ECON 1001 AB Introduction to Economics I Dr. Ka-fu WONG

1. ECON 1001 ABIntroduction to Economics IDr. Ka-fu WONG Eighth weekof tutorial sessions KKL 925, KKL 1010, K812, KKL 106 Clifford CHAN KKL 1109 givencana@yahoo.ca

2. 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 toChapter 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

3. 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

4. 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!

5. 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!

6. 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

7. Problem #3, Chapter 8 • John Jones owns and manages a café in Collegetown whose annual revenue is $5,000. Annual expenses are as above

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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!)

14. 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

15. 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?

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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?

23. 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

24. 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

25. 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

26. 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

27. 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!

28. Solution to Extra #1 (3) S S S’ w/ new technology P P CS P* CS’ P* PS P*’ PS’ D D 0 Q Q 0 Q* Q* Q*’ CS’ > CS and PS’ > PS; total economic surplus increases

29. The end Thanks for coming! See you next week!!!