Question

A pizza baker can bake pizzas at a constant marginal cost equal to twelve crowns. He likes his job, but unfortunately he lives on the planet Mars together with just one other person, a pizza eater. The communications with Earth are broken and will remain so for the next several decades. On the other hand, the pizza baker knows everything about the pizza eater, including his willingness to pay at the margin for each time period. Furthermore, the pizza eater never eats anything but pizza and so the pizza baker is his only source for food.

i. Describe why we can or cannot say that the pizza baker makes a profit from the pizza eater, as well as whether this depends on how much the pizza baker knows about the willingness to pay of the pizza eater.

ii. Contrast the above with a hypothetical, socially optimal, outcome. How, if at all, does the situation in part i differ from this social optimum?

iii. Pick an example from reality that is of the same kind as the scenario in this question (though not necessarily of the same extreme degree with respect to how much is known about other people, nor the total number of individuals involved).

Answer 1

i) The profit of the baker would depend upon the price set and the costs incurred. Though,the costs are known, the willingness to pay is not known. The pizza eater may be willing to apy less than the MC of the pizza. Also, since the marginal utility with additional pizza consumption will reduce, it would depend upon the point when the marginal revenue or the price is greaater than the marginal cost or not such that it covers the fixed cost if any. There is whole lot of ambiguity to conclude if he earns profit or not.

ii) Social optimum is the one in which the social welfare is maximized. In this situation, it would completely depend upon the utility maximising level of pizza eater which would determine the outcome and it would not be socially optimal. In the socially optimum level, both the profits and utility would be together maximised ti ensure maximum social benefit which may not be same as the utility maximising level of pizza.

iii) A similar situation is when there are two or more types of buyers in the market and the producer cannot segregate them due to different prices or willingness to pay.