem to have a fire department run by a private firm because everybody would be willing to pay for it. As any public good, fire protection faces the two problems known as "free-rider problem" (you get the benefits of the service even if you don't pay, since public goods are nonexcludable) and the "drop-in-the- bucket problem" (fire protection is so costly that its provision does not depend on whether one single person pays). Because of these, any single individual has no incentive to pay once the service (the fire department) is set up. You might argue, however, that the non- excludability characteristic is not present in the case of fire protection: if you don't pay, fire-fighters won't come to your home
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2 when your house is burning. But your burning house is a danger to your neighbour, who (if she's paying) would demand the firefighters to
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ec1ps3an - Department of Economics University of...

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