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ANSWERS AUGUST 07 - ANSWERS AUGUST 07 1(a This question is...

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ANSWERS AUGUST 07 1. (a) This question is based on Chapter 9 Notes from the course web site. The following eight paragraphs discuss the relevant background information in the Notes. (Exam answers do not have to provide all of this background information.) Figure 4 in the Notes is relevant here. It shows two of the three possibilities listed on the exam: a binding zoning constraint at G, and neither a zoning constraint nor a limit on building permits at G’. Only the third possibility (a limit on building permits) is not shown in the figure. At point G we see the industry’s position with a binding zoning constraint, which is a minimum lot size (an equivalent zoning constraint would set a maximum number of residential units per acre of land). Note that at point G, and at all other points on the vertical line through G, firms will be using all land in the fixed 30- acre land supply. Equilibrium in the land market requires operation on that vertical line in the isoquant diagram – otherwise there will be excess demand for land or excess supply of land. Because of the zoning constraint, the industry cannot move along the u = 80 isoquant to the left of point G, even temporarily. If it did, housing firms would be using less land per residential unit than the legal minimum. Without the zoning constraint, the land market would adjust so that the isocost line and isoquant would be tangent at G. The process involved is referred to as factor substitution. Firms would temporarily use less land than 30 acres, so they could move onto lower isocost lines parallel to FG. That would mean some of the land is not rented, and land rent would fall until we have isoquant / isocost tangency at G. With the zoning constraint, that adjustment process is defeated, so non-tangency is possible in equilibrium. It will be zero economic profit that establishes equilibrium rent at G. There is no barrier to entry with the zoning constraint, so land rent will be bid up to a level that yields zero economic profit. With zero economic profit, all of the industry’s total revenue will go to land cost and capital cost (land and capital are the only inputs, as stated in the question). Since the vertical axis is in dollar units (capital is measured here in dollars rather than physical units), the dollar amount of total revenue will be the intercept of the isocost line on the C axis. With the Figure 4 numbers, $960,000 is capital cost, Total revenue is $2 million (point F). The difference (2 million minus $960,000) is land cost. Land cost is the number of acres of land in the land supply (30) times land rent per acre. From the geometry of the figure it is evident that land rent is the slope of isocost line FG (land cost divided by 30 acres). This is a general
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result: the isocost slope = land rent / acre whether there is tangency with an isoquant or not.
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