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# Answers August 06 - Answers August 06 Final 1 This question...

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Answers: August 06 Final 1 This question was discussed in class Feb. 6-7, 2007. (a) Total revenue from the demand curve with u = 160, p = \$50,000 = \$8Million. The payment to capital is obtained from the u = 160 isoquant (LC = \$128 m) as follows. With a fixed land supply = 40 acres, capital cost = \$128m / 40 = \$3.2 million. The limit on building permits does not interfere with factor substitution, so equilibrium land rent will make the industry isocost line tangent to the u = 160 isoquant at the point L = 40, C = \$3.2 million. From the slope expression (MRTS = - \$128 million / L 2 ), we have slope = rent per acre = \$128m / (40 X 40) = \$80,000. That makes total spending on land = 40 acres X \$80,000 = \$3.2 million. (This particular isoquant specification gives equal spending on both factors, which is not a general result.) With the limit on building permits we have a barrier to competition, so economic profit is possible. Economic profit is total revenue minus spending on capital and land (\$3.2 million on capital, \$3.2 million on land: total \$6.4 million), leaving \$1.6 million economic profit. Part (a) should include an isoquant / isocost line showing the u = 160 isoquant, a tangent isocost line at the point on that isoquant with L = 40. The tangent isocost line has slope = - \$80,000 and an intercept on the C axis = \$6.4 million. (b) We need a zoning policy that will limit output to 160 units. With 40 acres of land, a minimum lot size of 0.25 acres will achieve this result. With the zoning policy, economic profit is no longer possible. Any "wannabe" firm from outside the model can get a permit and bid for land. As a result of removing the barrier to competition, land rent will increase until there is zero economic profit. Output is the same (160 units) as in (a) so total revenue is still at \$8 million. However, all of that revenue not paid to capital will go to land rent, eliminating the economic profit in (a). So the \$8 million goes \$3.2 million to capital and \$4.8 million to land rent. Economic profit = zero. (c) The diagram that is useful to solving this part is Figure 1 in the web-site Chapter 9 notes (page 14 in the edition posted March 2007). With the August 06 exam question, however, the supply curve (marginal cost) would go through the origin instead of being as shown in Fig. 1. The reason is that rent and capital payments as determined in part (a) were equal (\$3.2 million each). The total of rent and capital payments in part (a) is the rectangle zncj (6.4 million). The capital half of that rectangle is the area under the supply curve, and the rent half is the area above it. The supply curve has to be the diagonal of the rectangle for these two amounts to be equal.

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Thus a modified version of Fig.1 should be drawn, with point z moved down so that it coincides with the origin. References to point z in what follows will be to that modified version – with z at the origin. Another change in the modified Figure 1 would be to replace 80 on the horizontal axis with 160. 120 will also have to replaced, but we will not know the replacement number until this part of the answer is complete.
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