Question

Question 4 Assess the validity of the following statements. Justify your answers. (5 parts)

a) A firm that believes it faces perfectly elastic supply curves for all of its inputs will believe that its marginal cost is constant (that is, its marginal cost does not vary with its output).

b) If possible, a risk-averse individual will choose to fully insure against a risky outcome.

c) The liability for accidents that occur during the mining of minerals and metals might be placed on either miners (that is, employees of mining companies) or on the owners of mining companies. Mine owners will spend more money on preventing mining accidents if they are made liable for such accidents than they would if the miners were made liable for such accidents. (Hint: Think about the assignment of liability for accidents to one party as being equivalent to the assignment of a property right over the level of safety involved in the operation of a mine to the other party.)

d)If widgets are an inferior good, then a decrease in the price of widgets, all else equal (that is, with no changes in any other economic parameters), will result in an income effect on the consumption of widgets that moves in the opposite direction to the substitution e↵ect on the consumption of widgets.

e) Rocky has a weekly income of $100. This weekly income has not changed at all over the period of time relevant to this question. Rocky’s local fitness centre recently altered the prices that it charges for its services. It used to charge a uniform price of $4 per hour that an individual used its facilities. It now charges a two-part tariff that involves a fixed weekly membership fee of $30 and a variable usage charge of $1 per hour that a member uses its facilities. Under the new pricing system, only members can use the facilities. Before the price change, Rocky used the fitness centre facilities for 10 hours per week. After the price change, Rocky has been using the fitness centre facilities for 25 hours per week. The change in the prices charged by Rocky’s local fitness centre has reduced his welfare. (5 marks.)

Answer 1

a) Since the supply curve is perfectly elastic, so a small change in price will highly fluctuate the demand. Thus if the output of the firm increases, there will be an increment in the requirement of inputs. However, a huge change in the demand for inputs will lead to only a small change in price. So the marginal cost remains almost constant since there is a very little fluctuation of price even with huge changes in demand.

b) A risk averse person will want to ensure that there is no loss in any way. So there will be an inclination to insure his outcome, However, if the cost of insuring the outcome is more than the loss that he can face, then he will not want to insure against a risky outcome.

c) For a mine owner, an accident means loss of the entire business. Simultaneously, it will be a loss of employment to all the workers. For the workers however, it is a personal matter entirely. So a liability of mining accident, if taken by owners, will mean a higher degree of safety and higher attention to prevent mining accidents.

d) Fall in prices of widgets cause 2 effects. The lower price changes the relative prices of widgets with respect to its substitutes favourably. The effect is called the substitution effect. This raises the quantity demanded of the widget. The price reduction also leads to an increase in the consumption power of people which is the income effect. This income effect leads to people consuming more of other products and less of the widget. So the demand for widget falls.

So we see that the income effect reduces the quantity of widgets demanded while the substitution effect increases the quantity of widgets demanded.. So income effect and substitution effect moves in opposite direction

e) When a two-part tariff is implemented, the entire consumer surplus is shifted to the producer. As a result, the consumer surplus goes down.

However, in this case, we see that initially his charges were $4 per hour.

Post 2 part tariff, he was charged 30 + 25 = 55 for 25 hours. So his average cost has gone down.

If he has a requirement of 25 hours of gymming, then his social welfare has definitely gone up.

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