Consider a town in which only two residents, Kevin and Maria, own wells that pro
ID: 1116813 • Letter: C
Question
Consider a town in which only two residents, Kevin and Maria, own wells that produce water safe for drinking. Kevin and Maria can pump and sell as much water as they want at no cost. For them, total revenue equals profit. The following table shows the town's demand schedule for water.
Price
Quantity Demanded
Total Revenue
(Dollars per gallon)
(Gallons of water)
(Dollars)
Suppose Kevin and Maria form a cartel and behave as a monopolist. The profit-maximizing price isper gallon, and the total output isgallons. As part of their cartel agreement, Kevin and Maria agree to split production equally. Therefore, Kevin's profit is, and Maria's profit is.
Suppose that Kevin and Maria have been successfully operating as a cartel. They each charge the monopoly price and sell half of the monopoly quantity. Then one night before going to sleep, Kevin says to himself, "Maria and I aren't the best of friends anyway. If I increase my production to 40 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow."
After Kevin implements his new plan, the price of water toper gallon. Given Maria and Kevin's production levels, Kevin's profit becomes and Maria's profit becomes.
Because Kevin has deviated from the cartel agreement and increased his output of water to 40 gallons more than the cartel amount, Maria decides that she will also increase her production to 40 gallons more than the cartel amount.
After Maria increases her production, Kevin's profit becomes, Maria's profit becomes, and total profit (the sum of the profits of Kevin and Maria) is now.
True or False: Based on the fact that both Kevin and Maria increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity.
True
False
Kevin and Maria have each cheated on their cartel agreement and increased production by 40 gallons more than the cartel amount. However, they both realize that if they continue to increase output beyond this amount, they'll each suffer a decrease in profit. (To see this for yourself, consider Kevin's profit when he produces 80 gallons more than the cartel amount compared to his profit when he produces 40 gallons more than the cartel amount.)
Neither Kevin nor Maria has an incentive to increase output further, nor does either have an incentive to decrease output. This outcome is an example ofpredatory pricing .
Price
Quantity Demanded
Total Revenue
(Dollars per gallon)
(Gallons of water)
(Dollars)
4.20 0 0 3.85 40 $154.00 3.50 80 $280.00 3.15 120 $378.00 2.80 160 $448.00 2.45 200 $490.00 2.10 240 $504.00 1.75 280 $490.00 1.40 320 $448.00 1.05 360 $378.00 0.70 400 $280.00 0.35 440 $154.00 0 480 0Explanation / Answer
a) The consumer's budget constraint for the current period:
c + s = y - ts, where ts= taxes in all the constraints given
b) The consumer's budget constraint for the future period:
c' = (1+r)s + y' - ts'
c' = (1+r)(1-t) + y' - ts'
c) One lifetime budget constraint:
s = c' - y' + ts'/ (1+r)
d) consumer problem occurs when he has to decide whether to choose present consumption or future consumption. The optimal point occurs where in the graph, the slope of the highest attained indifference curve is equivalent to the slope of the budget constraint.