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15
Market Failure and
Government
Intervention

OVERVIEW

This chapter reviews several reasons for direct government intervention

in private markets. In general, government intervention is economically jus-
tified when private market fail to provide socially-optimal level of goods
and services. Three important sources of market failure are market power,
externalities, and public goods. This chapter also focuses on specific
government remedies to problems arising from production and allocation
inefficiencies.
Firms, or group of firms, have market power when they are able to charge
a price that exceeds marginal cost of production. When firms or groups of
firms have market power, they are able to earn economic profits by reduc-
ing consumer surplus. Not all of the reduced consumer surplus is captured
by firms in the form of higher profits. The loss of consumer surplus not cap-
tured by firms is referred to as consumer deadweight loss. Moreover, since
the firms exercising market power do not produce at minimum per unit cost
there is a producer deadweight loss. This represents the loss to society from
the inefficient allocation of productive resources. Total deadweight loss is
the sum of the loss of consumer and producer surplus for which there are
no offsetting gains to society.
The failure of the market to maximize the total benefits to society occurs
when firms attempt to maximize industry profits by individually or collu-
sively exercising market power. Government can reduce or eliminate total
deadweight loss by making it illegal for firms to exercise market power.
Antitrust laws attempt to move industries closer to the ideal of perfectly-
competitive prices and output levels.
Copyright 2003 by Academic Press.
Managerial Economics: Theory and Practice 267 All rights of reproduction in any form reserved.
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268 Market Failure and Government Intervention

Market failure also occurs when third parties are positively or negatively
affected by a market transaction. These third party effects are called exter-
nalities. In the case of negative externalities, too much of a good or service
is being produced. In the case of positive externalities, too little of a good
or service is being produced. This chapter focused on the problems arising
from negative externalities, such as environmental pollution.
In the case of negative externalities, there are generally two ways in
which the government promotes a more socially beneficial outcome. On the
one hand, the government can establish conditions whereby the market
determines an efficient solution to the externality problem through the
assignment of well-defined private property rights. The theoretical justifi-
cation for this approach to the externality problem is the Coase theorem.
In the absence of well-defined property rights, governments can intervene
directly to resolve the problems of negative externalities through the use
of regulations, permits, and taxes.
Governments also intervene in private markets to provide public goods.
Public goods are distinguished from private goods by the characteristics
of non-excludability and non-depletability. A good or service is non-
excludable if no one can be excluded from its consumption. A good or
service is non-depletable if the consumption of a good or service by one
person does not reduce the amount of that good or service available for
consumption by some other person. Since no one can be excluded from
their consumption, individuals will not have an incentive to purchase public
goods. Instead, individuals will rely on others to pay for the good. This is
the free rider problem.
Governments overcome the free-rider problem by providing public
goods on behalf of society. Governments will generally finance the provi-
sion of public goods by levying taxes. In general, governments do not
provide socially efficient amounts of public goods because of an inability
to accurately assess societys preferences for these products.
An interesting application of the free-rider problem is political rent-
seeking behavior. Political rent seeking occurs when one group attempts to
use government to divert consumer or producer surplus away from another
group for its own benefit. An example of political rent-seeking behavior is
when legislators attempt to regulate monopoly prices at their perfectly com-
petitive level. From the point of view of the consumer, the potential gain
in consumer surplus can be viewed as a public good. While the potential
increase in consumer surplus for the group is substantial, the gain to any
individual consumer may be insignificant. Thus, each individual consumer
has an incentive to wait for others to underwrite the lobbying effort. On
the other hand, economic profits confer private benefits on the monopolist.
Thus, it is in the monopolists best interest to incur substantial costs to
prevent price regulation.
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Multiple Choice Questions 269

MULTIPLE CHOICE QUESTIONS

15.1 Market failure is usually the result of:

A. Market power.
B. Externalities.
C. Public goods.
D. Asymmetric information.
E. All of the above.

15.2 Consumer surplus is:

A. The difference between the quantities of goods or service
purchased and the quantities of goods and services consumed.
B. The savings received from purchasing bulk quantities of a good
or service.
C. The difference between what consumers are willing to pay for a
given quantity of a good or service and the amount that they
actually pay.
D. The difference between consumer expenditures calculated using
wholesale versus retail prices for final goods and services.

15.3 Producer surplus is:

A. The difference between the total revenues and what the firm
would have been willing to accept for the production and sale
of a given quantity of output.
B. The same thing as normal profit.
C. The value of the area below the producers marginal cost curve.
D. The difference between the total revenues and total economic
cost.
E. All of the above.

15.4 Total deadweight loss is:

I. The sum of consumer and producer deadweight loss.
II. The loss of consumption and production efficiency resulting
from noncompetitive market structures.
III. The loss of consumer and producer surplus when a monopolist
charges a price that is greater than the marginal cost of
production.
Which of the following is correct?
A. I only.
B. II only.
C. III only.
D. I and II only.
E. I, II and III.
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270 Market Failure and Government Intervention

15.5 All of the following are considered to be functions of government

except:
A. Provide a judicial system and legal framework to adjudicate
contract disputes.
B. To prevent industry abuse of monopoly power.
C. To provide public goods.
D. To reduce negative externalities.
E. All of the above are considered to be functions of the
government.

15.6 The objective of antitrust legislation is to:

A. Encourage the provision of public goods.
B. To prevent industry abuse of market power.
C. To eliminate the free rider problem.
D. Eliminate externalities.
E. All of the above.

15.7 The Sherman Act prohibits all of the following practices except:
A. Price discrimination.
B. Rebates.
C. Collusion.
D. Division of markets among competitors.
E. All of the above practices are prohibited.

15.8 A shortcoming of the Sherman Act was:

A. That no specific agency designated to enforce its provisions.
B. The rule of reason did not specifically define unreasonable
conduct.
C. It did not clearly define restraint of trade.
D. All of the above are correct.
E. None of the above are correct.

15.9 The Clayton Act:

A. Nullified many of the provisions of the Sherman Act.
B. Strengthened the Sherman Act.
C. Was completely unrelated to the Sherman Act.
D. Permitted monopolistic practices by industries engaged in the
national defense.
E. Authorized the practice of a firm selling a particular good or
service on the condition that customers buy other products
from the same firm.
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Multiple Choice Questions 271

15.10 Which of the following banned price discrimination?
A. The Sherman Act.
B. The Clayton Act.
C. The Federal Trade Commission Act.
D. The Willis-Graham Act.
E. The Celler-Kefauver Act.

15.11 The Clayton Act outlawed:

A. Price discrimination.
B. Exclusive and tying contracts.
C. Intercorporate stockholdings.
D. Interlocking directorates.
E. All of the above.

15.12 Which of the following gave the Federal Trade Commission the
authority to prosecute companies that engaged in false and
deceptive advertising.
A. The Clayton Act.
B. The Federal Trade Commission Act.
C. The Willis-Graham Act.
D. The Wheeler-Lea Act.
E. The Celler-Kefauver Act.

15.13 Which of the following exempted telephone company mergers

from antitrust review?
A. The Clayton Act.
B. The Federal Trade Commission Act.
C. The Willis-Graham Act.
D. The Wheeler-Lea Act.
E. The Celler-Kefauver Act.

15.14 Which of the following gave the government the authority to

prohibit vertical and conglomerate mergers provided that it can be
shown that such mergers substantially reduced competition or
tended to result in monopolies.
A. The Willis-Graham Act.
B. The Robinson-Patman Act.
C. The Wheeler-Lea Act.
D. The Celler-Kefauver Act.
E. The Hart-Scott-Rodino Act.
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272 Market Failure and Government Intervention

15.15 The U.S. government regulates which of the following industries?

A. Transportation
B. Communications
C. Financial services
D. Energy
E. All of the above industries are regulated by the U.S.
government.

15.16 According to U.S. Justice Department guidelines:

I. Proposed mergers in any industry with a Herfindahl-
Hirschman Index of 1,000 or less will go unchallenged.
II. Proposed mergers in any industry with a Herfindahl-
Hirschman Index between 1,000 and 1,800 will be challenged
if, as a result of the merger, the index rises by more than 50
points.
III. Mergers in any industry with a Herfindahl-Hirschman Index is
greater than 1,800 will be challenged if the index increases by
more than 100 points.
Which of the following is correct?
A. I only.
B. II only.
C. III only.
D. I, II and III.
E. Neither I nor II nor III are correct.

15.17 Natural monopolies:

A. Have a downward-sloping, long-run average total cost curve
over a range of production that will satisfy total market
demand for a good or service.
B. One firm can provide a good or service more efficiently than
many competing firms.
C. Exhibit significant economies of scale.
D. All of the above statements are true.
E. None of the above statements are true.

15.18 In principle, the objective of price regulation is to:

A. Provide consumers with essential services at fair prices.
B. Eliminate deadweight loss arising from exercise of market
power.
C. Prevent firms from earning monopoly profits.
D. Direct scarce resources to the production of more socially
desirable goods and services.
E. All of the above are correct.
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Multiple Choice Questions 273

15.19 Government efforts to increase social welfare through price
regulation may be handicapped due to:
A. The rent-seeking behavior of special interest groups.
B. The unwillingness of regulators to alienate big business.
C. An inability to accurately determine the market supply and
demand conditions.
D. The tendency of regulators to succumb to popular pressure for
unjustifiably low prices.
E. The existence of negative production externalities.

15.20 Consider Figure 1, which depicts a monopolist. The profit-

maximizing price and output level are indicated at points:
A. D and I.
B. C and I.
C. C and K.
D. B and I.
E. None of the above.

15.21 Consider Figure 1, which depicts

a profit-maximizing monopolist.
Consumer deadweight loss is
given by the area:
A. ABF.
B. ACJ.
C. BCGF.
D. FGJ.
E. CDHJ. FIGURE 1

15.22 Consider Figure 1, which depicts a profit-maximizing monopolist.

Producer deadweight loss is given by the area:
A. DEH.
B. CEJ.
C. BCGF.
D. CDHJ.
E. GHJ.

15.23 Consider Figure 1, which depicts a profit-maximizing monopolist.

The monopolists total profit is given by the area:
A. BEHF.
B. BDHF.
C. BCGF.
D. CDHG.
E. Cannot be determined from the information provided.
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274 Market Failure and Government Intervention

15.24 Consider Figure 1, which depicts a profit-maximizing monopolist.

At what price should the government regulate the monopolists
price to eliminate total deadweight loss?
A. A.
B. B.
C. C.
D. D.
E. E.

15.25 Consider Figure 1, which depicts a profit-maximizing monopolist. If

the government were to regulate the price that the monopolist
charges, the net gain to society is given by the area:
A. AEJ.
B. AEHF.
C. FHJ.
D. BDFH.
E. BDHJF.

15.26 In the long run, unregulated, profit-maximizing, natural monopolies

will always produce at an output level where:
A. P = MC.
B. P = ATCminimum.
C. MC = MR.
D. LRAC = MC.
E. Both C and D are correct.

15.27 Which of the following is most likely to generate positive external

economies?
A. A system of K-12 public education.
B. Private universities.
C. The state university system of California.
D. An interstate highway system.
E. All of the above.

15.28 Which of the following is most likely to generate negative external

economies?
A. Drug trafficking.
B. Smoking.
C. Dumping industrial wastes into rivers, lakes, and oceans.
D. State sponsored gambling, such as lotteries or off-track betting.
E. All of the above will probably generate negative external
economies.
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Multiple Choice Questions 275

15.29 Suppose that in a perfectly-competitive industry, the activities of a
single firm result in negative externalities. This would imply that:
A. Too little of a good or service is being produced.
B. The price of the good or service is too high, and is therefore
not in the public interest.
C. Too much of a good or service is being produce.
D. Third party effects have been taken into account, thus causing
the firms marginal production costs to be higher than
otherwise.
E. Third party effects have not been taken into account, thus
causing the selling price of the product to be too low.

15.30 Negative externalities exist because:

A. Private property rights to scarce productive resources are not
well defined.
B. Production invariably results in pollution.
C. Bargaining and transaction costs are not zero.
D. Third parties own the private property rights to scarce
productive resources.
E. All of the above.

15.31 Suppose that a chemical plant that produces sodium nitrate is

discharging waste into a nearby mountain stream. Downstream
from the chemical plant is a perfectly-competitive company that
uses water from the mountain stream to produce soft drinks. As a
result of the pollution, the water must be purified before use.
Which of the following statements is true?
A. To compensate for the higher production costs, the downstream
company must produce an a greater than socially optimal
output level to generate additional revenues to compensate for
the higher production costs.
B. The chemical plant is producing at a greater than socially
optimal level because the water from the mountain stream is
free.
C. The downstream company will charge a higher price for its soft
drinks sufficient to pay for the costs of water purification.
D. The chemical plant must charge a higher price for its product to
pay for the right to use the water from the mountain stream.
E. None of the above are correct.
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276 Market Failure and Government Intervention

15.32 Suppose that a chemical plant that produces sodium nitrate is

discharging waste into a nearby mountain stream. Downstream
from the chemical plant is a perfectly-competitive company that
uses water from the mountain stream to produce soft drinks. As a
result of the pollution, the water must be purified before use.
According to the Coase theorem, it should be possible to obtain
socially optimal levels of sodium nitrate and soft drinks by
assigning the private property rights to the mountain stream to:
A. The chemical plant.
B. Either the chemical plant or the soft-drink company.
C. To the soft-drink company.
D. Neither the chemical plant or the soft-drink company.
E. None of the above are correct. The Coase theorem suggests
that government can solve the pollution problem by levying an
excise tax on sales of sodium nitrate.

15.33 If the production of a good or service results in a positive

externality, then the activity should be:
A. Taxed.
B. Subsidized.
C. Regulated.
D. Prosecuted under the terms of the Wheeler-Lea Act.
E. Discontinued.

15.34 The presence of external economies results in:

A. A misallocation of productive resources.
B. Larger consumer surpluses.
C. Larger producer surpluses.
D. Increased economies of scale.
E. Efficient production.

15.35 In general, governments deal with the social costs arising from
environmental problems through the use of:
A. Price controls, quotas, pollution permits, and taxes.
B. Price controls, emission standards, penalty fees, and taxes.
C. Emission standards, penalty fees, emission standards, and
quotas.
D. Emission standards, penalty fees, pollution permits, and taxes.
E. Price controls, penalty fees, emission standards, and pollution
permits.
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Multiple Choice Questions 277

15.36 Penalty fees and taxes to eliminate pollution are preferred to the
implementation of emission standards because:
A. There are fewer information requirements about the likely
social costs.
B. There are fewer information requirements about the likely
social benefits.
C. They result in more efficient, market-determined outcomes
that.
D. All of the above.
E. None of the above.

15.37 The optimal level of pollution:

A. Is zero.
B. Occurs at the output level where the marginal cost of pollution
abatement is equal is equal to marginal cost of pollution.
C. Occurs when the marginal loss of social benefits from
production is less than the marginal cost of pollution.
D. Occurs when the marginal loss of social benefits from
production is greater than the marginal cost of pollution.
E. None of the above.

15.38 One problem with the use of emission standards and penalty fees
to encourage socially optimal levels of production is that
A. Regulators rarely have complete information about production
methods.
B. Regulators tend to set emission standards and penalty fees too
high to placate demand from environmental groups.
C. Regulators are often former employees of the very companies
that they are asked to regulate.
D. All of the above.
E. None of the above.

15.39 The sale of transferrable emission permits is the distinguishing

feature of:
A. The Clean Air Act.
B. The Environmental Protection Act.
C. The Occupational Safety and Health Act.
D. The Health and Public Safety Act.
E. The Resource Allocation Act.
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278 Market Failure and Government Intervention

15.40 When producers are required to internalize the marginal external

cost of pollution, the result is likely to be:
A. Higher prices, increased output, and the negative external
effects shifted from consumers of the product to society at
large.
B. Higher prices, increased output, and the negative external
effects shifted from producers of the product to consumers of
the product.
C. Higher prices, decreased output, and the negative external
effects shifted from society at large to producers of the product.
D. Lower prices, increased output, and the negative external
effects shifted from society at large to consumers of the
product.
E. Lower prices, lower output, and the negative external effects
shifted from society at large to producers of the product.

15.41 Public goods differ from private goods because:

A. Only public goods are financed through taxation.
B. Only public goods are provided for by the government.
C. Public goods have the properties of non-excludability and non-
depletability.
D. The provision of private goods often suffers from the free
rider problem, while the provision of public goods do not.
E. All of the above.

15.42 A good or service may be described as a public good if:

I. It is provided by the government.
II. Consumption by one person does not reduce the amount
available for consumption by some other person.
III. No one can be excluded from its consumption.
Which of the following is correct?
A. I only.
B. II only.
C. III only.
D. II and III only.
E. I, II and III are correct.

15.43 Examples of public goods include:

A. Public street lighting.
B. Radio and television broadcasts.
C. National defense.
D. Police and fire protection.
E. All of the above.
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Longer Problems 279

SHORTER PROBLEMS

15.1 A monopolists market demand and total cost equations are:

Q = 10,000 - 10P
TC = 100 + 0.125Q2
A. What is the monopolists profit-maximizing price and output?
B. What is the value of consumer deadweight loss? What is the
value of producer deadweight loss? Calculate the value of total
deadweight loss to society.

15.2 A group of MBA students from the Hobgoblin School of Business

have decided to offer a GMAT preparation course to
undergraduates. One of the members of the group, who is a
management science major, has estimated the following demand
equation for the groups services.
Q = 150 - 1.5P
where Q represents the number of students demanding the course,
and P the registration fee. The management science major
estimates that the marginal cost of providing the course is $5 per
student. The group has decided to charge each student $25 to take
the course.
A. Calculate the value of consumer, producer, and total surplus.
B. Is the price and output level efficient? Explain.

LONGER PROBLEMS

15.1 Suppose that the demand and supply curves for a perfectly
competitive market are given by the following linear equations:
QD = 1250 - 25P
QS = -150 + 15P
A. Determine the equilibrium price and output level.
B. At the perfectly competitive equilibrium price and output level
calculate consumer surplus, producer, and total surplus.
C. Suppose that the above industry is organized as a monopoly.
Assuming that the industry supply curve represents the
monopolists marginal cost of production, determine the profit-
maximizing price and output level.
D. Given your answer to part C, calculate consumer, producer, and
total surplus.
E. Given your answers to parts B and C, calculate total
deadweight loss.
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280 Market Failure and Government Intervention

15.2 Suppose that the demand equation for a firms product is:
Q = 640 - 8P
The firms cost equation has been estimated as:
TC = 85 + 5Q + 0.1875Q2
A. Suppose that the firm is an unregulated monopoly. Determine
the profit-maximizing price and output level. What is the firms
total profit at this output level?
B. Suppose that the government decides to regulate the price of
the firms product to maximize social welfare. At what price
should the government regulate the firms price? At this price
what is the market demand for the firms product? What is the
firms profit at this output level?
C. In terms of the general social welfare, how does your answer to
part A compare with your answer to part B?
D. What is the price elasticity of demand for the firms product at
the profit-maximizing price and output level calculated in part
A? What is the price elasticity of demand for the firms product
at the regulated price and output level calculated in part B?

15.3 Universal Telephone & Telegraph (UTT), the sole provider of

telecommunications services in the country of Ancient Elam, is
being targeted by the federal government for possible price
regulation. Researchers at the Ancient Elam Telecommunications
Network Agency (AETNA) have estimated the following demand
equation for local telephone service:
QD = 500 - 2.5P
where QD is the demand for local telephone service in millions of
minutes and P is the price of telephone service in Ancient Elam
dollars (AE$). AETNA researchers have also determined that
UTTs total cost equation is
TC = 50Q -5Q2 + 0.5Q3
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Longer Problems 281

A. What is UTTs profit-maximizing price and quantity?
B. What is UTTs profit at the profit-maximizing price and
quantity?
C. What price should AETNA regulate the price of telephone
service so that UTT earns only a normal profit?
D. Given your answer to part C, what is UTTs profit?
E. What is the socially optimal price of local telephone service?
F. At the socially optimal price of local telephone service, what is
UTTs profit?
G. Given your answers to parts A, C, and E, should AETNA
regulate the price of local telephone service, and at what price?

15.4 The MKUltra Company produces aromatic hydrocarbon that is

used in the manufacture of plastics, detergents, pesticides, and other
chemicals. This hydrocarbon has been identified as a cancer causing
carcinogen. Suppose that the marginal private cost of producing
benzene is
MPC = 5Q
If the manufacture of the hydrocarbon is not properly controlled,
the marginal externality cost is
MEC = 3Q
Finally, suppose that market demand for the hydrocarbon is
Q = 70 - 0.5P
A. What is the perfectly competitive price and output level?
B. If this industry was dominated by a single firm, what would be
the profit-maximizing price and output level?
C. What is the socially optimal price and output level?
D. Given your answer to part C, what per unit tax on output
should be levied by the government to achieve a socially
desirable output level?
E. What are government revenues at the socially optimal output
level?
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282 Market Failure and Government Intervention

ANSWERS TO MULTIPLE CHOICE QUESTIONS

15.1 E. 15.42 D.
15.2 C. 15.43 E.
15.3 A.
15.4 E.
15.5 E.
15.6 B.
15.7 A.
15.8 D.
15.9 B.
15.10 B.
15.11 E.
15.12 D.
15.13 C.
15.14 D.
15.15 E.
15.16 A.
15.17 D.
15.18 B.
15.19 C.
15.20 D.
15.21 D.
15.22 E.
15.23 E.
15.24 C.
15.25 C.
15.26 C.
15.27 E.
15.28 E.
15.29 C.
15.30 A.
15.31 B.
15.32 B.
15.33 B.
15.34 A.
15.35 D.
15.36 D.
15.37 B.
15.38 A.
15.39 A.
15.40 C.
15.40 C.
15.41 C.
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Solutions to Shorter Problems 283

SOLUTIONS TO SHORTER PROBLEMS

15.1 A. P = 100 - 0.125Q

TR = PQ = 100Q - 0.125Q2
MR = dTR/dQ = 100 - 0.25Q
MC = dTC/dQ = 0.25Q
To obtain the monopolists profit-maximizing level of output,
equate marginal cost with marginal revenue, i.e.,
MC = MR
Q = 100 - 0.25Q
Q* = 80
P* = 100 - 0.25(80) = $80
B. The value of consumer deadweight loss is given by the area of
the triangle ABE.

Consumer surplus = Area ABE

= 1/2 (80 - 71.43)(285.71 - 80) = $881.47
The value of producer deadweight loss is given by the area of
the triangle BCE.
Producer surplus = Area BCE
= 1/2 (71.43 - 20)(285.71 - 80) = $5,289.83
Total deadweight loss = Area ABE + Area BCE
= $881.47 + $5,289.83
= $6,171.30
= Area ACE
= 1/2 (80 - 20)(285.71 - 80)
= $6,171.30
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284 Market Failure and Government Intervention

15.2 A. The situation depicted is illustrated in the following diagram.

Consumer surplus = 1/2 (100 - 25)(112.5)

= $4,218.75
Producer surplus = (25 - 5)(138.75)
= $2,250
Total surplus = Consumer surplus + Producer surplus
= $4,218.75 + $2,250
= $6,468.75
B. The price and output level is not efficient because it does not
maximize the sum of consumer and producer surplus. This will
occur where P = MC. By lowering price from $25 to $5, the
value of consumer surplus becomes
Consumer surplus = 1/2 (100 - 5)(142.5) = $6,768.75
Total surplus = Consumer surplus + Producer surplus
= $6,768.75 + $0
= $6,768.75
Thus, when P = $5 total surplus is maximized at $6,768.75.

SOLUTIONS TO LONGER PROBLEMS

15.1 A. QD = QS
1,250 - 25P = -150 + 15P
40P = 1,400
P* = $35
Q* = 1,250 - 25(35) = -150 + 15(35) = 875
These results are illustrated in the following diagram:
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Solutions to Longer Problems 285

B. Consumer surplus and producer surplus are represented by the

shaded areas in the above figure. The value of consumer and
producer surpluses are calculated as
Consumer Surplus = 1/2 (50 - 35)375 = $2,812.50
Producer Surplus = 1/2 (35 - 10)375 = $4,867.50
Total Surplus = Consumer Surplus + Producer Surplus = $7,500
C. The monopolist maximizes profit by producing at an output
level where marginal cost is equal to marginal revenue. The
equation for total revenue is TR = PQ. Solving the demand for
price, and substituting this result into the above equation for
total revenue we obtain
TR = (50 - 0.04Q)Q = 50Q - 0.04Q2
The equation for marginal revenue is
MR = dTR/dQ = 50 - 0.08Q
Equating marginal revenue with marginal cost yields the profit-
maximizing level of output for the monopolist.
50 - 0.08Q = 10 + 0.067Q
Q* = 272.11
The profit-maximizing price is obtained by substituting the
profit-maximizing output level into the demand equation.
P* = 50 - 0.04(272.11) = $39.12
These results are illustrated in the following diagram:
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286 Market Failure and Government Intervention

D. Consumer surplus and producer surplus under monopoly are

represented by the shaded areas in the above figure. The value
of consumer and producer surpluses are calculated as
Consumer Surplus = 1/2 (50 - 39.12)272.11 = $1,480.29
Producer Surplus = (39.12 - 28.18)272.11 + 1/2 (28.18
- 10)272.11
= $2,976.88 + $2,473.48 = $5,450.36
Total Surplus = Consumer Surplus + Producer Surplus
= $6,930.65
E. From the above figure, consumer deadweight loss and producer
deadweight loss are calculated as
Consumer Deadweight Loss = 1/2 (39.12 - 35)(375 - 272.11)
= $211.95
Producer Deadweight Loss = 1/2 (35 - 28.18)(375 - 272.11)
= $350.85
Total Deadweight Loss = $211.95 + $350.85
= $562.80
Alternatively, total deadweight loss may be calculated as the
difference between total surplus before and after
monopolization of the industry.
Total Deadweight Loss = $7,500 - $6,930.65
= $569.35
which, except for rounding errors, is the same result as above.

15.2 A. P = 80 - 0.125Q
TR = 80Q - 0.125Q2
p = TR - TC
= (80Q - 0.125Q2) - (85 + 5Q + 0.1875Q2)
= -85 + 75Q - 0.3125Q2
dp/dQ = 75 - 0.625Q = 0, i.e., the first-order condition for p
maximization.
d2p/dQ2 = - 0.625 < 0, i.e., the second-order condition for p
maximization is satisfied.
Solving the first-order condition for Q we obtain
Q* = 120 units
P* = 80 - 0.125(120) = $65
p* = -85 + 75(120) - 0.3125(120)2 = $4,415
B. The upward sloping portion of the marginal cost (MC) curve,
above the average variable cost curve (AVC), is the supply
curve of a perfectly competitive firm. The government
determines the socially optimal, regulated price (Preg) equating
marginal cost to demand.
MC = dTC/dQ = 5 + 0.375Q
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Solutions to Longer Problems 287

Setting P = MC yield the market demand for the firms product.

80 - 0.125Q = 5 + 0.375Q
0.5Q = 75
Qreg = 150
Substituting this result into the demand equation yields the
socially optimal, regulated price of papaya extract.
Preg = 80 - 0.125(150) = 30 - 20 = $61.25
The firms profit at the regulated price is
preg = -85 + 75(150) - 0.3125(150)2 = $4,133.75
C. As an unregulated monopoly, consumer, producer, and total
surplus are:
Consumer Surplus = 1/2 (80 - 65)120 = $900
Producer Surplus = (65 - 50)120 + 1/2 (50 - 5)120
= $1,800 + $2,700 = $4,500
Total Surplus = Consumer Surplus + Producer Surplus = $5,400
As a regulated monopoly, consumer, producer, and total surplus
are:
Consumer Surplus = 1/2 (80 - 61.25)150 = $1,406.15
Producer Surplus = 1/2 (61.25 - 5)150 = $4,218.75
Total Surplus = Consumer Surplus + Producer Surplus =
$5,624.90
Total surplus increases by $224.90 from government regulation.
D. The price elasticity of demand for the firmss product at the
perfectly competitive price and output level is
ep = (dQ/dP)(P/Q) = (-8)(61.25/150) = -3.27, i.e. demand is
elastic.
The price elasticity of demand at the monopolists profit-
maximizing price and output level is
ep = (dQ/dP)(P/Q) = (-8)(65/120) = -4.33, i.e. demand is
somewhat more elastic.

15.3 A. The profit-maximizing condition is given by the expression

MR = MC. Solving the demand equation for P yields
P = 200 - 0.4Q
The respective total and marginal revenue equations are
TR = PQ = 200Q - 0.4Q2
MR = dTR/dQ = 200 - 0.8Q
The firms marginal cost equation is
MC = dTC/dQ = 50 - 5Q + 1.5Q2
Substituting these results into the profit-maximizing condition
yields
200 - 0.8Q = 50 - 5Q + 1.5Q2
-150 - 9.2Q + 1.5Q2 = 0
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288 Market Failure and Government Intervention

which can be solved using the quadratic equation

Q1,2 = {-b (b2 - 4ac)}/2a
where a = 1.5, b = -9.2, and c = -50. The solution values are
Q1 = 13.53
Q2 = -7.39
Since output cannot be negative, the profit-maximizing output
level is Qm = 13.53 million minutes. Substituting this result into
the demand equation yields
Pm = 200 -0.4(13.53) = AE$194.59
B. UTTs total profit is
pm = TR - TC = (200Qm - 0.4Qm2) - (50Qm - 5Qm2 + 0.5Qm3)
= 150Qm + 4.6Qm2 - 0.5Qm3 = 150(13.53) + 4.6(13.53)2
- 0.5(13.53)3
= 2,029.5 + 842.08 - 1,238.41 = AE$1,633.17 (million)
C. Normal profit is determined at the output level where
P = ATC
Average total cost is
ATC = TC/Q = 50 - 5Q + 0.5Q2
Substituting into the above condition yields
200 - 0.4Q = 50 - 5Q + 0.5Q2
-150 - 4.6Q + 0.5Q2 = 0
The solution values for this expression are
Q1 = 22.52
Q2 = -13.32
Since output cannot be negative, the normal profit output level
is Q = 22.52 million minutes. Substituting this result into the
demand equation yields
P = 200 - 0.4(22.52) = AE$190.99
D. UTTs total profit is
p = TR - TC = (200Q - 0.4Q2) - (50Q - 5Q2 + 0.5Q3)
= 150Q + 4.6Q2 - 0.5Q3 = 150(22.52) + 4.6(22.52)2 - 0.5(22.52)3
= 3,378 + 2,332.89 - 5,710.51 = AE$0 (million)
In other words, at P = AE$190.99, UTT earns zero economic
cost. UTT earns a positive normal profit, however, which is
included in the firms total economic cost.
E. The socially optimal price is determined at the output level
where P = MC.
Substituting into this condition yields
200 - 0.4Q = 50 - 10Q + 1.5Q2
-150 - 9.6Q + 1.5Q2 = 0
The solution values for this expression are
Q1 = 13.7
Q2 = -7.3
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Solutions to Longer Problems 289

Since output cannot be negative, the socially optimal level is Q
= 13.7 million minutes. Substituting this result into the demand
equation yields
P = 200 - 0.4(13.7)= AE$194.52
F. UTTs socially optimal profit is
p = TR - TC = (200Qo - 0.4Qo2) - (50Qo - 5Qo2 + 0.5Qo3)
= 150Qo + 4.6Qo2 - 0.5Qo3 = 150(13.7) + 4.6(13.7)2 - 0.5(13.7)3
= 2,055 + 863.37 - 1,285.68 = AE$1,632.69 (million)
G. The above paradoxical results suggest that the price at which
UTT earns only normal profits is lower, and output greater,
than at the socially optimal price and output level. Clearly,
consumer surplus is greater where P = AE$190.99. It could be
argued, therefore, that AETNA will probably regulate the price
of local telephone service at the price that generates only
normal profits for UTT.

15.4 A. A perfectly competitive industry will produce at an output level

where marginal private cost equals price, MPC = P.
P = 140 - 2Q
5Q = 140 - 2Q
Q* = 20
P* = 140 - 2(20) = $100
B. A monopolist maximizes profit by producing at an output
level where marginal private cost equals marginal revenue,
MPC = MR.
TR = PQ = (140 - 2Q)Q = 140Q - 2Q2
MR =dTR/dQ = 140 - 4Q
MPC = MR
5Q = 140 - 4Q
Q* = 15.56
P* = 140 - 2(15.56) = $108.89
C. The socially optimal level of output occurs at an output level
where marginal social cost (MSC) equals price. Marginal social
cost is the sum of marginal private cost (MPC) and marginal
externality costs (MEC).
MSC = MPC + MEC = P
5Q + 3Q = 140 - 2Q
Q* = 14
P* = 140 - 2(14) = $112
D. MPC = 5Q = 5(14) = $70
The per unit tax on output is
t = P* - MPC = 112 - 70 = $42
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290 Market Failure and Government Intervention

To verify that this tax will result in the socially optimal output
level, equate marginal private cost plus the tax to price.
MPC + t = P
5Q + 42 = 140 - 2Q
Q* = 14
E. Total government revenues at the socially optimal output level
is
tQ* = 42(14) = $588