SOLUTIONS MANUAL for Economics, 14th Edition by Michael Parkin by ACADEMIAMILL

Table of Contents

Preface  Part 1 Chapter 1 Appendix Chapter 2  Part 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7  Part 3 Chapter 8 Chapter 9  Part 4 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15  Part 5 Chapter 16 Chapter 17  Part 6 Chapter 18 Chapter 19 Chapter 20  Part 7 Chapter 21 Chapter 22

v Introduction What is Economics? Graphs in Economics The Economic Problem

1 9 21

How Markets Work Demand and Supply Elasticity Efficiency and Equity Government Actions in Markets Global Markets in Action

39 53 65 79 93

Households’ Choices Utility and Demand Possibilities, Preferences, and Choices

107 121

Firms and Markets Organizing Production Output and Costs Perfect Competition Monopoly Monopolistic Competition Oligopoly

137 151 165 179 197 209

Market Failure and Government Public Choices, Public Goods, and Healthcare Externalities

223 235

Factor Markets, Inequality, and Uncertainty Markets for Factors of Production Economic Inequality Uncertainty and Information

247 261 275

Monitoring Macroeconomic Performance Measuring the Value of Production: GDP Monitoring Jobs and Inflation

285 299

 Part 8 Chapter 23 Chapter 24 Chapter 25 Chapter 26

Macroeconomic Trends Economic Growth Finance, Saving, and Investment Money, the Price Level, and Inflation The Exchange Rate and the Balance of Payments

313 325 337 351

 Part 910Macroeconomic Fluctuations Chapter 27 Chapter 28 Chapter 29  Part 5 Chapter 30 Chapter 31

Aggregate Supply and Aggregate Demand Expenditure Multipliers The Business Cycle, Inflation, and Deflation

363 379 393

Macroeconomic Policy Fiscal Policy Monetary Policy

409 423

C h a p t e r

WHAT IS ECONOMICS?

Answers to the Review Quiz Page 2 1.

List some examples of the scarcity that you face. Examples of scarcity common to students include not enough income to afford both tuition and a nice car, not enough learning capacity to study for both an economics exam and a chemistry exam in one night, and not enough time to allow extensive studying and extensive socializing.

Find examples of scarcity in today’s headlines. A headline in The New York Times on June 17, 2021 was “What is a Megadrought?” The story defined a megadrought as a “period of extreme dryness that lasts for decades.” It then pointed out that the Western United States has suffered from drought conditions since 2000 and because of climate change the drought may continue. The entire story points out the role of scarcity because it is concerned with the scarcity of water, which is a vital resource.

During the Covid-19 pandemic, what incentives did you face and how did you respond? In some locales students and others faced incentives to wear a facemask, because if they did not wear a mask they could not legally enter particular stores and if they did so anyway, they might be fined. Some students and others faced the incentive to work remotely because that was the type of job being offered. Many students faced the incentive to take classes remotely because this was how almost all classes were offered.

Find an example of the distinction between microeconomics and macroeconomics in today’s headlines. Microeconomics: On June 17, 2021 a headline in East Bay Times was “The Housing Market Is So Hot Buyers Are Paying $1 Million Over Asking Price.” This story covers a microeconomic topic because it discusses how the choices of individuals and the interactions of the choices in the housing market have forced prices higher. Macroeconomics: On June 17, 2021, a headline in The Wall Street Journal was “Fed Pencils In Earlier Interest-Rate Increase.” This story covers a macroeconomic topic because it concerns interest rates, which affects the national economy.

Page 7 1.

Describe the broad facts about what, how, and for whom goods and services are produced. What gets produced is significantly different today than in the past. Today the U.S. economy produces more services, such as medical operations, teaching, and hair styling, than goods, such as pizza, automobiles, and computers. How goods and services are produced is by businesses determining how the factors of production, land, labor, capital and entrepreneurship, are combined to make the goods and services we consume. Land includes all natural resources, both renewable natural resources such as wood, and nonrenewable natural resources such as natural gas. Labor’s quality depends on people’s human capital. In the U.S. economy, human capital obtained through schooling has increased over the years with far more people completing high school and attending college than in past years. Finally, for whom are goods and services to be produced depends on the way income is distributed to U.S. citizens. This distribution is not equal; the 20 percent of people with the lowest income earn about 5 percent of the nation’s total income while the 20 percent of people with the highest incomes earn about 50 percent of © 2023 Pearson Education, Inc.

CHAPTER 1

total income. On the average, men earn more than women, whites more than non-whites, and college graduates more than high school graduates.

Give some examples to illustrate the potential for conflict between self-interest and the social interest during the Covid-19 pandemic. The decision whether to wear a facemask shows the potential conflict between self-interest and social interest. It was in the self-interest of some people to not wear a mask, possibly because they felt the mask was too constraining, but it was in the social interest to do so because it helped limit the spread of the disease. Similarly, it was in the self-interest of owners and employees of bars and restaurants to remain open at 100 percent capacity, but it was in the social interest to close them and, when they were allowed to reopen, to do so at a reduced capacity. It was in the self-interest of some parents to have their child (or children) attend school, perhaps because attendance helped the child learn or because the parents lacked daycare, but it was in the social interest to have schools closed and use remote classes.

Page 10 1.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today. A tradeoff reflects the point that when someone gets one thing, something else must be given up. What is given up is the opportunity cost of whatever is obtained. Three examples of tradeoffs that are common to students include: a) When a student sleeps in rather than going to his or her early morning economics class, the student trades off additional sleep for study time. The opportunity cost of the decision is a lower grade on the exam. b) When a student running late for class parks his or her car illegally, the student trades off saving time for the risk of a ticket. The potential opportunity cost of the decision is the goods and services that cannot be purchased if the student receives an expensive parking ticket. c) A student trades off higher income by spending time during the day working at a part-time job for less time spent at leisure time and study. The opportunity cost for the higher income is less leisure and lower grades in classes.

Explain what economists mean by rational choice and think of three choices that you’ve made today that are rational. A rational choice is one that compares the costs and benefits of the different actions and then chooses the action that has the greatest benefit over cost for the person making the choice. Three rational choices made by students include: a) The choice to skip breakfast to go to class. In this case the benefit is the higher grade in the class and the cost is the breakfast forgone. b) The choice to stop talking with a friend on the phone and start studying for an impending exam. In this case the benefit is the resulting higher grade in the class and the cost is the conversation forgone. c) The choice to do laundry today rather than watch television. In this case the benefit is the fact the student will have clean clothes to wear and the cost is the loss of the entertainment the television show would have provided.

Explain why opportunity cost is the best forgone alternative and provide examples of some opportunity costs that you have faced today. When a decision to undertake one activity is made, often many alternative activities are no longer possible. Often these activities are mutually exclusive so only the highest valued alternative is actually forgone. For instance, the decision to go to a student’s 8:30 AM class eliminates the possibility of sleeping in during the hour and of jogging during the hour. But in this case, it is impossible to both sleep in and to jog during the hour, so the opportunity cost cannot be both activities. What is lost is only the activity that otherwise would have been chosen—either sleeping in or jogging—which is whatever activity would have been chosen, that is, the most highly valued of the forgone alternatives. For students, attending class, doing homework, studying for a test are all activities with opportunity costs.

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today. Choosing at the margin means choosing to do a little more or a little less of some activity. Three common examples students encounter are: a) When a student faces a chemistry and an economics final exam in one © 2023 Pearson Education, Inc.

WHAT IS ECONOMICS?

day, the student must determine whether spending the last hour studying a little more chemistry or a little more economics will yield a better contribution (marginal benefit) to his or her overall GPA. b) A college student buying a computer must decide whether the marginal benefit of adding 1 GB of additional memory is worth the marginal cost of the additional memory. c) A student football fan with a choice of a cheap seat in the student bleachers located at the far end of the playing field or a more expensive seat located on the 30 yard line must determine whether the marginal benefit of watching the game from a better seat is worth the marginal cost of the higher ticket price.

Explain why choices you made during the Covid-19 pandemic were in your self-interest. Why might your choices not have been in the social interest? People making rational decisions in their self-interest about actions compare the marginal benefits to themself to the marginal costs to themself. Therefore people’s choices are in their self-interest because they are looking at their marginal benefits and marginal costs. Some of these choices may not have been in the social interest because the social interest includes costs imposed on other people. For example, in many college towns students visited nightclubs and did not socially distance nor wear masks because to these students the marginal benefit of socializing exceeded the marginal cost they incurred, say the likelihood of catching coronavirus. But this was not in the social interest because if the student was infected, then he or she in turn might infect others, including some high-risk individuals. The cost to the other people from catching COVID-19 is ignored by students who visited nightclubs with socially distancing or masking.

Page 11 1.

Distinguish between a positive statement and a normative statement and provide examples associated with the Covid-19 vaccine rollout. A positive statement is a description of how the world is. It is testable. A normative statement is a description of how the world ought to be. It is, by its very nature, not testable because there is no universally approved criterion by which the statement can be judged. “I will be vaccinated as quickly as possible,” is a positive statement—it might not be true, but it is testable. “I will be vaccinated because I think it is a good idea,” is a normative statement. Whether someone agrees with it depends on his or her interpretation of what makes for a “good” idea. “The percentage of the population fully vaccinated in my state is over 60 percent” is a positive statement—again, it might not be true, but it is testable. “The percentage of the population fully vaccinated in my state is too low” is a normative statement because it depends on people’s personal interpretation of what is “too low.”

What is a model? Can you think of a model that you might use in your everyday life? A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

How do economists try to disentangle cause and effect? Economists use models to understand some aspect of the economic world. Testing the predictions of models makes it necessary to disentangle cause and effect. To overcome this problem, economists have three methods of testing their models: Using a natural experiment, using a statistical investigation, and using economic experiments. A natural experiment is a situation that arises in the ordinary course of life in which one factor being studied varies and the other factors are the same. This method allows the economist to focus on the effect from the factor that differs between the two situations. A statistical investigation looks for correlations between variables but then determining whether the correlation actually reflects causation can be difficult. An economic experiment puts people into decision making situations and then varies the relevant factors one at a time to determine each factor’s effect.

CHAPTER 1

How is economics used as a policy tool? Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending college, paying cash or credit for a purchase, and working. Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on Brazilian ethanol.

Page 14 1.

What types of jobs do economists do? Economists are found in a large variety of jobs. Many of these jobs are analysts of various sorts. Some economists are market research analysts—they work with data on sales and try to predict a product’s success and the price that should be set for it. Other economists are financial analysts—they work with data on interest rates, stock and bond prices to try to forecast the cost of borrowing and the returns that can be expected on investments. Still other economists work as budget analysts—they use data on an organization’s cash inflows (its receipts) and its outflows (its payments) in order to prepare plans forecasting future cash flows.

What are the skills needed for an economics job? Economists need five important skills:  Critical-thinking skills: Economists need the ability to use logical thinking to clarify and then solve realworld problems.  Analytical skills: Economists must be able to use economic ideas and tools to analyze data to determine important patterns and reach logical conclusions.  Math skills: Economists need to be able to use mathematical and statistical tools to explore and analyze data to reach valid conclusions.  Writing skills: Economists must be able to clearly write reports presenting ideas, conclusions from any analysis and reasons why the conclusions are valid.  Oral communication skills: Economists need the ability to orally explain ideas, conclusions, and the reasons why the conclusions are correct to a variety of people, including those with little knowledge of economics.

What is the range and median level of economists’ pay? How do they compare to other college majors? Economists’ pay ranges from $56,500 to $139,600 a year and has a median salary of $105,100 a year. Students who earn a PhD in economics typically earn about $150,000 a year by mid-career. Economists who work as analysts have incomes that range from an average of $55,000 a year for market research analysts to $82,000 a year for financial analysts. Midcareer, petroleum engineering and operations research majors earn more than applied economics majors but the salaries for economics majors are higher than most other majors, such as chemical engineering, nuclear engineering, and corporate accounting and finance.

Why is the underrepresentation of women and minorities in economics an economic problem? The underrepresentation of women and minorities in economics is an economic problem because the outcome is inefficient. The marginal benefit of women and minorities working as economists exceeds their marginal cost. Resources are not being allocated efficiently. With a more diverse group of economists, likely more diverse questions will be studied in more diverse ways. This exploration should increase the quality and accuracy of economists’ advice and predictions.

WHAT IS ECONOMICS?

Answers to the Study Plan Problems and Applications 1.

Apple Inc. decides to make iTunes freely available in unlimited quantities. a. Does Apple’s decision change the incentives that people face? Apple’s decision changes people’s incentives. For example, it increases people’s incentives to buy an iPhone to take advantage of the newly “free” music available on iTunes.

b. Is Apple’s decision an example of a microeconomic or a macroeconomic issue? Apple’s decision is a microeconomic decision because the decision deals with the choices of individuals and a business and how they interact.

Which of the following pairs does not match? a. Labor and wages Labor earns wages, so this pair matches.

b. Land and rent Land earns rent, so this pair matches.

c. Entrepreneurship and profit Entrepreneurship earns profit, so this pair matches.

d. Capital and profit Capital earns interest, so this pair does not match.

Explain how the following news headlines concern self-interest and the social interest. a. Starbucks Expands in China Starbucks’ expansion is a decision made by Starbucks to further Starbucks’ interest. Thus the decision is directly in Srarbucks’ self interest. The social interest is affected because Starbucks’ expansion will have an effect in China. For instance, more Chinese citizens might drink coffee rather than tea and fewer coffee shops run by Chinese firms might open.

b. McDonald’s Moves into Online Ordering McDonald’s decision to use online ordering is a decision made by McDonald’s to further McDonald’s interest. Thus the decision is directly in McDonald’s self interest. The social interest is affected because more people will order online rather than queuing up to order in person.

c. Food Must Be Labeled with Nutrition Data The decision to require that food must be labeled with nutrition information is made in the social interest. This decision is not made by any one single firm and so does not (necessarily) reflect anyone’s self interest.

The night before an economics test, you decide to go to the movies instead of studying for the test. Your grade on the test was 50 percent, lower than your usual 70 percent score. a. Did you face a tradeoff? Yes, you faced a tradeoff. The tradeoff was between a higher test score and an evening with your friends at the movies.

b. What was the opportunity cost of your evening at the movies? The opportunity cost of going to the movies is the fall in your grade. That is the 20 points forgone from choosing to see the movie rather than study.

CHAPTER 1

5. Olympics Could Cost More Than $26 Billion Japanese media estimate that overall spending on Japan’s new expensive national venues is between $26 billion and $28 billion. Source: Los Angeles Times, December 20, 2019 What is Japan’s opportunity cost of hosting the Olympic Games? Explain your answer. What could otherwise have been purchased with the $26 billion to $28 billion spent on the new Olympic facilities is an opportunity cost of the Olympics if the funds would not have spent building these otherwise. However, if there were already plans underway to build the facilities, then their cost is not an opportunity cost of the Olympics because the cost would have been paid even if Japan did not host the Olympics. If the facilities would not otherwise have been built, then the expenditures on them are an opportunity cost of the Olympics.

Which of these statements is positive, which is normative? Explain why. a. The United States should cut its imports. The statement is normative and cannot be tested.

b. China imports U.S. pork and soybean. The statement is positive and can be tested.

c. If the iPhone price rises, iPhone sales will fall. The statement is positive and can be tested.

What are the five basic skills needed for an economics job? The five basic skills are critical-thinking skills (the ability to use logical thinking to clarify and solve realworld problems), analytical skills (the ability to use economic ideas and tools to analyze data to reach accurate conclusions), mathematical skills (the ability to use mathematical and statistical tools to analyze data to reach correct conclusions), writing skills(the ability to clearly write reports presenting ideas and conclusions), and oral communication skills (the ability to orally explain ideas, conclusions, and the reasons why the conclusions are correct to a variety of people).

How is the AEA trying to encourage more women and minorities to study economics? The AEA has created an undergraduate essay prize, a travel grant, and other similar programs to help encourage women and minorities to study economics.

How does the BLS expect jobs for economists to grow in the next decade? Between 2019 and 2029, the BLS expects relatively rapid growth in jobs for economists. The BLS expects that overall, jobs will grow by 3 percent. For economists, the picture is rosier. The BLS predicts that jobs for economists with a Ph.D. will grow by 14 percent, jobs for budget analysts will grow by 3 percent, jobs for financial analysts will grow by 5 percent, and jobs for market research analysts will grow by 18 percent.

WHAT IS ECONOMICS?

Answers to Additional Problems and Applications 10.

Swifties, Rejoice! Taylor Swift Will Perform a Free JamFest Source: USA Today, November 8, 2019 When Taylor Swift performs at JamFest, what is free and what is scarce? Explain your answer. The seats at JamFest are scarce—there are only a limited number. You don't pay any money to attend Taylor Swift's concert but you give up time to go to the concert, and you probably pay for transit or to park your car. The publicity Ms. Swift receives is not free because she must perform at the concert. Additionally, the publicity uses reporters’ scarce time to report on the concert rather than reporting on other news worthy events.

11.

How does the creation of a successful movie influence what, how, and for whom goods and services are produced? The “what” question is affected in two ways. First, one good or service that is produced is the successful movie. Second, spinoffs (Iron Man II) and/or similar films likely will be created in the future. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who, as the result of the blockbuster movie, have higher incomes so that more goods and services are produced for them.

12.

How does a successful movie illustrate self-interested choices that are also in the social interest? The a successful movie increases the income of the people involved with the movie. Hence these people’s choices are driven largely by self interest. However the creation of a successful movie also increases the quantity of widely enjoyed entertainment. The amount of entertainment available in the economy increases which benefits society. So the choices the people made in their self interest also reflected choices made in the social interest.

13.

Before starring in Guardians of the Galaxy, Chris Pratt had appeared in 11 movies that grossed an average of $7 million on the opening weekend. Guardians of the Galaxy grossed $94 million. a. How will the success of Guardians of the Galaxy influence the opportunity cost of hiring Chris Pratt? The salary that must be paid to Chris Pratt to appear in future movies increased because some of the success of Guardians of the Galaxy was attributed to Mr. Pratt. As a result the opportunity cost to movie producers of hiring Mr. Pratt increased.

b. How have the incentives for a movie producer to hire Chris Pratt changed? There are two effects on the incentives of producers to hire Mr. Pratt. First, because the opportunity cost of hiring Mr. Pratt increased, the incentive to hire him decreased. However because part of the success of Guardians of the Galaxy was attributed to Mr. Pratt acting in the leading role, producers expect that his acting will lead to increased success for future movies. This belief increases producers’ incentives to hire Mr. Pratt.

14.

What might be an incentive for you to take a class in summer school? List some of the benefits and costs involved in your decision. Would your choice be rational? Early graduation, smaller class sizes, and/or retaining eligibility for a scholarship are examples of incentives that encourage taking summer classes. The benefits of taking summer classes might include early graduation, more personal attention from the instructor, retained eligibility for a scholarship, and increased knowledge about some aspect of the world. Costs potentially include forgone summer jobs or internships, less time to spend with friends, and additional tuition and other class-related expenses if the class I not one that would be taken otherwise. The choice is rational as long as the student determines that taking summer classes offers the highest benefit over cost for the use of his or time and efforts. © 2023 Pearson Education, Inc.

15.

CHAPTER 1

Look at today’s Wall Street Journal. What is the leading economic news story? Which big economic questions and tradeoffs does it discuss or imply? On June 17, 2021, the top economic news story discussed the Supreme Court’s upholding of the Affordable Care Act. Congress had eliminated the penalty for not possessing health insurance and several states had sued seeking to eliminate the law. The Supreme Court ruled that the plaintiffs had suffered no harm and therefore did not have standing to bring the suit. This story clearly discusses the “for whom” question: With the Affordable Care Act still in place, more poor and disabled people will receive certain types of healthcare. It also discusses the “what” question: If more Americans have health insurance, more goods and services related to health care will be produced. The story implicitly illustrates a tradeoff: If choices are taken to limit the amount of healthcare poor and disabled people receive, their health will generally be worse than otherwise.

16.

Provide two microeconomic statements and two macroeconomic statements. Classify your statements as positive or normative, and explain your classifications. Microeconomic statements are: Fewer deep water oil wells should be drilled in the Gulf of Mexico. If less oil is produced, the price of oil will rise. The first statement is normative because it relies on what the person thinks “should” be done. The second statement is positive because it is possible to test the effect of less oil being produced. Macroeconomic statements are: The currently unemployment rate is too high. The current unemployment rate is higher for blacks than for whites. The first statement is normative because it depends on what is deemed “too high.” The second statement is positive because it can be checked to determine its validity.

17.

What might be an incentive for economics students to do a Ph.D.? What would be the opportunity cost of doing a Ph.D.? One incentive for a student to earn a Ph.D. in economics is the chance to continue to learn more economics. Another incentive is that the student may be better able to follow a preferred career, for example, as a researcher, as a policy analysist, as an instructor, or whatever the student prefers. A final incentive is the pay, which is higher than many other salaries. An opportunity cost is the time that a Ph.D. requires. The time spent earning the Ph.D. would otherwise be used for another endeavor, and this endeavor is the opportunity cost of the time. There may also be tuition and/or book costs, so whatever else would have been purchased in place of the tuition and/or books are opportunity costs of the Ph.D.

Appendix

GRAPHS IN ECONOMICS

Answers to the Review Quiz Page 30 1.

Explain how we “read” the three graphs in Figs. A1.1 and A1.2. The points in the graphs relate the quantity of the variable measured on the one axis to the quantity of the variable measured on the other axis. The quantity of the variable measured on the horizontal axis (the xaxis) is measured by the horizontal distance from the origin to the point. Similarly, the quantity of the variable measured on the vertical axis (the y-axis) is measured by the vertical distance from the origin to the point. The point relates these two quantities. For instance, in Figure A1.2, point A shows that at a price of $8.43 per ticket, 1.3 billion tickets are sold.

Explain what scatter diagrams show and why we use them. Scatter diagrams plot the value of one economic variable against the value of another variable for a number of different values of each variable. We use scatter diagrams because they quickly reveal if a relationship exists between the two variables. Moreover, if a relationship exists, scatter diagrams show whether increases in one variable are associated with increases or decreases in the other variable.

Explain how we “read” the three scatter diagrams in Figs. A1.3 and A1.4. The scatter diagram in Figure A1.3 shows the relationship between a film’s worldwide box office ticket sales and the film’s production budget. The figure shows that higher box office sales are associated with a higher production budget. The scatter diagram in Figure A1.4a shows the relationship between income, in thousands of dollars per year, and expenditure, also in thousands of dollars per year, for the years 2000 to 2020. The scatter diagram shows that higher income leads to higher expenditure. The figure also shows that the relationship is relatively strong. The scatter diagram in Figure A1.4b shows the relationship between the inflation rate and the unemployment rate for the years 2001 to 2020. The figure shows that there is no relationship between the inflation rate and unemployment rate.

APPENDIX 1

Draw a graph to show the relationship between two variables that move in the same direction. A graph that shows the relationship between two variables that move in the same direction is shown by a line that slopes upward. Figure A1.1 illustrates such a relationship.

Draw a graph to show the relationship between two variables that move in opposite directions. A graph that shows the relationship between two variables that move in the opposite directions is shown by a line that slopes downward. Figure A1.2 illustrates such a relationship.

GRAPHS IN ECONOMICS

Draw a graph of two variables whose relationship shows (i) a maximum and (ii) a minimum. A graph that shows the relationship between two variables that have a maximum is shown by a line that starts out sloping upward, reaches a maximum, and then slopes downward. Figure A1.3 illustrates such a relationship with curve B. A graph that shows the relationship between two variables that have a minimum is shown by a line that starts out sloping downward, reaches a minimum, and then slopes upward. Figure A1.3 illustrates such a relationship with curve A.

Which of the relationships in Questions 4 and 5 is a positive relationship and which is a negative relationship? The relationship in Question 4 between the two variables that move in the same direction is a positive relationship. The relationship in Question 5 between the two variables that move in the opposite directions is a negative relationship.

What are the two ways of calculating the slope of a curved line? To calculate the slope of a curved line we can calculate the slope at a point or across an arc. The slope of a curved line at a point on the line is defined as the slope of the straight line tangent to the curved line at that point. The slope of a curved line across an arc—between two points on the curved line—equals the slope of the straight line between the two points.

How do we graph a relationship among more than two variables? To graph a relationship among more than two variables, hold constant the values of all the variables except two. Then plot the value of one of the variables against the other variable.

10.

Explain what change will bring a movement along a curve. A movement along a curve occurs when the value of a variable on one of the axes changes while all of the other relevant variables not graphed on the axes do not change. The movement along the curve shows the effect of the variable that changes, ceteris paribus (holding all of the other non-graphed variables constant).

11.

Explain what change will bring a shift of a curve. A curve shifts when there is a change in the value of a relevant variable that is not graphed on the axes. In this case the entire curve shifts.

12.

Netflix’s monthly fee for 1 screen is $8.99, for 2 screens $13.99, and for 4 screens is $17.99. Describe the relationship between the fee and the number of screens. The relationship is positive because a higher fee is associated with more streams.

APPENDIX 1

Answers to the Study Plan Problems and Applications Use the spreadsheet to work Problems 1 to 3. The spreadsheet provides data on the U.S. economy: Column A is the year, column B is the inflation rate, column C is the interest rate, column D is the growth rate, and column E is the unemployment rate.

1 2 3 4 5 6 7 8 9 10 11

A 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

B 1.6 3.1 2.1 1.5 1.6 0.1 1.3 2.1 2.4 1.8 1.2

C 0.1 0.1 0.1 0.1 0.0 0.1 0.3 1.0 2.0 2.1 0.4

D 2.6 1.6 2.2 1.8 2.5 3.1 1.7 2.3 3.0 2.2 ─3.5

E 9.6 8.9 8.1 7.4 6.2 5.3 4.9 4.4 3.9 3.7 8.1

Draw a scatter diagram of the inflation rate and the interest rate. Describe the relationship. To make a scatter diagram of the inflation rate and the interest rate, plot the inflation rate on the x-axis and the interest rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.4. The pattern made by the dots tells us that as the inflation rate increases, the interest rate usually increases so there is a (weak) positive relationship.

Draw a scatter diagram of the growth rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the growth rate and the unemployment rate, plot the growth rate on the xaxis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.5. The pattern made by the dots tells us that when the growth rate increases, the unemployment rate usually decreases so there is a weak negative relationship.

GRAPHS IN ECONOMICS

Draw a scatter diagram of the interet rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the interest rate and the unemployment rate, plot the interest rate on the x-axis and the unemployment rate on the yaxis. The graph will be a set of dots and is shown in Figure A1.6. The pattern made by the dots tells us that when the interest rate increases, the unemployment rate usually decreases so there is a negative relationship.

Use the following news clip to work Problems 4 to 6.

Star Wars Tops the Box Office: Source: Boxofficemojo.com, Data for weekend of January 3-5, 2020 4. Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship. Figure A1.7 shows the relationship. As the figure shows, there is positive relationship.

Movie Star Wars Episode IX: The Rise of Skywalker Jumanji: The Next Level Little Women Frozen II

Calculate the slope of the relationship in Problem 4 between 3,308 and 4,134 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters, or ($4,114  $6,344)/(3,308  4,134) which equals $2.70 per theater.

Calculate the slope of the relationship in Problem 4 between 3,175 and 4,406 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters, or ($3,733  $7,835)/(3,175  4,406) which equals $3.33 per theater.

Theaters (number) 4,406

Revenue (dollars per theater) $7,835

4,134

$6,344

3,308 3,175

$4,114 $3,733

APPENDIX 1

Calculate the slope of the relationship shown in Figure A1.8.

The slope is 5/4. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the yaxis divided by the change in the variable on the x-axis. To calculate the slope, you must select two points on the line. One point is at 10 on the yaxis and 0 on the x-axis, and another is at 8 on the x-axis and 0 on the y-axis. The change in y from 10 to 0 is associated with the change in x from 0 to 8. Therefore the slope of the curve equals 10/8, which equals 5/4.

Use the relationship shown in Figure A1.9 to work Problems 8 and 9. 8. Calculate the slope of the relationship at point A and at point B.

The slope at point A is 2, and the slope at point B is 0.25. To calculate the slope at a point on a curved line, draw the tangent to the curved line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the y-axis at 10. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 4 (6 minus 10) and the change in x equals 2 (2 minus 0). The slope at point A is 4/2, which equals 2. Similarly, the slope at point B is 0.25. The tangent at point B goes through the point (4, 2). The change in y equals 0.5, and the change in x equals 2. The slope at point B is 0.25.

Calculate the slope across the arc AB.

The slope across the arc AB is 1.125. The slope across an arc AB equals the change in y, which is 4.5 (6.0 minus 1.5) divided by the change in x, which equals 4 (2 minus 6). The slope across the arc AB equals 4.5/4, which is 1.125.

GRAPHS IN ECONOMICS

Use the table to work Problems 10 and 11. The table gives the price of a balloon ride, the temperature, and the number of rides a day. 10. Draw a graph to show the relationship between the price and the number of rides, when temperature is 70°F. Describe this relationship.

Price (dollars per ride) 5 10 15

Figure A1.10 shows the relationship between the price and the number of balloon rides when the temperature is 70F. The relationship between the price and the number of rides is inverse; that is, when the price rises, the number of rides decreases.

11.

What happens in the graph in Problem 10 if the temperature rises to 90°F? If the temperature rises to 90F, the curve shifts rightward. This shift is illustrated in Figure A1.11. In that figure, both the initial curve, which applies when the temperature is 70F, and the new curve, which applies when the temperature is 90F, are illustrated. The curve when the temperature is 90F lies to the right of the curve when the temperature is 70F indicating that at every price, more balloon rides are taken when the temperature is 90F rather than 70F.

Balloon rides (number per day) 50F 70F 90F 32 40 50 27 32 40 18 27 32

APPENDIX 1

Answers to Additional Problems and Applications Use the spreadsheet to work Problems 12 to 14. The spreadsheet provides data on oil and gasoline: Column A is the year, column B is the price of oil (dollars per barrel), column C is the price of gasoline (cents per gallon), column D is U.S. oil production, and column E is the U.S. quantity of gasoline refined (both in millions of barrels per day).

12.

1 2 3 4 5 6 7 8 9 10 11

A 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

B 66 72 100 62 79 95 94 98 93 49 45

C 262 284 330 241 284 358 368 358 344 252 225

D 5.1 5.1 5.0 5.4 5.5 5.6 6.5 7.5 8.8 9.4 8.9

E 15.6 15.4 15.3 14.8 15.2 15.1 15.5 15.2 15.5 16.6 16.4

Draw a scatter diagram of the price of oil and the quantity of U.S. oil produced. Describe the relationship. Figure A1.12 shows the scatter diagram between the price of a barrel of oil and the quantity of U.S. oil produced. It shows a weak negative relationship.

13.

Draw a scatter diagram of the price of gasoline and the quantity of gasoline refined. Describe the relationship. Figure A1.13 shows the scatter diagram between the price of a gallon of gasoline and the quantity of gasoline refined. It shows a weak negative relationship.

GRAPHS IN ECONOMICS

14.

Draw a scatter diagram of the quantity of U.S. oil produced and the quantity of gasoline refined. Describe the relationship. Figure A1.14 shows the scatter diagram between the quantity of U.S. oil produced and the quantity of gasoline refined. It shows a positive relationship.

Use the following data to work Problems 15 to 17. Draw a graph that shows the relationship between the two variables x and y in the table to the right.

x y

0 25

1 24

2 22

3 18

4 12

5 0

To make a graph that shows the relationship between x and y, plot the x variable on the x-axis and the y variable on the y-axis. Figure A1.15 shows this graph.

15. a. Is the relationship positive or negative? The relationship is negative because x and y move in opposite directions: As x increases, y decreases.

b. Does the slope of the relationship become steeper or flatter as the value of x increases? The slope becomes steeper as x increases.

c. Think of some economic relationships that might be similar to this one. The less expensive a good, the greater is the number of people who buy it. The higher the interest rate, the smaller is the number of people who take out home mortgages. The less expensive gasoline, the greater the miles car owners drive.

16.

Calculate the slope of the relationship between x and y when x equals 3.

The slope equals 4.0. The slope of the curve at the point where x is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in y, 8, divided by the change in x, 2, so the slope is 4.0.

17.

APPENDIX 1

Calculate the slope of the relationship across the arc as x increases from 4 to 5. The slope is –12. The slope of the relationship across the arc when x increases from 4 to 5 is equal to the slope of the straight line joining the points on the curve at x equals 4 and x equals 5. When x increases from 4 to 5, y falls from 12 to 0. The slope equals the change in y, 12 (12 minus 0), divided by the change in x, 1 (4 minus 5), so the slope across the arc is 12.0.

18.

Calculate the slope of the curve in Figure A1.16 at point A.

The slope is 2. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, select two points on the line. One point is at 18 on the y-axis and 0 on the x-axis, and another is at 9 on the x-axis and 0 on the y-axis. The change in y from 18 to 0 is associated with the change in x from 0 to 9. Therefore the slope of the curve equals 18/9, which equals 2.

Use Figure A1.17to work Problems 19 and 20. 19. Calculate the slope at point A and at point B.

The slope at point A is 4, and the slope at point B is 1. To calculate the slope at a point on a curved line, draw the tangent to the line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the x-axis at 2.5. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 6 (6 minus 0) and the change in x equals 1.5 (1 minus 2.5). The slope at point A is 6/1.5, which equals 4. Similarly, the slope at point B is 1. The tangent at point B cuts the y-axis at 5. The change in y equals 3, and the change in x equals 3. The slope at point B is 1.

20.

Calculate the slope across the arc AB.

The slope across the arc AB is 2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals 2 (1 minus 3). The slope across the arc AB equals 4/2, which equals 2.

GRAPHS IN ECONOMICS

Use the following table to work Problems 21 to 23. The table gives information about umbrellas: price, the number purchased, and rainfall in Price inches. (dollars per 21. Draw a graph to show the relationship umbrella) between the price and the number of umbrellas purchased, holding the 20 30 amount of rainfall constant at 1 inch. 40 Describe this relationship. Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price. This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

What happens in the graph in Problem 21 if the price rises and rainfall is constant? If the price rises, the number of umbrellas decreases. In Figure A1.18, there is a movement upward along the (unchanged) curve.

23.

What happens in the graph in Problem 21 if the rainfall increases from 1 inch to 2 inches? As shown in Figure A1.19, the curve shifts rightward. In that figure, both the initial curve, which applies when the rainfall is 1 inch, and the new curve, which applies when the rainfall is 2 inches, are illustrated. The curve when the rainfall is 2 inches lies to the right of the curve when the rainfall is 1 inch indicating that at every price, more umbrellas are purchased when the rainfall is 2 inches than when the rainfall is 1 inch.

Umbrellas (numbers purchased per day) 0 1 2 (inches of rainfall) 4 7 8 2 4 7 1 2 4

C h a p t e r

THE ECONOMIC PROBLEM

Answers to the Review Quizzes Page 36 1.

How does the production possibilities frontier illustrate scarcity? The unattainable combinations of production that lie beyond the PPF illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs. Additionally, while moving along the PPF to increase the production of one good requires that the production of another good be reduced, which also illustrates scarcity.

How does the production possibilities frontier illustrate production efficiency? The combinations of outputs that lie on the PPF illustrate the concept of production efficiency. These points are the maximum production points possible and are attained only by producing the goods and services at the lowest possible cost. Any point inside the frontier reflects production where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient.

How does the production possibilities frontier show that every choice involves a tradeoff? Movements along the PPF frontier illustrate that producing more of one good requires producing less of other good. This observation reflects the result that a tradeoff must be made when producing output efficiently.

How does the production possibilities frontier illustrate opportunity cost? The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good.

Why is opportunity cost a ratio? The slope of the PPF is a ratio that expresses the quantity of lost production of the good on the y-axis to the increase in the production of the good on the x-axis moving downward along the PPF. The steeper the slope, the greater ratio, and the greater is the opportunity cost of increasing the output of the good measured on the horizontal axis.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced? Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increase in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza and more suited to making DVDs. This reallocation of resources yields a relatively small increase in pizza output for a large decrease in DVD output, creating a relatively high opportunity cost reflected in the steep © 2023 Pearson Education, Inc.

CHAPTER 2

slope of the PPF over this range of output. The opportunity cost of pizza production increases with the quantity of pizza produced as the slope of the PPF becomes ever steeper. This effect creates the bowed out effect (the concavity of the PPF function) and means that as more of a good is produced, the opportunity cost of producing additional units increases.

On the global PPF of healthcare supplies and other goods and services, how did the production point change as the Covid-19 pandemic spread across the globe? The production point moved along the global PPF so that more healthcare supplies were produced and fewer other goods and services were produced.

Page 39 1.

What is marginal cost? How is it measured? Marginal cost is the opportunity cost of producing one more unit of a good or service. Along a PPF marginal cost is reflected in the absolute value of the slope of the PPF. In particular, the magnitude of the slope of the PPF is the marginal cost of a unit of the good measured along the x-axis. As the magnitude of the slope changes moving along the PPF, the marginal cost changes.

What is marginal benefit? How is it measured? The marginal benefit of a good or service is the benefit received from consuming one more unit of it. It is measured by what an individual is willing to give up (or pay) for an additional that last unit.

How does the marginal benefit of a good change as the quantity produced of that good increases? As the more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and is larger than the marginal benefit of the unit consumed immediately after it. This set of results is known as the principle of decreasing marginal benefit and is often assumed by economists to be a common characteristic of an individual’s preferences over most goods and services in the economy.

What is allocative efficiency and how does it relate to the production possibilities frontier? Production efficiency occurs when production takes place at a point on the PPF. This indicates that all available resources are being used for production and society cannot produce additional units of one good or service without reducing the output of another good or service. Allocative efficiency, however, requires that the goods and services produced are those that provide the greatest possible benefit. This definition means that the allocative efficient level of output is the point on the PPF (and hence is a production efficient point) for which the marginal benefit equals the marginal cost.

What conditions must be satisfied if resources are used efficiently? Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

How do you think Covid-19 pandemic changed the marginal benefit of an effective vaccine? The Covid-19 pandemic drastically increased the marginal benefit of an effective vaccine. With the pandemic, people were willing to give up more for an effective vaccine.

Page 44 1.

What gives a person a comparative advantage? A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else, If the person gives up the least amount of other goods and services to produce a particular good or service, the person has the lowest opportunity cost of producing that good or service.

THE ECONOMIC PROBLEM

Distinguish between comparative advantage and absolute advantage. A person has a comparative advantage in producing a good when he or she has the lowest opportunity cost of producing it. Comparative advantage is based on the output forgone. A person has an absolute advantage in production when he or she uses the least amount of time or resources to produce one unit of that particular good or service. Absolute advantage is a measure of productivity in using inputs.

Why do people specialize and trade? People can compare consumption possibilities from producing all goods and services through self-sufficiency against specializing in producing only those goods and services that reflect their comparative advantage and trading their output with others who do the same. People can then see that the consumption possibilities from specialization and trade are greater than under self-sufficiency. Therefore it is in people’s own selfinterest to specialize. It was Adam Smith who first pointed out in the Wealth of Nations how individuals voluntarily engage in this socially beneficial and cooperative activity through the pursuit of their own selfinterest, rather than for society’s best interests.

What are the gains from specialization and trade? From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade. From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

What is the source of the gains from trade? As long as people have different opportunity costs of producing goods or services, total output is higher with specialization and trade than if each individual produced goods and services under self-sufficiency. This increase in output is the gains from trade.

Why does specialization and the gains from trade make the economy’s PPF outward bowed? Specialization and the gains from trade make the economy’s PPF bow outward because the resources that have the comparative advantage in producing a good or service are the first to be utilized to produce that good or service. Consequently when the good or service is first produced, its opportunity cost—the amount of the other good or service forgone—is small and so the PPF is relatively flat. Ultimately, when so much of the good or service is produced such that resources without a comparative advantage in it must be utilized, the opportunity cost becomes larger so that the PPF becomes steeper. When the PPF starts out flatter and becomes steeper, it bows outward.

Why is not specializing and reaping the gains from trade inefficient? By not specializing and trading, some suppliers are not producing the good in which they have a comparative advantage. Consequently production occurs inside the PPF at a production inefficient point. All of the economy’s resources might be employed but they are misallocated.

How do you think the Covid-19 pandemic influenced Liz’s and Joe’s gains from trade? Explain your answer. If Liz’s and Joe’s restaurants were closed due to the pandemic, their gains from trade would vanish. Presuming their stores were allowed to remain open, if there is a decrease in the resources necessary to produce one or both goods, then both their PPFs would have shifted inward which means the Liz-Joe Economy PPF also shifts inward. This change reduces the gains from trade because the total production of one or both of the goods decreases with the inward shift of the PPF.

Page 47 1.

What generates economic growth? The two key factors that generate economic growth are technological change and capital accumulation. Technological change allows an economy to produce more with the same amount of limited resources,

CHAPTER 2

Capital accumulation, the growth of capital resources including human capital, means that an economy has increased its available resources for production.

How does economic growth influence the production possibilities frontier? Economic growth shifts the PPF outward. Persistent outward shifts in the production possibility frontier— economic growth—are caused by the accumulation of resources, such as more capital equipment or by the development of new technology.

What is the opportunity cost of economic growth? When a society devotes more of its scarce resources to research and development of new technologies, or devotes additional resources to produce more capital equipment, both decisions lead to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

Explain why Singapore has experienced faster economic growth than the United States. Singapore chose to devote a greater proportion of its available resources to the production of capital than the United States. This allowed Singapore to grow at a faster rate than the United States. By foregoing production of some consumption goods and producing a greater proportion of capital goods over the last few decades, Singapore was able to achieve output per person equal to 150 percent of that in the United States.

Does economic growth overcome scarcity? Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For instance, it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied but it does not eliminate scarcity.

How does economic growth change the patterns of production? In low-income nations a large fraction of production is agriculture with distinctly less devoted to industry. For example, in Ethiopia agriculture accounts for 35 percent of production and industry for 22 percent. As the nation grows to middle income, investment in capital and new technology leads to an increase in the fraction of production that is industrial and a decrease in the fraction that is agricultural. For example, in China 8 percent of production is agriculture and 41 percent is industry. Finally, in high-income nations, services becomes an increasingly large proportion of production. In the United States, for example, services account for 80 percent of production while industry and agriculture together account for 20 percent of production.

Why does economic growth destroy some jobs and create new jobs? Economic growth leads to changes in the pattern of production—some sectors and products increase while others decrease. In the areas that increase in size, new jobs are created while in those that decrease, jobs are destroyed. Often workers who lose their jobs in the declining sectors need to acquire new skills for the new jobs and/or uproot their life to move to a new location. Some unemployed workers are unwilling to incur these costs and, as a result, remain unemployed, leading the economy to produce at a point inside its PPF.

Page 49 1.

Why are social institutions such as firms, markets, property rights, and money necessary? These social institutions factors necessary for a decentralized economy to coordinate production. Firms are necessary to allow people to specialize. Without firms, specialization would be limited because a person would need to specialize in the entire production of a good or service. With firms people are able to specialize in producing particular bits of a good or service. For a society to enjoy the fruits of specialization and trade, the individuals who comprise that society must voluntarily desire to specialize in the first place. Discovering trade opportunities after a person has specialized in his or her comparative advantage in production is what allows that person to gain from his or her own specialization efforts. Trading © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

opportunities can only take place if a market exists where people observe prices to discover available trade opportunities. Money is necessary to allow low-cost trading in markets. Without money, goods would need to be directly exchanged for other goods, a difficult and unwieldy situation. Finally people must enjoy social recognition of and government protection of property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

What are the main functions of markets? The main function of a market is to enable buyers and sellers to get information and to do business with each other. Markets have evolved because they facilitate trade, that is, they facilitate the ability of buyers and sellers to trade with each other.

What are the flows in the market economy that go from firms to households and the flows from households to firms? On the real side of the economy, goods and services flow from firms to households. On the monetary side of the economy, payments for factors of production, wages, rent, interest, and profits, flow from firms to households. Flowing from households to firms on the monetary side of the economy are the expenditures on goods and services and on the real side are the factors of production, labor, land, capital, and entrepreneurship.

CHAPTER 2

Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3. Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. The table to the right sets out Brazil’s production possibilities for ethanol and food crops. 1. a. Draw a graph of Brazil’s PPF and explain how your graph illustrates scarcity. Figure 2.1 shows Brazil’s PPF. The production possibilities frontier indicates scarcity because it shows the limits to what can be produced. In particular, production combinations of ethanol and food crops that lie outside the production possibilities frontier are not attainable.

Ethanol (barrels per day) 70 64 54 40 22 0

and and and and and and

Food crops (tons per day) 0 1 2 3 4 5

b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce to achieve production efficiency? If Brazil produces 40 barrels of ethanol per day, it achieves production efficiency if it also produces 3 tons of food per day.

c. Why does Brazil face a tradeoff on its PPF? Brazil faces a tradeoff on its PPF because Brazil’s resources and technology are limited. For Brazil to produce more of one good, it must shift factors of production away from the other good. Therefore to increase production of one good requires decreasing production of the other, which reflects a tradeoff.

2. a. If Brazil increases ethanol production from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol? When Brazil is production efficient and increases its production of ethanol from 40 barrels per day to 54 barrels per day, it must decrease its production of food crops from 3 tons per day to 2 tons per day. The opportunity cost of the additional ethanol is 1 ton of food per day for the entire 14 barrels of ethanol or 1/14 of a ton of food per barrel of ethanol.

b. If Brazil increases food production from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food? When Brazil is production efficient and increases its production of food crops from 2 tons per day to 3 tons per day, it must decrease its production of ethanol from 54 barrels per day to 40 barrels per day. The opportunity cost of the additional 1 ton of food crops is 14 barrels of ethanol.

c. What is the relationship between your answers to parts (a) and (b)? The opportunity costs of an additional barrel of ethanol and the opportunity cost of an additional ton of food crop are reciprocals of each other. That is, the opportunity cost of 1 ton of food crops is 14 barrels of ethanol and the opportunity cost of 1 barrel of ethanol is 1/14 of a ton of food crops.

Does Brazil face an increasing opportunity cost of ethanol? What feature of Brazil’s PPF illustrates increasing opportunity cost? Brazil faces an increasing opportunity cost of ethanol production. For instance, when increasing ethanol production from 0 barrels per day to 22 barrels the opportunity cost of a barrel of ethanol is 1/22 of a ton of food while increasing ethanol production another 18 barrels per day (to a total of 40 barrels per day) has © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

an opportunity cost of 1/18 of a ton of food per barrel of ethanol. The PPF’s bowed outward shape reflects the increasing opportunity cost.

Use the above table (for Problems 1 to 3) to work Problems 4 and 5. 4. Define marginal cost and calculate Brazil’s marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day. The marginal cost of a good is the opportunity cost of producing one more unit of the good. When the quantity of food produced is 2.5 tons, the marginal cost of a ton of food is the opportunity cost of increasing the production of food from 2 tons per day to 3 tons per day. The production of ethanol falls from 54 barrels per day to 40 barrels per day, a decrease of 14 barrels per day. The opportunity cost of increasing food production is the decrease in ethanol product, so the opportunity cost of producing a ton of food when 2.5 tons of food per day are produced is 14 barrels of ethanol per day.

Define marginal benefit. Explain how it is measured and why the data in the table does not enable you to calculate Brazil’s marginal benefit of food. The marginal benefit of a good is the benefit received from consuming one more unit of the good. The marginal benefit of a good or service is measured by the most people are willing to pay for one more unit of it. The data in the table do not provide information on how much people are willing to pay for an additional unit of food. The table has no information on the marginal benefit of food.

Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency. Production efficiency occurs when goods and services are produced at the lowest cost. This definition means that production efficiency occurs at any point on the PPF. Therefore all of the production points on the PPF are production efficient. Allocative efficiency occurs when goods and services are produced at the lowest cost and in the quantities that provide the greatest possible benefit. The allocatively efficient production point is the single point on the PPF that has the greatest possible benefit.

Use the following data to answer questions 7 and 8. In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. 7. a. Calculate Sue’s opportunity cost of producing a cap. Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of producing one cap is (4 jackets)/(40 caps) or 0.1 jacket per cap.

b. Calculate Tessa’s opportunity cost of producing a cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets)/(80 caps) or 0.05 jacket per cap.

c. Who has a comparative advantage in producing caps? Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps.

d. If Sue and Tessa specialize in producing the good in which they have a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade? Tessa specializes in caps and Sue specializes in jackets. Both Sue and Tessa gain from trade. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket)/(15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap.

Suppose that Tessa buys a new machine that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets? Sue forgoes 40 caps to produce 4 jackets, so Sue’s opportunity cost of producing one jacket is (40 caps)/(4 jackets) or 10 caps per jacket. Tessa forgoes 80 caps to produce 20 jackets, so Tessa’s opportunity cost of © 2023 Pearson Education, Inc.

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producing one jacket is (80 caps)/(20 jackets) or 4 caps per jacket. Tessa has the comparative advantage in producing jackets because her opportunity cost of a jacket is lower than Sue’s opportunity cost.

b. Can Sue and Tessa still gain from trade? Tessa and Sue can still gain from trade because Tessa (now) has a comparative advantage in producing jackets and Sue (now) has a comparative advantage in producing caps. Tessa will produce jackets and Sue will produce caps.

c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer. Sue and Tessa will not be willing to trade 1 jacket for 15 caps. In particular, Sue, whose comparative advantage lies in producing caps, can produce 1 jacket at an opportunity cost of only 10 caps. So Sue will be unwilling to pay any more than 10 caps per jacket.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm’s PPF. The PPF is illustrated in Figure 2.2 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the “conventional” bowed-outward shape.

b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. On your graph sketch the impact of the new technology on the farm’s PPF. The new technology rotates the PPF outward from PPF0 to PPF1.

c. With the farm using the new technology in part (b), has the opportunity cost of producing a ton of wheat changed? Explain and illustrate your answer. The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.2, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

d. Is the farm more efficient with the new technology than it was with the old one? Why? The farm is able to produce more with the new technology than with the old, but it is not necessarily more efficient. If the farm was producing on its PPF before the new technology and after, the farm was production efficient both before the new technology and after.

10.

For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. a. Why would you expect Cuba’s production possibilities (per person) to be smaller than those of the United States? Cuba’s economy is almost surely less efficient than the U.S. economy. The Cuban central planners do not know people’s production possibilities or their preferences. The plans that are created wind up wasting resources and/or producing goods and services that no one wants. Because firms in Cuba are owned by the government rather than individuals, no one in Cuba has the self-interested incentive to operate the firm © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

efficiently and produce goods and services that consumers desire. Additionally, Cuba does not actively trade so Cuba produces most of its consumption goods rather than buying them from nations with a comparative advantage. Because Cuba uses its resources to produce consumption goods, it cannot produce many capital goods, so its economic growth rate has been low.

b. What are the social institutions that Cuba might lack that help the United States to achieve allocative efficiency? Of the four social institutions, firms, money, markets, and property rights, Cuba’s economy has firms and money. Markets, however, are less free of government intervention in Cuba. But the major difference is the property rights in the Cuban economy. In Cuba the government owns most of the firms; that is, the government has the property right to run the producers. Because the firms are not motivated to make a profit, the managers of these firms have little incentive to operate the firm efficiently or to produce the goods and services that consumers desire. In the United States, firms are owned by individuals; that is, people have the property right that allows them to run firms. These owners have the self-interested incentive to operate the firm efficiently and to produce the goods and services people want, an incentive sorely lacking in the Cuban economy.

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Answers to Additional Problems and Applications Use the table to work Problems 11 and 12. Suppose that Yucatan’s production possibilities are given in the table. 11. a. Draw a graph of Yucatan’s PPF and explain how your graph illustrates a tradeoff. Yucatan’s PPF is illustrated in Figure 2.3. The figure illustrates a tradeoff because moving along Yucatan’s PPF producing more of one good requires producing less of the other good. Yucatan trades off more production of one good for less production of the other.

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency? If Yucatan produces 150 pounds of food per month, then the point labeled A on the PPF in Figure 2.11 shows that Yucatan must produce 75 gallons of sunscreen per month to achieve production efficiency.

c. What is Yucatan’s opportunity cost of producing (i) 1 pound of food and (ii) 1 gallon of sunscreen? Yucatan’s PPF is linear so the opportunity cost of producing 1 pound of food is the same at all quantities. Calculate the opportunity cost of producing 1 pound of food when increasing the production of food from 0 to 100 pounds per month. Between these two ranges of production, the quantity of sunscreen produced falls from 150 gallons per month to 100 gallons per month, a decrease of 50 gallons. The opportunity cost is 50 gallons of sunscreen to gain 100 pounds of food. The opportunity cost per pound of food equals (50 gallons of sunscreen)/(100 pounds of food), or an opportunity cost of 0.5 gallon of sunscreen per pound of food. Yucatan’s PPF is linear so the opportunity cost of producing 1 gallon of sunscreen is the same at all quantities. Calculate the opportunity cost of producing 1 gallon of sunscreen when increasing the production of sunscreen from 0 to 50 gallons per month. Between these two ranges of production, the quantity of food produced falls from 300 pounds per month to 200 pounds per month, a decrease of 100 pounds. The opportunity cost is 100 pounds of food to gain 50 gallons of sunscreen, or (100 pounds of food)/(50 gallons of sunscreen) which yields an opportunity cost of 2.0 pounds of food per gallon of sunscreen.

e. What is the relationship between your answers to part (c)? Answers (c) and (d) reflect the fact that opportunity cost is a ratio. The opportunity cost of gaining a unit of a good moving along the PPF equals the quantity of the other good or service forgone divided by the quantity of the good or service gained. The opportunity cost of one good, food, is equal to the inverse of the opportunity cost of the other good, sunscreen.

12.

What feature of a PPF illustrates increasing opportunity cost? Explain why Yucatan’s opportunity cost does or does not increase. If opportunity costs increase, the PPF bows outward. Yucatan’s PPF is linear and along a linear PPF the opportunity cost is constant. Yucatan does not face an increasing opportunity cost of food because the © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

opportunity cost remains constant, equal to 0.5 gallons of sunscreen per pound of food. Yucatan’s resources must be equally productive in both activities.

13.

In problem 11, what is the marginal cost of 1 pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan? The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

14.

The table describes the preferences in Yucatan. a. What is the marginal benefit of sunscreen and how is it measured?

Sunscreen (gallons per month) 25 75 125

Willingness to pay (pounds of food per gallon) 3 2 1

The marginal benefit of sunscreen is the benefit enjoyed by the person who consumes one more gallon of sunscreen. It is equal to the willingness to pay for an additional gallon. For example, in the table when 75 gallons of sunscreen are produced, the marginal benefit of a gallon is 2 pounds of food per gallon.

b. Using the table in Problem 11, what does Yucatan produce to achieve allocative efficiency? To achieve allocative efficiency, the marginal benefit of a gallon of sunscreen must equal the marginal cost of a gallon of sunscreen. Yucatan’s marginal cost of a gallon of sunscreen is 2 pounds of food per gallon. When Yucatan produces 75 gallons of sunscreen, the table shows that Yucatan’s marginal benefit is 2 pounds of food per gallon. Therefore, allocative efficiency is achieved when 75 gallons of sunscreen and, from the PPF, 150 pounds of food are produced.

15.

Up To 10,000 Retail Stores Could Close This Year Up to 10,000 U.S. storefronts could disappear by the end of 2021. Consumers prefer the safety of shopping online during the Covid-19 pandemic. Source: CBS News, January 28, 2021 a. Draw the PPF curves for storefront and online retailers before and after the Covid-19 pandemic. Before the Covid-19 pandemic, the production possibilities frontier was PPF0 in Figure 2.4. With thousands of storefronts closing, the PPF shifts inward along the horizontal axis to PPF1.

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b. Draw the marginal cost and marginal benefit curves for storefront retailers and online retailers before and after the Internet became available. The marginal benefit for the goods is the same regardless of whether they came from an online store or a storefront retailer. Therefore in Figure 2.5 the marginal benefit curve for retail goods is MB. The marginal cost of storefront retailing increases as the quantity increases, so both preand post-Internet, the storefront marginal cost curve is MCSTORE. Before the Internet, no online retailing could occur so the marginal cost curve is the vertical marginal cost curve MCPRE-INT running along the y-axis. After the Internet was developed online retailers have a lower marginal cost than do brick-and-mortar retailers, so the marginal cost curve of online retailers is MCPOST-INT.

c. Explain how changes in production possibilities, preferences, or both have changed the way in which goods are retailed. The change in production possibilities, which created lower-cost online retailers, have changed the way retail goods are produced. In addition, the Covid-19 pandemic changed people’s preferences in favor of online retailing. With the lower cost of online retailing and the increased preferences for online retailing, the quantity of online retailing increased.

Use the following news clip to work Problems 16 and 17. Defeat Malaria in a Generation—Here’s How The world could be free of malaria within a generation, a major report says. Malaria eradication within a generation is ambitious, achievable, and necessary. The report estimates around $4.3bn is spent on malaria every year. But it would need a further $2bn a year to rid the world of malaria by 2050. Source: BBC News, September 9, 2019 16. Does the report describe production efficiency or allocative efficiency or both? The report describes both allocative efficiency and production efficiency. The allocatively efficient quantity occurs when marginal cost equals marginal benefit. The assessment that malaria eradication is “necessary” indicates that it this is allocatively efficient quantity of malaria cases. It also discusses production efficiency when it suggests that spending an additional $2 billion a year is necessary to eliminate malaria. This increased spending represents a movement along the PPF.

THE ECONOMIC PROBLEM

17.

Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph, (i) Draw curves to show the marginal cost and marginal benefit of malaria eradication. (ii) Identify the quantity of malaria eradicated that achieves allocative efficiency. Figure 2.6 shows a marginal cost curve and a marginal benefit curve that are consistent with the report. The allocatively efficient quantity is the percentage of malaria cases eliminated for which the marginal benefit equals the marginal cost. The figure shows this allocatively efficient quantity to be 100 percent of malaria cases eliminated but because the article did not present enough detail, it the allocatively efficient quantity might less than 100 percent.

Use the following data to work Problems 18 and 19. Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour. 18. a. Calculate Kim’s opportunity cost of a pie and Liam’s opportunity cost of a pie. If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

b. If each spends 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each produce? Kim produces 20 pies and 200 cakes. Liam produces 50 pies and 100 cakes. The total number produced is 70 pies and 300 cakes.

c. Who has a comparative advantage in producing (i) pies and (ii) cakes? Liam has the comparative advantage in producing pies because his opportunity cost of a pie is less than Kim’s opportunity cost. Kim has the comparative advantage in producing cakes because her opportunity cost of a cake is less than Liam’s opportunity cost.

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19. a

Draw a graph of Kim’s PPF and Liam’s PPF and show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes.

Kim’s PPF is illustrated in Figure 2.7; Liam’s PPF is illustrated in Figure 2.8. Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

b. On your graph, show what Kim produces and what Liam produces when they specialize. Kim will specialize in cakes and Liam will specialize in pies. Point B in both figures shows the production points when each specializes.

c. When they specialize and trade, what are the total gains from trade? Kim will specialize in cakes and Liam will specialize in pies. If they specialize and trade, the total production of both cakes and pies increase. When each spends 30 minutes making cakes and 30 minutes making pies, together they produce 300 cakes and 70 pies. When they specialize, together they produce 400 cakes and 100 pies. The 100 increase in cakes and the 30 increase pies is the gains from trade.

d. If Kim and Liam share the total gains equally, what trade takes place between them? Kim will trade 50 cakes (half of the gain in cake production) to Liam in exchange for 15 pies (half of the increase in pie production).

Tony’s Production Possibilities Snowboards Skis (units per week) (units per week) 25 and 0 20 and 10 15 and 20 10 and 30 5 And 40 0 And 50 20.

Patty’s Production Possibilities Snowboards Skis (units per week) (units per week) 20 and 0 10 and 5 0 and 10

Tony and Patty produce skis and snowboards. The tables show their production possibilities. Tony produces 5 snowboards and 40 skis a week; Patty produces 10 snowboards and 5 skis a © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

week. a. Who has a comparative advantage in producing (i) snowboards and (ii) skis? (i) Tony’s opportunity cost of a snowboard is (10 skis)/(5 snowboards), or 2 skis per snowboard. Patty’s opportunity cost of a snowboard is (5 skis)/(10 snowboards), or 0.5 skis per snowboard. Patty’s opportunity cost of a snowboard is lower than Tony’s opportunity cost, so Patty has the comparative advantage. (ii) Tony’s opportunity cost of a ski is (5 snowboards)/(10 skis), or 0.5 snowboards per ski. Patty’s opportunity cost of a ski is (10 snowboards)/(5 skis), or 2.0 snowboards per ski. Tony’s opportunity cost of a ski is lower than Patty’s opportunity cost, so Tony has the comparative advantage.

b. If Tony and Patty specialize and trade 1 snowboard for 1 ski, what are the gains from trade? Tony has a comparative advantage in producing skis, so he specializes in producing skis. Patty has a comparative advantage in producing snowboards, so she specializes in snowboards. Tony now produces 50 skis and Patty produces 20 snowboards. Before specializing they produced a total of 45 skis (Tony’s 40 plus Patty’s 5) and 15 snowboards (Tony’s 5 plus Patty’s 10). By specializing, the total production of skis increases by 5 and the total production of snowboards increases by 5. This increase in total production is the gains from trade. By trading 1 ski for 1 snowboard, they can share these gains. Tony obtains snowboards from Patty for less than it costs him to produce them and Patty obtains skis from Tony for less than it costs her to produce them.

21.

Capital accumulation and technological change bring economic growth: Production that was unattainable yesterday becomes attainable today; production that is unattainable today will become attainable tomorrow. Why doesn’t economic growth bring an end to scarcity one day? Scarcity is always being defeated yet will never suffer defeat. Scarcity reflects the existence of unmet wants. People’s wants are infinite—regardless of what a person already possesses, everyone can easily visualize something else he or she wants, if only more time in the day to enjoy their possessions. Because people’s wants are insatiable, scarcity will always exist regardless of economic growth.

22.

SpaceX Plans to Send Three Tourists to the International Space station Next Year SpaceX CEO Elon Musk announced that SpaceX has plans to send three tourists on a 10-day trip to the International Space station in 2021. Source: The Verge, March 5, 2020 a. What is the opportunity cost of creating the technology for trips to the International Space Station? The opportunity cost of creating the technology is the next best alternative forgone by the resources used to develop this technology. For example, the engineers who are working to develop SpaceX’s technology might otherwise be assisting in the production of technology used to more powerful batteries, so the opportunity cost is the decrease in production of the more powerful battery.

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b. Sketch SpaceX’s PPF for trips to the International Space Station and other goods and services and show Space X’s planned production in 2021. Figure 2.9 shows SpaceX’s PPF. In 2021, SpaceX planned a trip to send three tourists to the International Space Station. Its planned production point in 2021 is labeled A, where it sends one trip to the International Space Station.

23.

On a graph of the circular flows in the market economy, indicate the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store. Figure 2.10 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

b. Apple Inc. pays the designers of the iPad. Apple’s payment to the designers of the iPad is the payment of a wage to a factor of production. This flow is in the grey arrow indicated by point b in the figure. The flow of design services from the designer to Apple is in the black arrow in the opposite direction to the grey arrow labeled b.

c. Apple Inc. decides to expand and rents an adjacent building. Apple’s decision to expand by renting a building means that Apple is increasing the capital it uses. This flow is in the black arrow indicated by point c in the figure. The flow of the payment for the rental services of the building is in the grey arrow in the opposite direction to the black arrow labeled c.

THE ECONOMIC PROBLEM

d. You buy a new e-book from Amazon. Your purchase of an e-book from Amazon is the purchase of a good from a firm. This flow is in the black arrow indicated by point d in the figure. When you pay for the e-book, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled d.

e. Apple Inc. hires a student to work as an intern. Apple’s decision to hire a student intern is Apple increasing the labor it uses. The flow of labor services is in the black arrow indicated by point e in the figure. The flow of the payment for the labor services is in the grey arrow in the opposite direction to the black arrow labeled c.

Economics in the News 24. After you have studied Reading Between the Lines on pp. 50–51, answer the following questions. a. How did Covid-19 change U.S. production possibilities in 2020? Covid-19 decreased the U.S. production possibilities and shifted the U.S PPF inward.

b. How did the rapid development and rollout of vaccines change the U.S. production possibilities in 2021? The rapid development and rollout of vaccines increased U.S. production possibilities and shifted the U.S. PPF outward.

c. How do productive resources get reallocated between private and government goods and services? Productive resources are reallocated so that the economy is producing at the allocatively efficient point.

d. How might the Biden spending packages change U.S. production possibilities after 2021? Some of the items in the $6 trillion Biden plan are productivity enhancing capital goods, such as transportation infrastructure, research and development, and education. The increase in the production of these items increases production possibilities, which would result in an increase in U.S. production possibilities after 2021.

25. Disney Hopes Wall Street Bets on New Global Streaming Service Walt Disney Co. unveiled details of a family-friendly streaming service on Thursday with TV shows and movies from some of the world’s most popular entertainment franchises. Disney says its new streaming service, Disney Plus, will cost $6.99 US per month. Source: Reuters, April 11, 2019 a. How has live streaming changed the production possibilities of video entertainment and other goods and services? b.

Live streaming has increased the production possibilities. For any quantity of other goods and services, now more video entertainment can be produced. The production possibilities frontier has changed so that the maximum quantity of video entertainment has increased but the maximum quantity of other goods and services has not changed.

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b. Sketch a PPF for video entertainment and other goods and services before live streaming. The PPF should have video entertainment on one axis and other goods and services on the other as illustrated in Figure 2.11. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of inexpensive live streaming has changed the PPF. The arrival of inexpensive live streaming shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.11. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve and marginal cost curve for video entertainment before and after live streaming. In Figure 2.12, the marginal benefit and marginal cost from video entertainment is measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis. As the figure shows, the marginal benefit curve is a conventional downward-sloping marginal benefit curve and the marginal cost curve is a conventional upward-sloping marginal cost curve. The introduction of low cost live streaming does not change the marginal benefit curve—it remains MB. But it lowers the marginal cost and shifts the marginal cost curve from MC0 to MC1.

e. Explain how the efficient quantity of video entertainment has changed. As Figure 2.12 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.12, the allocatively efficient quantity increases from 4 million units per year to 6 million units per year

C h a p t e r

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Answers to the Review Quizzes Page 60 1.

What is the distinction between a money price and a relative price? The money price of a good is the dollar amount that must be paid for it. The relative price of a good is its money price expressed as a ratio to the money price of another good. Thus the relative price is the amount of the other good that must be foregone to purchase a unit of the first good.

Explain why a relative price is an opportunity cost. The relative price of a good is the opportunity cost of buying that good because it shows how much of the next best alternative good must be forgone to buy a unit of the first good.

Think of examples of goods whose relative price has risen or fallen by a large amount. Some examples of items where both the money price and the relative price have risen over time are gasoline, college tuition, and food. Some examples of items where both the money price and the relative price have fallen over time are personal computers, HD televisions, and calculators.

Describe a competitive market in which you buy or sell a good or service. Fruits and vegetables have highly competitive markets. Students who buy in these markets have no influence over the price because there are literally millions of buyers and any students whose families (or themselves) who sell in these markets also have no influence over the price because there are hundreds of thousands of sellers.

Page 65 1.

Define the quantity demanded of a good or service. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

What is the law of demand and how do we illustrate it? The law of demand states: “Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.” The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the smaller is the quantity demanded and the lower the price of a good, the greater is the quantity demanded.

What does the demand curve tell us about the price that consumers are willing to pay? For any fixed quantity of a good available, the vertical distance of the demand curve from the x-axis shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

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List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand. Influences that change the demand for a good include:  The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good. A rise (fall) in the price of a complement decreases (increases) the demand for the first good.



The expected future price of the good. A rise (fall) in the expected future price of a good increases (decreases) the demand in the current period.



Income. An increase (decrease) in income increases (decreases) the demand for a normal good. An increase in income decreases (increases) the demand for an inferior good.



Expected future income and credit. An increase (decrease) in expected future income or credit increases (decreases) the demand.



The population. An increase (decrease) in population increases (decreases) the demand.



People’s preferences. If people’s preferences for a good rise (fall), the demand increases (decreases).

Why does demand not change when the price of a good changes with no change in the other influences on buying plans? If the price of a good falls and nothing else changes, then the quantity of the good demanded increases and there is a movement down along the demand curve, but the demand for the good remains unchanged and the demand curve does not shift.

During the Covid-19 lockdown, yeast’s popularity increased as millennials and home chefs were willing and able to spend more time cooking. Did yeast’s increased popularity increase demand or the quantity of yeast demanded. Yeast’s popularity reflects an increase in demand due to a change in people’s preferences.

Page 69 1.

Define the quantity supplied of a good or service. The quantity supplied of a good or service is the amount of the good or service that firms plan to sell in a given period of time at a specified price.

What is the law of supply and how do we illustrate it? The law of supply states that “other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.” The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied and the lower the price of a good, the smaller is the quantity supplied.

What does the supply curve tell us about the producer’s minimum supply price? For any quantity, the vertical distance between the supply curve and the x-axis shows the minimum price that suppliers must receive to produce that quantity of output. As a result, the price is the marginal cost of the last unit produced at this level of output.

List all the influences on selling plans, and for each influence, say whether it changes supply. Changes in the price of the good change the quantity supplied. They do not change the supply of the good. Influences that change the supply of a good include:  Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good.

DEMAND AND SUPPLY



Prices of related goods produced. If the price of a substitute in production rises (falls), firms decrease (increase) their sales of the original good and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease).



The expected future price of the good. A rise (fall) in the expected future price of the good decreases (increases) the amount suppliers sell today. This change in expectations decreases (increases) the supply in the current period.



The number of sellers. An increase (decrease) in the number of sellers in a market increases the quantity of the good available at every price, and increases (decreases) the supply.



Technology. An advance in technology increases the supply.



The state of nature. A good (bad) state of nature, such as good (bad) weather for agricultural products, increases (decreases) the supply.

What happens to the quantity of smartphones supplied and the supply of smartphones if the price of a smartphone falls? If the price of a smartphones falls and nothing else changes, then the quantity of smartphones supplied will decrease and there is a movement down along the supply curve for smartphones. The supply of smartphones, however, remains unchanged and the supply curve does not shift.

The price of the cheese that goes on top of a burger rose 18 percent during 2020. Did this higher price change the quantity of burgers supplied or the supply of burgers? The higher price changed the supply of burgers because it reflects a change in the price of a factor of production.

Page 71 1.

What is the equilibrium price of a good or service? The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

Over what range of prices does a shortage arise? What happens to the price when there is a shortage? A shortage arises at market prices below the equilibrium price. A shortage causes the price to rise, decreasing quantity demanded and increasing quantity supplied until the equilibrium price is attained.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus? A surplus arises at market prices above the equilibrium price. A surplus causes the price to fall, decreasing quantity supplied and increasing quantity demanded until the equilibrium price is attained.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price? At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by producers. At this price, the plans of producers and consumers are coordinated and there is no influence on the price to move away from equilibrium.

Why is the equilibrium price the best deal available for both buyers and sellers? The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service and is just equal to the minimum price that suppliers require for delivering it. Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. Hence neither demanders not suppliers can do business at a better price.

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Page 77 What is the effect on the price and quantity of smartphones if 1. The price of a music-streaming subscription falls or the price of a wireless plan rises? (Draw the diagrams!) Because a large majority of smartphone owners listen to streaming music on their smartphones (68 percent according to a study published by Digital Music News), streaming music is a complement of a smartphone. A fall in the price of a music-streaming subscription increases the demand for smartphones. The demand curve for smartphones shifts rightward. Supply remains unchanged. The price of a smartphone rises and the quantity increases. Figure 3.8 on page 72 illustrates this sort of change. A rise in the price of a wireless plan decreases the demand for smartphones because a wireless plan is a complement of a smartphone. The demand curve for smartphones shifts leftward. Supply remains unchanged. The price of a smartphone falls and the quantity decreases.

More firms produce smartphones or electronics workers’ wages rise? (Draw the diagrams!) An increase in the number of firms that produce smartphones increases the supply of smartphones. The supply curve of smartphones shifts rightward. Demand remains unchanged. The price of a smartphone falls and the quantity of smartphones increases. You can illustrate this outcome by drawing a diagram like Figure 3.9 on page 74. A rise in the wages of electronic workers decreases the supply of smartphones because it increases the cost of producing smartphones. The supply curve of smartphones shifts leftward. Demand remains unchanged. The price of a smartphone rises and the quantity of smartphones decreases.

Any two of these events in questions 1 and 2 occur together? (Draw the diagrams!) There are six combinations: (1) If the price of a music streaming service falls and the price of a wireless plan rises, supply is unchanged and demand might increase, decrease, or not change so the outcome cannot be predicted. (2) If the price of a music streaming service falls and more firms produce smartphones, demand increases and supply increases so the quantity increases and the price might rise, fall, or not change. (3) If the price of a music-streaming service falls and the wages paid electronic workers rise, demand increases and supply decreases so the price rises and the quantity might increase, decrease, or not change. (4) If the price of a wireless plan rises and more firms produce smartphones, demand decreases and supply increases so the price falls and quantity might increase, decrease, or remain the same. (5) If the price of a wireless plan rises and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise, fall, or remain the same. (6) If more firms produce smartphones and the wages paid electronics workers rise, demand is unchanged and supply might increase or decrease or remain unchanged, so the outcome cannot be predicted.

DEMAND AND SUPPLY

Answers to the Study Plan Problems and Applications 1.

In April 2014, the money price of a carton of milk was $2.01 and the money price of gallon of gasoline was $3.63. Calculate the relative price of a gallon of gasoline in terms of milk. The relative price of a gallon of gasoline in terms of milk equals ($3.63 per gallon of gasoline)/($2.01 per carton of milk) = 1.81 cartons of milk per gallon of gasoline.

The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to other goods and services. The law of demand applies to food because there is both a substitution and an income effect that reinforce each other. When the price of food rises, people substitute to different foods. For instance, some might substitute home cooked meals for dining at a restaurant. And when the price rises, there is a negative income effect, so people buy less food overall with the rising price. On both counts, the higher price of food decreases the quantity of food demanded.

b. Explain how the substitution effect influences food purchases when the price of food rises and other things remain the same. When the price of food rises, people substitute away from (some) foods and toward other foods and other activities. People substitute cheaper foods for more expensive foods and they also substitute diets for food.

c. Explain how the income effect influences food purchases and provide some examples of the income effect. Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

Which of the following goods are likely substitutes and which are likely complements? (You may use an item in more than once.): coal, oil, natural gas, wheat, corn, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPad, smartphone, text message, email Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; laptop and iPad; and, text message and email. Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPad; roller blades and iPad; video game (those played on a computer) and laptop; smartphone and text message; and, smartphone and email.

As the average income in China continues to increase, explain how the following would change: a. The demand for beef Beef is a normal good. The increase in income increases the demand for beef.

b. The demand for rice Rice is probably an inferior good. The increase in income decreases the demand for rice.

In 2016, the price of corn fell and some corn farmers will switch from growing corn in 2017 to growing soybeans. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: the lower price of corn decreases the quantity of corn grown.

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b. Why would a corn farmer grow soybeans? Corn and soybeans are substitutes in production and soybeans have become more profitable. A corn farmer would switch to soybeans because the profit from growing soybeans exceeds that from growing corn.

Dairies make low-fat milk from full-cream milk, and in the process they produce cream, which is made into ice cream. The following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With a drought forecasted, dairies raise their expected price of low-fat milk next year. (v) New technology lowers the cost of producing ice cream. Explain the effect of each event on the supply of low-fat milk. (i) Dairy workers are a factor used to produce low-fat milk. The price of a factor of production rises, which decreases the supply of low-fat milk. (ii) Cream and low-fat milk are complements in production. The price of a complement in production rises, which increases the supply of low-fat milk. (iii) A rise in the price of low-fat milk does not change the supply of low-fat milk. It does, however, increase the quantity of low-fat milk supplied. (iv) The higher expected price of low-fat milk decreases the (current) supply of low-fat milk. (v) Ice cream and low-fat milk are complements in production. The lower cost of producing ice cream increases the quantity of ice cream produced, which increases the supply of low-fat milk.

The demand and supply schedules for gum are in the table. a. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

Price (cents per pack) 20 40 60 80

Quantity Quantity demanded supplied (millions of packs a week) 180 60 140 100 100 140 60 180

At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

b. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts. At 30 cents a pack, there is a shortage of gum and the price rises. At 30 cents a pack, the quantity demanded is 160 million packs a week and the quantity supplied is 80 million packs a week. There is a shortage of 80 million packs a week. The price rises until market equilibrium is restored at a price of 50 cents a pack.

The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs. Explain the effect of each of these events on the market for gasoline. (ii) and (iii) and (iv) change the demand for gasoline. The demand for gasoline will change if the price of a car rises, all speed limits on highways are abolished, or robot production cuts the cost of producing a car. If the price of a car rises, the quantity of cars bought decrease and the demand for gasoline decreases. If all © 2023 Pearson Education, Inc.

DEMAND AND SUPPLY

speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

In Problem 7, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes. As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.1, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. At the time as the fire, the teenage population increases and the quantity of gum demanded increases 40 million packs a week at each price. What is the new market equilibrium? Show the changes on your graph. The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.2 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

10.

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Singing the Blues: March Frost Destroys State Blueberry Crop Chris and Rhonda Luther had big plans for their small blueberry farm, but freezing temperatures killed these plans, reducing their usual output by about 95 percent. The Georgia Department of Agriculture estimates the freeze to have cut production 80 percent. Source: Red and Black, March 25, 2017 Make a graph to illustrate the market for blueberries before and after the unusually cold March weather. Figure 3.3 shows the effect of the freezing temperatures on the blueberry market. The demand curve is labeled D. The freeze did not affect the demand for blueberries, so the demand curve does not shift. The freeze was a bad state of nature and decreased the supply of blueberries, shifting the supply curve leftward. The supply curve labeled S0 reflects the supply before the freeze and the supply curve labeled S1 shows the supply after the freeze. The equilibrium price of a pound of blueberries rises from $0.60 per pound to $2.40 per pound and the equilibrium quantity decreases from 5 million pounds of blueberries 1 million pounds.

DEMAND AND SUPPLY

Answers to Additional Problems and Applications 11.

What features of the world market for crude oil make it a competitive market? The world oil market is a competitive market because there are a large number of sellers and a large number of buyers. There are so many sellers and so many buyers that no individual seller or individual buyer can influence the price of oil.

12.

The money price of a textbook is $90 and the money price of the Nintendo Switch game Super

Mario 3D All Stars is $45. a. What is the opportunity cost of a textbook in terms of the Nintendo Switch game? A textbook costs $90 and a Switch game costs $45. Purchasing 1 textbook forces the buyer to give up 2 Switch games. So the opportunity cost of a textbook in terms of Switch games is 2 Switch games per textbook.

b. What is the relative price of the Nintendo Switch game in terms of textbooks? The relative price of a Switch game in terms of textbooks equals ($45 per Switch game)/($90 per textbook), which is 1/2 of a textbook per Switch game.

13.

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services. When the price of gasoline rises, people decrease the quantity of gasoline they demand. Both the substitution effect and the income effect lead consumers to decrease the quantity of gasoline demanded.

b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people substitute other goods and services for gasoline. For instance, people substitute public transport (such as buses), carpools, motorcycles, walking, and bicycles for driving alone in a car to work.

c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people’s real incomes fall. People respond by decreasing their demand for normal goods, such as gasoline. In the gasoline market, some people trade in large, fuel guzzling cars because they can no longer afford to fuel the large vehicle. Others will not purchase a car or truck because they are not able to afford the gasoline necessary to use it.

14.

Think about the demand for the three game consoles: Xbox Series X, PlayStation 5, and Wii U. Explain the effect of the following events on the demand for Xbox Series X games and the quantity of Xbox Series X games demanded, other things remaining the same. The events are: a. The price of an Xbox Series X falls. An Xbox Series X and an Xbox Series X game are complements. When the price of an Xbox Series X falls, consumers respond by increasing the quantity of Xbox Series X demanded so the equilibrium quantity of Xbox Series X increases. Consumers increase their demand for Xbox Series X games because an Xbox Series X console is useless without Xbox Series X games.

b. The prices of a PlayStation 5 and a Wii U fall. A PlayStation 5 and a Wii U are substitutes for an Xbox Series X. When these game consoles fall in price, the demand for Xbox Series X consoles decreases and so the equilibrium quantity of Xbox Series X decreases. Consumers decrease their demand for Xbox Series X games because an Xbox Series X game is useless without an Xbox Series X console.

c. The number of people writing and producing Xbox Series X games increases. The increase in the number of people writing Xbox Series X games increases the supply of Xbox Series X games. The demand for Xbox Series X games does not change but the increase in the supply lowers the © 2023 Pearson Education, Inc.

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price of an Xbox Series X game. The fall in the price of Xbox Series X games increases the quantity of Xbox Series X demanded.

d. Consumers’ incomes increase. Xbox Series X games are surely a normal good. So, an increase in consumers’ incomes increases the demand for Xbox Series X games.

e. Programmers who write code for Xbox Series X games become more costly to hire. The increase in the cost of programmers decreases the supply of Xbox Series X games. When the supply of a good or service decreases, the price of that good or service rises. Xbox Series X games are not an exception, so the price of an Xbox Series X game rises. The rise in the price of an Xbox Series X game decreases the quantity of Xbox Series X games demanded.

The expected future price of an Xbox Series X game falls. When the price of an Xbox Series X game is expected to fall, the (current) demand for Xbox Series X games decreases.

g. A new game console that is a close substitute for Xbox Series X comes onto the market. The new game console decreases the demand for Xbox Series X consoles. As a result, the equilibrium quantity of Xbox Series X consoles decreases. Consumers decrease their demand for Xbox Series X games because an Xbox Series X game is useless without an Xbox Series X console.

15.

Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Bottled water and health club memberships Bottled water and health club memberships are neither substitutes in production nor complements in production. (For consumers, these are complements because people in health clubs drink a lot of bottled water.)

b. French fries and baked potatoes For a restaurant that produces both French fries and baked potatoes, they are substitutes in production. (For a consumer, they are substitutes.)

c. Leather boots and leather shoes Leather boots and leather shoes are substitutes in production.

d. Hybrids and SUVs For an auto company that produces both on the same assembly line, they are substitutes in production. (For a consumer, hybrids and SUVs are substitutes.)

e. Diet coke and regular coke For a soda company that produces both on the same assembly line, they are substitutes in production. (For a consumer, Diet coke and regular coke are substitutes.)

16.

When a timber mill makes logs from trees it also produces sawdust, which is used to make plywood. a. Explain how a rise in the price of sawdust influences the supply of logs. The rise in the price of sawdust motivates timber mills to make more sawdust, which thereby increases the demand for logs and raises the price of logs. There is no change in the supply of logs but instead a change in the quantity of logs supplied.

b. Explain how a rise in the price of sawdust influences the supply of plywood. The rise in the price of sawdust motivates timber mills to make more sawdust, which thereby increases the supply of plywood.

DEMAND AND SUPPLY

17.

New Maple Syrup Tap Method With the new way to tap maple trees, farmers could produce 10 times as much maple syrup per acre. Source: cbc.ca, February 5, 2014 Will the new method change the supply of maple syrup or the quantity supplied of maple syrup, other things remaining the same? Explain. The new technology increases the supply of maple syrup. At each price, the new technology increases the quantity that will be supplied. The supply curve shifts rightward.

Use Figure 3.4 to work Problems 18 and 19. 18. a. Label the curves. Which curve shows the willingness to pay for a pizza? The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

b. If the price of a pizza is $16, is there a shortage or a surplus arise? Does the price rise or fall? If the price of a pizza is $16, there is a surplus of pizza; the quantity supplied of pizzas exceeds the quantity demanded. The surplus forces the price lower to the equilibrium price of $14 a pizza.

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza? Sellers are willing to accept less than $16 because if they charge $16 the surplus means that some sellers have unsold pizzas. From their perspective it is better to have a lower price for the pizza and sell the (decreased) quantity they produce than to keep the price at $16 and be left with unsold pizza.

19. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $12, there is a shortage of pizza; the quantity demanded of pizzas exceeds the quantity supplied. The shortage forces the price higher to the equilibrium price of $14 a pizza.

b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza? If the price of a pizza is $12 the shortage means that not all buyers can buy a pizza. From their perspective they would rather pay more than $12 and be able to purchase a pizza than to keep the price at $12 and leave them without a pizza.

20.

The demand and supply schedules for potato chips are in the table. a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity. Figure 3.5 (on the next page) draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

Price (cents per bag) 50 60 70 80 90 100

Quantity Quantity demanded supplied (millions of bags a week) 160 130 150 140 140 150 130 160 120 170 110 180

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b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust? At 60¢ a bag, there is a shortage of potato chips and the price rises. At 60¢ a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 140 million bags a week. The difference is a shortage of 10 million bags a week. The price rises until market equilibrium is restored—65¢ a bag and 145 million bags a week.

21.

In Problem 20, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change. As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change? Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.6 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

22.

In Problem 20, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change? The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

23.

If the virus in Problem 22 hits just as the new dip in Problem 21 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change? The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

DEMAND AND SUPPLY

24.

Car Rental Costs are Spiking During Covid, the used car market turned red hot. Rental companies sold vehicles and slashed replacement orders. Now leisure travel is increasing, and a car rental is going to be expensive. Source: nbcnews.com, April 16, 2021 a. Explain how the market for rental cars changed as the used car market “turned red hot.” Draw a graph to illustrate your answer.

In the market for rental cars the supply of rental cars decreased as the companies sold their vehicles and cut replacement orders. As illustrated in Figure 3.7, the supply curve of rental cars shifted leftward, from S0 to S1, so the price of a rental increased, from $10 per day to $30 per day, and the quantity decreased, from 5 million per day to 3 million per day.

b. How did the increase in leisure travel change the car rental market? Illustrate your answer. The increase in leisure travel increased the demand for rental cars. As illustrated in Figure 3.8, the demand curve for rental cars shifted rightward, from D0 to D1, so the price of a rental increased, from $30 per day to $50 per day, and the quantity increased, from 3 million per day to 4 million per day.

25.

Why Is the Covid-19 Pandemic Causing a Ketchup Shortage? More takeout orders mean more ketchup packets. A ketchup shortage caused packet prices to rise 13% since January 2020. Heinz is working to increase production to 12 billion packets a year. Source: abc7news.com, April 7, 2021 a. Explain the effect of more takeout orders on the market for ketchup. Ketchup packets are frequently included as part of takeout orders for burgers, fries, and so forth. An increase in the number of takeout orders increased the demand for ketchup, so the demand curve for ketchup shifted rightward.

b. Why did a ketchup shortage raise the price? The ketchup shortage meant that at the current price the quantity of ketchup demanded exceeded the quantity supplied. When there is a shortage of ketchup, consumers who value ketchup more highly than its current price are willing to pay the higher price, and producers who see unsatisfied customers raise the price and increase output. © 2023 Pearson Education, Inc.

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c. How will Heinz’s increased production change the ketchup market? Heinz’s increased production is a movement up along Heinz’s supply curve. This will increase the quantity of ketchup supplied in the market and reduce any shortage.

26.

True Cause of the Toilet Paper Shortage Grocers say there isn’t a supply shortage but it takes time for manufacturers to catch up to the big spike in demand. Suppliers are shipping more than normal, but consumers are buying much more than normal. Source: washingtonpost.com, April 7, 2020 What happens to the market equilibrium when “suppliers are shipping more than normal, but consumers are buying much more than normal”? Both the demand and supply curve shift rightward, however the shift in the demand curve exceeds the shift in the supply in the supply curve. As a result, the price of toilet paper rises and the quantity increases.

27.

Supply and Demand: Shortages Across America Run Deep Microchip shortages are limiting production of new cars and sending prices of used cars soaring. Car dealerships across the country are now in a dog eat dog fight to buy up used cars. Source: abcactionnews.com, May 11, 2021 Explain the effect of microchip shortages on the market for new cars and the market for used cars. In the market for new cars, the microchip shortages decrease the supply of new cars, thereby shifting the supply curve to the left. The price of a new car rises and the quantity decreases. New cars and used cars are substitutes for consumers. The rise in the price of a new car increases the demand for used cars, and the demand curve for used cars shifts rightward. Consequently, the price of a used car rises and the quantity increases.

28.

After you have studied Economics in the News on pp. 78–79, answer the following questions. a. Why are spirits and hand sanitizer substitutes in production? Hand sanitizer is made from alcohol. Spirits, such as vodka or gin or whiskey, are also made from alcohol. Distilleries, which make alcohol, can use the alcohol to produce either hand sanitizer or spirits, so hand sanitizer and spirits are substitutes in production.

b. Why did the increase in demand for hand sanitizer increase the quantity supplied and not increase supply? The increase in demand for hand sanitizer increased the price of hand sanitizer. A higher price increases the quantity supplied and creates a movement upward along the supply curve. It does not increase the supply and does not shift the supply curve.

c. What would have happened to the supply of hand sanitizer if the price of spirits had fallen? If the price of spirits fell, distilleries would have shifted from producing spirits to hand sanitizer. This change would increase the supply of hand sanitizer and shift its supply curve rightward.

d. How would the supply of spirits have changed when the price of hand sanitizer increased? If the price of hand sanitizer rose, distilleries would have shifted from producing spirits to hand sanitizer. This change would decrease the supply of spirits and shift its supply curve leftward.

e. What are the powerful market forces that operated in the market for hand sanitizer? Consumers’ preferences changed so they demanded more hand sanitizer because of the pandemic, which created a shortage of hand sanitizer. Powerful market forces operated to eliminate the shortage by raising the price. The higher price increased the quantity of hand sanitizer supplied, as firms produced more hand sanitizer to profit from the higher price, which worked to eliminate the shortage. The higher price decreased the quantity of hand sanitizer demanded, which also worked to eliminate the shortage.

C h a p t e r

ELASTICITY

Answers to the Review Quizzes Page 94 1.

Why do we need a units-free measure of the responsiveness of the quantity demanded of a good or service to a change in its price? The elasticity of demand is a units-free measure. Compare it as a measure of the responsiveness to some other candidate that depends on the units, such as the slope. The slope of the demand curve changes as the units measuring the same quantity of the good change (going from pounds to ounces, for example). The value of the elasticity is independent of the units used to measure the price and quantity of the product. As a result, the elasticity can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. The elasticities of different goods also can be compared even though they are measured in different units.

Define the price elasticity of demand and show how it is calculated. The price elasticity of demand is units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. It equals the absolute value (or magnitude) of the ratio of the percentage change in the quantity demanded to the percentage change in the price. The percentage change in quantity (price) is measured as the change in quantity (price) divided by the average quantity (price).

What makes the demand for some goods elastic and the demand for other goods inelastic? The magnitude of the price elasticity of demand for a good depends on three main influences:



Closeness of substitutes. The more easily people can substitute other items for a particular good, the larger is the price elasticity of demand for that good.



The proportion of income spent on the good. The larger the portion of the consumer’s budget being spent on a good, the greater is the price elasticity of demand for that good.



The time elapsed since a price change. Usually, the more time that has passed after a price change, the greater is the price elasticity of demand for a good.

Why is the demand for a luxury generally more elastic (or less inelastic) than the demand for a necessity? Demand for a necessity is generally less elastic than demand for a luxury because there are fewer substitutes for a necessity. Because there are more substitutes for a luxury than a necessity, the elasticity of demand for a luxury is larger is than the elasticity of demand for a necessity.

What is the total revenue test? The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue, given a change in price, holding all other things constant. The total revenue test shows that a price cut increases total revenue if demand is elastic, decreases total revenue if demand is inelastic, and does not change total revenue if demand is unit elastic.

What does the sign (positive/negative) of the total revenue test tell us about the good? If the sign of the total revenue test is positive when the price rises, this tells us that the demand is inelastic. If the sign of the total revenue test is negative when the price rises, this tells us that the demand is elastic. © 2023 Pearson Education, Inc.

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If the sign of the total revenue test is positive when the price falls, this tells us that the demand is elastic. If the sign of the total revenue test is negative when the price falls, this tells us that the demand is inelastic.

Page 98 1.

What does the income elasticity of demand measure? The income elasticity of demand measures how the quantity demanded of a good responds to a change in income. The formula for the income elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in income.

What does the sign (positive/negative) of the income elasticity of a good tell us about the good? The sign of the income elasticity of demand reveals whether a good is a normal good or an inferior good: The income elasticity of demand is positive for normal goods and negative for inferior goods.

What does the cross elasticity of demand measure? The cross elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good. The formula for the cross elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in the price of the related good.

Show how to calculate the cross elasticity of demand. The cross elasticity of demand equals the percentage change in the quantity of one good demanded divided by the percentage change in the price of a complement or substitute.

What does the sign (positive/negative) of the cross elasticity of demand tell us about the relationship between two goods? The sign of the cross elasticity of demand reveals whether two goods are substitutes or compliments: The cross elasticity of demand is positive for substitutes and negative for complements.

Page 100 1.

Why do we need a units-free measure of the responsiveness of the quantity supplied of a good or service to a change in its price? The elasticity of supply is a units-free measure. We need a units-free measure of the elasticity of supply for the same reason we need a units-free measure of the elasticity of demand: Because the value of the elasticity of supply is independent of the units used to measure the price and quantity of the good, the elasticity of supply can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. In addition, the elasticities of supply of different goods also can be compared even though they are measured in different units.

Define the elasticity of supply and show how it is calculated. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. The elasticity of supply is calculated by the percentage change in the quantity supplied divided by the percentage change in the price.

What are the main influences on the elasticity of supply that make the supply of some goods elastic and the supply of other goods inelastic? The main influences on the elasticity of supply are: 

Resource substitution possibilities: the greater the suppliers’ ability to substitute resources, the greater will be their ability to react to price changes and the greater the elasticity of supply.



Time frame for the supply decision: the greater the amount of time available after the price change, the greater is the suppliers’ ability to adjust quantity supplied, and the greater the elasticity of supply.

ELASTICITY

4. Provide examples of goods or services whose elasticities of supply are (a) zero, (b) greater than zero but less than infinity, and (c) infinity. Here are some examples: a) The momentary supply of wheat is perfectly inelastic. Once farmers have brought their wheat to market, there is no other alternative use for it and they sell it all regardless of the going price. b) The short-run supply of wheat. If the farmers already have a mature wheat crop but have not yet harvested it, farmers with both relatively high and low yield fields may chose to harvest both types of fields if the price for wheat is high. However, the farmers will not harvest their low yield fields when the price of wheat is relatively low to economize on added labor costs. c) The supply of wheat to an individual buyer. Any one buyer can purchase as much wheat at the going price as he or she desires. However, no quantity of wheat will be supplied at a lower price.

How does the time frame over which a supply decision is made influence the elasticity of supply? Explain your answer. The momentary supply, short-run supply, and long-run supply all illustrate the response of suppliers to changes in the price, but they differ according to how much time has elapsed after the price change. 

The momentary supply is frequently the least elastic and shows how suppliers cannot easily respond to a price change immediately after the price change occurs. Changing the quantity produced means changing the inputs into the production process, which takes time to complete. Sometimes the momentary supply is perfectly inelastic.



The short-run supply shows suppliers’ response after enough time has elapsed for some, but not all, of the possible technological adjustments have occurred. Short-run supply generally is intermediate in elasticity between the momentary supply and the long-run supply.



The long-run supply shows how suppliers react after enough time has passed that all possible adjustments to factors of production have been made to accommodate the price change. It usually is the most elastic of the three supplies.

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Answers to the Study Plan Problems and Applications 1.

Rain spoils the strawberry crop, the price rises from $4 to $6 a box, and the quantity demanded decreases from 1,000 to 600 boxes a week. a. Calculate the price elasticity of demand over this price range. The price elasticity of demand is 1.25. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price rises from $4 to $6 a box, a rise of $2 a box. The average price is $5 a box. So the percentage change in the price is $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 1,000 to 600 boxes, a decrease of 400 boxes. The average quantity is 800 boxes. So the percentage change in quantity is 400 divided by 800, which equals 50 percent. The price elasticity of demand for strawberries is 50 percent divided by 40 percent, which equals 1.25.

b. Describe the demand for strawberries. The price elasticity of demand exceeds 1, so the demand for strawberries is elastic.

If the quantity of dental services demanded increases by 10 percent when the price of dental services falls by 10 percent, is the demand for dental services inelastic, elastic, or unit elastic? The demand for dental services is unit elastic. The price elasticity of demand for dental services equals the percentage change in the quantity of dental services demanded divided by the percentage change in the price of dental services. The price elasticity of demand is 10 percent divided by 10 percent, which equals 1. The demand is unit elastic.

The demand schedule for hotel rooms is in the table. a. What happens to total revenue when the price falls from $400 to $250 a room per night and from $250 to $200 a room per night?

Price (dollars per night) 200 250 400 500 800

Quantity demanded (millions of rooms per night) 100 80 50 40 25

When the price is $400, the total revenue is equal to $400 × 50 million rooms, or $20 billion. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. When the price is $200, the total revenue is equal to $200 × 100 million rooms, or $20 billion. So, the total revenue does not change when the price falls from $400 to $250 a night.

b. Is the demand for hotel rooms elastic, inelastic or unit elastic? The total revenue is the same at all prices, $20 billion. Because a change in price does not change the total revenue at any price, the demand is unit elastic at all prices.

ELASTICITY

The figure shows the demand for pens. Calculate the elasticity of demand when the price rises from $4 to $6 a pen. Over what price range is the demand for pens elastic? The price elasticity of demand is 0.72. When the price of a pen rises from $4 to $6, the quantity demanded of pens decreases from 80 to 60 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $4 to $6, an increase of $2 a pen. The average price is $5 per pen. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 80 to 60 pens, a decrease of 20 pens. The average quantity is 70 pens. So, the percentage change in quantity demanded equals 20 divided by 70 and then multiplied by 100, which equals 28.6 percent. The price elasticity of demand for pens equals 28.6 percent divided by 40 percent, which is 0.72. The demand for pens is elastic at all prices higher than the price at the midpoint of the demand curve, which indicates that the demand for pens is elastic at prices between $12 per pen and $6 per pen.

In 2015, an outbreak of Avian Flu decreased the quantity of eggs produced by 18 percent. A shortage of eggs was avoided by a rise in their wholesale price from $1.34 to $2.40 per dozen. a. If the demand for eggs didn’t change, what is your estimate of the price elasticity of demand for eggs? Using the data in the question, the price elasticity of demand is 0.32. The change in the price is $1.06 and the average of the two prices is $1.87, so the percentage change in the price is ($1.06/$1.87)  100, which equals 56.7 percent. The increase in the quantity demanded was 18 percent. The price elasticity of demand equals (18.0 percent)/(56.7 percent), or 0.32.

b. Thinking about the influences on the price elasticity of demand, why would you expect the demand for eggs to be inelastic? The smaller the proportion of income spent on a good, the smaller the elasticity of demand for that good. In many circumstances, the amount of a person’s income spent on eggs is small, so that the demand for eggs is inelastic.

When Judy’s income increased from $130 to $170 a week, she increased her demand for concert tickets by 15 percent and decreased her demand for bus rides by 10 percent. Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

a. b. 7.

The income elasticity of demand for (a) concert tickets is 0.56 and (b) bus rides is −0.375. The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $40 and the average income is $150, so the percentage change in income equals 26.7 percent. The change in the quantity demanded of concert tickets is 15 percent. The income elasticity of demand for concert tickets equals 15/26.7, which is 0.56. The change in the quantity demanded of bus rides is 10 percent. The income elasticity of demand for bus rides equals 10/26.7, which is 0.375.

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demanded by 22 percent and increases the quantity of apple juice demanded by 14 percent, calculate the a. Price elasticity of demand for orange juice. The price elasticity of demand for orange juice is 1.83. The price elasticity of demand is the percentage change in the quantity demanded of the good divided by the percentage change in the price of the good. So the price elasticity of demand equals 22 percent divided by 12 percent, which is 1.83.

b. Cross elasticity of demand for apple juice with respect to the price of orange juice. The cross elasticity of demand between orange juice and apple juice is 1.17. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. So the cross elasticity of demand is the percentage change in the quantity demanded of apple juice divided by the percentage change in the price of orange juice. The cross elasticity equals 14 percent divided by 12 percent, which is 1.17.

If a rise in the price of sushi from 98¢ to $1.02 a piece decreases the quantity of soy sauce demanded from 101 units to 99 units an hour and decreases the quantity of sushi demanded by 1 percent an hour, calculate the: a. Price elasticity of demand for sushi. The price of sushi rises by ($1.02 − $0.98)/$1.00 = 4 percent. Therefore the price elasticity of demand for sushi equals |( −1 percent)/(4 percent)|, which is 0.25.

b. Cross elasticity of demand for soy sauce with respect to the price of sushi. The quantity of soy sauce decreases by (99 – 101)/100 = −2 percent. Therefore the cross elasticity of demand for soy sauce with respect to the price of sushi equals |( −2 percent)/(4 percent), which is −0.5.

The table sets out the supply schedule of jeans. a. Calculate the elasticity of supply when the price rises from $125 to $135 a pair.

Price (dollars per pair) 120 125 130 135

Quantity supplied (millions of pairs per year) 24 28 32 36

The elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in price. The percentage change in the quantity demanded equals [(36  28)/32] × 100, which is 25.0 percent. The percentage change in the price equals [($135  $125)/$130] × 100, which is 7.7 percent. The elasticity of supply equals (25.0 percent/7.7 percent), which is 3.25.

b. Calculate the elasticity of supply when the average price is $125 a pair. To find the elasticity at an average price of $125 a pair, change the price such that $125 is the average price—for example, a rise in the price from $120 to $130 a pair. To calculate the elasticity when the average price is $125, calculate the elasticity over the price range from $120 to $130. The percentage change in the quantity demanded equals [(32  24)/28] × 100, which is 28.6 percent. The percentage change in the price equals [($130  $120)/$125] × 100, which is 8.0 percent. The elasticity of supply equals (28.6 percent/8.0 percent), which is 3.58.

c. Is the supply of jeans elastic, inelastic, or unit elastic? The supply of jeans is elastic.

ELASTICITY

Answers to Additional Problems and Applications 10.

With higher fuel costs, airlines raised their average fare from 75¢ to $1.25 per passenger mile and the number of passenger miles decreased from 2.5 million a day to 1.5 million a day. a. What is the price elasticity of demand for air travel over this price range? The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The quantity demanded changes by 1.0 million passenger miles and the average passenger miles is 2.0 million. The percentage change in the quantity demanded is (1.0 million)/(2.0 million)  100, which is 50 percent. The price changes by $0.50 and the average price is $1.00. The percentage change in the quantity demanded is ($0.50 /($1.00)  100, which is 50 percent. So the price elasticity of demand is (50 percent)/(50 percent), or 1.00.

b. Describe the demand for air travel. The demand for air travel between these two prices is unit elastic. The 50 percent price hike leads to a 50 percent decrease in the quantity of air miles traveled.

11.

Figure 4.2 shows the demand for gum. a. Calculate the elasticity of demand when the price of a pack of gum rises from $3 to $5. The price elasticity of demand is 2. When the price of a pack of gum rises from $3 to $5, the quantity demanded of gum decreases from 75 to 25 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $3 to $5, an increase of $2 per pack of gum. The average price is $4 per pack. So the percentage change in the price equals $2 divided by $4 and then multiplied by 100, which equals 50 percent. The quantity decreases from 75 to 25 packs, a decrease of 50 packs. The average quantity is 50 packs. So the percentage change in quantity demanded equals 50 divided by 50 and then multiplied by 100, which equals 100 percent. The price elasticity of demand for packs of gum equals 100 percent divided by 50 percent, which is 2.

b. At what price is the elasticity of demand for gum equal to 1? The price elasticity of demand equals 1 at $3 for a pack. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve intersects the y-axis. That price is $3 for a pack of gum.

Use the following table to work Problems 12 to 14. The demand schedule for computer chips is in the table. 12. a. What happens to total revenue if the price falls from (i) $400 to $350 a chip and from (ii) $350 to $300 a chip? (i) When the price of a chip is $400, 30 million chips are sold and total revenue equals $12,000 million. When the price of a chip falls to $350, 35 million chips are sold and total revenue is $12,250 million. The total revenue increases when the price falls. © 2023 Pearson Education, Inc.

Price (dollars per chip) 200 250 300 350 400

Quantity demanded (millions of chips per year) 50 45 40 35 30

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(ii) When the price is $350 a chip, 35 million chips are sold and total revenue is $12,250 million. When the price of a chip is $300, 40 million chips are sold and total revenue decreases to $12,000 million. The total revenue decreases as the price falls.

b. At what price is total revenue at a maximum? Total revenue is maximized at $350 a chip. When the price of a chip is $300, 40 million chips are sold and total revenue equals $12,000 million. When the price is $350 a chip, 35 million chips are sold and total revenue equals $12,250 million. Total revenue increases when the price rises from $300 to $350 a chip. When the price is $400 a chip, 30 million chips are sold and total revenue equals $12,000 million. Total revenue decreases when the price rises from $350 to $400 a chip. Total revenue is maximized when the price is $350 a chip.

13.

At an average price of $350, is the demand for chips elastic, inelastic, or unit elastic? Use the total revenue test to answer this question. The demand for chips is unit elastic. The total revenue test says that if the price changes and total revenue remains the same, the demand is unit elastic at the average price. For an average price of $350 a chip, cut the price from $400 to $300 a chip. When the price of a chip falls from $400 to $300, the total revenue remains at $12,000 million. So at the average price of $350 a chip, demand is unit elastic.

14.

At $250 a chip, is the demand for chips elastic or inelastic? Use the total revenue test to answer this question. The demand for chips is inelastic. The total revenue test says that if the price falls and total revenue falls, the demand is inelastic. When the price falls from $300 to $200 a chip, total revenue decreases from $12,000 million to $10,000 million. So at an average price of $250 a chip, demand is inelastic.

15.

Your price elasticity of demand for bananas is 4. If the price of bananas rises by 5 percent, what is a. The percentage change in the quantity of bananas you buy? The quantity of bananas you buy decreases by 20 percent. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. Rearranging this formula shows that the percentage change in the quantity demanded equals the price elasticity of demand multiplied by the percentage change in the price. The percentage change in the quantity demanded equals 4  5 percent, which is 20 percent.

b. The change in your expenditure on bananas? Your total expenditure decreases because your demand is elastic. The fall in expenditure is approximately 15 percent, the 5 percent rise in price offset by the 20 percent decrease in the quantity purchased.

16.

Average Movie Ticket Rises to $9.26 in the Second Quarter The average price of a movie ticket rose to $9.26 in the second quarter of 2019, up from $9.01 during the first three months of the year. Admissions dipped 2.5 percent. Source: The Hollywood Reporter, July 18, 2019. a. Use the information in the news clip to calculate the price elasticity of demand for movie tickets. The price elasticity of demand for movie tickets equals the percentage change in the quantity demanded, 2.5 percent, divided by the percentage change in the price of a ticket. The average price rose 25¢ from $9.01 to $9.26, which makes the average price $9.14. So the percentage change in the price is (0.25/9.14) × 100 or 2.7 percent. Consequently the price elasticity of demand for road trips equals (2.5 percent/2.7 percent) or 0.93.

ELASTICITY

b. How do you think the price elasticity of demand for movie tickets has changed over the past two decades? Why?” The closer the substitutes for a good, the more elastic is its demand. Most likely, the demand for movie tickets has become more elastic over the past two decades because advances in technology have created close substitutes such as in-home movie streaming.

Public Transit Hopes to Win Back Riders After Crushing Year Transportation alternatives such as Uber and Lyft ride-share programs—and bike shares and scooters, not to mention driverless cars—threaten to eat away at transit ridership. Source: apnews.com, May 2, 2021 17. Are Uber rides and transit rides complements or substitutes? Explain your answer. Uber rides and transit rides are complements when people take Uber to extend a journey started with transit, and substitutes when people can take either Uber or transit to arrive at a destination.

18.

Is the cross elasticity of demand for Uber rides with respect to the price of public transit rides positive or negative? Explain your answer. If transit rides and Uber rides are substitutes, as the price of an Uber ride falls, the demand for transit rides decreases, so the cross elasticity of demand is positive. If they are complements, as the price of an Uber ride falls, the demand for transit rides increases, so the cross elasticity of demand is negative.

19.

When Alex’s income was $3,000, he bought 4 bagels and 12 donuts a month. Now his income is $5,000 and he buys 8 bagels and 6 donuts a month. Calculate Alex’s income elasticity of demand for (a) bagels and (b) donuts. a.

The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $4,000, so the percentage change in income equals 50 percent. The change in the quantity demanded is 4 bagels and the average quantity demanded is 6 bagels, so the percentage change in the quantity demanded equals 66.67 percent. The income elasticity of demand for bagels equals (66.67 percent)/(50 percent), which is 1.33.

From part (a), the percentage change in income is 50 percent. The change in the quantity demanded is −6 donuts and the average quantity demanded is 9 donuts, so the percentage change in the quantity demanded is −66.67 percent. The income elasticity of demand for donuts equals (−66.67 percent)/(50

percent), which is −1.33.

20.

This Was the Cost of a Wedding in 2020 The 2020 national average cost of a wedding was $19,000, a drop from 2019’s average wedding cost of $28,000. This number includes the ceremony and the reception. On average, incomes fell in 2020. Source: theknot.com, February 11, 2021 a. Do the data imply that a wedding event is a normal good or an inferior good? Explain. The news article’s $19,000 “cost” is the total expenditure on a wedding event. The expenditure can change because the prices of the elements of the event changed and/or because the quantity of elements changed. If the prices do not change, then the fall in the expenditure on a wedding event means the quantity of wedding elements demanded decreased. Because the quantity demanded decreased when incomes decreased, wedding events are normal goods because the income elasticity of demand for wedding events is positive. If the prices of the elements of a wedding changed, then we cannot infer how a change in income affects the quantity demanded of wedding events so we cannot determine if the income elasticity of demand for wedding events is positive or negative.

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b. Why do we need to be cautious about making inferences about the income elasticity of demand for wedding events during the pandemic? Wedding events are a luxury and it is common to invite many people to the event. In the pandemic, social distancing as well as stay-at-home orders made large celebrations impossible. Consequently during the pandemic the demand for weddings decreased not only as a result of the fall in income but also because of the pandemic.

21.

Despite Pet Industry’s Strengths, Expected Decline in Sales for 2020 The pet industry is famously recession resistant but not in the Covid-19 pandemic. Sales in non-medical pet services and non-food pet supplies are expected to fall. Growth is expected in pet food and cat litter. Source: petfoodindustry.com, April 3, 2020 a. What does this news clip imply about the income elasticity of demand for non-medical pet services, non-food pet supplies, pet food, and cat litter? Income fell during the pandemic. Because the demand for non-medical pet services and non-food pet supplies fell during the recession, these goods are normal, so the income elasticity of demand is positive. In contrast, because the demand for pet food and cat litter rose, these goods are inferior, so the income elasticity of demand is negative.

b. Explain why the income elasticity of demand differs across sectors of the pet industry. Goods like pet food and cat litter are necessities. Even when incomes decrease, the quantity demanded changes by a small amount, so the income elasticity of demand is small. In contrast, goods like nonmedical pet services and non-food pet supplies are not necessities. When incomes decrease, pet owners decrease purchases of these items or stop buying them altogether, so the income elasticity of demand is large.

22.

If a 5 percent fall in the price of chocolate sauce increases the quantity demanded of chocolate sauce by 10 percent and increases the quantity of ice cream demanded by 15 percent, calculate the: a. Price elasticity of demand for chocolate sauce. The price elasticity of demand for chocolate sauce equals the percentage change in the quantity of chocolate sauce demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the price elasticity of demand equals (10 percent)/(−5 percent), which is 2.0.

b. Cross elasticity of demand for ice cream with respect to the price of chocolate sauce. The cross elasticity of demand for ice cream with respect to the price of chocolate sauce equals the percentage change in the quantity of ice cream demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the cross elasticity of demand equals (15 percent)/(−5 percent), which is −3.0. Ice cream and chocolate sauce are complements.

23.

The table sets out the supply schedule of body wash. Calculate the elasticity of supply when a. The price falls from $20 to $15 a bottle.

Price (dollars per bottle) 5 10 15 20

Quantity supplied (millions of bottles per month) 200 400 600 800

The elasticity of supply is 1. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. When the price falls from $20 to $15, the change in the price is $5 and the average price is $17.50. The percentage change in the price is 28.57 percent. When the price falls from $20 to $15, the quantity supplied decreases from 800 to 600 bottles. The change in the quantity supplied is 200 bottles, and the average quantity is 700 bottles, so the percentage change in the quantity supplied is 28.57 percent. The elasticity of supply equals (28.57 percent)/(28.57 percent), which is 1. © 2023 Pearson Education, Inc.

ELASTICITY

b. The average price is $10 a bottle. The elasticity of supply is 1. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity at an average price of $10 a bottle, change the price such that $10 is the average price—for example, a fall in the price from $15 to $5 a bottle. When the price falls from $15 to $5, the change in the price is $10 and the average price is $10. The percentage change in the price is 100 percent. When the price falls from $15 to $5, the quantity supplied decreases from 600 to 200 bottles. The change in the quantity supplied is 400 bottles and the average quantity is 400 bottles. The percentage change in the quantity supplied is 100 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 1.

24.

The Road to Retail Recovery With our lips and half of our faces covered, lip care and color purchases fell 15 percent last year. Prices fell 28 percent. But as makeup sales fall, skincare is taking more market share. forbes.com, March 26, 2021 a. Calculate the price elasticity of supply of lip care and color products assuming no change in supply. The price elasticity of supply of lip care and color products equals the percentage change in the quantity of lip care and color products supplied divided by the percentage change in the price of lip care and color products. The data in the problem gives the percentage change in the quantity supplied as −15 percent and the percentage change in price as ─28 percent. Consequently, the price elasticity of supply equals (–15 percent)/(–28 percent), which is 0.54.

b. Is the supply of makeup elastic or inelastic? The price elasticity of supply of makeup is 0.54. This elasticity is less than 1.0 in value, so the supply of makeup is inelastic.

Economics in the News 25. After you have studied Economics in the News on pp. 102–103, answer the following questions. a. Why does the information in the news article enable us to estimate the short-run elasticity of supply and not the momentary or long-run elasticities? The article is about the short-run elasticity of supply. Some adjustments have been made to production. We cannot estimate the momentary elasticity of supply because we do not have data on how the price or the quantity supplied changed immediately after the increase in demand. Nor can we estimate the longrun elasticity of supply because we do not have data on how the price or the quantity supplied changed in the long run after the completion of all adjustments to the number of companies producing face masks and the amount of face masks each company makes.

b. Would you expect the momentary elasticity of supply to be greater than or less than 1.2? Why? The momentary elasticity of supply will be less than 1.2. The short-run elasticity of supply allows for some adjustments to be made (more firms start to produce face masks) that increase the quantity produced but are impossible to make immediately after the increase in demand. Consequently, the increase in the momentary quantity supplied to any increase in price will be substantially less than the increase in the short-run quantity supplied.

c. Would you expect the long-run elasticity of supply to be greater than or less than 1.2? Why? The long-run elasticity of supply will be greater than 1.2. In the long run all technologically possible ways of adjusting supply have been taken and even more companies can begin to produce face masks, thereby further increasing the quantity of face masks supplied. This further increase in the quantity supplied will increase the magnitude of the elasticity of supply.

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d. How would people making their own face masks influence the elasticity of supply? People making their own face masks will increase the elasticity of supply by increasing the quantity of face masks produced. This increase occurs because homemade masks are produced by using available household resources that could have been allocated to a wide variety of alternative tasks. The greater the resource substitution possibilities, the greater is the elasticity of supply.

26.

Netflix Maintains Its Lead Over Streaming Rivals Netflix isn’t alone. Streaming services grew across the board in 2020, as recent entrants such as Disney Plus and HBO Max built momentum. Source: fastcompany.com, December 30, 2020 a. How does the entry of Disney Plus and HBO Max into the online video service market influence the demand for Netflix’s service? The entry of Disney Plus and HBO Max provides consumers with an alternative (a substitute) for Netflix’s online service and so it decreases the demand for Netflix’s service.

b. Given your answer to part (a), explain why Netflix might lower its price. With the lower demand for its service, Netflix might lower its price to limit the number of customers it loses.

c. What can you say about the effect of the entry of Disney Plus and HBO Max on the price elasticity of demand for Netflix online movie viewing? This entry into the online video service market increases the number of substitutes for Netflix’s online service. Accordingly, it increases the price elasticity of demand for Netflix’s online video service.

25.

Oil Prices Dive as Saudi Arabia Takes Aim at Russian Production Saudi Arabia cut its price by 10 percent today in retaliation for Russia’s refusal to join in the large production cut last month by the Organization of the Petroleum Exporting Countries. Falling prices are a huge problem for Saudi Arabia because they erode petroleum revenues. Source: nytimes.com, March 8, 2020 a. How can you use the information in the news clip to determine whether the demand for Saudi Arabian oil is elastic or inelastic? The total revenue test reveals that the demand for oil from Saudi Arabia is inelastic. The total revenue test concludes that if the demand is inelastic and the price falls, then the total revenue decreases, which is exactly what the article says occurs.

b. Does the news clip tell us whether the supply of Saudi Arabian oil is elastic or inelastic? Explain. The article does not allow us to determine the price elasticity of supply because it does not suggest that the demand for oil changed. Consequently, we do not have information about how the quantity supplied changed when the price changed.

C h a p t e r

EFFICIENCY AND EQUITY

Answers to the Review Quizzes Page 111 1.

Why do we need methods of allocating scarce resources? Because resources are scare, it is not possible to fulfill everyone’s wants. As a result, some method of deciding which wants will be fulfilled and which will not—that is, some method of allocating resources—must be utilized.

Describe the alternative methods of allocating scarce resources. Resources can be allocated using:  Market price: People who are willing and able to pay the price get the resource.  Command: Someone in command decides who gets the resource.  Majority rule: The majority vote decides how resources are allocated.  Contest: Winners receive the resource.  First-come, first-served: People first in line get the resource.  Lottery: Randomly selected winners receive the resource.  Personal characteristics: People with the “right” characteristics get the resource.  Force: The stronger person or group gets the resource.

Provide an example of each allocation method that illustrates when it works well. Below are examples of when each allocation scheme works well:  Market price: Generally works well in competitive markets and for most goods and services. An example is the allocation of cat food.  Command: Generally works well in organizations where lines of authority are clear and it is easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tells a worker to clean the tables.  Majority rule: Generally works well when large numbers of people are affected by the allocation. An example is an election in which people vote whether or not to support a tax to build more parks.  Contest: Generally works well when the efforts of the participates are hard to monitor. An example is the contest run by Pfizer in which three top managers competed to see who would be appointed CEO.  First-come, first-served: Generally works well when a resource can be used by only one user at a time. An example is a line at a movie ticket booth.  Lottery: Generally works well when there is no way to easily distinguish which user of a resource would use it most effectively. An example is the lottery used to allocate cell phone frequencies.  Personal characteristics: Generally works well when resource use is such that different people consume the same resources. An example is the decision whom to marry.  Force: Generally works well when used to uphold the rule of law. An example is the state imprisoning thieves and thereby preventing resource allocation by the thief stealing the resource. © 2023 Pearson Education, Inc.

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Provide an example of each allocation method that illustrates when it works badly. Below are examples of when each allocation scheme would work poorly:  Market price: Deciding court cases on the basis of who will pay the most for the decision.  Command: Running an economy.  Majority rule: Deciding how many acres of wheat to plant.  Contest: Allocating food in a winner-take-all contest.  First-come, first-served: Admitting students to college based on who applied first.  Lottery: Assigning grades based on random chance.  Personal characteristics: Renting only to married couples.  Force: Stealing by threat of physical harm.

Describe the alternative methods of allocating the Covid-19 vaccine. In most countries the Covid-19 vaccine was distributed using personal characteristics and first-come, first-served. The personal characteristics attribute of the vaccination distribution is apparent when certain groups—medical providers, first responders, and so forth—were allocated the first doses of the vaccine. After this the doses were generally allocated according to age groups—only people over 75 were eligible, for example. Within the age group the vaccine was generally distributed according to first-come, first served. Sometimes the vaccine was distributed using a lottery, as when people who randomly arrived at a vaccination site, such as a drug store, were offered the vaccine to use all the doses within a container.

Page 115 1.

What is the relationship between the marginal benefit, value, and demand? The value of one more unit of a good is its marginal benefit. The marginal benefit of a good or service is measured by the maximum amount that consumers are willing to pay for one more unit of a good or service. The demand curve shows the maximum consumers are willing to pay for each additional unit, so the demand curve is the same as the marginal benefit curve.

What is the relationship between individual demand and market demand? The market demand equals the sum of the individual quantities demanded by all the demanders at each price. Therefore the market demand curve equals the horizontal sum of the individual demand curves.

What is consumer surplus? How is it measured? Consumer surplus is the excess of the benefit received from a good over the amount paid for it. The total consumer surplus is the sum of the consumer surpluses on all the units purchased. It is measured as the area under the demand curve and above the price.

What is the relationship between the marginal cost, minimum supply-price, and supply? The marginal cost is the cost of producing an additional unit of a good. The marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale. This minimum supply-price determines the supply of the good, so the supply curve is the same as the marginal cost curve.

What is the relationship between individual supply and market supply? The market supply equals the sum of the individual quantities supplied by all the producers at each price. The market supply curve is equal to the horizontal sum of all the individual supply curves.

What is producer surplus? How is it measured? Producer surplus is the excess of the amount received from the sale of a good or service over the cost of producing it. The producer surplus is measured as the area under the price and above the supply curve over the entire quantity sold.

EFFICIENCY AND EQUITY

Page 119 1.

Do competitive markets use resources efficiently? Explain why or why not. In the absence of the obstacles mentioned earlier in the chapter, competitive markets use society’s resources efficiently. For resources to be used efficiently they must be allocated to produce the quantity of a good or service where the marginal cost of the last unit produced in the market is equal to the marginal benefit. This condition will be met in a competitive market because the quantity occurs where the demand curve (which equals the marginal social benefit curve) intersects the supply curve (which equals the marginal social cost curve).

What is deadweight loss and under what conditions does it occur? The deadweight loss is the decrease in total surplus that results from an inefficient level of production. This is the decrease in consumer surplus plus the decrease in producer surplus that occurs when the market either overproduces or underproduces relative to the efficient quantity.

What are the obstacles to achieving an efficient allocation of resources in the market economy? Markets with price or quantity regulations, taxes or subsidies, externalities, public goods or common resources, monopoly power, or high transactions costs will not produce the efficient quantity of a good or service. In each of these situations, the market prices charged or quantities produced and sold will not result in the efficient allocation of resources. Efficiency requires that the marginal social benefit of the last unit produced be equal to the marginal social cost. The equilibrium at the intersection of the demand and supply curves in the competitive market creates this result. When the market price or quantity is pulled away from the market equilibrium, the marginal social benefit of the last unit produced does not equal its marginal social cost.

Page 123 1.

What are the two big approaches to thinking about fairness? The two big approaches to thinking about fairness are:  “It’s not fair if the result isn’t fair,” or utilitarianism.  “It’s not fair if the rules aren’t fair,” or equality of opportunity.

What is the utilitarian idea of fairness and what is wrong with it? The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resources to be “fair.” There should be income transfers from the rich to the poor until equality is achieved, because the marginal benefit of the last dollar of income is the same for everybody. There are two problem with utilitarianism:  It ignores the cost of implementing the income transfers, which will decrease the total goods and services that the finite resources of society can produce. The size of the economic pie will be smaller.  It ignores the Big Tradeoff, the tradeoff between efficiency and fairness. Taxing people’s incomes makes them work less, which decreases the size of the economic pie and thereby diminishes the total amount that can be transferred to the poor.

Explain the big tradeoff. What idea of fairness has been developed to deal with it? The big tradeoff is the tradeoff between efficiency and fairness. Redistributing incomes changes the incentives facing producers and consumers. Taxing income decreases producer surplus and taxing purchases decreases consumer surplus. Producers produce less and consumers consume less, and total economic activity declines, such that the size of the economic pie decreases. The big tradeoff has led to the idea that the fairest distribution is that which makes the poorest person as well off as possible.

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What is the idea of fairness based on fair rules? The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation of resources to be “fair.” This is the economic application of the symmetry principle, that people in similar situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed:  The government must enforce laws that establish and protect rights to private property that are held by individuals in society, and  Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.

EFFICIENCY AND EQUITY

Answers to the Study Plan Problems and Applications At Chez Panisse, a restaurant in Berkeley, reservations are essential. At Aladdin’s Cave, a restaurant near the University of California San Diego, reservations are recommended. At Eli Cannon’s, a restaurant in Middletown, Connecticut, reservations are not accepted. Describe the method of allocating scarce table resources at these three restaurants. Why do you think restaurants don’t use the market price to allocate their tables? All these restaurants use a first-come, first-serve system. Eli Cannon’s uses this system directly. Chez Panisse uses a first-come, first-serve system because the first person to call to make a reservation at a particular time is allocated the table at that time. Aladdin’s cave uses a combination of the immediate first-come, first-serve system and the reservation based first-come, first-serve system. Market allocation requires that customers pay for a table and the price would fluctuate from one hour to the next depending on the number of customers who arrive. Customers would be uncertain about the price they would pay. Uncertainty decreases the demand for meals and hence the restaurant’s profit.

Use the following table to work Problems 2 to 4. The table gives the demand Price schedules for train travel for the (dollars only buyers in the market, Ann, per mile) Beth, and Cy. 3 2. a. Construct the market 4 demand schedule. 5 The market demand schedule 6 shows the sum of the 7 quantities demanded by Ann, 8 Beth, and Cy at each price. 9

Ann 30 25 20 15 10 5 0

Quantity demanded (miles) Beth 25 20 15 10 5 0 0

Cy 20 15 10 5 0 0 0

When the price is $3 per mile, the market quantity demanded is 75 miles; when the price is $4 per mile, the market quantity demanded is 60 miles; when the price is $5 per mile, the marker quantity demanded is 45 miles; when the price is $6 per mile, the market quantity demanded is 30 miles; when the price is $7 per mile, the market quantity demanded is 15 miles; when the price is $8 per mile, the market quantity demanded is 5 miles; and when the price is $9 per mile, the market quantity demanded is 0 miles.

b. What is the maximum price that each traveler, Ann, Beth, and Cy, is willing to pay to travel 20 miles? Why? Each person’s demand schedule shows the maximum price that person is willing to pay to travel 20 miles. The maximum price Ann is willing to pay to travel 20 miles is $5 per mile, the maximum price Beth is willing to pay is $4 per mile, and the maximum price Cy is willing to pay is $3 per mile.

3. a. What is the marginal social benefit when the total distance travelled is 60 miles? The marginal social benefit when the quantity is 60 miles is $4 per mile. The marginal social benefit is determined from the consumers’ demand schedules and equals the maximum price that consumers will pay for the quantity. The demand schedule shows that the maximum price consumers will pay for 60 miles is $4 per mile and this price equals the marginal social benefit.

b. When the total distance traveled is 60 miles, how many miles does each travel and what is their marginal private benefit? The three travel a total distance of 60 miles when the price is $4 a mile. Each person’s marginal benefit is $4 per mile. At this price Ann travels 25 miles, Beth travels 20 miles, and Cy travels 15 miles.

4. a. What is each traveler’s consumer surplus when the price is $4 a mile? What is the market consumer surplus when the price is $4 a mile? Ann’s consumer surplus is $62.50; Beth’s consumer surplus is $40.00; Cy’s consumer surplus is $22.50. © 2023 Pearson Education, Inc.

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When the price is $4 per mile, Ann buys 25 miles. Ann’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Ann’s consumer surplus is 1/2  ($9  $4)  25, which equals $62.50. When the price is $4 per mile, Beth buys 20 miles. Beth’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Beth’s consumer surplus is 1/2  ($8  $4)  20, which equals $40.00 When the price is $4 per mile, Cy buys 15 miles. Cy’s consumer surplus is the triangular area under his demand curve and above the price. The demand curve is linear, so Cy’s consumer surplus is 1/2  ($7  $4)  15, which equals $22.50. The market consumer surplus is the sum of Ann’s consumer surplus, Beth’s consumer surplus, and Cy’s consumer surplus, or $125.00.

Use the following table to work Problems 5 to 7. The table gives the supply Price schedules of hot air balloon rides (dollars for the only sellers in the market, per ride) Xavier, Yasmin, and Zack. 100 5. a. Construct the market 90 supply schedule. 80

Xavier 30 25 20 15 10 5 0

Quantity supplied (rides per week) Yasmin 25 20 15 10 5 0 0

Zack 20 15 10 5 0 0 0

The market supply schedule 70 shows the sum of the 60 quantities supplied by Xavier, 50 Yasmin, and Zack at each 40 price. When the price is $100 per ride, the market quantity supplied is 75 rides; when the price is $90 per ride, the market quantity supplied is 60 rides; when the price is $80 per ride, the market quantity supplied is 45 rides; when the price is $70 per ride, the market quantity supplied is 30 rides; when the price is $60 per ride, the market quantity supplied is 15 rides; when the price is $50 per ride, the market quantity supplied is 5 rides; and when the price is $40 per ride, the market quantity supplied is 0 rides.

b. What are the minimum prices that Xavier, Yasmin, and Zack are willing to accept to supply 20 rides? Why? The minimum supply-price equals the lowest price at which a producer is willing to produce the given quantity. The supply schedule tells us the minimum supply-price. Xavier’s minimum supply-price for 20 rides is $80; Yasmin’s minimum supply-price is $90; and, Zack’s minimum supply-price is $100.

6. a. What is the marginal social cost when the total number of rides is 30? The quantity of rides supplied is 30 when the price is $70 per ride. The marginal social cost of any quantity is equal to the price for which that quantity will be supplied, so when the total number of rides is 30, the marginal social cost equals $70 per ride.

b. What is the marginal cost for each supplier when the total number of rides is 30 and how many rides does each of the firms supply? When the total number of rides is 30, Xavier supplies 15 rides, Yasmin supplies 10 rides, and Zack supplies 5 rides. The marginal cost for each firm is $70.

When the price is $70 a ride, what is each firm’s producer surplus? What is the market producer surplus? Xavier’s producer surplus is $225; Yasmin’s is $100; and, Zack’s is $25. When the price is $70 per ride, Xavier supplies 15 rides. Xavier’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Xavier’s producer surplus is 1/2  ($70  $40)  15, which equals $225. © 2023 Pearson Education, Inc.

EFFICIENCY AND EQUITY

When the price is $70 per ride, Yasmin supplies 10 rides. Yasmin’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Yasmin’s producer surplus is 1/2  ($70  $50)  10, which equals $100. When the price is $70 per ride, Zack supplies 5 rides. Zack’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Zack’s producer surplus is 1/2  ($70  $60)  5, which equals $25. The market producer surplus is equal to the sum of Xavier’s producer surplus, Yasmin’s producer surplus, and Zack’s producer surplus, which is $225 + $100 + $25 or $350.

The figure shows the competitive market for smartphones. a. What is the market equilibrium? The equilibrium price is $30 per smartphone and the equilibrium quantity is 100 smartphones per month.

b. Shade in the consumer surplus and label it. In Figure 5.2 the consumer surplus is the shaded area A.

c. Shade in the producer surplus and label it. In Figure 5.2 the producer surplus is the shaded area B.

d. Calculate total surplus. The total surplus is equal to the sum of the consumer surplus plus the producer surplus, or the triangle with area A + area B. The amount of the total surplus equals ½ × ($60 per smartphone − $15 per smartphone) × 100 smartphones, which is $2,250.

e. Is the market for smartphones efficient? The equilibrium quantity of smartphones is 100 smartphones per month because this is the quantity at which the demand and supply curves intersect. The demand curve is the marginal social benefit curve and the supply curve is the marginal social cost curve. Therefore the efficient quantity of smartphones is 100 cell phones per month because this is the quantity at which these two curves intersect. This competitive market is efficient because the equilibrium quantity equals the efficient quantity.

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Explain why the allocation method used by each restaurant in Problem 1 is fair or not fair. According to the “fair rules” approach, all of the methods are fair because everyone faces the same rules and therefore the same chance of obtaining a table. According to the “fair results” approach, none of the methods are fair because in each case some people get a table and others do not.

10.

In the Worked Problem (p. 126), how can the 50 bottles available be allocated to beachgoers? Would the possible methods be fair or unfair? The 50 bottles could be allocated by market price (the price would be $15, the price that allocates the 50 bottles among the buyers), by command (someone, perhaps the beach patrol, declares who gets the bottles), by majority rule (beach goers vote to determine who gets the bottles), by a contest (the winners of a beach volleyball game receive the bottles), by first-come, first-served, by a lottery, by personal characteristics (perhaps light-skinned people get the bottles), and by force. None of the methods are fair by the “results” view of fairness unless the personal characteristics method use income, with poorer people getting the bottles. The market exchange method is the only fair method under the “rules” view of fairness.

EFFICIENCY AND EQUITY

Answers to Additional Problems and Applications 11.

At McDonald’s, no reservations are accepted; at Panorama at the St. Louis Art Museum, reservations are accepted; at the Bissell Mansion restaurant, reservations are essential. Describe the method of allocating tables in these three restaurants. Why do restaurants have different reservation policies? All these restaurants use a first-come, first-serve system. McDonald’s uses this system directly. Bissell Mansion uses a first-come, first-serve because the first person to call to make a reservation at a particular time is allocated the table at that time. Puck’s uses a combination of the immediate first-come, first-serve system and the reservation based first-come, first-serve system. The speed with which tables turn over at the different restaurants probably is quite different and the customers probably have quite different values of time. Bissell Mansion has a low turnover rate—only 1 or 2 groups of customers can use a table each night—and its customers have a high value of time. If Bissell Mansion refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Bissell Mansion profits would be lower. At McDonald’s, the tables have a high turnover rate (indeed, many customers do not use the tables at all, buying their food to go) and the customers have a lower value of time. Allowing reservations would be costly for McDonald’s and would spare its customers only a slight wait at most so that allowing reservations would decrease McDonald’s profits. At Puck’s, the turnover rate of the tables is between that at Bissell Mansion and McDonald’s, so it uses a combination of phone reservation first-come, first-serve and appear in person first-come, first-serve.

Use the following table to work Problems 12 to 15. The table gives the supply schedules Price for jet-ski rides by the only suppliers: (dollars Rick, Sam, and Tom. per ride) 12. What is each owner’s minimum 10.00 supply-price of 10 rides a day? 12.50 Rick’s minimum supply- price for 15.00 10 rides is $15.00, Sam’s 17.50 minimum supply-price is $17.50, 20.00 and Tom’s minimum supply-

Rick 0 5 10 15 20

Quantity supplied (rides per week) Sam 0 0 5 10 15

Tom 0 0 0 5 10

price is $20.00.

13.

Which owner has the largest producer surplus when the price of a ride is $17.50? Explain. Rick has the largest producer surplus when the price is $17.50. Rick’s producer surplus is largest because he produces the largest quantity and his costs are lower than those of the other producers. More formally, each supplier’s producer surplus is equal to the area under the price and above that producer’s supply curve. Calculating these areas of producer surplus, Rick’s producer surplus is $56.25, Sam’s producer surplus is $25.00, and Tom’s producer surplus is $6.25.

14.

What is the marginal social cost of 45 rides a day? 45 rides are produced when the price is $20.00, so the marginal social cost of producing 45 rides a day is $20.00.

15.

Construct the market supply schedule of jet-ski rides. When the price is $10.00, the quantity of rides supplied is 0; when the price is $12.50, the quantity supplied is 5 rides; when the price is $15.00, the quantity supplied is 15; when the price is $17.50, the quantity supplied is 30; and, when the price is $20, the quantity supplied is 45.

16.

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The table gives the demand and supply schedules for sandwiches. a. What is the maximum price that consumers are willing to pay for the 200th sandwich? The demand schedule shows the maximum price that consumers will pay for each sandwich. The maximum price consumers will pay for the 200th sandwich is $2.

Price (dollars per sandwich) 0 1 2 3 4 5 6

b. What is the minimum price that producers are willing to accept for the 200th sandwich?

Quantity Quantity demanded supplied (sandwiches per hour) 300 0 250 50 200 100 150 150 100 200 50 250 0 300

The supply schedule shows the minimum price that producers will accept for each sandwich. The minimum price that producers are willing to accept for the 200th sandwich is $4.

c. If 200 sandwiches a day are available, what is the total surplus? 200 sandwiches a day are more than the efficient quantity because the marginal social benefit (the maximum price consumers will pay) is less than the marginal social cost (the minimum price suppliers will accept). Because production is inefficient, there is a deadweight loss, equal to the sum of the consumer surplus and producer surplus lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (200  150) multiplied by ($4  $2)/2, which is $50. This deadweight loss must be subtracted from the surplus that would be obtained if the market was efficient to calculate the total surplus when 200 sandwiches are produced. When the market produces the efficient quantity, 150 sandwiches are produced. The total surplus at this efficient quantity equals the area of the triangle under the demand curve and above the supply curve to the quantity of 150. This area is ½  ($6  $0)  150, which is $450. So the total surplus when 200 sandwiches are produced equals $450  $50, which is $400.

17.

Minnesota Gasps at the Financial Damage It Faces From the Texas Freeze February’s freeze-up in Texas cut supplies of natural gas to Minnesota. Minnesota’s gas companies are increasing customer bills to recoup extraordinary expenses. Source: washingtonpost.com, April 26, 2021 a. How is the price of natural gas determined? The price of natural gas is determined in the market for natural gas by demand and supply. It is the price at which the quantity demanded equals the quantity supplied.

b. When supply decreases, explain the process by which the market adjusts. When supply decreases, at the initial equilibrium price there is a shortage. The shortage forces the price to rise. As the price rises, the quantity demanded decreases and the quantity supplied increases. The price continues to rise until the quantity demanded equals the quantity supplied. That price is the new equilibrium price. Once that price is reached, there are no further changes.

c. On a graph, show the effect of the decrease in supply on consumer surplus and producer surplus. Figure 5.3a (on the next page) shows the initial consumer surplus (labeled A) and producer surplus (labeled B). After the decrease in supply, Figure 5.3b shows the new consumer surplus (again labeled A) and the new producer surplus (again labeled B).

EFFICIENCY AND EQUITY

18.

Use the data in the table in Problem 16. a. If the sandwich market is efficient, what is the consumer surplus, what is the producer surplus, and what is the total surplus? 150 sandwiches is the efficient quantity and the equilibrium price is $3. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the consumer surplus triangle is ½  ($6  $3)  150, which is $225. The producer surplus is the area of the triangle above the supply curve below the price. The price is $3 and the quantity is 150. The area of the triangle is 1/2  ($3  $0)  150, which is $225. The total surplus is the sum of the consumer surplus plus the producer surplus, which is $450.

b. If the demand for sandwiches increases and sandwich makers produce the efficient quantity, what happens to producer surplus and deadweight loss? If the demand for sandwiches increases, the price and quantity of sandwiches both rise. The producer surplus definitely increases. There is no deadweight loss because sandwich makers are producing the efficient quantity.

Use the following news clip to work Problems 19 to 21. Spotify Has Announced a Controversial Price Hike Many users were left aghast when, for the first time ever, Spotify announced they are raising subscription prices. The Premium Family Plan is rising from $14.99 to $15.99 a month. Source: techradar.com, May 2, 2021 19. a. Draw a graph of the market for streaming music when the price is $15 a month. On your graph, show consumer surplus and producer surplus. Figure 5.4 shows this market. The MSC curve runs along the x-axis, that is the MSC of additional streaming is zero because the cost of operating a © 2023 Pearson Education, Inc.

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streaming service doesn't change if more people stream more songs The consumer surplus is area A and the producer surplus is area B.

b. With a price of $15 a month, is the market efficient or inefficient? If it is inefficient, show the deadweight loss on your graph. The market is inefficient. Efficiency requires producing the quantity at which the marginal social benefit equals the marginal social cost, which in this case is the quantity at which the marginal social benefit curve intersects the marginal social benefit. Accordingly, the deadweight loss is equal to the area C.

20.

Suppose that at a market price of $15 a month, demand is unit elastic. When the market price rises to $16 a month, how do consumer surplus, producer surplus, and the deadweight loss change? The higher price itself decreases consumer surplus. Additionally, the higher price decreases the quantity of streaming consumed, which also decreases consumer surplus, so consumer surplus unambiguously decreases. With the marginal cost of zero, the producer surplus is equal to the total consumer expenditure on streaming. Because demand is unit elastic, the increase in price means that the total consumer expenditure on streaming does not change so the producer surplus does not change. The deadweight loss increases.

21. a. When the market price rises to $16 a month, is the market efficient or inefficient? Explain. The market is inefficient. Efficiency requires that the amount be the quantity for which the marginal social benefit equals the marginal social cost, which in this case is the quantity at which the marginal social benefit curve intersects the horizontal axis.

b. When the market price rises to $16 a month, is the new price a competitive market price? Explain. With a pure competitive-market price, the price is determined by supply and demand and is $0. The $16 price is not a competitive market price.

22.

Only 1 percent of the world supply of water is fit for human consumption. Some places have more water than they can use; some could use much more than they have. The 1 percent available would be sufficient if only it were in the right place. a. What is the major problem in achieving an efficient use of the world’s water? Water needs to be transported from where it is available to where it is needed. This basic issue leads to two major problems: Overproduction in some areas and underproduction in other areas. Often overproduction in an area leads to underproduction later in the same area. In particular, markets in water are not competitive. In many areas, water is “free” to whoever digs a deep enough well. As a result, too many people dig wells and water is overproduced. If the overproduction is bad enough, the level of groundwater can be reduced so far that it becomes literally impossible to extract any water. Then water needs to be transported to the now arid area. In this case, often the government transports the water and sells it at a very low price or gives it away. But because the government does not sell the water at an equilibrium price (and because the government is not motivated by seeking profit) less water is transported than the efficient quantity.

b. If there were a global market in water, like there is in oil, how do you think the market would be organized? The market for water would be more efficient than the current situation. Areas with a great deal of water, say Canada, could export water to areas with less water, say Mexico. If water was purchased and sold in markets, there would be greater incentive to build desalination plants where they are practical as well as greater incentive to conserve water where it is in abundance.

c. Would a free world market in water achieve an efficient use of the world’s water resources? Explain why or why not. A free world market in water likely would (eventually) bring an efficient use of resources as the necessary infrastructure was constructed. Of the factors that can lead to inefficiency (government price and © 2023 Pearson Education, Inc.

EFFICIENCY AND EQUITY

quantity regulations, monopoly power, and so forth) the only issue that could possibly lead to inefficiency is the point that water is a common resource in some situations.

23.

Use the information in Problem 22. Would a free world market in water achieve a fair use of the world’s water resources? Explain why or why not and be clear about the concept of fairness that you are using. A “fair results” approach to fairness would argue that in third world countries, very poor inhabitants (for example, nomads) would not be able to afford “enough” water and so some redistribution is needed for the sake of fairness. A “fair rules” approach to fairness asserts that a competitive market is enough to insure fairness because the exchange of water is voluntary.

24.

The winner of the men’s and women’s tennis singles at the U.S. Open is paid twice as much as the runner-up, but it takes two players to have a singles final. Is the compensation arrangement fair? The compensation arrangement is efficient because all the participants play their hardest in an attempt to win the prize. As a result, the quality of play is extremely high and the “amount” of tennis produced is large. But the efficient outcome is not necessarily a fair outcome. The fair results approach to fairness asserts that the compensation scheme is unfair because income is not equally distributed. The fair rules approach asserts that the scheme is fair because the players voluntarily enter the tournament and the symmetry principle is not violated.

Biden Warns Against Gas Price Gouging After Cyberattack President Joe Biden has warned gasoline stations not to engage in price gouging as motorists wait for fuel to start flowing reliably through the Colonial Pipeline. The pipeline has reopened after falling victim to a cyberattack. Source: Associated Press, May 13, 2021 a. Is the rising price of gasoline an example of price gouging or of competitive markets doing their job of allocating scarce resources? Explain. The example reflects how a decrease in supply results in a higher price. From this perspective, the example demonstrates a competitive market allocating scarce resources.

b. Is the rising price of gasoline fair? According to the fair rules approach, the higher price is fair. According to the fair results approach, the higher price is probably not fair unless the higher price allocated the gasoline to the poor, which seems unlikely.

c. Is prohibiting the price of gasoline from rising during and immediately following the cyberattack fair? According to the fair rules approach, it is not fair to prohibit rising prices because that prohibition prevents voluntary exchange. Under the fair results approach, if the prohibition means that poorer people receive the gasoline, the prohibition is fair. But it is unlikely that prohibiting rising prices will mean that the gasoline goes exclusively (or even generally) to people with lower than average incomes.

Economics in the News 25.

After you have studied Economics in the News on pp. 124–125, answer the following questions. a. What is the method used to allocate highway space in Boston and what is the method used in Singapore? Highway space in Boston is allocated using first-come, first-serve. Highway space in Singapore is allocated using market price.

b. Who benefits from Boston’s method of highway resource allocation? Explain your answer using the ideas of marginal social benefit, marginal social cost, consumer surplus, and © 2023 Pearson Education, Inc.

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producer surplus. In Boston, roads are allocated using first-come, first-served. This allocation is inefficient and so deadweight loss is created. Drivers with a low valuation of time (that is, a low marginal benefit) gain consumer surplus and thereby benefit because they are willing to drive even though they create congestion. Some gas stations, oil refiners, and other producers of highway-related goods and services gain producer surplus because of the extra gallons of gasoline wasted because of the congestion.

c. Who benefits from Singapore’s method of highway resource allocation? Explain your answer using the ideas of marginal social benefit, marginal social cost, consumer surplus, and producer surplus. In Singapore, roads are allocated using market price. Drivers who have marginal benefit that exceeds the price will drive and will gain consumer surplus. Producers of highway services will gain producer surplus. Because market price is used, the allocation is efficient so the sum of consumer surplus and producer surplus is maximized.

d. If road use were rationed by limiting drivers with even-date birthdays to drive only on even days (and odd-date birthdays to drive only on odd days), would highway use be more efficient? Explain your answer. Allocation by personal characteristic, such as birthdays, does not make the use of highways more efficient. Efficiency requires that drivers with the highest marginal benefits from highway use are those who use the highways. Allocation by birthdays means that some drivers with high marginal benefits are forbidden from driving on the freeway on days that do not align with their birthday.

26.

Water Rate Hikes Have Farmers Steaming Most residents of Ventura County, California, pay $3.10 per 100 cubic feet of water. Agricultural water users pay $1.79 per 100 cubic feet. Water officials propose to increase these prices to $4.24 for residential users and to $4.92 for agricultural users by 2020. Water district officials say these price increases are fair. Source: Moorpark Acorn, January 13, 2017 a. Do you think that the allocation of water between agricultural and residential users is likely to be efficient? Explain your answer. The allocation of water is almost surely inefficient. If the marginal social cost of distributing water is the same for agricultural and residential users, as is probably the case, the only way that the allocation scheme can be efficient is if agricultural users receive a smaller marginal social benefit than residential users. This is unlikely because agricultural users require water to grow crops, so agricultural users probably receive greater marginal social benefit than residential users.

b. If agricultural users paid a higher price, would the allocation of resources be more efficient? If agricultural users paid a higher rate for water, probably the allocation of resources would be more efficient. Efficiency requires that marginal social benefit equals marginal social cost. Currently it is likely the case that the marginal social benefit of the last unit of water for agricultural users is less than the marginal social cost of producing the last unit of water.

c. If agricultural users paid a higher price, what would happen to consumer surplus and producer surplus from water? If the price paid by agricultural users rises, the consumer surplus of agricultural users decreases and the producer surplus increases.

d. Is the proposed change in prices paid by agricultural and residential users fair? The price is proposed to rise so residential users wind up paying $4.24 per 100 cubic feet of water and agricultural users end up paying more, $4.92. According to the “fair results” approach, the difference in price is fair if agricultural users are wealthier than residential users but if they are poorer than or comparable to residential users, the difference in price is not fair. The difference in price is not fair according to the “fair rules” approach because the price is not determined in competitive markets. © 2023 Pearson Education, Inc.

C h a p t e r

GOVERNMENT ACTIONS IN MARKETS

Answers to the Review Quizzes Page 134 1.

What is a rent ceiling and what are its effects if it is set above the equilibrium rent? A rent ceiling is a specific example of a price ceiling. A rent ceiling is a government-imposed regulation that makes it illegal to charge a rent higher than a specified level. If a rent ceiling is set above the equilibrium rent, it has no effect because it does not make the equilibrium rent illegal.

What are the effects of a rent ceiling that is set below the equilibrium rent? If the rent ceiling is set below the equilibrium rent, the quantity of housing units demanded by renters exceeds the quantity supplied by landlords. Since landlords are not forced to supply more units than the supply curve would indicate for the rent ceiling price, the quantity of housing units actually rented equals the quantity supplied, rather than the quantity demanded. This causes a shortage in the rental housing market.

How are scarce housing resources allocated when a rent ceiling is in place? With an effective rent ceiling, some means for allocation of housing units (other than by price) becomes necessary. Some housing is allocated by first-come, first-serve. Other housing is allocated by discrimination. Illicit markets also develop, where housing units are allocated at a rent higher than the regulated rent.

Why does a rent ceiling create an inefficient and unfair outcome in the housing market? A rent ceiling creates inefficiency because at the quantity of apartments that are rented, the marginal social benefit exceeds the marginal social cost. Rent ceilings are unfair under the “fair rules” approach because rent ceilings prevent voluntary transactions. Rent ceilings are unfair under the “fair results” approach because there is no assurance that apartments go to those with lower incomes. Indeed, rent ceilings lead to discrimination, which is perhaps the antithesis to fairness.

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What is a minimum wage and what are its effects if it is set above the market equilibrium wage? A minimum wage is a price floor applied to the labor market. A minimum wage is a government-imposed regulation that makes it illegal to charge (or pay) a wage rate lower than a specified level. If the minimum wage is set above the market equilibrium wage, it creates a surplus of labor—unemployment—and decreases workers’ and firms’ surplus.

What are the effects of a minimum wage set below the market equilibrium wage? If the minimum wage is set below the market equilibrium wage, then the law has no impact on the labor market equilibrium wage and quantity.

Explain how scarce jobs are allocated when a minimum wage is in place. If a minimum wage is set above the market equilibrium wage, the ability of the competitive market to allocate resources is thwarted and other means must be used. Sometimes the method used is first-come, © 2023 Pearson Education, Inc.

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first-served so that those who are first in line to apply for openings are given the jobs. Other times discrimination is used so that those from favored groups are allocated the jobs.

Explain why a minimum wage creates an inefficient allocation of labor resources. A competitive labor market allowed to reach its equilibrium creates an efficient allocation of resources. At the equilibrium, the amount of employment is such that the marginal social cost of labor to workers equals the marginal social benefit of labor to firms. A minimum wage set above the equilibrium wage rate creates a surplus of labor—the quantity of labor supplied exceeds the quantity of labor demanded. The minimum wage reduces employment so that it is less than the efficient amount.

Explain why a minimum wage is unfair. Workers who receive wage hikes and retain their jobs gain from the minimum wage but workers who lose their jobs and workers who must extensively search for a job lose. Those who keep (or find) jobs are not necessarily the least well off, so the minimum wage fails the fair results approach to fairness. And the minimum wage also fails the fair rules approach to fairness because the minimum wage blocks voluntary transactions that otherwise would occur.

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How does the elasticity of demand influence the incidence of a tax, the tax revenue, and the deadweight loss? The more elastic the demand for a given supply, the smaller the increase in the price paid by the buyers and the greater the decrease in the price received by the sellers, which means that the incidence on buyers is smaller. Additionally, the more elastic the demand, the smaller the quantity bought so the smaller the tax revenue and the larger the deadweight loss.

How does the elasticity of supply influence the incidence of a tax, the quantity bought, the tax revenue, and the deadweight loss? The more elastic the supply for a given demand the larger the increase in the price paid by the buyers and the smaller the decrease in the price received by the sellers, which means that the incidence on buyers is larger. Additionally, the more elastic the supply, the smaller the quantity bought so the smaller the tax revenue and the larger the deadweight loss.

Why is a tax inefficient? The imposition of a tax on a market causes a wedge to be driven between the price received by the seller and the price paid by the buyer. This causes the marginal social benefit of the last unit sold to be higher than its marginal social cost, and the market will under-produce the good or service being taxed. If more of the good or service were produced, the marginal social benefit gained would be greater than the marginal social cost incurred, and the net benefit to society would increase.

When would a tax be efficient? A tax is efficient, that is, creates no deadweight loss, when demand is perfectly inelastic or supply is perfectly inelastic. In both these cases a tax does not change the quantity produced and so creates no deadweight loss.

What are the two principles of fairness that are applied to tax systems? The two principles of fairness are the benefits principle and the ability-to-pay principle. The benefits principle asserts that people should pay taxes equal to the benefits they receive from the government provided services. The ability-to-pay principle asserts that people should pay taxes according to how easily they can bear the burden of the tax.

GOVERNMENT ACTIONS IN MARKETS

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Summarize the effects of a production quota on the market price and the quantity produced. A production quota set below the equilibrium quantity raises the price and decreases the quantity.

Explain why a production quota is inefficient. A production quota is inefficient because it decreases production. As a result, the marginal social benefit of the last unit produced exceeds the marginal cost. Because the marginal benefit exceeds the marginal social cost, there is a deadweight loss.

Explain why a voluntary production quota is difficult to operate. A voluntary quota is difficult to operate because a production quota results in a massive incentive to “cheat” on the production quota by increasing production. A production quota decreases the quantity produced. By decreasing the quantity produced, a production quota raises the price and reduces the marginal social cost of the last unit produced. Because the price exceeds the marginal social cost, producers have an incentive to increase their production (beyond the quota amount) to boost their profit.

Summarize the effects of a subsidy on the market price and the quantity produced. A subsidy increases the price received by sellers, shifts the supply curve rightward, and places a wedge between the marginal social benefit and marginal social cost of producing the good. The subsidy creates a deadweight loss, a higher equilibrium quantity sold, over-production, and a lower price paid by the consumers. The subsidy increases farm revenues to all farmers.

Explain why a subsidy is inefficient. A subsidy creates inefficiency because a subsidy leads to a lower price and increased production. Marginal social benefit equals the price and so the lower price signals that the marginal social benefit falls. And the increased production means that the marginal social cost of production rises. So, at the level of production with a subsidy, the marginal social benefit is less than the marginal social cost and inefficiency is created.

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How does the imposition of a penalty for selling an illegal drug influence demand, supply, price, and the quantity of the drug consumed? If the penalty is levied on the seller, the penalty is added to the minimum price required for supplying the good or service. The demand curve remains unchanged, but the supply curve shifts leftward, so that the vertical distance between the initial supply curve and the supply curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the good rises and the equilibrium quantity decreases.

How does the imposition of a penalty for possessing an illegal drug influence demand, supply, price, and the quantity of the drug consumed? If the penalty is levied on the buyer, the penalty is subtracted from the maximum willingness to pay for the good. The supply curve remains unchanged and the demand curve shifts leftward, so that the vertical distance between the initial demand curve and the demand curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the good falls and the equilibrium quantity decreases.

How does the imposition of a penalty for selling or possessing an illegal drug influence demand, supply, price, and the quantity of the drug consumed? If buyers and sellers face penalties, both the demand and supply curves shift leftward. If the shift of the supply curve is larger, the equilibrium price rises and quantity decreases; if the shift of the demand curve is larger, the price falls and quantity decreases; if the shifts are the same magnitude, the price is unchanged and the quantity decreases.

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Is there any case for legalizing drugs? To reduce the consumption of drugs, they can be legalized and taxed. Legalizing and then taxing drugs has the benefit of raising funds for the government that could be used to help educate people about the danger of consuming drugs. However, if very high taxes are necessary to reduce the consumption of illegal drugs to the level of use when they were banned, this will cause buyers and sellers to engage in unreported trade in the illicit market and avoid the tax through tax evasion.

GOVERNMENT ACTIONS IN MARKETS

Answers to the Study Plan Problems and Applications Use Figure 6.1, which shows the market for rental housing in Townsville, to work Problems 1 and 2. 1. a. What are the equilibrium rent and equilibrium quantity of rental housing? The equilibrium rent is $450 a month and the equilibrium quantity is 20,000 housing units.

b. If a rent ceiling is set at $600 a month, what is the rent paid? What is the shortage of housing? If the rent ceiling is set at $600 per month, it is above the equilibrium rent and so is ineffective because renters still pay the equilibrium rent, $450 per month. There is no shortage of housing units: The quantity of housing demanded, 20,000 units, equals the quantity of units supplied.

If the rent ceiling is $300 a month, what is the quantity rented, the shortage of housing, and the maximum price that someone is willing to pay for the last unit of housing available? The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent ceiling. The shortage of housing is 20,000 housing units. At the rent ceiling, the quantity of housing demanded is 30,000, but the quantity supplied is 10,000, so there is a shortage of 20,000 housing units. The maximum price that someone is willing to pay for the 10,000th unit available is $600 a month. The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

Use the following data on the demand and supply schedules of teenage labor to work Problems 3 and4. 3.

Calculate the equilibrium wage rate, the hours worked, and the quantity of unemployment.

Wage rate (dollars per hour) 6 7 8 9

Quantity Quantity demanded supplied (hours per month) 2,500 1,500 2,000 2,000 1,500 2,500 1,000 3,000

The equilibrium wage rate is $7 an hour and 2,000 hours a month are worked. Unemployment is zero. Everyone who wants to work for $6 an hour is employed.

The minimum wage for teenagers is $8 an hour. a. How many hours are unemployed? At $8 an hour, 1,500 hours a month are employed and 1,000 hours a month are unemployed. The quantity of labor employed equals the quantity demanded at $8 an hour. Unemployment is equal to the quantity of labor supplied at $8 an hour minus the quantity of labor demanded at $8 an hour. The quantity supplied is 2,500 hours a month and the quantity demanded is 1,500 hours a month, so 1,000 hours a month are unemployed.

b. If the demand for teenage labor increases by 500 hours a month, what is the wage rate and how many hours are unemployed? The wage rate is $8 an hour, and unemployment is 500 hours a month. At the minimum wage of $8 an hour, the quantity demanded is 2,000 hours a month and the quantity supplied is 2,500 hours a month so 500 hours a month are unemployed. © 2023 Pearson Education, Inc.

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The table sets out the demand and supply schedules for chocolate brownies. a. If sellers are taxed 20¢ a brownie, what is the price and who pays the tax? The price paid by buyers, including the tax, is 70 cents a brownie. The price received by sellers, excluding the tax, is 50 cents a brownie. If there is no tax, the price is 60 cents a brownie, so consumers and sellers each pay 10 cents of the tax on a brownie.

Price (cents per brownie) 50 60 70 80

Quantity Quantity demanded supplied (millions per day) 5 3 4 4 3 5 2 6

b. If buyers are taxed 20¢ a brownie, what is the price and who pays the tax? The price received by sellers, excluding the tax, is 50 cents a brownie, and 3 million brownies a day are consumed. The price paid by buyers, including the tax, is 70 cents a brownie. Consumers and sellers each pay 10 cents of the tax.

Use the following data to work Problems 6 and 7. The demand and supply schedules for rice are in the table. Calculate the price, the marginal cost of rice, and the quantity produced if the government 6. Sets a production quota of 2,000 boxes a week.

Price (dollars per box) 1.20 1.30 1.40 1.50 1.60

Quantity Quantity demanded supplied (boxes per week) 3,000 1,500 2,750 2,000 2,500 2,500 2,250 3,000 2,000 3,500

With a production quota of 2,000 boxes a week, the price is $1.60 a box, the marginal cost $1.30 a box, and the quantity produced is 2,000 boxes a week. The production quota decreases the quantity supplied to 2,000 boxes a week. The marginal cost of producing 2,000 boxes of rice is given by the supply schedule and is $1.30 a box.

Introduces a subsidy of $0.30 a box. With a subsidy of $0.30 a box for rice, the price is $1.20 a box, the marginal cost $1.50 a box, and the quantity produced is 3,000 boxes a week. The subsidy of $0.30 lowers the price at which each quantity in the table is supplied. For example, rice farmers will supply 3,000 boxes a week if the price is $1.50 minus $0.30, which is $1.20. With a subsidy, the market equilibrium occurs at a price of $1.20 a box. At this price, the quantity demanded is 3,000 boxes and the quantity supplied is 3,000 boxes. The marginal cost of producing rice is given by the supply schedule and is $1.50 a box.

GOVERNMENT ACTIONS IN MARKETS

Figure 6.2 shows the market for an illegal good. Calculate the market price and the quantity bought if a penalty of $20 a unit is imposed on a. Sellers only or buyers only. With a penalty of $20 a unit on sellers, the price is $70 a unit and the quantity consumed is 100 units. The $20 penalty on sellers decreases the supply. The supply curve shifts leftward so that the vertical distance between the initial supply curve and the new supply curve is $20. In Figure 6.3, the supply curve shifts to S1 and the demand curve remains D. With this new supply curve, the equilibrium is at point A in Figure 6.3, with an equilibrium price of $70 a unit and an equilibrium quantity of 100 units. If the penalty is imposed on only buyers, the price is $50 a unit and the quantity consumed is 100 units. The $20 penalty on buyers decreases the demand. The demand curve shifts leftward so that the vertical distance between the initial demand curve and the new demand curve is $20. In Figure 6.3, the demand curve shifts to D1 and the supply curve remains S. With this new demand curve, the equilibrium is at point B in Figure 6.3, with an equilibrium price of $50 a unit and an equilibrium quantity of 100 units.

b. Both sellers and buyers. With a penalty of $20 a unit on sellers and on buyers, the price is $60 a unit and the quantity consumed is 90 units. The $20 penalty on sellers decreases the supply. The supply curve shifts leftward so that the vertical distance between the initial supply curve and the new supply curve is $20. The $20 penalty on buyers decreases the demand. The demand curve shifts leftward so that the vertical distance between the initial demand curve and the new demand curve is $20. In Figure 6.3, the supply curve shifts to S1 and the demand curve shifts to D1. With these new supply and demands curves, the equilibrium is at point C in Figure 6.3, with an equilibrium price of $60 a unit and an equilibrium quantity of 90 units.

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Answers to Additional Problems and Applications The table sets out the demand and supply schedules for college meals. 9. a. What are the equilibrium meal price and equilibrium quantity of meals? The equilibrium price of a meal is $6 per meal and the equilibrium quantity is 2,500 meals per week.

Price (dollars per meal) 4 5 6 7 8

b. If the college put a price ceiling on meals at $7 a meal, what is the price students pay for a meal? How many meals do they buy?

Quantity Quantity demanded supplied (meals per week) 3,000 1,500 2,750 2,000 2,500 2,500 2,250 3,000 2,000 3,500

The price ceiling is above the equilibrium price, so it is ineffective. The price of a meal remains at $6 per meal and students buy 2,500 meals per week.

10.

If the college put a price ceiling on meals at $4 a meal, what is the quantity bought, the shortage of meals, and the maximum price that someone is willing to pay for the last meal available? The price ceiling is below the equilibrium price, so it has an effect. The quantity of meals purchased is the quantity supplied at the price of $4 per meal, 1,500 meals per week. At this price, the quantity of meals demanded is 3,000, so the shortage of meals is 3,000 meals demanded minus 1,500 meals supplied, or 1,500 meals. For 1,500 meals, the most someone is willing to pay for a meal is above $8. Indeed, if the demand schedule continues to be linear as in the table, someone is willing to pay $10 for the last meal.

Use the following news clip to work Problems 11 and 12. European Commission to Launch Consultations on First E.U. Minimum Wage “Europe’s economy must provide people with quality jobs that pay an adequate wage,” said Commissioner for Jobs and Social Rights Nicolas Schmit. Six of the Euro members—Italy, Cyprus, Austria, Denmark, Finland, and Sweden—do not have a national minimum wage. Source: forbes.com, January 16, 2020. 11. On a graph of the market for low-skilled labor, show the effect of the minimum wage on the quantity of labor employed. Assuming that the minimum wage is set above the market equilibrium wage, Figure 6.4 shows the effect. In the absence of the minimum wage, employment equals 16 million workers. With the minimum wage, employment falls to 8 million.

12.

Explain the effects of the minimum wage on the workers’ surplus, the firms’ surplus, and the efficiency of the market for low-skilled workers. The minimum wage decreases both the workers’ surplus and the firms’ surplus. Importantly, it makes the market less efficient by increasing the deadweight loss.

GOVERNMENT ACTIONS IN MARKETS

13.

The government wants to discourage the consumption of sugary drinks and proposes introducing a 20 percent tax on them. A survey shows that the demand for sugary drinks is perfectly elastic and people are equally happy to stop consuming those drinks and switch to healthier alternatives. Producers of sugary drinks complain and say they will increase their prices by 20 percent. Explain, and illustrate with a graph, why sugary drinks producers are wrong. Sugary drink producers are wrong because the demand is perfectly elastic. Consequently, consumers are not willing to pay a price that is higher than the price at which the demand is elastic. Figure 6.5 illustrates this situation. The initial price of a drink is $1.00 and the demand for drinks is perfectly elastic at this price. Once the tax is imposed, the supply curve shifts upward by the amount of the tax, 20 percent of the price without the tax, to the supply curve labeled S + tax. The new equilibrium price demanders pay is the same as the price they paid without the tax: $1.00 per drink. Not only can the producers not mark up the price by 20 percent, but they also cannot mark it up by anything at all! In this case, the entire incidence of the tax falls on the sellers.

14.

The demand and supply schedules for tulips are in the table. a. If tulips are not taxed, what is the price and how many bunches are bought? The price is $14 per bunch and 80 bunches are purchased.

b. If tulips are taxed $6 a bunch, what are the price and quantity bought? Who pays the tax?

Price (dollars per bunch) 10 12 14 16 18

Quantity Quantity demanded supplied (bunches per week) 100 40 90 60 80 80 70 100 60 120

If tulips are taxed $6 a bunch, consumers pay $18 per bunch, suppliers receive $12 per bunch, and 60 bunches per week are bought. Of the $6 tax, consumers pay $4 in the form of a higher price paid and suppliers pay $2 in the form of a lower price received.

15.

Maryland Tobacco Tax Increase Is a Big Win Maryland is raising the state tobacco tax by $1.75 a pack. This is a health win that will reduce smoking and save lives, a financial win that will raise much-needed revenue, and a political win that polls show is popular with voters. Source: prnewswire.com, February 12, 2021 a. How will the Maryland market for cigarettes respond to the tax increase? The new taxes will increase the wedge between the price the buyers pay and the price the sellers get. It will raise the price the buyers pay and reduce the price the sellers get. The quantity bought will decrease.

b. Cigarette prices are lower in neighboring Virginia and West Virginia. How does shopping in these states impact the elasticity of demand for cigarettes in Maryland? When the tax raises the price of tobacco Maryland, shoppers may go to Virginia or West Virginia where the price will stay lower. Because shopping in Virginia or West Virginia is a good substitute for shopping © 2023 Pearson Education, Inc.

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in Maryland, the elasticity of demand in Maryland is larger than it otherwise would be.

c. Does an increase in the tax necessarily bring an increase in the tax revenue? Tax revenue equals the tax wedge multiplied by the quantity bought. If the demand is elastic, then the percentage decrease in the quantity bought is larger than the percentage increase in the tax and the tax wedge, so that the government collects less tax revenue.

Use the following news clip to work Problems 16 to 18. Biden’s Farm Problem With the highest commodity prices in seven years, many farmers are anticipating high profits in 2021. Should Washington peel back the extensive subsidies that have kept farmers afloat for years? Source: politico.com, February 18, 2021 16. a. Why are U.S. farmers subsidized? The federal government subsidizes farmers because of extensive farm lobbying. The subsidies help farmers avoid low prices and low incomes.

b. Explain how a subsidy paid to dairy farmers affects the price of milk and the marginal cost of producing it. A subsidy increases the supply of milk. The increase in supply lowers the price of milk and increases the quantity produced. With the increase in the quantity produced the marginal cost of producing milk rises.

17.

Explain how a subsidy paid to dairy farmers affects the consumer surplus and the producer surplus from milk. Does the subsidy make the milk market more efficient or less efficient? Explain. A subsidy increases the production of milk and lowers the market price consumers pay. Without taking account of the loss of surplus from taxes that must be paid in order to finance the subsidy, the consumer surplus increases. The subsidy increases the producer surplus because they produce more and receive a higher price (including the subsidy) than they otherwise would. With the subsidy, production increases so that marginal social cost exceeds marginal social benefit. Consequently, the subsidy makes the market less efficient.

18.

If subsidies to dairy farmers decrease in 2021, how will the price and quantity of milk bought and sold change? A decrease in the subsidies result in less milk being produced, which decreases the supply of milk. Accordingly, the equilibrium price of milk rises, and the equilibrium quantity of milk bought and sold decreases.

GOVERNMENT ACTIONS IN MARKETS

Use the Figure 6.6, which shows the market for tomatoes, to work Problems 19 and 20. 19. If the government subsidizes growers at $4 a pound, what is the quantity produced, the quantity demanded, and the subsidy paid to growers? If the government subsidizes growers at $4 a pound, the supply increases. As shown in Figure 6.7, the supply curve shifts downward by $4. The demand does not change. The new price is $4 per pound and at this price the quantity produced is 3 billion pounds and the quantity demanded is 3 billion pounds. The government pays ($4 a pound) × (3 billion pounds), which is $12 billion.

20.

If the government subsidizes growers at $4 a pound, who gains and who loses from the subsidy? What is the deadweight loss? Could the subsidy be regarded as being fair? The suppliers and demanders of tomatoes gain from the subsidy. The taxpayers, who must send the government $12 billion in taxes, lose. Tomato producers in other countries lose because they receive a lower price. The deadweight loss is equal to the area of the grey triangle in Figure 6.7. Accordingly, the deadweight loss is equal to ½ × (3 billion pounds – 2 billion pounds) × $4 a pound, which is $2 billion. Using the “fair results” approach, the subsidy is fair if the growers and consumers of tomatoes have lower incomes than the taxpayers. If not, then the tax is unfair. Using the “fair rules” view, the subsidy is unfair because the taxpayers are forced to pay the tax.

21.

The table gives the demand and supply schedules for an illegal drug. Price a. What is the price and how many units are (dollars per bought if there is no penalty on drugs? unit) The price is $60 per unit and 400 units are 50 consumed. 60 b. If the penalty on sellers is $20 a unit, what 70 are the price and quantity consumed? 80 The price is $70 per unit and 300 units are 90

Quantity Quantity demanded supplied (units per day) 500 300 400 400 300 500 200 600 100 700

consumed.

c. If the penalty on buyers is $20 a unit, what are the price and quantity consumed? The price $50 per unit and 300 units are consumed.

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Economics in the News 22. After you have studied Economics in the News on pp. 148–149, answer the following questions. a. If the federal minimum wage rate increases to $15 an hour, what do you expect will happen to unemployment? Illustrate your answer with a graph. Unemployment will increase. In Figure 6.8, the initial minimum wage is $7.25 an hour. With that minimum wage, unemployment is 1 million workers. When the government sets a new minimum wage of $15 an hour, unemployment rises to 3 million workers.

b. Describe the gains and losses that will arise if the federal minimum wage is raised to $15 an hour and employers find ways of making labor more productive. If employers find ways to make workers more productive, the demand for labor increases. This change will increase employment and decrease unemployment. Workers who otherwise would have been unemployed without the increase in productivity but are employed with it, gain. Workers who remain unemployed neither gain nor lose. Firms will gain because their workers are more productive so that the firms’ profits will be higher.

c. The news article says evidence suggests that increases of the minimum wage up to 59 percent of the median wage have little negative impact on employment. What does this evidence imply about a $15 minimum wage? The current median wage is $20.17 an hour. 59 percent of this wage is $11.90. The proposed minimum wage of $15.00 an hour is well above 59 percent of the median wage, so the effect on employment and unemployment may be larger than proponents of a higher minimum wage predict.

GOVERNMENT ACTIONS IN MARKETS

23.

New York’s 13% Cannabis Tax May Be Too High Some experts say New York’s 13% tax may be too high to compete with a popular illicit market. But it’s better than the original plan to impose a 20% tax, which would allow the illicit market to continue to thrive. Source: marketwatch.com, April 3, 2021 Assume that the marginal cost of producing a gram of marijuana (legal or illegal) is a constant $10 and that legal marijuana bears a tax of $2 per gram. a. Draw a graph of the market for marijuana, assuming that there are no penalties on either buyers or sellers for breaking the law. Because the cost of producing a gram of marijuana is constant at $10, as Figure 6.9 shows, the supply is perfectly elastic (the supply curve is horizontal) at the price of $10 per gram. The equilibrium price is $10 per gram and the equilibrium quantity is 50,000 pounds per month.

b. How does a $2 tax change the market outcome? Show the effects in your graph. Suppose the $2 tax per gram is imposed on sellers; a $2 tax imposed on buyers has the same equilibrium prices and quantities. With the tax imposed on sellers, the $2 tax shifts the supply curve upward by $2 per gram, to the supply curve labeled S + tax. The buyers pay $12.00 per gram and the sellers get $10 per gram. The quantity is 20,000 pounds per month.

c. With no penalty on buyers, if a penalty for breaking the law is imposed on sellers at more than $2 per gram, how does the market work and what is the equilibrium price? The supply decreases and the supply curve shifts up by whatever the amount of the penalty. The price buyers pay rises above $12.00 per gram and the quantity decreases to less than 20,000 pounds.

d. With no penalty on sellers, if a penalty for breaking the law is imposed on buyers at more than $2 per gram, how does the market work and what is the equilibrium price? The demand decreases and the demand curve shifts down by whatever the amount of the penalty. Buyers still pay $10.00 per gram but the quantity decreases to less than 20,000 pounds.

e. What is the marginal benefit of an illegal gram of marijuana in the situations described in parts (c) and (d)? In both cases the marginal benefit is equal to the height of the demand curve at the equilibrium quantity, $12. At this quantity, the marginal benefit exceeds the marginal cost.

Can legalizing and taxing marijuana achieve the same quantity of marijuana use as occurs if marijuana is illegal? Yes. The government can impose a sufficiently large tax that it decreases the equilibrium quantity so that it equals the quantity that was traded when marijuana was illegal.

C h a p t e r

GLOBAL MARKETS IN ACTION

Answers to the Review Quizzes Page 158 1.

Describe the situation in the market for a good or service that the United States imports. The goods and services the United States will import are those in which the United States has a higher opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is higher than the world price. With trade the quantity produced in the United States is less than the quantity consumed and the difference is imported.

Describe the situation in the market for a good or service that the United States exports. The goods and services the United States will export are those in which the United States has a lower opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is lower than the world price. With trade the quantity produced in the United States exceeds the quantity consumed and the excess is exported.

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How is the gain from imports distributed between consumers and domestic producers? Consumers gain consumer surplus from imports and domestic producers lose producer surplus from imports.

How is the gain from exports distributed between consumers and domestic producers? Consumers lose consumer surplus from exports and domestic producers gain producer surplus from exports.

Why is the net gain from international trade positive? The net gain from international trade is positive because the gain to the winners exceeds the losses to the losers. For instance, in the case of an imported good, all the loss of producer surplus is transferred to consumers as consumer surplus. In addition, however, consumers also gain additional consumer surplus from the units imported. The total gain of consumer surplus exceeds the loss of producer surplus so that the net surplus increases. The situation is similar for exports: The total gain of producer surplus exceeds the loss of consumer surplus.

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What are the tools that a country can use to restrict international trade? A country can use tariffs, import quotas, other import barriers such as health, safety, and regulation barriers, and voluntary export restraints to restrict international trade. Export subsidies given by a nation decrease other countries’ exports and thereby restrict their international trade.

Explain the effects of a tariff on domestic production, the quantity bought, and the price. A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

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Explain who gains and who loses from a tariff and why the losses exceed the gains. Domestic consumers lose consumer surplus from the tariff. Domestic producers gain producer surplus from the tariff. The government also gains revenue from the tariff. But the gain in producer surplus plus the gain in government revenue is less than the loss of consumer surplus, so on net a tariff creates a deadweight loss.

Explain the effects of an import quota on domestic production, consumption, and price. An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

Explain who gains and who loses from an import quota and why the losses exceed the gains. Domestic consumers lose consumer surplus from the import quota. Domestic producers gain producer surplus from the import quota. The importers also gain additional profit from the import quota. But the gain in producer surplus plus the importers’ profits is less than the loss of consumer surplus, so on net an import quota creates a deadweight loss.

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What are the infant industry and dumping arguments for protection? Are they correct? The attempt to stimulate the growth of new industries is the infant-industry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets. This argument is based on the idea that as firms mature they become more productive. However this argument for protection only works if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade. The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production. Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits. This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping since it is impossible to verify a firm’s production costs. The test most commonly used is if the firm’s price when it exports is lower than its domestic price. This test only examines the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case) then it is natural for a firm to price the domestic goods higher than the exports. Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market. And, even if there is global monopoly it is more efficient to regulate it than to impose trade restrictions on its products.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited? There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are: 

Trade restrictions save domestic jobs: Free international trade does, indeed, cost jobs in the importcompeting markets. But this argument ignores the fact that, under free trade, consumers in the exporting country will have greater disposable income. These consumers will use part of their higher income to buy goods and services from other countries, thereby increasing employment in the exporting sector of the nation. So, although international trade rearranges jobs—decreasing them in import-competing markets and increasing them in exporting markets—it does not, on net, cost jobs.

GOVERNMENT ACTIONS IN MARKETS



Trade restrictions penalize lax environmental standards: Not all developing countries have lax environmental standards. Also, a clean environment is a normal good. Countries that are relatively poor and have lax pollution standards do not care as much about the environment because imposing clean air, water, and land standards have a high opportunity cost because they will slow economic development. The best way to encourage environmental quality is not to restrict economic development but to encourage rapid economic growth, which will more quickly increase citizen demand for a cleaner environment in those developing countries. Trade restrictions prevent rich countries from exploiting poorer countries: Importing goods made in countries with low wage levels increases the demand for labor in those countries, increasing the number of jobs available and raising wages over time. The more free trade that occurs with these countries, the more quickly the wages will rise and the working conditions will increase in quality and safety.

What is offshore outsourcing? Who benefits from it and who loses? Offshore outsourcing occurs when a firm in the United States buys finished goods, components, or services from firms in other countries. Workers who have skills for jobs that have been sent abroad lose from offshore outsourcing. Consumers who consume the goods and services produced abroad and imported into the United States benefit.

What are the main reasons for imposing a tariff? There are two main reasons for imposing tariffs on imports. First the government receives tariff revenues from imports, which can be useful when revenues from income taxes and sales taxes are less effective ways of gaining government revenue. Second rent seeking by individuals in industries that would be hurt by foreign competition can influence the government to impose tariffs.

Why don’t the winners from free trade win the political argument? Trade restrictions are enacted despite the inherent inefficiency because of the political actions of rent seeking groups, which fear that foreign competition might have a negative impact on their industry, firm, or jobs. The anti-trade groups are easily organized and have much to gain from trade restrictions, whereas the vast millions of consumers, who would win from free trade, are difficult to organize because each individual has only a small amount of loss when trade restrictions are imposed. Hence the winners from trade restrictions frequently out-lobby the winners from free trade.

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 Price Quantity Quantity to 3. (dollars per demanded supplied Wholesalers buy and sell roses in containers container) (millions of containers per year) that hold 120 stems. The table provides 100 15 0 information about the wholesale market for 125 12 2 roses in the United States. The demand 150 9 4 schedule is the wholesalers’ demand and the 175 6 6 supply schedule is the U.S. rose growers’ 200 3 8 supply. Wholesalers can buy roses at auction 225 0 10 in Aalsmeer, Holland, for $125 per container. 1. a. Without international trade, what would be the price of a container of roses and how many containers of roses a year would be bought and sold in the United States? Without international trade, in the United States the price of a container of roses is $175 and 6 million containers of roses are bought and sold.

b. At the price in your answer to part (a), does the United States or the rest of the world have a comparative advantage in producing roses? The price of roses in the United States exceeds the price in the rest of the world, so the rest of the world has a comparative advantage in producing roses.

If U.S. wholesalers buy roses at the lowest possible price, how many do they buy from U.S. growers and how many do they import? The price of roses in the United States is $125 per container. At this price, U.S. rose growers supply 2 million containers per year and U.S. wholesalers demand 12 million containers of roses. U.S. wholesalers buy the 2 million containers from U.S. growers and purchase 10 million containers from foreign sources, which are imported into the United States.

Draw a graph to illustrate the U.S. wholesale market for roses. Show the equilibrium in that market with no international trade and the equilibrium with free trade. Mark the quantity of roses produced in the United States, the quantity imported, and the total quantity bought. In Figure 7.1, the equilibrium without international trade is determined at the intersection of the demand curve and the supply curve. Without international trade the equilibrium price is $175 per container and 6 million containers per year are bought and produced. With international trade the world price is $125 per container, as shown in Figure 7.1. The quantity produced in the United States is 2 million containers and the quantity bought in the United States is 12 million containers. Imports into the United States account for the difference between the quantity bought and the quantity produced, 10 million containers.

GOVERNMENT ACTIONS IN MARKETS

international trade in roses compared to a situation in which Americans buy only roses grown in the United States. U.S. rose wholesalers, who are the consumers in the problem, gain from free international trade. U.S. rose growers lose from free international trade.

b. Draw a graph to illustrate the gains and losses from free trade. Figure 7.2 illustrates the market with free trade. Consumer surplus before international trade is equal to area A; after international trade consumer surplus is equal to area A + area B + area C. Producer surplus before international trade is equal to area B + area D; after international trade producer surplus is equal to area D.

c. Calculate the gain from international trade. The gain from international trade is area C in Figure 7.2. It is equal to ½  ($175  $125)  (10 million containers) which is $250 million.

Use the information on the U.S. wholesale market for roses in Problem 1 to work Problems 5 to 10. 5. If the United States puts a tariff of $25 per container on imports of roses, explain how the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported change. The U.S. price of roses rises from $125 per container (the price with free trade) to $150 per container. The quantity of roses produced in the United States increases from 2 million containers (the quantity produced with free trade) to 4 million containers. The quantity of roses consumed in the United States decreases from 12 million containers (the quantity consumed with free trade) to 9 million containers. The quantity imported decreases from 10 million containers to 5 million containers.

Who gains and who loses from this tariff? U.S. rose consumers lose from the tariff. U.S. rose producers gain from the tariff. The U.S. government gains revenue from the tariff.

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Draw a graph of the U.S. market for roses to illustrate the gains and losses from the tariff and on the graph identify the gains and losses, the tariff revenue, and the deadweight loss created. Figure 7.3 shows the effect of the tariff. The amount of the tariff per container is equal to the height of the light gray arrow. Before the tariff U.S. consumer surplus was equal to area A + area B + area C + area E + area F. After the tariff U.S. consumer surplus is equal to area A. U.S. consumers lose consumer surplus equal to area B + area C + area E + area F. Before the tariff U.S. producer surplus was equal to area G. After the tariff U.S. producer surplus is equal to area G + area B. U.S. producers gain producer surplus equal to area B. After the tariff the U.S. government gains tariff revenue equal to area E. The deadweight loss from the tariff is equal to area C + area F.

If the United States puts an import quota on roses of 5 million containers, what happens to the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported? The U.S. price of roses rises to $150 per container. 9 million containers of roses are purchased in the United States and 4 million containers of roses are produced in the United States. The difference, 5 million containers, is imported into the United States.

Who gains and who loses from this quota? U.S. rose growers and importers of roses gain from the quota. U.S. rose wholesalers lose from the quota.

10.

Draw a graph to illustrate the gains and losses from the import quota and on the graph identify the gains and losses, the importers’ profit, and the deadweight loss. Figure 7.4 shows the effect of the import quota. The amount of the quota is equal to the length of the gray arrow. Before the quota U.S. consumer surplus was equal to area A + area B + area C + area E + area F. After the quota U.S. consumer surplus is equal to area A. U.S. consumers lose consumer surplus equal to area B + area C + area E + area F. Before the quota U.S. producer surplus was equal to area G. After the quota U.S. producer surplus is equal to area G + area B. U.S. producers gain producer surplus equal to area B. After the quota the importers of the rose containers earn profit equal to area E. The deadweight loss from the import quota is equal to area C + area F.

GOVERNMENT ACTIONS IN MARKETS

11.

Dependence on China for Medicine Is a Safety Threat 95% of ibuprofen and 70% of acetaminophen is imported from China. Since the pandemic began, imported generic drugs have entered the U.S. without proper inspection. Source: lasvegassun.com, February 13, 2021 a. What does the news clip imply about the comparative advantage of producing pharmaceuticals in the United States and China? Because these pharmaceuticals were produced in China, the news clip suggests that China has the comparative advantage in producing these pharmaceuticals.

b. Could product quality be a valid argument against free trade? If it could, explain how. Product quality is not a valid argument against free trade. Quality is a valid concern for consumers. If consumers cannot judge quality themselves, then government inspection might be necessary. But in that case government inspection of both imported and domestically produced goods is required. To single out imported goods or services makes little sense.

c. If China began proper inspection of drugs, who would gain and who would lose from free trade between the United States and China? With proper inspections insuring the safety of the drugs, the prices of the drugs would be lower in the United States after trade. With lower prices, U.S. consumers of the drugs would buy more drugs and would gain, that is, consumer surplus would increase. The lower prices, however, would lead to U.S. producers of the drugs decreasing the quantity they produce and losing, that is, the producer surplus would decrease.

d. With no safety threat, if the United States imposed a quota on generic drug imports from China, who would win and who would lose from the quota? With no safety threat, imposing a quota would raise prices in the United States. Winners from the higher prices would be U.S. producers of the drugs, who produce more and whose producer surplus increases, and importers of the drugs. Losers would be U.S. consumers, who buy less and whose consumer surplus decreases.

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Answers to Additional Problems and Applications 12.

Suppose that the world price of sugar is 10 cents a pound, the United States does not trade internationally, and the equilibrium price of sugar in the United States is 20 cents a pound. The United States then begins to trade internationally. a. How does the price of sugar in the United States change? The price of sugar in the United States falls.

b. Do U.S. consumers buy more or less sugar? As a result of the lower price, U.S. consumers buy more sugar.

c. Do U.S. sugar growers produce more or less sugar? As a result of the lower price, U.S. growers produce less sugar.

d. Does the United States export or import sugar and why? The United States imports sugar. The quantity of sugar demanded increases while quantity supplied decreases. The difference is made up by imports.

13.

Suppose that the world price of steel is $100 a ton, India does not trade internationally, and the equilibrium price of steel in India is $60 a ton. India then begins to trade internationally. a. How does the price of steel in India change? The price of steel in India rises to equal the world price.

b. How does the quantity of steel produced in India change? Producers respond to the higher price by increasing the quantity of steel produced.

c. How does the quantity of steel bought by India change? Steel users in India respond to the higher price by decreasing the quantity of steel bought.

d. Does India export or import steel and why? Because the price of steel in India is lower than the world, India has a comparative advantage in the production of steel. India will export steel.

14.

A semiconductor is a key component in your laptop, smartphone, and iPad. The table provides information about the market for semiconductors in the United States. Producers of semiconductors can get $18 a unit on the world market. a. With no international trade, what would be the price of a semiconductor and how many semiconductors a year would be bought and sold in the United States?

Price (dollars per unit) 10 12 14 16 18 20

Quantity Quantity demanded supplied (billions of units per year) 25 0 20 20 15 40 10 60 5 80 0 100

With no international trade the price of a semiconductor in the United States is $12 per unit. 20 billion units are bought and sold in the United States.

b. Does the United States have a comparative advantage in producing semiconductors? The United States has a comparative advantage in producing semiconductors because the U.S. price is lower than the price in the world market.

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15.

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Good News for Corn Growers. Corn prices have hit their highest levels in almost eight years as drivers returning to the road following the pandemic are increasing the demand for ethanol. Source: wsj.com, March 30, 2021 a. Why is the world price of corn rising? The use of corn to produce ethanol used in gasoline has increased, thereby increasing the demand for corn and raising the price of corn.

b. How does the change in the world price of corn affect the quantity of corn produced in a poor developing country with a comparative advantage in producing corn, the quantity it consumes, and the quantity that it either exports or imports? The higher world price of corn decreases the consumption of corn and increases the production of corn in poor developing countries. Because the country has a comparative advantage it will export corn. The higher price leads the country to increase its exports.

16.

Draw a graph of the market for corn in the poor developing country in Problem 15(b) to show the changes in consumer surplus and producer surplus. Figure 7.5 shows the situation in the poor country that exports corn. With the initial lower price, the country produces 60 million bushels, exports 20 million bushels, and consumes 40 million bushels. The consumer surplus is equal to area A + area B and the producer surplus is equal to area E. After the world price of corn rises to $8 per bushel, the country produces 80 million bushels of corn, exports 60 million bushels, and consumes 20 million bushels. Consumer surplus decreases to area A and producer surplus increases to area B + area C + area E. The country gains additional surplus equal to area C.

Use the following news clip to work Problems 17 and 18. Scotland’s Haggis Makers Heartened at Prospect of US Breakthrough Haggis, Scotland’s national dish has been banned in the United States since 1971. The United States does not allow sheep lungs—a primary ingredient in haggis—in food products. The UK wants the US to end its ban. Source: foodnavigator.com, August 3, 2020 17. a. Explain how the U.S. import ban on haggis affected haggis producers and consumers in Scotland. The U.S. import ban lowered the price of haggis in Scotland. The lower price led to decreased production in Scotland, which made Scottish producers worse off. The lower price also led to increased consumption in Scotland, which made Scottish consumers better off.

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b. Draw a graph of the market for haggis in Scotland to illustrate your answer to part (a). Identify the changes in consumer surplus and producer surplus in Scotland. Figure 7.6 shows the effect of the U.S. import ban. Prior to the ban, presuming the only Scottish exports of haggis were to the United States, the price of haggis in Scotland was $5 per pound. At this price the quantity consumed in Scotland was 30,000 pounds of haggis per year and the quantity produced in Scotland was 80,000 pounds per year. The difference, 50,000 pounds per year, was exported to the United States. Producer surplus in Scotland was equal to area B + area C + area E and consumer surplus in Scotland was equal to area A. With the import ban, the price of haggis in Scotland falls to $4 per pound. At this price 60,000 pounds of haggis per year are produced and consumed in Scotland. There are no exports. Producer surplus in Scotland shrinks to only area E and consumer surplus grows to area A + area B.

18. a. Explain how lifting the U.S. import ban on haggis affects producers and consumers of haggis in the United States. Lifting the U.S. ban lowers the price of haggis in the United States. U.S. consumption increases and U.S. production decreases so U.S. consumers are better off and U.S. producers are worse off.

b. Draw a graph to illustrate your answer to (a) and identify the changes in U.S. consumer surplus and producer surplus. Figure 7.7 shows the situation in the U.S. market for haggis. With no trade the U.S. price of haggis is $6 per pound. The United States produces and consumes 30,000 pounds of haggis. At this price consumer surplus in the United States is equal to area A and producer surplus is equal to area B + area E. When the U.S. import ban is eliminated, the price in the United States falls to $5 per pound. U.S. production falls to 20,000 pounds per year and U.S. consumption rises to 50,000 pounds. The difference, 30,000 pounds, is imported from Scotland. U.S. producer surplus decreases to only area E. U.S. consumer surplus increases to area A + area B + area C.

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Use the following information to work Problems 19 to 21. Before 1995, trade between the United States and Mexico was subject to tariffs. In 1995, Mexico joined NAFTA and all U.S. and Mexican tariffs have gradually been removed. 19. Explain how the price that U.S. consumers pay for goods from Mexico and the quantity of U.S. imports from Mexico have changed. Who are the winners and who are the losers from this free trade? With NAFTA, the prices that U.S. consumers pay for goods from Mexico have fallen and, as a result, the quantity of imports from Mexico have increased. Winners from this free trade are Mexican producers of goods exported to the United States and U.S. consumers of these goods. Losers are Mexican consumers of the goods and U.S. producers of the goods.

20.

Explain how the quantity of U.S. exports to Mexico and the U.S. government’s tariff revenue from trade with Mexico have changed. The prices of U.S. goods in Mexico have fallen and, as a result, the quantity of U.S. goods exported to Mexico has increased. The U.S. government’s tariff revenue from tariffs imposed on trade with Mexico decreased.

21.

Suppose that in this year tomato growers in Florida lobby the U.S. government to impose an import quota on Mexican tomatoes. Explain who in the United States would gain and who would lose from such a quota. U.S. tomato growers gain from such a quota. The importers who hold the quota rights also gain. U.S. consumers of tomatoes lose from such a quota.

Use the following information to work Problems 22 and 23. Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. 22. Explain how the tariff on textiles will change the price that U.S. buyers pay for textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. The tariff raises the U.S. price of textiles. As a result, the quantity of textiles consumed in the United States decreases and the quantity produced increases. Imports of textiles into the United States decrease.

23.

Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain? The decrease in trade means that the U.S. and Chinese gains from trade decrease. In the United States, U.S. producers gain from the tariff. The U.S. government also gains revenue from the tariff. U.S. textile consumers lose.

Use the following information to work Problems 24 and 25. With free trade between Australia and the United States, Australia would export beef to the United States. But the United States imposes an import quota on Australian beef. 24.

Explain how this quota influences the price that U.S. consumers pay for beef, the quantity of beef produced in the United States, and the U.S. and the Australian gains from trade. The quota raises the price of beef in the United States. By raising the U.S. price, the quota increases the quantity of beef produced in the United States and decreases the quantity of beef consumed in the United States. The U.S. and Australian gains from trade decrease.

25.

Explain who in the United States gains from the quota on beef imports and who loses. U.S. beef producers gain from the quota. The people who hold the import quota rights also gain. U.S. beef consumers lose from the quota.

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Can Biden Bring Manufacturing Back to the U.S.? Nearly 5 million net manufacturing jobs have disappeared since 1997, and critics blame freetrade policies. The Biden administration wants to slow or reverse manufacturing job losses, a process known as “reshoring.” Source: fortune.com, April 23, 2021 a. What are the arguments for bringing jobs back to America? Explain why these arguments are faulty. The primary argument advanced for being jobs back to America is that it will increase employment in America and the benefits to the U.S. workers who gain these jobs outweigh the costs of restricting trade. The fact this argument is off base is demonstrated by comparing the cost of saving a job to the wage paid on the job. The cost of restricting trade falls on American consumers, especially low-income Americans, who would face higher prices for imported products such as clothes, shoes, and toys. The cost inflicted on U.S. consumers from higher prices outweighs the benefit of a job to the worker, that is, the wage rate paid on the job.

b. Is there any merit in bringing jobs back? There is merit to the workers whose jobs are brought back and/or and who might not receive any government assistance if their jobs are not brought back. There also is merit to the politicians who can obtain a reward from lobbyists for the protection. There is no merit, however, to society as a whole.

Economics in the News 27. After you have studied Economics in the News on pp. 172–173, answer the following questions. a. Why, in Fig.1, does a U.S. tariff on memory chips not increase U.S. production of these chips? No U.S. production of these chips occurs because even with the tariff, the price of chips in the United States is less than the minimum price at which U.S. producers will manufacture chips.

b. Why, when the United States imposes a tariff on chips imported from China, does the quantity of chips imported from Vietnam not equal the quantity previously imported from China? The price of chips produced in Vietnam is higher than the price of chips produced in China. The higher price decreases the quantity of chips demanded in the United States and thereby fewer chips are imported from Vietnam than were imported from China.

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c. Draw a graph to show who loses from China’s tariff on pork. Chinese consumers lose from the tariff. Figure 7.8 shows the effect of the tariff. Before the tariff, the price is $2.00 per pound, indicated by the line labeled WP. China’s consumer surplus is equal to the area of the triangle ACB. After the tariff the price rises to $2.50 per pound. China’s new consumer surplus is equal to the area of the triangle AEF. Chinese consumers lose surplus equal to the grey area, EFBC.

28.

Got Trade? Dairy Farmers Stand to Gain From the USMCA Under NAFTA, U.S. dairy farmers were left behind because Canada restricted how much U.S. milk it imports. Under the USMCA, U.S. dairy farmers will be able to sell three times as much to Canadian markets as they could before. Canada has agreed to get rid of tariffs for American dairy exports. Source: wsj.com, December 13, 2019 a. What is the USMCA free trade agreement? What is its aim? USMCA is the trade agreement that replaced NAFTA, the first free-trade agreement among Canada, the United Sates, and Mexico. USMCA is a free trade agreement between Canada, the United States, and Mexico that seeks to eliminate trade barriers between Canada, the United States, and Mexico.

b. In the market for milk, explain how barriers to free trade influence the quantity of milk produced and consumed in Canada. Illustrate your answer with an appropriate graph. Figure 7.9 illustrates how a barrier to trade, a tariff, affects the quantity of milk produced and consumed in Canada. With free-trade in milk, the price would be the word price, WP or $3 per gallon. 10 million gallons per year would be produced in Canada and 60 million gallons would be consumed. The barrier to trade forces the Canadian price higher, to WP + tariff or $5 per gallon in the figure. The higher price increases the quantity of milk produced in Canada, from 10 million gallons per year to 20 million gallons, and decreases the quantity of milk consumed, from 60 million gallons per year to 40 million gallons.

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c. Show on your graph the changes in consumer surplus and producer surplus that result from free trade in milk. By reducing the price of milk in Canada, free trade increases the consumer surplus by an amount equal to area B plus area C and decreases producer surplus by an amount equal to area B.

d. Explain why Canadian milk producers oppose free trade in milk with the United States. Canadian milk producers oppose free trade in milk because the price of milk will be lower in Canada with free trade and they will sell less milk. The lower price of milk means that Canadian milk producers’ producer surplus shrinks.

C h a p t e r

UTILITY AND DEMAND

Answers to the Review Quizzes Page 184 1.

Explain how a consumer’s income and the prices of goods limit consumption possibilities. A consumer’s consumption possibilities are limited by the consumer’s income and the prices of the goods. The consumer is unable to consume limitless quantities of goods and services because the consumer must pay a price for each good or service consumed and the consumer’s income is limited. If the consumer’s income increases and/or the prices of the goods and services fall, the quantity of goods and services the consumer can afford increases, thereby increasing the consumer’s consumption possibilities.

What is utility and how do we use the concept of utility to describe a consumer’s preferences? Utility is the benefit a person gets from the consumption of goods and services. We use total utility to describe a consumer’s preferences by looking at the (total) utility from the consumption of all the goods and services. We use marginal utility to measure the gain in utility from consuming another unit of a good or service.

What is the distinction between total utility and marginal utility? Total utility is the entire amount of satisfaction an individual obtains from the total amount of goods and services consumed. Marginal utility is the change in total utility from a one-unit increase in the consumption of a good or service.

What is the key assumption about marginal utility? Generally, more consumption gives more utility. A key assumption about marginal utility is that it generally declines as more units of the good are consumed. This assumption is the principle of diminishing marginal utility.

Page 188 1.

Why does a consumer spend the entire budget? The more goods and services a person consumes, the higher the person’s utility. By spending his or her entire budget, the person is consuming the maximum quantity of goods and services, which means the utility can be at its maximum.

What is the marginal utility per dollar and how is it calculated? The marginal utility per dollar equals the marginal utility of the good or service divided by its price. The marginal utility per dollar tells the additional utility gained from spending one more dollar on a good or service.

What two conditions are met when a consumer is maximizing utility? The two conditions that must be met to ensure that a consumer is maximizing his or her utility are: i) all available income is spent, and ii) the marginal utility per dollar spent is equal for all goods and services consumed.

Explain why equalizing the marginal utility per dollar for all goods maximizes utility. Equating the ratio of marginal utility per dollar for each good and service consumed maximizes utility because it measures the utility gained when an additional dollar of a good or service is consumed. This allows the consumer to weigh the utility gained from additional consumption of a dollar’s worth of one good against the utility lost from the forgone consumption of a dollar’s worth of another good. When the © 2023 Pearson Education, Inc.

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marginal utility per dollar for each good and service is equalized, there is no additional utility available from any other consumption combination.

Page 194 1.

When the price of a good falls and the prices of other goods and a consumer’s income remain the same, explain what happens to the consumption of the good whose price has fallen and to the consumption of other goods. When the price of a good falls, the marginal utility per dollar for that good increases. The marginal utility per dollar for other goods does not change. To maximize total utility, a consumer makes marginal utility per dollar equal for all goods, so the consumer buys more of the good that has experienced the fall in price and less of the goods whose marginal utilities per dollar have not changed.

Elaborate on your answer to the previous question by using demand curves. For which good does demand change and for which good does the quantity demanded change? After the price of a good falls, the consumer increases consumption of the good to lower the marginal utility per dollar. This action means that more of the good is consumed at the lower price, which implies that the demand curve for the good is downward sloping. The consumer increases the quantity demanded of this good. Additionally, the consumer decreases the quantity of the other goods and services consumed, despite the price of other goods and services remaining unchanged. This change implies that the demand curves for each of the other goods and services shift leftward.

If a consumer’s income increases and if all goods are normal goods, explain how the quantity bought of each good changes. If the consumer’s income increases and all the goods consumed are normal goods, then the consumption of all goods increase. With the increase in income, the initial consumption possibility is now affordable with money left over. If the consumer’s utility for all goods increases with consumption, because the consumer seeks to maximize utility subject to prices and available income, he or she will use the money left over from the initial bundle to increase the quantity consumed for all goods and services. By doing so the consumer increases his or her total utility. This increase occurs while the price of these goods and services remained unchanged, which indicates there is a rightward shift of the demand curve for all goods and services.

What is the paradox of value and how is the paradox resolved? The paradox of value asks: “Why is water, which is essential to life, far cheaper than diamonds, which are not essential?” Consumers have diminishing marginal utility for water. The marginal utility of the last unit of water consumed is low because water is readily available and so the quantity consumed is very high. Consumers also have diminishing marginal utility for diamonds. The marginal utility of the last diamond consumed is high because diamonds are very scarce and so the quantity consumed is very low. Consumers maximize utility by equating the marginal utility per dollar for both goods. The scarcity of diamonds (high marginal utility) and the abundance of water (low marginal utility) indicate people are willing to pay a higher price for an additional unit of diamonds than for an additional unit of water.

What are the similarities between utility and temperature? The scales of both utility and temperature are arbitrary. The units used to measure both can be changed without changing their predictive abilities. For instance, the scale used to “measure” utility can be changed without consequence and the scale used to measure temperature (such as Celsius, Fahrenheit, or Kelvin) also can be changed without consequence. Additionally, although neither utility nor temperature can be directly observed, both can be used to make predictions about the observable world.

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Page 197 1.

Define behavioral economics. Behavioral economics studies the ways that limits on the ability of people’s brains to compute and implement rational decisions influence their economic actions.

What are the three limitations on human rationality that behavioral economics emphasizes? Behavioral economics studies bounded rationality (the point that people’s brain-computing power is limited and this limits people’s ability to make rational decisions), bounded willpower (the point that people’s will power is limited so that at times they make decisions they know they will later regret), and bounded self-interest (the point that at times people make decisions that do not advance their selfinterest).

Explain what behavioral economists call the endowment effect. The endowment effect is the tendency for people to value something more highly just because they own it. If consumers maximize their utility, they would be willing to sell a good they own at the same price they would pay to buy an identical good. The endowment effect means that people are only willing to sell a good they own at a price higher than what they are willing to pay for an identical good.

Define neuroeconomics. Neuroeconomics studies the activity of the human brain when it makes an economic decision.

What do behavioral economics and neuroeconomics seek to achieve? Behavioral economics and neuroeconomics seek to explain why we do not always make rational economic decisions. Behavioral economists study how the bounded limitations they study affect people’s decisions so that not all decisions are the consequence of rational behavior. Neuroeconomists study how the brain works to make decisions so that neuroeconomists have a better understanding of the decisions people make.

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Answers to the Study Plan Problems and Applications Jerry has $12 a week to spend on yogurt and berries. The price of yogurt is $2, and berries are $4 a box. 1. List the combinations of yogurt and berries that Jerry can afford. Draw a graph of Jerry’s budget line with the quantity of berries plotted on the x-axis. Jerry can buy 6 yogurts and 0 boxes of berries; 4 yogurts and 1 box of berries; 2 yogurts and 2 boxes of berries; and, 0 yogurts and 3 boxes of berries. Figure 8.1 shows Jerry’s budget line.

How do Jerry’s consumption possibilities change if, other things remaining the same, (i) the price of berries falls and (ii) Jerry’s income increases. (i) If the price of a box of berries falls, Jerry’s consumption possibilities increase. His budget line rotates outward around the unchanged vertical intercept, which shows the (unchanged) maximum quantity of yogurt Jerry can buy. (ii) If Jerry’s income increases, Jerry’s consumption possibilities increase. His budget line shifts outward and its slope does not change.

Use the following data to work Problems 3 to 13. Max has $35 a day to spend on windsurfing and snorkeling and he can spend as much time as he likes doing them. The price of renting equipment for windsurfing is $10 an hour and for snorkeling is $5 an hour. The table shows the total utility Max gets from each activity. 3.

Calculate Max’s marginal utility from windsurfing at each number of hours per day. Does Max’s marginal utility from windsurfing obey the principle of diminishing marginal utility?

Hours per day 1 2 3 4 5 6 7

Total utility from windsurfing 120 220 300 360 396 412 422

Total utility from snorkeling 40 76 106 128 140 150 158

Max’s marginal utility from windsurfing 1 hour per day is 120; from windsurfing 2 hours per day is 100; from windsurfing 3 hours per day is 80; from windsurfing 4 hours per day is 60; from windsurfing 5 hours per day is 36; from windsurfing 6 hours per day is 16; and, from windsurfing 7 hours per day is 10. Max’s marginal utility from windsurfing obeys the principle of diminishing marginal utility because it decreases as consumption increases.

Calculate Max’s marginal utility from snorkeling at each number of hours per day. Does Max’s marginal utility from snorkeling obey the principle of diminishing marginal utility? Max’s marginal utility from snorkeling 1 hour per day is 40; from 2 hours per day is 36; from snorkeling 3 hours per day is 30; from snorkeling 4 hours per day is 22; from snorkeling 5 hours per day is 12; from snorkeling 6 hours per day is 10; and, from snorkeling 7 hours per day is 8. Max’s marginal utility from snorkeling obeys the principle of diminishing marginal utility because it decreases as consumption increases.

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Which does Max enjoy more: his 6th hour of windsurfing or his 6th hour of snorkeling? Max’s marginal utility from his 6th hour of windsurfing is 16 and his marginal utility from his 6th hour of snorkeling is 10. Max enjoys his 6th hour of windsurfing more than his 6th hour of snorkeling.

Make a table of the combinations of hours spent windsurfing and snorkeling that Max can afford. The table is to the right. The first Marginal Marginal and third columns show the utility per utility per combinations of windsurfing and dollar from dollar from Hours Hours snorkeling Max can afford. snorkeling windsurfing windsurfing snorkeling Add two columns to your table in 3 8.0 1 8.0 Problem 6 and list Max’s 2 10.0 3 6.0 marginal utility per dollar from 1 12.0 5 2.4 windsurfing and from snorkeling. 0 7 1.6 The columns are in the table, in the second and fourth columns.

8. a. To maximize his utility, how many hours a day does Max spend on each activity? To maximize his utility, Max windsurfs for 3 hours and snorkels for 1 hour. Max uses his $35 so that all the $35 is spent and so that the marginal utility per dollar from each activity is the same. When Max windsurfs for 3 hours and snorkels for 1 hour, he spends $30 renting the windsurfing equipment and $5 renting the snorkeling equipment—a total of $35. The marginal utility from the third hour of windsurfing is 80 and the rent of the windsurfing equipment is $10 an hour, so the marginal utility per dollar from windsurfing is 8. The marginal utility from the first hour of snorkeling is 40 and the rent of the snorkeling equipment is $5 an hour, so the marginal utility per dollar from snorkeling is 8. The marginal utility per dollar from windsurfing equals the marginal utility per dollar from snorkeling.

b. If Max spent a dollar more on windsurfing and a dollar less on snorkeling than in part (a), how would his total utility change? If Max windsurfs another hour, he pays $10 and gains 60 units of utility (the marginal utility from the 4th hour), which is 6.0 units of utility per dollar. So, if he spends a dollar more on windsurfing, his utility from windsurfing increases by 6.0. If he spends an hour less on snorkeling, he saves $5 and loses 40 units of utility (the marginal utility from the 1st hour of snorkeling), which is 8.0 units of utility per dollar. So if he spends a dollar less on snorkeling, he loses 8.0 units of utility. Overall, spending a dollar more on windsurfing and a dollar less on snorkeling lowers Max’s total utility by 2.0 units of utility.

c. If Max spent a dollar less on windsurfing and a dollar more on snorkeling than in part (a), how would his total utility change? If Max snorkels another hour, he pays $5 and gains 36 units of utility (the marginal utility from the 2nd hour), which is 7.2 units of utility per dollar. So, if he spends a dollar more on snorkeling, his utility from snorkeling increases by 7.2. If he spends an hour less on windsurfing, he saves $10 and loses 80 units of utility (the marginal utility from the 3rd hour of windsurfing), which is 8.0 units of utility per dollar. So if he spends a dollar less on windsurfing, he loses 8.0 units of utility. Overall, spending a dollar more on snorkeling and a dollar less on windsurfing lowers Max’s total utility by 0.8 units of utility.

If the price of renting windsurfing equipment is cut to $5 an hour, how many hours a day does Max spend on each activity? Max will now maximize his total utility by spending 5 hours windsurfing and 2 hours snorkeling. This combination of windsurfing and snorkeling uses all of Max’s income and sets the marginal utility per dollar from windsurfing equal to the marginal utility per dollar from snorkeling.

10.

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$10 an hour, is Max’s demand for windsurfing equipment elastic or inelastic? From Problem 8 (a), when the price of renting windsurfing equipment is $10 per hour, Max rents windsurfing equipment for 3 hours. From Problem 9, when the price of renting windsurfing equipment is $5 per hour, Max rents windsurfing equipment for 5 hours. These points lead to the demand curve in Figure 8.2. Max’s elasticity of demand for renting windsurfing equipment is inelastic because a fall in the price decreases Max’s total expenditure on renting windsurfing equipment.

11.

How does Max’s demand for snorkeling equipment change when the price of windsurfing equipment falls? What is Max’s cross elasticity of demand for snorkeling with respect to the price of windsurfing? Are windsurfing and snorkeling substitutes or complements for Max? When the price of windsurfing falls, Max increases the hours he snorkels from 1 hour to 2 hours. Max’s demand for snorkeling increases when the price of windsurfing falls. Max’s cross elasticity of demand equals (1 hour/1.5 hours)/($5/$7.50) = 1.00. Windsurfing and snorkeling are complements for Max.

12.

If Max’s income increases from $35 to $55 a day, how does his demand for rented windsurfing equipment change? Is windsurfing a normal good? Explain. To maximize his utility, Max windsurfs for 4 hours and snorkels for 3 hours. Max uses his $55 such that all of the $55 is spent and marginal utility per dollar for each activity is the same. When Max windsurfs for 4 hours and snorkels for 3 hours, he spends $40 renting the windsurfing equipment and $15 renting the snorkeling equipment—a total of $55. The marginal utility from the fourth hour of windsurfing is 60 and the rent of the windsurfing equipment is $10 an hour, so the marginal utility per dollar from windsurfing is 6. The marginal utility from the third hour of snorkeling is 30 and the rent of the snorkeling equipment is $5 an hour, so the marginal utility per dollar from snorkeling is 6. The marginal utility per dollar from windsurfing equals the marginal utility per dollar from snorkeling. Max’s demand for rented windsurfing equipment increases. The quantity of windsurfing equipment rented at $10 per hour increases from 3 hours (problem 8 (a)) to 4 hours (this problem). Max’s demand curve for rented windsurfing equipment shifts rightward as shown in Figure 8.3 by the shift from D1 to D2. Windsurfing equipment is a normal good.

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If Max’s income increases from $35 to $55 a day, how does his demand for snorkeling equipment change? Is snorkeling a normal good? Explain. Max’s demand for rented snorkeling equipment increases. The quantity of snorkeling equipment demanded at a price of $5 per hour increases from 1 hour (problem 8 (a)) to 3 hours (this problem). As a result Max’s demand curve for rented snorkeling equipment shifts rightward as illustrated in Figure 8.4 by the shift from D1 to D2. Snorkeling equipment is a normal good.

Use the following news clip to work Problems 14 and 15. Baseball Fans Get Never-Ending Ballpark Buffet The all-you-can-eat seating at sports venues is making baseball’s summer chorus sound more like “Take Me Out to the Buffet.” Source: foxnews.com, 2021 14.

What conflict might exist between overeating and utility-maximization? What is the feature of marginal utility that enables sports venues to make this “all-you-can-eat” offer? Utility maximization means that the person will eat until the marginal utility per dollar of food equals the marginal utility per dollar of all other goods and services. Overeating implies that the person’s objective is to eat until he or she has eaten more than the utility-maximizing amount. The point that the marginal utility from ballpark food decreases as more is consumed means that fans will be (at least somewhat) limited in the quantity of food and drink they consume and not increase the cost beyond all bounds.

15.

How can overeating be reconciled with marginal utility theory? Which ideas of behavioral economics are consistent with the overeating at a sports venue? The marginal utility of food consumption includes not only the “usual utility” from food but also the utility from simply overeating. So, the fan receives utility from not only the food but also the reason for overeating. Bounded willpower seems very consistent with the information. Undoubtedly the people who overeat in the stadium regret their decisions at later dates when they either have less income to spend than they desire and/or need to lose weight.

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Answers to Additional Problems and Applications 16.

Tim buys 2 pizzas and sees 1 movie a week when he has $16 to spend, a movie ticket is $8, and a pizza is $4. Draw Tim’s budget line. If the price of a movie ticket falls to $4, describe how Tim’s consumption possibilities change. Figure 8.5 shows Tim’s budget line as BL1. Pizza is on the vertical axis and movies on the horizontal axis. If the price of a movie ticket falls to $4, then Tim’s budget line rotates outward, as illustrated in Figure 8.5 by the rotation from BL1 to BL2. Tim’s consumption possibilities expand.

17.

Cindy has $70 a month to spend, and she can spend as much time as she likes playing golf and tennis. The price of an hour of golf is $10, and the price of an hour of tennis is $5. The table shows Cindy’s marginal utility from each sport.

Hours per month 1 2 3 4 5 Make a table that shows Cindy’s affordable 6 combinations of hours playing golf and 7 tennis. If Cindy increases her expenditure to $100, describe how her consumption possibilities change.

Marginal utility from golf 80 60 40 30 20 10 6

The table showing Cindy’s affordable combinations of hours playing golf and tennis is to the right. If Cindy increases her expenditure, then for each entry of tennis hours in the table, her hours of playing golf increase by 3 hours. Alternatively, for each entry of golf hours in the table her hours of playing tennis increase by 6. In terms of a diagram, Cindy’s budget line shifts to the right and its slope does not change.

Use the information in Problem 17 to work Problems 18 to 24. 18. a. How many hours of golf and how many hours of tennis does she play to maximize her utility? Cindy plays golf for 5 hours and tennis for 4 hours to maximize her utility. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis.

Marginal utility from tennis 40 36 30 10 5 2 1

Hours playing golf 7 6 5 4 3 2 1 0

Hours playing tennis 0 2 4 6 8 10 12 14

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b. Compared to part (a), if Cindy spent a dollar more on golf and a dollar less on tennis, by how much would her total utility change? If Cindy played another hour of golf, she pays $10 and gains 10 units of utility (the marginal utility from the 6th hour), which is 1.0 unit of utility per dollar. So if she spends a dollar more on golf, her utility from golf increases by 1.0. If she spends an hour less playing tennis, she saves $5 and loses 10 units of utility (the marginal utility from the 4th hour of tennis), which is 2.0 units of utility per dollar. So if she spends a dollar less on tennis, she loses 2.0 units of utility. Overall, spending a dollar more on golf and a dollar less on tennis lowers Cindy’s total utility by 1.0 unit of utility.

c. Compared to part (a), if Cindy spent a dollar less on golf and a dollar more on tennis, by how much would her total utility change? If Cindy spends an hour less playing golf, she saves $10 and loses 20 units of utility (the marginal utility from the 5th hour), which is 2.0 unit of utility per dollar. So if she spends a dollar less on golf, her utility from golf decreases by 2.0. If she spends an hour more playing tennis, she spends $5 and gains 5 units of utility (the marginal utility from the 5th hour of tennis), which is 1.0 unit of utility per dollar. So if she spends a dollar more on tennis, she gains 1.0 units of utility. Overall, spending a dollar less on golf and a dollar more on tennis lowers Cindy’s total utility by 1.0 unit of utility.

19.

Explain why, if Cindy equalized the marginal utility per hour of golf and tennis, she would not maximize her utility. Cindy would not maximize her utility by equalizing the marginal utility per hour of golf and tennis because golf and tennis have different prices. Golf is twice as expensive as tennis, so effectively every unit of utility that Cindy buys from playing golf costs her twice as much as buying a unit of utility from playing tennis. Equalizing the marginal utilities means that the marginal utility per dollar from tennis is greater than her marginal utility per dollar from golf. This inequality means that Cindy can increase her utility if she spends a dollar less on golf and a dollar more on tennis.

Cindy’s tennis club raises its price of an hour of tennis from $5 to $10, other things remaining the same. 20. a. List the combinations of hours spent playing golf and tennis that Cindy can now afford and her marginal utility per dollar from golf and from tennis. The lists of affordable combinations are in the first and third columns in the table to the right. The lists of the marginal utilities per dollar are in the second and fourth columns in the table.

b. How many hours does Cindy now spend playing golf and how many hours does she spend playing tennis?

Hours playing golf 7 6 5 4 3 2 1 0

Marginal utility per dollar from golf 0.6 1.0 2.0 3.0 4.0 6.0 8.0

Hours playing tennis 0 1 2 3 4 5 6 7

Marginal utility per dollar from tennis 4.0 3.6 3.0 1.0 0.5 0.2 0.1

Cindy now plays golf for 4 hours and plays tennis for 3 hours. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis.

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Use the information in Problem 20 to draw Cindy’s demand curve for tennis. Over the price range of $5 to $10 an hour of tennis, is Cindy’s demand for tennis elastic or inelastic? One point on her demand curve is 4 hours of tennis when the price is $5 per hour. Another point is 3 hours of tennis when the price is $10 per hour. Cindy’s demand curve is in Figure 8.6. The price elasticity of demand between these two points on her demand curve is 0.43, so Cindy’s demand is inelastic.

22.

Explain how Cindy’s demand for golf changed when the price of an hour of tennis increased from $5 to $10 in Problem 20. What is Cindy’s cross elasticity of demand for golf with respect to the price of tennis? Are tennis and golf substitutes or complements for Cindy? The quantity of golf Cindy plays falls from 5 hours before the price of tennis increased to 4 hours after the price increased. Cindy’s demand for golf decreases. Her cross elasticity of demand is −0.33. Tennis and golf are complements because the cross elasticity of demand is negative.

23.

Cindy loses her math tutoring job and the amount she has to spend on golf and tennis falls from $70 to $35 a month. With the price of an hour of golf at $10 and of tennis $5, calculate the change in the hours she spends playing golf. For Cindy, is golf a normal good or an inferior good? Is tennis a normal good or an inferior good? With an income of $35, Cindy now plays golf for 2 hours and tennis for 3 hours to maximize her utility. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis. Golf is a normal good because the fall in income leads to a decrease in Cindy’s demand for hours spent playing golf from 5 hours to 2 hours. Tennis is a normal good because the fall in income leads to a decrease in Cindy’s demand for hours spent playing tennis from 4 hours to 3 hours.

24.

Cindy takes a Club Med vacation, the cost of which includes unlimited sports activities. With no extra charge for golf and tennis, Cindy allocates a total of 4 hours a day to these activities. a. How many hours does Cindy play golf and how many hours does she play tennis? Cindy plays golf for 3 hours and plays tennis for 1 hour.

b. What is Cindy’s marginal utility from golf and from tennis? Cindy’s marginal utility from golf and from tennis both equal 40.

c. Why does Cindy equalize the marginal utilities rather than the marginal utility per dollar from golf and from tennis? Because the equipment is free, Cindy does not have to allocate her income between the two activities; instead, she allocates her time between the two activities because time is now the factor that limits her. Because each activity is in hour increments, Cindy equalizes the marginal utility per hour and thereby sets the marginal utilities equal to each other.

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Jim has made his best affordable choice of muffins and coffee. He spends all of his income on 10 muffins at $1 each and 20 cups of coffee at $2 each. Now the price of a muffin rises to $1.50 and the price of coffee falls to $1.75 a cup. a. Can Jim now buy 10 muffins and 20 coffees? Before the changes in price, Jim spent all his income on muffins and coffee. Therefore Jim’s income is (10 muffins) × ($1 each) + (20 cups of coffee) × ($2 each) = $50. After the change in prices, the cost of 10 muffins and 20 coffees is (10 muffins) × ($1.50 each) + (20 cups of coffee) × ($1.75 each), which is $50. Therefore, Jim can buy 10 muffins and 20 coffees.

b. If Jim changes the quantities he buys, will he buy more or fewer muffins and more or less coffee? Explain your answer. If Jim changes the quantities he buys, he will buy more coffee and fewer muffins. He will make these changes because coffee has fallen in relative price while muffins have risen in relative price.

26.

Ben spends $50 a year on 2 bunches of flowers and $50 a year on 10,000 gallons of tap water. Ben is maximizing utility and his marginal utility from water is 0.5 unit per gallon. a. Are flowers or water more valuable to Ben? In total, water is more valuable to Ben because water has a (much!) higher total utility. On the margin, an additional bunch of flowers has larger marginal utility than does an additional 1,000 gallons of water.

b. Explain how Ben’s expenditure on flowers and water illustrates the paradox of value. Flowers are more expensive than water even though water is essential to life. The reason flowers are more expensive is because people, such as Ben, enjoy fewer flowers than they do water. Because Ben consumes so much water, its marginal utility is quite low even though its total utility is tremendous. Because so few flowers are enjoyed, their marginal utility is relatively high even though their total utility is small. Prices, though, reflect the marginal utility of the good and so flowers are more expensive than water.

Use the following news clip to work Problems 27 to 29. Putting a Dollar Value on Life? Governments Already Do The World Health Organization suggests governments pay for treatments that cost less than three times a country’s GDP per person for each year of good health it provides. The W.H.O. considers treatments that cost less than the annual GDP per person to be highly cost effective. Source: nytimes.com, May 11, 2020 27.

Why might the W.H.O. recommend rationing healthcare to treatments that cost less than three times annual GDP per person as opposed to providing as much treatment as is needed by a patient, regardless of cost? Increasing the quantity of health care lowers the marginal utility from the last unit of healthcare. At some amount of healthcare, the point is reached such that the marginal utility per dollar of healthcare is less than the marginal utility per dollar from other goods and services. At that point the quantity of healthcare being provided is too much and society would be better off with less healthcare.

28.

What conflict might exist between a person’s valuation of his or her own life and the rest of society’s valuation of that person’s life? The marginal utility that an individual places on another year of their own life likely approximates infinity. The marginal utility that the rest of society places on another year of the person’s life is not as high. Hence the individual’s valuation of their life is much higher than society’s valuation.

29.

How does the potential conflict between self-interest and the social interest complicate setting a financial threshold for healthcare treatments? Each individual has a very high marginal utility from an additional year of life. Hence each individual’s marginal utility per dollar from extending their life is extremely high and so their self-interested demand

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will be very high. But the rest of society’s marginal utility per dollar from an additional year of the person’s life is much lower and the socially interested demand will be much lower.

Economics in the News 30. After you have studied Economics in the News (pp. 198–199), answer the following questions. a. If after the pandemic the prices of streaming services doubled with an unchanged price of a movie ticket: (i) How would Joe change the number of streaming services he buys? As the law of demand demonstrates, Joe would decrease the number of streaming services he buys.

(ii) How would he change the number of times he goes to the movies? Because Joe now has “extra” income that he no longer is spending on streaming services, Joe would probably attend more movies. This change lowers MUMOVIE/PMOVIE back to equality with MUSTREAM/PSTREAM.

(iii) How would the quantities of other goods and services he buys change? Once again, because Joe now has “extra” income that he no longer is spending on streaming services, Joe would probably buy more other goods and services. This change lowers MUOTHER/POTHER back to equality with MUSTREAM/PSTREAM.

b. If after the pandemic Joe’s marginal utilities of streaming services doubled: (i) How would Joe change the number of streaming services he buys? Joe would increase the number of streaming services he buys.

(ii) How would he change the number of times he goes to the movies? Because Joe is now spending more on streaming services, Joe would probably attend fewer movies.

(iii) How would the quantities of other goods and services he buys change? Because Joe is now spending more on streaming services, Joe would probably buy fewer other goods and services.

31.

Hermès Birkin Bag Made From Crocodile Skin and Diamonds A Hermès bag sold for $300,000 during Christie’s online auction. The rare Hermès Diamond Himalaya Birkin 25 is made from the skin of Africa’s Niloticus crocodile and features 18k gold and diamonds. Source: independent.co.uk, July 30, 2020 a. If the price of an ordinary bag is $100, what can we infer about the marginal utility of an ordinary bag and the marginal utility of a Hermès Diamond Himalaya Birkin 25 for a person who buys one ordinary bag and one Hermès Diamond Himalaya Birkin 25? To maximize his or her utility, the person will buy the quantity of Hermès bags and ordinary bags that sets (MUH/PH) = (MUO/PO) where MUH is the marginal utility of a Hermès bag, MUO is the marginal utility from an ordinary bag, PH is the price of a Hermès bag, and PO is the price of an ordinary bag. The marginal utility per dollar condition can be rearranged to MUH = (PH/PO) × MUO. Because PH = $300,000 and PO = $100, the rearranged equation shows that MUH = 3,000 × MUO. In other words, the marginal utility from the first Hermès bag is 3,000 times the marginal utility of the first ordinary bag.

b. Why might the marginal utility from a Hermès Diamond Himalaya Birkin 25 decrease more rapidly than the marginal utility from an ordinary bag? One of the major attributes of a Hermès bag is the “statement” it makes that the consumer is one of the few who can afford it. But typically, a consumer carries around only bag. So, the marginal utility of a second Hermès bag is quite low compared to the marginal utility of the first bag. Women own several “ordinary” bags because they like to change the purse with the outfit color, the season, and occasion: daytime or nighttime use, so the marginal utility of “ordinary” bags falls more slowly. © 2023 Pearson Education, Inc.

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Maybe Money Can Help Buy Happiness, After All Previous research suggested that an annual income of more than $75,000 might not improve people’s day-to-day lives. But new data show evidence that happiness rises continuously, far above incomes of $75,000. Source: usnews.com, January 21, 2021 a. Based on previous research, how does an increase in income above $75,000 influence total utility and marginal utility? “Utility” and “happiness” may not be synonymous because utility is an arbitrary measure that tells how people value different consumption bundles at a point in time while happiness presumably is a measure that tells how pleased people are with their entire life. But supposing they measure the same thing, according to the previous research, an increase in income for people who earn more than $75,000 has zero marginal utility and therefore does not change their total utility.

b. Based on new data, how does an increase in income above $75,000 influence total utility and marginal utility? If “happiness” is the same as utility, then the additional income increases total utility so that the marginal utility of additional income is positive.

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Answers to the Review Quizzes Page 208 1.

What does a household’s budget line show? The budget line plots combinations of goods that require all a household’s income and describes the limits to its consumption choices.

How does the relative price and a household’s real income influence its budget line? The magnitude of the slope of the budget line equals the relative price of the good or service measured on the horizontal axis. A fall in the price of the good measured on the horizontal (vertical) axis decreases that good’s relative price and decreases (increases) the slope of the budget line. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. An increase (decrease) in household income causes a parallel shift of the budget line rightward (leftward). The slope of the budget line does not change when income changes.

If a household has an income of $40 and buys only bus rides at $2 each and magazines at $4 each, what is the equation of the household’s budget line? The budget equation states that a household’s spending must equal its income. The budget equation is derived for two goods, bus rides and magazines. The amount spent on bus rides is (Pbus ride)×(Qbus ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and the consumer’s income is y. We know that (Pmagazine)×(Qmagazine) + (Pbus ride)×(Qbus ride) = y. Rearrange this equality by subtracting the amount spent on bus rides from both sides to give (Pmagazine)×(Qmagazine) = y – (Pbus ride)×(Qbus ride). Finally, divide both sides by the price of magazine to give the budget equation Qmagazine = y/Pmagazine – (Pbus ride /Pmagazine)×(Qbus ride). Substituting in our values, y = $40, P bus ride = $2 and P magazine = $4, gives Qmagazine = $40/$4 – ($2/$4)×(Qbus ride) which is equal to Qmagazine = 10 – 0.5 Qbus ride

If the price of one good changes, what happens to the relative price and the slope of the household’s budget line? A relative price is the price of one good divided by the price of another good. For example, the magnitude of the slope of the budget line (Pmovie/Psoda) is the relative price of a movie in terms of soda. This relative price shows how many sodas must be forgone to see an additional movie. A fall in the price of the good on the horizontal (vertical) axis increases the total affordable quantity of that good, decreases its relative price, and decreases (increases) the magnitude of the slope of the budget line.

If a household’s money income changes and prices do not change, what happens to the household’s real income and budget line? A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. For example, the vertical intercept for a budget line measuring soda on the vertical axis is (y/Psoda), which is the consumer’s real income in terms of sodas. A change in a household’s money income changes the household’s real income in terms of both goods and causes a parallel shift of the budget line. If a household’s money income increases, its budget line shifts rightward and if a household’s money income decreases, its budget line shifts leftward. © 2023 Pearson Education, Inc.

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Page 212 1.

What is an indifference curve and how does a preference map show preferences? An indifference curve shows those combinations of goods for which a consumer is indifferent. The consumer has the same level of satisfaction for any combination on a given indifference curve. The family of indifference curves is the preference map. This map shows the person’s preferences because it shows how the person ranks each combination of goods. In particular, the person prefers combinations on higher indifference curves to combinations on lower indifference curves.

Why does an indifference curve slope downward and why is it bowed toward the origin? The downward slope of an indifference curve illustrates the tradeoff between two goods while maintaining the same level of total satisfaction. Since the consumer is indifferent among all points on an indifference curve, when moving along it any increase in satisfaction from gaining one good must be matched by an equal decrease in satisfaction from a loss in the other good. An indifference curve is bowed toward the origin because the more of good x that is consumed the less you are willing to give up of good y to get more of good x and remain indifferent.

What do we call the magnitude of the slope of an indifference curve? The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). The MRS measures the rate at which the consumer gives up one good to get more of another good, while remaining on the same indifference curve (keeping the consumer indifferent about the changes). The bowed-in shape of the indifference curve is due to the assumption of diminishing MRS.

What is the key assumption about a consumer’s marginal rate of substitution? The key assumption about the marginal rate of substitution is that it is diminishing as a consumer moves down an indifference curve, creating the bowed-in shape.

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When a consumer chooses the combination of goods and services to buy, what is she or he trying to achieve? The consumer is trying to achieve the highest level of well being possible.

Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms budget line, marginal rate of substitution, and relative price in your explanation.) At the optimal consumption choice, the consumer’s consumption bundle is 1) on the budget line, 2) on the highest attainable indifference curve, 3) such that the slope of the budget line, which is the relative price of the two goods, equals the slope of the indifference curve, which is the MRS.

If the price of a normal good falls, what happens to the quantity demanded of that good? If the price of a normal good falls, the quantity demanded of that good increases because the substitution effect and the income effect both bring an increase in the quantity demanded.

Into what two effects can we divide the effect of a price change? A price change can be divided into a substitution effect and an income effect. The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation. The income effect is the effect of a change in income sufficient to get the consumer to the highest indifference curve that is affordable on the new budget line reflecting the price change. © 2023 Pearson Education, Inc.

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For a normal good, does the income effect reinforce the substitution effect or does it partly offset the substitution effect? For a normal good the substitution effect and the income effect reinforce each other, and a decrease (increase) in the price of a good will always result in an increase (decrease) in the quantity of the good demanded.

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Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 to 2. Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of a smoothie is $3. 1. Calculate Sara’s real income in terms of smoothies. Calculate her real income in terms of popcorn. What is the relative price of smoothies in terms of popcorn? What is the opportunity cost of a smoothie? Sara’s real income is 4 smoothies. Sara’s real income in terms of smoothies is equal to her money income divided by the price of a smoothie. Sara’s money income is $12, and the price of a smoothie is $3. Sara’s real income is $12 divided by $3 a smoothie, which is 4 smoothies. Sara’s real income is 4 bags of popcorn. Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn, which is $12 divided by $3 a bag or 4 bags of popcorn. The relative price of a smoothie is 1 bag of popcorn per smoothie. The relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3 divided by $3 a bag, which equals 1 bag of popcorn per smoothie. The opportunity cost of a smoothie is 1 bag of popcorn. The opportunity cost of a smoothie is the quantity of popcorn that must be forgone to get a smoothie. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so to buy one smoothie Sara must forgo 1 bag of popcorn.

Calculate the equation for Sara’s budget line (with bags of popcorn on the left side). Draw a graph of Sara’s budget line with the quantity of smoothies on the x-axis. What is the slope of Sara’s budget line? What determines its value? The equation that describes Sara’s budget line is QP = 4 – QS. Call the price of popcorn PP and the quantity of popcorn QP, the price of a smoothie PS and the quantity of smoothies QS, and income y. Sara’s budget equation is PPQP + PSQS = y. If we substitute $3 for the price of popcorn, $3 for the price of a smoothie, and $12 for the income, the budget equation becomes $3QP + $3QS = $12. Dividing both sides by $3 and subtracting QS from both sides gives QP = 4 – QS. To draw a graph of the budget line, plot the quantity of smoothies on the x-axis and the quantity of popcorn on the y-axis. The budget line is a straight line from 4 bags of popcorn on the yaxis to 4 smoothies on the x-axis. The slope of the budget line, when smoothies are plotted on the x-axis, is minus 1. The magnitude of the slope is equal to the relative price of a smoothie. The slope of the budget line is “rise over run.” If the quantity of smoothies decreases from 4 to 0, the quantity of popcorn increases from 0 to 4. The rise is 4 and the run is 4. Therefore, the slope equals 4/4, which is 1.

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Use the following data to work Problems 3 and 4. Sara’s income falls from $12 to $9 a week, while the price of popcorn is unchanged at $3 a bag and the price of a smoothie is unchanged at $3. 3. What is the effect of the fall in Sara’s income on her real income in terms of (a) smoothies and (b) popcorn? a.

Sara’s real income falls from 4 smoothies to 3 smoothies. Sara’s real income in terms of smoothies is equal to her money income divided by the price of a smoothie. Sara’s money income is now $9 and the price of a smoothie is $3. Sara’s real income is now $9 divided by $3 a smoothie, which is 3 smoothies. Sara’s real income falls from 4 bags of popcorn to 3 bags of popcorn. Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn. Sara’s money income is now $9 and the price of a bag of popcorn is $3. Sara’s real income is now $9 divided by $3 a bag, which is 3 bags of popcorn.

What is the effect of the fall in Sara’s income on the relative price of a smoothie in terms of popcorn? What is the slope of Sara’s new budget line if it is drawn with smoothies on the xaxis? The relative price of a smoothie is 1 bag of popcorn per smoothie, the same relative price as before her income fell. The relative price does not depend on Sara’s income. Instead the relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3 divided by $3 a bag. The relative price equals 1 bag per smoothie. The slope of the budget line, when smoothies are plotted on the x-axis is minus 1, the same slope as before her fall in income. The magnitude of the slope of the budget line is equal to the relative price of a smoothie. The relative price does not change when Sara’s income decreases so the slope of the budget line does not change.

Sara’s income is $12 a week. The price of popcorn rises from $3 to $6 a bag, and the price of a smoothie is unchanged at $3. Explain how Sara’s budget line changes with smoothies on the xaxis. The budget line rotates inward around the unchanged x intercept. The magnitude of the slope of the budget line is equal to the relative price of a smoothie. The relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The rise in the price of a bag of popcorn lowers the relative price of a smoothie in terms of popcorn. The relative price has fallen so the magnitude of the slope of the budget line has fallen.

Draw figures that show your indifference curves for the following pairs of goods. For each pair, are the goods perfect substitutes, perfect complements, substitutes, complements, or unrelated goods?  Right gloves and left gloves Figure 9.2A is to the right. Right gloves/left gloves are perfect complements. Because these are perfect complements, the indifference curves are right angles.

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Coca-Cola and Pepsi Figure 9.2B is to the right. These are, for most students, almost perfect substitutes. The indifference curves should either be linear (for perfect substitutes, as shown in Figure 9.2B) or nearly linear.

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Desktop computers and laptop computers Figure 9.2C is to the right. These are substitutes, though not perfect substitutes. The indifference curves are bowed inward toward the origin.

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Strawberries and ice cream Figure 9.2D is to the right. These are probably complements for many students, though not perfect complements. The indifference curves are not right angles, as they would be for perfect complements, but instead are bowed inward toward the origin.

Discuss the shape of the indifference curve for each of the following pairs of goods. Explain the relationship between the shape of the indifference curve and the marginal rate of substitution as the quantities of the two goods change.  Orange juice and smoothies Orange juice and smoothies are substitutes. They are not perfect substitutes, so the indifference curves are bowed in toward the origin. The marginal rate of substitution falls moving down along an indifference curve.

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Baseballs and baseball bats These are complements but probably not perfect complements. The indifference curves should be significantly bowed inward. (If a student says these goods are perfect complements, the indifference curves should be right angles, such as those in Figure 9.2A.) If the indifference curves are not right angles, then the marginal rate of substitution falls rapidly moving down along an indifference curve. (If the goods are perfect complements, the marginal rate of substitution does not change moving down along the indifference curve except when moving around the 90 degree point where it goes from infinity to zero.)

Left running shoe and right running shoe These are perfect complements so the indifference curves are right angles, as shown in Figure 9.2A. The marginal rate of substitution does not change moving down along the indifference curve except when moving around the 90 degree point where it goes from infinity to zero.



Eyeglasses and contact lenses The indifference curves should either be linear (for perfect substitutes, as shown in Figure 9.2B) or nearly linear as in Figure 9.2C. If the indifference curves are linear, then the marginal rate of substitution does not change moving down along the indifference curve; if the indifference curves are nearly linear, then the marginal rate of substitution falls slightly moving down along an indifference curve.

Use the following data to work Problems 8 and 9. Pam has made her best affordable choice of cookies and granola bars. She spends all of her weekly income on 30 cookies at $1 each and 5 granola bars at $2 each. Next week, she expects the price of a cookie to fall to 50¢ and the price of a granola bar to rise to $5. 8. a. Will Pam be able to buy and want to buy 30 cookies and 5 granola bars next week? Pam can still buy 30 cookies and 5 granola bars. When Pam buys 30 cookies at $1 each and 5 granola bars at $2 each, she spends $40 a week. Now that the price of a cookie is 50 cents and the price of a granola bar is $5, 30 cookies and 5 granola bars will cost $40. So Pam can still buy 30 cookies and 5 granola bars. But Pam will not want to buy 30 cookies and 5 granola bars because the marginal rate of substitution does not equal the relative price of the goods. Pam will move to a point on the highest indifference curve possible where the marginal rate of substitution equals the relative price.

b. Which situation does Pam prefer: cookies at $1 and granola bars at $2 or cookies at 50¢ and granola bars at $5? Pam prefers cookies at 50 cents each and granola bars at $5 each because she can get onto a higher indifference curve than when cookies are $1 each and granola bars are $2 each. To see why Pam can move to a higher indifference curve, note that the new budget line and the old budget line both pass through the point 30 cookies and 5 granola bars. If granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal to the relative price of a granola bar at the original prices, which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference curve at 30 cookies and 5 granola bars. Pam’s new equilibrium combination of cookies and granola bars must be on an indifference curve at a point steeper than the initial indifference curve. Because the new budget line is steeper and passes through the initial equilibrium combination, the new best affordable point must lie above the initial equilibrium point so it must be on a higher indifference curve.

9. a. If Pam changes how she spends her weekly income, will she buy more or fewer cookies and more or fewer granola bars? Pam will buy more cookies and fewer granola bars. The new budget line and the old budget line pass through the point at 30 cookies and 5 granola bars. If granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal to the relative price of a granola bar at the original prices, which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference curve at 30 cookies and 5 granola bars. Pam will buy more cookies and fewer granola bars. © 2023 Pearson Education, Inc.

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b. When the prices change next week, will there be an income effect, a substitution effect, or both at work? There will be a substitution effect and an income effect. A substitution effect arises when the relative price changes and the consumer moves along the same indifference curve to a new point where the marginal rate of substitution equals the new relative price. An income effect arises when the consumer moves from one indifference curve to another, keeping the relative price constant.

Use the following information to work Problems 10 and 11. Second-Hand Clothing Is More Popular Than Ever. Even in a Pandemic Resale has been doing very well through the pandemic. At Poshmark, which connects buyers with sellers of new and used merchandise, sales are up 50% year-over-year from mid-April into May. Source: cnn.com, June 12, 2020 10. a. According to the news clip, is second-hand clothing a normal good or an inferior good? If the price of second-hand clothing falls and income remains the same, explain how the quantity of second-hand clothing bought changes. According to the article, the demand for second-hand clothing increased when the economy was in the pandemic and incomes fell. Because the demand increased when income decreased, second-hand clothing is an inferior good. If the price of second-hand clothing falls and income remains the same, the quantity of second-hand clothing purchased increases as long as the substitution effect is larger than the income effect.

b. Describe the substitution effect and the income effect that occur. The price fall creates both a substitution effect and an income effect. The substitution effect leads to an increase in the quantity of second-hand clothing demanded. The price decrease increases consumers’ real incomes. Because used clothing is an inferior good, the income effect leads to a decrease in the quantity of vintage clothing purchased.

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Draw a graph of a person’s indifference curves for second-hand clothing and other goods. Then draw two budget lines to show the effect of a fall in income on the quantity of secondhand clothing purchased. In Figure 9.3, the fall in income shifts the budget line from BL1 to BL2. The quantity of second-hand clothing purchased increases, in the figure from 4 items per month to 6 items per month.

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Answers to Additional Problems and Applications Use the following data to work Problems 12 to 15. Marc has a budget of $20 a month to spend on root beer and DVDs. The price of root beer is $5 a bottle, and the price of a DVD is $10. 12. What is the relative price of root beer in terms of DVDs and what is the opportunity cost of a bottle of root beer? The relative price of root beer is 1/2 DVD. The relative price of root beer is the price of root beer divided by the price of a DVD. The price of root beer is $5 a bottle and the price of a DVD is $10, so the relative price of root beer is $5 a bottle divided by $10 a DVD, which equals 1/2 DVD per bottle. The opportunity cost of a bottle of root beer is 1/2 DVD. The opportunity cost of a bottle of root beer is the quantity of DVDs that must be forgone to obtain a bottle of root beer. The price of root beer is $5 a bottle and the price of a DVD is $10, so to buy one bottle of root beer Marc must forgo 1/2 DVD.

13.

Calculate Marc’s real income in terms of root beer. Calculate his real income in terms of DVDs. Marc’s real income is 4 bottles of root beer. Marc’s real income in terms of bottles of root beer is equal to his money income divided by the price of a bottle of root beer. Marc’s money income is $20, and the price of root beer is $5 a bottle. Marc’s real income is $20 divided by $5 a bottle of root beer, which is 4 bottles of root beer. Marc’s real income is 2 DVDs. Marc’s real income in terms of DVDs is equal to his money income divided by the price of a DVD, which is $20 divided by $10 a DVD or 2 DVDs.

14.

Calculate the equation for Marc’s budget line (with the quantity of root beer on the left side). The equation that describes Marc’s budget line is QR = 4 – 2QDVD. Call the price of a bottle of root beer PR and the quantity of root beer QR, the price of a DVD PDVD and the quantity of DVDs QDVD, and income y. Marc’s budget equation is PRQR + PDVDQDVD = y. If we substitute $5 for the price of a bottle of root beer, $10 for the price of a DVD, and $20 for income, the budget equation becomes $5QR + $10QDVD = $20. Next, divide both sides by $5 to obtain QR + 2QDVD = 4. Finally subtract 2QDVD from both sides to give QR = 4 – 2QDVD.

15.

Draw a graph of Marc’s budget line with the quantity of DVDs on the x-axis. What is the slope of Marc’s budget line? What determines its value? The budget line is illustrated in Figure 9.4. The slope of the budget line, when DVDs are plotted on the x-axis is 2. The magnitude of the slope is equal to the relative price of a DVD. The slope of the budget line is “rise over run.” If the quantity of DVDs decreases from 2 to 0, the quantity of root beer increases from 0 to 4 bottles. The rise is 4 and the run is 2. So the slope equals 4/2, which is 2.

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Use the following data to work Problems 16 to 19. Amy has $20 a week to spend on coffee and cake. The price of coffee is $4 a cup, and the price of cake is $2 a slice. 16.

Calculate Amy’s real income in terms of cake. Calculate the relative price of cake in terms of coffee. Amy’s real income in terms of cake is $20/($2 per slice), which is 10 slices. The relative price of cake in terms of coffee is ($2 per slice)/($4 per cup) = 0.5 cups of coffee per slice of cake.

17.

Calculate the equation for Amy’s budget line (with cups of coffee on the left side). The equation that describes Amy’s budget line is QCOFFEE = 5 – 0.5QCAKE. Call the price of a cup of coffee PCOFFEE and the quantity of coffee QCOFFEE, the price of a slice of cake PCAKE and the quantity of cake QCAKE, and income y. Amy’s budget equation is PCOFFEEQCOFFEE + PCAKEQCAKE = y. If we substitute $4 for the price of a cup of coffee, $2 for the price of a slice of cake and $20 for income, the budget equation becomes $4QCOFFEE + $2QCAKE = $20. Next, divide both sides by $4 to obtain QCOFFEE + 0.5QCAKE = 5. Finally subtract 0.5QCAKE from both sides to give QCOFFEE = 5 – 0.5QCAKE.

18.

If Amy’s income increases to $24 a week and the prices of coffee and cake remain unchanged, describe the change in her budget line. Amy’s budget line shifts outward and its slope does not change.

19.

If the price of cake doubles while the price of coffee remains at $4 a cup and Amy’s income remains at $20, describe the change in her budget line. Amy’s budget line rotates inward. If the quantity of cake is plotted on the horizontal axis, the budget line rotates inward around the unchanged vertical intercept (which is the maximum number of cups of coffee Amy can purchase) and becomes steeper.

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Use the following news clip to work Problems 20 and 21. Memorial Day Travel to Soar 60% Even as Gas Hits $3 a Gallon AAA is projecting a 60% year-over-year increase in Memorial Day weekend travelers even as gas prices soar to their highest level in seven years. Source: cnbc.com, May 11, 2021 20. a. Sketch a budget line for a household that spends its income on only two goods: gasoline and hotel rooms. Identify the combinations of the two goods that are affordable. Figure 9.5 shows a budget line. The combinations of gasoline and hotel room stays that lie on and inside the budget line are affordable. The combinations of gasoline and hotel room stays that lie beyond the budget line are unaffordable.

b. Sketch a second budget line to show how a rise in the price of gasoline changes the affordable and unaffordable combinations of gasoline and hotel rooms. Describe how the household’s consumption possibilities change. The rise in the price of gasoline rotates the budget inward, as illustrated in Figure 9.6. Some initially affordable combinations of gasoline and hotel room stays have become unaffordable. The dark gray triangle shows these combinations.

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21.

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How does a rise in the price of gasoline change the relative price of a hotel room? How does a rise in the price of gasoline change real income in terms of hotel rooms? The relative price of a hotel room equals the price of a hotel room divided by the price of gasoline. The rise in the price of gasoline lowers the relative price of a hotel room. The fall in the price of gasoline does not change real income in terms of hotel rooms.

Use the following information to work Problems 22 and 23. Rashid buys only books and take-out meals and Figure 9.7 shows his preference map. 22. a. If Rashid chooses 3 books and 2 take-out meals, what is his marginal rate of substitution? Rashid’s marginal rate of substitution is 1 book per take-out meal. Rashid’s marginal rate of substitution equals the magnitude of the slope of his indifference curve. If Rashid buys 3 books and 2 take-out meals, the slope of his indifference curve at this point is minus 1 book per take-out meal.

b. If Rashid chooses 2 books and 6 take-out emals, what is his marginal rate of substitution? Rashid’s marginal rate of substitution is 1/2. Rashid’s marginal rate of substitution equals the magnitude of the slope of his indifference curve. If Rashid buys 2 books and 6 take-out meals, the slope of his indifference curve at this point is minus 1/2 book per take-out meal.

23.

Do Rashid’s indifference curves display diminishing marginal rate of substitution? Explain why or why not. Rashid’s indifference curves display diminishing marginal rate of substitution. When moving along either indifference curve the slope becomes smaller as the consumption of take-out meals increases, which means that Rashid has diminishing marginal rate of substitution of books for take-out meals.

24.

Workers Thrive When They Feel Respected Sarah’s boss gave her complete autonomy but the new boss by-passed Sarah to deliver directives to her team and changed many of her decisions. Despite being well paid, Sarah resigned. She felt disrespected. Source: worldnewsera.com, October 30, 2020 An earlier survey found that trust in management is a big component of job satisfaction. Say you get a new boss and your trust in management goes up a bit (say, up 1 point on a 10-point scale). That’s like getting a 36-percent pay raise. In other words, that increased level of trust will boost your level of overall satisfaction in life by about the same amount as a 36-percent raise would. a. Measure trust in management on a 10-point scale, measure pay on the same 10-point scale, and think of them as two goods. Sketch an indifference curve (with trust on the x-axis) that is consistent with the news clip. The clip implies that a 1 point increase in trust combined with a 3.6 point (which is 36 percent on a 10 © 2023 Pearson Education, Inc.

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point scale) decrease in income leaves the person indifferent. So, as illustrated in Figure 9.8, the indifference curve is linear showing the tradeoff between trust and income.

b. What is the marginal rate of substitution between trust in management and pay according to this news clip? The news clip implies that the indifference curves are linear (as illustrated in Figure 9.8) which means that the marginal rate of substitution is constant and equal to 3.6 in the figure.

c. What does the news clip imply about the principle of diminishing marginal rate of substitution? Is that implication likely to be correct? The news clip implies that the indifference curves are linear, as illustrated in Figure 9.8. Linear indifference curves mean that the marginal rate of substitution is constant, that is, the principle of diminishing marginal rate of substitution does not hold. This assumption is likely to be incorrect. Increasing trust in management from 0 to 1 is likely to be very worthwhile and the person will give up a large amount of income to gain this unit increase. But increasing trust in management from, say, 8 to 9 is probably not nearly so worthwhile because at 8 management is already highly trusted. So to gain this unit increase in trust, the person is likely willing to give up only a small amount of income. Hence, contrary to the article, increasing trust in management is subject to a diminishing rate of substitution.

Use the following information to work Problems 25 and 26. Jim has made his best affordable choice of muffins and coffee. He spends all of his income on 10 muffins at $1 each and 20 cups of coffee at $2 each. Now the price of a muffin rises to $1.50 and the price of coffee falls to $1.75 a cup. 25. a. Will Jim now be able and want to buy 10 muffins and 20 coffees? Jim is able to buy 10 muffins and 20 coffees because this combination remains affordable. Jim will not want to buy this combination, however, because the relative price of muffins and coffee has changed. At his consumer equilibrium, Jim’s MRS equals the relative price of muffins and coffee and because the relative price has changed, Jim’s MRS has changed so Jim will change his consumption point.

b. Which situation does Jim prefer: muffins at $1 and coffee at $2 a cup or muffins at $1.50 and coffee at $1.75 a cup? Jim prefers the $1.50 per muffin/$1.75 per coffee prices because he can attain a higher indifference curve. The new budget line goes through the old budget line at the initial consumption point. But, with coffee measured along the horizontal axis, the new budget line is flatter than the old budget line and lies beyond the initial budget line at all points below the initial consumption point.

26. a. If Jim changes the quantities that he buys, will he buy more or fewer muffins and more or less coffee? Explain your answer. Jim will buy more coffee and fewer muffins because the relative price of coffee has fallen and the relative price of a muffin has risen.

b. When the prices change, will there be an income effect, a substitution effect, or both at work? Explain your answer. Price changes can always be divided into an income effect and a substitution effect so there will always be both at work. © 2023 Pearson Education, Inc.

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Use the following data to work Problems 27 to 29. Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of cola is $1.50 a can. Figure 9.9 shows Sara’s preference map for popcorn and cola. 27.

What quantities of popcorn and cola does Sara buy? What is Sara’s marginal rate of substitution at the point at which she consumes? Sara buys 6 cans of cola and 1 bag of popcorn. Sara’s budget line runs from 8 cans of cola on the xaxis to 4 bags of popcorn on the y-axis and is tangent to indifference curve I1 at 6 cans of cola and 1 bag of popcorn. Sara’s marginal rate of substitution is ½. The marginal rate of substitution is the magnitude of the slope of the indifference curve at Sara’s consumption point, which equals the magnitude of the slope of the budget line. The slope of Sara’s budget line is ½ bag of popcorn per can of cola so the marginal rate of substitution is ½ bag of popcorn per can of cola.

28.

Suppose that the price of cola rises from $1.50 to $3.00 a can while the price of popcorn and Sara’s income remain the same. What quantities of cola and popcorn does Sara now buy? What are two points on Sara’s demand curve for cola? Draw Sara’s demand curve. Sara buys 2 cans of cola and 2 bags of popcorn. Sara buys the quantities of cola and popcorn that moves her onto the highest indifference curve, given her income and the (new) price of cola and price of popcorn. The budget line is tangent to indifference curve I0 at 2 cans of cola and 2 bags of popcorn. Two points on Sara’s demand for cola are the following: At $3 a can of cola, Sara buys 2 cans of cola. At $1.50 a can of cola, Sara buys 6 cans. Her demand curve is downward sloping and, as Figure 9.10 shows, goes through these two points.

29.

Suppose that the price of cola rises to $3.00 a can and the price of popcorn and Sara’s income remain the same. a. What is the substitution effect of this price change and what is the income effect of the price change? The substitution effect is 1 can of cola. To divide the price effect into a substitution effect and an income effect, take enough income away from Sara and gradually move her new budget line back toward the original indifference curve until it just touches Sara’s first indifference curve I1. The point at which this © 2023 Pearson Education, Inc.

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budget line just touches indifference curve I1 is 5 cans of cola. The substitution effect is the decrease in the quantity of cola from 6 cans to 5 cans along the indifference curve I1. The substitution effect is 1 can of cola. The income effect is 3 cans of cola. The income effect is the change in the quantity of cola from the price effect minus the change from the substitution effect. The price effect is 4 cans of cola (2 cans minus the initial 6 cans). The substitution effect is a decrease in the quantity of cola from 6 cans to 5 cans. So the income effect is 3 cans of cola.

b. Is cola a normal good or an inferior good? Explain. Cola is a normal good for Sara because the income effect is positive.

Economics in the News 30. After you have studied Economics in the News on pp. 218–219, answer the following questions. a. If both sugary and healthy drinks are taxed at the same rate and if Sam’s drinks budget remains at $30 a month, how does her drinks consumption change? When both sugary and healthy drinks are taxed at the same rate, their relative price does not change. Consequently, Sam’s budget line shifts inward and its slope remains the same. Because the relative price does not change, there is no substitution effect from this tax policy. However, her real income in terms of both healthy drinks and sugary drinks has decreased. For Sam, healthy drinks are neither an inferior food nor a normal good, so she continues to consume the same quantity of healthy drinks, 15 per month. But sugary drinks are a normal good, so with the decrease in real income, Sam’s consumption of sugary drinks decreases.

b. Which tax has the larger substitution effect and income effect: a tax on all drinks or a tax on sugary drinks? The tax on all drinks has no substitution effect because no relative prices are changed. The tax on only sugary drinks has a substitution effect because it raises the relative price of sugary drinks, so its substitution effect is larger. Both taxes have an income effect. Compared to the tax on only sugary drinks, when the tax is imposed on both drinks Sam spends more of her $30 of income on healthy drinks (because she does not change the quantity of healthy drinks she consumes), thereby leaving her less income to spend on sugary drinks. Accordingly, the income effect is larger with the tax on both drinks.

c. Draw a graph like Fig. 3 to illustrate your answers to parts a and b. Figure 9.11 illustrates the answers to parts a and b. Sam’s initial best affordable point is point A. After the tax increases the price of both healthy and sugary drinks to $1 per can her budget line shifts inward and she moves to her new best affordable point, B. At this point she consumes the same number of healthy drinks as she did before the tax but her consumption of sugary drinks falls from 25 per month to 15 per month. The decrease in her consumption of sugary drinks is entirely due to the income effect from the higher-priced drinks.

C h a p t e r

ORGANIZING PRODUCTION

Answers to the Review Quizzes Page 230 1.

What is a firm’s fundamental goal and what happens if the firm doesn’t pursue this goal? A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either eliminated or bought out by other firms maximizing profit.

Why do accountants and economists calculate a firm’s cost and profit in different ways? Accountants and economists have different reasons for computing a firm’s costs. An accountant calculates a firm’s cost and profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. An economist calculates a firm’s cost and profit in a way that enables him or her to predict the firm's decisions.

What are the items that make opportunity cost differ from the accountant’s measure of cost? A firm’s opportunity cost includes the cost of using resources bought in the market, owned by the firm and supplied by the firm's owner. Economists and accountants both include the price of resources bought in the market as costs. But accountants omit costs included by economists. For instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity costs not recorded by an accountant.

Why is normal profit an opportunity cost? Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labor to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, such as running another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm’s opportunity cost of production.

What are the constraints that a firm faces? How does each constraint limit the firm’s profit? The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. Market constraints mean that what each firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.

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Is a firm technologically efficient if it uses the latest technology? Why or why not? Technological efficiency occurs when a firm produces a given level of output using the least amount of inputs. Adopting the latest available technology does not necessarily imply that a firm’s production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.

Is a firm economically inefficient if it can cut its costs by producing less? Why or why not? Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.

Explain the key distinction between technological efficiency and economic efficiency. The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.

Why do some firms use large amounts of capital and small amounts of labor while others use small amounts of capital and large amounts of labor? The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods.

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Explain the distinction between a command system and an incentive system. A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.

What is the principal-agent problem? What are three ways in which firms try to cope with it? The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal; long-term contracts tie managers’ or workers’ long-term rewards to the long-term performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.

What are the three types of firms? Explain the major advantages and disadvantages of each. The three main ways of organizing a firm have both advantages and disadvantages:  Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. DISADVANTAGES—bad decisions on the part of the owner are not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive.  Partnership. ADVANTAGES—easy to set up; has diversified decision-making so that more than one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and profits are © 2023 Pearson Education, Inc.

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taxed only once. DISADVANTAGES—all the owners’ wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs are high compared to corporations; and capital costs can be high. Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available, largescale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. DISADVANTAGES—potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.

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What are the four market types? Explain the distinguishing characteristics of each. Economists identify four market types: 1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry. 2. Monopolistic competition is a market with many firms that produce similar but slightly different goods. 3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods. 4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist’s product and there are barriers to entry that protect the firm from competition of entering firms.

What are the two measures of concentration? Explain how each measure is calculated. Two measures of concentration have been developed and are in common use: the four-firm concentration ratio and the Herfindahl–Hirschman Index (HHI). 1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry. 2. The Herfindahl–Hirschman Index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.

Under what conditions do the measures of concentration give a good indication of the degree of competition in a market? Concentration measures give a good indication of the degree of competition in a market if the following characteristics of the industry market are correct: 1. The industry market is national in scope, rather than local or international. 2. There are no concerns about over-stating or under-stating the extent of barriers to entry. 3. Firms are not misclassified with respect to their markets.

Is the U.S. economy competitive? Is it becoming more competitive or less competitive? The U.S. economy would be considered competitive since three-quarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.

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What are the two ways in which economic activity can be coordinated? Firms and markets both coordinate resources.

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2. 3. 4.

Firms may reduce transactions costs, which are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled. Firms can capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise. Firms can engage in team production, in which the individuals specialize in mutually supportive tasks.

Firms coordinate economic activity when they can perform a task more efficiently than markets can. In such a situation, it is profitable to set up a firm. If markets can perform a task more efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace such market coordination will be doomed to failure.

What are the main reasons why firms can often coordinate production at a lower cost than markets can? Firms can often coordinate production at a lower cost than can markets because firms lower transactions costs and achieve economies of scale, scope, and team production. These opportunities are not present when markets coordinate production.

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Answers to the Study Plan Problems and Applications 1.

One year ago, Jack and Jill set up a vinegar-bottling firm (called JJVB). Use the following data to calculate JJVB’s opportunity cost of production during its first year of operation:  Jack and Jill put $50,000 of their own money into the firm and bought equipment for $30,000.  They hired one worker at $20,000 a year.  Jack quit his old job, which paid $30,000 a year worked full-time for JJVB.  Jill kept her old job, which paid $30 an hour, but gave up 500 hours of leisure a year to work for JJVB.  JJVB bought $10,000 of goods and services.  The market value of the equipment at the end of the year was $28,000.  Jack and Jill have a $100,000 home loan on which they pay interest of 6 percent a year. The wages paid, $20,000, and the goods and services bought from other firms, $10,000, are opportunity costs to JJVB. Other opportunity costs include the interest forgone on the $50,000 put into the firm, which could have been used to pay part of the mortgage, so the interest forgone is $3,000; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is the value of 500 hours of Jill’s leisure; and the economic depreciation of $2,000 ($30,000 minus $28,000). JJVB’s total opportunity cost is the sum of all these opportunity costs and is $80,000.

Joe, who has no skills, no job experience, and no alternative employment, runs a shoeshine stand. Other operators of shoeshine stands earn $10,000 a year. Joe pays rent of $2,000 a year, and his total revenue is $15,000 a year. Joe spent $1,000 on equipment, which he used his credit card to buy. The interest on a credit card balance is 20 percent a year. At the end of the year, Joe was offered $500 for his business and all its equipment. Calculate Joe’s opportunity cost of production and his economic profit. Joe’s opportunity costs are the $2,000 paid to the airport for the space; the $200 for the interest paid on the $1,000 credit card balance; the $10,000 of normal profit; and the $500 for the depreciation of his equipment (which equals the $1,000 paid for the chair, polish, and brushes minus the $500 he was offered for this equipment). Joe’s total opportunity cost is the sum of these costs, which is $12,700. Joe’s economic profit is his total revenue, $15,000, minus his total opportunity cost, $12,700, for an economic profit of $2,300.

Four ways of laundering 100 shirts are in the table. a. Which methods are technologically efficient? All the methods are technologically efficient.

b. Which method is economically efficient if the hourly wage rate and the implicit rental rate of capital are: (i) Wage rate $1, rental rate $100?

Method A B C D

Labor (hours) 1 5 20 50

Capital (machines) 10 8 4 1

Method D is economically efficient because the total cost is the least. Method D’s costs are 50  $1 + 1  $100, or $150.

(ii) Wage rate $5, rental rate $50? Method D and Method C are economically efficient because the total cost is the least. Method C’s costs are 20  $5 + 4  $50, or $300 and Method D’s costs are 50  $5 + 1  $50, also $300.

(iii) Wage rate $50, rental rate $5?

Method A is economically efficient because the total cost is the least. Method A’s costs are 1  $50 + 10  $5, or $100.

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CEO Pay Surged in a Year of Upheaval CEOs at 300 of the largest U.S. public companies earned on average $13.7 million last year in salary, stock, and other compensation. Compensation increased in part due to the stock market’s performance. Source: wsj.com, April 11, 2021 What is the economic problem that CEO compensation schemes are designed to solve? Would paying executives with stock align their interests with shareholders’ interest? CEO compensation schemes are designed to overcome the principal-agent problem. A CEO’s decisions can have large effects on the company’s profitability. The principals, the shareholders of the corporation, want the CEO, the agent, to carefully consider the decisions and make decisions that boost the firm’s profit. The CEO, however, has the incentive to shirk and to make decisions that boost his or her wellbeing rather than the company’s profit. Paying executives with stock helps align their interests with shareholders. If the profit rises, then the company’s stock price will rise. If the CEO’s pay is largely determined by changes in the stock price, then the CEO’s decisions are directly linked to the company’s fortunes.

Sales of the firms in the tattoo industry are in the table. Calculate the four-firm concentration ratio. What is the structure of the tattoo industry?

Sales (dollars per year) 450 325 250 200 800

Firm The four-firm concentration ratio is 60.49. The four-firm Bright Spots concentration ratio equals the ratio of the total sales of the Freckles largest four firms to the total industry sales expressed as a Love Galore percentage. The total sales of the largest four firms is $450 + Native Birds $325 + $250 + $200, which equals $1,225. Total industry Other 15 firms sales equal $1,225 + $800, which equals $2,025. The fourfirm concentration ratio equals ($1,225/$2,025)  100, which is 60.49 percent. This industry is highly concentrated because the four-firm concentration ratio exceeds 60 percent.

Laptops By The Numbers The combined desktop/laptop market share in the United States in 2018 was HP, 30%, Dell, 24%, Lenova, 14%, Apple, 12%, Acer, 8%, and ASUS, 4%. Source: fortunly.com, January 8, 2021 HP has the largest market share, 30 percent, Dell the second largest, 24 percent, Lenova the third largest, 14 percent, and Apple the fourth largest, 12 percent. Consequently, the four-firm concentration ratio equals 30 + 24 + 14 + 12 which is 80 percent. The HHI equals the sum of the squared market shares of the 50 largest firms. HP’s contribution to the HHI is 302 which is 900; Dell’s contribution to the HHI is 242 which is 576; Lenova’s contribution to the HHI is 142 which is 196; Apple’s contribution to the HHI is 122 which is 144; Acer’s contribution to the HHI is 82 which is 64; and, Asus’s contribution is 42 which is 16. If there are three other firms each with a market share of 2.7 percent, the HHI attains its maximum of 1,918. If there are 8 other firms each with a market share of 1 percent, the HHI equals 302 + 242 + 142 + 122 + 82 + 42 + 8×12 = 1,904. So the HHI can range from about 1,904 to about 1,918.

FedEx contracts with independent truck operators to pick up and deliver its packages and pays them on the volume of packages carried. Why doesn’t FedEx buy more trucks and hire more drivers? What incentive problems might arise from this arrangement? FedEx does not buy more trucks and hire more drivers because FedEx faces a principal-agent problem. In particular, it is not easy to monitor its drivers and insure that they are working hard to efficiently deliver

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packages. FedEx overcomes this problem by hiring independent contractors and then paying them based on the amount of packages they deliver. Essentially, FedEx uses a piecework method of payment. FedEx pays its drivers based on the volume of packages they deliver. This method of payment creates a few incentive potential problems for FedEx. First, FedEx must worry about the quality of its service. In particular, unless FedEx bases part of the payment on quality, its drivers have an incentive to drop the package and race off to the next delivery with no concern for how the packages are handled. Second, FedEx must take care that drivers do not attempt to select only packages that are close to the FedEx location and avoid packages that have a greater than average driving time. Finally, FedEx also must worry that its drivers do not take undue risks while driving in order to deliver as many packages as possible. If FedEx trucks were involved in too many accidents, FedEx would suffer bad publicity and, presumably, would lose some business.

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Answers to Additional Problems and Applications Use the following data to work Problems 8 and 9. Lee is a computer programmer who earned $35,000 in 2020. But on January 1, 2021, Lee opened a body board manufacturing business. At the end of his first year, he gave his accountant the following data:  He stopped renting out his cottage for $3,500 a year and used it as his factory. The market value of the cottage increased from $70,000 to $71,000.  He spent $50,000 on materials, phone, etc.  He leased machines for $10,000 a year.  He paid $15,000 in wages.  He used $10,000 from his savings account, which earns 5 percent a year interest.  He borrowed $40,000 at 10 percent a year.  He sold $160,000 worth of body boards.  Normal profit is $25,000 a year. 8. Calculate Lee’s opportunity cost of production and his economic profit. Lee has costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; $3,500 of forgone rent for the cottage plus $1,000 for the “depreciation” of the cottage (the cottage actually appreciated); $500 in forgone interest from the savings account; wages forgone of $35,000; and, $25,000 for normal profit. These give a total opportunity cost of $142,000. Lee’s economic profit is the total revenue, $160,000, minus the total opportunity cost, $142,000, for an economic profit of $18,000.

Lee’s accountant recorded the depreciation on his cottage during 2021 as $7,000. According to the accountant, what profit did Lee make? Lee’s accountant will include costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; and, $7,000 of depreciation expense for a total opportunity cost of $86,000. The total profit according to the accountant will equal total revenue, $160,000, minus total cost, $86,000, for a profit of $74,000.

10.

In 2020, Toni taught music and earned $20,000. She also earned $4,000 by renting out her basement. On January 1, 2207, she quit teaching, stopped renting out her basement, and began to use it as the office for her new app designing business. She took $2,000 from her savings account to buy a computer. During 2021, she paid $1,500 for the lease of a Web server and $1,750 for high-speed Internet service. Her total revenue from app designing was $45,000 and she earned interest at 5 percent a year on her savings account balance. At the end of 2021, Toni could have sold her computer for $500. If normal profit on app designing is $55,000 a year, calculate Toni’s opportunity cost of production and her economic profit in 2021. Toni has costs of $1,500 for the lease of a Web server; $1,750 for high-speed Internet service; $55,000 for normal profit; $20,000 of forgone earnings from teaching; $4,000 of forgone rent from renting her basement; $100 of forgone interest from her saving account; and $1,500 for the depreciation of her computer (which equals the $2,000 paid for it minus the $500 for which she could have sold it). These various costs sum to a total opportunity cost of $83,850. Toni’s economic profit is her total revenue, $45,000, minus her total opportunity cost, $83,850, for an economic loss of $38,850.

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Bacardi Expands Canned Cocktail Range Lisa Pfenning, vice president, Bacardi for North America said, “As the world opens up again, we want to continue to enliven the moments where people can come together safely.” Source: drugstorenews.com, May 24, 2021 a. Does the news clip imply that Bacardi’s goal is customer satisfaction and not profit maximization? The news clip definitely implies that Barcardi’s goal is customer satisfaction because it says Bacardi wants to “enliven the moments where people can come together safely.”

b. What would happen to Bacardi if it didn’t focus on maximizing profit, but instead focused its production and pricing decisions to “enliven the moments where people can come together safely”? In general customers want very tasty, potentially very costly-to-produce cocktails sold for an exceptionally low price. In particular, customers want to pay the lowest price possible regardless of the company’s profit. If Barcardi focused on only giving customers the products to “enliven the moments where people can come together safely,” Barcardi would incur a loss and ultimately would either close or be purchased by another company.

12.

Why Now Is the Time to Invest in Watches In addition to the hype around owning a Rolex or Richard Mille, luxury watches have historically retained their value or even become significantly more valuable over time. Source: businessinsider.com, December 21, 2020 a. What is the cost of buying a watch? The (opportunity) cost of buying a watch is the loss of whatever else would have been purchased with the funds.

b. What is the opportunity cost of owning a watch? The opportunity cost of owning a watch is the annual forgone return, such as the forgone interest from buying a watch rather than placing the funds in a savings account, and the depreciation of the watch.

c. Does owning a watch create an economic profit opportunity? Yes, owning a watch creates an economic profit opportunity. If the watch appreciates at a rapid clip, so that the gain in the value of the watch over time exceeds the normal profit from the funds used to purchase the watch, then owning the watch has lead to an economic profit.

Use the following data to work Problems 13 and 14. Four methods of completing a tax return and the time taken are: Using a laptop, 1 hour; a calculator, 12 hours; a calculator and paper and pen, 12 hours; and a pen and paper, 16 hours. The laptop and its software cost $1,000, the calculator costs $10, and the pen and paper cost $1. 13. Which, if any, of the methods is technologically efficient? All methods other than “calculator with paper and pen” are technologically efficient. To use a calculator with paper and pen to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a calculator alone but it uses more capital.

14.

Which method is economically efficient if the wage rate is (i) $5 an hour? The economically efficient method is the technologically efficient method that allows the task to be done at least cost. When the wage rate is $5 an hour, total cost with a laptop is $1,005, total cost with a calculator is $70, and total cost with paper and pen is $81. Total cost is least with a calculator.

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(ii) $50 an hour? When the wage rate is $50 an hour, total cost with a laptop is $1,050, total cost with a calculator is $610, and the total cost with paper and pen is $801. The calculator is economically efficient.

(iii) $500 an hour? When the wage rate is $500 an hour, total cost with a laptop is $1,500, total cost with a calculator is $6,010, and total cost with pen and paper is $8,001. The laptop is economically efficient.

15.

Robotic Surgeries Surge to 15% of All Procedures, Despite Limited Evidence Robotic surgery for common surgical procedures is on the rise. Robotic surgery is replacing some conventional laparoscopic procedures that may not be complex enough to warrant the expensive use of robots. Source: medtechdive.com, January 14, 2020 a. Assume that performing a surgery with a surgical robot requires fewer surgeons and nurses. Is using the surgical robot technologically efficient? Using the surgical robot is technologically efficient because the production technique uses less labor (and more capital) than the non-robotic technique.

b. What additional information would you need to be able to say that switching to surgical robots is economically efficient for a hospital? To determine if the production technique is economically efficient, information about the cost of the robot and the cost of the nurses and doctors and about the number of doctors and nurses each production technique uses is needed.

16.

Worldwide, Walmart has more than 10,500 stores, 2.3 million employees and total annual revenue of more than $550 billion. Babita Gupta owns Nirmal Designs, an Indian firm with 35 employees that supplies Walmart with cushion covers, bedspreads, and aprons. a. How does Wal-Mart coordinate its activities? Is it likely to use mainly a command system or also to use incentive systems? Explain. Wal-Mart is a huge organization. As such, it uses both command and incentive systems. At the lower, store level, command is the system that is most commonly used. (For instance, an associate is told that he or she will help unload a delivery and stack the packages against the South wall.) At the higher, corporate level, incentive is the system most commonly used. (For instance, regional directors have part of their income tied to their region’s performance.) However, even at the store level some incentive systems are used (associates can enroll in a profit sharing plan) and even at the corporate level some command systems are used (regional directors are told that they must report to their supervisors on a weekly basis).

b. How does Babita Gupta most likely coordinate the activities of Nirmal Designs? Is she likely to use mainly a command system or also to use incentive systems? Explain. Babita Gupta probably uses a command system significantly more often than an incentive system. Her firm has few employees and so it is easy to tell each employee what to do, when to do it, and where to do it. Possibly the only use of an incentive system might be if she has some higher-ranking family members on a profit-sharing program.

c. Describe, compare, and contrast the principal–agent problems faced by Walmart and Nirmal Designs. How might these firms cope with their principal–agent problems? Wal-Mart faces many more principal-agent problems than does Nirmal Designs. For Nirmal Designs, it is relatively straightforward to monitor each employee so employees will find it difficult to shirk. If, however, Ms. Babita Gupta hires friends, they might try to take advantage of the friendship by shirking. In this case, the friends could be offered profit-sharing packages to discourage shirking. Additional, Ms. Babita Gupta owns the firm herself, and so there is no principal-agent problem associated with a difference between the owners and the managers. Wal-Mart, however, has more than two million employees. Each of these employees realizes that if he or she shirks, it will make little difference to Wal-Mart’s overall performance. © 2023 Pearson Education, Inc.

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So Wal-Mart’s managers must be constantly alert to this problem. Wal-Mart also faces the principal-agent problem that results because its owners are not its managers. As a result, the owners must try to create incentives for the managers to behave in the best interests of the owners. Wal-Mart has a number of ways that it can try to overcome the principal-agent problems it faces. Its top management is given stock options. Regional managers, store managers, and top level store management are given profit-sharing packages that depend on the performance of the region or a particular store. Buyers for Wal-Mart—people employed by Wal-Mart to determine which products Wal-Mart will purchase—are often given profitsharing packages that increase the buyer’s income depending on how well the products the buyer purchased perform in the stores. All of these are designed to give the recipient the incentive to make decisions that boost Wal-Mart’s profit and thereby its stock price, which benefit the owners.

17.

Google Says It Still Uses the ‘20-Percent Rule’ The idea is simple: Employees divide their time, so that at least 20 percent is used to explore projects that show no promise of paying immediate dividends but might reveal big opportunities later. Source: inc.com, November 1, 2020 a. What is the method of organizing production when a firm uses the 20-Percent Rule? In some sense Google is using a command system because Google “orders” its employees to use 20 percent of their time to explore projects with no promise of immediate payoffs. But in a larger sense Google is using an incentive system. If one of the projects turns out to be wildly profitable, the employees who worked on it will benefit by gaining stature and possibly income within Google.

b. What are the potential gains and opportunity costs associated with this method? The potential gain is that the creative people working for Google will apply their creativity to develop new and better products for Google. The potential drawback is the principal-agent problem. The employees might use their time for on-the-job leisure rather than for new, cutting edge research.

18.

Market shares of chocolate makers are in the table. Calculate the Herfindahl-Hirschman Index. What does the HHI say is the structure of the chocolate industry? The Herfindahl-Hirschman Index is 1,800. The HerfindahlHirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl-Hirschman Index equals 152 + 102 + 202 + 152 + 252 + 152, which equals 1,800. This industry is moderately concentrated because the Herfindahl-Hirschman Index lies in the range 1,500 to 2,500.

Firm Truffles, Inc. Magic, Inc. Mayfair, Inc. All Natural, Inc. Gold, Inc. Bond, Inc.

Market share (percent) 25 20 15 15 15 10

Use the following information to work Problems 19 to 21. Two design firms, Astro Studios of San Francisco and Hers Experimental Design Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox 360 video game console. IBM, ATI, and SiS designed the Xbox 360’s hardware. Three firms manufactured the Xbox 360 at their plants in China and Taiwan. 19.

Describe the roles of market coordination and coordination by firms in the design, manufacture, and marketing of the Xbox 360. Microsoft entered the market to hire various firms, Astro Studios and Hers Experimental Design Laboratory to design the Xbox 360 and then entered the market again to hire IBM, ATI, and SiS to design the hardware of the Xbox 360. Finally, Microsoft once again entered the market to hire three firms to produce the Xbox 360. Once Microsoft had contracted with these firms, the design, manufacture, etc. takes place within the firm.

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performing all the required tasks itself? Microsoft works with a large number of firms rather than doing everything in-house because it is less expensive for Microsoft to work with other firms. These other firms have specialized in various tasks and so have gained economies of scale that Microsoft does not possess. Therefore, it is cheaper for Microsoft to enter the market and hire the expertise it needs than to do it all itself.

b. What are the roles of transactions costs, economies of scale, economies of scope, and economies of team production in the design, manufacture, and marketing of the Xbox? Microsoft needed to determine what part of designing, building, and marketing the Xbox would take place inside of Microsoft and what would take place in other companies that Microsoft hired. Hiring other companies means that Microsoft incurs the transactions costs of using markets. However, other companies that specialized in different tasks have economies of scale, economies of scope, and/or economies of team production that lower the cost to Microsoft of hiring them. So, Microsoft had to determine which parts of the Xbox 360 would be cheaper to undertake inside of Microsoft and which parts would be cheaper to enter the market to contract with other firms.

21.

Why do you think the Xbox is designed in the United States and Japan but built in China? The Xbox is designed in America and Japan because America and Japan have a large number of highlyskilled workers who can successfully design the Xbox. With a large number of technically adept workers, it is less expensive to design the Xbox in these countries. Manufacturing the Xbox, however, takes place in China because China has a large number of lower-skilled workers and so it is less expensive to build the Xbox in China.

Economics in the News 22. After you have studied Economics in the News on pp. 244–245, answer the following questions. a. What products do Amazon, Facebook, and Google sell? Amazon sells online shopping services and also search services for products. Facebook sells social networking services; that is, it allows its users to keep up with their friends. Google sells search services; that is, it helps its users search the Internet for the topics in which they are interested.

b. In what markets do Amazon, Facebook, and Google compete? Amazon, Facebook, and Google compete against each other in the markets for advertising and online search.

c. How do social networks and Internet search providers generate revenue? Both social network Internet sites and Internet search providers generate revenue from sale of advertisements.

d. What is special about an online shopping sites that make them attractive to advertisers? Online shopping sites, such as Amazon, have millions of users. Users typically use online shopping sites to search for goods and services they want to purchase. Therefore, these sites are attractive to advertisers because an advertiser gains a large audience of people who have a tendency to be interested in the advertiser’s product.

e. What is special about Internet search providers that make them attractive to advertisers? Users of Internet search providers often are searching for either a particular product or else a product to fill a particular need. Often users are searching with an intention to buy. Advertisers are attracted to these web sites because they allow the advertiser to target an audience that is frequently going to purchase the product the advertiser has for sale.

What technological changes might increase the profitability of Amazon compared to social networks and Internet search providers? Technological change that enables Amazon to more precisely target the preferences of individual consumers—such as more efficient use of past buying history from or better information about preferences © 2023 Pearson Education, Inc.

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via the consumer’s past web browsing on Amazon or on other web sites—would make advertising on Amazon more profitable because the ads would more precisely reflect the potential buyer's interests. This change would enable Amazon to set a higher price for each advertisement, thereby increasing its profitability compared to other Internet search providers.

23.

Teacher Merit Pay Linked to Higher Test Scores Merit pay is based on the idea that teachers work harder when paid according to student achievement. The effectiveness eventually wears off because the same teachers continually earn the merit pay and others stop seeing it as attainable. Source: k12dive.com, February 24, 2020 How does merit pay for teachers attempt to cope with the principal–agent problem in public education? Does the news clip suggest that it works? The principal-agent problem with teachers in public education is the concern that teachers will not work hard in the classroom. Teachers’ efforts are difficult to monitor and so teachers have the incentive to shirk by working less diligently and teaching their students less. Merit pay is an incentive system that links the teachers’ pay to their students’ achievement, in the case at hand, performance on standardized exams. With this linkage teachers will be paid more the better their students’ performance which gives the teachers the self-interested incentive to work diligently to instruct their students. According to the results from this news, until it wore off (when other teachers who did not see student success gave up striving to receive merit pay) merit pay worked because students had higher test scores.

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Answers to the Review Quizzes Page 252 1.

Distinguish between the short run and the long run. The short run is a period of time during which the quantity of at least one factor of production is fixed and cannot be changed. The long run is a period of time long enough so that the quantities of all factors of production can be varied.

Why is a sunk cost irrelevant to a firm’s current decisions? Sunk cost is irrelevant because it cannot be changed by any decision. It is already incurred and so must be paid. The only costs that concern the firm are costs that the firm can change with its current decisions.

Page 256 1.

Explain how the marginal product and average product of labor change as the labor employed increases (a) initially and (b) eventually. Initially, as the quantity of labor is increases, the firm experiences increasing marginal returns, which means that the marginal product increases as more labor is employed. Increasing marginal returns occur because hiring additional workers allows the workers to specialize and become more productive. Eventually, the firm will experience diminishing marginal returns which means that the marginal product decreases as more labor is employed. Decreasing marginal returns occur because eventually the gains from specialization diminish and because more and more workers are working with the same fixed amount of capital. The average product of labor follows the marginal product of labor. Initially, when the marginal product of labor is increasing, the average product also increases. As long as the marginal product of labor exceeds the average product of labor, the average product continues to increase. Eventually when the marginal product is falling it falls enough so that it is less than the average product, at which point the average product of labor decreases.

What is the law of diminishing returns? Why does marginal product eventually diminish? The law of diminishing returns states that as a firm uses more of a variable factor of production with a given quantity of fixed factors of production, the marginal product of the variable factor eventually diminishes. Diminishing marginal returns arises from the fact that ever more workers are using the same capital and working in the same space.

Explain the relationship between marginal product and average product. As the quantity of labor initially increases the firm experiences increasing marginal returns and the marginal product of labor increases. The marginal product of labor is greater than the average product over this range of labor, so the average product of labor increases when the quantity of labor increases. Eventually, diminishing marginal returns causes the marginal product of labor to fall. When the marginal product of labor falls below the average product, the average product decreases as the quantity of labor increases.

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Page 263 1.

What relationships do a firm’s short-run cost curves show? The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all related in the short run:  When the MC curve lies above (lies below) the AVC curve, the AVC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the AVC curve at its lowest point.  When the MC curve lies above (lies below) the ATC curve, the ATC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the ATC curve at its lowest point.  As output increases, the ATC curve becomes vertically closer to the AVC curve.

How does marginal cost change as output increases (a) initially and (b) eventually? At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor, but as output increases further, marginal cost eventually increases because of the law of diminishing returns.

What does the law of diminishing returns imply for the shape of the marginal cost curve? The law of diminishing returns states: As a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes. The law of diminishing returns means that each additional worker produces a successively smaller addition to output. So to get an additional unit of output, ever more workers are required. The cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward.

What is the shape of the AFC curve and why does it have this shape? Average fixed cost (AFC) equals total fixed cost divided by total product. As the quantity produced increases, the fixed costs are spread over a larger and larger quantity of output so average fixed cost decreases. So the AFC curve slopes downward as the quantity produced increases.

What are the shapes of the AVC curve and the ATC curve and why do they have these shapes? The average variable cost (AVC), and average total cost (ATC) curves are both U-shaped.  The marginal cost (MC) curve shows how total cost changes when output increases by one unit. If the MC curve lies below the AVC curve, AVC is falling. Diminishing marginal returns means that eventually the MC curve slopes upward. At some point the MC curve lies above the AVC curve, and the AVC curve is upward sloping.  ATC is the sum of average fixed cost (AFC) and AVC. Initially the ATC curve falls as the quantity produced increases because the AFC is initially quite large, but drops rapidly as total fixed costs are spread over greater levels of output. However, eventually diminishing returns cause marginal product to fall below average product, and average product decreases. As a result AVC increases as the quantity produced increases. If AVC rises more quickly than AFC falls, then the ATC curve is upward sloping.

Page 267 1.

What does a firm’s production function show and how is it related to a total product curve? A firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor. The total product curve shows the maximum output that a given quantity of labor can produce for a given quantity of capital.

Does the law of diminishing returns apply to capital as well as labor? Explain why or why not. The law of diminishing returns applies to capital as well as labor. The marginal product of capital is the change in the total product resulting from a one-unit increase in capital, holding the quantity of labor constant. As the quantity of capital increases for a given level of labor, the first units of capital will increase output substantially. But as capital continues to increase, eventually the increase in production starts to get smaller and diminishing returns to capital are occurring. © 2023 Pearson Education, Inc.

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What does a firm’s LRAC curve show? How is it related to the firm’s short-run ATC curves? The long-run average cost curve (LRAC) shows the relationship between the lowest attainable ATC and output when both plant size and labor are varied. The LRAC curve reflects the minimum possible ATC the firm can attain for any given level of output. For any level of output the firm might choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular plant size. Once the firm has chosen that plant size, it will incur costs corresponding to the ATC curve associated with that plant size.

What are economies of scale and diseconomies of scale? How do they arise? What do they imply for the shape of the LRAC curve? Economies of scale are features of a firm’s technology that lead to falling long-run average cost (LRAC) as output increases. As plant size increases, the minimum attainable average total cost (ATC) for each plant size falls with output. Diseconomies of scale are features of a firm’s technology that lead to rising LRAC as output increases. As plant size increases, the minimum attainable ATC for each plant size rises with output. A firm initially experiences economies of scale up to some output level and over this range of output the LRAC curve is downward sloping as output increases. Beyond that output level, it may move toward diseconomies of scale. When there are diseconomies of scale, the LRAC slopes upward as output increases, resulting in a U-shaped LRAC curve.

What is a firm’s minimum efficient scale? Minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. If the long-run average cost curve has the typical U shape, the minimum point of the LRAC identifies the level of output that represents the firm’s minimum efficient scale.

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Answers to the Study Plan Problems and Applications 1.

Best Buy Expects to Shutter More Than 20 Stores Best Buy plans to close some large-format stores and revamp other locations to fulfill orders from its online business. Some employees are being moved to virtual sales, chat, phone, and remote support. Source: marketwatch.com, March 1, 2021 Which of the items in the news clip involves a short-run decision and which involves a longrun decision? Explain. Closing some large format stores is a long-run decision because it reduces the size of all of Best Buy’s factors of production, labor and the capital stock. Revamping other locations is also a long-run decision because it changes all of the factors of production in the revamped stores. Moving employees into virtual sales, chat, phone, and remote support are short run decisions because they involved changing only one factor of production—labor—and all the other factors remained fixed.

Use the table to work Problems 2 to 6. The table sets out Sue’s Surfboards’ total product schedule. 2. Draw the total product curve. To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping and is illustrated in Figure 11.1.

Calculate the average product of labor and draw the average product curve. The average product of labor is equal to total product divided by the quantity of labor employed. For example, when 3 workers are employed, they produce 120 surfboards a week, so average product is 40 surfboards per worker. As Figure 11.2 (on the next page) shows, the average product curve is upward sloping when up to 3 workers are hired and then is downward sloping when more than 4 workers are hired.

Labor (workers per week) 1 2 3 4 5 6 7

Output (surfboards per week) 30 70 120 160 190 210 220

Calculate the marginal product of labor and draw the marginal product curve. The marginal product of labor is equal to the increase in total product that results from a oneunit increase in the quantity of labor employed. For example, when 3 workers are employed, total product is 120 surfboards a week. When a fourth worker is employed, total product increases to 160 surfboards a week. The marginal product of increasing the number of workers from 3 to 4 is 40 surfboards. We plot the marginal product at the halfway point, so at a quantity of 3.5 workers, the marginal product is 40 surfboards per worker per week. As Figure 11.2 shows, the marginal product curve is upward sloping when up to 2.5 workers a week are employed and it is downward sloping when more than 2.5 workers a week are employed.

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5. a. Over what output range does Sue’s Surfboards enjoy the benefits of increased specialization and division of labor? The firm enjoys the benefits of increased specialization and division of labor over the range of output for which the marginal cost decreases. This range of output is the same range over which the marginal product of labor rises. For Sue’s Surfboards, the benefits of increased specialization and division of labor occur until 2.5 workers are employed.

b. Over what output range does Sue’s Surfboards experience diminishing marginal product of labor? The marginal product of labor decreases after the 3rd worker is employed.

c. Over what output range does Sue’s Surfboards experience an increasing average product of labor but a diminishing marginal product of labor? The marginal product of labor decreases and the average product of labor increases between 2.5 and 3.5 workers.

Explain how it is possible for a firm to experience simultaneously an increasing average product but a diminishing marginal product. As long as the marginal product of labor exceeds the average product of labor, the average product of labor rises. For a range of output the marginal product of labor, while decreasing, remains greater than the average product of labor, so the average product of labor rises. Each additional worker, while producing less than the previous worker hired is still producing more than the average worker.

Use the following data to work Problems 7 to 11. Sue’s Surfboards, in Problem 2, hires workers at $500 a week and its total fixed cost is $1,000 a week. 7. Calculate total cost, total variable cost, and total fixed cost of each output in the table. Plot these points and sketch the short-run total cost curves passing through them. Total cost is the sum of the costs of all the factors of production that Sue’s Surfboards uses. Total variable cost is the total cost of the variable factors. Total fixed cost is the total cost of the fixed factors. For example, the total variable cost of producing 120 surfboards a week is the total cost of the workers employed, which is 3 workers at $500 a week, which equals $1,500. Total fixed cost is $1,000, so the total cost of producing 120 surfboards a week is $2,500. Figure 11.3 shows these total cost curves.

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Calculate average total cost, average fixed cost, average variable cost, and marginal cost of each output in the table. Plot these points and sketch the short-run average and marginal cost curves. Output (surfboards) 30

AFC (dollars per surfboard) 33.33

AVC (dollars per surfboard) 16.67

ATC (dollars per surfboard) 50.00

14.29

28.58

120

8.33

12.50

20.83

160

6.25

12.50

18.75

190

5.26

13.16

18.42

210

4.76

14.29

19.05

220

4.55

15.91

20.46

MC (dollars per surfboard) 12.50 10.00 12.50 16.67 25.00 50.00

Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output. For example, take the case in which the firm makes 160 surfboards a week. Total fixed cost is $1,000, so average fixed cost is $6.25 per surfboard; total variable cost is $2,000, so average variable cost is $12.50 per surfboard; and, total cost is $3,000, so average total cost is $18.75 per surfboard. Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 120 to 160 surfboards a week, total cost increases from $2,500 to $3,000, an increase of $500. This $500 increase in total cost means that the increase in output of 40 surfboards increases total cost by $500. Marginal cost is equal to $500 divided by 40 surfboards, which is $12.50 a surfboard. The table shows these data schedules and the curves are plotted in Figure 11.4.

OUTPUT AND COSTS

Illustrate the connection between Sue’s AP, MP, AVC, and MC curves in graphs like those in Fig. 11.7. Labor (workers) 1

Output (surfboards) 30

AP (surfboards per worker) 30.0

35.0

120

40.0

160

40.0

190

38.0

210

35.0

220

31.4

MP (surfboards per worker)

AVC (dollars per surfboard) 16.67

40.0

12.50 10.00 12.50

40.0

12.50 12.50

30.0

16.67 13.16

20.0

25.00 14.29

10.0

50.00 15.91

The table sets out the data used to draw the curves. Figure 11.5 shows the curves and the relationships. When the AP curve rises the AVC curve falls and vice versa. When the MP curve rises the MC curve falls and vice versa.

Sue’s Surfboards rents a factory. If the rent rises by $200 a week and other things remain the same, how do Sue’s Surfboards’ short-run average cost curves and marginal cost curve change? The rent is a fixed cost, so total fixed cost increases. The increase in total fixed cost increases total cost but does not change total variable cost. Average fixed cost is total fixed cost per unit of output. The average fixed cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve and average variable cost curve do not change.

11.

MC (dollars per surfboard)

14.29 50.0

10.

157

Workers at Sue’s Surfboards negotiate a wage increase of $100 a week per worker. If other things remain the same, explain how Sue’s Surfboards’ short-run average cost curves and marginal cost curve change. The increase in the wage rate is a variable cost, so total variable cost increases. The increase in total variable cost increases total cost but total fixed cost does not change. Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward while the average fixed cost curve does not change. © 2023 Pearson Education, Inc.

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Use the following data to work Problems 12 to 14. Jackie’s Canoe Rides rents Labor canoes at $100 per day and (workers pays $50 per day for each per day) Plant 1 canoe operator it hires. The 10 20 table shows the firm’s 20 40 production function. 30 65 40 75 12. Graph the average total Canoes 10 cost curves for Plant 1 and Plant 2. Explain why they differ.

Output (rides per day) Plant 2 Plant 3 40 55 60 75 75 90 85 100 20 30

Plant 4 65 85 100 110 40

To find the average total cost for each plant, at the different levels of output add the cost of the workers, $50 per worker, and the fixed cost, the cost of the canoes, $100 per canoe. So for plant 1, the total cost for 20 rides is $1,500; for 40 rides is $2,000; and, for 65 rides is $2,500. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.6. (The average total cost curve for one plant, ATC1, is the same as the thicker curve through the first 4 points.) The curves differ because the number of plants differs.

13.

Graph the average total cost curves for Plant 3 and Plant 4. Explain why they differ. These are drawn in Figure 11.6. The curves differ because the number of plants differs.

14. a. On Jackie’s LRAC curve, what is the average cost of producing 40, 75, and 85 rides a week? The long-run average total cost curve is illustrated in Figure 11.6 as the thicker curve. It is comprised of the parts of the short-run average total cost curves that are the minimum average total cost for the different levels of output. From this curve, the average cost of producing 40 rides is $50; of producing 75 rides is $40; and the average cost of producing 85 rides is $47.06.

b. What is Jackie’s minimum efficient scale? Jackie’s minimum efficient scale is the smallest quantity at which the long-run average cost is the lowest. Jackie’s minimum efficient scale is 65 canoe rides where, with one plant, the average total cost is $38.46.

c. Does Jackie’s production function feature economies of scale or diseconomies of scale? Jackie’s has both economies of scale for up to 65 canoe rides and then diseconomies of scale for more than 65 canoe rides.

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Answers to Additional Problems and Applications 15.

Nestlé Purina PetCare Plans to Open New Factory in North Carolina Nestlé Purina PetCare announced a $450 million investment to open a new factory in North Carolina. Purina plans to employ more than 300 people at its new factory location. Source: prnewswire.com, September 30, 2020 a. Which of Nestlé Purina’s decisions described in the news clip is a short-run decision and which is a long-run decision? Opening the new factory is a long-run decision because it changes the amount of all of Nestlé Purina’s inputs including its input of capital. Nestlé Purina is changing its plant and this is always a long-run decision. Adding the 300 people is a short-run decision.

b. Why is Nestlé Purina’s long-run decision riskier than its short-run decision? Nestlé Purina’s long-run decisions are riskier than its short-run decision because it is more difficult to change the long-run decisions. In particular if Nestlé Purina decides to reverse its short-run decision to hire more people, it is straightforward to fire them. However, to reverse the long-run decision of opening a new factory is more difficult and takes much longer to do.

16.

A Bad Fit: Why You Should Care About Sunk Costs We all relate to wearing an ill-fitting pair of shoes to get our money’s worth. When we come to our senses, we ditch the toe crunchers and buy shoes that don’t destroy our feet. Source: bizjournals.com, May 27, 2021 a. What type of cost is expenditure on shoes? Once the pair of shoes is purchased, its cost is a sunk cost.

b. Why is the price paid for the shoes irrelevant to your decision about whether to keep on wearing a pair that cause pain? The cost of the shoes is a sunk cost; that is, the cost of the shoes has already been incurred. Because the cost of the shoes is the same regardless if you wear them or not, their cost is irrelevant to your decision whether to wear them or not.

17.

Terri runs a rose farm. One worker produces 1,000 roses a week; hiring a second worker, doubles her total product; hiring a third worker doubles her output again; hiring a fourth worker increased her total product but by only 1,000 roses. Construct Terri’s marginal product and average product schedules. Over what range of workers do marginal returns increase? The easiest way to construct Labor Output Average Marginal the marginal product and (workers (roses product product average product schedules is per week per week) (roses per week) (roses per week) to use the total product 1 1,000 1,000 schedule, in the table to the 1,000 left. Then the average 2 2,000 1,000 product of labor is equal to 2,000 the output divided by the 3 4,000 1,333 quantity of labor and the 1,000 marginal product of labor is 4 5,000 1,250 equal to the change in output divided by the change in the quantity of labor. Marginal returns increase over the range of 3 workers. After the third worker, the marginal product decreases as more workers are hired.

18.

Read the information about Nestlé Purina’s business decisions in the news clip in Problem 15. Explain how Nestlé Purina’s short-run decision will change its average variable cost and its © 2023 Pearson Education, Inc.

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short-run average total cost curve. Nestlé Purina’s short-run decision to hire more workers creates a movement along its AVC curve and its ATC curve as output increases. But we do not know the relative size of the change in output versus the change in costs, so we cannot determine if the average variable cost and average total cost increase or decrease; the net effects are ambiguous.

19.

Bill’s Bakery has a fire and Bill loses some of his cost data. The bits of paper that he recovers after the fire provide the information in the following table (all the cost numbers are dollars). Bill asks you to come to his rescue and provide the missing data in the five spaces identified as A, B, C, D, and E.

TP 10

AFC 120

AVC 100

ATC 220

150

130

MC 80 90 130

40 30 C D A is the average fixed cost, AFC, when the output is E 20. Average fixed cost equals total fixed cost divided 50 24 108 132 by output, or AFC = TFC ÷ Q. Rearranging gives TFC = AFC × Q. So the total fixed cost for the problem equals $120 × 10, which is $1,200. A equals $1,200, TFC, divided by 20, Q, which is $60. B is the average variable cost, AVC, when output is 20. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC  AFC, so average variable cost equals $150  $60, which is $90. D is the average total cost, ATC, when output, Q, equals 40. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So, the total cost when 30 units are produced is $130 × 30, which is $3,900. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = TC ÷ Q. Rearranging gives TC = MC × Q, so the change in total cost between Q = 30 and Q = 40 is $130 × 10, or $1,300. Therefore, the total cost when Q equals 40 is $3,900 + $1,300, or $5,200. The average total cost when Q is 40 is $5,200 ÷ 40, or $130. C is the average variable cost, AVC, when output, Q, equals 40. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC  AFC. As a result, average variable cost equals $130  $30, or $100. E is the marginal cost, MC, when output increases from 40 units to 50 units. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = TC ÷ Q. To calculate marginal cost, the total cost when output is 40 and the total cost when output is 50 are needed. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So, the total cost when 40 units are produced is $130 × 40, which is $5,200 and total cost when 50 units are produced is $132 × 50, which is $6,600. So the marginal cost equals ($6,600  $5,200) ÷ 10, which equals $140.

Use the following table to work Problems 20 and 21. ProPainters hires students at $250 a week to paint houses. It leases equipment at $500 a week. The table sets out its total product schedule. 20. If ProPainters paints 12 houses a week, calculate its total cost, average total cost, and marginal cost. At what output is average total cost a minimum?

Labor (students) 1 2 3 4 5 6

Output (houses painted per week) 2 5 9 12 14 15

To paint 12 houses, ProPainters hires 4 students. The total variable cost is $1,000 (paid to the students) and the total fixed cost is $500 (the leased equipment). Therefore, the total cost is $1,500. The average total cost equals $1,500/12, which is $125 per house. The marginal cost of 10½ houses is $83.33 and the marginal cost of 13 houses is $125.00. These mean that the marginal cost of 12

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houses is $104.17. Using the data in the table, the average total cost is at its minimum of $125 per house when 13 houses are painted.

21.

Explain why the gap between ProPainters’ total cost and total variable cost is the same no matter how many houses are painted. The gap between total cost and total variable cost is total fixed cost. Because the fixed cost is the same at all levels of output, the difference between the total cost and total variable cost is constant.

22.

Skyrocketing Meat Costs May Prompt Restaurant Price Increases With soaring meat costs, Americans might soon have to dish out more money than usual at restaurants. Executive Chef Luca Corrazina says his restaurant is already charging its customers “a little bit extra.” Source: nbcchicago.com, May 24, 2021 a. Does the rising price of meat change a restaurant’s fixed cost, variable cost, or marginal cost? Meat is a variable input, so increases in its price do not change the restaurant’s fixed cost but do increase the restaurant’s variable cost and its marginal cost.

b. Explain how the rising price of meat influences a restaurant’s short-run cost curves. Meat is a variable input, so the increase in its price does not change the restaurant’s fixed cost curve. However, the rise in the price of meat increases the restaurant’s total variable costs, its average variable cost, its total cost, its total average cost, and its marginal cost. All of these curves shift upward when the price of meat rises.

Use the table in Problem 20 and the following information to work Problems 23 and 24. If ProPainters doubles the number of students it hires and doubles the amount of equipment it leases, it experiences diseconomies of scale. 23.

Explain how the ATC curve with one unit of equipment differs from that when ProPainters uses double the amount of equipment. Because ProPainters experiences diseconomies of scale, when ProPainters doubles its inputs the minimum average cost is higher than when it uses the lesser quantities of inputs. Even so, at high levels of output the average total cost of producing the large level of output with the greater quantities of inputs is lower than the average total cost of producing this large level of output with the smaller quantities of inputs.

24.

Explain what might be the source of the diseconomies of scale that ProPainters experiences. ProPainters might experience diseconomies of scale because when it gets larger the complexity of operating the business increases, which increases the costs of running the business and making decisions.

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Use the following information to work Problems 25 to 27. The table shows the Labor production function of (workers Bonnie’s Balloon Rides. per day) Plant 1 Bonnie’s pays $500 a day for 10 6 each balloon it rents and $25 20 10 a day for each balloon 30 13 operator it hires. 40 15 25. Graph the average 50 16 total cost curves for Balloons 1 Plant 1 and Plant 2. Explain why they differ.

Output (rides per day) Plant 2 Plant 3 10 13 15 18 18 22 20 24 21 25 2 3

Plant 4 15 20 24 26 27 4

To find the average total cost for each plant, at the different levels of output add the variable cost, which is the cost of the workers or $25 per worker, to the fixed cost, which is the cost of the balloons or $500 per balloon. For Plant 1, the total cost for 6 rides is $750; for 10 rides is $1,000; for 13 rides is $1,250; for 15 rides is $1,500; and, for 16 rides is $1,750. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.7. The curves differ because the number of plants differs.

26.

Graph the average total cost curves for Plant 3 and Plant 4. Explain why they differ. Figure 11.7 shows these ATC curves. These curves differ because the number of plants differs.

27. a. On Bonnie’s LRAC curve, what is the average cost of producing 15 rides and 18 rides a day? The long-run average total cost curve is illustrated in Figure 11.7 as the darker line. The long-run average cost curve is comprised of the segments of the different short-run average total cost curves that have the minimum average total cost for the different levels of output. For 15 rides a day the average cost is $100 and for 18 rides a day the average cost is $97.22.

b. Explain how Bonnie’s uses its long-run average cost curve to decide how many balloons to rent. Bonnie’s will use its long-run average total cost curve by building the size of the plant that minimizes its long-run average cost at the number of balloon rides that Bonnie’s expects to produce.

Economics in the News 28. After you have studied Economics in the News on pp. 268-269, answer the following questions. a. Explain the distinction between the short run and the long run, and identify when Amazon would want to make each type of decision. The short run is a time frame during which the quantity of at least one factor of production is fixed. The long run is a time frame in which the quantities of all factors of production can be varied. Amazon will make changes that lower its costs. It will make a short-run change when it wants to make an immediate

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change or when it wants to make a change that it will reverse in the near future. Amazon will make a longrun change when it wants to make a change that will be permanent.

b. Explain constant returns to scale. Why does Amazon reap constant returns to scale in the example with the assumed costs on p. 269? Constant returns to scale occur when a firm’s average total cost does not change as the firm’s output changes. Amazon has constant returns to scale because the assumed cost of production at the new Goodyear center is the same as at the Tucson center. Consequently, the average total cost of processing orders at the Goodyear center is the same as at the Tucson center.

c. Amend the graph in Fig. 2 on p. 269 to illustrate Amazon’s ATC1 and LRAC curves if it experiences economies of scale. Figure 11.8 shows Amazon’s long-run average total cost, LRAC, when it experiences economies of scale.

29.

Marriott is Testing Contactless Check-in Via Kiosks Marriott is testing its new contactless arrival kiosks, eliminating the need for face-to-face check-ins. The kiosks help speed up the check-in process. Source: yahoo.com, April 11, 2021 a. What is the total fixed cost of operating one contactless check-in kiosk? The total fixed cost is the cost of the kiosk itself plus the cost of the software necessary to run it.

b. Explain how the fixed costs, variable costs, and total costs differ if you check in at a hotel using a contactless kiosk or check in with an employee at the front desk. Checking in with a kiosk has no variable costs, only the fixed cost of the kiosk. Accordingly, the total cost is equal to the fixed cost and does not change as the number of check ins changes. Checking in at the front desk has fixed costs—the cost of installing and maintaining the desk, computers, and other capital equipment used—as well as variable costs, such as the cost of the employee who checks you in. Consequently, the total cost is the sum of the fixed costs plus the variable costs so the total cost changes as the number of check ins changes.

c. Sketch the marginal cost and average cost curves implied by your answer to part (b). Figure 11.9 shows the different marginal costs and average total cost curves. The costs with the kiosk check-in are labeled “1” and the costs with the front-desk check in are labeled “2”. Because the total cost of the kiosk check in are all fixed costs, which do not change when the number of check ins changes, the marginal cost of a kiosk © 2023 Pearson Education, Inc.

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check in is zero. The average total cost of the kiosk check in is higher than that of the front-desk check in at low levels of people checking in and is lower than the average total cost of the front-desk check ins-at higher levels of check ins.

Use the following news clip to work Problems 30, 31, and 32. Macy’s Plans to Open Smaller Stores Macy’s CEO Jeff Gennette believes that Macy’s has high potential outside of malls and in smaller formats. The department store chain is planning to test several smaller Macy’s stores outside of malls. Source: today.com, September 2, 2020 30. Thinking of a Macy’s store as a production plant, explain why Macy’s is opening smaller stores. Is Macy’s decision a long-run decision or a short-run decision? Macy’s believes that its stores are too large and that it is operating where it has diseconomies of scale. By reducing the size of its plant (its stores) Macy’s can slide down its LRAC curve and decrease its average cost. Macy’s decision is a long-run decision because it involves the size of the firm’s plant.

31.

Is Macy’s expecting to benefit from economies of scale or does the firm think there are diseconomies of scale? Explain your answer. Macy’s believes that it is operating where there are diseconomies of scale. By opening smaller stores, Macy’s believes its average total cost of serving busy millennial shoppers will be lower in its smaller stores than in its conventional-sized stores.

32.

Draw a graph to illustrate Macy’s average total cost curves for a small format store and the regular Macy’s store. Figure 11.10 shows Macy’s long-run average cost curve (LRAC), its average total cost for a larger store (ATCLARGE), and a smaller store (ATCSMALL). When serving the smaller number of customers per day, 600 in the figure, the smaller store’s average total cost is less than $1 compared to $2 for a conventional store.

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Answers to the Review Quizzes Page 277 1.

Why is a firm in perfect competition a price taker? One firm’s output is a perfect substitute for another firm’s output and each firm is a small part of the market. These points imply that each firm cannot unilaterally influence the market price at which it can sell its good or service. It must accept, or “take” the market equilibrium price—hence the term, price taker.

In perfect competition, what is the relationship between the demand for the firm’s output and the market demand? The market demand curve for the goods and services in a perfectly competitive market is downward sloping. However, no single firm in this market can influence the price at which it sells its output. This point means a firm that is a price taker must take the equilibrium market price as given, and the firm faces a perfectly elastic demand.

In perfect competition, why is a firm’s marginal revenue curve also the demand curve for the firm’s output? A perfectly competitive firm’s demand curve is a horizontal line at the market price. This result means that the price it receives is the same for every unit sold. The marginal revenue received by the firm is the change in total revenue from selling one more unit, which is the constant market price. So a perfectly competitive firm’s demand curve is the same as its marginal revenue curve.

What decisions must a firm make to maximize profit? The firm has three decisions it must make. First it must determine how to produce at the minimum cost. Then it must determine how much to produce. Finally it must decide whether to enter or exit a market.

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Why does a firm in perfect competition produce the quantity at which marginal cost equals price? A firm’s total profit is maximized by producing the level of output at which marginal revenue for the last unit produced equals its marginal cost, or MR = MC. In a perfectly competitive market, MR is equal to the market price P for all levels of output. These points imply that a perfectly competitive firm will maximize profit by producing the quantity at P = MC.

What is the lowest price at which a firm produces an output? Explain why. The lowest price at which a firm will produce output is the price that equals the firm’s minimum AVC. At this price the firm has just enough total revenue to cover its total variable costs. The firm’s loss is equal to its fixed costs. At any lower market price the firm’s loss would be greater than its fixed costs. In this case the firm can avoid losses that are greater than its fixed cost by shutting down.

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What is the relationship between a firm’s supply curve, its marginal cost curve, and its average variable cost curve? The firm will produce output as long as the price is greater than the minimum AVC. It will choose the level of output where MC = P, which means the firm’s supply curve is the firm’s MC curve above minimum AVC and along the vertical axis, producing zero, below the minimum AVC.

Page 285 1.

How do we derive the short-run market supply curve in perfect competition? The short-run market supply curve is the horizontal sum of each individual firm’s supply curve. That is, the amount supplied by the total market equals the sum of what each firm in the industry supplies at a given price.

In perfect competition, when market demand increases, explain how the price of the good and the output and profit of each firm changes in the short run. When market demand increases, the market price of the good rises, and the market quantity increases. Because price equals marginal revenue, the rise in the price means marginal revenue rises. As a result, each firm moves up its marginal cost curve and increases the quantity it produces. The firm’s economic profit rises (or its economic loss decreases). If the firm had been making a normal profit before the increase in demand, after the increase the firm makes an economic profit.

In perfect competition, when market demand decreases, explain how the price of the good and the output and profit of each firm changes in the short run. When market demand decreases, the market price of the good falls and the market quantity decreases. Because the price equals marginal revenue, the fall in the price means marginal revenue falls. As a result, each firm moves down its marginal cost curve so each firm decreases the quantity it produces. The firm’s economic profit falls (or its economic loss increases). If the firm had been making a normal profit before the decrease in demand, after the decrease the firm incurs an economic loss.

Page 287 1.

What triggers entry in a competitive market? Describe the process that ends further entry. When firms in a competitive market make an economic profit, the economic profit serves as an inducement to other firms to enter the market. As the other firms enter, the supply increases and the price falls. The fall in the price eventually eliminates the economic profit, at which time entry stops.

What triggers exit in a competitive market? Describe the process that ends further exit. When firms in a competitive market are incurring an economic loss, some of the firms will exit the market. As these firms exit, the supply decreases and the price rises. The rise in the price eventually eliminates the economic loss, at which time exit stops.

Page 291 Describe what happens to output, price, and economic profit in the short run and in the long run in a competitive market following: 1.

An increase in demand. An increase in demand increases the market quantity, and the market price rises above ATC for each firm. In the short run, firms in the market make an economic profit, attracting firms from outside the market to enter the market in the long run. This entry shifts the market supply curve rightward, lowering the price as the market quantity continues to increase. The fall in the price shrinks the firms’ economic profit until the price again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic profit and entry stops. In the long run, the price returns to the original level, market output is © 2023 Pearson Education, Inc.

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larger than the original amount, the number of firms is larger, and economic profit for each firm returns to zero.

A decrease in demand. Starting from an initial point of long-run equilibrium, a permanent decrease in demand decreases the market quantity, and the price falls below the minimum ATC for each firm. In the short run, firms in the market incur an economic loss, which leads some firms to exit the market in the long run. This exit shifts the market supply curve leftward, raising the price and continuing to decrease the market quantity. The increase in the price shrinks the economic loss for each remaining firm. Exit continues until the price again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic profit and exit stops. In the long run, the market price returns to the original level, market output is less than the original amount, the number of firms is less, and economic profit for each firm returns to zero.

The adoption of a new technology that lowers production costs. Technological advances result in lower costs for the firm that adopts them and initially these firms make an economic profit. Two actions occur in the market: i) firms from outside the market enter the market; ii) firms with old technology either exit the market or adopt the new technology. These two actions shift the market supply rightward, decreasing market price and increasing market quantity. In the long run, all firms in the industry will be new technology firms, economic profit for each firm will return to zero, market quantity will increase, and market price will fall to the new minimum ATC for each firm.

Page 293 1.

State the conditions that must be met for resources to be allocated efficiently. Resource use is efficient when the economy produces the goods and services that people value most highly. This situation requires that consumers are on their demand curves, thereby allocating their budgets to get the most possible value from their income. If the people who consume a good or service are the only ones who benefit from it, then the market demand curve measures the benefit to the entire society and is the marginal social benefit curve. Efficient resource use also requires that firms are on their supply curves, thereby getting the most value out of their resources. If the firms that produce a good or service bear all the costs of producing it, then the market supply curve measures the marginal cost to the entire society and the market supply curve is the marginal social cost curve. And resources are used efficiently when marginal social benefit equals marginal social cost.

Describe the choices that consumers make and explain why consumers are efficient on the market demand curve. Consumers allocate their budgets so they get the most value from their budgets. When consumers are on their demand curves, they are getting the most value out of their resources and are efficient.

Describe the choices that producers make and explain why producers are efficient on the market supply curve. Competitive firms maximize profit. We derive the firm’s supply curve by finding the profit-maximizing quantity at each price, which means that firms are efficient and get the most value out of their resources at all points along their supply curve.

Explain why resources are used efficiently in a competitive market. Resources are used efficiently in a competitive market because the market demand curve is the same as the marginal social benefit curve and the market supply curve is the same as the marginal social cost curve. The equilibrium quantity, determined by where the demand and supply curves intersect, is the same quantity where the marginal social benefit and marginal social cost curves intersect, which is the efficient quantity.

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Answers to the Study Plan Problems and Applications 1.

Lin’s makes fortune cookies. Anyone can make and sell fortune cookies, so there are dozens of producers. All fortune cookies are the same and buyers and sellers know this fact. In what type of market does Lin’s operate? What determines the price of fortune cookies? What determines Lin’s marginal revenue? Lin is operating in a perfectly competitive market. The equilibrium price is determined at the intersection of the market demand curve and the market supply curve. Lin’s marginal revenue equals the market price of a box of cookies.

Use the following table to work Problems 2 to 4. Pat’s Pizza Kitchen is a price taker and the table shows its costs of production. 2. Calculate Pat’s profit-maximizing output and economic profit if the market price is (i) $14 a pizza, (ii) $12 a pizza, (iii) $10 a pizza. (i)

(ii)

(iii)

Output (pizzas per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 10 21 30 41 54 69

At $14 a pizza, Pat’s profit-maximizing output is 4 pizzas an hour and economic profit is $2 an hour. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $14 a pizza. The marginal cost is the change in total cost when output is increased by 1 pizza an hour. The marginal cost of increasing output from 3 to 4 pizzas an hour is $13 ($54 minus $41). The marginal cost of increasing output from 4 to 5 pizzas an hour is $15 ($69 minus $54). So the marginal cost of the fourth pizza is half-way between $13 and $15, which is $14. Marginal cost equals marginal revenue when Pat produces 4 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $56 ($14 multiplied by 4). Total cost is $54, so economic profit is $2. At $12 a pizza, Pat’s profit-maximizing output is 3 pizzas an hour and economic profit is $5. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. Marginal revenue equals price, which is $12 a pizza. The marginal cost of increasing output from 2 to 3 pizzas an hour is $11 ($41 minus $30). The marginal cost of increasing output from 3 to 4 pizzas an hour is $13. So the marginal cost of the third pizza is half-way between $11 and $13, which is $12. Marginal cost equals marginal revenue when Pat produces 3 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $36 ($12 multiplied by 3). Total cost is $41, so economic profit is $5. At $10 a pizza, Pat’s profit-maximizing output is 2 pizzas an hour and economic profit is $10. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. Marginal revenue equals price, which is $10 a pizza. The marginal cost of increasing output from 1 to 2 pizzas an hour is $9 ($30 minus $21). The marginal cost of increasing output from 2 to 3 pizzas an hour is $11. So the marginal cost of the second pizza is half-way between $9 and $11, which is $10. Marginal cost equals marginal revenue when Pat produces 2 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $20 ($10 multiplied by 2). Total cost is $30, so economic profit is $10.

What is Pat’s shutdown point and what is Pat’s economic profit if it shuts down temporarily? The shutdown point is the price that equals minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($10—when output is zero, total variable cost is $0, so total cost at zero output equals total fixed cost) from total cost. Average variable cost equals total variable cost divided by the quantity produced. The average variable cost of producing 2 pizzas is $10 a pizza. Average variable cost is a © 2023 Pearson Education, Inc.

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minimum when marginal cost equals average variable cost. The marginal cost of producing 2 pizzas is $10. So Pat’s shutdown point is a price of $10 a pizza. When Pat shuts down the economic “profit” is actually an economic loss equal to Pat’s fixed cost. In particular Pat’s economic loss is $10.

Derive Pat’s supply curve. Pat’s supply curve is the same as the marginal cost curve at prices equal to or above $10 a pizza. The supply curve is the y-axis (0 pizzas) at prices below $10 a pizza.

The market for paper is perfectly competitive and 1,000 firms produce paper. The first table sets out the market demand schedule for paper. Price Quantity demanded The second table sets out the costs of each (dollars per box) (thousands of boxes per week) producer of paper. Calculate the market 3.65 500 price, the market output, the quantity 5.20 450 produced by each firm, and the firm’s 6.80 400 economic profit or loss. 8.40 350 The market price is $8.40 per box of paper. 10.00 300 The market price is the price at which the 11.60 250 quantity demanded equals the quantity 13.20 200 supplied. The firm’s supply curve is the same as its marginal cost curve at prices above minimum average variable Output Marginal cost Average Average cost. Average variable cost is at its (boxes (dollars per variable cost total cost minimum when marginal cost equals per week) additional box) (dollars per box) average variable cost. Marginal cost 200 6.40 7.80 12.80 equals average variable cost at the 250 7.00 7.00 11.00 quantity 250 boxes a week. So the 300 7.65 7.10 10.43 firm’s supply curve is the same as the 350 8.40 7.20 10.06 marginal cost curve for the outputs 400 10.00 7.50 10.00 equal to 250 boxes or more. When 450 12.40 8.00 10.22 the price is $8.40 a box, each firm 500 20.70 9.00 11.00 produces 350 boxes and the quantity supplied by the 1,000 firms is 350,000 boxes a week. The quantity demanded at $8.40 is 350,000 a week. The market output is 350,000 boxes a week. Each firm produces 350 boxes a week. Each firm incurs an economic loss of $581 a week. Each firm produces 350 boxes at an average total cost of $10.06 a box. The firm sells the 350 boxes for $8.40 a box. The firm incurs a loss on each box of $1.66 and incurs a total economic loss of $581 a week.

In Problem 5, new technology decreases the demand for paper. The table sets out the new demand schedule for paper. If firms have the same costs set out in Problem 5, what is the market price and the firm’s economic profit or loss in the short run?

Price (dollars per box) 2.95 4.13 5.30 6.48 7.65 8.83 10.00 11.18

Quantity demanded (thousands of boxes per week) 500 450 400 350 300 250 200 150

The market price is $7.65 a box, the equilibrium market quantity is 300,000 boxes a week, and each firm incurs an economic loss of $834 a week. When the price is $7.65 a box, each firm produces 300 boxes and the total quantity supplied by the 1,000 firms is 300,000 boxes a week. The market quantity © 2023 Pearson Education, Inc.

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demanded at $7.65 is 300,000 boxes a week. Each firm produces 300 boxes at an average total cost of $10.43 a box. The firm sells the 300 boxes for $7.65 a box. At this price and quantity the firm incurs a loss on each box of $2.78 and incurs an economic loss of $834 a week.

In Problem 5, what is the market price and the quantity of paper produced in the long run? How many producers of paper will operate in the market in the long run? In the long run, the price equals the minimum average total cost, $10 a box. The number of firms in the long run is 750. In the long run, as firms exit the industry, the price rises. In the long-run equilibrium the price will equal the minimum average total cost. When output is 400 boxes a week, marginal cost equals average total cost and average total cost is a minimum at $10 a box. In the long run, the price is $10 a box. Each firm remaining in the industry produces 400 boxes a week. The quantity demanded at $10 a box is 300,000 boxes a week. The number of firms is 300,000 boxes divided by 400 boxes per firm, which is 750 firms. In the long run, the 750 firms together produce the equilibrium quantity of 300,000 boxes.

If the market demand for paper remains the same as in Problem 6, calculate the market price, market output, and the economic profit or loss of each firm. In the long run, the price equals the minimum average total cost, which is $10.00 a box, the equilibrium industry quantity is 200,000 boxes a week, and each firm makes zero economic profit.

In perfect competition in long-run equilibrium, can consumer surplus or producer surplus be increased? Explain your answer. Once at the competitive equilibrium quantity, which is the same as the efficient quantity, the sum of consumer surplus plus producer surplus is as large as possible. If the price is lowered, consumer surplus increases but only at the expense of a larger decrease in producer surplus. And the lower price is not the long-run equilibrium price. If the price is raised, producer surplus increases but only at the expense of a larger decrease in consumer surplus. And the higher price is not the long-run equilibrium price.

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Answers to Additional Problems and Applications Use the following news clip to work Problems 10 to 12. Summer Road Trip? Gas Prices Should Remain Steady Jeanette McGee of AAA says to expect gas prices to move between $2.95 and $3.10 over the next few months. Motorists can expect to see lower prices toward the end of September. Source: abcnews.go.com, June 4, 2021 1. Describe the market for gasoline in your town. What determines the price of gasoline and the marginal revenue from gasoline. Gas stations operate in a highly or perfectly competitive market: Gasoline is virtually identical at each station, there are many gas stations, and the prices are highly visible. The equilibrium price is determined at the equilibrium between the market demand and the market supply. The marginal revenue from a gallon of gasoline equals the market price of a gallon.

Describe the price elasticity of demand for gas in your town. Each gas station’s elasticity of demand is very high. When one station raises its price even a bit, it loses a lot of customers to its competitors. And when one of the stations lowers its price, it gains a lot of customers from its competitor.

Why does a gasoline station have so little control over the price of the gasoline it sells? Gas stations face a large amount of competition from all nearby gas stations. If a firm raises its price it loses a vast number of customers so each firm is severely limited in raising its price. And there is no need for a firm to lower its price much below the going price because the firm can already increase its sales drastically with only a slight lowering of its price.

13.

Figure 12.1 shows the costs of Seaclusion, one of many shops located along the beach. If the market price of a beach ball is $10, calculate Seaclusion’s a. Profit-maximizing output. Seaclusion’s profit-maximizing quantity is 80 beach balls per day. Seaclusion maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $10 a beach ball. Marginal cost is $10 a beach ball when Seaclusion sells 80 beach balls a day.

b. Economic profit. Seaclusion’s economic profit is $240 a day. Economic profit equals total revenue minus total cost. Total revenue equals $800 a day ($10 a beach ball multiplied by 80 beach balls). The average total cost of selling 80 beach balls is $7 a beach ball, so total cost equals $560 a day ($7 multiplied by 80 beach balls). So economic profit equals $800 minus $560, which is $240 a day.

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How Coronavirus Grounded the Airline Industry With Americans under stay-at-home orders, airlines are parking planes. Delta is parking its Boeing 717 and Airbus A350 fleets, as it downsizes to try to weather the industry storm. Source: washingtonpost.com, April 1, 2020 a. Explain how Delta’s shutdown decision will affect its TFC, TVC, and TC. The shutdown decision has no effect on Delta’s TFC. It will lower Delta’s TVC and TC.

b. Under what conditions would Delta’s shutdown decision maximize its economic profit (or minimize its loss)? Explain your answer. Delta will shut down its plant—its flights—when the price of an airline ticket is less than its average variable cost, that is, when P < AVC. By shutting down, Delta incurs an economic loss equal to its total fixed cost, which is the minimum loss that it can incur in this situation.

c. Under what conditions will Delta start flying its Boeing 717 and Airbus A350 fleets? Explain your answer Delta will resume flying again when the price f an airline ticket exceeds its average variable cost, that is, when P > AVC. In this case, even if Delta is still incurring an economic loss, its loss will be less if it produces than if it shuts down.

15.

The market for smoothies is perfectly competitive and the market demand schedule is in the first table. Each of the 100 producers of smoothies has the costs given in the second table when it uses its least-cost plant. a. What is the market price of a smoothie?

Price (dollars per smoothie) 1.90 2.00 2.20 2.91 4.25 5.25 5.50

Quantity demanded (smoothies per hour) 1,000 950 800 700 550 400 300

The market price is the price at which the market quantity demanded equals the market quantity supplied. The firm’s supply curve is the same as its marginal cost curve at prices Output Marginal cost Average Average above minimum average (smoothies (dollars per variable cost total cost variable cost. Average variable per hour) additional smoothie) (dollars per smoothie) cost is a minimum when 3 2.50 4.00 7.33 marginal cost equals average 4 2.20 3.53 6.03 variable cost. Marginal cost 5 1.90 3.24 5.24 equals average variable cost at 6 2.00 3.00 4.67 the quantity 7 smoothies an 7 2.91 2.91 4.34 hour. So the firm’s supply 8 4.25 3.00 4.25 curve is the same as the 9 8.00 3.33 4.44 marginal cost curve for outputs greater than and equal to 7 smoothies. When the price is $2.91 a smoothie, each firm produces 7 smoothies and the market quantity supplied by the 100 firms is 700 smoothies an hour. The market quantity demanded at $2.91 is 700 smoothies an hour so the market price is $2.91

b. What is the market quantity of smoothies? The market quantity of smoothies is 700 smoothies an hour.

c. How many smoothies does each firm sell? Each firm sells 7 smoothies an hour.

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d. What is the economic profit made or economic loss incurred by each firm? Each firm incurs an economic loss. Each firm produces 7 smoothies at an average total cost of $4.34 a smoothie. The firm sells the 7 smoothies for $2.91 each. The firm incurs a loss on each smoothie of $1.43 and incurs a total economic loss of $10.01 an hour.

16.

Corn is the Latest Commodity to Soar The post-Covid economy means more drivers and greater demand for corn to produce ethanol for blending into gasoline. Corn prices are rising. Source: wsj.com, May 10, 2021 Why is the price of corn rising? Draw a graph to show the short-run effect on an individual farmer’s economic profit. The price of corn is rising due to increased demand for corn to turn into ethanol. The increase in the demand for corn drives the price of corn higher. Figure 12.2 shows the effect of the higher price on the economic profit of an individual farmer. The price of a bushel of corn rises from $2 per bushel to $4 per bushel. The farmer’s marginal revenue curve therefore shifts upward from MR0 to MR1. When the price is $2 per bushel, the firm produces 45,000 bushels per year and incurs an economic loss (because P < ATC). After the price rises to $4 per bushel, the firm produces 70,000 bushels per year and makes an economic profit (because P > ATC).

17.

In Problem 15, do firms enter or exit the market for smoothies in the long run? What is the market price and the equilibrium quantity in the long run? The firms are incurring economic losses, so some firms exit the market. As firms exit the market, the market supply decreases so that in the long run the price rises to equal the minimum average total cost, $4.25 per smoothie. When the price is $4.25 for a smoothie, the equilibrium quantity is 550 smoothies per hour.

18.

In Problem 14, under what conditions would Delta stop supplying air flights and exit the travel market. Explain your answer. Delta will permanently shut down and exit the market in the long run if the price of an airline ticket is less than Delta’s average total cost. In this situation, if it remained open Delta would incur an economic loss but if it exited the market, it would no longer incur an economic loss.

19.

Nabisco Plant to Close A Nabisco plant that produces baked goods in New Jersey will close for good by summer’s end after 63 years of operation. The plant has aging infrastructure and outdated production capabilities. Source: abcnews.go.com, February 6, 2021 a. Is Nabisco making a decision to shutdown or a decision to exit in the baked goods market? Nabisco is making an exit decision. It is permanently leaving the market.

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b. Under what conditions will this decision maximize Nabisco’s economic profit? This decision maximizes Nabisco’s economic profit if Nabisco’s operations are incurring an economic loss with the price less than the average total cost. In this case by closing its plant, Nabisco increases its economic profit.

c. How might Nabisco’s decision affect the economic profit of other baked goods producers? Nabisco’s exit will decrease the number of plants producing baked goods. This decrease in the number of plants decreases the supply and raises the market price of baked goods. As a result of the higher market price the other producers’ profits rise.

20.

TV Trends to Watch in 2021 In 2021, expect larger and cheaper 4K TVs, a new level of voice control, interaction with other smart products, and mini Led backlights to improve color contrast and overall picture quality. Source: consumerreports.org, January 6, 2021 a. Explain how the advance in TV technology will influence the market for streaming services in the short run and in the long run. Illustrate your explanation with a graph. An advance in TV technology increases the demand for streaming services. In the short run, the price of streaming services rises. As Figure 12.3 shows with the increase in demand from D0 to D1, the price rises from $12 per month to $15 per month along supply curve S0. The higher price increases the profit of the streaming service firms, so new firms enter the market. The supply of streaming services increases, shifting the supply curve rightward, in the figure from S0 to S1. The increase in the supply lowers the price back to $12 per month. The quantity increases from 50 million subscribers ultimately to 150 million.

b. Explain how the market for streaming services will influence the market for 4K TVs. As the popularity of streaming services increases, the demand for 4K TVs will increase. The increase in the demand for these televisions raises their price, so that the firms producing them make an economic profit. The economic profit, however, attracts entry by new firms, which increases the supply and then lowers the price.

21.

In a perfectly competitive market, each firm maximizes its profit by choosing only the quantity to produce and regardless of whether the firm makes an economic profit or incurs an economic loss, the short-run equilibrium is efficient. Is the statement true? Explain why or why not. The statement is true. A perfectly competitive firm is a price taker and so it has no choice about what price it will charge. If there are no external benefits or external costs, then when a competitive market is in equilibrium, it is efficient. Regardless of the firms’ profits, as long as they are producing along their supply curves they are producing efficiently and obtaining the most value for their resources.

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Economics in the News 22. After you have studied Economics in the News on pp. 294–295, answer the following questions. a. What features of the market for fitness services make it competitive? The market for fitness services is highly competitive because there are many producers and buyers of fitness services, there are no restrictions on entry, established fitness service sellers have no advantages over new sellers, and sellers and buyers of fitness services are well informed about prices.

b. If the decrease in demand for gym membership was expected to be temporary, how would gym operators have acted and what would have happened to the price of gym membership during the pandemic? If gym operators expected the decrease in membership to be temporary, they would remain open as long as if P > AVC and would temporarily shut down if P < AVC, planning to reopen when customers returned. The price of gym membership would have fallen because of the decrease in demand.

c. How would you expect the development of on-demand fitness classes online to change the market for gym membership in the long run? On-demand fitness classes over the Internet are a substitute for gym membership. The development of these online fitness classes will decrease the demand for gym membership. The decrease will lower the price so that gyms incur an economic loss. The economic loss will lead to exit from the market, thereby raising the price enough so that the surviving gyms make a normal profit.

d. Illustrate your answer to part (c) with an appropriate graphical analysis. Initially the demand for gym membership is given by demand curve D0 and supply is given by supply curve S0 so the price of membership is $40 per month and there are 300 million memberships. The development of online fitness classes decreases the demand for gym membership to D1. The price of membership falls to $20 per month and the number of members decreases to 200 million. With the fall in price, some gyms exit the market, thereby decreasing the supply to S1. With the new supply curve, the price of gym membership rises back to $40 and the number of members falls to 100 million.

23.

The Chinese-Made, Sub-$100 Smartphone is Africa’s Fastest-Growing Handset More than half of all smartphones sold in Africa cost less than $100 and are made in China. As phone networks are upgraded across Africa, social media rises in popularity, and mobile internet access becomes more affordable, the demand for smartphones increases. Source: az.com, March 19, 2020 a. Explain the effects of the increase in demand for smartphones in Africa on the market for smartphones and on an individual smartphone producer in the short run. The market demand for smartphones increases. In the short run, the price of a smartphone rises and the market equilibrium quantity increases. Because the market price rises, individual smartphone producers increase the quantity they produce and make an economic profit.

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b. Draw a graph to illustrate your explanation in part (a).

Figure 12.5 shows the short-run outcome. Figure 12.5a shows the market equilibrium. In the market, demand increases, and the demand curve shifts rightward from D0 to D1. In the short run the supply curve remains S0. As a result of the increase in demand the market price rises to $100 a smartphone and the market quantity increases to 400 million. Figure 12.5b shows the situation at a representative firm. The rise in the market price raises the firm’s demand and marginal revenue curve from MR0 to MR1. The firm responds by increasing the quantity it produces from 8 million smartphones a year to 9 million smartphones a year. It makes an economic profit because the price exceeds the firm’s average total cost.

c. Explain the long-run effects of the increase in global demand for smartphones on the market for smartphones. In the long run the economic profit attracts entry into the market. The market supply increases which drives the price down. The market equilibrium quantity increases. The fall in the price decreases and, in the long run, eliminates the firms’ economic profits so the firms make zero economic profit.

24.

Distillers Enter the Hand Sanitizer Market The demand for hand sanitizer surged during the COVID-19 pandemic and the price increased from $2.50 to $12.50 per bottle. U.S. sales revenues jumped 300 percent in the last week of February and 470 percent in the first week of March, compared to one year ago. Source: CNBC, March 28, 2020 a. What features of this market make it competitive? The market for hand sanitizer is highly competitive because there are many producers and buyers of hand sanitizers, there are no restrictions on entry, established producers have no advantages over new producers, and sellers and buyers of hand sanitizer are well informed about prices.

b. Describe and explain the changes in the price, quantity, and economic profit as the hand sanitizer market responded to COVID-19. The market demand for hand sanitizer increased. In the short run, the market price of hand sanitizer rises (from $2.50 per bottle to $12.50 per bottle) and the market equilibrium quantity increases. Because the market price rises, individual hand sanitizer producers increase the quantity they produce and make an economic profit. The economic profit, however, attracts entry. As new firms enter the market for hand © 2023 Pearson Education, Inc.

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sanitizer, the market supply of hand sanitizer increases. The increase in supply drives the price down. The market equilibrium quantity increases. The fall in the price decreases and, in the long run, eliminates the firms’ economic profits so the firms make zero economic profit. Once this price is reached, entry of new firms ceases and the market is in its long-run equilibrium.

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Answers to the Review Quizzes Page 303 1.

How does monopoly arise? Monopoly arises if a firm is selling a good that has no close substitutes and if the firm is protected from competition by a barrier to entry. As a result, a monopoly is the only firm in its market.

How does a natural monopoly differ from a legal monopoly? The barrier to entry protecting a natural monopoly is the firm’s cost. For a natural monopoly, the costs are such that one firm can supply the entire market at lower cost than could two or more firms. The barrier to entry protecting a legal monopoly is a legal prohibition preventing competitors from entering the market. Copyrights, patents, government licenses, and public franchises are legal barriers to entry.

Distinguish between a price-discriminating monopoly and a single-price monopoly. A single-price monopoly charges every consumer the same price for each unit of the good or service the consumer buys. A price-discriminating monopolist might charge different consumers different prices for the same good or service or charge the same consumer different prices for different units of the good or service. When a firm practices price discrimination, it sells different units of a good or service for different prices.

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What is the relationship between marginal cost and marginal revenue when a single-price monopoly maximizes profit? A single-price monopoly firm maximizes profit by producing an amount of output so that marginal cost equals marginal revenue (MR = MC).

How does a single-price monopoly determine the price it will charge its customers? The market demand curve is the monopolist’s demand curve. The demand curve shows the maximum price at which the monopoly can sell its profit-maximizing level of output. So the monopoly finds the quantity it will produce and then uses its demand curve—the market demand curve—to determine the price it will charge.

What is the relationship between price, marginal revenue, and marginal cost when a singleprice monopoly is maximizing profit? MR < P for every level of output. A profit-maximizing monopoly firm produces the amount of output that sets MR = MC. As a result, MC must be below price: MC = MR < P.

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Why can a monopoly make a positive economic profit even in the long run? Barriers to entry prevent the monopoly firm from enduring the pressure of competition, and allow it to choose the quantity of output that is associated with the profit-maximizing market price. This allows a monopoly firm to potentially enjoy positive economic profit, even in the long run.

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Why does a single-price monopoly produce a smaller output and charge more than the price that would prevail if the market were perfectly competitive? The market supply curve for a competitive market is the horizontal sum of the individual firm’s marginal cost curves. Equilibrium output in this competitive market is determined where the market supply curve intersects the market demand curve, and at this point price equals marginal cost, that is P = MC. Equilibrium output for a single-price monopoly is determined at the intersection of its marginal cost curve and its marginal revenue curve. Marginal revenue is less than price, which means that MR = MC at less output than that for which P=MC, so the monopoly produces less than a perfectly completive market. For a monopoly price exceeds marginal revenue which, in turn, equals marginal cost. Therefore for a monopoly, P > MC which means the monopoly price exceeds the price in a perfectly competitive market.

How does a monopoly transfer consumer surplus to itself? The monopoly raises price by lowering the quantity offered for sale. This raises the price consumers must pay for the good compared to the competitive market price. This difference in price multiplied by the quantity the monopolist sells represents the amount of consumer surplus that is transferred to producer surplus.

Why is a single-price monopoly inefficient? In a competitive market, the supply curve is the marginal social cost curve for society, and the demand curve is the marginal social benefit curve to society. The perfectly competitive market is efficient because production occurs where the quantity supplied equals the quantity demanded so that MSB = MSC. The monopolist is inefficient because price exceeds marginal cost at the quantity of output the monopoly produces. When the monopoly equates MC = MR to choose the profit-maximizing level of output, it charges a price from the demand curve that is greater than marginal cost, which means MSB > MSC. Consumer and producer surplus are not maximized and society suffers a deadweight loss.

What is rent seeking and how does it influence the inefficiency of monopoly? Rent seeking is the pursuit of wealth by capturing economic rent. Any surplus—consumer surplus, producer surplus, or economic profit—is called economic rent. There are two forms of rent seeking activity to pursue a monopoly status: i) Buying a monopoly, where a person expends resources seeking to purchase monopoly rights for a price slightly less than the monopoly profit, or ii) Creating a monopoly, where a person expends resources seeking political influence, such as lobbying legislators to provide preferential market status by restricting domestic or international competition. The resources expended in rent seeking will be equal to the economic profit that a monopoly status would create for the owner. Economic profit is zero because it has been lost in rent seeking. The cost of rent seeking is a fixed cost so the marginal cost does not change, which means the monopoly does not change its (inefficient) amount of output. Consumer surplus is unaffected. But the deadweight loss of monopoly has increased because it now includes the original deadweight loss triangle plus the lost producer surplus.

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What is price discrimination and how is it used to increase a monopoly’s profit? Price discrimination is the practice of selling different units of a good or service for different prices. To practice price discrimination, a monopoly must be able to: i) identify and separate different buyer types, and ii) sell a product that cannot be resold. The key idea to price discrimination is to charge different © 2023 Pearson Education, Inc.

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consumers different prices, according to their willingness to pay for the good. This transfers potential consumer surplus under the single-price scenario into producer surplus, raising the monopoly’s profit.

Explain how consumer surplus changes when a monopoly price discriminates. When a monopoly price discriminates, it charges different prices for different units of the product or it charges different prices to different consumers. Consumer surplus is the value (or marginal benefit) of a good minus the price paid for it, summed over the quantity bought. When the monopoly price discriminates, it decreases the consumer surplus on the units for which it charges a higher price to its initial customers. But it increases the consumer surplus on units for which it charges a lower price to new customers. If a monopoly is able to perfectly price discriminate, it totally eliminates consumer surplus because it charges every consumer the highest price the consumer is willing to pay.

Explain how consumer surplus, economic profit, and output change when a monopoly perfectly price discriminates. Perfect price discrimination occurs when a monopoly charges each consumer the maximum price he or she is willing to pay. The closer the price paid is to the value placed on the good, the smaller is the consumer surplus. This transfers the entire consumer surplus to producer surplus. Consumer surplus is eliminated. Producer surplus increases because it gains an amount equal to the lost consumer surplus. Producer surplus also increases because the quantity produced increases to the output at which price equals marginal cost. The monopoly increases its economic profit compared to charging a single-price to all customers. This outcome achieves efficiency by eliminating the deadweight loss.

What are some of the ways that real-world airlines price discriminate? Vacation travelers are willing to pay less than business travelers, so airlines need to sort vacation travelers from business travelers. Vacation travelers generally know well in advance when their vacation will occur and so they are able to purchase their tickets in advance. In addition vacation travelers are often willing to spend a weekend at their destination. Travelers who either buy their tickets in advance and/or are willing to spend a weekend at the destination are identifying themselves as vacation travelers and airlines charge them a lower price. The airline companies make airline tickets non-transferable, preventing the vacation travelers with the lower willingness to pay from reselling their less expensive tickets to the business travelers with the higher willingness to pay.

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What is the pricing rule that achieves an efficient outcome for a regulated monopoly? What is the problem with this rule? Regulating the actions of a natural monopoly to achieve an efficient outcome implies setting the level of output at the quantity where MB = MC, and the monopoly must set its price equal to marginal cost. This type of regulation is called the marginal cost pricing rule. A marginal cost pricing rule maximizes total surplus. However, when the monopoly price equals marginal cost, average total cost exceeds price and the monopoly incurs an economic loss. A monopoly that is required to use a marginal cost pricing rule will not stay in business because it is not covering its costs. Two possible ways of enabling the firm to cover its costs are by price discrimination and by using a two-part price (called a two-part tariff). The government might also grant the firm a subsidy. But this subsidy must be raised through imposing taxes on other economic activity, which creates deadweight loss and prevents efficient resource allocation in the markets affected by the tax.

What is the average cost pricing rule? Why is it not an efficient way of regulating monopoly? An average cost pricing rule requires that the firm set its price equal to its average total cost and produce the quantity at which the LRAC curve intersects the demand curve. This pricing rule leads to an inefficient quantity of output. Allocative efficiency requires that the quantity produced be the amount for which the marginal social benefit, shown on the demand curve, equal marginal social cost, which is shown on the © 2023 Pearson Education, Inc.

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marginal cost curve. Efficiency requires that P = MC. When a natural monopoly is regulated using an average cost pricing rule, P = LRAC and at the quantity produced LRAC > MC. Combining these results shows that P > MC, which means that the firm is producing an inefficient amount of output.

What is a price cap? Why might it be a more effective way of regulating monopoly than rate of return regulation? A price cap is a price ceiling, a regulation that sets the maximum price the regulated firm can charge. This type of regulation might be a more effective method of regulation than rate of return regulation because rate of return regulation gives managers the incentive to inflate their costs. Price cap regulation, however, gives the regulated firm the incentive to operate efficiently and not inflate its costs.

Compare the consumer surplus, producer surplus, and deadweight loss that arise from average cost pricing with those that arise from profit-maximization pricing and marginal cost pricing. For a natural monopoly, marginal cost is less than average total cost at all levels of output in the market. Compared to an average cost pricing rule a marginal cost pricing rule generates greater consumer surplus and less producer surplus because P = MC (which determines production with the marginal cost pricing rule) at a larger level of output than when P = LRAC (which determines production with an average cost pricing rule). With a marginal cost pricing rule the monopoly market will be efficient (MSB = MSC) and not experience a deadweight loss. However, the firm’s average total cost exceeds its price and the monopoly suffers an economic loss. The monopoly will stay in business only if it receives a subsidy to make up for the economic loss, returning it to a normal profit. Yet this subsidy must be provided through taxing other markets, causing inefficient resource allocations in those markets. So with a marginal cost pricing rule the other markets affected by the tax will experience an increase in deadweight loss. The average cost pricing rule generates a deadweight loss in the monopoly market because MSB no longer equals MSC. This result occurs because the monopoly produces where P = LRAC and LRAC exceeds MSC at this level of output. Finally, compared to a profit-maximizing firm, a firm regulated with an average cost pricing rule has greater consumer surplus, smaller producer surplus, and smaller deadweight loss.

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Answers to the Study Plan Problems and Applications 1.

The U.S. Postal Service has a monopoly on non-urgent First Class Mail. Esperion Therapeutics makes Nexletol, a prescription drug that lowers cholesterol. SkyCity is the sole restaurant that provides 360-degree views of Seattle. Are any of these firms protected by a barrier to entry? Do any of these firms produce a good or service that has a substitute? Might any of them be able to profit from price discrimination? Explain your answers. The U.S. Postal Service and Esperion Therapeutics are protected by legal barriers to entry. The Postal Service has the legal right given to it by the Private Express Statutes to be the only first class non-urgent mail service and Esperion Therapeutics has a patent on Nexletol. SkyCity has a barrier to entry because it is located in the Space Needle. It is the only restaurant that can locate in there and have a 360 degree view of the city. Substitutes for the U.S. Postal Service include email, fax, and private delivery services, such as FedEx or UPS. Substitutes for Nexletol are statin drugs, such as Lipitor and Zocor, non-statin drugs that also lower cholesterol, and exercise. Substitutes for SkyCity are other restaurants. The Postal Service and Esperion Therapeutics practice price discrimination. The second ounce in a first class letter is less expensive to mail than the first ounce. Nexletol’s price varies according to the insurance policy a customer has. SkyCity does not price discriminate.

Use the following table to work Problems 2 to 4. Minnie’s Mineral Springs is a Total cost Price Quantity demanded single-price monopoly. Columns (bottles per hour) (dollars per hour) (dollars per bottle) 1 and 2 of the table set out the 10 0 1 market demand schedule for 8 1 3 Minnie’s water and columns 2 6 2 7 and 3 set out Minnie’s total cost 4 3 13 schedule. 2 4 21 0 5 31 2. Calculate Minnie’s marginal revenue schedule and draw a graph of the market demand curve and Minnie’s marginal revenue curve. Explain why Minnie’s marginal revenue is less than the price. To calculate Minnie’s marginal revenue, we first need to calculate the total revenue. Minnie’s total revenue schedule lists the total revenue at each quantity sold. For example, Minnie’s can sell 1 bottle for $8 a bottle, which is $8 of total revenue at the quantity 1 bottle. Minnie’s entire total revenue schedule is in the table on the next page. The marginal revenue schedule lists the marginal revenue that results from increasing the quantity sold by 1 bottle. For example, Minnie’s can sell 1 bottle for total revenue of $8. Minnie’s can sell 2 bottles for $6 each, for total revenue of $12. So by increasing the quantity sold from 1 bottle to 2 bottles, marginal revenue is $4 a bottle ($12 minus $8). In the table on the next page, this marginal revenue is placed midway between the quantities 1 bottle and 2 bottles. Minnie’s demand curve and marginal revenue curve are in Figure 13.1 (on the next page). The demand curve intersects the vertical axis at a price of $10 and intersects the horizontal axis at a quantity of 5. The marginal revenue curve intersects the vertical axis at a price of $10 and intersects the horizontal axis at a quantity of 2.5. Minnie’s marginal revenue is less than her price because to sell an additional unit of output, Minnie must lower her price on all units sold. So when Minnie sells an additional unit of output, her revenue consists of the price she receives for this extra unit minus what she loses on all previous units she sells now at the new, lower price

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Price (dollars per bottle) 10

Quantity demanded (bottles per hour) 0

Total revenue (dollars) 0

Marginal revenue (dollars per bottle) 8 4 0 −4 −8

At what price is Minnie’s total revenue maximized and over what range of prices is the demand for water elastic? Why will Minnie not produce a quantity at which the market demand is inelastic? Interpolating along the demand curve, Minnie’s total revenue is maximized at a price of $5. At this price she sells 2.5 bottles an hour for total revenue of $12.50. The demand for Minnie’s Mineral Springs water is elastic between $5 per bottle and $10 per bottle. Minnie will not produce a quantity at which the demand for her water is inelastic because producing at such a price does not maximize her profit. If Minnie is producing where her demand is inelastic, she can decrease the quantity she produces and 1) increase her total revenue, and 2) decrease her total cost. Because her total revenue increases and her total cost decreases, Minnie’s total profit increases. Anytime Minnie’s production is at a quantity at which demand is inelastic, she can always increase her total profit by decreasing her production.

Calculate Minnie’s profit-maximizing output and price and economic profit. Minnie’s profit-maximizing output is 1.5 bottles and her profit-maximizing price is $7a bottle. To maximize profit Minnie’s needs to produce the quantity at which marginal revenue equals marginal cost. The marginal cost of increasing the quantity from 1 bottle to 2 bottles is $4 a bottle ($7 minus $3). That is, the marginal cost at 1.5 bottles of water is $4 a bottle. The marginal revenue of increasing the quantity sold from 1 bottle to 2 bottles is $4 ($12 minus $8). So the marginal revenue from 1.5 bottles is $4 a bottle. The profit-maximizing output is 1.5 bottles. The profit-maximizing price is the highest price that Minnie’s can sell the profit-maximizing output of 1.5 bottles. Minnie’s can sell 1 bottle for $8 and 2 bottles for $6, so it can sell 1.5 bottles for $7 a bottle. Economic profit equals total revenue minus total cost. Total revenue equals price ($7 a bottle) multiplied by quantity (1.5 bottles), which is $10.50. Total cost of producing 1 bottle is $3 and the total cost of © 2023 Pearson Education, Inc.

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producing 2 bottles is $7, so the total cost of producing 1.5 bottles is $5. Minnie’s economic profit equals $10.50 minus $5, which is $5.50.

Use the data in Problem 2 to work Problem 5. a. Use a graph to illustrate the producer surplus generated from Minnie’s Mineral Springs’ water production and consumption. Figure 13.2 shows Minnie’s producer surplus. The producer surplus equals the area of the grey polygon on the figure.

b. Is Minnie’s an efficient producer of water? Explain your answer. Minnie’s is not an efficient producer of water. Efficiency requires that the amount of production sets the marginal cost of water equal to its marginal benefit. The marginal benefit is measured by the demand curve, so in Figure 13.2 the efficient quantity of water to produce is the quantity where the marginal cost curve intersects the demand curve, which is 2 1/9 bottles per hour.

c. Suppose that new wells were discovered nearby to Minnie’s and Minnie’s faced competition from new producers. Explain what would happen to Minnie’s output, price, and profit. Competition would force Minnie’s to lower its price. Minnie’s output would decrease as would its economic profit.

LaBella Pizza can produce a pizza for a marginal cost of $2. Its price of a pizza is $15. a. Could La Bella Pizza make a larger economic profit by offering a second pizza for $5? Use a graph to illustrate your answer. La Bella Pizza is price discriminating, which increases its profit. It is charging consumers a second price for the second pizza they buy. This sort of price discrimination essentially is moving downward along a consumer’s demand curve and increasing the quantity the consumer purchases. On both counts, La Bella is increasing its sales and, because its marginal revenue from these additional sales, $5 per pizza, exceeds its marginal cost of $2, the additional sales increase La Bella’s profit. Figure 13.3 illustrates La Bella Pizza’s situation. With no price discrimination La Bella produces 300 pizzas and sells them at a price of $15 a pizza. With the price discrimination, La Bella still sells 300 pizzas at a price of $15 and also sells an additional 200 pizzas at a price of $5. The economic profit when La Bella sells at one price is equal to the large, light grey area. When La Bella price discriminates, it makes additional economic profit equal to the darker grey rectangle. © 2023 Pearson Education, Inc.

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b. How might La Bella Pizza make even more economic profit? Would La Bella Pizza then be more efficient than it would be if it charged $15 for each pizza? La Bella could further price discriminate. For instance, it might sell a third pizza for $4, which, given the marginal cost of $2, would still increase economic profit. A firm that can price discriminate increases its production relative to what it would produce if it could not price discriminate. So the quantity of pizza La Bella produces is closer to the efficient quantity with the price discrimination that it would be if La Bella did not price discriminate.

Use the Figure 13.4 to work Problems 7 to 9. Calypso, a U.S. natural gas distributor, is a natural monopoly that cannot price discriminate. The figure shows Calypso’s costs and the market demand for natural gas. What quantity will Calypso produce, what price will it charge, and what will be the total surplus and deadweight loss if Calypso is: 7. An unregulated profit-maximizing firm? As shown in Figure 13.5, Calypso will produce 2 million cubic feet a day and sell it for 6 cents a cubic foot. The marginal revenue curve will run from 10 cents on the y-axis to 2.5 cubic feet on the x-axis. The profit-maximizing output is 2 million cubic feet at which marginal revenue equals marginal cost. The price charged is the highest that people will pay for 2 million cubic feet a day, which is 6 cents a cubic foot. The consumer surplus is $40,000, the producer surplus is $80,000, and the deadweight loss is $40,000. The consumer surplus is the triangular area under the demand curve and above the price. The price is 6 cents, so consumer surplus equals (10 cents minus 6 cents) multiplied by 2 million cubic feet/2, which is $40,000. The producer surplus is the rectangular area under the price and above the MC curve. The price is 6 cents, so producer surplus equals (6 cents minus 2 cents) multiplied by 2 million cubic feet a day, which is $80,000. The efficient output is 4 cubic feet, at which marginal cost equals price (marginal benefit). The deadweight loss is the triangular area between the demand (or marginal social benefit) curve and the marginal cost curve between the equilibrium quantity and the efficient quantity. So the deadweight loss equals (4 million cubic feet minus 2 million cubic feet) multiplied by (6 cents minus 2 cents)/2, which is $40,000 a day.

Regulated to make zero economic profit? If Calypso is regulated to make zero economic profit, it produces the output at which price equals average total cost—at the intersection of the demand curve and the LRAC curve. Calypso will produce 3 million © 2023 Pearson Education, Inc.

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cubic feet a day and charge 4 cents a cubic foot. The consumer surplus is $90,000, the producer surplus is $60,000, and the deadweight loss is $10,000. The consumer surplus is the triangular area under the demand curve and above the price. The price is 4 cents, so consumer surplus equals (10 cents minus 4 cents) multiplied by 3 million cubic feet/2, which is $90,000. The producer surplus is the rectangular area under the price and above the MC curve. The price is 4 cents, so producer surplus equals (4 cents minus 2 cents) multiplied by 3 million cubic feet, which is $60,000. The efficient output is 4 million cubic feet, at which marginal cost equals price (marginal benefit). The deadweight loss is the triangular area between the demand (or marginal social benefit) curve and the marginal cost curve between the equilibrium quantity and the efficient quantity. So the deadweight loss equals (4 million cubic feet minus 3 million cubic feet) multiplied by (4 cents minus 2 cents)/2, which is $10,000 a day.

Regulated to be efficient? If the firm is regulated to be efficient, it will produce the quantity at which price (marginal social benefit) equals marginal social cost—at the intersection of the demand curve and the marginal cost curve. Calypso will produce 4 million cubic feet a day and charge 2 cents a cubic foot. The consumer surplus is $160,000, the producer surplus is $0, and the deadweight loss is $0. The consumer surplus is the triangular area under the demand curve and above the price. The price is 2 cents, so consumer surplus equals (10 cents minus 2 cents) multiplied by 4 million cubic feet/2, which is $160,000. There is no producer surplus because the price equals the marginal cost. And there is no deadweight loss because the quantity produced is the efficient quantity.

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Answers to Additional Problems and Applications Use the following list, which gives some information about seven firms, to answer Problems 10 and 11.  Coca-Cola cuts its price below that of Pepsi-Cola in an attempt to increase its market share.  A single firm, protected by a barrier to entry, produces a personal service that has no close substitutes.  A barrier to entry exists, but the good has some close substitutes.  A firm offers discounts to students and seniors.  A firm can sell any quantity it chooses at the going price.  The government issues Nike an exclusive license to produce golf balls.  A firm experiences economies of scale even when it produces the quantity that meets the entire market demand. 10. In which of the seven cases might monopoly arise? The second, sixth, and seventh cases suggest that a monopoly might be a possibility.

11.

Which of the seven cases are natural monopolies and which are legal monopolies? Which can price discriminate, which cannot, and why? It is not possible to determine if the second case is a legal barrier or natural barrier to entry because we do not know the type of barrier. The sixth case describes a legal barrier to entry because Nike has been given an “exclusive license” by the government. The seventh case is a natural monopoly because it describes the firm as having economies of scale over the entire market demand. Coca-Cola in the first case cannot price discriminate because there are not separate classes of customers with different willingness to pay. The fifth case, the firm that can sell any quantity it wants at the going price, is a perfect competitor and cannot price discriminate. The fourth case, the firm offering discounts to students, and seniors, is price discriminating. The other situations describe firms that might be able to price discriminate if there are different classes of customers and if the firm can determine into which class a customer falls.

Use the following information to work Problems 12 to 16. Hot Air Balloon Rides is a single-price Price monopoly. Columns 1 and 2 of the table set out (dollars the market demand schedule and columns 2 and per ride) 3 set out the total cost schedule. 220 12. Construct Hot Air’s total revenue and 200 marginal revenue schedules. 180 The table showing Hot Air’s total revenue 160 schedule and marginal revenue schedule is on 140 the next page. Total revenue equals price 120

Quantity demanded (rides per month) 0 1 2 3 4 5

Total cost (dollars per month) 80 160 260 380 520 680

multiplied by quantity. Marginal revenue equals the change in total revenue divided by the change in quantity. For example, between 1 ride and 2 rides the total revenue increases by $160 and the quantity increases by 1 ride, so the marginal revenue equals $160/1, which is $160. This marginal revenue is placed midway between the 1 ride and 2 rides rows.

MONOPOLY

Price (dollars per ride) 220

Quantity demanded (rides per month) 0

Total revenue (dollars per month) 0

200

180

360

160

480

140

560

120

600

189

Marginal revenue (dollars per ride) 200 160 120 80 40

13.

Draw a graph of the market demand curve and Hot Air’s marginal revenue curve. Figure 13.6 illustrates Hot Air’s demand curve and marginal revenue curve.

14.

Find Hot Air’s profit-maximizing output and price and calculate the firm’s economic profit. Hot Air’s marginal cost equals marginal revenue at 2 1/2 rides a month, where both equal $120. From the demand curve, the price is $170 a ride. Economic profit equals total revenue minus total cost. The total cost of 2 1/2 rides a month is $320. Hot Air’s total revenue equals the number of rides multiplied by the price per ride, which is (2 1/2 rides per month)  ($170) = $425. So, the economic profit is total revenue minus total cost, which is $425  $320 = $105.

15.

If the government imposes a tax on Hot Air’s profit, how do its output and price change? As a result of the tax, Hot Air’s fixed cost changes, but its marginal cost does not. The profit-maximizing level of output is still 2 1/2 rides a month and the price still equals $170. The tax decreases Hot Air’s economic profit but does not change its output or price.

16.

If instead of taxing Hot Air’s profit, the government imposes a sales tax on balloon rides of $30 a ride, what are the new profit-maximizing quantity, price, and economic profit? A $30-a-ride tax increases Hot Air’s marginal cost by $30 at every level of output. With the increase in the marginal cost, Hot Air now sells 2 rides a month because this is the level at which the new marginal cost equals the marginal revenue (both equal $140). From the demand curve, Hot Air sets a price of $180 a ride. Economic profit equals total revenue minus total cost. The total revenue is 2 rides  $180 which is $360. The total cost is $260 plus the tax of $60, which is $320. So the new economic profit is $360  $320 = $40.

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Figure 13.7 illustrates the situation facing the publisher of the only newspaper containing local news in an isolated community. a. On the graph, mark the profit-maximizing quantity and price and the publisher’s total revenue per day. Profit is maximized when the firm produces the output at which marginal cost equals marginal revenue. As Figure 13.8 shows, the marginal revenue curve runs from 100 on the y-axis to 500 on the xaxis. The marginal revenue curve cuts the marginal cost curve at the quantity 267 newspapers a day. The highest price for which the publisher can sell 267 newspapers a day is read from the demand curve. So the profit-maximizing quantity is 267 newspapers a day and price is 73 cents a paper. The daily total revenue is $194.91 (267 papers at 73 cents each). This amount is equal to the rectangular area C in Figure 13.8.

b. At the price charged, is the demand for this newspaper elastic or inelastic? Why? Demand is elastic. Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the demand curve. The price at the midpoint is 50 cents. So, at 73 cents a paper, demand is elastic.

18.

Show on the graph in Problem 17 the consumer surplus from newspapers and the deadweight loss created by the monopoly. Explain why this market might encourage rent seeking. Figure 13.8 shows the consumer surplus, area A, and the deadweight loss, area B. The consumer surplus is $36.05 a day and the deadweight loss is $8.65 a day. The consumer surplus is the area marked A in Figure 13.8 and the deadweight loss is the darker area marked B in the figure. The consumer surplus is the area under the demand curve and above the price. The price is 73 cents, so consumer surplus equals (100 cents minus 73 cents) multiplied by 267/2 papers a day, which is $36.05 a day. Deadweight loss arises because the publisher does not produce the efficient quantity. Output is restricted to 267 newspapers rather than 400, and the price is increased to 73 cents rather than 60 cents. The deadweight loss equals (73 cents minus 46.6 cents) multiplied by 133/2, $17.56. Any surplus—consumer surplus, producer surplus, or economic profit—is called economic rent. Rent seeking would occur in this industry because new entrepreneurs would hope to capture some of the consumer surplus currently being earned.

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If the newspaper market in Problem 17 were perfectly competitive, what would be the quantity, price, consumer surplus, and producer surplus? Mark each on the graph. The quantity would be 400 newspapers a day and the price would be 60 cents a newspaper. The consumer surplus is the triangular area under the demand curve and above the price, marked as area A in Figure 13.9. The price is 60 cents, so consumer surplus equals (100 cents minus 60 cents) multiplied by 400/2 papers a day, which is $80 a day. The producer surplus is the triangular area under the price and above the supply curve, marked as area B in Figure 13.9. The price is 60 cents, so producer surplus equals (60 cents minus 20 cents) multiplied by 400/2 papers a day, or $80 a day.

20.

Samsung and Huawei Drop Lawsuits in Latest Smartphone Truce Huawei and Samsung have filed more than 40 lawsuits against each other for allegedly infringing on patents on 4G wireless and other technology. Now they have called it quits. Source: asia.nikkei.com, May 15, 2019 a. If smartphone producers had been prevented from using new smartphone technologies by Huawei patents, leaving Huawei a monopoly, who would benefit and who would lose? If Huawei became a monopoly, Huawei would gain and other suppliers would lose. Consumers would lose. Society would lose because the total surplus is smaller in a monopoly market than in a perfectly competitive market.

b. Compared to a smartphone monopoly, who would benefit and who would lose if hundreds of firms entered the smartphone market, each producing an identical smartphone, making the market perfectly competitive? If the smartphone market became perfectly competitive, consumers would gain because they can buy more smartphones at a lower price. Apple loses because they sell fewer smartphones and receive a lower price. Other producers who enter the market gain. Overall, the gains exceed the losses, so society gains because the total surplus is larger in a perfectly competitive market than in a monopoly market.

c. Explain which market would be efficient: a perfectly competitive one or a monopoly. A perfectly competitive market is efficient. A monopoly produces less output than does a perfectly competitive market, thereby creating a deadweight loss. There is no deadweight loss in a perfectly competitive market.

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Best Deals For College Students in 2021 As a college student, you can score impressive deals. You can get YouTube Music for $5 a month (regularly $10) and Hulu for $2 a month (regularly $4). Just be ready to prove your eligibility. Source: cnet.com, May 14, 2021 a. Explain why YouTube Music’s and Hulu’s plans might be price discrimination. YouTube Music’s and Hulu’s plans are price discrimination because users pay a different price per month depending on whether or not they are a college student. YouTube Music’s and Hulu’s marginal cost is the same, regardless of who is streaming, so the price difference does not reflect a difference in cost.

b. Draw a graph to illustrate your answer to part a. Figure 13.10 illustrates the situation for YouTube Music; Hulu’s plan is similar. YouTube charges non-college students $10 per month and, at this price, has 40 million subscribers. YouTube’s total revenue from this user base is equal to the area of the dark gray rectangle in the figure. YouTube also charges college students $5 per month and, at this price, has 20 million subscribers. YouTube’s total revenue from these additional customers is equal to the area of light gray rectangle in the figure.

22.

A Push to Break up Google’s Ad Tech Business State attorneys general say that Google’s actions hinder online ad competition. The states and the Justice Department are investigating Google’s search, ad technology, and android business. Source: cnbc.com, June 5, 2020 a. How would we test whether Google is a monopoly in the Internet advertising market? For Google to be a monopoly, it needs to be the only firm in market, producing a product with no close substitutes and which is protected by a barrier to entry. The fact that there are other search providers demonstrates that Google is not a textbook monopolist.

b. Explain why the Internet advertising market might be a natural monopoly. The market for Internet advertising might be a natural monopoly because the marginal cost of displaying another Internet advertisement is virtually zero. Consequently a firm such as Google has massive economies of scale so that its long-run average cost curve is downward sloping over a vast range of output.

c. How does Google’s dominant position as a provider of Internet advertising influence the price and quantity in this market? Google’s dominant position allows it to determine what price it charges for an Internet advertisement and the quantity of Internet advertisements it sells.

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d. How would breaking Google into two providers of Internet advertising influence the price and quantity in this market? The effect depends on whether Google is a natural monopoly. If it is a natural monopoly, breaking it into two providers will increase the firm’s average costs, so that the price of an Internet advertisement rises and the quantity decreases. If Google is not a natural monopoly, breaking it into two firms would bring some competition into the market. The price of an Internet advertisement falls and the quantity increases.

Economics in the News 23. After you have studied Economics in the News on pp. 320–321, answer the following questions. a. Why does the Department of Justice say that Google is misusing its monopoly power? Do you agree? Explain why or why not. The Department of Justice asserted that Google was abusing its power in search to sign exclusionary deals that made Google the default search engine on Web browsers and other devices, such as the iPhone. The Justice Department also said that Google has used anticompetitive means to maintain and extend its monopolies in the markets for search, such as general search services, search advertising, and general search advertising.

b. Explain why it would be inefficient to regulate Google to make it charge the same price per keyword click to all advertisers. Efficiency requires that Google sell the number of clicks so that the marginal social cost of a click equals the marginal social benefit of a click. The marginal social cost of a click equals the marginal cost and the marginal social benefit equals the price. Only if the price per click equals the marginal cost of a click would Google sell the efficient number of clicks. At any other price Google would sell an inefficient quantity of clicks. So only if the marginal social cost of all clicks is the same and Google is regulated to charge precisely that price would this regulation be efficient.

c. Explain why selling keywords to the highest bidder can lead to an efficient allocation of advertising resources. Selling keywords to the highest bidder allocates the words to those bidders who value them most highly, which means the words and hence advertising resources, are allocated efficiently. By selling each click at a separate price to the highest bidder, Google is trying to perfectly price discriminate. If Google perfectly price discriminates, then the market achieves the efficient outcome, albeit with no consumer surplus

24.

Big Drugmakers Just Raised Their Prices Major pharmaceutical companies are raising prescription prices by an average of 4.6 percent this year. President-elect Joe Biden’s plan to combat rising drug prices includes the use of a price cap. Source: cbsnews.com, January 25, 2021 a. What barrier to entry exists in the prescription drug market? Prescription drugs often have patents, which are a legal barrier to entry. Additionally, the FDA must approve any drug marketed and sold in the United States, which is another legal barrier to entry.

b. How can a price cap on prescription drugs achieve a more efficient outcome? If the pharmaceutical company is a monopoly and is not regulated, it will set the monopoly price and create a deadweight loss. Price-cap regulation can help decrease the deadweight loss by lowering the price the firm sets and increasing the quantity of drugs it provides.

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c. Draw a graph to illustrate the effects of introducing a price cap in the prescription drug market on price, quantity, total surplus, and deadweight loss. Figure 13.11 shows the effect a price cap has in the prescription drug market when the firm is a natural monopoly. The quantity in the market is the number doses per year and the price is the price of a dose. The efficient quantity of doses is 200 million per year because that is the quantity that sets the marginal social benefit, measured by the demand curve, equal to the marginal social cost, measured by the marginal cost curve. When the efficient quantity is produced, the total surplus is equal to the area of triangle ABC. When a price cap is in place, the price is $100 per dose and the quantity of doses is 150 million per year. The deadweight loss is equal to the small, dark gray triangle. If the price cap is removed and the firm is free to maximize its profit, it sells 100 million doses per year (the quantity that sets MR = MC) for a price of $150 per dose. The deadweight loss is larger—it is equal to the area of the gray quadrilateral plus the dark gray triangle.

25.

Intel Ordered to Pay $2.2 Billion After Losing Patent Lawsuit Intel infringed two patents owned by VLSI Technology. The patents cover inventions that increase the power and speed of processors. Source: fortune.com, March 2, 2021 a. What are the barriers to entry in the smartphone processor market? The major barrier to entry is patents. This legal barrier to entry prevents other firms from using patented technology to produce processors.

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b. Show in a graph how the price and quantity of smartphone processors are determined. Presuming that the VLSI Technology’s patent makes it a monopolist in the smartphone processor market, Figure 13.12 shows this market. The profit-maximizing quantity is 200 million chips per year because that quantity sets its marginal revenue equal to its marginal cost. The price is $300 per processor because that is the highest price that still enables the firm to sell the 200 million processors it will produce.

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Answers to the Review Quizzes Page 329 1.

What are the distinguishing characteristics of monopolistic competition? The distinguishing characteristics of monopolistic competition are: i) a large number of firms, each producing a differentiated product than its competitors, ii) firms compete on quality, price, and marketing, and iii) there are no barriers to entry into the industry.

How do firms in monopolistic competition compete? Firms in monopolistic competition compete in three areas: Quality—the physical attributes of a product, including the product’s design and reliability, the service provided with the product, and the ease of access to the product; price—because the firms produce differentiated products, each firm faces a downwardsloping demand curve for its own product; and marketing—firms must make consumers aware of the quality of their differentiated products through advertising and packaging.

Provide some examples of industries near your school that operate in monopolistic competition (excluding those given on the text page in the figure). Hamburger restaurants, coffee shops, and juice bars are examples of firms competing in their own respective industry, each industry being a market described by monopolistic competition.

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How does a firm in monopolistic competition decide how much to produce and at what price to offer its product for sale? A firm that has already decided the quality of its product and its marketing program produces the output at which its marginal revenue equals its marginal cost (MR = MC) because this output maximizes profit. The price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.

Why can a firm in monopolistic competition make an economic profit only in the short run? A firm in monopolistic competition can make an economic profit only in the short-run because economic profit induces entry, which decreases the demand for the firm’s product, lowers its profit-maximizing output, price, and economic profit. In long-run equilibrium, when entry ends, each firm makes zero economic profit.

Why do firms in monopolistic competition operate with excess capacity? A firm’s capacity output is the output at which average total cost is at its minimum. In monopolistic competition in the long run, MR = MC and P = ATC. At the long run equilibrium, it is the case that MC < ATC, which means that ATC is falling in this range and so production occurs at an output level that is less than capacity output.

Why is there a price markup over marginal cost in monopolistic competition? A firm’s markup is the amount by which price exceeds marginal cost. There is a markup in monopolistic competition because P > MR at all levels of output. Since the firm produces the quantity at which MR = MC, the fact that P > MR means that P > MC, so that there is a markup.

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Is monopolistic competition efficient? Monopolistic competition is not efficient by the requirement for allocative efficiency MSB = MSC. The price equals the consumer’s willingness to pay, which is the marginal social benefit and the firm’s marginal cost is the marginal social cost. Product differentiation in monopolistic competition means that P > MR, which implies that P > MC at the quantity where MR = MC. Because P = MSB and MC = MSC, the result is that MSB > MSC, which signals inefficiency. However, when compared to the perfectly competitive alternative that all goods are identical, the variety offered by monopolistic competition makes monopolistic competition potentially efficient.

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How, other than by adjusting price, do firms in monopolistic competition compete? The two main ways firms in monopolistic competition compete other than by adjusting price is through product development and advertising.

Why might product development be efficient and why might it be inefficient? Product development might be efficient if the development represents actual improvements to the product and not simply the perception of improvement. The value of these new innovations to the consumer is the marginal benefit or the extra amount consumers are willing to pay to have the new product. If the marginal benefit to the consumer is equal to the marginal cost of product development, then development is efficient.

Explain how selling costs influence a firm’s cost curves and its average total cost. Selling costs increase a firm’s fixed cost, which increase the firm’s total cost. This means that an increase in selling costs shifts the average fixed cost (AFC) curve and the average total cost (ATC) curve upward. Variable costs do not change, so the marginal cost (MC) and average variable cost (AVC) curves remain unchanged.

Explain how advertising influences the demand for a firm’s product. If a firm’s advertising program is successful, it will shift the firm’s demand curve rightward in the short run. But if this shift in demand increases economic profit, it will attract firms to enter the industry, shifting each existing firm’s demand curve back leftward as they each lose some market share. In the long run, each firm makes zero economic profit, and demand for the firm’s product will not increase through advertising.

Are advertising and brand names efficient? Advertising and brand names can increase consumer information about product differences and quality. This information increases consumers’ wellbeing and increases efficiency. But advertising and creating a brand name also are costly endeavors. If the MSB from the advertising and brand names is greater than the MSC of the advertising and brand names, then advertising and brand names increase efficiency. But if the MSB from the advertising and brand names is less than the MSC of the advertising and brand names, then advertising and brand names decrease efficiency. Basically, if the additional benefit that consumer’s gain from advertising and brand names exceed the costs, then advertising and brand names have a surplus for society and should be increased until their marginal social benefit equals their marginal social cost.

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Answers to the Study Plan Problems and Applications 1.

Which of the following items are sold by firms in monopolistic competition? Explain your selections.  Cable television service 

The cable television market is not an example of monopolistic competition because at any locale, there are not a lot of firms competing.

Wheat The wheat market is not an example of monopolistic competition because the many competing firms each produce an identical product.

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Athletic shoes The athletic shoe market is an example of monopolistic competition. There are several producers of athletic shoes, with extensive product differentiation and competition on quality, price, and marketing.

 

Soda The soda market is not an example of monopolistic competition because there are only two producers who together have a very large market share.

Toothbrushes The toothbrush market is an example of monopolistic competition. There are many producers of toothbrushes, with extensive product differentiation and competition on quality, price, and marketing.

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Ready-mix concrete The ready-mix concrete market is not an example of monopolistic competition.

The four-firm concentration ratio for audio equipment makers is 30 and for electric lamp makers it is 89. The HHI for audio equipment makers is 415 and for electric lamp makers is 2,850. Which of these markets is an example of monopolistic competition? The audio equipment market is an example of monopolistic competition.

Use the following information to work Problems 3 and 4. Sara is a dot.com entrepreneur who has established a Web site at which people can design and buy sweatshirts. Sara pays $1,000 a week for her Web server and Internet connection. The sweatshirts that her customers design are made to order by another firm, and Sara pays this firm $20 a sweatshirt. Sara has no other costs. The table sets out the demand schedule for Sara’s sweatshirts. 3. Calculate Sara’s profit-maximizing output, price, and economic profit.

Price (dollars per sweatshirt) 0 20 40 60 80 100

Quantity demanded (sweatshirts per week) 100 80 60 40 20 0

Sara produces the quantity that sets her marginal cost equal to her marginal revenue. Sara’s marginal cost is $20. Between the quantity of 20 and 40 sweatshirts, Sara’s marginal revenue is $40. Between 40 and 60 sweatshirts, Sara’s marginal revenue is $0. So at the quantity of 40 sweatshirts Sara’s marginal revenue is $20. To maximize her profit, Sara produces 40 sweatshirts. When Sara produces 40 sweatshirts, the price from the demand schedule is $60 per sweatshirt. Sara’s total revenue is $2,400. Her total cost is $1,000 (fixed cost) plus $800 (variable cost), or $1,800. Sara’s economic profit equals $2,400  $1,800 or $600.

4. a. Do you expect other firms to enter the Web sweatshirt business and compete with Sara? Sara is making an economic profit so other firms will enter the Web sweatshirt business and compete with Sara.

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b. What happens to the demand for Sara’s sweatshirts in the long run? What happens to Sara’s economic profit in the long run? As new firms enter the Web sweatshirt industry, the demand for Sara’s sweatshirts will decrease. In the long run Sara’s economic profit is zero—a normal profit.

Use Figure 14.1, which shows the situation facing Flight Inc., a producer of running shoes, to work Problems 5 to 8. 5. What quantity does Flight produce, what price does it charge, and what is its economic profit? To maximize profit, Flight produces the quantity at which marginal revenue equals marginal cost, so it produces 100 pairs a week. Flight charges the highest price that enables it to sell the 100 pairs of shoes. As read from the demand curve, Flight charges $80 a pair. Economic profit equals total revenue minus total cost. The price is $80 a pair and the quantity sold is 100 pairs, so total revenue is $8,000. Average total cost is $60 a pair, so total cost equals $6,000. Economic profit equals $8,000 minus $6,000, so Flight makes an economic profit of $2,000 a week.

In the long run, how does Flight change its price and the quantity it produces? What happens to the market output of running shoes? The price of a pair of Flight’s running shoes falls and the quantity decreases in the long run. Flight is making an economic profit and this profit attracts entry into the market, so the number of firms increases. As new firms enter the market, the demand for Flight’s shoes decreases. The decrease in demand leads to the price of Flight’s running shoes falling and the quantity of running shoes decreasing. The quantity of running shoes in the market as a whole increases in the long run. As new firms enter, each existing firm decreases its output a bit. But the new firms produce more shoes and, on net, the quantity of shoes in the entire market increases.

Does Flight have excess capacity in the long run? If it has excess capacity in the long run, why doesn’t it decrease its capacity? In the long run, monopolistically competitive firms produce less output than the amount which minimizes the average total cost, which means that in the long run they have excess capacity. Flight produces at the average total cost that is the minimum average total cost for the quantity it produces. If Flight decreased its capacity, it would shift its average total cost curve upward. This shift would increase its average total cost for its profit-maximizing quantity and Flight would incur an economic loss.

Is the market for running shoes efficient or inefficient in the long run? Explain your answer. Based on the allocative efficiency criterion of producing the quantity at which MSB = MSC, the market for running shoes is not efficient. Producing at the allocatively efficient quantity P (which equals MSB) equals MC (which equals the MSC). But a monopolistically competitive industry produces so that P > MC and therefore is not allocatively efficient. However, based on a broader measure of efficiency the market might be efficient. In particular due to the monopolistically competitive nature of the market there are a variety of running shoes produced. People value variety and if consumers’ benefit from the product variety equals the cost of producing this variety then, in this broader sense, the market is efficient.

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Suppose that Tommy Hilfiger’s marginal cost of a jacket is a constant $100 and the total fixed cost at one of its stores is $2,000 a day. This store sells 20 jackets a day, which is its profitmaximizing number of jackets. Then the stores nearby start to advertise their jackets. The Tommy Hilfiger store now spends $2,000 a day advertising its jackets, and its profitmaximizing number of jackets sold jumps to 50 a day. a. What is this store’s average total cost of a jacket sold (i) before the advertising begins and (ii) after the advertising begins? Before the advertising begins, the average total cost of a jacket is $200. The average total cost equals the total cost divided by the quantity. The fixed cost is $2,000. Because the marginal cost is $100 per jacket, the total variable cost is $2,000. So the total cost is the $2,000 fixed cost plus the $2,000 variable cost, which is $4,000. So the average total cost is $4,000/20, which is $200. After the advertising begins, the average total cost of a jacket is $180. The average total cost equals the total cost divided by the quantity. The fixed cost is $4,000. Because the marginal cost is $100 per jacket, the total variable cost is $5,000. So the total cost is the $4,000 fixed cost plus the $5,000 variable cost, which is $9,000. The average total cost is $9,000/50, which is $180.

b. Can you say what happens to the price of a Tommy Hilfiger jacket, Tommy’s markup, and Tommy’s economic profit? Why or why not? If the advertising has decreased the demand and made it more elastic, which is likely the case if all firms advertise, then the price will fall. However, if the advertising has increased the demand and made the demand less elastic, then the price will rise. If the price falls, then the makeup falls; if the price rises, then the markup rises. It is not possible to determine the effect on the profit in the short run. In the long run, however, the economic profit will equal zero as it does for all monopolistically competitive firms in the long run.

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Answers to Additional Problems and Applications 10.

Which of the following items are sold by firms in monopolistic competition? Explain your selection.  Orange juice 

There are many firms that produce orange juice and they produce many different varieties. Orange juice is an example of monopolistic competition.

Canned soup While there are many different varieties of canned soup, a few very large firms have a very large market share. Canned soup is an example of an oligopoly.

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Tablet computers There are many firms that produce tablet computers and they produce many different varieties. Tablet computers are an example of monopolistic competition.

 

Chewing gum While there are many different varieties of chewing gum, two firms—Wrigley and Cadbury—dominate the industry. Chewing gum is an example of an oligopoly.

Breakfast cereals While there are many different varieties of breakfast cereals, the four largest firms have a four-firm concentration of over 80. Breakfast cereal is an example of an oligopoly.



Corn There are many producers of corn, but each producer produces an identical product. Because corn is not a differentiated product, the market for corn is perfect competition.

11.

The HHI for motorcycles is 4,672, for sporting goods it is 373, for light bulbs it is 3,395, and for jewelry it is 550. Which of these markets is an example of monopolistic competition? Sporting goods and jewelry are examples of monopolistically competitive markets.

Use the following information to work Problems 12 and 13. Lorie teaches singing. Her fixed costs are $1,000 a month, and it costs her $50 of labor to give one class. The table shows the demand schedule for Lorie’s singing lessons. 12.

Calculate Lorie’s profit-maximizing output, price, and economic profit.

Price (dollars per lesson) 0 50 100 150 200 250

Quantity demanded (lessons per month) 250 200 150 100 50 0

Lorie produces the quantity of singing lessons that sets her marginal cost equal to her marginal revenue. Lorie’s marginal cost is $50. Between the quantity of 50 and 100 lessons, Lorie’s marginal revenue is $100. Between 100 and 150 lessons, Lorie’s marginal revenue is $0. So at the quantity of 100 lessons Lorie’s marginal revenue is $50. To maximize her profit, Lorie sells 100 lessons. When Lorie sells 100 lessons, the price from her demand schedule is $150 per lesson. Lorie’s total revenue is $15,000. Her total cost is $1,000 (her fixed cost) plus $5,000 (her variable cost), which is $6,000. Lorie’s economic profit equals $15,000  $6,000, which is $9,000.

13. a. Do you expect other firms to enter the singing lesson business and compete with Lorie? Lorie is making an economic profit so other firms will enter the singing-lesson industry to compete with Lorie.

b. What happens to the demand for Lorie’s lessons in the long run? What happens to Lorie’s economic profit in the long run? As new firms enter the singing-lesson industry, the demand for Lorie’s lessons will decrease. In the long run Lorie’s economic profit is eliminated and Lorie makes zero economic profit—a normal profit.

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Use Figure 14.2, which shows the situation facing Mike’s Bikes, a producer of mountain bikes, to work Problems 14 to 18. The demand and costs of other mountain bike producers are similar to those of Mike’s Bikes. 14. What quantity does the firm produce and what is its price? Calculate the firm’s economic profit or economic loss. Mike’s Bikes produces 100 mountain bikes per week because this is the quantity at which MR = MC. The price of a mountain bike is $250 per bike because this is the highest price that people are willing to pay at the profit-maximizing quantity of 100 bikes. Mike’s Bikes incurs an economic loss. The average total cost of a bike is $300 and the price of a bike is $250. So Mike’s Bikes’ economic loss is equal to ($300  $250)  100 bikes, which is an economic loss of $5,000.

15.

What will happen to the number of firms producing mountain bikes in the long run? The firms are incurring an economic loss, so some firms exit the market. In the long run, the number of firms producing mountain bikes decreases.

16. a. How will the price of a mountain bike and the number of bikes produced by Mike’s Bikes change in the long run? As long as Mike’s Bikes is a survivor, the demand for Mike’s Bikes increases. When demand increases, the marginal revenue also increases so Mike’s Bikes increases the quantity of bikes it produces.

b. How will the quantity of mountain bikes produced by all firms change in the long run? In the long run the price of a mountain bike rises, so in the long run the quantity of mountain bikes demanded (and the quantity produced) in the entire market decreases.

17.

Is there any way for Mike’s Bikes to avoid having excess capacity in the long run? If Mike’s Bikes maximizes its profit, it will have excess capacity. If Mike’s Bikes increases its production so that it produces at the minimum of its average total cost, it will incur an economic loss.

18.

Is the market for mountain bikes efficient or inefficient in the long run? Explain your answer. Based on the strict requirement for allocative efficiency, MSB=MSC, the market is definitely not efficient. In monopolistic competition the price of a mountain bike, which is the MSB of a mountain bike, is greater than the marginal cost of a mountain bike, which is the MSC of a mountain bike. However, viewed more widely the mountain bike market might be efficient. There are a variety of mountain bike producers, each producing a differentiated mountain bike. This large variety of different mountain bikes benefits consumers because it is more likely that each consumer will be able to find a mountain bike he or she likes.

Use the following news clip to work Problems 19 and 20. Potent—and Pricey—Samuel Adams’ Utopias Beer Illegal in 15 States Samuel Adams’ Utopias beer is an upmarket beer with double the alcoholic content as other brands of beer and its price is $210 a bottle. Also, Utopias beer is only sold in specialty stores, and it is more like Port or a fine Sherry. Source: chicago.suntimes.com, October 18, 2019 19. a. Explain how Samuel Adams has differentiated its Utopias to compete with other beer brands in terms of quality, price, and marketing. Samuel Adams differentiated Utopias by selling it only in specialty stores, brewing the beer to have a high © 2023 Pearson Education, Inc.

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alcohol content, and setting its price much higher than other beers.

b. Predict whether Samuel Adams produces Utopias at, above, or below the efficient scale in the short run. In the short run Samuel Adams might produce at, above, or below its efficient scale; it is not possible to predict which.

c. Predict whether Samuel Adams produces Utopias at, above, or below the efficient scale in the long run. Because Samuel Adams is a monopolistic competitor, in the long run it will produce below its efficient scale.

20. a. Predict whether the $210 price tag on the Utopias is at, above, or below marginal cost (i) in the short run In the short run the price exceeds the marginal cost. For a monopolistically competitive firm, P > MR. And to maximize its profit, the firm produces so that MR = MC. Combining these results shows P > MC.

(ii) in the long run In the long run the price will exceed the marginal cost. For a monopolistically competitive firm, P > MR. And to maximize its profit, the firm produces so that MR = MC. Combining these results shows P > MC.

b. Do you think that Samuel Adams Utopias makes the market for beer inefficient? Samuel Adams Utopias possibly makes the beer market inefficient. On the one hand, allocative efficiency requires that MSB=MSC. The price of a Utopias beer, which is its MSB, is greater than its marginal cost, which is the MSC. So production of Utopias is not allocatively efficient. On the other hand, viewed more widely the beer market might be more efficient with Utopias. Utopias adds to the variety of beers available so that it is more likely that some consumers will be able to find a beer, such as Utopias, that they like.

Use the following news clip to work Problems 21 and 22. CCM Has Released Equipment Tailored to Women One of the fastest growing sports in North America is women’s ice hockey. For years, women have worn ill-fitting men’s gear. Now CCM has addressed the problem with a new line of women’s pants and shoulder pads. Source: bardown.com, May 22, 2020 21. a. How is CCM attempting to maintain economic profit? CCM is innovating by differentiating between men’s hockey equipment and women’s hockey equipment by creating ice hockey equipment, pants and shoulder pads, for women. They expect that the demand for women’s ice hockey equipment will be high and so they will be able to (temporarily) make an economic profit.

b. Draw a graph to illustrate CCM’s cost and revenue curves in the market for women’s ice hockey equipment. Figure 14.3 shows the situation at CCM. The firm produces 200,000 pieces of hockey equipment per year and sets a price of $140 for each.

c. Show on your graph in part (b) CCM’s shortrun economic profit. The economic profit equals the area of the darkened rectangle labeled A in Figure 14.3.

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22. a. Explain why the economic profit that CCM makes on women’s ice hockey equipment is likely to be temporary. The economic profit is temporary because there are no barriers to entry. If CCM is indeed able to make an economic profit other firms will enter the market by producing women’s ice hockey equipment. As more firms produce the equipment the demand for CCM’s equipment will decrease. As a result the quantity and price of CCM’s equipment will decrease, which lowers its economic profit. In the long run, entry will eliminate the economic profit.

b. Draw a graph to illustrate CCM’s cost and revenue curves in the market for women’s ice hockey equipment in the long run. Mark the firm’s excess capacity. Figure 14.4 shows the long-run equilibrium for CCM. The firm produces 150,000 pieces of women’s ice hockey equipment and sets a price of $130 per piece of equipment. The firm makes zero economic profit (a normal profit) because its price equals its average total cost. The firm’s excess capacity is 150,000 pieces of equipment, shown in the figure by the length of the grey arrow between the quantity the firm produces and the quantity that minimizes the firm’s average total cost.

Use the following information to work Problems 23 to 25. Bianca bakes delicious cookies. Her total fixed cost is $40 a day, and her average variable cost is $1 a bag. Few people know about Bianca’s Cookies, and she is maximizing her profit by selling 10 bags a day for $5 a bag. Bianca thinks that if she spends $50 a day on advertising, she can increase her market share and sell 25 bags a day for $5 a bag. 23. If Bianca’s advertising works as she expects, can she increase her economic profit by advertising? If additional advertising enables sales to increase so that total revenue increases more than total cost, she can increase economic profit. In the case at hand, her total revenue will increase by $75 and her total cost will increase by $50 plus whatever is the increase in her variable cost of producing the cookies. Because her AVC when she produces 10 bags is only $1, it is likely that her variable costs will increase by less than $25, which means that advertising will be profitable.

24.

If Bianca advertises, will her average total cost increase or decrease at the quantity produced? Before she advertised, Bianca’s total variable cost was $10 and her total fixed cost was $40, so her total cost was $50. With this total cost and production of 10 bags of cookies, Bianca’s average total cost was $5 a bag. After she advertises, if her average variable cost remains $1 a bag, her total variable costs become $25, her total fixed costs are $90 (the initial fixed costs of $40 plus her advertising costs of $50) so her total cost is $115. With this total cost and production of 25 bags a day, Bianca’s average total cost is $4.60 a bag.

25.

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price? In the short run, presuming that advertising raises her demand, Bianca will raise the price of her cookies. In the long run Bianca’s price will equal her average total cost. If her average total cost remains below $5 a bag, in the long run her price will be forced down below $5 a bag.

Use the following news clip to work Problems 26 and 27. Covid-19 Supercharged Online Advertising When the pandemic hit, Mondelez International, maker of Oreos, moved its March Madness and Summer Olympic TV ads to digital platforms. Investing in digital advertising gives Mondelez a 25% better return than TV ads. Source: wsj.com, March 19, 2021 26. a. What is the main objective of Mondelez’s marketing plan? Mondelez’s marketing plan is attempting to differentiate its products from those of its competitors and to do so its advertising must be seen by customers. By switching to online advertising, Mondelez’s marketing was more effective, presumably because more customers saw it and the cost per customer may have been lower for online ads.

b. Is Mondelez’s advertising expenditure a fixed cost or a variable cost? Mondelez’s advertising expenditure is a fixed cost.

27.

How does Mondelez’s marketing change the firm’s cost and revenue curves and its economic profit? Does average total cost at the profit-maximizing output increase or decrease? Mondelez’s marketing increases Mondelez’s fixed cost and hence its total cost, thereby shifting its average total cost curve upward. It has no effect on Mondelez’s marginal cost curve. If the marketing works, it increases the demand, thereby increasing Mondelez’s total revenue. Mondelez’s demand and marginal revenue curves shift rightward. Mondelez’s economic profit might increase, total revenue increases more than total cost, not change, if total revenue increases by the same amount as total cost, or decrease, if total revenue increases by less than total cost. It is not possible to determine if Mondelez’s average total cost at the profit-maximizing output increases or decreases.

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Dick’s Sporting Goods Launches Its Own Men’s Athleisure Line Dick’s Sporting Goods is introducing VRST, its new men’s athletic apparel wear. Dick’s is entering a highly competitive market that includes Nike, Lululemon, Adidas, and Under Armour. Source: cnbc.com, March 16, 2021 How will Dick’s entry into the athletic apparel market influence other firms in the market? Illustrate your answer with a graph. Dick’s entry into the athletic clothing market will decrease the demand for Nike’s, Lululemon’s. Adidas’s, and Under Armour’s clothing. As Figure 14.5 shows, their demand and marginal revenue curves will shift leftward, from D0 to D1 and MR0 to MR1, respectively. Their price will fall from $100 per item to $60 per item and the quantity they each produce will decrease from 100,000 units of clothing per week to 50,000. They were making an economic profit before Dick’s entered (which is why Dick’s entered the market) but Dick’s entry decreased their economic profit.

Economics in the News 29. After you have studied Economics in the News on pp. 338–339, answer the following questions. a. Why did Amazon buy MGM? Amazon is improving its streaming service with more choices to maximize its profit, thereby keeping up with and, hopefully from Amazon’s perspective, surpassing its rivals by offering an increased amount of differentiated content.

b. How will Prime’s cost curves (MC and ATC ) change with the acquisition of MGM? Adding MGM’s array of movies increased Amazon’s fixed cost and thereby increased its average total cost, so the ATC curve shifts upward. However, because the $8.5 billion Amazon paid is a fixed cost, Amazon’s marginal cost does not change so its MC curve does not change.

c. How do you think Prime’s lineup including the MGM catalog influences the demand for other firms’ streaming services? Amazon’s purchase of MGM for its Prime service decreased the demand for other firms’ streaming services.

d. Explain the effects on Netflix and other firms in the market for video streaming services of the availability of MGM movies on Prime. The effect of Amazon’s addition of MGM movies to its Prime streaming service on Netflix is similar to the effect on all the other firms in the market. The demand for Netflix’s streaming service decreases. The price of Netflix’s streaming services and the quantity produced both decrease. If Netflix was making an economic profit before the introduction, Netflix’s economic profit decreases.

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e. Draw a graph to illustrate your answer to part (c). Explain your answer. Amazon’s purchase of MGM decreased the demand for other firm’s streaming services. Netflix is representative of the impact on all other producers. Figure 14.6 shows the effect the introduction of MGM’s movies on Amazon Prime’s streaming service has on Netflix. The demand for Netflix’s streaming service decreases and, as the figure shows, the demand curve for Netflix’s streaming service shifts leftward. The demand for Netflix’s streaming service decreases from D0 to D1 because some consumers who otherwise would have purchased for Netflix’s streaming service instead switch to Amazon Prime because they prefer MGM’s movies.

What do you predict will happen to the markup on streaming services? Because the demand for the other firms’ streaming services decreases, their price falls so that the markup between the marginal cost and the price decreases.

g. What do you predict will happen to the excess capacity in the market for streaming services? Explain your answer. In the long run, similar to all firms in monopolistic competition, the producers of streaming services will have excess capacity. In the short run, however, the firms might not have excess capacity. Indeed, in the short run it is possible for the manufacturers to produce at a point beyond their capacity output.

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OLIGOPOLY

Answers to the Review Quizzes Page 347 1.

What are the two distinguishing characteristics of oligopoly? Oligopoly has two distinguishing characteristics: Natural or legal barriers prevent the entry of new firms, and a small number of firms compete in the industry.

Why are firms in oligopoly interdependent? Firms in oligopoly are interdependent because each firm has a large market share and so each firm’s decisions have a major influence on its competitors’ profits.

Why do firms in oligopoly face a temptation to collude? Firms in oligopoly face the temptation to collude because if they can successfully collude, they can boost their economic profit.

Can you think of some examples of oligopolies that you buy from? The market for graphic accelerator cards is close to an oligopoly; the market for long-distance land-based telephone service is close to an oligopoly; the market for soft drinks is an oligopoly; and, the market for beer is an oligopoly.

Page 355 1.

What are the common features of all games? All games share four common features: rules, strategies, payoffs, and outcome.

Describe the prisoners’ dilemma game and explain why the Nash equilibrium delivers a bad outcome for both players. In the prisoners’ dilemma game, each prisoner faces two strategies: confess or deny. There are four outcomes: i) Both prisoners confess and each receives more years in prison than if they both did not confess, ii) both prisoners deny, iii) prisoner A confesses and prisoner B denies, and iv) prisoner B confesses and prisoner A denies. In these last two outcomes, the confessing prisoner gets a lower sentence than if both confessed and lower than if they both denied. The dominant strategy for both prisoners is to confess. Regardless of what the other prisoner does, the best strategy for each prisoner is to confess, and both prisoners confess. This outcome is worse for both prisoners than if they each denied the crime, which creates the dilemma.

Why does a collusive agreement to restrict output and raise price create a game like the prisoners’ dilemma? Each firm has the possibility of sharing monopoly profits with other members of the cartel if each firm complies with the agreement. But each firm has an incentive to cheat on the collusive agreement in a cartel. If they all cheat, the outcome for each firm is worse than if they had all held to the agreement.

What creates an incentive for firms in a collusive agreement to cheat and increase output? All firms in a collusive agreement face the same optimal strategies: their payoff is high if they all comply, but the payoff to any one firm that cheats is even higher if all the other firms comply. This motivates each firm to cheat on the agreement.

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What is the equilibrium strategy for each firm in a duopolists’ dilemma and why do the firms not succeed in colluding to raise the price and profits? Each firm sees that its own profit is higher if it cheats on the agreement, and this strategy is best regardless of how any of the other firms act. This motivates all firms to cheat, and they all suffer an outcome that is far less profitable than if they all had complied with the agreement.

Describe the payoffs for an R&D game of chicken and contrast them with the payoffs in a prisoners’ dilemma. In the R&D game of chicken, a firm can use the R&D if either it conducts the R&D or if its competitor conducts the R&D. So if one firm conducts the R&D, it bears the cost and reaps the reward but the other firm reaps only the reward because it pays none of the costs. In a game of chicken, neither firm “wants” to do the R&D—both firms would prefer that the other conduct the R&D. In the prisoners’ dilemma R&D game, a firm can use the R&D only if it conducts R&D. If one firm conducts R&D, the firm incurs the costs of the R&D but then it alone reaps the rewards of the R&D. In this situation, both firms have the incentive to cheat on any agreement to restrict R&D because each firm knows that if it, and it alone cheats, its profit will increase.

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If a prisoners’ dilemma game is played repeatedly, what punishment strategies might the players employ and how does playing the game repeatedly change the equilibrium? Two strategies for motivating compliance in a repeated prisoner’s dilemma game are: i) a tit-for-tat strategy, where cheating by one firm in the current period is punished by the other firm cheating in the next period, but compliance by one firm in the current period is rewarded by compliance in the next period, ii) a trigger strategy, where cheating by one firm in the current period is punished by cheating by the other firm in all subsequent periods. Both strategies may create a cooperative equilibrium where all players share in the maximum possible benefit.

If a market is contestable, how does the equilibrium differ from that of a monopoly? A contestable market occurs when the firms in a market face potential entry from other firms due to low barriers to entry. While a monopoly free from the threat of entry will charge a high price and maximize economic profit, the firm or firms in a contestable market will keep price low and quantity produced high to deter potential entry by other firms outside the market. This benefits consumers, who enjoy nearcompetitive levels of output and a competitive market price.

Page 363 1.

What are the two main antitrust laws and when were they enacted? The two acts of Congress that make up our main antitrust law and the years of their enactment are: a. The Sherman Act of 1890 b. The Clayton Act of 1914

When is price fixing not a violation of the antitrust laws? Price fixing among competitors always is a violation of antitrust law, whether or not the act was found to be harmful to consumers. If the Justice Department can prove the existence of price fixing, a defendant can offer no acceptable excuse. Price fixing between a supplier and a reseller is not illegal as long as it is not anticompetitive.

What is an attempt to monopolize an industry? In theory, attempts to monopolize an industry mean a firm is trying to become a monopoly. In practice, attempts to monopolize an industry are more difficult to define and are a matter of interpretation by the courts. The “rule of reason” seemed to say that size alone doesn’t constitute an attempt to monopolize as in the 1920 U.S. Steel case. But the “rule of reason” was overturned when size did matter as in the 1945 Alcoa case. Even in more recent cases, it is difficult to predict what the court will define as an attempt to monopolize. Decisions continue to be divided in this area of the law. © 2023 Pearson Education, Inc.

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What are resale price maintenance, tying arrangements, and predatory pricing? Resale price maintenance occurs when a manufacturer agrees with a distributor about the minimum price at which the product will be resold. Resale price maintenance agreements are illegal only if they are anticompetitive. Resale price maintenance can create inefficiency if it allows the manufacturer to set the monopoly price for its product. However, it can create efficiency when it enables manufacturers to induce retail sellers to give the efficient level of sales service for the product. Tying arrangements occur when the seller agrees to sell one product to a buyer only if the buyer also buys another, different product. Tying can sometimes allow the producer to price discriminate and increase its profit. Tying arrangements can be illegal under the Clayton Act. Predatory pricing is setting a low price to drive competitors out of business to then set a high, monopoly price when the competition has gone. If predatory pricing occurs, it can lead to monopoly, but economists are skeptical that it occurs often because the firm trades off a sure loss for an uncertain future profit.

Under what circumstances is a merger unlikely to be approved? A merger is likely to be approved by FTC as long as the pre-merger HHI is less than 1,500. If the premerger HHI is between 1,500 and 2,500, the merger would be challenged if it raises the HHI by 100 or more points. If the pre-merger HHI is greater than 2,500, the merger generally would be blocked if it raises the HHI index by 200 or more points.

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Answers to the Study Plan Problems and Applications 1.

Intel and Advanced Micro Devices make most of the chips that power a PC. What makes the market for PC chips a duopoly? Sketch the market demand and cost curves that describe the situation in this market and that prevent other firms from entering. The market for PC chips, in particular the processor, is a natural oligopoly, most likely a natural duopoly. There are only two firms in the market, Intel and AMD, and there are no legal barriers to entry which limit the number of firms to two. Because other firms could enter the market but do not do so supports the idea that this industry is a natural duopoly. The cost curves and demand curve for this market would be similar to those in Figure 15.1, which shows the situation for a market in which two firms can satisfy the market demand. In this situation if a new firm entered the market it would be at a significant cost disadvantage compared to Intel and AMD and would likely incur an economic loss. Such a prospect deters entry by new competitors.

Cigarette Manufacturers Raise List Prices for First Time in 2020 The Big Three manufacturers are raising their list prices by 8 cents per pack although traditional cigarette-industry sales continue to decline. PhilipMorris’ market share was at 52.3%. Reynolds remained at 32%, and ITG at 7.3%. Source: Winston-Salem Journal, February 22, 2020 In what type of market are cigarettes sold? Explain your answer. Cigarettes are sold in an oligopolistic market. There are three major sellers of cigarettes: PhillipMorris, Reynolds, and ITG. These three firms taken along have a concentration ratio of 91.6%. So, the market for cigarettes has a small number of interdependent firms. Each firm's actions influence the profits of the other firms. The news clip tells us that all Big Three manufacturers are raising their prices by the same amount

Duracell, Energizer End Lawsuits Over Battery Life Claims In the U.S. market for household alkaline batteries, Duracell has a 45% share and Energizer has a 26% share. Both firms went to court claiming the other had falsely advertised battery life. Source: money.usnews.com, December 7, 2020 a. Describe the U.S. market for household alkaline batteries. Batteries are sold in an oligopolistic market. There are two major sellers of batteries: Duracell and Energizer. The 4-firm concentration ratio is approximately 90%.

b. What barriers to entry might limit competition in the battery market? A legal barrier to entry exists when competition and entry are restricted by patents. In the battery market, presumably Duracell and Energizer have patents covering the length of their batteries’ lives. In addition, with the limited number of firms, the providers are able to reap economies of scale, so a natural barrier is created.

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c. Draw a graph to illustrate your answer to part (a). Figure 15.2 show the market for batteries. The ATC curve in the figure is the average total cost curve for a battery manufacturer. It reaches its minimum at 150 billion batteries per year and an average cost of $1.00 per battery. If Duracell and Energizer each produce at this minimum point and there are 400 billion batteries sold per year, they would control 75 percent of the market, which is approximately what they sell. The ATC curve shows that one or two other firms with approximately 10 percent market shares might be in the market because their production would be high enough to lower their average total costs enough to be able to compete with Duracell and Energizer.

Consider a game with two players who cannot communicate, and in which each player is asked a question. The players can answer the question honestly or lie. If both answer honestly, each receives $100. If one player answers honestly and the other lies, the liar receives $500 and the honest player gets nothing. If both lie, then each receives $50. a. Describe the strategies and payoffs of this game. The game has 2 players (A and B), and each player has 2 strategies: to answer honestly or to lie. There are 4 payoffs: Both answer honestly and both receive $100; both lie and both receive $50; A lies, and B answers honestly and A receives $500 and B receives $0; and B lies, and A answers honestly and A receives $0 and B receives $500. A’s strategies b. Construct the payoff matrix. The payoff matrix has the following Honest Lie cells: Both answer honestly: A gets $100, and B gets $100; both lie: A $100 $500 gets $50, and B gets $50; A lies and Honest B answers honestly: A gets $500, and $100 $0 B gets $0; B lies and A answers B’s honestly: A gets $0, and B gets $500. strategies The payoff matrix is to the right. $0 $50 c. What is the equilibrium of this Lie game? The equilibrium is that each player $50 $500 lies and gets $50. If B answers honestly, the best strategy for A is to lie because he would get $500 rather than $100. If B lies, the best strategy for A is to lie because he would get $50 rather than $0. So A’s best strategy is to lie, no matter what B does. Repeat the exercise for B. B’s best strategy is to lie, no matter what A does.

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Explain. The game is the same as a prisoners’ dilemma. In this game, as in the prisoners’ dilemma game, both players get the jointly worse equilibrium outcome because they cannot trust the other player to cooperate. If the players could cooperate, they would achieve a better result.

Soapy Inc. and Suddies Inc., the only laundry detergent producers, collude and agree to share the market equally. If neither firm cheats, each makes $1 million profit. If one firm cheats, it makes $1.5 million, while the complier incurs a loss of $0.5 million. If both cheat, they break even. Neither firm can monitor the other’s actions. a. What are the strategies in this game? Construct the payoff matrix for this game. Each firm has two strategies: to comply with the agreement or to cheat on the agreement. The payoff matrix has the following cells: Both comply by the agreement: Soapy makes $1 million profit, and Suddies makes $1 million profit; both cheat: Soapy makes $0 profit, and Suddies makes $0 profit; Soapy cheats and Suddies complies with the agreement: Soapy makes $1.5 million profit, and Suddies incurs a $0.5 million loss; Suddies cheats and Soapy complies with the agreement: Suddies makes $1.5 million profit, and Soapy incurs Soapy’s strategies $0.5 million loss. These payoffs are shown, in millions of dollars, Comply Cheat in the matrix to the right.

b. If the game is played only once what is the equilibrium? Is it a dominant-strategy equilibrium? Explain.

$1 M

Comply Suddie’s strategies

$1 M

$1.5 M $.5 M

The equilibrium is that both firms cheat and each makes 0 $.5 M normal profit. The equilibrium is a dominant Cheat strategy equilibrium because for $1.5 M 0 each firm, regardless of the opponent’s choice, the best strategy is to cheat. If Suddies complies with the agreement, the best strategy for Soapy is to cheat because it would make a profit of $1.5 million rather than $1 million. If Suddies cheats, the best strategy for Soapy is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $0.5 million. So Soapy’s best strategy is to cheat, no matter what Suddies does. Repeating the exercise for Suddies shows that Suddies’s best strategy also is to cheat, no matter what Soapy does.

American and JetBlue Are Teaming Up. Is a Merger in the Works? JetBlue Airways and American Airlines plan to code-share flights and integrate some of their networks. JetBlue will feed more passengers to JFK for American’s domestic and international flights. Source: barrons.com, July 16, 2020 a. Explain how airline mergers might (i) increase fares or (ii) lower airline production costs. (i) Mergers can allow the firms to cut capacity, which will decrease supply and raise the price of air travel. If some routes wind up being served by only a handful of airlines and become oligopolistic in nature, a price-boosting cartel might emerge and persist. (ii) The merged firms might be able to enjoy economies of scale from the increased production. For instance, they might be able to eliminate duplicate services (such as advertising agencies and accounting departments). It might also be able to gain some economies of scale, perhaps because the larger air fleet allows its mechanics to specialize in servicing particular types of planes. © 2023 Pearson Education, Inc.

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b. Explain how lower costs might be passed on to travelers or boost airlines’ profits. If, after a merger and cut in capacity, the market remains competitive, competition forces the price down toward the (lower) average total cost. Hence competition can lead to the cost savings being passed along to consumers. On the other hand, if a merger and cut in capacity makes the market significantly less competitive, it becomes more likely that the airlines will be able to form a cartel (or reach an implicit agreement) to keep their prices high and thereby increase their profits.

If Soapy Inc. and Suddies Inc. play the game in Problem 5 repeatedly, on each round of play: a. What strategies might each firm might adopt? Each firm can adopt a tit-for-tat strategy or a trigger strategy, strategies that were not possible in a onetime game.

b. Can the firms adopt a strategy that gives the game a cooperative equilibrium? The game has a cooperative equilibrium. If the firms employ a trigger strategy or a tit-for-tat strategy, they can reach the cooperative comply/comply outcome. Take the case of the tit-for-tat strategy. If both firms comply for, say, three periods, both firms make $3 million profit. If a firm cheats in the first period while its opponent complies, the cheater makes a $1.5 million profit. In the second period, the opponent cheats, so if the first firm complies, it losses $0.5 million. In the third period the opponent will comply so the first firm can again cheat and make $1.5 million. However, in these three periods the total profit is only $2.5 million, so the cooperative equilibrium is possible.

c. Would one firm still be tempted to cheat in a cooperative equilibrium? Explain your answer. If the firms employ a trigger strategy or a tit-for-tat strategy, they can reach the cooperative comply/comply outcome. In these cases, the long-run profit from complying with the agreement exceeds that from cheating and so the cooperative equilibrium is likely. But a firm’s short-run profit would be larger if the firm (and that firm alone) cheated. So each firm still has an incentive to cheat because each firm can temporarily increase its profit.

A federal judge ruled that a $37 billion merger between the health insurers Aetna and Humana would not be in the interest of its consumers and should not be permitted. Source: The New York Times, January 23, 2017 What are the guidelines used by the FTC when deciding cases like the one in the news clip? The FTC uses guidelines based on the Herfindahl-Hirschman Index (HHI). A market in which the HHI is less than 1,500 is regarded as competitive and mergers will not be challenged. A market with an index between 1,500 and 2,500 is considered moderately concentrated, so a merger in this market that would increase the index by 100 points is challenged by the FTC. Finally, a market with an index above 2,500 is a concentrated market, and a merger in this market that would increase the index by 200 points is usually blocked.

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Answers to Additional Problems and Applications 9.

Pet Food Market to Reach $127.21 Billion By2027 The global pet food market has four dominant firms that produce more than 50 percent of the market. These firms strive to maintain their dominance by using marketing tools like opening pet food kitchens and unique product launches. Source: globenewswire.com, June 19, 2020 a. According to the news clip, what is the market structure of the global pet food market? The structure of the pet food market might be an oligopoly or it might be monopolistic competition. The four largest firms are said to have more than a 50 percent share of the market, so the 4-firm concentration ratio exceeds 50 percent. But there is no information on the HHI and a 4-firm ratio of 50 percent does not necessarily indicate an oligopoly.

What might be the reason that only four firms dominate the global pet food market? These four firms might dominate the pet food market because large economies of scale may make them a natural oligopoly. The large (fixed) cost of advertising or developing unique product launches and pet food kitchens can mean that the average cost of new entrants is higher than that of the existing four firms so that they are able to set lower prices than could new entrants.

Use the following data to work Problems 10 and 11. Bud and Wise are the only two producers of aniseed beer, a New Age product designed to displace root beer. Bud and Wise are trying to figure out how much of this new beer to produce. They know: (i) If they both produce 10,000 gallons a day, they will make the maximum attainable joint economic profit of $200,000 a day, or $100,000 a day each. (ii) If either firm produces 20,000 gallons a day while the other produces 10,000 gallons a day, the one that produces 20,000 gallons will make an economic profit of $150,000 and the other will incur an economic loss of $50,000. (iii) If both produce 20,000 gallons a day, each firm will make zero economic profit. 10. Construct a payoff matrix for the Bud’s strategies game that Bud and Wise must play. Limit Expand The payoff matrix has four cells: Both limit production: Bud makes $150 $100 Limit $100,000 profit, and Wise makes $100,000 profit; both expand $100 $50 production: Bud makes $0 profit, Wise’s and Wise makes $0 profit; Bud strategies limits production and Wise expands 0 $50 production: Bud incurs an economic Expand loss of $50,000, and Wise makes an economic profit of $150,000; Bud $150 0 expands production and Wise limits production: Bud makes an economic profit of $150,000, and Wise incurs an economic loss of $50,000. These payoffs, in thousands of dollars, are shown in the payoff matrix.

11.

Find the Nash equilibrium of the game that Bud and Wise play. The Nash equilibrium is for both Bud and Wise to expand production. From Bud’s perspective, if Wise limits production Bud’s profit is larger if it expands production. If Wise expands production then Bud’s profit is larger if Bud expands production. For Bud “expand production” is a dominant strategy. Wise’s situation is similar, so Wise, too, has a dominant strategy of “expand production.” © 2023 Pearson Education, Inc.

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An Unsavoury Business: The Story of Canada’s Syrup Cartel More than 75 percent of the world’s maple syrup comes from Canada’s Federation of Quebec Maple Syrup Producers. All of Quebec’s maple syrup producers must sell their syrup to the Federation. The Federation holds back supply during surplus years and inflates the price. Source: capx.co, March 26, 2020 a. If the Federation of Quebec Maple Syrup Producers acts as a profit-maximizing colluding oligopoly, explain how it would influence the price of maple syrup. To maximize its profit, the Federation would instruct Quebec’s maple syrup producers to decrease the quantity of maple syrup produced and then the Federation would raise its price. Similar to any monopoly, the Federation would aim to produce the quantity of maple syrup so that the marginal cost equals the marginal revenue and then use the demand curve to determine the highest price that enables it to sell the profit-maximizing quantity.

b. Draw a graph to illustrate your answer to (a). Figure 15.3 shows the outcome of this cartel in the market for maple syrup. Before the Federation existed, suppose the maple syrup market was competitive. The equilibrium price and quantity were determined by the intersection of the market demand and market supply. In the figure the competitive market supply curve is MC, so before the oligopoly the equilibrium price was $4.50 per pound of maple syrup and 300 million pounds were produced. After the Federation was created, the equilibrium quantity decreases to 200 million pounds and the price of a pound of maple syrup rises to $6.00 per pound.

c. Why is it difficult for the Quebec cartel to act like a monopoly? Use the ideas of game theory to explain. The Quebec cartel finds it difficult to successfully collude for two reasons. First, as is the case in any successful cartel, the incentive is for each producer to cheat on the collusive agreement by producing more syrup. This incentive lowers the likelihood that the cartel will succeed. In addition, the members of the cartel are not the only maple syrup producers. Maple syrup is also produced in the United States and as the price of maple syrup rises, U.S. producers increase their production, which will drive the price back down.

13.

Suppose that Mozilla and Microsoft each develop their own versions of an amazing new Web browser that allows advertisers to target consumers with great precision. Also, the new browser is easier and more fun to use than existing browsers. Each firm is trying to decide whether to sell the browser or to give it away. What are the likely benefits from each action? Which action is likely to occur? The more people use a particular browser, the more advertisers are willing to pay. And charging for a browser also generates profit. If the browser is given away and the competitor charges, likely the one given away gains market share and that company makes a large economic profit. The other company incurs an economic loss. If both browsers are given away, both companies probably make a comparable economic profit. And if both browsers are sold, both companies probably make the largest economic profit because they collect from both advertisers and consumers.

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A payoff matrix is to the right that reflects this analysis. The numbers in the matrix are the economic profit in millions of dollars. Microsoft’s profits are in the grey upper triangles and Mozilla’s profits are in the white lower triangles. The fact that for any given situation Microsoft’s profits are larger than Mozilla’s is realistic but does not affect the analysis. The joint profit is the largest when the browser is sold and is the smallest when the browser is given away. With the profits in the payoff matrix, the Nash equilibrium is to give the browsers away for free.

14.

Microsoft’s strategies Free

$100

$300

Free Mozilla’s strategies

Charge

$100

$700

$900

$700

Charge $300

$500

Why do Coca-Cola and PepsiCo spend huge amounts on advertising? Do they benefit? Does the consumer benefit? Explain your answer by constructing a game to illustrate the choices Coca-Cola and PepsiCo make. Coca-Cola and PepsiCo are engaged Coca-Cola’s strategies in an advertising game. In an Advertise Do not advertise advertising game, two firms can advertise or not advertise. $100 Advertising is costly but if one firm $100 Advertise advertises and the other does not, the one not advertising loses market $100 $500 Pepsi’s share and profit while the one strategies advertising gains market share and profit. Both firms would be better if $500 $300 neither advertised but the Nash Do not equilibrium is that both firms advertise $300 $100 advertise. The game to the right is a possibility. Both companies have the choice of whether to advertise or not. Coke’s economic profits, in millions of dollars, are in the grey triangles and Pepsi’s profits, also in millions of dollars, are in the white triangles. If both advertise, each makes a profit of $100 million; if one advertises but the other does not, the one advertising makes a profit of $500 million and the one not advertising incurs a loss of $100 million; and if neither advertise, each makes a profit of $300 million. The Nash equilibrium of this game is for each firm to advertise. Consumers benefit if the advertising gives them new information, for example information about a new drink. They also benefit if the advertising allows the firms to increase their production and enjoy economies of scale that allow lower prices. At one time in history, it is likely that consumers benefited from lower prices due to the increased economies of scale as Coca-Cola and PepsiCo drove smaller firms from the market. Today, however, most of the advertising does not convey new information and there are probably not many economies of scale left to exploit. It is likely that consumers are generally harmed by the advertising because the price of the product is higher.

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Use the following news clip to work Problems 15 and 16. Best Video Game Deals of Black Friday 2020 Nintendo Switch, PlayStation, and Xbox are all offering deals on their subscription services. Nintendo Switch isn’t shiny new like the PS5 and the new Xbox consoles but it’s still high in demand. Games for all three consoles are being offered at discounted prices. Source: arstechnica.com, November 27, 2020 15. a. Thinking about competition in game consoles as a game, describe the firms’ strategies. Strategies are all the possible actions of each of the players. The news clip shows that the current strategy in the game between Sony, Microsoft, and Nintendo is based on the prices of the subscription services and games.

b. What, based on the information provided, turned out to be the equilibrium of the game? The equilibrium turned out to that all the firms lowered their price. All three are lowering the price of their subscription services and games for their consoles are being offered at discounted prices.

16.

Can you think of reasons why the three consoles are different? The consoles are so different because the firms also are competing, in large part, in innovation and technology. In particular, each manufacturer is innovating in a way that it expects will most appeal to a different type of consumers, thereby allowing it to maximize its profit.

17.

If Bud and Wise in Problems 10 and 11 play the game repeatedly, what is the equilibrium of the game? If the game is played repeatedly, then Bud and Wise might be able to reach the cooperative equilibrium (both limit production) if they use a tit-for-tat or trigger strategy.

18.

Agile Airlines’ profit on a route on which it has a monopoly is $10 million a year. Wanabe Airlines is considering entering the market and operating on this route. Agile warns Wanabe to stay out and threatens to cut the price so that if Wanabe enters it will make no profit. Wanabe determines that the payoff matrix for the game in which it is engaged with Agile is shown in the table. Does Wanabe believe Agile’s assertion? Does Wanabe enter or not? Explain.

Agile’s strategies High price 7

Enter Wanabe’s strategies

Low price

1 0

10 Do not enter

5 0

Wanabe does not believe Agile’s assertion. If Wanabe does not enter, Agile’s best strategy is to set a high price. And, even if Wanabe enters the market, Agile’s best strategy is to set a high price because Agile has a larger payoff from setting a high price, 7, than by setting a low price, 1. So Wanabe has no reason to believe Agile’s assertion. Wanabe enters the market. If Wanabe does not enter, Wanabe receives a payoff of 0. If Wanabe enters, Agile sets a high price and so Wanabe receives a payoff of 5.

19.

Swatch is Taking on Silicon Valley Swatch, Switzerland’s largest watchmaker, is developing an alternative to Apple’s iOS and Google’s Android operating systems for smartwatches. Swatch says its technology will need less battery power and will protect data better. Source: The Toronto Star, March 17, 2017 What type of market does the news clip imply best describes the markets for smartwatches and © 2023 Pearson Education, Inc.

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their operating systems? The market for smartwatches is monopolistic competition. In monopolistic competition, a large number of firms compete with each other on product quality, price, and marketing, and each firm produces a differentiated product. The news clip implies that the market for smartwatches is a monopolistic competition because many different smartwatches are produced by many different firms. The market for smartwatch operating systems is an oligopoly. An oligopoly is a market structure in which a small number of firms compete. Each firm's actions influence the profits of all the other firms, so the firms are interdependent. The news clip implies that the market for smartwatch operating systems is best described as an oligopoly because Swatch, Apple, and Google are the only producers and these firms are interdependent.

Use the following news clip to work Problems 20 and 21. Generic Drug Maker Admits to Fixing Prices for Cholesterol Medication Apotex was fined $24.1 million for working with other drug companies to inflate the price of pravastatin. More than a dozen drug makers have been accused of conspiring to inflate prices by up to 1,000 percent on various medications. Source: nytimes.com, May 7, 2020 20. Which sections of the antitrust laws might have been violated by Apotex and other generic drugs producers? If Apotex and the other generic producers agreed to raise the prices on generic drugs, they violated Section 1 of the Sherman Act because price fixing—agreeing on prices—is per se illegal.

21.

Why might the price increases described in the news clip be against the social interest and benefit only the producer? The price increases create a deadweight loss, which harms society because less than the allocative efficient quantities of the drugs are sold. The producers benefit because the higher prices increase their economic profit.

22.

Discovery and Warner Media Merge The merger of Discovery and Warner Media creates one of the largest U.S. media businesses. The deal still needs to receive FTC approval. Source: nbcnews.com, June 15, 2021 a. What is the difference between a merger and an acquisition? A merger occurs when two or more firms agree to combine to create one larger firm. An acquisition occurs when one firm buys another.

b. Why would the FTC block this merger? The FTC would block this merger if the FTC believes it will create a market in which consumers are harmed because prices will rise and production decrease, thereby creating a deadweight loss.

c. How does the HHI influence the FTC’s decision? The FTC uses guidelines based on the Herfindahl-Hirschman Index (HHI). Mergers in markets with higher HHI’s are more likely to be challenged or blocked. A market in which the HHI is less than 1,500 is regarded as competitive and mergers will not be challenged. A market with an index between 1,500 and 2,500 is considered moderately concentrated, so a merger in this market that would increase the index by 100 points is challenged by the FTC. Finally, a market with an index above 2,500 is a concentrated market, and a merger in this market that would increase the index by 200 points is usually blocked.

Economics in the News 23. After you have studied Economics in the News on pp. 364–365, answer the following questions. a. What are the strategies of AT&T and Verizon in the market for wireless Internet service? The strategies of AT&T and Verizon are to invest in 5G service or not invest. © 2023 Pearson Education, Inc.

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b. Why, according to the news article, are the three firms investing heavily in 5G service? The three firms are in a fierce battle because it is believed that the leader in 5G will retain the top spot for at least 10 years, thereby potentially making a larger economic profit.

c. Why wouldn’t Verizon stick with its 4G network and leave AT&T to incur the cost of establishing 5G service? If AT&T invests in 5G service, Verizon’s profit is larger if it also invests in 5G service. If Verizon does not invested, its sales would suffer and its profit would be significantly smaller.

d. Could one of the firms do something that would make it the market leader? Would that action maximize its profit? One of the firms might lower its price to gain more market share. But by so doing the firm could suffer a loss because its costs are higher and therefore it would not be maximizing its profit.

24.

Southwest to Buy 100 New Boeing 737 MAX Jets Southwest’s fleet is composed entirely of Boeing 737 jets. With a need to replace older jets, Southwest had been considering the Airbus A220 but executives decided to stay with the lower maintenance and training costs of a single fleet type. Source:wsj.com, March 29, 2021 a. In what type of market are commercial airplanes sold? There are only two sellers of big airplanes, so this market is an oligopoly.

b. Thinking of competition between Boeing and Airbus as a game, what are the strategies and the payoffs? Boeing and Airbus are playing the duopolists’ game. They can set either low prices or high prices. If both Boeing and Airbus set low prices, then they will both make a smaller profit, perhaps even zero economic profit. If they both set high prices, then both will make a large economic profit. However, if one sets a low price and the other sets a high price, then the one with the low price will make a very large economic profit and the one with the high price will incur an economic loss.

c. Set out a hypothetical payoff matrix for the game you’ve described in part (b). What is the equilibrium of the game? The payoff matrix is to the right. In it the profits are in millions of dollars. The equilibrium is the prisoners’ dilemma equilibrium, that is, both firms set low prices and both make zero economic profit.

Boeing’s strategies High price High price Airbus’s strategies

Low price

$700

$1,000 - $200

$500

- $100 Low price

$800

$0 $0

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d. Do you think the market for commercial airplanes is efficient? Explain and illustrate your answer. The market for big airplanes is probably not efficient. It is efficient only if Boeing and Airbus compete against each other as if they were in perfect competition. But this outcome is unlikely. More likely is an outcome in which Boeing and Airbus together operate a monopoly or, if not precisely as a monopoly, then approaching that status. This outcome is especially likely because Boeing and Airbus will be playing a repeated game in which they (potentially) compete with each other for over two decades. In that situation, the repeated game makes it more likely that they will reach the cooperative equilibrium in which they operate together as a monopoly. Figure 15.4 shows the range of outcomes. If the two firms compete with each other, the equilibrium will be the competitive equilibrium, where they sell a total of 300 planes per year at a price of $15 million per plane. This outcome is the efficient outcome. However if Boeing and Airbus attain the cooperative equilibrium in which they act together to reach the monopoly outcome, then a total of 200 planes per year is sold and the price is $20 million per plane. In this case the outcome is inefficient and a deadweight loss results.

C h a p t e r

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Answers to the Review Quizzes Page 377 1.

List the economic functions of governments. Governments exist to establish and maintain property rights, to provide nonmarket ways of allocating resources, and to create methods that redistribute income and wealth.

Describe the political marketplace. Who are the participants, what do they do, and what is a political equilibrium? Voters, firms, politicians, and bureaucrats interact in the political marketplace. Voters and firms demand policies. Voters provide votes and/or funds while firms supply funds and other help to politicians or political parties that supply the policies they want. Politicians and political parties supply the policies and in exchange receive votes and/or contributions from voters and firms. Politicians attempt to supply proposals that attract enough votes to be elected and then reelected. Bureaucrats are in charge of implementing the policies. The political equilibrium is a situation in which no one has the incentive to change their efforts or their policies.

Distinguish among public goods, private goods, common resources, and club goods. Public goods are nonexcludable and nonrival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s use of the good does not decrease the amount available for other people. Private goods are excludable and rival. As a result, only the person who pays for the good can consume it and one person’s use decreases the amount available for others. Common resources are nonexcludable and rival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s consumption decreases the amount available for other people’s consumption. Club goods are nonrival and excludable. Potential users of the good can be excluded if they do not pay but once having paid their use of the good is nonrival.

Why are healthcare and education not public goods and why do governments play a large role in the markets for these services? Healthcare and education are not public goods because they are rival and excludable. But governments play a major role in the market for these services because a majority of voters want these goods provided to people regardless of the people’s ability to pay for them. Because of this view, public choices are used to determine the quantity of healthcare and education services provided.

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What is the free-rider problem? Why do free riders make the private provision of a public good inefficient? If a firm were to provide a public good, it would suffer from the free-rider problem, which arises when nonpaying consumers consume the public good without paying, enjoying a “free ride.” Public goods are, in part, characterized by inability to exclude nonpaying consumers. A private firm would not receive a sufficient level of revenue to provide the efficient level of the public good.

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Under what conditions will competition among politicians for votes result in an efficient provision of a public good? Competition in the political marketplace will provide the efficient quantity of a public good only if the voters are well informed and are motivated to carefully evaluate the alternative policies that the politicians propose.

How do rationally ignorant voters and budget maximizing bureaucrats prevent the political marketplace from delivering the efficient quantity of a public good? If the marginal benefit to the voter of becoming well informed about a particular policy issue is much smaller than the marginal cost of becoming well informed, the voter is likely to remain rationally ignorant about the policy and the level of any related public goods provision. The marginal benefit of providing public goods is very high to both bureaucrats and the contractors who are employed to produce and distribute the public goods. So they have a concentrated interest in lobbying politicians to direct the bureaucrats to provide more than the efficient quantity of the public good, even to where the net benefit to the economy is zero.

Explain why public choices might lead to the overprovision rather than the underprovision of a public good. Rational ignorance of voters, combined with lobbying by public goods contractors and bureaucrats, causes the political equilibrium to provide public goods at a higher level than is economically efficient. In this case, it is in the self-interest of the politicians to provide more than the efficient quantity of the public good because they reap benefits from the lobbyists and bureaucrats while suffering little or no loss from voters.

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What is special about healthcare that makes it a good provided by the government? The government provides healthcare services because the marginal social benefit of healthcare exceeds the marginal benefit perceived by its consumers, Consumers underestimate the benefit of healthcare because they underestimate the health risks they face. They also underestimate their future needs for healthcare. And some people cannot afford the healthcare they need. For these reasons the majority of voters want healthcare to be available on need rather than on the ability and willingness to pay

Why would the market economy produce too little healthcare? The markets for healthcare will produce less than the efficient quantity because consumers of healthcare take account of only the benefits that accrue to them. They ignore the marginal social benefit that exceeds their perceived marginal benefit. Therefore the consumers’ demand for healthcare is less than the marginal social benefit of healthcare so the quantity of healthcare services produced is less than the efficient quantity.

How do Canada and the United Kingdom deliver healthcare and what is the problem left unresolved? Canada and the United Kingdom provide healthcare using a universal coverage, single payer system. Everyone is covered by health insurance and the government pays for all healthcare services. The government’s public choice determines the quantity of healthcare services provided. Consumers pay little or nothing for any healthcare service. Consequently the quantity of healthcare services demanded exceeds the quantity provided by the government which creates a problem: There often is a long waiting period until a patient receives services.

What are the problem with Medicare and Medicaid? The government expenditure on Medicare and Medicaid are determined by the quantity of healthcare demanded, not by a fixed government budget. The scale of expenditure on Medicare and Medicaid in the United States is much than that in other rich nations. The U.S. population is aging. Older people demand © 2023 Pearson Education, Inc.

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more healthcare services than do younger people. Consequently, without changes in the Medicare and Medicaid programs, the expenditure on these programs, already huge, will increasingly grow.

What is the problem that Obamacare seeks to solve and how does the solution work? The Patient Protection and Affordable Care Act, or Obamacare, attempts to overcome the problem of too many people who do not have health insurance. It seeks to make quality, affordable, private healthinsurance plans available for those currently uninsured and to stop insurance companies from denying coverage of pre-existing conditions, This act created a Health Insurance Market in which subsidized health insurance is provided. On the supply-side of the market are private healthcare insurance companies. On the demand-side are individuals. Many of the consumers qualify for subsidies which lower the cost to them of the healthcare insurance. By reducing the price, the act increases the number of people with healthcare insurance.

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Answers to the Study Plan Problems and Applications 1.

Classify each of the following items as excludable, nonexcludable, rival, or nonrival. Explain your answer.  A Big Mac 

A Big Mac is excludable and rival. It’s excludable because a person must pay for a Big Mac to consume it. It’s rival because one person’s consumption decreases the quantity available for others to consume.

Brooklyn Bridge The Brooklyn Bridge is nonexcludable (because there is no toll for using it) and rival (especially when it is crowded).



A view of the Statue of Liberty Viewing the Statue of Liberty is nonexcludable and nonrival. It is nonexcludable because a person cannot be prevented from viewing the statue and it is nonrival because one person’s view does not decrease people’s views.



A hurricane warning system A hurricane warning system is nonexcludable and nonrival. It is nonexcludable because once a warning is sounded, everyone can learn of it and nonrival because one person learning of the warning does not limit other people’s use of the warning.

Classify each of the following items as a public good, a private good, a club, or a common resource. Explain your answer.  Highway control services 

Highway control services are nonexcludable and nonrival so they are a public good.

Internet service Internet service is a club good. Internet service is excludable because a consumer must pay for the service or else he or she does not receive it. But once access is granted, use of Internet service is nonrival.



Fish in the Atlantic ocean



UPS courier service

Fish in the ocean are a common resource because they are nonexcludable and rival. UPS is rival (a carrier cannot deliver a package to my house and your house simultaneously) and excludable (a user must pay) so it is a private good.

For each of the following goods, explain why a free-rider problem arises or how is it avoided.  July 4th fireworks display The fireworks display is a public good so there is a potential free-rider problem. Area residents might be taxed to finance the display, but visitors to the area, who don’t pay local taxes, are free riders.



Interstate 81 in Virginia Interstate 81 potentially has a free rider problem. However if the state of Virginia uses the gas tax revenue it receives from the sale of gasoline near the interstate to pay to maintain the freeway, then users of the Interstate pay for the road. In this case there is no free rider problem.

Wireless Internet access in hotels Wireless Internet access in hotels can avoid the free rider problem if the hotel limits access to guests staying at the hotel.



The public library in your city The public library has a free rider problem because people can use the library even if they pay no taxes to support it. Potentially the free rider problem can be mitigated if the library charges a fee for its services.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

The table sets out the benefits that Terri and Sue receive from on-campus police at night. Suppose that Terri and Sue are the only students on the campus. Draw a graph to show the marginal social benefit of the police at night. The marginal social benefit at every number of police officers equals Terri’s marginal benefit plus Sue’s marginal benefit. Figure 16.1 shows the marginal social benefit curve.

Use the data on a mosquito control program in the table to work Problems 5 and 6. 5. What quantity of spraying would a private firm provide? What is the efficient quantity of spraying? In a single-issue election on mosquito spraying, what quantity would the winner provide?

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Police officers on duty (number per night) 1 2 3 4 5

Marginal benefit Terri Sue (dollars per police officer) 18 22 14 18 10 14 6 10 2 6

Quantity (square miles sprayed per day) 1 2 3 4 5

Marginal Marginal social cost social benefit (thousands of dollars per day) 2 10 4 8 6 6 8 4 10 2

Mosquito spraying is a public good and subject to free riding. As a result, a private mosquito would supply no spraying. The efficient quantity of spraying is 3 square miles a day, which is the quantity at which marginal social cost equals marginal social benefit. In a single-issue election, the outcome will be that each party eventually proposes spraying 3 square miles per day and the election outcome will be the efficient quantity of spraying.

If the government appoints a bureaucrat to run the program, would mosquito spraying most likely be underprovided, overprovided, or provided at the efficient quantity? With the bureaucratic department in charge of spraying, mosquito spraying likely would be overprovided.

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Use the figure, which shows the marginal benefit of health insurance and the willingness and ability to pay for it, to work Problems 7 to 10. The marginal cost of insurance is a constant $6,000 per family per year. Insurance brings a marginal social benefit that exceeds the willingness and ability to pay by a constant $4,000 per family per year. 7.

With no public health insurance market, how many families buy insurance, what is the premium, and is the coverage efficient? With a private and competitive health insurance market, the price of health insurance equals the marginal cost, or $6,000 per year. At this price, 10 million families buy insurance. The coverage is not efficient because the marginal social benefit exceeds the marginal (private) benefit. When 10 million families are insured the marginal social benefit is $10,000, which exceeds the marginal cost of the insurance. Accordingly insurance is underprovided by the private market.

If the government provides healthcare to achieve the efficient coverage, how many families are covered and how much must taxpayers pay? The efficient quantity of health insurance is 50 million families covered. At this quantity, the marginal social benefit equals the marginal benefit of $2,000 plus $4,000, or $6,000. Therefore, the marginal social benefit equals the marginal cost, so 50 million families covered is the efficient quantity. With 50 million families insured, the demand curve shows that consumers will pay $2,000 per family. The marginal cost of this quantity of policies is $6,000 so the taxpayers must subsidize each family by an amount of $6,000 − $2,000, or $4,000. Therefore, the total subsidy taxpayers must pay is $4,000 per family multiplied by 50 million families, or $200 billion.

If the government subsidizes private insurers, what subsidy will achieve the efficient coverage? To insure 50 million families, the insurers’ total cost equals $6,000 per family multiplied by 50 million, or $300 billion. With 50 million families covered, the demand curve shows that a family is willing to pay $2,000 per policy. Accordingly, families will pay 50 million × $2,000, or $100 billion. Therefore, the government must provide a subsidy of $200 billion to private insurers.

10.

If the government gave coverage to everyone what problems would arise in the related market for healthcare services? If the government gave everyone coverage, then 70 million families—the quantity of insurance policies demanded at a price of $0—will be insured. This larger quantity of insured households means that the quantity of healthcare services will be larger. Unless the government is going to provide additional healthcare services, there will be a long wait until a patient can receive treatment, at least for non-life threatening ailments.

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Answers to Additional Problems and Applications 11.



Classify each of the following items as excludable, nonexcludable, rival, or nonrival. Homeland security Homeland security is nonrival (the use of homeland security by one person does not decrease the quantity available for someone else) and nonexcludable (it is impossible to prevent anyone from benefiting from it).



A Starbucks coffee



A view of the Liberty Bell

A Starbucks coffee is rival and excludable.



A view of the Liberty Bell is nonexcludable and nonrival.

The Appalachian Trail The Appalachian Trail is nonexcludable. It is generally nonrival except in areas where is becomes very crowded.



A Google Search A Google search is nonexcludable because anyone can search for the same item and is nonrival because one person’s search does not decrease the searches available to anyone else.

12.

Classify each of the following items as a public good, a private good, a club, or a common resource. Explain your answer.  Measles vaccinations Measles vaccination is a private good. It is excludable and rival.



Tuna in the Pacific Ocean



Air service in the United States

Tuna in the ocean are a common resource because they are nonexcludable and rival. Airline flights are a private good because they are excludable and rival.



Local storm-water system The local storm water system is a club good because it is excludable but once access is granted, use of it is nonrival.

13.

Classify each of the following goods as either a private good, a public good, a club good, or none of the above.  Chewing gum 

Chewing gum is excludable and rival so it is a private good.

Cable TV Cable TV is a club good. It is excludable because a consumer must pay for access. But once access is granted, use of the cable TV system is nonrival.



The New York City subway The subway is a private good because it is excludable and, when crowded, is rival.



A skateboard



The Santa Monica beach

A skateboard is a private good. The beach at Santa Monica is nonexcludable and rival so it is none of the above. (It is a common resource.)

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The table sets out the marginal benefits that Sam and Nick receive from the town’s street lighting: a. Is the town’s street lighting a private good or a public good? It is a public good.

b. Suppose that Sam and Nick are the only residents of the town. Draw a graph to show the marginal social benefit of the town’s street lighting.

Number of street lights 1 2 3 4 5

Marginal benefit Sam Nick (dollars per street light) 10 12 8 9 6 6 4 3 2 0

Figure 16.3 shows the marginal social benefit curve. The marginal social benefit at every quantity equals Sam’s marginal benefit plus Nick’s marginal benefit.

15.

What is the principle of diminishing marginal benefit? In Problem 14, does Sam’s, Nick’s, or the society’s marginal benefit diminish faster? The principle of declining marginal benefit asserts that as the quantity of the good or service consumed increases, the marginal benefit of an additional unit decreases. Society’s marginal benefit decreases more rapidly than does Sam’s marginal benefit or Nick’s marginal benefit. For every additional street light, Sam’s marginal benefit decreases by $2, Nick’s marginal benefit decreases by $3, and society’s marginal benefit decreases by $5.

Use the following news clip to work Problems 16 and 17. NJ Gas Tax Hike of 9.3 Cents Per Gallon Goes Into Effect New Jersey’s gas tax, which is rising from 30.9 to 40.2 cents per gallon, is needed to support the state’s Transportation Trust Fund (TTF). The TTF funds infrastructure improvements to the state’s roadways and bridges. Source: nbcnewyork.com, October 1, 2020 16. Why might an increase in the gas tax to finance transportation infrastructure be a political equilibrium? In a political equilibrium, the choices of voters, firms, politicians, and bureaucrats are all compatible and no group can see a way of improving its position by making a different choice. If voters believe that repairing bridges and roads is worth the increase in the gas tax, they will vote for politicians who support these policies. The bureaucrats in charge of the transportation policies and as well as the firms that build and repair roads and bridges will support these policies, so the political equilibrium is for politicians to also support them.

17.

Roads and bridges are constructed by private engineering companies yet are public goods. Distinguish between public production and public provision. Give three other examples that illustrate the distinction. The difference between private provision of a public good and public provision hinges around who—the private sector or the public sector—actually produces the public good. For instance, many local governments contract with private agencies to provide street sweeping services, a public good. For another © 2023 Pearson Education, Inc.

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example, some states have contracted with private companies for the day-to-day running of parks. Finally, some states, such as Texas, have allowed private firms to produce toll roads.

18.

If You are Healthy and Refuse to Take the Vaccine, You Are a Free Rider Healthy people who refuse to be vaccinated gain the benefits of living in a community without paying the cost. Being vaccinated allows a person to live with less fear. The vaccine’s ultimate goal—the return of normal life—is achieved only when we act together. Source: Washingtonpost.com, April 15, 2021 a. Explain why someone who is healthy and has not opted out of receiving the Covid-19 vaccine on medical or religious grounds and refuses to be vaccinated is a “free rider.” The person who has not been vaccinating is free riding because he or she is benefiting from the people who have been vaccinated. The people who have been vaccinated will be much less likely to spread the disease to others. The people who have not been vaccinated are enjoying a free ride because they are not providing the same disease prevention benefit to others.

b. Should Covid-19 vaccinations be compulsory? Explain your answer. Compulsory vaccination, with exceptions allowed for medical and religious reasons, would eliminate free riding and make the market more efficient.

19.

Obamacare Sign-ups Reach 1 Million During Special Enrollment Window President Joe Biden says that 1 million more Americans now have the peace-of-mind that comes from having health insurance. The enrollment period for the Affordable Care Act was extended due to the pandemic. Source: nbcnews.com, May 11, 2021 a. If the Obamacare enrollment is the efficient quantity of families, how would that quantity have been determined? The target would be the quantity of families that sets the marginal social benefit of healthcare insurance equal to the marginal cost.

b. Draw a graph to illustrate the health insurance market and illustrate how the Obamacare subsidy influences the number of families covered. Figure 16.4 shows the market for health insurance. In the absence of any subsidy, the price of a health insurance policy is $4,000 per year and 30 million families buy a policy. The subsidy under Obamacare increases the quantity of families buying health insurance. Presuming that the subsidy brings about the efficient outcome, the figure shows that the subsidy is $4,000 per family. With this subsidy, 50 million families will buy insurance because the price paid for a policy falls to $2,000. In the figure, Obamacare has increased the number of families insured from 30 million to 50 million.

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Use the following information and figure to work Problems 20 and 22. The marginal cost of health insurance is a constant $8,000 a year and the figure shows the marginal benefit and willingness and ability to pay curve. Insurance brings a marginal social benefit that exceeds the willingness and ability to pay by a constant $2,000 per family per year. 20. If all health insurance is private and the market for insurance is competitive, how many families are covered, what is the premium, and what is the deadweight loss created? If the market is private and competitive, the price of health insurance is $8,000 a year. As Figure 16.6 shows, the equilibrium quantity of policies is 10 million families insured. The efficient quantity, however, is 20 million quantities because that is the quantity that sets the marginal social benefit, MSB, equal to the marginal cost, MC. When only 10 million families are insured, the deadweight loss is the grey triangle in the figure. The area of this triangle is the amount of the deadweight loss and is equal to ½ × 10 million × $2,000 = $10 billion.

21.

If the government decides to provide public health insurance (like Canada), what healthcare fee does it charge to achieve an efficient coverage? How much will taxpayers have to pay? If the government provides public health insurance as does Canada, Canada will insure 20 million families. The cost of insuring each family is $8,000. Canada uses a single payer method of health care, which means that the Canadian government pays for all health care expenditures. Therefore Canadian taxpayers must pay for the entire cost of the insurance, $8,000 × 20 million or $160 billion.

22.

If the government decides to subsidize health insurance (like Obamacare), what subsidy will achieve the efficient coverage? The subsidy must lead to insuring 20 million families because that is the efficient quantity that sets the marginal social benefit equal to the marginal cost. The demand and marginal benefit curve, D = MB, © 2023 Pearson Education, Inc.

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shows that the price of an insurance policy must be $6,000 per year to have 20 million families enrolled. The subsidy per family equals $8,000 − $6,000, or $2,000 per family.

Economics in the News 23. After you have studied Economics in the News on pp. 388–389, answer the following questions: a. What is the source of revenue for constructing and maintaining the transportation? User fees, such as tolls, fuel taxes (such as the gasoline tax), and vehicle registrations are the main source of funds for constructing and maintaining the transportation capital.

b. Why has that revenue source not grown fast enough to deliver an efficient scale of infrastructure provision? Some of the sources of funds, such as fuel taxes, have not grown rapidly because as cars become more fuel efficient or run using electricity, they use less gasoline, thereby generating less fuel tax revenue. Additionally, as the infrastructure ages, it likely becomes more costly to maintain it.

c. What other revenue sources can you suggest that could provide a solution to underprovision? While President Biden proposed using a corporate income tax to help pay, general tax revenue also could be used to maintain the infrastructure. More tolls could be established for using bridges and freeways, with the funds generated devoted to the infrastructure. Drivers might be taxed for the miles they drive rather than the fuel they use, which could generate additional funds. A higher tax could be imposed on the purchase of new or used cars.

d. How would you expect population growth to influence the marginal social benefit that highways and bridges bring? Population growth increases the marginal social benefit of highways and bridges.

e. Illustrate your answer to (d) by drawing a version of the figure on p. 389 that shows the effect of an increase in population. Figure 16.7 shows how the marginal social benefit curve shifts rightward to MSB1. As a result, the efficient number of bridges to repair increases from 6,000 per year to 8,000 per year.

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Poland’s PM Labels Under-Spending NATO Countries “Free Riders” NATO’s target is for its 29 member countries to spend 2% of GDP on defense. Poland’s prime minister, Mateusz Morawiecki, says that Western European countries such as France and Germany are paying less than 2 percent and are free riders. Nine countries, including Poland, the UK and the US are meeting or exceeding their goals. Source: forces.net, January 23, 2020 a. Explain the free-rider problem described in this news clip. The free rider problem is that most NATO nations rely on the United States, Poland, the United Kingdom, and six others to provide defense services against aggression. These nations meet their NATO pledge to spend at least 2 percent of their gross domestic product on defense while other NATO nations fall short.

b. Does the free-rider problem in international defense mean that the world has too little defense against aggression? Free riding because of the public goods aspect of defense means that the world has too little defense against aggression.

c. How do nations try to overcome the free-rider problem among nations? Nations can sign treaties that either obligate them to cut their weapons systems or jointly develop new weapon systems. By cutting weapons, less additional defense spending is required, which limits the total amount of free riding that occurs. By jointly developing new weapon systems the nations eliminate free riding because all the nations who signed the treaty help pay for the weapons system.

25.

Think Twice Before Moving to New Brunswick, Warns New Resident Rodney Pavlica moved to New Brunswick on Canada’s east coast in 2018. Like tens of thousands of people in New Brunswick, Pavlica can’t find a doctor. Pavlica was told by a TeleCare operator that he should expect a three- to four-year wait. Source: cbc.ca, May 10, 2021 a. How are healthcare services allocated under Canada’s universal coverage, single payer healthcare system? In Canada healthcare services are allocated on a first-come, first-served basis, which often leads to a long wait for treatment.

b. Explain why the outcome in the Canadian healthcare system is inefficient. The outcome in Canada is inefficient for two reasons. First, the government decides how much healthcare services will be provided. This decision is made via a political process and is less than the efficient quantity where the MSB and MSC curves intersect. Second, patients pay nothing directly for the services they receive, so some patients who arrived early receive treatment even though the MB and MSB of their treatment is less than its MSC while others, who arrived later, must wait even though the MB and MSB of their treatment exceeds its MSC.

c. Is the outcome fair? Defenders of the system asset that the outcome is fair because everyone has equal access to health. Opponents, however, point out that some patients “play the system” and jump ahead of their place in the queue.

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Answers to the Review Quizzes Page 396 1.

What are the four types of externality? Externalities can be: a negative production externality, a positive production externality, a negative consumption externality, or a positive consumption externality.

Provide an example of each type of externality that is different from the ones described above. Dumping dangerous chemicals in river while producing paper is an example of a negative production externality. Baking bread and the resulting odor enjoyed by by-passers is an example of a positive production externality. Littering while hiking is an example of a negative consumption externality. Planting a beautiful bamboo garden that by-passers enjoy is an example of a positive consumption externality.

Provide examples of externalities that arose during the Covid-19 pandemic. An immediate externality is the positive consumption externality created by being vaccinated against Covid-19. In this case, the person vaccinated benefits as does anyone who interacts with this person because the probability of catching Covid-19 from the person is diminished. There is also the negative externality of an ill person transmitting the coronavirus to someone else. Wearing a mask also created a positive externality because it made the person less likely to catch Covid-19 and also made it less likely for the person to transmit it to others if the person was infected.

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What is the distinction between private cost and social cost? A private cost of production is the cost of producing a good or service that is borne only by the producer. A social cost of production includes the private costs of production as well as the external costs of production borne by people other than the producer.

How do external costs prevent a competitive market from allocating resources efficiently? External costs create a marginal social cost (MSC) that exceeds the marginal private cost (MC) for producing or consuming a good or service. That is, with an external cost, MSC > MC. When the firm produces a good or service with an external cost, it chooses to produce the quantity at which marginal cost equals marginal benefit, MC = MB. Marginal benefit equals marginal social benefit, MSB. In this case, the firm produces the quantity at which MC = MSB. This level of production exceeds the level at which MSC = MSB. Too much of the good or service is produced, resulting in an inefficient allocation of resources.

How can external costs be eliminated by assigning property rights? The existence of a negative externality means some group must bear some of the costs of a production or consumption activity for which they are not involved. The Coase theorem implies that assigning a property right to either the group generating the externality or the group bearing the externality costs will eliminate the inefficient allocation of resources. The Coase theorem applies if the number of parties involved is small and if transactions costs are low.

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How do taxes and cap-and-trade work to reduce emissions? An emissions tax on the producers of the activities that generate pollution or other negative externality will force these producers, when deciding about their level of production, to take account of the external costs they impose on society. Producers' costs increase and, in response, they decrease their production, which decreases pollution emissions. For cap-and-trade, the regulating agency first determines the total amount of pollution to be allowed. Each firm that might potentially pollute is then assigned a permitted amount of pollution to be emitted per period and is allocated sufficient permits to allow this amount of pollution. For any firm to exceed this amount, it must buy permits held by another firm. Those firms with lower costs of cleaning pollution will sell their permits to those firms with higher costs. The total amount of pollution emitted will equal the total amount allowed.

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What is the tragedy of the commons? Give two examples, including one from your state. The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. The private market place will not produce the efficient quantity of a common resource. Some examples include the congestion of traffic during rush hour, the congestion near a college football stadium whenever a major game is played, or the free Internet access computer at the local library.

Describe the conditions under which a common resource is used efficiently. A common resource is used efficiently when the marginal social benefit equals the marginal social cost at the quantity produced.

Review three methods that might achieve the efficient use of a common resource and explain the obstacles to efficiency. There are three different methods that government can use to obtain the efficient allocation of resources in the event of a common resource: 

Property Rights are assigned to private property, which is a resource that someone owns and has an incentive to use in a way that maximizes its value. However, assigning property rights to resources is not always feasible, such as with the fish that migrate over the vast depths of the oceans.



Production Quotas can be set for total catch and divided among harvesting consumers so that the marginal social benefit of harvesting equals the marginal social cost of harvesting. However, it is in every harvester’s best interest to cheat on the quota, because marginal private benefit of exceeding the quota allotment is greater than the marginal cost of harvesting.



An Individual Transferable Quotas (ITQ) is a production limit that is assigned to an individual harvester who is free to transfer the quota to someone else.

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Why would the market economy produce too little education? The markets for education will produce less than the efficient quantity because consumers of education take account of only the benefits that accrue to them. They ignore the marginal external benefit that others gain. Therefore the consumers’ demand for education is less than the marginal social benefit of education.

How might governments achieve an efficient provision of education? Governments could use public provision, private subsidies, or vouchers to achieve efficiency in the market for education. Public provision: The government could determine the efficient amount of education and create public colleges. This method is the primary method used for K-12 education. Private subsidies: The government could offer subsidies to private colleges. Vouchers: The government would give vouchers to students. Pell grants are an example of vouchers.

What are the key differences among public production, private subsidies, and vouchers?

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Public production means that the government is the producer of the product. Private subsidies, however, are given to private producers of the product. Both public production and private subsidies affect the supply-side of the market. Vouchers, however, are given to households to help pay for the product. Vouchers therefore affect the demand-side of the market.

Why do economists generally favor vouchers to achieve an efficient outcome? Economists generally favor vouchers because they allow for competition and they limit the opportunity for overproduction. First, a voucher gives the consumer of the good the buying power, which forces producers to compete for business. Vouchers allow for competition between public producers and private producers. Second, vouchers can also limit overproduction because setting the value of the vouchers and the total voucher budget is transparent so that bureaucrats have less ability to pad their budgets. In addition, vouchers spread the spending over millions of consumers so no one consumer has the incentive to lobby for increased spending.

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Answers to the Study Plan Problems and Applications 1.

Describe three consumption activities that create external costs. Wearing heavy perfume creates an external cost; littering fast-food containers or soda cans creates an external cost; and, a drunk at a bar creates an external cost.

Describe three production activities that create external benefits. Presuming people like the smell of baking bread, a bakery creates an external benefit; basic research creates an external benefit; and recycling at a business has an external benefit because it decreases the harm created by waste disposal sites.

Use Figure 17.1, which illustrates the market for cotton, to work Problems 3 and 4. Suppose that the cotton growers use a chemical to control insects and waste flows into the town’s river. The marginal social cost of producing the cotton is double the marginal private cost. 3. If no one owns the river and the town takes no action to control the waste, what is the quantity of cotton and the deadweight loss created? 400 tons of cotton is produced. In Figure 17.2, the deadweight loss that is created is equal to the area of the grey triangle. So, the deadweight loss is equal to ½ × ($100 per ton − $50 per ton) × 100 tons, which is $2,500.

If the town owns the river and taxes cotton growers so that the efficient quantity is grown. How much tax revenue does the town receive? Is the quantity of waste zero? Explain your answer. The tax is equal to the marginal external cost at the efficient quantity, $37.50 per ton of cotton. The efficient quantity of cotton is produced, 300 tons. Therefore, the town receives $37.50 per ton × 300 tons, which is $11,250. The quantity of waste is not zero because 300 tons of cotton are produced. But the quantity produced is the efficient amount, so the marginal social benefit of the last ton of cotton produced equals the marginal social cost, which includes the external cost.

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Use Figure 17.3 to work Problems 5 and 6. The figure illustrates the market for North Atlantic tuna. 5. a. What is the quantity of tuna that fishers catch and the price of tuna? Is the tuna stock being used efficiently? Explain why or why not. When the market is unregulated, the quantity of fish caught and their price is determined by the equilibrium between supply and demand. The demand curve is the same as the MSB curve so Figure 17.3 shows that the equilibrium quantity of tuna is 80 tons and the equilibrium price is $100 per ton. The tuna stock is not being used efficiently, The efficient quantity of tuna is determined by the intersection of the MSC curve and the MSB curve. Figure 17.3 shows that the efficient quantity of tuna is 40 tons. Tuna, a common resource, is overfished.

b. What would be the price of tuna, if the stock of tuna were used efficiently? If tuna were used efficiently, 40 tons per month would be caught and the price would be $150 per ton.

With a quota of 40 tons a month for the tuna fishing industry, what is the price of tuna and the quantity caught? Does overfishing occur? With a quota of 40 tons per month, the quantity of tuna caught will be 40 tons and the price will be $150 per ton. As long as the quota is enforced so that fishers cannot cheat on their allocation, the equilibrium with the 40-ton quota is efficient. Tuna is not overfished.

Use Figure 17.4, which shows the demand for college education, to work Problems 7 to 9. The marginal cost is a constant $6,000 per student per year. The marginal external benefit of a college education is a constant $4,000 per student per year. 7.

What is the efficient number of students? If all colleges are private, how many people enroll in college and what is the tuition? The efficient number of students is 50,000 because this quantity is the number of students that sets the marginal social benefit equal to the marginal cost. If all colleges are private, then 30,000 students enroll in college because this quantity is the number that sets the marginal benefit equal to the marginal cost.

If the government provides public colleges, what tuition will achieve the efficient number of students? How much will taxpayers have to pay? The tuition will be $2,000 because this tuition will lead 50,000 students to enroll. The taxpayers must pay $4,000 per student (the $6,000 marginal cost minus the $2,000 tuition) for 50,000 students, so the taxpayers will pay $200,000,000 in total.

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the efficient number of students? The efficient number of students is 50,000. The value of the voucher must be $4,000 a student. The private colleges charge tuition of $6,000 per student and, of this tuition, students pay $2,000 so 50,000 students enroll.

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Answers to Additional Problems and Applications 10.

What externalities arise from smoking tobacco products and how do we deal with them? There are at least two externalities from smoking. First, many people who do not smoke find the smell of smoking offensive. Second, tobacco smoke can pose a health risk for non-smokers. To deal with these external costs, many locations ban smoking. For example, smoking on airplanes is illegal. Many states have banned smoking in restaurants. Some college campuses and most hospitals have gone “smoke free” by prohibiting smoking while on their premises.

11.

What externalities arise from beautiful and ugly buildings and how do we deal with them? Beautiful buildings create external benefits from the pleasure that people get from observing them. For ugly buildings, it is the reverse: They create external costs from the displeasure people get from observing them. To try to create more beautiful buildings, some locations require architectural review in which the planned building must pass inspection. Buildings of significant historical value are given heritage designations. People who pile trash around their buildings are fined.

12.

Betty and Anna work at the same office in Philadelphia and they have to attend a meeting in Pittsburgh. They decide to drive to the out-of-town meeting together. Betty is a cigarette smoker and when she smokes a pack of cigarettes a day her marginal benefit is $40. Cigarettes are $6 a pack. Anna dislikes cigarette smoke, and her marginal benefit of a smoke-free environment is $50 a day. What is the outcome if a. Betty drives her car with Anna as a passenger? If Betty drives her car, Betty has the property right to the air in her car. Anna can offer to pay Betty some amount more than $34 and less than $50 to not smoke. Betty will accept and will not smoke on the trip. Betty’s net benefit of smoking is $34 (the net benefit equals the marginal benefit, $40, minus the price of the pack, $6) so for any amount greater than $34 she is willing to not smoke. Anna values a smoke-free environment at $50, so Anna is willing to pay any amount less than $50 for a smoke-free environment.

b. Anna drives her car with Betty as a passenger? If Anna drives her car, Anna has the property right to the air in her car. Betty will not smoke because she will not offer Anna a high enough price to allow Betty to smoke.

Use the following data and Figure 17.5, which illustrates the market for a pesticide with no government intervention, to work Problems 13 to 16. When factories produce pesticide, they also create waste, which they dump into a lake on the outskirts of the town. The marginal external cost of the waste is equal to the marginal private cost of producing the pesticide (that is, the marginal social cost of producing the pesticide is double the marginal private cost). 13.

What is the quantity of pesticide produced if no one owns the lake and what is the efficient quantity of pesticide? If no one owns the lake the equilibrium quantity of pesticide produced is determined at the intersection of the demand curve and supply curve, 30 tons per week. The efficient quantity is determined at the intersection of the marginal social benefit curve and the marginal social cost curve. The marginal social benefit curve is the same as the demand curve. But the marginal social cost curve differs from the supply © 2023 Pearson Education, Inc.

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curve because of the external cost. The efficient quantity of pesticide is 20 tons per week because at this quantity the marginal social benefit, $100 per ton, equals the marginal social cost, also $100 per ton.

14.

If the town owns the lake, what is the quantity of pesticide produced and how much does the town charge the factories to dump waste? Assuming that the transactions costs are low so that the Coase theorem applies, if the residents of the town own the lake, the efficient quantity of pesticide is produced, 20 tons per week. The residents charge the pesticide companies $50 per ton to dump their waste in the lake.

15.

If the pesticide factories own the lake, how much pesticide is produced? Assuming that the transactions costs are low so that the Coase theorem applies, if the pesticide companies own the lake, 20 tons of pesticide is produced. In this case the residents pay the company to limit the dumping of waste.

16.

If no one owns the lake and the government levies a pollution tax, what is the tax that achieves the efficient outcome? The tax is equal to the marginal external cost at the efficient quantity, which is $50 per ton of pesticide.

Use the following table to work Problems 17 to 19. The first two columns of the table show the demand schedule for electricity from a coalburning utility; the second and third columns show the utility’s cost of producing electricity. The marginal external cost of the pollution created equals the marginal cost. 17. With no government action to control pollution, what is the quantity of electricity produced, the price of electricity, and the marginal external cost of the pollution generated?

Price (cents per kilowatt) 4 8 12 16 20

Quantity demanded (kilowatts per day) 500 400 300 200 100

Marginal cost (cents per kilowatt) 10 8 6 4 2

With no pollution control, the quantity of electricity produced is 400 kilowatts per day, the price of electricity is 8¢ per kilowatt, and the marginal external cost of the pollution generated is 8¢ per kilowatt.

18.

With no government action to control pollution, what is the marginal social cost of the electricity generated and the deadweight loss created? With 400 kilowatts of electricity being produced, the marginal social cost is 16¢ per kilowatt. To calculate the deadweight loss, it is necessary to determine the efficient quantity of electricity. That quantity is 300 kilowatts per day because that is the quantity at which the marginal social cost, 12¢ per kilowatt, equals the marginal social benefit (the price from the demand curve, also 12¢). The deadweight loss then equals the area of the triangle with a base equal to the difference between the efficient quantity and the equilibrium quantity, 100 kilowatts, and a height equal to the marginal external cost at the equilibrium quantity, 8¢ per kilowatt. The deadweight loss equals ½ × 100 kilowatts per day× 8¢ per kilowatt, which is $4 per day.

19.

If the government levies a pollution tax such that the utility produces the efficient quantity, what is the price of electricity, the tax levied, and the government’s tax revenue per day? The tax will equal the amount of the marginal external cost at the efficient quantity, 6¢ per kilowatt. The quantity of electricity generated is 300 kilowatts per day and the price of electricity is 12¢ per kilowatt. The government collects as revenue 6¢ per kilowatt × 300 kilowatts per day, which is $18 per day.

20.

More Shippers and Shipping Companies Promise to Avoid Arctic Routes As the Arctic ice melts, shipping companies are discovering a new route from the Atlantic to the Pacific. Environmentalists want to stop all shipping through the Arctic. Many companies © 2023 Pearson Education, Inc.

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have agreed, but the Russians need to join the group. Source: cbc.ca, January 13, 2020 a. What characteristics of the Arctic Ocean make it a common resource? Because no one owns the Arctic Ocean, it is nonexcludable—everyone is free to use it as desired. Furthermore, it is rival because as shippers create pollution there, other shippers have a more polluted environment. Consequently, when someone uses the Arctic Ocean as a shipping route and perhaps dumps waste in the ocean or creates greenhouse emissions in the Arctic, they do not pay all of the costs of their actions. Because the people dumping waste and creating greenhouse gas emissions do not pay all the costs of their actions, they have the incentive to overuse the ocean. The external costs of dumping waste or emitting greenhouse gases mean that the ocean is being used unsustainably.

b. Is zero shipping through the Arctic the best solution to this tragedy of the commons? Zero shipping is likely not the best solution because there is some shipping for which the marginal social benefit exceeds the marginal social cost.

Use Figure 17.6 to work Problems 21 to 23. A spring runs under a village. Everyone can sink a well on her or his land and take water from the spring. Figure 17.6 shows the marginal social benefit of and the marginal cost of taking water. 21.

What is the quantity of water taken and what is the private cost of the water taken? With no government intervention, the quantity of water taken is 400 gallons per day, determined in the figure by where the marginal social benefit and the marginal private cost curves intersect. The marginal private cost of this quantity of water is 20¢ per gallon.

22.

What is the efficient quantity of water taken and the marginal social cost at the efficient quantity? The efficient quantity of water taken is 200 gallons per day, determined in the figure by where the marginal social benefit and the marginal social cost curves intersect. The marginal social cost of this quantity of water is 30¢ per gallon.

23.

If the village council sets a quota on the total amount of water such that the spring is used efficiently, what would be the quota and the market value of the water taken per day? The quota would be set at 200 gallons per day. This quantity of water would sell for a price of 30¢ per gallon, so the market value of this quantity of water is 200 gallons × 30¢ per gallon, which is $60.

24.

If hikers and other visitors were required to pay a fee to use the Appalachian Trail, a. Would the use of this common resource be more efficient? The Appalachian Trail, or AT, is a common resource because it is nonexcludable and rival. As those who have hiked the AT know, this resource is over utilized; the natural beauty is adversely affected by the number of hikers. If there was a fee to hike the trail, its use would be more efficient

b. Would it be even more efficient if the most popular spots along the trail had the highest prices? It would be even more efficient if the fee to use the trail was higher in more popular areas, such as Annapolis Rock, because these areas are even more over-utilized than the less popular areas.

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c. Why do you think we don’t see more market solutions to the tragedy of the commons? It is probably the case that fees are not imposed because politicians resist imposing fees that their constituents must pay on goods and services that had previously been “free.”

Use the following data to work Problems 25 to 28. The table shows the demand for college education. The marginal cost of educating a student is a constant $4,000 a year and education creates an external benefit of a constant $2,000 per student per year. 25.

If all colleges are private and the market for education is competitive, calculate the number of students, the tuition, and the deadweight loss.

Price (dollars per student) 6,000 5,000 4,000 3,000 2,000

Quantity (students per year) 10,000 20,000 30,000 40,000 50,000

The equilibrium number of students will be 30,000 and the tuition will be $4,000. To calculate the deadweight loss, Figure 17.7 is helpful. The efficient quantity of students is 50,000. Therefore, the deadweight loss is equal to the area of the grey triangle in the figure, which is $20 million.

26.

If all colleges are public colleges, calculate the tuition that will achieve the efficient number of students. How much will taxpayers have to pay? The efficient quantity of students is 50,000. To have 50,000 students attending college, the tuition must be $2,000. The marginal cost of educating a student is $4,000 so taxpayers must pay $2,000 per student. The total amount paid by taxpayers equals $2,000 per student × 50,000 students, which is $100 million.

27.

If the government decides to subsidize private colleges, what subsidy will achieve the efficient number of college students? The subsidy must equal to the marginal external benefit at the efficient quantity, or $2,000 per student,

28.

If all colleges are private and the government offers vouchers to those who enroll at a college, calculate the value of the voucher that will achieve the efficient number of students. The subsidy must equal to the marginal external benefit at the efficient quantity, or $2,000 per student,

Economics in the News 29. After you have studied Economics in the News on pp. 414–415, answer the following questions: a. What are the marginal private benefits and marginal private costs of using carbon-free resources to generate electricity? The marginal private benefits from using carbon-free resources are the same as that from using other carbon-emitting resources, namely the marginal private benefits from electricity. The marginal private cost of using carbon-free resources is the cost paid by the utilities for these resources.

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to generate electricity? The marginal social benefits from using carbon-free resources are the same as that from using carbonemitting resources, namely the marginal social benefits from electricity. The marginal social cost of using carbon-free resources is the marginal private cost of the fuel (the price paid by the utilities for the fuel) plus the marginal external cost from the (smaller amount of) carbon dioxide emitted.

c. How will a carbon tax or pricing scheme change the price that households pay for electricity? A carbon tax or pricing scheme will raise the price that households pay for electricity.

d. How will a carbon tax or pricing scheme change the efficiency of electricity production? A carbon tax or pricing scheme will increase the efficiency of electricity production. Currently burning fossil fuels creates an external cost that is not paid by the power utilities and the ultimate users. The external cost creates a deadweight loss. A carbon tax or pricing scheme will raise the price of fossil fuels, which decreases the amount of them utilities use to produce electricity and also decreases the likelihood plants using fossil fuels will be built or repaired, all of which decrease the deadweight loss.

30.

Bill Aims to Ban Single-Serving Plastic Water Bottles in Maine Members of Maine’s legislature want to ban disposable plastic water bottles that contain one liter of water or less. There is also a move to ban plastic straws, stirrers, and lids. Plastic bags were banned in April 2020. Source: wgme.com, March 19, 2021 a. What is the externality that arises from drinking bottled water? Littering used plastic bottles could be an externality from drinking bottled water. Additionally, if the production of the plastic bottles creates pollution or accumulates in landfills, this could be another externality from drinking bottled water.

b. What methods other than a ban are available for dealing with the bottled-water externality? Bottled water could be taxed. Alternatively, the government could require users to recycle their bottles.

c. Is it likely that banning bottled water is efficient? Explain your answer. Banning bottled water would not be efficient. There are instances when water has a very high marginal benefit, for example, thirsty tourists or thirsty outdoor workers. Neither of these groups has easy access to tap water, so the marginal cost of using tap water for them is quite high. The marginal cost of bottled water, however, is much lower, so that it would be efficient for these people to drink bottled water.

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MARKETS FOR FACTORS OF PRODUCTION

Answers to the Review Quizzes Page 424 1.

What are the factors of production and their prices? The factors of production and their prices are: labor, which is paid a wage rate for labor services; capital, which is paid a rental rate for capital services; land, which is paid a rental rate for land services; and entrepreneurship, which receives a profit or bears a loss that results from business decisions.

What is the distinction between capital and the services of capital? Capital is the actual tools, instruments, machines, buildings, and constructions that have been produced in the past and that businesses now use to produce goods and services. Capital services are the services of the unit of capital. For example, a copy machine at a local Quik Print is capital but the copying performed by the machine is the service of that particular unit of capital.

What is the distinction between the price of capital equipment and the rental rate of capital? The price of a unit of capital is how much must be paid to acquire the piece of capital equipment. The rental rate of capital is the amount that must be paid to use the unit of capital equipment. For instance, the copy machine at the local Quik Print has a price of $10,000 but its services can be rented from the Quik Print for $50 per hour.

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What is the value of marginal product of labor? The value of marginal product of labor is the value to the firm of hiring one more unit of labor. The value of marginal product of labor, VMP, is the change in total revenue from employing an additional unit of labor.

What is the relationship between the value of marginal product of labor and the marginal product of labor? VMP is equal to the price of a unit of the output, P, multiplied by the marginal product of labor, MP. So VMP = P  MP.

How is the demand for labor derived from the value of marginal product of labor? The demand for labor is determined by the value of marginal product of labor. To maximize its profit a firm hires the number of workers that sets the wage rate equal to the value of marginal product of labor. When the wage rate changes, the firm changes the quantity of labor it demands so that the (new) wage rate equals the value of marginal product. Consequently, when the wage rate changes, the firm moves along its value of marginal product of labor curve to determine the quantity of labor demanded, thereby making its value of marginal product of labor curve its demand for labor curve.

What are the influences on the demand for labor? Factors that influence the demand for labor are the wage rate, the price of the firm’s output, the prices of other factors of production, and technology. A lower wage rate increases the quantity of labor demanded. A rise in the price of a substitute for labor or a fall in the price of a complement for labor increases the demand for labor. A new technology or new capital that increases the marginal product of labor increases the demand for labor. © 2023 Pearson Education, Inc.

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Page 434 1.

What determines the amount of labor that households plan to supply? When households decide how much labor to provide in the labor market, they compare the market wage rate to the value of the lost leisure that supplying labor would entail. If the market wage rate exceeds the individual’s reservation wage rate, the individual forgoes leisure and supplies labor to the labor market. The quantity of labor the person supplies depends on the wage rate. At most wage rates the substitution effect dominates the income effect so that a person increases the quantity of labor supplied if the wage rate rises. But at high wage rates the income effect dominates the substitution effect so that a person decreases the quantity of labor supplied if the wage rate increases.

How are the wage rate and employment determined in a competitive labor market? In a competitive labor market, the wage rate and employment are determined at the intersection of the demand for labor curve and the supply of labor curve.

How do labor unions influence wage rates? Unions increase their members’ wage rates by increasing the demand for their members’ labor and decreasing the supply of labor. In particular, to increase the demand for their members’ labor, unions: increase the value of marginal product of union members by sponsoring training schemes and apprenticeship programs; encourage import restrictions so that consumers must buy goods and services produced by union members; and, support minimum wage laws to raise the wage of a substitute for their members’ labor. Unions also try to restrict the supply of labor, say by supporting immigration restrictions to decrease the supply of low-skilled labor. By decreasing the supply of low-skilled labor, the wage rate paid low-skilled labor rises, which increases the demand for high-skilled union labor.

What is a monopsony and why is a monopsony able to pay a lower wage rate than a firm in a competitive labor market? A monopsony is a market with a single buyer. A monopsony uses its market power to force down the price it pays for what it buys in a similar way to how a monopoly uses its market power to force upward the price of the good it sells. Compared to a competitive labor market, a monopsony in a labor market hires fewer workers. Because it hires fewer workers, it pays a lower wage rate.

How is the wage rate determined when a union faces a monopsony? When a monopoly seller, such as union, bargains with a monopsony buyer, such as a large firm, the situation is called bilateral monopoly. The wage rate will be lower than the union’s monopoly wage rate and higher than the buyer’s monopsony wage rate. Within this range, the actual wage rate depends on the cost that each party can inflict on the other. Everything else the same, the more cost that one party can inflict on the other, the closer the actual wage rate will be to that party’s desired wage rate.

What is the effect of a minimum wage law in a monopsony labor market? A minimum wage rate can increase employment in a monopsony market. Over a range of employment, a minimum wage can lower the cost of hiring additional workers for a monopsony. In the absence of the minimum wage, the marginal cost of labor, MCL, curve exceeds the wage rate because hiring another worker requires that the firm must boost the pay of all its workers. With a minimum wage, hiring another worker at this wage rate requires that the firm pay this worker the minimum wage but the firm does not raise the wage rate paid its others workers because they, too, are paid the minimum wage. As a result, in this range of employment, a monopsony’s cost of hiring another worker is lower with a minimum wage. The lower cost of hiring workers leads the monopsony to increase its employment.

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What determines demand and supply in rental markets for capital and land? The demand for capital depends on the value of marginal product of capital; the demand for land depends on the value of marginal product of land. The higher the marginal product of capital or land, the greater the demand for capital or land. Additionally the demand for capital depends on the rental rate of capital © 2023 Pearson Education, Inc.

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and the demand for land depends on the rental rate of land. The higher the rental rates, the lower the quantities demanded. The supply of capital depends on the rental rate of capital. The higher the rental rate of capital, the greater is the quantity of capital supplied. The supply of land, however, is perfectly inelastic because its quantity is fixed.

What determines the demand for a nonrenewable natural resource? The demand for a nonrenewable natural resource depends on the resource’s value of marginal product and the expected future price of the resource.

What determines the supply of a nonrenewable natural resource? The supply of a nonrenewable natural resource depends on the total known amount, such as the known oil reserves in the market for oil. It also depends on the scale of current production facilities, which determines the marginal cost of producing the resource. For instance, when more oil wells are sunk, the supply of oil increases. The expected future price also affects the supply. The higher the future expected price, the smaller the present supply of the resource.

What is the market fundamentals price and how might it differ from the equilibrium price? The market fundamentals price is the price determined by the fundamental determinant of demand, the value of marginal product, and the fundamental determinant of supply, the marginal cost of extraction. When people’s expectations of the price differ from the market fundamentals price, then the demand and supply are affected by the expected price. At this point the equilibrium price, determined in part by people’s expectations, differs from the market fundamentals price.

Explain the Hotelling principle. The Hotelling principle is the result that the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate. Only when this situation exists can the market be in equilibrium. For example, if the price is expected to rise more rapidly than the interest rate, supply decreases and demand increases, and the present price rises. Supply will continue to decrease, demand will continue to increase, and the present price will continue to rise until the percentage increase from the present price to the future expected price equals the interest rate. At that point, which is the situation outlined by the Hotelling principle, the market is in equilibrium because supply stops decreasing and demand stops increasing.

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Answers to the Study Plan Problems and Applications 1.

Tim is opening a new online store. He plans to hire two workers at $10 an hour. Tim is also considering buying or leasing some new computers. The purchase price of a computer is $900 and after three years it is worthless. The annual cost of leasing a computer is $450. a. In which factor markets does Tim operate? Tim is operating in the labor market when he hires his workers. Tim also is operating in the capital market when he buys or leases his computers. Tim, himself, is an entrepreneur.

b. What is the price of the capital equipment and the rental rate of capital? The price of the capital equipment—Tim’s computer—is $900. The rental rate of capital is $450.

Use the following data to work Problems 2 to 6. Wanda’s is a fish store that hires students to pack the fish. Students can pack the amounts of fish shown in the table. The fish market is competitive and the price of fish is $1 a pound. The market for packers is competitive and their market wage rate is $12.50 an hour. 2. Calculate the value of marginal product of labor and draw the value of marginal product curve. The value of marginal product equals the marginal product multiplied by price. The value of marginal product when the number of students increases from 4 to 5 is $25, which is the marginal product of 25 pounds of fish multiplied by the price of $1 a pound. The value of marginal products calculated in this problem are plotted midway between the two levels of employment. Figure 18.1 shows the value of marginal product when the number of students increases from 4 to 5 as well as the other value of marginal products.

3. a. Find Wanda’s demand for labor curve. The demand for labor curve is the same as the value of marginal product curve.

b. How many students does Wanda employ? Wanda hires the number of students that makes the value of marginal product equal to the wage rate of $12.50 an hour. Figure 18.1 shows that when Wanda hires 7 students the value of marginal product is $12.50, so Wanda hires 7 students.

Number of students 1 2 3 4 5 6 7 8

Quantity of fish (pounds) 20 50 90 120 145 165 180 190

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Use the following additional information to work Problems 4 and 5. The market price of fish falls to 66¢ a pound, but the packers’ wage rate remains at $12.50 an hour. 4. How does the students’ marginal product change? How does the value of marginal product of labor change? The marginal product does not change. For example, as calculated in problem 2 between 4 and 5 workers the marginal product is still 25 pounds of fish. The value of marginal product decreases. For instance, between 4 and 5 workers, the marginal product is 25 pounds of fish. When Wanda now sells the fish for 66¢, the value of marginal product falls to $16.50, down from $25.00 when the price was $1 a pound.

How does Wanda’s demand for labor change? What happens to the number of students that Wanda employs? Wanda’s demand for labor decreases because her value of marginal product of labor decreases at each quantity of labor and her demand for labor curve shifts leftward. Wanda hires fewer students. At the wage rate of $12.50, the number of students Wanda hires decreases as the demand for labor curve shifts leftward.

At Wanda’s fish store, packers’ wages increase to $17.50 an hour, but the price of fish remains at $1 a pound. a. What happens to the value of marginal product of labor? The value of marginal product does not change. For example, if Wanda hires 4.5 students an hour, the marginal product is 25 pounds of fish, which she sells at $1 a pound. So, just as before in problem 2, the value of marginal product of labor remains at $25.00.

b. What happens to Wanda’s demand for labor curve? Wanda’s demand for labor and her demand for labor curve remain the same because the value of marginal product of labor has not changed.

c. How many students does Wanda employ? Wanda hires fewer students. At the wage rate of $17.50 an hour, Wanda hires the number of students that makes the value of marginal product equal to $17.50 an hour. Wanda now hires 6 students an hour— down from 7 students an hour when the wage rate was $12.50 an hour. The marginal product of 6 students is 17.50 pounds of fish an hour, and Wanda sells this fish for $1 a pound. The value of marginal product is $17.50 an hour.

Use the following news clip to work Problems 7 to 9. Canada Is Giving Their Essential Workers a Pay Raise They “Deserve” Prime Minister Justin Trudeau announced that Canada is raising the wage rate for essential workers. Canada’s healthcare unions welcome the news. Source: cnn.com, May 8, 2020 7. Why do unionized healthcare workers earn a higher wage rate than nonunionized healthcare workers? Unionized healthcare workers might earn a higher wage rate than nonunionized healthcare workers for two reasons. First, unions may be able to successfully limit the supply of the healthcare workers they represent. Second, the represented workers might have a higher value of marginal product than do nonunionized healthcare workers.

Were healthcare workers underpaid prior to the Covid-19 pandemic? Healthcare workers may have thought they were underpaid, but they were paid the equilibrium wage rate before the pandemic. There was neither a shortage nor a surplus of healthcare workers at this wage rate. If they were underpaid, that is, paid less than the equilibrium wage, there would have been a shortage of healthcare workers. © 2023 Pearson Education, Inc.

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What actions could Canada’s healthcare unions take to make the wage increase permanent? Unions can strive to limit the number of new healthcare workers that enter the market. They can also try to increase their members’ value of marginal product, say by offering additional educational possibilities.

10.

Demand for Farmland is Forcing Higher Prices Interest in buying farmland is growing. Farmland prices are up 5 to 15 percent in the last six months and commodity prices are strong. Source: agriculture.com, June 1, 2021 a. What is the relationship between strong commodity prices and the price of farmland? In your answer include a discussion of the demand for and supply of land. Because of strong commodity prices, the demand for farmland has increased. The increase in demand for farm products raised their price. The value of marginal product of farmland equals the marginal product of the land multiplied by the price of the farm products produced. The higher price increased the value of marginal product of farmland and thereby increased the demand for farmland. The supply is perfectly inelastic and has not changed. As commodity prices rise, the demand for farmland increases and, with no change in supply, the price of farmland rises.

b. Use a graph to show why the price of farmland is rising. Figure 18.2 shows the market for farmland. The supply is perfectly inelastic so the supply curve is vertical. Initially, the demand curve was D0 and the price was $2,000 per acre. As commodity prices rose and increase the demand, the new demand curve is D1 and the price rises to $6,000 per acre.

c. Is the supply of farmland perfectly inelastic? The supply of land is perfectly inelastic.

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Answers to Additional Problems and Applications 11.

Venus is opening a tennis school. She plans to hire a marketing graduate to promote and manage the school at $20 an hour. Venus is also considering buying or leasing a new tennis ball machine. The purchase price of the machine is $1,000 and after three years it is worthless. The annual cost of leasing the machine is $500. a. In which factor markets does Venus operate? Venus is operating in the labor market when she hires her marketing graduate and administrator. If she buys or leases a tennis ball machine, Venus is operating in the capital market. Venus, herself, is an entrepreneur.

b. What is the price of the capital equipment and the rental rate of capital? The price of Venus’s capital equipment is $1,000; the rental rate of her capital is $500 per year.

Use the following data to work Problems 12 to 16. Kaiser’s Ice Cream Parlor hires workers to produce milk shakes. The market for milk shakes is perfectly competitive, and the price of a milk shake is $4. The labor market is competitive, and the wage rate is $40 a day. The table shows the workers’ total product schedule. 12. Calculate the value of marginal product of labor and draw the value of marginal product of labor curve. Number of workers

Quantity produced (milk shakes per day)

Number of workers 1 2 3 4 5 6

Quantity produced (milk shakes per day) 7 21 33 43 51 55

Marginal product (milkshakes per worker)

Value of marginal product (dollars per worker)

$56

$48

$40

$32

$16

The value of marginal product equals the marginal product of labor multiplied by the price of the product. The table above presents the marginal product of labor. The price of a milkshake is $4, so the value of marginal product equals the marginal product of labor multiplied by $4, as shown in the table.

13.

Construct Kaiser’s Ice Cream Parlor’s demand for labor curve. Explain how many workers per day Kaiser’s hires. Kaiser’s demand for labor curve is the same as its value of marginal product of labor curve. Using the table in Problem 12, this means that the quantity of labor demanded by Kaiser is 2 workers when the wage rate is $52 an hour; 3 workers when the wage rate is $44 an hour; 4 workers when the wage rate is $36 an hour; and 5 workers when the wage rate is $24 an hour. Kaiser’s hires the quantity of labor at which the VMP equals the wage rate.

14.

If the price of a milkshake rises, explain how: a. The marginal product and the value of marginal product of labor change. The marginal product of labor does not change. For example, if Kaiser’s hires 3.5 students a day, as © 2023 Pearson Education, Inc.

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calculated in problem 12 the marginal product is still 10 milkshakes. The value of marginal product of labor equals price multiplied by the marginal product of labor. If the price rises and the marginal product of labor does not change, then the value of marginal product of labor increases.

b. Kaiser’s Ice Cream Parlor’s demand for labor changes. Will Kaiser’s hire more workers or fewer workers? Kaiser’s demand for labor is the same as its value of marginal product of labor. When the value of marginal product of labor increases, then the demand for labor increases and the demand for labor curve shifts rightward. Kaiser’s hires more workers after the increase in the price of a milkshake.

15.

If the market wage rate rises, but the price of a milkshake remains at $4, what happens to the value of marginal product of labor? Does Kaiser’s employ more workers or fewer workers? Kaiser’s demand for labor is the same as its value of marginal product of labor. Because neither the marginal product of labor nor the price of a milkshake has changed, the value of marginal product of labor does not change so the demand for labor does not change. However, the higher wage rate leads to a movement upward along the demand for labor curve so that Kaiser’s hires fewer workers after the increase in the market wage rate.

16.

Kaiser’s installs a new milkshake machine that increases the labor productivity. If the price of a milkshake remains at $4, does Kaiser’s change the number of workers it hires? Explain. The value of marginal product of labor equals price multiplied by the marginal product of labor. The new machine increases the marginal product of labor, so the value of marginal product of labor increases. Kaiser’s demand for labor is the same as its value of marginal product of labor. When the value of marginal product of labor increases, the demand for labor increases and the demand for labor curve shifts rightward. In response, Kaiser’s hires more workers after the increase in labor productivity.

17.

Bluegrass Distillers Creates Jobs for Lexington Rescue Mission Clients Bluegrass Distillers hired 20 people from the Lexington Rescue Mission to fill hand sanitizer orders. The company switched production from bourbon to hand sanitizer in response to Covid-19. Source: wkyt.com, April 14, 2020 a. What was the effect of the Covid-19 pandemic on the price of hand sanitizer, and how did this influence the market for labor at Bluegrass Distillers? The pandemic increased the demand for hand sanitizer, which thereby raised the price of hand sanitizer. The higher price of hand sanitizer increased the value of marginal product of labor of workers making hand sanitizer, so there was increase in demand for these workers at Bluegrass Distillers.

b. Draw a graph to illustrate your answer to part (a). Figure 18.3 shows the impact in the market for labor at Bluegrass Distillers. The demand for labor increases so the demand for labor curve shifts rightward from D0 to D1. At each wage rate Bluegrass Distillers’ demand for labor increases by 20 workers.

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Use the following news clip to work Problems 18 and 19. Arizona Steelworkers Continue Strike Despite Covid-19 Copper producer Asarco offered its unionized steelworkers a contract that raised worker healthcare premiums, reduced pensions, and denied workers their first salary increase in over a decade. The workers rejected the offer. Source: hcn.org, April 17, 2020 A fact: The employer is offering $24.50 an hour. Union members want $30 an hour. 18. Explain reasons for the wage rate differential between what the employer is offering and what the union members want. Draw a graph to illustrate why the workers rejected the offer. Asarco may provide a large fraction of total employment of steelworkers in the region. Hence Asarco might have monopsony power in the labor market. If Asarco is a monopsonist, it will maximize its profit by hiring the quantity of labor that sets its marginal cost of labor equal to the value of the marginal product and then paying the wage rate necessary to hire this quantity of workers, which is $24.50 an hour. However, Asarco is bargaining with a union, which decreases the supply of labor so the equilibrium wage rate in a competitive labor market with the union supply of labor is $30 an hour. Figure 18.4 shows this situation. In the figure, the monopsonist wage rate is $24.50 an hour whereas the wage rate in the market with the supply of labor curve SU is $30 an hour.

19.

Explain how the union might be able to raise the wage rate. The steelworkers union bargains with Asarco. This situation is a bilateral monopoly: a monopoly seller of labor services (the union) bargains with a monopsony buyer of labor services (Asarco). The wage rate depends on the relative strengths of the two and will lie between the monopsony wage Asarco offers and the wage the union wants. To increase the demand for its workers, and thereby their wage rates, the union might organize training that increases the workers’ value of marginal product.

Use the following news clip to work Problems 20 to 23. A Bitter Brew: For Sri Lanka’s Tea Estate Workers, Fair Wage Is Still Elusive Sri Lanka’s workers want a daily wage rate of 1,000 rupees. In January, trade unions and tea plantations negotiated an increase in the wage rate by 40 percent to 700 rupees a day. Academics say that even 1,000 rupees a day is less than what workers need to live. Source: thehindu.com, October 5, 2019 20.

Assuming that a tea plantation has market power in the market for tea workers, explain how it could use that power in setting the wage rate. Draw a graph to illustrate your answer. The tea plantation can use its market power to act as a monopsony: It hires the quantity of labor that sets the marginal cost of labor equal to the value of marginal product of labor and then pays the minimum wage that enables it to hire this quantity of workers. Consequently, it decreases the wage rate it pays and decreases the number of workers it hires. Figure 18.5 shows the tea plantation’s situation if it has a monopsony in the labor market. The plantation’s labor demand curve is the same as its value of marginal product curve and is labeled D = VMP © 2023 Pearson Education, Inc.

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in the figure. The labor supply curve, S, is upward sloping. The plantation’s marginal cost of labor exceeds the wage rate it pays so the marginal cost of labor curve, labeled MCL, lies above the labor supply curve. The planation’s profit-maximizing quantity of labor is determined at the intersection of the D = VMP curve and the MCL curve and is 50 workers. The tea plantation determines the wage rate from the labor supply curve as the lowest wage rate it can pay and hire its profitmaximizing quantity of labor, which is 700 rupees per day for 50 workers.

21. a. Explain how a tea workers’ union would attempt to counteract the plantation’s wage offer in a bilateral monopoly. In a bilateral monopoly, the wage rate depends on the bargaining strengths of the two negotiators. The tea workers’ union might attempt to increase its bargaining power by threatening a strike at the plantations.

b. Explain how the wage rate would be determined if the market were a bilateral monopoly. The plantation workers’ union will bargain with the tea plantations. This situation is a bilateral monopoly: a monopoly seller of labor services (the union) bargains with a monopsony buyer of labor services (the plantations). In this case the wage rate depends on the relative strengths of the two and will lie between the monopsony wage the plantations offer, 700 rupees a day, and the wage the union wants, 900 rupees a day.

22.

Based upon evidence presented in this news clip, do tea plantations function as a monopsony in labor markets, or is the market for tea workers competitive? Explain. One piece of evidence in the news clip is the point that the plantations raised their wages to 700 rupees a day. If the plantations had significant monopsony power, they probably would not raise their wage so drastically. The large increase in the wage rate indicates that they compete in a competitive labor market. On the other hand, 700 rupees a day remains below the minimum wage rate academics say is necessary to survive. And the tea plantations bargain as one with the union. Both points imply the market is a monopsony.

23.

If the market for tea workers is competitive, explain how a union can influence the wage rate and employment. Draw a graph to illustrate your answer. Figure 18.6 shows the effect a union may have in a competitive labor market. The union decreases the supply of labor, so the supply of labor curve shifts leftward from S0 to S1. The union increases the demand for labor and the demand for labor curve shifts rightward from D0 to D1. The wage rate rises, in the figure from 800 rupees a day to 1,000 rupees a day. If the change in the supply of labor is the same as the change in demand, as shown in the figure, employment does not change, starting at 700 workers and remaining at 700 workers. If the union can increase the demand more than it decreases the © 2023 Pearson Education, Inc.

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supply, then both the wage rate and amount of employment will increase.

24.

New technology has allowed oil to be pumped from much deeper offshore oil fields than before. For example, 28 deep-ocean rigs operate in the deep waters of the Gulf of Mexico. a. What effect do you think deep ocean sources have had on the world oil price? The deep ocean oil fields increased the supply of oil and have kept oil prices from rising higher than they would have otherwise.

b. Who will benefit from drilling for oil in the Gulf of Mexico? Explain your answer. The people benefiting from the new technology are the owners of the oil rigs and the firms selling this oil. Consumers also benefit because the price of oil is lower.

25.

Water is a natural resource that is plentiful in Canada but not plentiful in Arizona. a. If Canadians start to export bulk water to Arizona, what do you predict will be the effect on the price of bulk water? If Canadians export bulk water, the supply of bulk water increases. The increase in the supply lowers the price of bulk water.

b. Will Canada eventually run out of water? Water is a renewable resource in Canada so it will not run out.

c. Do you think the Hotelling Principle applies to Canada’s water? Explain why or why not. The Hotelling Principle does not apply to Canada’s water because the Hotelling Principle applies to nonrenewable natural resources. Canadian water is a renewable resource.

26.

Rising Kentucky Land Prices Make Renting Attractive to Producers Land prices in Kentucky are steadily rising. Cities and towns are experiencing substantial growth. Land close to cities is being eyed for development and as a result it is overvalued as farmland. More and more farmers are renting rather than buying because it is often cheaper to rent. Source: sentinel-echo.com, May 23, 2021 a. Explain why the price of land in Kentucky is rising. Cities are expanding and need land for buildings and factories. Shifting land from farm use to city use increases the marginal product of land and thereby raises the value of marginal product of the land, so the demand for land increases. The increase in the demand for land raises the price of land.

b. Why are farmers making the decision to rent? In your answer include a discussion of present value. Farmers are unwilling to pay the high price to buy the land. Instead they rent because they believe the present value of renting the land for as long as they will use it is less than the price of the land.

c. Draw a graph to illustrate your answer to part (a). Figure 18.7 shows the effect of the increase in the demand for land. The demand curve shifts rightward from D0 to D1. The supply of land is perfectly inelastic at 400,000 acres. The price of an acre of land rises from $2,000 per acre to $5,000 per acre. © 2023 Pearson Education, Inc.

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Economics in the News 27. After you have studied Economics in the News on pp. 440–441, answer the following questions: a. How is the demand for self-employed Uber drivers determined? The demand for self-employed Uber drivers depends on the demand for rides, the Uber technology, and the wage rate paid Uber drivers.

b. How is the demand for regular wage-employed taxi drivers determined? The demand for regular wage-employed taxi drivers is a derived demand based on the demand for taxi rides. The demand for regular wage drivers is the same as the value of marginal product for drivers, so it depends on the marginal product of a driver and the price of a taxi ride.

c. Which of the influences on the demand for self-employed drivers changed when Uber arrived to increase demand? When Uber arrived, its technology better matched Uber rides and people needing a ride, so the demand for self-employed Uber drivers increased as people needing a ride switched from taxi companies to Uber rides.

d. Which of the influences on the demand for wage-employed drivers changed when Uber arrived to decrease demand? When Uber arrived, because its technology better matched rides and people needing a ride, the people needing a ride switched from taxi companies to Uber rides. This substitution decreased the demand for taxi rides and thereby decreased the value of marginal product of regular wage-employed drivers, which lowered the wage paid these drivers.

e. Explain the two possible reasons why a decrease in the demand for wage-employed drivers can result in an increase in their level of employment. The decrease in demand for wage-employed taxi drivers can increase their employment for two potential reasons. First, the supply of these taxi drivers could be backward bending, so the lower wage rate increases the quantity of labor supplied, which will lead to an increase in equilibrium employment. Second, the entrance of Uber, which decreases the demand for wage-employed drivers, also increased awareness of this sort of job, thereby increasing the supply of wage-employed taxi drivers and leading to an increase in equilibrium employment.

Illustrate with a graph the backwardbending supply curve explanation for the fall in the wage rate and increase in employment of wage-employed drivers. Figure 18.8 shows the market for wage-employed taxi drivers when their supply curve is backward bending. In the figure, before Uber enters the market the demand is given by demand curve D0 so that the equilibrium is a wage rate of $18 per hour and 400,000 hours of labor. After Uber enters, the demand curve for wage-employed drivers shifts leftward from D0 to D1. The equilibrium wage rate falls to $12 per hour and the equilibrium employment increases to 500,000 hours per day.

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Keshia is opening a new bookkeeping service. She is considering buying or leasing some new laptop computers. The purchase price of a laptop is $1,500 and after three years it is worthless. The annual lease rate is $550 per laptop. The value of marginal product of one laptop is $700 a year. The value of marginal product of a second laptop is $625 a year. The value of marginal product of a third laptop is $575 a year. And the value of marginal product of a fourth laptop is $500 a year. a. How many laptops will Keshia lease or buy? Keshia will lease or buy 3 laptops. The fourth laptop’s value of marginal product is less than the annual lease rate, so Keisha will never lease the fourth laptop. And the present value of the value of marginal products for the fourth laptop is always less than $1,500 regardless of the interest rate. (The value of marginal products sum to $1,500 when not discounted, so when discounted they must sum to less than $1,500.) Keisha will never rent nor buy the fourth laptop because it is not profitable to do so. For each year the value of marginal product for the third laptop always exceeds the annual lease rate, so leasing that laptop will be profitable. Therefore Keisha will always be willing to lease the third laptop.

b. If the interest rate is 4 percent a year, will Keshia lease or buy her laptops? Keshia compares the present value of leasing the laptops to the price of buying the laptops. When the $550 $550 $550 interest rate is 4 percent, the present value of leasing the laptops is   $1,526. The 1.04 (1.04 ) 2 (1.04 )3 present value of leasing the laptops exceeds the price of buying the laptops, so Keisha buys the laptops.

c. If the interest rate is 6 percent a year, will Keshia lease or buy her laptops? Keshia again compares the present value of leasing the laptops to the price of buying the laptops. When the $550 $550 $550 interest rate is 6 percent, the present value of leasing the laptops is   $1,470. The 2 1.06 (1.06 ) (1.06 )3 present value of leasing the laptops is less than the price of buying the laptops, so Keisha leases the laptops.

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Answers to the Review Quizzes Page 456 1.

Which is distributed more unequally, income or wealth? Why? Which is the better measure? The distribution of wealth is more unequally distributed than income. Wealth is distributed more unequally than income because wealth data do not include the value of human capital, while the income data measure income from all wealth, including human capital. That is why income is a better measure for economic inequality than wealth.

How has the distribution of income changed in the past few decades? From 1970 economic inequality in the United States has increased. The share of income received by the richest quintile (20 percent) of the population has increased and this is the major change in the distribution of income.

What are the main characteristics of high-income and low-income households? There are four major characteristics that influence the amount of income earned by an individual: i) Education: The more education attained by a person the higher the human capital that person has, and the more income that person enjoys; ii) Type of household: Married couples earn more, on average, than single people living alone, especially females living alone; iii) The age of householder: The oldest and youngest households have lower incomes than middle age households; and iv) Race: Individuals living in households headed by an Asian person have the highest incomes, followed by white households, Hispanic households, and then black households.

What is poverty and how does its incidence vary across the races? Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. Poverty is a relative concept. Minorities have historically been over-represented among those households living in poverty in the United States. In particular, 9.1 percent of white households live in poverty while 15.7 percent of Hispanic-origin households and 18.8 percent of black households lived in poverty.

How much mobility through the income quintiles was there during 2007 to 2009? There is some mobility but not a vast amount, particularly in the lowest and highest quintiles. In both these quintiles, about 70 percent of households remained in the same quintile. In the other three quintiles, somewhere between 45 percent and 50 percent of households remained in the same quintile. But there was some mobility. In the bottom four quintiles, about 20 to 30 percent of households moved up a quintile. (It is impossible for a household in the top quintile to move up.) Similarly, in the top four quintiles, about 20 to 25 percent of households moved down a quintile. (It is impossible for a household in the bottom quintile to move down.) A few households also moved up and down by more than one quintile.

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In which countries are incomes distributed most unequally and least unequally? South Africa has the most unequally distributed incomes. Sweden (and some other European nations) has the most equally distributed incomes.

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Which income distribution is more unequal and why: the income distribution in the United States or in the entire world? The world Gini ratio is larger than the U.S. Gini ratio, which means that the distribution of world income is less equally distributed than in the United States. The world income distribution ranges from extremely poor individuals living on less than $1.90 per day to the very wealthy living in the United States and other advanced countries.

How can incomes become more unequally distributed within countries and less unequally distributed across countries? Income within nations generally has become distributed less equally. However because the average income within the poorest nations has been rising more rapidly than average income within richer nations, the world distribution of income has become more equally distributed.

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What role does human capital play in accounting for income inequality? In general acquiring human capital is a costly endeavor so the supply of workers with a lot of human capital is less than the supply of workers with little human capital. The difference in supply means that the more human capital an individual attains, the more income that individual will likely earn, other things remaining the same. Greater variation in human capital across the population of households increases the degree of income inequality among households. While the level of human capital attained varies across households, this factor alone does not completely explain the observed variation in income across households in the United States

What role might discrimination play in accounting for income inequality? If the levels of VMP of labor for a racial group or one sex are perceived to be higher than that of another racial group or the other sex, then the equilibrium wages earned will vary across these groups, despite the fact that the two groups have equal ability. Economists disagree to the extent that discrimination pervades the labor market. One line of reasoning states that those firms that practice race or sex discrimination in the labor market face higher production costs (pay higher wages for the same value of marginal product) than those firms that do not. If this line of reasoning is correct, the profit margins for the firms practicing discrimination will be lower and the market price of their goods and services would be higher than nondiscriminating firms. Either way, the market pressures increase the opportunity cost to firms (and the consumers who buy their goods) for practicing race or sex discrimination, eventually eliminating these practices.

What role might contests among superstars play in accounting for income inequality? Contests can explain why the super-rich have incomes that have increased greatly over the years. With increased globalization, the pool of “contestants” has increased dramatically. With the larger number of conspiracy, each contestant’s probability of winning has shrunk. So contests need to have larger differences in payouts for the winners versus the losers so as to induce larger efforts to win the contest. The result is that the contest winners—be they sports stars, entertainment stars, of CEOs—nowadays have much larger incomes than the vast number of losers.

How might technological change and globalization explain trends in the distribution of income? Technological change and globalization have both changed the distribution of income so that the “rich get richer and the poor get poorer.” More specifically, technological change has increased the demand for high-skilled workers and increased their wage rates and incomes. It also has decreased the demand for lowskilled workers and decreased their wage rates and their income. Globalization also has increased the demand for high-skilled workers and decreased the demand for low-skilled workers in the United States. Globalization has made contests worldwide, so the prizes for the best superstars—be they athletes or business managers—have increased with the increase in the size of the market. © 2023 Pearson Education, Inc.

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Does inherited wealth make the distribution of income less equal or more equal? An inheritance from older to a younger generations can only increase wealth and can never decreases wealth within a family, which helps make the distribution of wealth more unequal over time, all else equal. However if a generation is “lucky” and earns a high income and then passes some of it along as an inheritance to more typical less lucky lower-income generations, then inherited wealth makes the distribution of income more equal.

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How do governments in the United States redistribute income? The governments in the U.S. use three main ways to redistribute income and reduce, to some degree, economic inequality: i) Income taxes: Taxes on household income are charged by the U.S. federal government and by many state governments,; ii) Income maintenance programs: There are three major types of programs that provide direct payments to individuals; and iii) Subsidized services: A great deal of income redistribution takes the form of subsidized services, where people other than those who pay for services consume the services provided.

Describe the scale of redistribution in the United States. In the United States, income redistribution increases the share of total income received by the lowest 60 percent of households and decreases the share of total income received by the highest 40 percent of households. Specifically, the poorest 20 percent of households receive only 3.7 percent of total market income earned in the United States but receive 7.5 percent of income after taxes and benefits. The richest 20 percent of households receive 53.8 percent of total market income earned in the United States but receive only 47.0 percent of income after taxes and benefits.

What is one of the major welfare challenges today and how is it being tackled in the United States? The major welfare challenge is households headed by single mothers The poorest people in the United States are young, minority women who have not completed high school, have one or more dependent children, and live without a spouse. The Temporary Assistance for Needy Families (TANF) program is the current attempt to meet this challenge. TANF is a block grant paid to the states, which administer payments to individuals. It is not open-ended. Adults receiving assistance must work or perform community service. There is a five-year limit for assistance.

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Answers to the Study Plan Problems and Applications 1.

What is money income? Describe the distribution of money income in the United States in 2019. Money income equals market income (wages, interest, rent, and profit earned in factor markets, before paying income taxes) plus cash payments from the government. The distribution of money income in the United States is unequal. While the median household income was $68,703, the poorest 20 percent of household received approximately 3 percent of the total income and the richest 20 percent of household received approximately 52 percent of the total income.

The table shows money income shares in the United States in 2001. Draw a U.S. Lorenz curve in 2001. Was the U.S. distribution of income more equal in 2001 than in 2019 (see p. 447)? Explain your answer. The Lorenz curve is illustrated in Figure 19.1. To draw it, plot the cumulative percentage of households on the x-axis and the cumulative percentage of income on the y-axis. The Lorenz curve will pass through the following points: 20 percent on the x-axis and 3.5 percent on the y-axis; 40 percent on the x-axis and 12.3 percent on the y-axis; 60 percent on the x-axis and 26.8 percent on the y-axis; 80 percent on the x-axis and 49.9 percent on the y-axis; and 100 percent on the xaxis and 100 percent on the y-axis. The Lorenz curve for the U.S. economy in 2001 lies closer to the Line of equality than does the Lorenz curve in 2019, which means the distribution of money income was more equal in 2001. In 2001, the lowest `quintile received a greater percentage of income than in 2019 and the highest quintile received a smaller percentage of income than in 2019.

Households (quintile) Lowest Second Third Fourth Highest

Money income (percentage of total) 3.5 8.8 14.5 23.1 50.1

Incomes in China and India are a small fraction of U.S. income, but incomes in China and India are growing at more than twice the rate of U.S. incomes. a. Explain how economic inequality in China and India is changing relative to that in the United States. Inequality between people in China and India and people in the United States is lessening. Income for the typically poorer people in China and India is increasing more rapidly than income for the typically richer people in the United States, so the fraction of world income going to the people in China and India is growing.

b. How is the world Lorenz curve and world Gini ratio changing? The world Lorenz curve is moving closer to the line of equality and the Gini ratio is falling in value.

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Use the table to work Households United States Canada United Kingdom Problems 4 and 5. The (percentage) (percentage of total income) table shows the income Lowest 20 3 7 3 shares in the United Second 20 8 13 5 States, Canada, and the Middle 20 15 18 14 United Kingdom in 2009. Next highest 20 24 25 25 4. Draw the Lorenz Highest 20 50 37 53 curves for the United States and Canada. In which country was money income less equally distributed in 2009? To draw the Lorenz curve for Canada, it is necessary to calculate the cumulative percentage of households and cumulative percentage of income. The table to the right has these data. Figure 19.2 shows the Lorenz curve for the United States and Canada. Income is distributed less equally in the United States.

Canada Households (quintile) Lowest Second Third Fourth Highest

Cumulative percentage of income 7 20 38 63 100

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Draw the Lorenz curves for the United States and the United Kingdom. In which country was income less equally distributed in 2009? United Kingdom To draw the Lorenz curve for Canada, it is necessary to calculate the cumulative percentage of households Cumulative and cumulative percentage of income. The table to Households percentage of the right has these data. (quintile) income Figure 19.3, shows the Lorenz curve for the United Lowest 3 States and the United Kingdom. Income is distributed Second 8 less equally in the United Kingdom. Third 22 Fourth 47 Highest 100

Figure 19.4 shows the market for low-skilled labor. The value of marginal product of highskilled workers is $16 an hour greater than that of low-skilled workers at each quantity of labor. The cost of acquiring human capital adds $12 an hour to the wage that must be offered to attract high-skilled labor. Compare the equilibrium wage rates of lowskilled labor and high-skilled labor. Explain why the difference between these wage rates equals the cost of acquiring human capital. The wage rate adjusts to make the quantity of labor demanded equal to the quantity supplied. Figure 19.4 shows that the wage rate of lowskilled labor is $12 an hour. The value of marginal product of high-skilled labor at each employment level is $16 greater than the value of marginal product of low-skilled labor, so firms are willing to pay high-skilled labor a higher wage rate than © 2023 Pearson Education, Inc.

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they are willing to pay low-skilled labor. For example, the demand curve for low-skilled labor tells us that firms are willing to hire 4,000 hours of low-skilled labor at a wage rate of $8 an hour. Because the value of marginal product of high-skilled labor is $16 greater than the value of low-skilled labor, firms are willing to hire 4,000 hours of high-skilled labor at a wage rate of $24 an hour. The demand curve for high-skilled labor lies above the demand curve for low-skilled labor such that at each quantity of labor the wage rate paid high-skilled labor is $16 greater than that paid low-skilled labor. The supply curve of high-skilled labor lies above the supply curve of low-skilled labor such that the vertical distance between the two supply curves equals the cost of acquiring the human capital—$12 an hour. That is, high-skilled labor will supply any amount of labor a day if the wage rate is $24 an hour. Equilibrium in the labor market for high-skilled labor occurs at a wage rate of $24 an hour. The wage rate increases by exactly the cost of acquiring the skill because the supply of labor is perfectly elastic. High-skilled labor is willing to supply any amount of labor at a wage rate of $24 an hour. They will supply no labor at wage rates below $24 an hour.

Use the table to work Problems 7 and 8. The table shows three redistribution schemes. 7.

Which scheme has (i) a proportional tax? (ii) a regressive tax? (iii) a progressive tax?

Before-tax income (dollars) 10,000 20,000 30,000

Plan A tax (dollars) 1,000 2,000 3,000

Plan B tax (dollars) 1,000 4,000 9,000

Plan C tax (dollars) 2,000 2,000 2,000

Tax Plan A is a proportional tax. At each level of income, 10 percent of income is paid in taxes. Tax Plan C is regressive. When income is $10,000, 20 percent of income is paid in taxes; when income is $20,000, 10 percent of income is paid in taxes; and, when income is $30,000, 6.67 percent of income is paid in taxes. Tax Plan B is progressive. When income is $10,000, 10 percent of income is paid in taxes; when income is $20,000, 20 percent of income is paid in taxes; and, when income is $30,000, 30 percent of income is paid in taxes.

Which scheme will (i) increase economic inequality? (ii) reduce economic inequality? (iii) have no effect on economic inequality? Tax Plan C increases inequality. The poor pay 20 percent of their income as tax while the rich pay only 6.7 percent. Tax Plan B decreases inequality. The poor pay only 10 percent of their income as tax while the rich pay 30 percent. Tax Plan A has no effect on inequality because all income groups pay 10 percent of their income as tax.

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Answers to Additional Problems and Applications Use the table to work Problems 9 and 10. The table shows the distribution of market income in the United States in 2007. 9. a. What is the definition of market income? Market income is the before-tax income earned by factors of production in the marketplace. Labor earns wages, capital earns interest, land earns rent, and entrepreneurship earns profit.

Households (quintile) Lowest Second Third Fourth Highest

Market income (percentage of total) 1.1 7.1 13.9 22.8 55.1

b. Draw the Lorenz curve for the distribution of market income. Figure 19.5 shows the distribution of market income. To draw this Lorenz curve, plot the cumulative percentage of households on the xaxis and the cumulative percentage of market income on the y-axis. Make the scale on the two axes the same. The Lorenz curve will pass through the following points: 20 percent on the x-axis and 1.1 percent on the y-axis; 40 percent on the x-axis and 8.2 percent on the y-axis; 60 percent on the x-axis and 22.1 percent on the yaxis; 80 percent on the x-axis and 44.9 percent on the y-axis; and 100 percent on the x-axis and 100 percent on the y-axis.

10.

Compare the distribution of market income with the distribution of money income shown in Fig. 19.3 on p. 451. Which distribution is more unequal and why? U.S. money income is distributed more equally than market income. The Lorenz curve for money income in 2019 lies closer to the line of equality than does the Lorenz curve for U.S. market income. Money income is distributed more equally than market income because money income includes cash payments to poor households, which increases their money income, and subtracts tax payments from rich incomes, which decreases their money income.

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Use the table to work Problems 11 to 13. The table shows shares of income in Australia. 11. Draw the Lorenz curve for the income distribution in Australia and in South Africa (use the data in Fig. 19.6 on p. 457). Is income distributed more equally or less equally in South Africa than in Australia? Figure 19.6 shows these Lorenz curves. Income is distributed less equally in South Africa.

12.

Households (quintile) Lowest Second Third Fourth Highest

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Market income (percent of total) 7 13 18 24 38

Is the Gini ratio for Australia larger or smaller than that for South Africa? Explain your answer. The Gini ratio is the ratio of the area under the line of equality and above the Lorenz curve to the area under the line of equality. Figure 19.6 shows that the Gini ratio smaller in Australia, which means that the distribution of income is more equally distributed in Australia.

13.

What are some reasons for the differences in the distribution of income in Australia and in South Africa? In South Africa there are wealthy citizens descended from European settlers and poorer citizens descended from large indigenous native populations. The income disparity between these two relatively large groups creates an unequal distribution of income in South Africa. In Australia the indigenous native population is smaller, so the population is comprised mainly of citizens descended from European settlers. Because there is not a large pool of low-income indigenous natives, the distribution of income is more equal in Australia.

14.

Figure 19.7 shows the market for a group of workers who are discriminated against. Suppose that other workers in the same industry are not discriminated against and their value of marginal product is perceived to be twice that of the workers who are discriminated against. Suppose also that the supply of these other workers is 2,000 hours per day less at each wage rate. a. What is the wage rate of the workers who are discriminated against? The wage rate of workers who are discriminated against is $10 an hour.

b. For workers who are discriminated against, what quantity of labor is employed? Firms employ 5,000 hours of labor per day from workers facing discrimination.

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not face discrimination? Because the value of marginal product of workers not facing discrimination is perceived to be twice the value of marginal product of the other workers, firms are willing to pay the workers not facing discrimination twice the wage rate that they are willing to pay the workers who face discrimination. For example, the demand curve for the workers being discriminated against tells us that firms are willing to hire 6,000 hours of these workers at a wage rate of $8 an hour. So with workers not facing discrimination perceived to be twice as productive as the other workers, firms are willing to hire 6,000 hours of labor from the non-discriminated group at $16 an hour. The demand curve for labor for the workers not facing discrimination lies above the demand curve for workers facing discrimination such that at each quantity of workers the wage rate for workers not facing discrimination is double that of workers facing discrimination. The supply curve of workers not facing discrimination lies to the left of the supply curve of workers facing discrimination by 2,000 hours of labor. The vertical distance between the two supply curves is $4 an hour. That is, workers not facing discrimination will supply 6,000 hours a day if the wage rate is $16 an hour. The equilibrium wage rate of workers who do not face discrimination is $16 an hour.

d. For workers who do not face discrimination, what quantity of labor is employed? Firms employ 6,000 hours of labor per day from workers not facing discrimination.

15.

Statement from President Joe Biden Closing the gender pay gap is more than just an economic imperative—it’s a moral imperative. For every dollar a White man earns, an AAPI women earns 87 cents. For Black women, it’s 63 cents. For Native American women, it’s 60 cents. And for Hispanic women, it’s 55 cents. Those gaps are an affront to our values as a nation. Source: whitehouse.gov, April 15, 2021 a. Explain why the gender pay gap might be caused by discrimination and why it might not be caused by discrimination. The pay gap might be caused by discrimination against women. This discrimination could reflect either paying women less than men in comparable positions or by hiring men for higher-pay positions rather than comparably qualified women. The pay gap might also not be caused by discrimination. For the highpaying positions, there may be few suitably qualified women, so men fill more of the high-paying positions than do women.

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b. Draw a graph to illustrate how discrimination can result in female workers getting paid less than male workers for some jobs. Figure 19.8 shows a labor market in which women are discriminated against in favor of men. With the discrimination, the value of marginal product of men exceeds that of women. As a result, the value of marginal product curve for males, labeled VMPM, lies above the value of marginal product curve for females, labeled VMPF. In the figure the supply of male labor is the same as that of females, so the supply curve is labeled SM = SF. The figure shows that the wage rate paid men, $100,000 per year, exceeds the wage rate paid women, $80,000 per year.

Use the following data to work Problems 16 and 17. In 2016, 12.8 million Americans had management jobs that paid an average of $71,240 a year while 1.8 million Americans had retail sales jobs that paid an average of $32,400 a year. Managers require a high school certificate while retail sales people don’t but they undergo training. Source: Bureau of Labor Statistics 16.

Explain why managers are paid more than retail salespeople. Managers have more human capital than retail salespeople. Their higher human capital means that their value of marginal product is higher, so the demand for managers exceeds that of retail salespeople. Additionally the cost of acquiring their human capital means that the supply of managers is less than the supply of retail salespeople. The higher demand for managers combined with the lower supply of managers means that their salaries exceed those of retail salespeople.

17.

If the online shopping trend continues, how do you think the market for salespeople will change in coming years? Shopping on-line decreases the demand for in-person salespeople. If on-line shopping continues to increase in importance, the decrease in demand for salespeople will lower the salary and decrease the quantity of salespeople. If, in response to the lower salary, the supply of salespeople also decreases, then the employment definitely decreases but the effect on the salary becomes ambiguous.

18.

Use the information provided in Problem 9 and in Fig. 19.3 on p. 451. a. What is the percentage of total income that is redistributed from the highest income group? The highest income group receives 55.1 percent of total market income and 51.8 percent of total money income. So redistribution lowers the highest income group’s share by 3.3 percent of total income.

b. What percentages of total income are redistributed to the lower income groups? The lowest income group receives 1.1 percent of market income and 3.1 percent of total money income. So redistribution raises the lowest income group’s share by 2.0 percent of total income. Redistribution raises the second lowest income group’s share by 1.2 percent, the middle income group by 0.2 percent, and the second highest income group by 0.1 percent. © 2023 Pearson Education, Inc.

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Describe the effects of increasing the amount of income redistribution in the United States to the point at which the lowest income group receives 15 percent of total income and the highest income group receives 30 percent of total income. If the highest income group’s share falls from 55.1 to 30 percent of total income, redistribution takes 25.1 percent of income from this group. If the lowest income group’s share rises from 1.1 to 15 percent, redistribution raises this group’s share by 13.9 percent of total income. The other 11.2 percent (25.1 minus 13.9 percent) would be distributed to other groups. This redistribution scheme would require a tax on the highest groups of 45.5 percent— (25.1/55.1)  100 percent. Such a large increase in the tax rate and redistribution might create the big tradeoff effect. The highly taxed people might choose to do less work and if they do, total income decreases.

Use the following news clip to work Problems 20 and21. Biden Budget Shows Focus on Wealth Redistribution President Biden wants to reverse the widening racial income and wealth gaps. The Biden budget includes funding for early childcare and colleges, and investment in minority-owned businesses. These expenditures will be funded by an additional tax of $1.5 trillion on wealthy American households. Source: Bloomberg.com, May 28, 2021 20. How would the changes cited in the news clip change the distribution of income across the quintiles and how would the Lorenz curve change? The distribution of income would change so that the highest quintile would have a smaller percentage of the total income and the lower quintiles would have larger percentages. The Lorenz curve would shift closer to the line of equality.

21.

How would the changes cited in the news clip change the U.S. Gini ratio? Because the distribution of income would become more equal, the Gini ratio falls in size.

Economics in the News 22. After you have studied Economics in the News on pp. 466–467, answer the following questions. a. What information in the news article is consistent with the view that Covid-19 restrictions brought increased inequality? One consistent bit of information in the article is that richer Americans regained jobs more rapidly than poorer Americans, such as “racial minorities, women, lower earners, those without college degrees, and workers in the service economy” where the financial pain was harshest. Another consistent bit of information is that nearly 8 million people fell into poverty between June and November 2020.

b. If college tuition was free and more people got degrees in computer programming, how would the wage gap between programmers and retail sales clerks change? The supply of computer programmers would increase, which lowers the wage paid programmers. The wage gap between computer programmers and retail-sales clerks would shrink.

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c. Draw a graph to illustrate your answer to (b). In Figure 19.9, the supply of computer programmers increases so that the supply curve shifts rightward from S0 to S1. The increase in the supply lowers the wage rate from $80,000 per year to $60,000. The decrease in the wage paid programmers decreases the wage gap between computer programmers and retail clerks.

23.

Average Salary by Education Level Is the increase in pay worth the time, effort, and money spent earning your college degree? The answer is yes! Median weekly earnings without a high school diploma are $592, with a high school diploma, $746, with a bachelor’s degree, $1,248, with a master’s degree, $1,497, and with a doctorate or professional degree, $1,861. Source: northeastern.edu, June 2, 2020 a. Why do people with different levels of education have different salaries? The differences in salaries are the result of differences in the demand for and supply of people with different levels of education. Different levels of education create different skill sets and different amounts of human capital. These differences mean that the value of marginal product and therefore the demand for people with the more education can be substantially different than those with less. In addition different numbers of workers receive more education because some acquiring more education is costly in terms of time and/or effort. This difference means that the supply of people with the more education will be less than those with less education.

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b. Draw a graph of the labor markets for people with a professional degree and for people who don’t have a high school diploma to illustrate your explanation of the differences in the salaries of these two groups. Workers with professional degrees (more education) have more human capital and more marketable skills than do drop-out workers who do not have a high school diploma (less education), so the demand for professional degree workers is greater than the demand for workers without a high school degree. Additionally, it is significantly more costly to obtain a professional degree than to drop out of high school, so the supply of workers with a professional degree is less than that of those without a high-school diploma. Both these differences are illustrated in Figure 19.10. In the figure the demand curve for professional degree holders is labeled DPROF and lies to the right of the demand curve for high-school dropouts, labeled DHIGH SCH. Also in the figure is the supply curve of high-school dropouts, labeled SHIGH SCH, which lies to the right of the supply curve of professional degree holders, labeled SPROF. These different demand and supply curves result in an annual salary for professional degree holders of $90,000 and for high-school dropouts of $30,000.

24.

It Would Take a Typical Worker 169 Years to Amass a CEO’s Salary A typical CEO at one of the biggest U.S. companies earned $12.3 million last year. It would take two lifetimes for the typical employee to earn what their CEO did in one year. Lisa Su of Advanced Micro Devices, who earned $58.5 million, topped the list. Source: cbsnews.com, May 27, 2020 a. Why are CEOs paid so much more than their workers? Compared to their workers, because they control the entire company CEOs have a significantly higher value of marginal product, so the demand for CEOs is greater than the demand for their workers. The supply of CEOs is smaller than the supply of their workers because the skills of CEOs are costlier to acquire than the skills of their workers. Because the demand for CEOs is greater and the supply of CEOs is smaller than their workers, CEOs are paid much more than their workers.

b. As globalization has increased the CEO talent pool, how do you think the world Gini ratio might have changed? The competition for CEO positions has dramatically increased the salaries the all-ready highly-paid CEOs receive and consequently increased the size of the world Gini ratio

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Answers to the Review Quizzes Page 476 1.

What is the distinction between expected wealth and expected utility? Expected wealth is the money value of what a person expects to own at a point in time. Expected utility is the utility value of what a person expects to own at a point in time. These concepts both measure the value of what a person expects to own at a point in time but they differ because expected wealth is the money value and expected utility is the utility value.

How does the concept of utility of wealth capture the idea that pain of loss exceeds the pleasure of gain? The utility of wealth has diminishing marginal utility. Diminishing marginal utility means that the decrease in utility from a dollar decrease in wealth, that is, the pain of loss, is greater than the increase in utility from a dollar increase in wealth, that is, the pleasure of gain.

What do people try to achieve when they make a decision under uncertainty? When making decisions under uncertainty people maximize their expected utility.

How is the cost of risk calculated when making a decision with an uncertain outcome? A decision made with uncertainty has an expected wealth and an expected utility that depend on the probability, wealth, and utility associated with the different outcomes. Because people are risk averse, the amount of certain wealth that creates the utility equal to the expected utility in the uncertain case is less than the expected wealth in the uncertain case. The difference between the expected wealth in the uncertain case and the certain wealth that creates the same level of utility is the cost of risk.

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How does insurance reduce risk? Insurance reduces the risk any individual faces because insurance pools risks. Everyone pays into the pool but only the small fraction of people who suffer a loss are paid from the pool. Essentially people reduce the risk of a large adverse financial outcome in exchange for the small, certain payment to the insurance company.

How do we determine the value (willingness to pay) for insurance? The amount that someone would be willing to pay to avoid risk is measured using the person’s utility of wealth schedule or curve. The important feature of the curve is that the marginal utility of wealth diminishes as wealth increases. The rate at which the marginal utility of wealth declines determines the degree of the individual’s risk aversion, that is, how much he or she is willing to pay to avoid risk. Suppose a person faces the risky situation of receiving wealth of W1 (with utility of U 1 ) or a smaller amount, W2 (with utility of U 2 ). The expected wealth from this situation is EW, and the expected utility is EU. This risky situation has the same utility as receiving some amount of certain wealth, W. The difference in wealth between the risky high level of wealth and the sure case, W1 – W, measures the value © 2023 Pearson Education, Inc.

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of insurance in this situation to this individual. The more rapidly the marginal utility of wealth declines, the more risk averse is the person because the more wealth the individual is willing to give up to guarantee a certain (albeit lower) amount of wealth. That is, the more concave the utility of wealth curve, the less is the certain wealth that has the same utility as the expected utility from an uncertain, risky outcome.

How can an insurance company offer people a deal worth taking? Why do both the buyers and the sellers of insurance gain? Insurance companies work by pooling risks so that everyone pays into the pool but only the (small) fraction of people who suffer a loss are paid from the pool. Although the likelihood of a bad occurrence is small for each individual, for a large enough group the total number and total amount of losses can be estimated very closely. The insurance company can calculate the size of the pool required to cover losses. From this calculation the company can compute the amount of the premium each person must pay into the pool to cover all the anticipated losses and other costs the company incurs. People buy insurance because they are risk averse; they want to avoid unwanted outcomes. Insurance is worth buying because people are willing to give up a relatively small amount of income all the time to guarantee that they do not face the uncommon occurrence of having to give up a large amount of income since this deal increases their expected utility. An insurance company will always try to take in more in premiums paid than claims paid out to claimants so that their owners receive at minimum a normal profit.

What kinds of risks can’t be insured? Insurance works because the risks of adverse outcomes are independent, that is, one person suffering a loss does not affect the likelihood that other people will suffer similar losses. If the losses from an event are not independent, so that “everyone” suffers a loss at the same time, then the risk of loss cannot be insured.

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How does private information create adverse selection and moral hazard? Both moral hazard and adverse selection are the result of private information. Moral hazard occurs when, after an agreement has been reached, one of the parties to the agreement has the incentive to gain additional benefits at the expense of the other party. Adverse selection refers to people who accept certain contracts and have private information that allows them to benefit from the contract while harming the other party. Both moral hazard and adverse selection can affect negatively the way in which markets function.

How do markets for cars use warranties to cope with private information? Warranties serve to limit the adverse selection and moral hazard problems in the market for cars. Essentially, warranties (and guarantees in general) are signals provided to potential buyers that the product under consideration has been examined by experts and is a high-quality item. Without the existence of these signals, the lemon problem, whereby only low-quality products are offered for sale, may occur because buyers realize that all sellers claim that they are selling high-quality goods but that adverse selection implies that the goods sold are of low quality.

How do markets for loans use signaling and screening to cope with private information? Lenders in the loans market want to separate high-risk borrowers from low-risk borrowers so that they can charge high-risk borrowers a high interest rate and low-risk borrowers a low interest rate. They use signals and screens to help them do so. They screen borrowers by asking for information that helps them assess the riskiness of the loan and the borrower. If the borrower does not reveal the information requested, the lender has screened the borrower into the high-risk category. The information requested will provide signals about the borrower’s riskiness. For instance, if a borrower has defaulted on debt in the past this fact signals that the borrower is a high-risk individual.

How do markets for insurance use no-claim bonuses to cope with private information? “No-claim” bonuses are commonly used in auto insurance. One of the most important pieces of information a person can give an auto insurance company is his or her propensity to drive safely and avoid accidents. However, this information is only believable to the extent that driving records really do © 2023 Pearson Education, Inc.

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differentiate good drivers from bad drivers. Driving records cover only a short period of time and, randomly, some bad drivers will establish good records. So a good driving record is not a guarantee that the driver is a safe driver. The screening device that insurance companies use to overcome this potential problem is the “no-claim” bonuses that drivers accumulate when they do not make an insurance claim. Presumably, having not made a claim means that you were a good driver and did not need to make a claim!

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Thinking about information as a good, what determines the information people are willing to pay for? People are willing to pay for information so long as the marginal cost is less than or equal to its marginal benefit. For instance, consumers are willing to purchase information that has a marginal benefit to them that exceeds the price they must pay. Consumers might be willing to purchase information about the price(s) of large-ticket goods and services that are of interest. Workers might well be interested in buying information about salaries paid in occupations that interest them or salaries paid their co-workers. Employers are willing to buy information about the average salary offer given to college graduates with different majors.

Why is it inefficient to be overinformed? Information is costly to obtain. If the marginal cost of obtaining the information exceeds its marginal benefit, the individual would be better off by not obtaining the information. It is inefficient to acquire the information because the marginal benefit from the information does not make up for the marginal cost of obtaining it.

Why are some of the markets that provide information likely to be dominated by monopolies? Objective information about, say, the quality of a good or service or the risk associated with a particular activity is costly to obtain. Once it is obtained, however, the marginal cost of disseminating it is low. With the low marginal cost, the firm can enjoy significant economies of scale, so these markets might be close to natural monopolies, that is, a market in which one firm can meet the demand at lower cost than could two or more firms.

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Answers to the Study Plan Problems and Applications 1.

The figure shows Lee’s utility of wealth curve. Lee is offered a job as a salesperson in which there is a 50 percent chance that she will make $4,000 a month and a 50 percent chance that she will make nothing. a. What is Lee’s expected income from taking this job?

Lee’s expected income is (0.5  $4,000) + (0.5  $0) = $2,000 a month.

b. What is Lee’s expected utility from taking this job? When Lee’s income is $4,000, her utility is 100. When Lee’s income is $0, her utility is 0. So Lee’s expected utility is (0.5  100) + (0.5  0) = 50.

c. How much would another firm have to offer Lee with certainty to persuade her not to take the risky sales job? Lee would have to be offered about $1,250 a month with certainty to persuade her not to take the risky job. Lee would have to be offered the income that would give her with certainty 50 units of utility. This income, $1,250, is read from the graph at the 50 units on the y-axis.

d. What is Lee’s cost of risk? Lee’s cost of risk is the difference between Lee’s expected income, $2,000, and the certain income that gives her the same total utility, $1,250. Lee’s cost of risk is $750.

Use the following data to work Problems 2 and 3. Larry lives in a neighborhood in which 20 percent of the cars are stolen every year. Larry’s car, which he parks on the street overnight, is worth $20,000. (This is Larry’s only wealth.) The table shows Larry’s utility of wealth schedule. 2. If Larry cannot buy auto theft insurance, what is his expected wealth and his expected utility? Larry’s expected wealth is $20,000 × 0.80 + $0 × 0.20, which is $16,000. Larry’s expected utility is 400 × 0.80 + 0 × 0.20, or 320.

Wealth (dollars) 20,000 16,000 12,000 8,000 4,000 0

Utility (units) 400 350 280 200 110 0

High-Crime Auto Theft, an insurance company, offers to sell Larry insurance at $8,000 a year and promises to provide Larry with a replacement car worth $20,000 if his car is stolen. Is Larry willing to buy this insurance? If not, is he willing to pay $4,000 a year for such insurance? If Larry buys the insurance for $8,000 his wealth will be $12,000 with no risk. This amount of wealth gives him utility of 280. This amount of utility is less than what his utility would be if he did not buy insurance, so Larry will not buy the insurance for $8,000. If Larry buys the insurance for $4,000 his wealth will be $16,000 with no risk. This amount of wealth gives him utility of 350. This amount of utility is more than what his utility would be if he did not buy insurance, so Larry will buy the insurance for $4,000.

Suppose that there are three national soccer leagues: Time League, Goal Difference League, and Bonus for Win League. The leagues are of equal quality, but the players are paid differently. Players in the Time League are paid by the hour for time spent practicing and © 2023 Pearson Education, Inc.

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playing. Players in the Goal Difference league are paid an amount that depends on the goals scored by the team minus the goals scored against it. Players in the Bonus for Win League are paid one wage for a loss, a higher wage for a tie, and the highest wage of all for a win. a. Describe the predicted differences in the quality of the games played by each of the leagues. In the Time League, players have no incentive to play hard or to win the game. In this league the games are likely to be dull, drawn out, low quality affairs with players not playing particularly hard. In the Goal Difference League, the players have the incentive to play as hard as possible throughout the game to score as many goals as possible. These games are likely to be action-oriented, high quality games. In the Bonus for Win League the players have an incentive to play hard but not as hard as in the Goal Difference League. For instance, if one team is ahead by a couple of points near the end of the game, the players on that team have the incentive to shirk as long as the other team does not tie or win the game. So these games will be medium quality.

b. Which league is the most attractive to players? Assuming that the average salaries are the same, if players are risk averse then the Time League is most attractive.

c. Which league will generate the largest profits? If fans like action packed games and if the average salary is the same in all leagues, then the Goal Difference League will attract the most fans and be the most profitable.

You can’t buy insurance against the risk of being sold a lemon. Why isn’t there such a market? How does the market provide a buyer with some protection against being sold a lemon? What are the main ways in which markets overcome the lemons problem? There is not a market for “lemon insurance” for several reasons. Defining a “lemon” is far from clear cut. The definition would need to be specified in the contract. But that leads to a moral hazard problem because a buyer with a car close to meeting the requirements for a lemon will behave in a way that increases the probability that the car will be deemed a lemon. Moral hazard also arises once the insurance is purchased but before the car is bought. Once the customer has the insurance, he or she will no longer search for a “non-lemon,” a creampuff. So it is likely that many of the cars purchased by people with the insurance will be lemons. These reasons combine to make it impossible for an insuring company to offer the insurance at a price that customers will pay and that allows the insurance firm to make a profit. Adverse selection also enters because people who are less likely to spend time searching for a high-quality car are more likely to buy the lemon insurance. Even without insurance, the market does give protection against lemons. Warranties are designed to help cope with the moral hazard and adverse selection problems on cars. Warranties signal that the car is not a lemon because if the car is a lemon servicing the car would be costly. The fact that the seller, who is the person with the private information, is willing to offer a warranty signals that the car is not a lemon.

When You Find Out a Coworker Makes More Money than You Do Finding out that a co-worker with similar qualifications, working at the same job but getting paid more than you is infuriating. Let your boss know you’d like to discuss your compensation. Tell her how hard you’ve been working, how much you’ve enjoyed your job, and ask how you can get a significant raise. Source: cnbc.com, June 18, 2019 Explain why a worker might be willing to pay for the salary information of other workers. A worker could demand a higher salary by comparing his or her pay with that of a (perceived) less valuable colleague. The worker would be willing to pay for the salary information if the marginal cost of obtaining the information is less than or equal to the marginal benefit of obtaining it.

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Answers to Additional Problems and Applications Use the table, which shows Jimmy’s and Zenda’s utility of wealth schedules, to work Problems 7 to 9. 7. What are Jimmy’s and Zenda’s expected utilities from a bet that gives them a 50 percent chance of having a wealth of $600 and a 50 percent chance of having nothing?

Jimmy’s utility 0 200 300 350 375 387 393 396

Wealth 0 100 200 300 400 500 600 700

Jimmy’s expected utility is (0.5 393) + (0.5  0) = 196.5. Zenda’s expected utility is (0.5  683) + (0.5  0) = 341.5.

Zenda’s utility 0 512 640 672 678 681 683 684

8. a. Calculate Jimmy’s and Zenda’s marginal utility of wealth schedules. The table to the right sets out their marginal utility of wealth schedules.

b. Who is more risk averse, Jimmy or Zenda? How do you know? Zenda is more risk averse because her marginal utility of wealth decreases more quickly as wealth increases than does Jimmy’s marginal utility of wealth.

Wealth 0

Jimmy’s utility 0

100

200

300

350

400

375

Jimmy’s marginal utility

Zenda’s utility 0

2.00

Zenda’s marginal utility 5.12

512 1.00

1.28 640

0.50

0.32 672

0.25

0.06 678

0.12 0.03 Suppose that Jimmy and 500 387 681 Zenda each have $400 and are 0.06 0.02 offered a business investment 600 393 683 opportunity that involves 0.03 0.01 committing the entire $400 to 700 396 684 the project. The project could return $600 (a profit of $200) with a probability of 0.85 or $200 (a loss of $200) with a probability of 0.15. Who goes for the project and who hangs on to the initial $400? Jimmy puts his money into the project, but Zenda does not. Jimmy maximizes his expected utility. If Jimmy puts his money into the project and it makes a profit, his utility is 393; if Jimmy puts his money into the project and it fails, his utility is 300. So Jimmy’s expected utility from the project is (0.85  393) + (0.15  300), which equals 379. If Jimmy keeps his $400 and does not join the project, his utility is 375. Jimmy will choose to join the project because joining gives him greater utility. Zenda maximizes her expected utility. If Zenda puts her money into the project and it makes a profit, her utility is 683; if Zenda puts her money into the project and it fails, her utility is 640. So Zenda’s expected utility from the project is (0.85  683) + (0.15  640), which equals 677. If Zenda keeps her $400 and does not join the project, her utility is 678. Zenda will choose not to join the project because not joining gives her greater utility.

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Use the following information to work Problems 10 to 12. Two students, Jim and Kim, are offered summer jobs managing a student house-painting business. There is a 50 percent chance that either of them will be Wealth Jim’s utility Kim’s utility successful and end up with $21,000 of wealth to get them 0 0 0 through the next school year. But there is also a 50 3,000 100 200 percent chance that either will end up with only $3,000 6,000 200 350 of wealth. Each could take a completely safe but back9,000 298 475 breaking job picking fruit that would leave them with a 12,000 391 560 guaranteed $9,000 at the end of the summer. The table 15,000 482 620 shows Jim’s and Kim’s utility of wealth schedules. 18,000 572 660 21,000 660 680 10. Does anyone take the painting job? If so, who takes it and why? Does anyone take the job picking fruit? If so, who takes it and why? Jim will take the painting job. If Jim takes the job managing the house painters, his expected utility is 0.5 × 660 + 0.5 × 100, which is 380. If Jim takes the job picking fruit, his expected (and actual) utility is 298. Jim will take the job managing the house painters because his expected utility from that job is larger than his expected utility from picking fruit. Kim will take the fruit-picking job. If Kim takes the job managing the house painters, her expected utility is 0.5 × 680 + 0.5 × 200, which is 440. If Kim takes the job picking fruit, her expected (and actual) utility is 475. Kim will take the picking fruit because her expected utility from that job is larger than her expected utility from managing the house painters.

11.

In Problem 10, what is each student’s maximized expected utility? Who has the larger expected wealth? Who ends up with the larger wealth at the end of the summer? Jim’s expected utility is 380; Kim’s expected utility is 475. Jim has higher expected wealth. Jim’s expected wealth is $12,000; Kim’s expected (and actual) wealth is $9,000. It is not possible to determine who has the actual larger wealth because Jim’s wealth is uncertain.

12.

In Problem 10, if one of the students takes the risky job, how much more would the fruitpicking job have needed to pay to attract that student? Jim takes the risky job. His expected utility with the risky job is 380. The fruit picking job must offer pay that gives Jim utility of more than 380. If the fruit picking job paid $12,000, Jim’s utility would be 391 and he would take the fruit picking job. So to entice Jim to take the fruit picking job, it would need to pay $3,000 more than its current payment of $9,000.

Use the table, which shows Chris’s utility of wealth schedule, to work Problems 13 and 14. Chris’s wealth is $5,000 and it consists entirely of her share in a risky ice cream business. If the summer is cold, the business will fail, and she will have no wealth. Where Chris lives there is a 50 percent chance each year that the summer will be cold. 13.

If Chris cannot buy cold-summer insurance, what is her expected wealth and what is her expected utility? Chris’s expected wealth is $5,000 × 0.50 + $0 × 0.50, which is $2,500. Her expected utility is 150 × 0.50 + 0 × 0.50, which is 75.

Wealth (dollars) 5,000 4,000 3,000 2,000 1,000 0

Utility (units) 150 140 120 90 50 0

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Business Loss Recovery, an insurance company, is willing to sell Chris cold-summer insurance at a price of $3,000 a year and promises to pay her $5,000 if the summer is cold and the business fails. Is Chris willing to buy this loss insurance? If she is, is she willing to pay $4,000 a year for it? If Chris buys the insurance for $3,000 her wealth will be $2,000 with no risk. This amount of wealth gives her utility of 90, which is more than what her utility would be if she did not buy insurance. Chris will buy the insurance for $3,000. If Chris buys the insurance for $4,000 her wealth will be $1,000 with no risk. This amount of wealth gives her utility of 50, which is less than what her utility would be if she did not buy insurance. Chris will not buy the insurance for $4,000.

Use the following information to work Problems 15 to 17. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one. 15. If both Larry and Harry are offering their cars for sale at the same price, from whom would you most want to buy, Larry or Harry, and why? If you know that Larry’s car is a good car and Harry’s car is a lemon, you most want to buy from Larry. If you do not know that Larry’s car is a good car and Harry’s car is a lemon, you are indifferent between the two.

16.

If you made an offer of the same price to Larry and Harry, who would sell to you and why? Describe the adverse selection problem that arises if you offer the same price to Larry and Harry. The price offered will be the price for which a lemon sells. Harry, who has a lemon, will be willing to sell at that price; Larry, who has a good car, will not be willing to sell. The adverse selection problem that arises is that only sellers with lemons are willing to sell their cars at the going (lemon) price.

17.

How can Larry signal that he is selling a good car so that you are willing to pay Larry the price that he knows his car is worth, and a higher price than what you are willing to offer Harry? Larry can offer a warranty on his car. For instance, Larry might offer to pay any repair bills (aside from accidents!) that come about for the next 6 months.

18.

Pam is a safe driver and Fran is a reckless driver. Each knows what type of driver she is, but no one else knows. What might an automobile insurance company do to get Pam to signal that she is a safe driver so that it can offer her insurance at a lower premium than it offers to Fran? One possibility is to offer insurance with a higher deductible at a lower cost. Pam knows that she is less likely to need the insurance, so she is willing to accept the higher deductible to save on the insurance premiums. Fran knows that she is more likely to use the insurance, so she is not interested in a high deductible. Fran is more likely to pay the higher insurance premiums to have the low deductible.

19.

Why do you think it is not possible to buy insurance against having to put up with a lowpaying, miserable job? Explain why a market in insurance of this type would be valuable to workers but unprofitable for an insurance provider and so would not work. Insurance against a low-paying job is not available because of moral hazard and adverse selection. In particular, the moral hazard exists that once someone purchased this type of insurance, the person could then take a low-paying job that he or she, for some reason, enjoyed. The person could then easily document that the job is low-paying and could also (falsely) assert the job was miserable and thereby collect on the insurance. Adverse selection also makes the insurance unlikely because the people most likely to wind up with low-paying jobs are the most likely to buy the insurance, whereas people who are most likely to wind up with high-paying jobs are least likely to buy the insurance. © 2023 Pearson Education, Inc.

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Use the following news clip to work Problems 20 and 21. How to Stop Worrying About Things You Can’t Change There are several factors in life we can’t control and stressing about things like coronavirus and global emergencies isn’t unusual. We may not know what’s headed our way, but we can follow a healthy lifestyle so we can help others when a challenging situation does occur. Source: patient.info, April 6, 2020 20.

Explain how “[s]tressing about things like coronavirus and global emergencies” can result in people making decisions that not only fail to satisfy social interest, but also fail to satisfy selfinterest. What action does the news clip suggest we can take in the self-interest and in the social interest. By worrying about things we cannot change, society sometimes devotes its scarce resources in ways that do not make people as well off as possible. For example, people stressing about earthquakes might lead governments to devote resources to strengthening buildings even though these resources might be better utilized to fight the coronavirus. Similarly, individuals can make decisions that do not advance their well being. For instance, a vaccinated, young person’s decision to leave a desirable job where coronavirus is common and move cross-country to a less desirable job where coronavirus is less common while continuing to smoke and not use seat belts ignores the likelihood that these latter two actions have a greater chance of being more harmful than the coronavirus. The article suggests a healthy lifestyle, which implicitly means that we are better off worrying about events we can control, is in our self-interest and by being healthy we can help others, which is in the social interest.

21.

How can information be used to improve people’s decision making? Information can improve people’s decision making by providing them with data about the marginal benefit and marginal cost of their decisions. With this information readily at hand, decision-making is improved and leads to a more efficient allocation of resources.

Economics in the News 22. After you have studied Economics in the News on pp. 486–487, answer the following questions. a. What information do accurate grades provide that grade inflation hides? Accurate grades provide valuable information about the student’s productivity and the extent of the student’s skill base. High grades would be correlated with high skills and high ability so that these students would be sorted into higher paying jobs immediately upon graduation. Of course, this result also means that students with lesser skills are sorted in lower paying jobs immediately upon graduation.

b. Do you think grade inflation is in anyone’s self-interest? Explain who benefits and how they benefit from grade inflation. The people who benefit from grade inflation are the students who first received inflated grades. At this time potential employers and graduate schools were unaware that higher grades were commonplace and so assigned more informational content to the high grades than was justified.

c. How do you think grade inflation might be controlled? Grade inflation could be controlled if the university put limits on the number of high grades that can be assigned in a class.

d. Explain who would benefit and how they benefit from a national exit exam. High-school students who are trying to compare the quality of different schools would benefit, as would the schools when they compare themselves with their peers. Students who score well o he exam would also benefit because they have a publicly available confirmation of their learning.

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e. Do you think a third-party certified exam would be in the social interest? Why? As long as the certified exam was not too costly, it would be in the social interest because it would make more valuable information available.

23.

How to Get Paid What You’re Worth To get paid what you are worth you must be able and willing to stand up for your value, break away from the HR wall chart, break free from low pre-set annual pay increases, negotiate, be willing to say ‘no’, and quit. To get hired and paid what you’re worth, first compare your pay with that on Salary.com and Payscale.com, but remember these data are averages of what employers are paying people who share your job title. Your real key to success is to discover what is paining the hiring manager and let her or him talk about the pain. Talk about him or her and his or her problems! That’s how you’ll get the hiring manager’s attention. Source: Forbes, August 7, 2015 a. Explain the role of asymmetric information in the situation described in the news clip. The point that the worker does not know the maximum a hiring agent is willing to pay is an important piece of asymmetric information. The news clip offers advice about how a worker can negotiate a wage that is higher, up to the maximum the firm is willing to offer.

b. What adverse selection problem exists in the advice given in the news clip? The essential advice of the news clip is to be empathetic and attempt to befriend the hiring manager. If the job seeker succeeds, the hiring manager is more likely to offer the person a wage that is closer to the highest that the firm will pay or perhaps even tell him or her the maximum and then offer it. This result reflects a potential adverse selection problem for the firm. The firm wants to hire productive workers, not necessarily sympathetic or friendly workers. But if workers take the advice in the news clip, the firm will be more likely to hire empathetic workers regardless of their productivity.

c. How would public information about everyone’s wage rate change the adverse selection that arises? With public information about everyone’s wages, job seekers can better infer the maximum a firm will pay and so no longer need to attempt to befriend the hiring manager to gain this important bit of information. Additionally, the hiring manager knows that if he or she pays a high wage to a particularly friendly but low productivity worker, this fact will quickly become known, which may cost the hiring manager his or her position. Both of these effects diminish the adverse selection problem that the hiring manager will offer high wages to particularly sympathetic job seekers.

C h a p t e r

MEASURING THE VALUE OF PRODUCTION: GDP

Answers to the Review Quizzes Page 498 1.

Define GDP and distinguish between a final good and an intermediate good. Provide examples. GDP is the market value of all the final goods and services produced within a country in a given time period. A final good or service is an item that is sold to the final user, that is, the final consumer, government, a firm making investment, or a foreign entity. An intermediate good or service is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. For instance, bread sold to a consumer is a final good, but wheat sold to a baker to make the bread is an intermediate good. Distinguishing between final goods and services and intermediate goods and services is important because only final goods and services are directly included in GDP; intermediate goods must be excluded to avoid double counting them. For example, counting the wheat that went into the bread as well as the bread would double count the wheat—once as wheat and once as part of the bread.

Why does GDP equal aggregate income and also equal aggregate expenditure? GDP equals aggregate income because one way to value production is by the cost of the factors of production employed. The cost of the factors production employed—wages, interest, rent, and profit— equal aggregate income and therefore aggregate income equals GDP. GDP equals aggregate expenditure because another way to value production is by the price that buyers pay for the production in the market. Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus imports, which is the total amount spent buying the production in the market. Therefore GDP equals aggregate expenditure.

What are the distinctions between domestic and national, and gross and net? “Domestic” means that the production being measured is within a country no matter by whom; “national” means that the production is produced by residents of the nation anywhere within the world. “Gross” means before subtracting depreciation. “Net” means after subtracting depreciation. The terms apply to investment, business profit, and aggregate production.

Page 501 1.

What is the expenditure approach to measuring GDP? The expenditure approach measures GDP by focusing on aggregate expenditures. Data are collected on the different components of aggregate expenditure and then summed. Specifically, the Bureau of Economic Analysis collects data on consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports, X − M. These expenditures are valued at the prices paid for the goods and services, called the market price. GDP is then calculated as C + I + G + X − M.

What is the income approach to measuring GDP? The income approach measures GDP by focusing on aggregate income. This approach sums all the incomes paid to households by firms for the factors of production they hire. The National Income and Product Accounts divide income into five categories: compensation of employees; net interest; rental income; corporate profits; and proprietors’ income. Adding these income components does not quite equal GDP, because it values the output at factor cost rather than the market price and omits depreciation. So, © 2023 Pearson Education, Inc.

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further adjustments must be made to calculate GDP: Indirect taxes and depreciation must be added and subsidies subtracted.

What adjustments must be made to total income to make it equal GDP? Total income is net domestic product at factor cost. To convert it to gross domestic product at market prices, we must add the depreciation of capital and add indirect taxes minus subsidies.

What is the distinction between nominal GDP and real GDP? Nominal GDP is the value of final goods and services produced in a given year valued at the prices of that year. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. By comparing the value of production in the two years at the same prices, we reveal the change in production.

How is real GDP calculated? The traditional method of calculating real GDP is to value each year’s production using the constant prices of a fixed base year and then sum all the values.

Page 507 1.

Distinguish between real GDP and potential GDP and describe how each grows over time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Potential GDP is the maximum amount of real GDP that can be produced while avoiding shortages of labor, capital, land, and entrepreneurial ability that would bring rising inflation. So real GDP is the actual amount produced with the actual level of employment of the nation’s factors of production while potential GDP is the amount that would be produced if there were full employment of all factors of production with no shortages. Real GDP fluctuates from one year to the next, though it grows more often than it shrinks. Potential GDP grows from one year to the next because the quantity of the nation’s resources and technology increase from one year to the next.

How does the growth rate of real GDP contribute to an improved standard of living? A benefit of long-term economic growth is the increased consumption of goods and services that is made possible. Growth of real GDP also allows more resources to be devoted to areas such as health care, research, and environmental protection.

What is a business cycle and what are its phases and turning points? The business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. A business cycle has two phases: recession and expansion. The turning points are the peak and the trough. A business cycle runs from a trough to an expansion to a peak to a recession to a trough and then back to an expansion.

What is PPP and how does it help us to make valid international comparisons of real GDP? PPP is purchasing power parity. To make the most valid international comparisons of real GDP, we need to value each nation’s production using the same prices rather than by using exchange rates and the prices within each country because relative prices within different countries can vary widely. As a result, if the real GDP of each country is valued using the same prices, then the comparison of real GDP among the countries is more accurate.

Explain why real GDP might be an unreliable indicator of the standard of living. Real GDP is sometimes used to measure the standard of living but real GDP can be misleading for several reasons. Real GDP does not include household production, productive activities done in and around the house by the homeowner. Because these tasks often are an important component of people’s work, this omission creates a major measurement problem. Real GDP omits the underground economy, economic activity that is legal but unreported or that is illegal. In many countries the underground economy is an important part of economic activity, and its omission creates a serious measurement problem. The value of leisure time is not included in real GDP. People value their leisure hours and an increase in people’s leisure that enhances people’s economic welfare can lower the nation’s real GDP. Environmental damage is © 2023 Pearson Education, Inc.

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excluded from real GDP. So an economy wherein real GDP grows but at the expense of its environment, as was the case with Eastern European countries under communism, falsely appears to offer greater economic welfare than a similar economy that grows slightly more slowly but at less environmental cost.

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Answers to the Study Plan Problems and Applications 1.

Classify the following items as a final good or service or an intermediate good or service and identify each item as a component of consumption expenditure, investment, or government expenditure on goods and services:  Airline ticket bought by a student. Airline tickets are intermediate goods that are used for the final service, airline flights. They are part of consumption expenditure.



New airplanes bought by Southwest Airlines. New airlines purchased by Southwest Airlines are a final good. They are part of investment.



Cheese bought by Domino’s.



Your purchase of a new iPhone.

Cheese bought by Domino’s is an intermediate good. This purchase is a final good. It is part of consumption expenditure.



New house bought by Bill Gates. A new house purchased by Bill Gates is a final good. It is part of investment.

Use the following figure illustrates the circular flow model.

During 2021, flow A was $13.0 trillion, flow B was $9.1 trillion, flow D was $3.3 trillion, and flow E was –$0.8 trillion. Calculate (i) GDP and (ii) Government expenditure. (i) Flow A is aggregate income. GDP equals aggregate income, so GDP is $13.0 trillion. (ii) Government expenditure is $1.4 trillion. Aggregate expenditure equals GDP, which from part (i) is $13.0 trillion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore government expenditure equals aggregate expenditure minus consumption expenditure minus investment minus net exports. Government expenditure equals $13.0 trillion minus $9.1 trillion minus $3.3 trillion minus $0.8 trillion, which is $1.4 trillion.

MEASURING THE VALUE OF PRODUCTION: GDP

3.     

289

Use the following data to calculate aggregate expenditure and imports of goods and services. Government expenditure: $20 billion Aggregate income: $100 billion Consumption expenditure: $67 billion Investment: $21 billion Exports of goods and services: $30 billion Aggregate expenditure equals aggregate income, so aggregate expenditure equals $100 billion. Aggregate expenditure also equals consumption expenditure plus investment plus government expenditures on goods and services plus exports of goods and services minus imports of goods and services, so imports of goods and services equals consumption expenditure plus investment plus government expenditure on goods and services plus exports minus aggregate expenditure. Using this formula gives imports of goods and services equals $67 billion + $21 billion + $20 billion + $30 billion − $100 billion, which is $38 billion.

The table lists some national accounts data for the United States in 2019. a. Calculate U.S. GDP in 2019. GDP equals consumption expenditure plus investment plus government expenditure plus net exports, so GDP equals $14,266 billion + $3,784 billion + $3,683 billion − $634 billion, or $21,099 billion.

b. Explain the approach (expenditure or income) that you used to calculate GDP.

Item Wages Consumption expenditure Other factor incomes Investment Government expenditure Net exports Depreciation

Billions of dollars 11,317 14,266 4,935 3,784 3,683 −634 3,402

The expenditure approach was used.

Use the following data to work Problems 5 and 6. Tropical Republic produces only Quantities bananas and coconuts. The base year is Bananas 2021, and the tables give the quantities Coconuts produced and the prices. 5. Calculate nominal GDP in 2021 Prices and 2022. Bananas In 2021, nominal GDP is $5,600. Coconuts

2021 800 bunches 400 bunches

2022 900 bunches 500 bunches

2021 $2 a bunch $10 a bunch

2022 $4 a bunch $5 a bunch

In 2022, nominal GDP is $6,100. Nominal GDP in 2021 is equal to total expenditure on the goods and services produced by Tropical Republic in 2021. Expenditure on Tropical Republic on bananas is 800 bunches of bananas at $2 a bunch, which is $1,600. Expenditure on coconuts is 400 bunches at $10 a bunch, which is $4,000. Total expenditure is $5,600, so nominal GDP in 2021 is $5,600. Nominal GDP in 2022 is equal to total expenditure on the goods and services produced by Tropical Republic in 2022. Expenditure on Tropical Republic on bananas is 900 bunches of bananas at $4 a bunch, which is $3,600. Expenditure on coconuts is 500 bunches at $5 a bunch, which is $2,500. Total expenditure is $6,100, so nominal GDP in 2022 is $6,100.

Calculate real GDP in 2022 expressed in base-year prices. Real GDP in 2022 using base-year prices is $6,800. The base-year prices method calculates the market value of the 2022 quantities at the base-year prices of 2021. To value the 2022 output at 2021 prices, real expenditure on Tropical Republic on bananas is 900 bunches at $2 a bunch, which is $1,800, and real

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expenditure on coconuts is 500 bunches at $10 a bunch, which is $5,000. Adding these two expenditures shows that real GDP in 2022 using the base-year prices method is $6,800.

Use the table to work out in which year the U.S. standard of living (i) increases and (ii) decreases. Explain your answer. The standard of living is measured by real GDP per person. The standard of living increased in 2018 and 2019 because in both years real GDP per person increased. The standard of living decreased in 2020 because real GDP per person decreased.

An island economy produces only fish and crabs. Calculate the island’s chained-dollar real GDP in 2021 expressed in 2020 dollars.

Year 2017 2018 2019 2020 Quantities Fish Crabs

Real GDP $18.1 trillion $18.7 trillion $19.1 trillion $18.4 trillion

Population 325.1 million 326.7 million 328.5 million 330.1 million

2020 1,000 tons 500 tons

2021 1,100 tons 525 tons

Real GDP in 2021 is $27,300. The Prices chained-dollar method uses the prices of Fish $20 a ton $30 a ton 2020 and 2021 to calculate the growth Crabs $10 a ton $8 a ton rate in 2021. The value of the 2020 quantities at 2020 prices is $25,000. The value of the 2021 quantities at 2020 prices is $1,100 tons of fish × $20 a ton + 525 tons of crab × $10 a ton, which is $27,250. Using 2020 prices, the increase in GDP for these two years is $2,250, so the percentage increase is ($2,250  $25,000)  100, which is 9.0 percent. Next the value of the 2020 quantities at 2021 prices is 1,000 tons of fish × $30 a ton + 500 tons of crab × $8 a ton, which is $34,000. The value of the 2021 quantities at 2021 prices is $37,200. Using 2021 prices, the increase in GDP for these two years is $3, 200 so the percentage increase is ($3,200 ÷ $34,000) × 100, which is 9.4 percent. The chained dollar method calculates the growth rate as the average of these two percentage growth rates, which means that the growth rate in 2021 is 9.2 percent. So real GDP in 2021 is equal to $25,000, which is real GDP in the base year (and is equal to nominal GDP in that year) multiplied by one plus the growth rate. Real GDP in 2021 is $27,300.

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Answers to Additional Problems and Applications 9.

Classify each of the following items as a final good or service or an intermediate good or service and identify which is a component of consumption expenditure, investment, or government expenditure on goods and services:  Banking services bought by Amazon The banking services are an intermediate service.



Security system bought by the New York Stock Exchange The security system is a final good. It is part of investment.



Coffee beans bought by Starbucks



New coffee grinders bought by Starbucks

Coffee beans bought by Starbucks are an intermediate good. A new coffee grinder bought by Starbucks is a final good. It is part of investment.



Starbuck’s latte bought by a student



New battle ship bought by the U.S. navy

The Starbuck’s drink is a final good. It is part of consumption expenditure. The battleship is a final good. It is part of government expenditure on goods and services.

Use Figure 21.2 to work Problems 10 and 11.

10.

In 2020, flow A was $1,000 billion, flow C was $250 billion, flow B was $650 billion, and flow E was $50 billion. Calculate investment. Investment is $50 billion. Aggregate expenditure equals aggregate income, which is flow A, $1,000 billion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore investment equals aggregate expenditure minus consumption expenditure minus government expenditure on goods and services minus net exports. Investment equals $1,000 billion minus $650 billion minus $250 billion minus $50 billion, which is $50 billion.

11.

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was $4 trillion. Calculate consumption expenditure. Consumption expenditure is $5 trillion. Aggregate expenditure equals aggregate income, which is flow A, $10 trillion. Aggregate expenditure is the sum of consumption expenditure (Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore consumption expenditure equals aggregate expenditure minus investment minus government expenditure on goods and services minus net exports. Consumption expenditure equals $10 trillion minus $2 trillion minus $4 trillion minus $1 trillion, which is $5 trillion.

Use the following information to work Problems 12 and 13. Mitsubishi Heavy Industries makes the wings of the new Boeing 787 Dreamliner in Japan. Toyota assembles cars for the U.S. market in Kentucky. 12. Explain where these activities appear in the U.S. National Income and Product Accounts. When the Dreamliner wings are sent from Japan to the United States, they are counted in the U.S. National Income and Product Accounts as imports, which is a negative entry in the expenditure approach to U.S. GDP. Toyota’s production of cars in Kentucky is included in U.S. GDP because it represents production within the United States. Expenditure on the cars is counted as part of consumption expenditure (if the cars are purchased by U.S. consumers) or investment (if the cars are purchased by U.S. firms) or government expenditure (if the cars are purchased by a government) in the expenditure approach to GDP. If any of the parts of the cars are imported from Japan, the value of these parts is included among U.S. imports. The incomes earned by the factors of production that produce the cars are part of the wages, interest, rent, and profit income that are used in the income approach to GDP.

13.

Explain where these activities appear in Japan’s National Income and Product Accounts. Mitsubishi Heavy Industries’ production of Dreamliner wings in Japan is included in Japanese GDP because it represents production within Japan. When these wings are sent to the United States, they are counted in the National Income and Product Accounts as part of Japanese exports. If any of the parts of wings are imported into Japan, the value of these parts is included among Japanese imports. The incomes earned by the factors of production that produce the wings are part of the wages, interest, rent, and profit income that are used in the income approach to GDP. Toyota’s production of cars in Kentucky is not directly included in Japan’s GDP unless some of the parts for these cars are exported from Japan to the United States. In that case the value of the parts are included in Japan’s GDP as exports.

Use the following news clip to work Problems 14 and 15, and use the circular flow model to illustrate your answers. Gannett Outsourcing Nearly 500 Jobs to India Gannett (the largest U.S. newspaper publisher by daily circulation) is outsourcing 485 jobs to India. Source: newjerseyglobe.com, December 11, 2020 14. Explain how Gannett’s outsourcing to India will change India’s GDP. Outsourcing of jobs means that the goods and services these jobs produce are now produced in India. Goods and services produced within India are part of India’s GDP. Gannett’s decision to outsource jobs to India means that India’s GDP increases. These goods and services are exported to the United States, so India’s exports of goods and services increase.

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15.

293

Explain how Gannett’s outsourcing to India will change U.S. GDP. Outsourcing of jobs means that the goods and services these jobs produce are now produced in India. Consequently, this production is not produced within the United States and so it is not part of U.S. GDP. This production of goods and services is sent back to the United States, and so it subtracts from U.S. GDP as imports. Gannett’s purchase of these goods and services from firms in India is flow is Flow A, an import into the United States. This flow travels through the goods market and goes to Gannett as Flow B.

Use the following data to work Problems 16 and 17. The table lists some macroeconomic data for Item the United States in 2016. Wages 16. Calculate U.S. GDP in 2016. Consumption expenditure GDP equals consumption expenditure plus investment plus government expenditure plus net exports, so GDP equals $12,498 billion + $3,037 billion + $3,254 billion − $507 billion, or $18,282 billion.

17.

Other factor incomes Investment Government expenditure Net exports

Billions of dollars 9,908 12,498 4,567 3,037 3,254 −507

Explain the approach (expenditure or income) that you used to calculate GDP. The expenditure approach was used.

Use the following data to work Problems 18 to 19. An economy produces only apples and Quantities oranges. The base year is 2022, and the Apples table gives the quantities produced and Oranges the prices. 18.

Calculate nominal GDP in 2022 and 2023. In 2022 nominal GDP is $50 and in 2023 nominal GDP is $600.

Prices Apples Oranges

2022 60 80

2023 160 220

2022 $0.50 $0.25

2023 $1.00 $2.00

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Nominal GDP in 2022 is equal to total value of the goods and services produced in 2022. The value of apples is 60 apples at $0.50 each, which is $30, and the value of oranges is 80 oranges at $0.25 each, which is $20. The total value is $50 so nominal GDP in 2022 is $50. Nominal GDP in 2023 is equal to total value of the goods and services produced in 2023. The value of apples is 160 apples at $1.00 each, which is $160 and the value of oranges is 220 oranges at $2.00 each, which is $440. The total value is $600 so nominal GDP in 2023 is $600.

19.

Calculate real GDP in 2022 and 2023 expressed in base-year prices. Real GDP in 2022 is $50 and in 2023 is $135. Real GDP in the base year, 2022, is equal to nominal GDP. Real GDP in 2023 using base-year prices is equal to the quantities produced in 2023 valued at baseyear, 2022, prices. Real GDP in 2023 is 160 apples at $0.50 each, which is $80, and the value of oranges is 220 oranges at $0.25 each, which is $55. The total value of 2023 production using 2022 prices is $135, so real GDP in 2023 is $135.

Use the following news clip to work Problems 20 and 21. China’s Economy Accelerates as Retail, Investment Pick Up China’s real GDP increased 6.9 percent in the first quarter of 2017 from a year earlier. Investment grew by 9.2 percent and retail sales by 10.9 percent. In current prices, GDP increased by 11.8 percent from a year earlier. Source: Bloomberg News, April 17, 2017 20. Explain how China’s real GDP can grow at a 6.9 percent rate when consumption and investment grew faster than 6.9 percent. Even though consumption and investment both grew more rapidly than 6.9 percent, the other components of GDP, government expenditure and net exports grew more slowly, so the net effect from all four parts of GDP was 6.9 percent growth.

21.

Explain why the growth rate of GDP in current prices does not provide information about how quickly the economy is really growing. GDP in current prices can grow because both production grows and prices grow. The growth in prices does represent growth in the economy. Growth in the economy is measured using the growth rate of real GDP because real GDP measures only production.

22.

The United Nations’ Human Development Index (HDI) is based on GDP per person, life expectancy at birth, and indicators of the quality and quantity of education. a. Explain why the HDI might be better than GDP as a measure of economic welfare. The HDI might be a better measure of economic welfare because it includes some important factors that affect welfare and which are omitted from GDP. In particular, life expectancy is included in the HDI but not in GDP and on this count the HDI is superior. The HDI also includes direct measures of the quality and quantity of education. These are indirectly included in GDP because they affect GDP per person, but it might be the case that the direct inclusion in the HDI is better.

b. Which items in the HDI are part of GDP and which items are not in GDP? The HDI is based on GDP per person and so directly includes GDP. In addition, the quality and quantity of education affect people’s productivity, which is closely related to GDP per person. So GDP indirectly includes some of the education effects explicitly included in the HDI.

c. Do you think the HDI should be expanded to include items such as pollution, resource depletion, and political freedom? Explain. Ideally factors such as pollution, political freedom, and so forth should be included in a broad measure of welfare. Two difficulties, however, occur. One difficulty comes when trying to measure these variables. For instance, how can political freedom be measured in a way that is accepted by all? A second difficulty is weighting these factors. For instance, how much political freedom should be weighted relative to GDP per person? © 2023 Pearson Education, Inc.

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d. What other items should be included in a comprehensive measure on economic welfare? Aside from the factors listed above, potentially some measure of culture might be included. Another set of factors might attempt to take into account sustainability. Religious freedom, discrimination, and civil and international conflict might also matter. But all these factors are hard to measure and to weight.

Use the following information to work Problems 23 and 24. Comparing Real GDP Per Person The International Monetary Fund reported the following data on gross domestic product per capita, measured in U.S. dollars at market exchange rates in 2019: Canada $46,400, China $10,243, United Kingdom $42,417, and United States $65,254. Source: International Monetary Fund, World Economic Outlook Database, April 2021 23. Explain the special complications involved with attempting to compare the economic welfare in China and the United States by using the GDP for each country. This comparison does not determine which nation has a higher standard of living. One reason is that the analysis uses the exchange rate to transform prices in one country into prices of the other country. But a more accurate analysis uses purchasing power parity (PPP) prices to value the goods and services in both countries. Relative prices in China and the United States are quite different. When looking at prices of identical or near-identical goods, more of these prices are lower in China than in the United States. So even if China and the United States produced the exact same quantities of these goods and services, China’s GDP, using China’s lower prices, would value China’s production at a smaller amount than would U.S. GDP, using U.S. higher prices. To have a valid comparison of Chinese and U.S. GDP, PPP prices must be used to value Chinese and U.S. production because then prices are the same for China and the United States. By using PPP prices, the analysis can better measure the goods and services available to citizens of each country. Additionally, looking only at GDP per person omits the effects from household production, leisure time, and environmental quality, differences that probably loom large when comparing the United States and China. Because China is significantly less advanced than the United States, household production is probably larger in China than in the United States. On this count, Chinese economic welfare is closer to that in the United States than GDP per person would indicate. But U.S. residents enjoy more leisure time and better environmental quality than do their counterparts in China, which makes the relative U.S. standard of living higher than measured by GDP per person.

24.

Explain why the data reported here might be a poor indicator of the differences in economic welfare among Canada, the United Kingdom, and the United States, but nevertheless provide the correct ranking of the countries. Using GDP per person to measure the economic welfare in Canada, the U.K. and the United States omits other factors, such as household production, underground economic activity, the value of leisure time, and environmental quality. Because Canada, the U.K. and the United States are all developed nations, the differences in these four factors are probably small, and almost surely are smaller than the differences in real GDPs per person. So, using real GDP per person will provide the correct the correct ranking of the counties.

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25. The Forbes Billionaires List: Africa’s Billionaires 2020 Africa’s billionaires are richer than a year ago. As a group, the continent’s 20 billionaires are worth $73.4 billion, an increase of $4.7 billion from a year ago. Source: cnbcafrica.com, February 21, 2020 One-third of Africans earn about $2 a day. a. Why might GDP per person misrepresent the standard of living of the average African? There are a few reasons why this measurement of GDP per person misrepresents the standard of living of the average African. First GDP includes only goods and services bought and sold in markets. In Africa many goods and services are produced by the household itself and this home production, while boosting the household’s standard of living, is not included in GDP. Second the prices used to value African production and thereby calculate African GDP are likely quite different than the prices used to value U.S. production and calculate U.S. GDP. When looking at prices of identical or near-identical goods, it is likely that more of these prices are lower in Africa than in the United States. So, even if the actual quantities produced are the same, using African prices means that Africa’s production would be valued less than U.S. production and Africa’s GDP would be less than U.S. GDP. If the same prices, such as purchasing power parity prices, were used to value Africa’s GDP and U.S. GDP, Africa’s GDP per person would be closer to U.S. GDP per person.

b. Why might $2 a day underestimate the standard of living of the poorest Africans? One important reason why the $2 a day estimate undervalues the standard of living of the poorest Africans is because much of these people’s transactions do not occur in markets. GDP is calculated using only goods and services bought and sold in markets. So if a poor, self-sufficient farmer grows only enough food for his or her family and does not buy or sell food in the market, the farmer will be estimated to have a very low income. But this low income vastly understates the farmer’s standard of living because it omits all the food the person produced on his or her land. Another reason why the standard of living of the poorest Africans is underestimated is because the estimate is made using prices that prevail in Africa and then compared to the standard of living in the United States. Prices in Africa are often much lower than in the United States, so comparing what the income can purchase in the United States understates the standard of living.

Economics in the News 26. After you have studied Economics in the News on pp.508–509, answer the following questions. a.

How did the BEA estimates of the real GDP growth rate in the second and third quarters of 2020 change from the advanced estimate to the final estimate? The BEA estimates of the fall in the second quarter rose slightly between the advanced estimate and the final estimate. The BEA estimates of the rise in the third quarter rose very slightly between the advanced estimate and the final estimate.

How did the NY Fed nowcast of the second quarter growth rate change through the quarter? The NY Fed’s nowcast of the second quarter growth rate fell drastically from late March until May, after which it rose strongly, winding up about halfway between the most positive nowcast of 0 percent in March and the most negative of a fall of around 40 percent in May.

How did the NY Fed nowcast of the third quarter growth rate change through the quarter? The NY Fed’s nowcast of third quarter started out at a low, positive growth rate and then quickly rose during the next month to about a 17 percent growth rate after which it fluctuated slightly around this higher growth rate.

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Describe the common feature of the relationship between the BEA and the NY Fed estimates of real GDP present since 2002 and visible in the second and third quarters of 2020. The NY Fed nowcasts generally track the BEA’s final estimate of the growth rate in real GDP but the nowcasts tend to underestimate the change. This underestimation is particularly evident in the second and third quarters of 2020, in which the nowcast drastically underestimated the severe fall in real GDP during the second quarter and underestimated the impressive rise in GDP during the third quarter.

27.

GDP Outdated, Here Are the Alternatives A panel of high-profile economists suggest measuring the economic well-being of families and removing the emphasis on GDP growth. Some economists propose including a value on housework and making better estimates of healthcare improvements. Nobel Laureate Angus Deaton suggests conducting a survey to ask people how happy they are. Source: weforum.org, February 10, 2020 Suppose that a new index is calculated using the suggestions in the news clip. a. Would the new index be a better measure of the standard of living than GDP per person? Explain your answer. GDP is not a measure of the standard of living. GDP focuses on the amount of goods and services produced. While goods and services lead to improving people’s welfare, there are other factors that also come into play. Including the value of work around the house and better estimates of healthcare improvements would make for a better measure of production and so would improve GDP’s measurement of production and so a better measure of the standard of living. Including a measurement of how happy people are might make for a better measure of the standard of living.

b. Explain the challenges involved in trying to incorporate the new index. Measuring the value of housework and making better estimates of healthcare improvements are both difficult to do. Including people’s happiness also presents some major problems. Even if this variable could be accurately measured, determining the weighting scheme to be used is very difficult. For instance, how much should “happiness” be weighted compared to “GDP per person”?

c. Explain how the United Nations’ Human Development Index compares with the new index. The Human Development Index (HDI), combines GDP per person, life expectancy and health, and education. GDP definitely does not include housework and probably undervalues the quality improvements that are available in today’s healthcare. If these were correctly valued, then the HDI would be higher. While the HDI does not directly include “happiness,” likely the GDP per person, life expectancy and health, and education all contribute to happiness, so the HDI probably captures some fraction of what “happiness” measures.

d. Is there likely to be a high correlation between GDP per person and the new index? Why or why not? Likely there is a high correlation between GDP per person and the new index that have been proposed. Countries with higher levels of GDP per person probably also have happier inhabitants and be the location where healthcare improvements are most likely to be employed. Consequently, adding these variables would probably create a new index that is highly correlated with GDP per person.

28.

Use the information in Problem 18 to calculate the chained-dollar real GDP in 2023 expressed in 2022 dollars. Real GDP in 2023 is $135.70. The chained-dollar method uses the prices of 2022 and 2023 to calculate the growth rate in 2023. The value of the 2022 quantities at 2022 prices is $50. The value of the 2023 quantities at 2022 prices is $135. Using 2022 prices, the increase in GDP for these two years is $85, so the percentage increase is ($85  $50)  100, which is 170.0 percent. Next the value of the 2022 quantities at 2023 prices is 60 apples × $1.00 per apple + 80 oranges × $2.00 an orange, which is $220. The value of the 2023 quantities at 2023 prices is $600. Using 2023 prices, the © 2023 Pearson Education, Inc.

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increase in GDP for these two years is $380 so the percentage increase is ($380 ÷ $220) × 100, which is 1.727  100, which is 172.7 percent. The chained dollar method calculates the growth rate as the average of these two percentage growth rates, which means that the growth rate in 2023 is 171.4 percent. So real GDP in 2023 is equal to $50, which is real GDP in the base year (and is equal to nominal GDP in that year) multiplied by one plus the growth rate. Real GDP in 2023 is $135.70.

C h a p t e r

MONITORING JOBS AND INFLATION

Answers to the Review Quizzes Page 524 1.

What determines if a person is in the labor force? Workers who have a job and workers who are unemployed are in the labor force. To be “officially” counted as unemployed, and thus in the labor force, means that the person does not have a job but is available and willing to work and has made some effort to find work within the past four weeks, or waiting to be called back to a job from which he or she has been laid off, or waiting to start a new job within 30 days.

What distinguishes an unemployed person from one who is not in the labor force? A general definition of unemployment is a person who wants to work but does not have a job. A person who is not in the labor force does not have a job and does not want one. More specifically to be considered as unemployed, and thus in the labor force, the person must not have a job but must be available and willing to work. The person must also have made some effort to find work within the past four weeks, or be waiting to be called back to a job from which he or she has been laid off, or be waiting to start a new job within 30 days.

Describe the trends and fluctuations in the U.S. unemployment rate from 1981 to 2021. The unemployment rate has had several significant fluctuations around its average of 6.2 percent. It started by rising to a high that exceeded 10 percent during the 1982 recession. Then there was a gradual downward trend particularly insofar as the peaks during the recessions in 1990-1991 and 2001 were much lower than in 1982. But that situation reversed itself with the severe and prolonged recession of 2008-2009 when the unemployment once more jumped (slightly) above 10 percent. After that peak the unemployment rate fell to around 4.5 percent but skyrocketed to near 14 percent during the pandemic recession before quickly falling back to near 6 percent.

Describe the trends and fluctuations in the U.S. employment-to-population ratio and labor force participation rate from 1981 to 2021. The labor force participation rate and the employment-to-population ratio had an upward trend from 1981 until about 2000 after which they turned downward. Both show fluctuations around these trends, especially the employment-to-population ratio which rises during expansions and falls during recessions but its fall between 2008 and 2010 was particularly severe. The labor force participation rate also fell between 2008 and 2010 but the fall was not as dramatic. After this recession the labor force participation rate has leveled off and was near 63 percent and the employment-to-population ratio turned back up and rose to near 60 percent. Both immediately plummeted during the 2020 Covid-19 recession, especially the employment-to-population which fell from near 62 percent to 52 percent. However, both quickly turned back up and were rising in 2021.

Describe the alternative measures of unemployment. The Bureau of Labor Statistics keeps track of 6 alternative measures of unemployment:  U-1 measures long-term unemployment. It counts as unemployed only workers who have been unemployed for 15 or more weeks. © 2023 Pearson Education, Inc.

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 U-2 measures job losers; that is, only workers who lost their jobs (as opposed to quitting or reentering the labor market) are counted as unemployed.  U-3 is the conventional measure of unemployment.  U-4 adds discouraged workers to the conventional measure of unemployment.  U-5 adds all marginally attached workers to the U-4 measure of unemployment.  U-6 adds part-time workers who would like a full-time job (economic part-time workers) to the U5 measure of unemployment.

Page 527 1.

Why does unemployment arise and what makes some unemployment unavoidable? In a dynamic economy some unemployment is unavoidable. For instance, growth means that some workers will always be entering the labor force without a job and therefore be unemployed. Consumers changing their demand for one good over another means workers in the newly less-favored industry will lose their jobs and also be unemployed. Moreover some workers will always be leaving their current job to search for a better job and these workers, too, will be unemployed. So some unemployment is unavoidable as the economy churns and reacts to changes.

Define frictional unemployment, structural unemployment, and cyclical unemployment. Give examples of each type of unemployment. Frictional unemployment is the unemployment that arises from the normal labor turnover from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. For instance, newly graduated students entering the labor market looking for work are frictionally unemployed. Structural unemployment represents the unemployment created by changes in technology or international competition that change the skills needed to perform jobs or change the locations of jobs in the economy. For instance, workers are structurally unemployed if they lose their jobs because of changes in the amount of foreign competition and if they have different skills from those required by new jobs or if they live in a different region of the country from where new jobs are being created. Finally, cyclical unemployment is the unemployment created by business cycle fluctuations in economic activity. Specifically the higher than normal unemployment at a business cycle trough and the lower than normal unemployment at a business cycle peak is called cyclical unemployment. For instance, a worker laid off in 2020 because of the recession is cyclically employed.

What is the natural unemployment rate? The natural unemployment rate is the unemployment rate when no cyclical unemployment exists. That is, when all unemployment is frictional or structural then the unemployment rate equals the natural unemployment rate. Full employment occurs when there is no cyclical unemployment and the unemployment rate equals the natural unemployment rate.

How does the natural unemployment rate change and what factors might make it change? Changes in the natural unemployment rate arise because of changes in frictional and structural unemployment. Any factor that changes frictional unemployment or structural unemployment changes the natural unemployment rate. For instance, a change in the age distribution of the population, a change in the scale of structural changes that are occurring, a change in the minimum wage rate or efficiency wages, or a change in unemployment benefits all change the natural unemployment rate.

Why is the unemployment rate never zero, even at full employment? The unemployment rate is never zero because there is always churning going on the economy. There are always new workers entering the labor market and searching for work, there are always workers leaving one job to search for another, better job, and there are always firms laying off workers. All these cases lead to unemployment as the workers search for a job. © 2023 Pearson Education, Inc.

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What is the output gap? How does it change when the economy goes into recession? The output gap equals the difference between real GDP and potential GDP. When the economy goes into a recession, the output gap becomes negative.

How does the unemployment rate fluctuate over the business cycle? During a recession the unemployment rate is generally rising. During an expansion the unemployment rate is generally falling.

Page 533 1.

What is the price level? The price level is the average level of prices.

What is the CPI and how is it calculated? The CPI is the Consumer Price Index. The CPI equals (Cost of CPI basket at current prices ÷ Cost of CPI basket at base-period prices) ×100.

How do we calculate the inflation rate and what is its relationship with the CPI? The inflation rate is the percentage change in a price index from one year to the next. The rate of change of the CPI is often used as a measure of inflation as faced by consumers.

What are the four main ways in which the CPI is an upward-biased measure of the price level? The CPI is biased upward because of the new goods bias; the quality change bias; commodity substitution bias; and outlet substitution bias. The new goods bias reflects the point that new goods, such as DVDs are generally more expensive than the old goods they replace, VHS tapes. The quality change bias points out that part of the reason goods and services rise in price is because their quality is improved. Commodity substitution bias occurs because consumers substitute away from goods and services that have risen in the price more than other goods and services. Outlet substitution bias occurs because consumers will use discount stores more frequently when goods and services rise in price.

What problems arise from the CPI bias? The upward bias in the CPI distorts private contracts and government outlays that include formulas based on CPI change as a measure of inflation. If the intent is to maintain the real value of a payment, indexing payments to the CPI will in fact increase the real value of payments over time if the CPI has an upward bias. In one year, the effect of the bias may not be much, but it will accumulate over time.

What are the alternative measures of the price level and how do they address the problem of bias in the CPI? The first of three alternative price level is the chained CPI. The chained CPI is calculated in a similar manner as chained-dollar real GDP. The chained CPI overcomes the commodity substitution and new goods bias because it uses current as well as previous period quantities. The second alternative price level is the personal consumption expenditure Price Index or PCEPI. The PCEPI is calculated from real and nominal consumption expenditure. The PCEPI uses a broader basket of goods and services than the CPI and, similar to the chained CPI, it overcomes the commodity substitution and new goods bias because it also is calculated using a chained method. The third alternative is the GDP deflator. The GDP deflator is similar to the PCEPI except the GDP deflator uses the prices from all the goods and services included in GDP. Because it is calculated using a chained method, it overcomes the commodity substitution and new goods bias.

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Answers to the Study Plan Problems and Applications 1.

The BLS reported the following data for January 2021: Labor force: 159 million Employment: 148 million Working-age population: 261 million

Calculate the a. Unemployment rate. The unemployment rate is 6.9 percent. The unemployment rate is the percentage of the labor force that is unemployed. The labor force is the sum of the people unemployed and the people employed. So the number of people who are unemployed is 159 million minus 148 million, which is 11 million. The unemployment rate equals (the number of people unemployed divided by the labor force) multiplied by 100. That is, (11 million/159 million)  100, which is 6.9 percent.

b. Labor force participation rate. The labor force participation rate is 60.9 percent. The labor force participation rate is the percentage of the working-age population that is in the labor force. The working-age population is 261 million and the labor force is 159 million, so the labor force participation rate is (159 million/261 million) 100, which equals 60.9 percent.

c. Employment-to-population ratio. The employment-to-population ratio is 56.7 percent. The employment-to-population ratio is the percentage of the people of working age who have jobs. The employment-to-population ratio is equal to the number of people employed divided by the working-age population then multiplied by 100. The employment-to-population ratio is (148 million/261 million)  100, which is 56.7 percent.

In July 2021, in the economy of Sandy Island, 10,000 people were employed, 1,000 were unemployed, and 5,000 were not in the labor force. During August 2021, 80 people lost their jobs and didn’t look for new ones, 20 people quit their jobs and retired, 150 unemployed people were hired, 50 people quit the labor force, and 40 people entered the labor force to look for work. Calculate for July 2021 a. The unemployment rate. The unemployment rate in July is 9.1 percent. The unemployment rate is the number unemployed as a percentage of the labor force. The number of unemployed workers is 1,000. The labor force is the number employed plus the number unemployed so in July it is 11,000. The unemployment rate equals (1,000/11,000)  100, which is 9.1 percent.

b. The employment-to-population ratio. The employment-to-population ratio is 62.5 percent. The employment-to-population ratio is the number employed as a percentage of the working-age population. The number of employed people is 10,000. The working-age population is the sum of the labor force and the number of people who are not in the labor force, which is 16,000. The employment-to-population ratio is (10,000/16,000)  100, which is 62.5 percent.

And calculate for the end of August 2021 c. The number of people unemployed. The number of people who are unemployed at the end of August is 840. The number of people who are unemployed at the end of August equals the number unemployed in July plus the number of people who lost their job and who stayed in the labor market plus the number of people entering the labor market minus the number of people who were hired minus the number of people who left the labor market. So the number of people unemployed equals 1,000 + 40  150  50, which is 840.

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d. The number of people employed. The number of people who are employed at the end of August is 10,050. The number of people who are employed at the end of August equals the number employed in July minus the people whom lost their jobs plus the number of people who gained jobs.

e. The unemployment rate. The unemployment rate at the end of August is 7.7 percent. The unemployment rate equals the number unemployed expressed as a percentage of the labor force. The number of people who are unemployed is 840. The labor force equals the number employed plus the number unemployed and at the end of August it is 10,890. The unemployment rate at the end of August equals (840/10,890)  100, which is 7.7 percent.

Use the following data to work Problems 3 and 4. In June 2015, the U.S. unemployment rate was 5.2 percent. In June 2017, the unemployment rate was 4.4 percent. 3. Predict what happened to unemployment between June 2015 and June 2017, if the labor force was constant. If the labor force is constant, the only way the unemployment rate can decrease is if the number of unemployed workers decreases.

Predict what happened to the labor force between June 2015 and June 2017, if unemployment was constant. If unemployment is constant, the only way the unemployment rate can decrease is if the labor force increases.

April’s Expected Hiring Boom Goes Bust Although the unemployment rate didn’t fall as much as expected in April, the measure of unemployment that includes discouraged workers and workers holding part-time jobs for economic reasons decreased to its lowest level in over a year. Source: cnbc, May 7, 2021 What is a discouraged worker? Explain how a decrease in discouraged workers influences the official unemployment rate and a broader measure. What is the broader measure? A discouraged worker is a person who currently is not working, would like a job, has looked for one in the recent past, but has stopped looking for work because of repeated failures in finding a job. If a worker who had not been looking for work starts looking, the official unemployment rate, U-3, rises (until the worker finds a job). U-4 includes discouraged workers among the ranks of the unemployed so when the worker starts looking for work and is no longer a discouraged worker, the U-4 unemployment rate does not change.

Use the following news clip to work Problems 6 and 7. U.S. Job Openings Soar to Record 8.1 Million Employers in the restaurant, hotel, theater, and amusement park sectors are eager to hire more workers, but they say they can’t find qualified workers to hire. Add to that problem, an increasing number of people who are employed are quitting because they think they can find a better job elsewhere. Source: marketwatch.com, May 11, 2021 6. If the labor market is working properly, why would there be any unemployment at all? Unemployment will always exist in the labor market because of normal labor market frictions. People newly entering the labor market, workers quitting a job to look for a better job, firms laying-off workers because consumers no longer want to buy the goods produced by the firms will always be part of the labor

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market. All of these events create unemployment, so even when the labor market is operating at peak efficiency, unemployment will always be present.

Are workers who quit their jobs and look for another counted as part of the economy’s structural unemployment, frictional unemployment, or cyclical unemployment? These workers are unemployed as the result of the normal ebb and flow in the labor market. These workers are part of the economy’s frictional unemployment.

Use the following information to work Problems 8 and 9. The people on Coral Island buy only juice and cloth. The CPI basket contains the quantities bought in 2020. The average household spent $60 on juice and $30 on cloth in 2020 when the price of juice was $2 a bottle and the price of cloth was $5 a yard. In 2021, juice is $4 a bottle and cloth is $6 a yard. 8.

Calculate the CPI basket and the percentage of the household’s budget spent on juice in 2020. The CPI basket is 30 bottles of juice and 6 yards of cloth. The total amount spent on the CPI basket in 2012 was $90 and of that $60 was spent on juice. The percentage of the household’s budget spent on juice was ($60/$90) × 100, which is 66.7 percent.

Calculate the CPI and the inflation rate in 2021. The CPI in 2021 is 173.3. To calculate the CPI, divide the value of the CPI basket in 2021 prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in 2021 prices is: ($4  30) + ($6  6) = $156. The value in base-year prices is $60 + $30 (provided in the question), which equals $90. So the CPI is ($156/$90)  100 = 173.3. The inflation rate in the 2014 is 73.3 percent. The inflation rate equals the CPI in 2021 year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the base-year CPI is 100, the inflation rate is [(173.3 – 100)/ 100] × 100 = 73.3 percent.

Use the following data to work Problems 10 to 11. The BLS reported the following CPI data: June 2019 256.1 June 2020 257.8 June 2021 271.7 10. Calculate the inflation rates for the years ended June 2020 and June 2021. How did the inflation rate change in 2021? The inflation rate for the year ended June 2020 is 0.7 percent; the inflation rate for the year ended June 2021 is 5.4 percent. The inflation rate is the percentage change in the price level. It is equal to [(Pthis year – Plast year)/ Plast year]  100. For the year ended in June 2020 the inflation rate is [(257.8 – 256.1)/256.1]  100, which is 0.7 percent. For the year ended in June 2021 the inflation rate is [(271.7 – 257.8)/257.8]  100, which is 5.4 percent. The inflation rate increased in 2021.

11.

Why might these CPI numbers be biased? How can alternative price indexes avoid this bias? Which alternative index might be least biased and why? The CPI numbers might be biased because of the new goods bias, the quality change bias, the commodity substitution bias, and the outlet substitution bias. The new goods bias is that new goods are often more expensive than the older goods that they replace. The quality change bias is that increases in the quality of a good are often accompanied by increases in the good’s price. The commodity substitution bias reflects the point that consumers will buy less of a good whose price increased and more of a good whose price has not changed. Finally the outlet substitution bias points out that when prices rise, consumers shop more frequently at stores with cheaper prices. © 2023 Pearson Education, Inc.

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Each of the alternative price indexes attempts to overcome some of the bias in the CPI numbers. The chained CPI uses prices and quantities from the previous period and the current period. The chaining process overcomes the commodity substitution process. And because it contains current period quantities, it also does not suffer from the new goods bias. The personal consumption expenditure price index contains goods and services omitted from the CPI. It is calculated from the nominal and real consumption expenditure data and so it, too, is computed using a chaining procedure. Because the personal consumption expenditure price index is calculated using a chaining procedure, it does not suffer from the commodity substitution bias or the new goods bias. The GDP deflator is calculated from nominal and real GDP data. It is broader than the personal consumption expenditure price index because it contains goods and services in consumption expenditure, investment, government expenditure, and net exports. The GDP deflator is calculated using a chaining procedure and so it also avoids the commodity substitution bias and new goods bias. The GDP deflator is possibly the least biased because it is a chained index and contains a broader selection of goods and services than the personal consumption expenditure price index.

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Answers to Additional Problems and Applications 12.

What is the unemployment rate supposed to measure and why is it an imperfect measure? Ideally the unemployment rate would measure the underutilization of labor resources. But it is an imperfect measure for two reasons. First the unemployment rate does not include some underutilized labor. In particular the unemployment rate completely omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate. Second the unemployment rate counts as fully employed workers who are working part time but who want full-time jobs. These workers are underutilized because they would like to work for more hours than is presently the case.

13.

The BLS reported data for February 2019: Labor force participation rate: 63 percent Working-age population: 258 million Employment-to-population ratio: 60.4 Calculate the a. Labor force. The labor force participation rate equals the labor force divided by the working-age population then multiplied by 100. Rearranging this formula shows that the labor force equals the working-age population multiplied by the labor force participation rate then divided by 100. Using this last formula and the data given in the problem shows that the labor force equals 258 million × 63/100, which is 162.5 million.

b. Employment. The employment-to-population ratio equals employment divided by the working-age population then multiplied by 100. Rearranging this formula shows that employment equals the working-age population multiplied by the employment-to-population ratio then divided by 100. Using this last formula and the data given in the problem shows that employment equals 258 million × 60.4/100, or 155.8 million.

c. Unemployment rate. The unemployment rate equals the number of people unemployed divided by the labor force. The labor force, from part (a), is 162.5 million. The labor force equals the number of people employed plus the number of people unemployed. Employment, from part (b), is 155.8 million so the number of people unemployed is 6.7 million. The unemployment rate equals the number of people unemployed divided by the labor force, then multiplied by 100. Using this last formula shows that the unemployment rate equals (6.7 million/162.5 million) × 100, which is 4.1 percent.

14.

U.S. Jobs Growth Picks Up Jobs growth increased in May as the unemployment rate fell to 5.8 percent. The labor force participation rate fell slightly from 61.7 percent in April to 61.6 percent in May. It remains well below its 63.3 percent level prior to the pandemic. Bloomberg.com, June 4, 2021 a. If all the newly hired people had been unemployed, how would the labor force participation rate and unemployment rate have changed? The labor force would not have changed, so the labor force participation rate would not have changed. The number of people unemployed would have decreased so the unemployment rate would have fallen.

b. If all the newly hired people had previously given up on their job search, how would the labor force participation rate and unemployment rate have changed? The labor force would have increased, so labor force participation rate would have risen. The number of people unemployed would not have changed but the increase in the labor force means that the unemployment rate would have fallen.

15.

The BLS reported that in the second quarter of 2016, employment increased by 100,000 to 150,959,000 and the unemployment rate fell from 5 percent to 4.9 percent. About 1.3 million © 2023 Pearson Education, Inc.

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people were marginally attached workers and 0.6 million of them were discouraged. a. Calculate the change in unemployment in the second quarter of 2016. At the start of the second quarter employment was 150,959,000 − 100,000 = 150,859,000. The unemployment rate, which at the start of the second quarter was 5.0 percent, equals (Unemployment/[Unemployment + Employment]) × 100. Using the data for the start of the second quarter gives the result that 0.050 = (Unemployment/[Unemployment + 150,859,000]). Solving for the amount of unemployment shows that unemployment at the start of the second quarter was 7,939,947 workers. Similar calculations show that at the end of the second quarter the amount of unemployment was 7,778,118 workers. Unemployment decreased in the second quarter by 161,829 workers.

b. With 1.3 million marginally attached workers and 0.6 million of them discouraged workers, what are the characteristics of the other 0.7 million marginally attached workers? The other 0.7 million marginally attached workers would like a job but have stopped looking for work. Because they are not discouraged workers, these 0.7 million workers have stopped looking for reasons other than their inability to find a job. For example, a stay-at-home spouse might prefer working in the job market but have quit looking to undertake some home repairs.

16.

A high unemployment rate tells us that a large percentage of the labor force is unemployed but not why the unemployment rate is high. What unemployment measure tells us if (i) people are searching longer than usual to find a job, (ii) more people are economic part-time workers, or (iii) more unemployed people are job losers? U-1 measures long-term unemployment of 15 weeks or more. If U-1 exceeds its normal value, then people are taking longer than usual to find a job. U-6 equals U-5 plus part-time workers who want full-time jobs as unemployed, so the difference between U-6 and U-5 is the result of part-time workers who want a fulltime job. If this difference is unusually large, then more workers than normal are working at part-time jobs. U-2 measures unemployment resulting from people losing their jobs. If U-2 is larger than normal, then more unemployment than normal results from people losing their jobs.

17.

Why might the unemployment rate underestimate the underutilization of labor resources? The official unemployment rate underestimates the underutilization of labor resources for two reasons. First the official unemployment rate completely omits some underutilized labor. In particular the official unemployment rate omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate because they are not searching for a job, though if the labor market was better and jobs more plentiful they would reenter the labor market. Marginally attached workers, however, are not a major source of mismeasurement because they are a small subset of people. Second the unemployment rate counts as fully employed workers who are working part time but who want full time jobs. These workers are underutilized because they would like to work for more hours than is presently the case. These workers are a significantly more substantial source of error because they account for a much larger part of the labor force.

18.

There Are Now More Jobs Available Than Before the Pandemic More than 15 million jobs were vacant in March but employees fearful of returning to work didn’t rush to fill them. Now with many vaccinated, employers claim that generous unemployment benefits and stimulus payments are keeping workers at home. Source: nbcnews.com, April 9, 2021 a. Using the information in the news clip, how do you predict the labor force participation rate, employment-to-population ratio, and unemployment rate changed? To the extent workers rejoin the labor force, the labor force participation rises. Even though there are more vacant jobs than before the pandemic, the clip suggests that the labor force participation rate did not change by much because not many workers rejoined the labor force to search for a job. Probably a few unemployed workers accepted jobs so the employment-to-population ratio rose, but because most of these © 2023 Pearson Education, Inc.

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jobs remained vacant, it is likely that not many unemployed workers became employed in which case the employment-to-population ratio did not change by much. With only very small changes to the labor force and employment, the unemployment rate most likely did not change by much.

b. If the government slashed unemployment benefits, how would the numbers in the news clip change? Why? Slashing unemployment benefits increases the cost of being unemployed and thereby decreases the unemployment rate as people take less time to search for a new job. The number of job openings would not be directly affected but the number of workers hired would increase so vacancies would decrease.

Use the following data to work Problems 19 to 21. The IMF World Economic Outlook reports the unemployment rates in the table. 19. What do these numbers tell us about the phase of the business cycle in these countries in 2016?

Region United States Spain Venezuela Singapore

2015 5.3 22.1 7.4 1.9

2016 4.9 19.6 21.2 2.1

The unemployment rates were low in the United States and very low in Singapore, so it is probably the case that both countries were in an expansionary period. The unemployment rate in Spain fell, so Spain might be entering an expansionary period. The unemployment rate in Venezuela rose drastically, so Venezuela was in a recession.

20.

What do these numbers tell us about the relative size of their natural unemployment rates? These numbers cover only two years, so making inferences about the relative size of the natural unemployment rates is potentially dangerous. To the extent that these data are representative, the natural unemployment rate is likely the highest in the Venezuela and Spain and the lowest in Singapore.

21.

Do these numbers tell us anything about the relative size of the labor force participation rates and employment-to-population ratios? The numbers tell us nothing about the relative sizes of the labor force participation rates or the employment-to-population ratios in these three regions.

22.

Retail Workforce Could Face Permanent Decline The pandemic has caused seismic changes for the retail industry. Many stores permanently closed their doors as growing numbers of customers shifted to online shopping. Analysts believe that even after the pandemic, retail jobs won’t rebound. Source: cnbc.com, July 22, 2020 What types of unemployment is the news clip discussing? Retailers are laying off these workers due to the recession, so the unemployment initially is cyclical. To the extent that the laid off workers do not have the necessary skills for other jobs, structural unemployment also increases.

23.

More Call For Retraining as Many Jobs Might Not Return Job postings for administrative assistants, human resources personnel, food service workers, beauty consultants, and pet groomers have dwindled. Two-thirds of those unemployed are considering switching occupations, which in many cases will mean retraining. Source: bizjournals.com, February 18, 2021 a. What is the main type of unemployment that retraining programs seek to avoid? Explain. Retraining programs attempt to reduce structural unemployment. The education would retrain workers so that they have the skills that business need for the jobs that are available.

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b. How might government funded retraining influence the natural unemployment rate? Explain. If retraining is successful, it will decrease the natural unemployment rate. Natural unemployment is comprised of frictional and structural unemployment. By decreasing structural unemployment, the retraining decreases the natural unemployment rate.

24.

A typical family on Sandy Island consumes only juice and cloth. Last year, which was the base year, the family spent $40 on juice and $25 on cloth. In the base year, juice was $4 a bottle and cloth was $5 a length. This year, juice is $4 a bottle and cloth is $6 a length. Calculate a. The CPI basket. The CPI basket is 10 bottles of juice and 5 lengths of cloth.

b. The CPI in the current year. The CPI in the current year is 107.7. To calculate the CPI, divide the value of the CPI basket in current year prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in current year prices is: ($4  10) + ($6  5) = $70. The value in base-year prices is $40 + $25 (provided in the question), which equals $65. So the CPI is ($70/$65)  100 = 107.7.

c. The inflation rate in the current year. The inflation rate in the current year is 7.7 percent. The inflation rate equals the CPI in the current year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the base-year CPI is 100, the inflation rate is [(107.7 – 100)/ 100] × 100 = 7.7 percent.

25.

A firm agreed to pay its workers $20 an hour in 2019 and $22 an hour in 2020. The price level for these years was 256 in 2019 and 260 in 2020. Calculate the real wage rate in each year. What is the real wage increase received by these workers in 2020? The real wage rate equals the nominal wage rate divided by the price level. In 2019 the real wage rate was $20/256 × 100, for a real wage rate of $7.81. In 2020 the real wage rate was $22/260 × 100, for a real wage rate of $8.46. The workers got a real pay raise between 2019 and 2020 of $0.65.

26.

News release In the first quarter of 2020, real personal consumption expenditure was $13,117 billion and the PCEPI deflator was 110.88. In the first quarter of 2021, real personal consumption expenditure was $13,353 billion and (nominal) personal consumption expenditure was $15,070 billion. Source: BEA, July 24, 2021 Calculate personal consumption expenditure in the first quarter of 2020 and the PCEPI in the first quarter of 2021. Was the percentage increase in real personal consumption expenditure greater or smaller than that in personal consumption expenditure? Personal consumption expenditure = (real personal consumption expenditure) × (PCEPI) ÷ 100, so in the first quarter of 2020 personal consumption expenditure was $13,117 billion × 110.88 ÷ 100 = $14,544 billion. PCEPI = ([personal consumption expenditure] ÷ [real personal consumption expenditure) × 100, so in the first quarter of 2021 the PCEPI = ($15,070 billion ÷ $13,353 billion) × 100 = 112.86. The percentage increase in real personal consumption expenditure was smaller than the percentage increase in personal consumption expenditure. Personal consumption expenditure grows because real personal consumption expenditure grows and/or because the PCE deflator grows. During this period, both real personal consumption expenditure grew and because the PCE deflator grew so the percentage increase in (nominal) personal consumption exceeded the percentage increase in real personal consumption expenditure.

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How Much the U.S. Minimum Wage Was Actually Worth the Year You Were Born The first federal minimum wage was established in 1938 at $0.25 an hour. Adjusted for inflation, that would be worth $4.63 an hour in 2021. In 2002, the federal minimum wage was $5.15 an hour. In 2021 dollars, that is the equivalent of $7.65. Source: chicagotribune.com, April 5, 2021 Using the data in the news clip, by what percentage did the CPI increase between 1938 and 2021, and between 2002 and 2021? According to the problem, the minimum wage of $0.25 in 1938 is equivalent to $4.63 in 2021. This equality means that the real values of the federal minimum wage in 1938 and in 2021 are the same. If we set 1938 as the base year, then the price level in 1938 is 100, and the real federal minimum wage in 1938 is equal to the nominal federal minimum wage in 1938, $0.25. So $0.25/1.00 = $4.63/P2021. Solving the equation for P2021 and multiplying the answer by 100 to get the index value gives P2021 = 1852. The inflation rate is the percentage change in the price levels, so the inflation rate equals [(1852 − 100)/100] × 100, which is 1752 percent. Also according to the problem, the minimum wage of $5.15 in 2002 is equivalent to $7.65 in 2021. This equality means that the real values of the federal minimum wage in 2002 and in 2021 are the same. If we set 2002 as the base year, then the price level in 2002 is 100, and the real federal minimum wage in 2002 is equal to the nominal federal minimum wage in 2002, $5.15. So $5.15/1.00 = $7.65/P2021. Solving the equation for P2021 and multiplying the answer by 100 to get the index value gives P2021 = 149. The inflation rate is the percentage change in the price levels, so the inflation rate equals [(149 − 100)/100] × 100, which is 49 percent.

28.

After you have studied Economics in the News on pp. 534–535, answer the following questions. a. How did the unemployment rate change during the Covid recession? The unemployment rate rapidly rose during the start of the Covid recession.

b. Which measure of unemployment, U-3 or U-6, was measured incorrectly because of a classification error? Both U-3 and U-6 were affected by the misclassification error.

c. What was the classification error and did it understate or overstate the unemployment rate? The classification error involved workers who were on temporary layoff due to the pandemic. These workers were classified as “employed” when the correct classification should have been “unemployed” for those that did not work at all during the time period. Because these workers were misclassified as employed, the reported unemployment rate understated the actual unemployment rate.

d. Classified by sex, race, and education, who experienced the highest unemployment rate and why? Female workers, Hispanic workers, Black workers, and workers who did not complete high school had the highest unemployment rates. They had the highest unemployment rates because they were preferentially employed in the travel, hospitality, and retail sectors which were the sectors hardest hit by the pandemic.

e. Classified by sex, race, and education, who experienced the lowest unemployment rate and why? Male workers, White workers, workers who completed college had the lowest unemployment rates. They had the lowest unemployment rates because they were employed in sectors and in jobs that were not hard hit by the pandemic and could easily work at home.

29.

Older Workers Are Being Pushed Out of the Job Market Compared to pre-pandemic levels, the number of people aged 55 and over who are in the labor force has decreased by 2 million. Corporate trends like the abandonment of middlemanagement jobs tend to eliminate older workers. As these jobs are cut, the older, higher-paid © 2023 Pearson Education, Inc.

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workers are fired and their jobs restructured for younger, lower-paid workers. Source: forbes.com, February 16, 2021 a. What type of unemployment might older workers be more prone to experience? Older workers are more likely to experience structural unemployment.

b. Explain how the unemployment rate of older workers is influenced by the business cycle. Older workers might be more likely to be fired when the economy enters a recession because the business cuts middle management positions and changes the jobs so they can be filled by younger, lower-paid workers. If this takes place, then the unemployment rate of older workers will rise more than that of other groups when the economy enters a recession.

c. Why might older unemployed workers become marginally attached or discouraged workers? Older workers have a higher unemployment rate than younger workers and they may have a significantly more difficult time finding a new job than do younger unemployed workers. It would be easy for some older workers to become discouraged about their job prospects and either quit looking entirely, thereby becoming marginally attached or discouraged workers.

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Answers to the Review Quizzes Page 546 1.

What is economic growth and how do we calculate its rate? Economic growth is the sustained expansion of production possibilities. It is measured by the increase in real GDP over a given time period. The economic growth rate is the annual percentage change in real GDP.

What is the relationship between the growth rate of real GDP and the growth rate of real GDP per person? The growth rate of real GDP tells how rapidly the total economy is expanding while the growth rate of real GDP per person tells how the standard of living is changing. The growth rate of real GDP per person approximately equals the growth rate of real GDP minus the population growth rate.

Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP per person in 20 years. The rule of 70 states that the number of years it takes for the level of any variable to double is approximately equal to 70 divided by the growth rate. If the level of real GDP doubles in 20 years, the rule of 70 gives 20 = 70  (growth rate) so that the growth rate equals 70  20, which is 3.5 percent per year.

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What has been the average growth rate of U.S. real GDP per person over the past 120 years? In which periods was growth most rapid and in which periods was it slowest? Over the past 120 years, U.S. real GDP per person grew at an average rate of 2 percent per year. Slow growth occurred during mid-1950s and 1973–1983. Very slow growth (negative growth!) also occurred during the Great Depression. Growth was rapid during the 1920s and 1960s. Growth was also (extremely!) rapid during World War II.

Describe the gaps between real GDP per person in the United States and in other countries. For which countries is the gap narrowing? For which is it widening? For which is it the same? Amongst the rich countries, for about the ten years after 1980 Japan closed the gap with the United States but then it widened back to what it was initially while the gaps between the United States and Canada, and the “Europe Big 4” (France, Germany, Italy, and the United Kingdom) have increased slightly as the United States has grown slightly more rapidly. The gap between Russia and the United States initially widened, then rapidly narrowed and recently has been widening again. The gap between Mexico and the United States has widened. The gap between the United States and Nigeria has narrowed slightly. Some nations in Asia— including Hong Kong, Singapore, Korea, and China—have grown very rapidly. The gap between these nations and the United States has shrunk; indeed, Singapore has slightly surpassed the United States and Hong Kong has virtually tied the United States.

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Compare the growth rates in Hong Kong, Korea, Singapore, Taiwan, China, and the United States. In terms of real GDP per person, how far is China behind these others? Since 1980, real GDP per person in the nations of Hong Kong, Singapore, Korea, Taiwan, and China has grown very rapidly and is rapidly catching up to the United States. Income per person in Hong Kong is virtually the same as that in the United States and income per person in Singapore slightly exceeds that in the United States. Income in Korea also is relatively close. Income in China is the lowest, though recently China has been growing the most rapidly. China’s level of income in 2020 is similar to that of Hong Kong in 1980.

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What is the aggregate production function? The aggregate production function is the relationship that tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same.

What determines the demand for labor, the supply of labor, and labor market equilibrium? The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. A fall in the real wage rate increases the quantity of labor demanded because of diminishing returns. The demand for labor also depends on productivity. If productivity increases, the demand for labor increases. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. An increase in the real wage rate increases the quantity of labor supplied because more people enter the labor force and the hours supplied per person increases. The real wage adjusts so that the labor market is in equilibrium. If the real wage rate is above (below) its equilibrium, there is a surplus (shortage) of labor that then causes the real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium level, there is a surplus of labor so the real wage rate falls until it reaches its equilibrium. The equilibrium quantity of employment is the full employment quantity of labor.

What determines potential GDP? Potential GDP is determined from the labor market equilibrium. When the labor market is in equilibrium, there is full employment. The quantity of real GDP produced by the full employment quantity of labor is potential GDP.

What are the two broad sources of potential GDP growth? The two broad sources of growth in potential GDP are growth of the supply of labor and growth of labor productivity.

What are the effects of an increase in the population on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor? An increase in population increases the supply of labor. Employment increases and the real wage rate falls. The increase in employment creates a movement along the aggregate production function so potential GDP increases. Because of diminishing returns, potential GDP per hour of labor decreases.

What are the effects of an increase in labor productivity on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor? The increase in labor productivity shifts the aggregate production function curve upward. The demand for labor increases, and the demand for labor curve shifts rightward. The increase in the demand for labor raises the real wage rate and increases employment. The increase in employment as well as the upward shift of the aggregate production function increase potential GDP. Potential GDP per hour of labor increases.

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What are the preconditions for labor productivity growth? The fundamental preconditions for labor productivity growth are the existence of: firms, markets, property rights, and money. These fundamental preconditions create an incentive system that can lead to labor productivity growth.

Describe the sources of economic growth and identify the source of the growth slowdown. Economic growth can be divided into two sources: Growth in work hours and growth in labor productivity. Both sources contributed to the slowdown in economic growth after 1999. Growth in work hours, after growing slowly between 1989 and 1999, disappeared after 1999 and contributed nothing to economic growth. Growth in productivity, while not totally disappearing, slowed compared to previous eras. For both reasons, economic growth after 1999 has been less than during other periods.

Explain the influences on the pace of labor productivity growth. Once the preconditions for growth are in place, the sources of labor productivity growth are: physical capital growth, human capital growth, and advances in technology. All of these activities enable an economy to grow and they all increase labor productivity. They all also interact: human capital creates new technologies, which are then embodied in both new human capital and new physical capital. Similarly advances in technology also lead to increases in labor productivity.

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What is the key idea of classical growth theory that leads to the dismal outcome? The “dismal outcome” in classical theory is the conclusion that in the long run real GDP per person equals the subsistence level. In classical growth theory, an increase in real GDP per person causes population increases that return real GDP per person to the subsistence level. In the classical growth theory, an increase in income creates a population boom. The increase in population increases the supply of labor. Because of diminishing returns to labor, the increase in the supply of labor lowers the real wage rate and people’s incomes. Eventually the real wage rate falls to equal the subsistence level, at which time the population stops growing.

What, according to neoclassical growth theory, is the fundamental cause of economic growth? In neoclassical growth theory, growth results from technological advances, which are determined by chance.

What is the key proposition of new growth theory that makes economic growth persist? The key proposition that makes growth persist indefinitely in the new growth theory is the assumption that the returns to knowledge and human capital do not diminish. As a result, increases in knowledge do not cause diminishing returns and the incentive to innovate remains high. As people accumulate more knowledge, the incentive to innovate does not fall and so people continue to innovate new and better ways to produce new and better products. This innovation means that economic growth persists indefinitely.

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Answers to the Study Plan Problems and Applications 1.

Mexico’s real GDP was 18,163 billion pesos in 2017 and 18,526 billion pesos in 2018. Mexico’s population was 123.5 million in 2017 and 124.7 million in 2018. Calculate a. The growth rate of real GDP.

Between 2017 and 2018 this growth rate equals [(18,526 billion pesos  18,163 billion pesos)/18,163 billion pesos]  100, which is 2.0 percent.

b. The growth rate of real GDP per person.

Mexico’s population grew at [(124.7 million  123.5 million)/123.5 million]  100, which is 1.0 percent. Mexico’s growth rate of real GDP is 2.0 percent, so the growth rate of real GDP per person is 2.0 percent  1.0 percent, or 1.0 percent.

c. The approximate number of years it takes for real GDP per person in Mexico to double if the 2018 growth rate of real GDP and the population growth rate are maintained. Mexico’s real GDP per person is growing at 1.0 percent a year. The rule of 70 tells us that Mexico’s real GDP per person will double in 70/1.0 = 70.0 years.

The IMF projects that China’s real GDP per person will be 57,163 yuan in 2017 and 60,334 yuan in 2018 and that India’s real GDP per person will be 98,028 rupees in 2017 and 104,191 rupees in 2018. By maintaining their current growth rates, which country will be first to double its standard of living and when will that happen? China’s growth rate of real GDP per person is [(60,334 yuan  57,163 yuan)/57,163 yuan]  100, which is 5.5 percent. India’s growth rate of real GDP per person is [(104,191 rupees  98,028 rupees)/98,028 rupees]  100, which is 6.3 percent. China’s real GDP per person will double in approximately 70/5.5 = 12.7 years and India’s real GDP per person will double in approximately 70/6.3 = 11.1 years, so India’s standard of living will double first in about the year 2029.

China was the largest economy for centuries because everyone had the same type of economy— subsistence—and so the country with the most people was economically biggest. Then the Industrial Revolution sent the West on a more prosperous path. Now the world is returning to a common economy, this time technology- and information-based, so once again population triumphs. a. Why was China the world’s largest economy until 1890? GDP equals GDP per person multiplied by the number of people. Until 1890 most people in the world had approximately the same subsistence level of income so that every nation’s GDP per person was about the same. Because China had, by far, the world’s largest population, China also had the world’s largest GDP.

b. Why did the United States surpass China in 1890 to become the world’s largest economy? The United States benefited from the industrial revolution that was sweeping Western nations at the time while China did not. U.S. economic growth accelerated well beyond Chinese economic growth so that the U.S. GDP became larger than China’s GDP.

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Use the following tables to work Problems 4 to 6. The first table describes an economy’s labor market in 2020 and the second table describes its production function in 2020. Real wage rate (dollars per hour) 80 70 60 50 40 30 20 4.

Labor hours supplied 45 40 35 30 25 20 15

Labor hours demanded 5 10 15 20 25 30 35

Labor (hours) 5 10 15 20 25 30 35 40

Real GDP (2009 dollars) 425 800 1,125 1,400 1,625 1,800 1,925 2,000

What are the equilibrium real wage rate, the quantity of labor employed in 2020, labor productivity, and potential GDP in 2020? The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 25 hours. With employment of 25 hours, the production function shows that potential GDP is $1,625. Labor productivity equals $1,625  25 hours, or $65.00 per hour.

In 2021, the population increases and labor hours supplied increase by 10 at each real wage rate. What are the equilibrium real wage rate, labor productivity, and potential GDP in 2021? The equilibrium real wage rate is $30 per hour and the equilibrium quantity of employment is 30 hours. With employment of 30 hours, the production function shows that real GDP is $1,800. Labor productivity equals $1,800  30 hours, or $60.00 per hour.

In 2021, the population increases and labor hours supplied increase by 10 at each real wage rate. Does the standard of living in this economy increase in 2021? Explain why or why not. The effect on the standard of living is ambiguous. The standard of living is equal to real GDP per person. Here, real GDP increases but so, too, does the population. If the growth of real GDP exceeds that of the population, the standard of living increases but f the growth of the population exceeds that if real GDP, the standard of living decreases.

Productivity and Costs The BLS reported the following data for year ended March 2021: In the nonfarm sector, output increased 1.1 percent and labor productivity increased 4.1 percent. In the manufacturing sector, output decreased by 0.9 percent and labor productivity increased by 1.8 percent. Source: bls.gov/news.release, June 3, 2021 Did the quantity of labor (aggregate hours) increase or decrease in the nonfarm sector and the manufacturing sector? In which sector was the change in the quantity of labor larger? Labor productivity equals real GDP divided by aggregate labor hours, so aggregate labor hours equals real GDP divided by labor productivity. In terms of growth rates, this last formula means that the growth in aggregate labor hours approximately equals the growth in real GDP minus the growth in labor productivity. (This is the same calculation as on page 544 of the text for the approximation formula for growth in real GDP per person.) Using this equation, in the nonfarm sector labor hours changed by 1.1 percent – 4.1 percent = ─3.0 percent and in the manufacturing sector labor hours changed by ─0.9 percent – 1.8 percent = ─2.7 percent. Labor fell in both sectors and the fall was the largest in the nonfarm sector. © 2023 Pearson Education, Inc.

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Explain the processes that will bring the growth of real GDP per person to a stop according to a. Classical growth theory. According to the classical theory, population growth continues at a rapid pace as long as real GDP per person exceeds the subsistence level. With population growth, the supply of labor increases and diminishing returns lowers real GDP per person. Eventually real GDP per person equals the subsistence amount, at which time economic growth ends.

b. Neoclassical growth theory. In the neoclassical model, technological growth leads to increased saving so that capital accumulates and real GDP per person grows. When technological growth stops, capital continues to accumulate but diminishing marginal returns drives the return on capital lower and so decreases investment and saving. Eventually the capital stock stops growing and economic growth stops.

c. New growth theory. According to the new growth theory, economic growth will not stop.

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Answers to Additional Problems and Applications 9.

In 2018 Brazil’s real GDP is growing at 1.7 percent a year and its population is growing at 0.7 percent a year. If these growth rates continue, in what year will Brazil’s real GDP per person be twice what it is in 2018? The growth rate of real GDP per person equals the growth rate of real GDP minus the population growth rate. Brazil’s real GDP per person is growing at a rate of 1.7 percent – 0.7 percent = 1.0 percent. Then using the rule of 70, it will take 70/1.0 = 70 years for Brazil’s real GDP per person to double, which means it will double in approximately 2088.

10.

Canada’s real GDP was $1,830 billion in 2017 and $1,866 billion in 2018. Canada’s population was 36.7 million in 2017 and 37.1 million in 2018. Calculate a. The growth rate of real GDP.

Between 2018 and 2017 this growth rate equals [($1,866 billion  $1,830 billion)/$1,830 billion]  100, which is 2.0 percent.

b. The growth rate of real GDP per person.

Canada’s population grew at [(37.1 million  36.7 million)/36.7 million]  100, which is 1.1 percent. Canada’s growth rate of real GDP is 2.0 percent, so the growth rate of real GDP per person is 2.0 percent  1.1 percent, or 0.9 percent.

c. The approximate number of years it takes for real GDP per person in Canada to double if the 2018 growth rate of real GDP and the population growth rate are maintained. Canada’s real GDP per person is growing at 0.9 percent a year. The rule of 70 tells us that Canada’s real GDP per person will double in 70/0.9 = 77.8 years.

11.

Australia’s real GDP was $1,730 billion in 2017 and $1,782 billion in 2018. Australia’s population was 24.6 million in 2017 and 25.0 million in 2018. Calculate a. The growth rate of real GDP.

The growth rate of real GDP between 2017 and 2018 is [($1,782 billion  $1,730 billion)/$1,730 billion]  100 = 3.01 percent.

b. The growth rate of real GDP per person.

Australia’s population growth rate is equal to [(25.0 million  24.6 million)/24.6 million]  100, which is 1.63 percent. Australia’s economic growth rate is 3.01 percent, so the growth rate of real GDP per person is 3.01 percent  1.63 percent, or 1.38 percent.

c. The approximate number of years it will take for real GDP per person in Australia to double if the current real GDP and population growth rate maintained. Australia’s real GDP per person is growing at 1.38 percent a year. The rule of 70 tells us that Australia’s real GDP per person will double in 70/1.38 = 50.7 years.

12.

A Shifting Global Economic Landscape Global growth for 2016 is estimated at 3.1 percent. Advanced economies are projected to grow by 1.9 percent in 2017 and 2.0 percent in 2018. The primary factor underlying the strengthening global outlook over 2017–18 is the projected pickup in developing economies’ growth estimated at 4.1 percent in 2016, and projected to reach 4.5 percent for 2017. A further pickup in growth to 4.8 percent is projected for 2018. Notably, the growth forecast for 2017 was revised up for China to 6.5 percent. Source: International Monetary Fund, January 2017 Do the growth rates projected by the IMF indicate that gaps in real GDP per person around the world are shrinking, growing, or staying the same? Explain. © 2023 Pearson Education, Inc.

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The data in the news clip indicate that the gap in real GDP between the advanced economies and the developing economies will decrease a bit in 2017 and 2018 because the developing economies are projected to grow about 2.5 percentage points more rapidly than the advanced economies. As long as the population in the developing economies grows less than 2.5 percentage points more rapidly than growth in the advanced economies, the gap in real GDP per person will also shrink.

13.

If a large increase in investment increases labor productivity, explain what happens to a. Potential GDP. The production function curve shifts upward and equilibrium employment increases, both of which increase potential GDP.

b. Employment. Employment increases. The demand for labor increases, which increases equilibrium employment.

c. The real wage rate. The real wage rate rises. The demand for labor increases, which raises the equilibrium real wage rate.

14.

If a severe drought decreases labor productivity, explain what happens to a. Potential GDP. The production function curve shifts downward and equilibrium employment decreases, both of which decrease potential GDP.

b. Employment. Employment decreases. The demand for labor decreases, which decreases equilibrium employment.

c. The real wage rate. The real wage rate falls. The demand for labor decreases, which lowers the equilibrium real wage rate.

Use the following tables to work Problems 15 to 17. The first table describes an economy’s labor market in 2021 and the second table describes its production function in 2021. Real wage rate (dollars per hour) 80 70 60 50 40 30 20 15.

Labor hours supplied 55 50 45 40 35 30 25

Labor hours demanded 15 20 25 30 35 40 45

Labor (hours) 15 20 25 30 35 40 45 50

Real GDP (2009 dollars) 1,425 1,800 2,125 2,400 2,625 2,800 2,925 3,000

What are the equilibrium real wage rate and the quantity of labor employed in 2021? The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 35 hours.

16.

What are labor productivity and potential GDP in 2021? Potential GDP is $2,625, the quantity of real GDP produced with the equilibrium quantity of employment. Labor productivity equals $2,625  35 hours, or $75.00 per hour.

17.

Suppose that labor productivity increases in 2022.What effect does the increased labor productivity have on the demand for labor, the supply of labor, potential GDP, and real GDP per person? The increase in labor productivity increases the demand for labor. The supply of labor does not change. The equilibrium wage rate rises and equilibrium employment increases. Potential GDP increases for two © 2023 Pearson Education, Inc.

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reasons: First, the increase in labor productivity increases potential GDP; second, the increase in equilibrium employment increases potential GDP. Real GDP per person increases.

18.

Why Is India’s Labor Productivity Growth Faltering? India’s labor productivity grew by more than 14 percent a year between 2004 and 2008. But between 2016 and 2018, labor productivity grew by only 3.7 percent a year. Between 2001 and 2018, capital intensity increased, that is capital used per worker increased but the value of output per unit of capital decreased. Source: indianexpress.com, November 4, 2019 What is happening to India’s labor productivity and capital productivity? How does this influence India’s economic growth? India’s labor productivity fell from 14 percent between 2004 and 2008 to 3.7 percent between 2016 and 2018. Similarly, India’s capital productivity (output per unit of capital) also fell. The decrease in labor and capital productivity decreased India’s economic growth.

19.

The Productivity Watch According to former Federal Reserve chairman Alan Greenspan, IT investments in the 1990s boosted productivity, which boosted corporate profits, which led to more IT investments, and so on, leading to a nirvana of high growth. Source: Fortune, September 4, 2006 Which of the growth theories that you’ve studied in this chapter best corresponds to the explanation given by Mr. Greenspan? Mr. Greenspan is describing the new growth theory. According to this theory, economic growth will persist indefinitely because of the perpetual pursuit of profit.

20.

Is faster economic growth always a good thing? Argue the case for faster growth and the case for slower growth. Then reach a conclusion on whether growth should be increased or slowed. More rapid economic growth brings increased consumption possibilities in the future, which is the benefit from economic growth. Economic growth has costs: Decreased current consumption and the possibility of increased resource depletion and environmental damage. (Of course, the technological change that results from economic growth might allow for less resource depletion and less environmental damage.) Whether economic growth should be increased or decreased depends on the benefits of more rapid growth relative to the costs of more rapid growth.

21.

Embracing Technology as a Service Will Fuel the Circular Economy The “product-as-a-service” business model can generate large profits. Instead of producing and selling a product, the producer is responsible for the product for its entire life. The customer uses the product for as long as needed. When returned, the producer prepares its components for recycling or reuse. The European Commission plans to incentivize this plan to help meet its climate objectives. Source: weforum.org, April 19, 2021 Explain which growth theory best describes the news clip. The new growth theory stresses the role of innovation and the life cycle of firms, from the birth of new firms to the death of old ones. The new growth theory best describes the article because the article describes the life cycle of a product. New products are developed and if these novel products are successful, then firms that produce them will thrive by taking care of them until they become outdated so that the consumer no longer wants them. The products will die and, at that time, if the business has not successfully innovated new replacement products, it will be displaced by firms that have.

22.

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keeps it in motion? The fundamental fact that drives the perpetual motion machine is that our wants always exceed our ability to satisfy them. As firms innovate new ways to satisfy these wants and our standard of living grows, so too do our wants for an even higher standard of living.

23.

Describe the components of the new growth theory perpetual motion machine and explain the role played by incentives in keeping the machine in motion. Major components of the new growth theory are people’s insatiable wants and firms’ pursuit of profit. Because people’s wants always exceed what they have, firms, in search of profit, have the incentive to innovate new production techniques and create new products to satisfy these wants. As firms innovate new and better ways to produce new and better products, old firms and old jobs are destroyed while new firms and new jobs are created. The new jobs are more productive than the old ones, so they pay more than the old jobs, which gives people the incentive to take the new jobs. Along with the higher pay, the more productive techniques allow more leisure. The increased leisure and better products bring a higher standard of living. But people’s wants remain insatiable, so they want a still higher standard of living, which continues to give firms the incentive to continue to innovate.

24.

Why and how does new growth theory imply that technological change, even robots and artificial intelligence, will create as many jobs as it will destroy? The creation new technology, including robots and artificial intelligence, is the result of people’s knowledge capital increasing. This sort of capital is not subject to diminishing returns, so the return from still more additional knowledge capital is still high. That means there will be more technological breakthroughs to satisfy people’s insatiable wants and hence more jobs producing these products, including the production of more robots and more artificial intelligence.

25.

Coronavirus Vaccine: When Will We Have One? Under normal circumstances the vaccine creation process takes years, but with 200 groups of researchers committed to the task, an effective vaccine is expected to be available in months. Source: bbc.com, July 20, 2020 Explain how new growth theory explains this news clip. New growth theory emphasizes firms’ incentives to make profits. In the situation with the Coronavirus, firms have the incentive to discover a vaccine as quickly as possible in order to make a large profit. The incentive created by Covid-19 increases the demand for researchers who discover new and better techniques in vaccine creation, and as more discoveries are made even more jobs will be created. Clearly this incentive worked because vaccines were developed very quickly in record-breaking times.

Economics in the News 26. After you have studied Economics in the News on pp. 564–565, answer the following questions. a. Distinguish between economic growth and recovery from recession and identify two years in Fig. 1 when China was recovering from recession rather than growing faster. Economic growth occurs when production possibilities expand and recovery from recession is taking up the slack from a previous recession. The most prominent years during which China was recovering from a recession are in the mid-1970s, around 1975, the early 1980s, around 1983, the start of the 1990s, around 1990, and recently, in 2021.

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b. Over which years did China’s growth rate of potential GDP increase, what were the high growth rate years, and when did growth begin to slow? China’s extremely rapid economic growth began in the early 1980s. High growth years include the mid1980s, around 1985, the mid-1990s, around 1995, and the late 2000s, around 2008. Economic growth slowed after 2008.

c. At its peak growth rate, how many years did it take for China’s real GDP to double? At its peak, Chinese economic growth was about 15 percent a year. At this rate it takes approximately 70/15 = 4.67 years to double.

d. What did the government of China do in 2008 to avoid recession in the global financial crisis? China increased its investment rate to 52 percent of GDP, thereby maintaining spending during the recession.

e. Why did China’s growth rate slow down despite an increase in investment? When the Chinese increased China’s investment rate to 52 percent of GDP, much of the new investment was in less-productive government capital, which, due to its lack of productivity, slows the growth rate. Funding this investment also created an increase in debt.

27.

Historic Drought in India Is so Severe That It’s Now Visible from Space India is facing a country-wide drought. Chennai, a major automotive producing city, has 99 percent less water than a year ago. Its factories must cut production to save water. Source: globalnews.ca, June 24, 2019 Explain the effect of the drought on India’s labor productivity, potential GDP, and employment. As factories close to save water, India’s employment and labor productivity both decrease. This decrease reduces India’s potential GDP.

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Answers to the Review Quizzes Page 576 1.

Distinguish between physical capital and financial capital and give two examples of each. Physical capital is the actual tools, instruments, machines, buildings and other items that have been produced in the past and are presently used to produce goods and services. Financial capital is the funds that businesses use to acquire their physical capital. Examples of physical capital are the pizza ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of new buildings.

What is the distinction between gross investment and net investment? Gross investment is the total amount spent on new capital; net investment is the change in the value of the capital stock. Net investment equals gross investment minus depreciation.

What are the three main types of markets for financial capital? The main types of markets for financial capital are the loan markets, the bond markets, and the stock markets.

Explain the flows of funds that finance business investment. The funds that finance business investment (I) can come from three sources: household saving (S), a government budget surplus (T – G), and borrowing from the rest of the world (M – X). In terms of the national income accounts, I = S + (T – G) + (M – X) These funds flow into the financial market, where financial institutions, such as commercial banks, government-sponsored mortgage lenders, mutual funds, pension funds, and insurance companies, use the funds to make loans to business that want to borrow to finance their investment.

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Define and distinguish between future value and present value. The value of future dollars, that is, dollars to be received or paid in the future, is called future value, while the value of current dollars, that is, dollars currently being received or paid, is called present value. The present value of a future dollar is the current amount of dollars that, with interest, will grow to be as large as the future amount. Converting a future amount of money to its present value is called discounting.

What is the present value of $500, three years in the future if the interest rate is 5 percent? The present value of $500 three years in the future when the interest rate is 5 percent is equal to: Present value = ($500)/(1.05)3 = $431.92.

What is net present value and how is it used in financial decisions? Net present value is the present value of all the future flows of money that result from a financial decision minus the initial cost of the decision. Net present value is used to make financial decisions. Setting aside risk, if the net present value of a decision is positive, the decision should be undertaken but if it is negative, the decision should not be undertaken. If risk and uncertainty play a role, then the decision should be undertaken if the net present value is sufficiently positive that a loss is sufficiently unlikely. © 2023 Pearson Education, Inc.

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Explain the relationship between asset prices and the interest rate. There is an inverse relationship between the price of a financial asset and its interest rate. When the price of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls, the price of the asset rises.

Explain why the real interest rate is the opportunity cost of loanable funds. The real interest rate is the opportunity cost of loanable funds because the real interest rate measures what is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the funds are borrowed, then the real interest is paid for the funds. The real interest rate forgone when funds are used either to buy consumption goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds.

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What is the loanable funds market? The loanable funds market is the market in which households, firms, governments, banks, and other financial institutions borrow and lend. It is the aggregate of all the individual financial markets and includes loan markets, bond markets, and stock markets. The real interest rate is determined in this market.

How do firms make investment decisions? To determine the quantity of investment, firms compare the expected profit rate from an investment to the real interest rate. The expected profit from an investment is the benefit from the investment. The real interest rate is the opportunity cost of investment. If the expected profit from an investment exceeds the cost of the real interest rate, so that the net present value is positive, then firms make the investment. If the expected profit from an investment is less than the cost of the real interest rate, so that the net present value is negative, then firms do not make the investment.

What determines the demand for loanable funds and what makes it change? The demand for loanable funds depends on the real interest rate and expected profit. If the real interest rate falls and nothing else changes, the quantity of loanable funds demanded increases. Conversely, if the real interest rate rises and everything else remains the same, the quantity of loanable funds demanded decreases. Movements along the loanable funds demand curve illustrate these events. If the expected profit increases and nothing else changes, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward. If the expected profit decreases and everything else remains the same, the demand for loanable funds decreases and the demand for loanable funds curve shifts leftward.

How do households make saving decisions? A household’s saving depends on five factors: the real interest rate, the household’s disposable income, the household’s expected future income, wealth, and default risk. A household increases its saving if the real interest rate increases, its disposable income increases, its expected future income decreases, its wealth decreases, or if default risk decreases.

What determines the supply of loanable funds and what makes it change? The supply of loanable funds depends on the real interest rate, disposable income, expected future income, wealth, and default risk. An increase in the real interest rate increases the quantity of loanable funds supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An increase in disposable income increases the supply of loanable funds; a decrease in disposable income decreases the supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a decrease in wealth increases the supply of loanable funds. An increase in expected future income decreases the supply of loanable funds; a decrease in expected future income increases the supply of loanable funds. Finally, an increase in default risk decreases the supply of loanable funds; a decrease in default risk increases the supply of loanable funds.

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How do changes in the demand for and supply of loanable funds change the real interest rate and quantity of loanable funds? The real interest rate is determined by the supply of loanable funds and the demand for loanable funds. The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Changes in the demand for or supply of loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. If the demand for loanable funds increases and the supply does not change, the real interest rate rises and the quantity of loanable funds increases. If the demand for loanable funds decreases and the supply does not change, the real interest rate falls and the quantity of loanable funds decreases. If the supply of loanable funds increases and the demand does not change, the real interest rate falls and the quantity of loanable funds increases. If the supply of loanable funds decreases and the demand does not change, the real interest rate rises and the quantity of loanable funds decreases.

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How does a government budget surplus or deficit influence the loanable funds market? A government budget surplus adds to the supply of loanable funds. A government budget deficit adds to the demand for loanable funds.

What is the crowding-out effect and how does it work? The crowding-out effect refers to the decrease in investment that occurs when the government budget deficit increases. An increase in the government budget deficit increases the demand for loanable funds. As a result the real interest rate rises. The rise in the real interest rate decreases—“crowds out”—investment.

What is the Ricardo-Barro effect and how does it modify the crowding-out effect? The Ricardo-Barro effect points out that the crowding out effect is less than predicted by looking only at the effect of a budget deficit on the demand for loanable funds. The Ricardo-Barro effect asserts that as a result of a government budget deficit households increase their saving to pay the higher taxes that will be needed in the future to repay the debt issued to fund the deficit. The increase in saving increases the supply of loanable funds. This increase in the supply of loanable funds offsets the rise in the real interest rate from the increase in the demand for loanable funds caused by the budget deficit. Because the real interest rate does not rise as much, the decrease in investment, that is the amount of crowding out, is less in the presence of the Ricardo-Barro effect.

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 and 2. Michael, an Internet service provider, bought an existing business worth $400,000 on December 31, 2021. During 2022, his business grew and he bought $500,000 of new servers. The market value of his older servers fell by $100,000. 1.

What was Michael’s gross investment, depreciation, and net investment during 2022? Michael’s gross investment was $500,000, his depreciation was $100,000, and his net investment was $400,000.

What is the value of Michael’s capital at the end of 2022? Michael’s capital at the end of 2022 is equal to his capital at the beginning of 2022, $400,000, plus his net investment during the year, also $400,000, for a total of $800,000.

Lori is a student who teaches golf on Saturdays. In a year, she earns $20,000 after paying her taxes. At the beginning of 2021, Lori owned $1,000 worth of books, clothes, and golf clubs and she had $5,000 in a savings account at the bank. During 2021, the interest on her savings account was $300 and she spent a total of $15,300 on consumption goods and services. There was no change in the market values of her books, clothes, and golf clubs. a. How much did Lori save in 2021? Lori’s saving equals her disposable income minus her consumption expenditure. Lori’s disposable income is $20,000 plus the interest on her savings account, $300, for a total of $20,300.Her consumption expenditure is $15,300, so her saving is $5,000.

b. What was her wealth at the end of 2021? Lori’s wealth at the end of 2021 is equal to the value of her wealth at the beginning of 2021 plus her saving during the year. At the beginning of 2021 Lori’s wealth is $6,000—the value of her books, clothes, golf clubs, and savings account. Lori saved $5,000 during 2021 so her wealth at the end of the year is $11,000.

Tom took out a $2,000 loan to buy a boat at an interest rate of 10 percent a year. He plans to repay the loan after 2 years. How much will he have to pay? Tom will have to pay the future value of his loan, ($2,000) × (1.10)2 = $2,420.

Joe has a term deposit that pays 10 percent a year and its value after two years will be $5,000. What is the present value of Joe’s term deposit? The present value of the term deposit is ($5,000)/(1.10)2 = $4,132.23.

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Use the following information to work Problems 6 and 7. First Call, Inc., a smartphone company, plans to build a factory—one that costs $10 million if the real interest rate is 6 percent a year; a larger plant that costs $12 million if the real interest rate is 5 percent a year; or a smaller plant that costs $8 million if the real interest rate is 7 percent a year. 6. Draw a graph of First Call’s demand for loanable funds curve. Figure 24.1 shows First Call’s demand for loanable funds curve.

First Call expects its profit to double next year. Explain how this increase in expected profit influences First Call’s demand for loanable funds. When First Call expects its profit to increase, First Call increases its investment. The increase in its investment leads First Call to increase its demand for loanable funds.

The table sets out data for an economy when the government’s budget is balanced. a. Calculate the equilibrium real interest rate, investment, and private saving.

Real interest rate (percent per year) 4 5 6 7 8 9 10

Loanable funds Loanable funds demanded supplied (trillions of 2012 dollars) 8.5 5.5 8.0 6.0 7.5 6.5 7.0 7.0 6.5 7.5 6.0 8.0 5.5 8.5

The equilibrium real interest rate is 7 percent per year. The equilibrium quantity of investment equals the quantity of loanable funds demand, $7.0 trillion and the equilibrium quantity of saving equals the quantity of loanable funds supplied, $7.0 trillion.

b. If planned saving increases by $0.5 trillion at each real interest rate, explain the change in the real interest rate. The increase in saving increases the supply of loanable funds. The equilibrium real interest rate falls. In the table, the new equilibrium real interest rate is 6.5 percent per year.

c. If planned investment increases by $1 trillion at each real interest rate, explain the change in the real interest rate. The increase in investment increases the demand for loanable funds. The equilibrium real interest rate rises. In the table, the new equilibrium real interest rate is 8 percent per year.

Use the data in Problem 8 along with news that the government now has a budget deficit of $1 trillion to work Problems 9 and 10. 9. What is the real interest rate? How much investment occurs? Does crowding out occur? The equilibrium real interest rate becomes 8 percent and the equilibrium quantity of investment is $6.5 trillion. There is crowding out of $500 billion of investment.

10.

If the Ricardo-Barro effect occurs, what are the real interest rate and investment? The equilibrium real interest rate remains 7 percent and the quantity of investment remains $7.0 trillion. © 2023 Pearson Education, Inc.

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There is no crowding out because the $1 trillion increase in the budget deficit leads to an offsetting $1 trillion increase in private saving.

Use the loanable funds data in Problem 8 and the following data to work Problems 11 and 12. Suppose that the quantity demanded increases by $1 trillion at each real interest rate and the quantity supplied increases by $2 trillion at each interest rate. 11. If the government budget remains balanced, what are the real interest rate, investment, and private saving? Does any crowding out occur? The table to the right, which shows the Real interest Loanable funds Loanable funds new demand for loanable funds and supplied rate demanded new supply of loanable funds schedules, (percent per year) (trillions of 2012 dollars) is helpful to answer the problem. The 4 9.5 7.5 new real interest rate is 6 percent. 5 9.0 8.0 Investment and private saving are both 6 8.5 8.5 $8.5 trillion. There is no crowding out. 7 8.0 9.0 12. If the government’s budget is a deficit 8 7.5 9.5 of $1 trillion, what are the real 9 7.0 10.0 interest rate and investment? Does 10 6.5 10.5 any crowding out occur? The equilibrium real interest rate becomes 7 percent. The equilibrium quantity of investment is $8.0 trillion. There is crowding out of $500 billion of investment.

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Answers to Additional Problems and Applications 13.

On January 1, 2022, Terry’s Towing Service owned 4 tow trucks valued at $300,000. During 2022, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2022, the market value of all of the firm’s trucks was $400,000. What was Terry’s gross investment? Calculate Terry’s depreciation and net investment. His gross investment was $180,000. His depreciation was $80,000. His net investment, equal to gross investment minus depreciation, was $100,000.

Use the following information to work Problems 14 and 15. The Bureau of Economic Analysis reported that the U.S. capital stock was $64.8 trillion at the end of 2017, $68.2 trillion at the end of 2018, and $70.7 trillion at the end of 2019. Depreciation in 2018 was $3.3 trillion, and gross investment during 2019 was $3.8 trillion. 14. Calculate U.S. net investment and gross investment during 2018. Net investment equals the change in the capital stock. In 2018, U.S. net investment was $68.2 trillion  $64.8 trillion, which is $3.4 trillion. Gross investment equals net investment plus depreciation. In 2018, U.S. gross investment was $3.4 trillion + $3.3 trillion, which is $6.7 trillion.

15.

Calculate U.S. depreciation and net investment during 2019.

16.

Annie runs a fitness center. On December 31, 2021, she bought an existing business with exercise equipment and a building worth $300,000. During 2022, business improved and she bought some new equipment for $50,000. At the end of 2022, her equipment and buildings were worth $325,000. Calculate Annie’s gross investment, depreciation, and net investment during 2022.

Net investment equals the change in the capital stock. In 2019, U.S. net investment was $70.7 trillion  $68.2 trillion, which is $2.5 trillion. Depreciation equals gross investment minus net investment. In 2019, U.S. depreciation was $3.8 trillion  $2.5 trillion, which is $1.3 trillion.

Annie’s net investment during 2022 is $25,000 because that is the change in her capital stock. Annie’s gross investment is $50,000 because that is her total purchase of capital equipment in 2022. Annie’s depreciation during 2022 is $25,000 because Annie’s net investment, $25,000, equals her gross investment, $50,000, minus her depreciation.

17.

Karrie is a golf pro, and after she paid taxes, her income from golf and interest from financial assets was $1,500,000 in 2020. At the beginning of 2020, she owned $900,000 worth of financial assets. At the end of 2020, Karrie’s financial assets were worth $1,900,000. a. How much did Karrie save during 2020? Karrie’s wealth increased by $1,000,000 in 2020. So her saving in 2020 is $1,000,000. (This answer assumes no capital gains or losses on her stocks and bonds.)

b. How much did she spend on consumption goods and services? Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which is $1,500,000  $1,000,000 = $500,000.

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In a speech at the CFA Society of Nebraska, William Poole (former Chairman of the St. Louis Federal Reserve Bank) said: Over most of the post-World War II period, the personal saving rate averaged about 6 percent, with some higher rates from the mid-1970s to mid-1980s. The negative trend in the saving rate started in the mid-1990s, about the same time the stock market boom started. Thus it is hard to dismiss the hypothesis that the decline in the measured saving rate in the late 1990s reflected the response of consumption to large capital gains from corporate equity [stock]. Evidence from panel data of households also supports the conclusion that the decline in the personal saving rate since 1984 is largely a consequence of capital gains on corporate equities. a. Is the purchase of corporate equities part of household consumption or saving? Explain your answer. The purchase of corporate equities, that is, shares of corporate stock, is part of household saving. Consumption refers to the purchase of goods and services that are then consumed, but corporate equities are not consumable goods or services.

b. Equities reap a capital gain in the same way that houses reap a capital gain. Does this mean that the purchase of equities is investment? If not, explain why it is not. The purchase of equities is not an investment because investment refers to the purchase of physical capital. Equities are not physical capital and so they are not investment.

19.

Draw a graph to illustrate the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds on the real interest rate and the equilibrium quantity of loanable funds. Figure 24.2 shows the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds. The demand curve for loanable funds shifts rightward from DLF0 to DLF1, and the supply curve of loanable funds shifts rightward from SLF0 to SLF1. The increase in supply is larger than the increase in demand, so the real interest rate falls (from 6 percent to 5 percent in the figure) and the quantity of loanable funds increases (from $2.3 trillion to $2.7 trillion in the figure).

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Draw a graph to illustrate how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged. Figure 24.3 shows the effect of an increase in the supply of loanable funds and a decrease in the demand for loanable funds. The supply of loanable funds curve shifts rightward from SLF0 to SLF1, and the demand for loanable funds curve shifts leftward from DLF0 to DLF1. The magnitude of the increase in supply is equal to the magnitude of the decrease in demand, so the real interest rate falls (from 7 percent to 4 percent in the figure) and the quantity of loanable funds does not change (staying at $2.5 trillion in the figure).

Use the following information to work Problems 21 and 22. In 2020, the Lee family had disposable income of $80,000, wealth of $140,000, and an expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8 percent, they save $25,000 a year. 21. Draw a graph of the Lee family’s supply of loanable funds curve. Figure 24.4 shows the Lee family’s supply of loanable funds curve.

22.

In 2021, suppose that the stock market crashes and the default risk increases. Explain how this increase in default risk influences the Lee family’s supply of loanable funds curve. If default risk increases the Lee family will decrease its saving. As a result, the Lee family’s supply of loanable funds decreases and its supply of loanable funds curve shifts leftward.

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Target to Invest $4 Billion to Speed Along New Stores and Remodels Target plans to spend $4 billion annually. It will invest in building new stores, remodeling existing stores, and carrying the inventory needed to fill online orders quickly. Source: cnbc, March 2, 2021 Show on a graph the effect of Target going to the loanable funds market to finance its renovations. Explain the effect on the real interest rate, private saving, and investment. Target’s demand for financial capital to fund its renovations increases the demand for loanable funds. As Figure 24.5 illustrates, the demand curve for loanable funds shifts rightward from DLF0 to DLF1. The real interest rate rises, in the figure from 2 percent per year to 3 percent per year. Private saving and investment both increase from $806 billion to $808 billion.

24.

The table sets out the data for an economy when the government’s budget is balanced. a. Calculate the equilibrium real interest rate, investment, and private saving. The equilibrium real interest rate is 4 percent per year. Equilibrium investment equals the quantity of loanable funds demanded, $6.0 trillion. Equilibrium saving equals the quantity of loanable funds supplied, (also) $6.0 trillion.

Real interest rate (percent per year) 2 3 4 5 6 7 8

Loanable funds Loanable funds demanded supplied (trillions of 2012 dollars) 8.0 4.0 7.0 5.0 6.0 6.0 5.0 7.0 4.0 8.0 3.0 9.0 2.0 10.0

b. If planned saving decreases by $1 trillion at each real interest rate, explain the change in the real interest rate and investment. If planned saving increases by $1 trillion, the supply of loanable funds increases. Consequently the equilibrium real interest falls and the equilibrium quantity of investment increases. In the table, the equilibrium real interest rate falls to 3.5 percent and equilibrium investment increases to $6.5 trillion.

c. If planned investment decreases by $1 trillion at each real interest rate, explain the change in saving and the real interest rate. If planned investment decreases by $1 trillion, the demand for loanable funds decreases. Consequently the equilibrium real interest falls and the equilibrium quantity of saving decreases. In the table, the equilibrium real interest rate falls to 3.5 percent and equilibrium saving decreases to $5.5 trillion. © 2023 Pearson Education, Inc.

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Use the following information to work Problems 25 to 27. India’s Fiscal Deficit Widens to 4.6% of GDP in 2019–20 India’s government budget deficit is 4.6 percent of GDP in 2019–2020. The government projected a deficit of 3.8 percent of GDP in 2020–2021, but experts think 6–7 percent is more likely because of the effects of Covid-19. Source: economictimes.indiatimes.com, May 29, 2020 25.

How will the outcomes in the loanable funds market differ if India’s government budget deficit is 3.8 percent or 7 percent of GDP? The demand for loanable funds is larger if India’s budget deficit is 7 percent of GDP rather than 3.8 percent. In this case, the real interest rate will be higher as will the equilibrium quantity of loanable funds.

26.

What is the effect of Covid-19 on India’s supply of loanable funds? Many Indians lost their jobs because Covid-19 shut down many businesses. Expected future income of many households decreased, which, other things remaining the same, increased saving today. Consequently, the supply of loanable funds increased.

27.

If India’s economic growth slows and incomes grow more slowly, and if the government budget deficit increases, what will be the outcome in the loanable funds market? If economic growth slows, the major effect will be an increase in the supply of loanable funds as households increase their saving in response to lower expected future incomes. If the slower growth also reduces expected future profits, then the demand for loanable funds will decrease. If the government budget deficit increases, the demand for loanable funds will increase. Supposing that the effect on the demand for loanable funds from the deficit is larger than that from decreased expected future profits, both the demand for loanable funds and the supply of loanable funds increase so the equilibrium quantity of loanable funds increases but the real interest rate might rise (if the change in the demand exceeds that in the supply), fall (the change in the supply exceeds that in the demand), or remain the same (if the two changes are equal).

28.

U.S. Budget Deficit Grew to Record $2.1 Trillion in Fiscal Year’s First Eight Months The U.S. budget deficit has reached a record high of $2.1 trillion during the first eight months of the fiscal year. The deficit is propelled by expenditures on jobless benefits, nutrition assistance, and Covid-19 relief programs. Source: wsj.com, June 10, 2021 Explain the effect of the U.S. budget deficit on U.S. investment, the real interest rate, and economic growth. The U.S. budget deficit increases the demand for loanable funds and, in the absence of a Ricardo-Barro effect, raises the real interest rate and crowds out investment. The decrease in investment means that the U.S. capital stock is lower than would otherwise be the case, which will decrease U.S. economic growth.

Economics in the News 29. After you have studied Economics in the News on pp. 586–587, answer the following questions. a. What is fintech, when did it begin, and how has it grown? Fintech (short for “financial technology”) firms are new firms the provide Internet-based financial services and customized apps, which automate transactions. They specialize in making unsecured personal loans. Their start date is 2005 and they have grown especially rapidly since 2013.

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b. In the market for personal loans, does fintech mainly change the demand for loanable funds or the supply of loanable funds? Draw a graph to illustrate your answer. Fintech makes it easier and faster to get loans, so they increase the supply of loanable funds. As shown in Figure 24.6, the supply curve of loanable funds has shifted to the right.

c. In the market for personal loans, how does fintech change interest rates and the quantities of loanable funds demanded and supplied? Draw a graph to illustrate your answer. As Figure 24.6 illustrates, the presence of fintech lowers the real interest on personal loans, from 10 percent per year to 6 percent, and increases the quantities of loanable funds demanded and supplied, from $120 billion without fintech to $140 billion with it.

d. Explain why personal loans from traditional financial institutions have not grown as quickly as those from fintech companies. Loans from traditional financial institutions have grown more slowly than fintech loans because fintech loans are applied for and granted online making them easier and faster to get than loans from traditional financial institutions. Additionally, fintech loans have lower interest rates than do loans from traditional financial institutions.

30.

G20 Will Miss 2018 Growth Targets The 2014 G20 meeting committed the 20 countries to boost investment, create new jobs, and boost world income by $2 trillion over 5 years. Source: World Finance, April 10, 2017 a. Explain the effect of the 2014 increase in planned investment on the demand for or supply of loanable funds. An increase in planned investment increases the demand for loanable funds to help finance the investment.

b. If G20 countries had succeeded in increasing global income, explain how the world real interest rate, saving, and investment would have been different from the 2018 outcome. An increase in world income increases household disposable income, which increases the supply of loanable funds. The increase in the supply of loanable funds lowers the real interest and increases the quantity of saving and investment.

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Answers to the Review Quizzes Page 596 1.

What makes something money? What functions does money perform? Why do you think packs of chewing gum don’t serve as money? Money is anything that is generally acceptable as a means of payment. Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later). Packs of chewing gum do not function as money because they are not particularly good as a store of value—gum deteriorates. Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange.

What are the problems that arise when a commodity is used as money? Commodities are not used as money because of several problems. Many commodities are bulky. And many commodities change in value over time. Using as money a commodity that changes in value would be awkward. Prices would change simply because the commodity’s value changed. Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone.

What are the main components of money in the United States today? The main components of money in the United States today are currency and deposits at banks and other depository institutions. What are the official measures of money? Are all the measures really money? The official measures of money are M1 (the sum of currency, demand deposits, and other liquid deposits) and M2 (the sum of M1, small-denomination time deposits, and retail money market mutual funds). All of the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 are not truly money because they are not a means of payment. (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these “non-money” assets are highly liquid so they are operationally similar to money.

Why are checks, debit cards, and credit cards not money? Checks, debit cards, and credit cards are not money because they are not a means of payment. A check or debit card swipe is an order to transfer a deposit from one person to another. The deposits are money but the checks and debit card are not. A credit card is an ID card that lets a person take out a loan at the instant he or she buys something. The loan still needs to be repaid with money so the credit card is not a means of payment, that is, it is not money.

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Page 600 1.

What are depository institutions? Depository institutions are financial firms that take deposits from households and firms. They then make loans available to other households and firms.

What are the functions of depository institutions? Depository institutions have four major economic functions: They create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers.

How do depository institutions balance risk and return? Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets such as loans. But these assets are risky. If the loans fail, then the bank might not have sufficient funds to repay their depositors. If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails.

How do depository institutions create liquidity, pool risks, and lower the cost of borrowing? Liquidity is the property of being easily convertible into a means of payment without loss in value. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans. Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk. Depository institutions lower the cost of borrowing because they specialize in borrowing. For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process.

How have depository institutions made innovations that have influenced the composition of money? Financial innovation has changed the composition of money. While the use of currency has not decreased, demand deposits, especially at thrift institutions, have become an increasing percentage of M1. Other liquid deposits have decreased as a percentage of money, while money market mutual funds have expanded.

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What is the central bank of the United States and what functions does it perform? The Federal Reserve System is the central bank of the United States. The Federal Reserve conducts the nation’s monetary policy and regulates the nation’s depository institutions. The Fed provides banking services to commercial banks.

What is the monetary base and how does it relate to the Fed’s balance sheet? The monetary base is the sum of Federal Reserve notes, coins, and depository institutions’ deposits at the Fed. Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities. Federal Reserve notes and depository institutions’ deposits are liabilities of the Federal Reserve.

What are the Fed’s three policy tools? The Federal Reserve has three policy tools: open market operations, discount window and discount rate, and interest on reserves rate.

What is the Federal Open Market Committee and what are its main functions? The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System. It decides upon the nation’s monetary policy as conducted through open market © 2023 Pearson Education, Inc.

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operations. The FOMC meets approximately once every six weeks.

How does an open market operation change the monetary base? The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Federal Reserve, that is, banks’ reserves. When the Federal Reserve conducts an open market operation, it either buys securities and pays for them with newly created reserves or it sells securities and is paid with reserves held by banks. In both cases the monetary base changes. In the first case, when the Fed buys securities, the monetary base increases. In the second case, when the Fed sells securities, the monetary base decreases.

Page 606 1.

How do banks create money? Banks within the banking system create money by creating deposits, which are part of the nation’s money. Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank. For instance, a student given a loan may purchase books at the local bookstore. The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking account. Thus the loan has created new deposits at the bookstore’s bank.

What limits the quantity of money that the banking system can create? The quantity of money that the banking system can create is limited by: the monetary base, desired reserves, and desired currency holdings.

A bank manager tells you that she doesn’t create money. She just lends the money that people deposit. Explain why she’s wrong. Though the manager does not see the entire process, nonetheless the loans the manager makes create more deposits and more money. Point out to the manager that when she makes a loan, the deposits at her bank initially increase. And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases. However, actions of other economic agents also affect the creation of money. For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil. But over time the quantity of money increases because banks gain more (unplanned) reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money.

If the desired reserve ratio and the currency drain ratio increase, how does the money multiplier change? If the desired reserve ratio or the currency drain ratio increase, the money multiplier decreases in magnitude.

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What are the main influences on the quantity of money that people and businesses plan to hold? The quantity of money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation. An increase in the price level increases the demand for money because more money is needed for transactions. An increase in the nominal interest rate decreases the quantity of money demanded, because the nominal interest rate is the opportunity cost of holding money. An increase in real GDP increases the demand for money, because more real GDP implies more transactions and an increase in the demand for money to finance the transactions. And, financial innovations that make it less costly to get by with less money on hand decrease the demand for money.

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Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve. An increase in the nominal interest rate decreases the quantity of money demanded. The slope of the demand for money curve shows how the quantity of money demanded depends on the nominal interest rate. As illustrated in Figure 25.1, a fall in the nominal interest rate results in a movement downward along the demand for money curve. A change in real GDP changes the demand for money. An increase in real GDP increases the demand for money and shifts the demand for curve for money rightward from MD0 to MD1, as shown in Figure 25.2.

How is money market equilibrium determined in the short run? If the Fed targets the monetary base or the quantity of money, the nominal interest rate adjusts to restore equilibrium to the money market. When the quantity of money demanded equals the quantity supplied, the nominal interest rate is at its equilibrium level. If the Fed targets the interest rate, the supply of money curve is horizontal and the quantity of money adjusts until it is equal to the quantity demanded.

How does a change in the supply of money change the interest rate in the short run? In the short run an increase in the supply of money lowers the interest rate and a decrease in the supply of money raises the interest rate. Suppose the Federal Reserve increases the supply of money. At the initial interest rate people hold more money than the quantity they demand. To restore the amount of money © 2023 Pearson Education, Inc.

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they hold to equality with the quantity demanded, people use the surplus in the loanable funds market to buy bonds. The price of a bond rises which means that the interest rate on the bond falls. When the Federal Reserve decreases the supply of money, the reverse occurs: At the initial interest rate people have less money than the quantity they demand so they sell bonds in the loanable funds market to acquire more money. Selling bonds lowers their price which raises the interest rate.

What is the effect of a change in the supply of money in the long run? In the long run a change in the supply of money does not change the interest rate. For example, suppose the Federal Reserve increases the supply of money (the effects from a decrease in the supply of money are the reverse of an increase). In the long run real GDP is determined by real factors and the real interest rate is determined by the supply of and demand for loanable funds. So both real GDP and the real interest return to their original values. The price level, however, rises. Eventually the price level rises by the same percentage as the change in the quantity of money.

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What is the quantity theory of money? The quantity theory of money is the proposition that in the long run an increase in the quantity of money creates an equal percentage increase in the price level.

How is the velocity of circulation calculated? The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. The velocity of circulation equals (nominal) GDP divided by the quantity of money.

What is the equation of exchange? The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price level, and Y is real GDP. The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M.

Does the quantity theory correctly predict the effects of money growth on inflation? The long-run historical and international evidence on the relationship between money growth and the inflation rate support the quantity theory. The data suggest a marked tendency for nations with high money growth rates to have high inflation rates.

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Answers to the Study Plan Problems and Applications 1.

Money in the United States today includes which of the following items?  Cash in Citibank’s cash machines Money includes currency outside the banks. Currency inside cash machines is not money.



U.S. dollar bills in your wallet The dollar bills inside your wallet are money.



Your Visa card The Visa card is not money.



Your loan to pay your college tuition The loan is not money.

In May 2020, currency held by individuals and businesses was $1,824 billion; demand deposits were $2,126 billion; other liquid deposits were $12,234 billion; small-denomination time deposits were $466 billion; and retail money market funds were $1,142 billion. Calculate M1 and M2 in May 2020. M1 consists of currency plus demand deposits plus other liquid deposits. In May, 2020 M1 equaled $1,824 billion + $2,126 billion+ $12,234 billion, or $16,184 billion. M2 consists of M1 plus small-denomination time deposits, and retail money market mutual funds. In May, 2020 M2 equaled $16,184 + $466 billion + $1,142 billion, or $17,792 billion.

The Fed Will Not Extend a Pandemic-Crisis Rule The Federal Reserve has decided against extending a pandemic-era rule that relaxed the amount of capital banks had to hold. Source: cnbc.com, March 19, 2021 What is the “capital” in the news clip? How did the requirement to hold less capital help the U.S. economy during the pandemic? The “capital” means owners’ capital; that is, funds the owners have invested in the bank. The requirement that banks may hold less capital means that they can make more make loans. This policy increased the supply of loanable funds and allowed more investment and consumption spending than otherwise would have occurred.

The FOMC sells $20 million securities to Wells Fargo. Enter the transactions that take place to show the changes in the following balance sheets. The first balance sheet to the right shows the Federal Reserve Bank of New York balance sheet of the Federal Reserve Bank of Assets Liabilities New York. The Fed’s assets decrease by $20 (millions) (millions) million because the Fed now has $20 million Securities $20 Wells Fargo reserve deposit $20 less securities. The Fed’s liabilities also decrease by $20 million because Wells Fargo pays for its purchases using the reserves that it has on deposit at the Fed. The second balance sheet to the right shows the balance Wells Fargo sheet of Wells Fargo Bank. Wells Fargo gains assets in Assets Liabilities the form of securities of $20 million. Simultaneously it (millions) (millions) also losses reserve deposit assets of $20 million because it pays for the government securities using its reserve Securities +$20 deposits at the Fed. Reserve deposit $20

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Households and firms hold $30 billion in bank notes. There are no coins. Calculate a. The monetary base and the quantity of money. The monetary base is $45 billion. The monetary base is the sum of the central bank’s notes, banks’ deposits at the central bank, and coins held by households, firms, and banks. There are $30 billion in notes held by households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks hold other reserves of $5 billion (which are notes), and there are no coins. The monetary base is $45 billion. The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion.

b. The banks’ desired reserve ratio and the currency drain ratio (as percentages). The banks’ reserve ratio is 5 percent. The banks’ reserve ratio is the percent of deposits that is held as reserves. In Nocoin, deposits are $300 billion and reserves are $15 billion, so the reserve ratio equals ($15 billion/$300 billion)  100, which is 5 percent. The currency drain is 10 percent. The currency drain is the ratio of currency to deposits. In Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals ($30 billion/$300 billion)  100, which is 10 percent.

China PBOC Lowers Banks’ Reserve Requirements to Encourage Lending The People’s Bank of China will cut the required reserve ratio by 0.5 percent to 8.9 percent. Source: marketwatch.com, May 21, 2021 Explain how the money multiplier will change. Lowering the required reserve ratio decreases banks’ desired reserves. Because their desired reserves decrease while their actual reserves do not change, banks have more unplanned reserves. When banks’ unplanned reserves increase they will make more loans so the quantity of money in China increases. Because the quantity of money increases while the monetary base does not change, the money multiplier increases. (The Mathematical Note shows that a decrease in the desired reserve ratio increases the money multiplier.)

The spreadsheet provides data about the demand for money in Minland. Columns A and B show the demand for money schedule when real GDP (Y0) is $10 billion and Columns A and C show the demand for money schedule when real GDP (Y1) is $20 billion. The quantity of money is $3 billion. What is the interest rate when real GDP is $10 billion? Explain what happens in the money market in the short run if real GDP increases to $20 billion.

A r

2 3 4 5 6 7 8

7 6 5 4 3 2 1

B Y0 1.0 1.5 2.0 2.5 3.0 3.5 4.0

C Y1 1.5 2.0 2.5 3.0 3.5 4.0 4.5

When real GDP is $10 billion, the equilibrium nominal interest rate is 6 percent because that is the interest rate that sets the quantity of money demanded equal to $3 billion. If real GDP increases to $20, the quantity of money demanded exceeds the quantity supplied, so people want to hold more money than is available. They try to increase the amount of money held by selling bonds. The prices of bonds fall, and the interest rate rises to its new equilibrium of 5 percent.

In year 1, the economy is at full employment and real GDP is $400 million, the GDP deflator is 200 (a price level is 2), and the velocity of circulation is 20. In year 2, the quantity of money increases by 20 percent. If the quantity theory of money holds, calculate the quantity of money, the GDP deflator, real GDP, and the velocity of circulation in year 2. The quantity of money in year 1 is $40 million. Because the equation of exchange tells us that MV = PY, we know that M = PY/V. Then, with P = 2.0, Y = $400 million, and V = 20, M = $40 million. Then in year 2 the quantity of money is $48 million because money grows by 20 percent, which is $8 million. The © 2023 Pearson Education, Inc.

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GDP deflator is 240. Because the quantity theory of money holds and because the factors that influence real GDP have not changed, the GDP deflator rises by the same percentage as the increase in the quantity of money, which is 20 percent. Real GDP is $400 million because it remains equal to potential GDP (the quantity of GDP produced at full employment). The velocity of circulation is 20. Because the factors that influence velocity have not changed, velocity is unchanged.

Mathematical Note 9.

In Problem 5, the banks have no unplanned reserves. Suppose that the central bank of Nocoin increases bank reserves by $0.5 billion. a. Explain the change in the quantity of money and why it is not equal to the change in the monetary base. The quantity of money increases by $3.67 billion. The quantity of money increases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33 (see part b), so when the monetary base increases by $0.5 billion, the quantity of money increases by $3.67 billion. The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect. The open market operation increases bank reserves and creates unplanned reserves, which banks use to make new loans. New loans are used to make payments and some of these loans are placed on deposit in banks. The increase in bank deposits increases banks’ reserves and increases desired reserves. But the banks now have unplanned reserves which they loan out and the process repeats until unplanned reserves have been eliminated.

b. Calculate the money multiplier. The money multiplier is 7.33. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 0.1 and R/D = 0.05, so the money multiplier equals (1 + 0.1)/(0.1 + 0.05), which equals 7.33.

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Answers to Additional Problems and Applications 10.

Sara withdraws $1,000 from her savings account at the Lucky S&L, keeps $50 in cash, and deposits the balance in her checking account at the Bank of Illinois. What is the immediate change in M1 and M2? M1 and M2 do not change. M1 is the sum of currency, checking deposits held by individuals and businesses, and other liquid assets. M2 is the sum of M1, time deposits, and money market mutual funds and other deposits. The withdrawal of $1,000 from a savings account leaves M1 unchanged because savings account, a liquid asset, is part of M1 and the $1,000 withdrawn from goes into other M1 types of money. M2 is unchanged because M1 is unchanged.

11.

Rapid inflation in Brazil in the early 1990s caused the cruzeiro to lose its ability to function as money. Which of the following commodities would most likely have taken the place of the cruzeiro in the Brazilian economy? Explain why. a. Tractor parts It is unlikely that tractor parts would be used as money because tractor parts are heavy and unwieldy to carry around for use as a medium of exchange.

b. Packs of cigarettes Packs of cigarettes would likely be used as a substitute for money because they are light to carry around, are durable, and can be easily divided into fractions of packs for making change.

c. Loaves of bread Loaves of bread would be unlikely to be used as a substitute for money because they would spoil too rapidly.

d. Impressionist paintings Impressionist paintings would be unlikely to be used as a substitute for money because they would be unwieldy to carry around and because their quality and value differs dramatically from one artist to another.

e. Baseball trading cards Baseball cards would be unlikely to be used as a substitute for money because most Brazilians are unfamiliar with baseball (and unlikely to value the cards per se) and because the cards are not very durable.

12.

Trading Up: One Woman’s Quest to Swap a Hairpin Demi Skipper is going to get a house by trading for it. She traded a hairpin for a pair of earrings, the earrings for four margarita glasses, and the glasses for a vacuum cleaner. Now she is looking to trade a Chipotle celebrity card that gives unlimited free Chipotle food for a year. Source: theguardian.com, May 12, 2021 Is barter a means of payment? Is barter just as efficient as money? Explain? Barter is a means of payment but it is not as efficient as money. Barter requires a “double coincidence of wants,” that is, both parties to the transaction must want what the other person is offering. Money requires only a single coincidence of wants, that is, one person wants what the other person is offering and pays for this with money so that the other person can use the money to buy what they want.

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Use the following news clip to work Problems 13 and 14. U.S. Bank Profits Rose 29% U.S. bank profits rose during the first quarter of 2021, up $58.3 billion from a year ago. Loan balances decreased and deposits increased. Total assets increased. No banks failed during the first quarter of 2021. The number of institutions on the problem bank list of the FDIC (Federal Deposit insurance Corporation) decreased by one to 55 from the previous quarter. Source: reuters.com, May 26, 2021 13. Explain the role of loans in the balancing act that a bank performs in the pursuit of profit. The bank knows that its profit will be higher the more loans are made. But loans are risky. Other assets, such as government securities pay a lower interest rate but are less risky. Banks must balance their holdings of high-yielding, risky loans with their holdings of lower-yielding, less-risky other assets.

14.

Explain how the pursuit of profit can sometimes lead to bank failures. Banks pursue profit by making loans, which are risky. Sometimes the person to whom the loan is made cannot repay the loan. If enough borrowers become unable to repay their loans, the bank may fail because its liabilities (the funds it owes its depositors) exceed its assets (its loans and securities) plus its net worth. Depositors may also demand their funds back if they become aware the bank is making risky loans.

15.

Explain the distinction between a central bank and a commercial bank. A central bank is basically a “bank for banks.” It will conduct business with commercial banks, such as making loans to them and holding their reserves. A central bank does not accept deposits from private citizens. A central bank also regulates the nation’s depository institutions and conducts the nation’s monetary policy. A commercial bank conducts business with firms and households. It accepts deposits from individuals and then makes loans to other people or firms. Commercial banks are privately owned and have as their objective the maximization of their profit.

16.

If the Fed makes an open market sale of $1 million of securities to a bank, what initial changes occur in the economy? If the Fed sells $1 million of securities to a bank, both the Fed’s balance sheet and the bank’s balance sheet change. The Fed’s holding of securities falls by $1 million and the bank’s holding of securities rises by $1 million. The bank pays for the purchase with its reserves, so the reserves held by the Fed fall by $1 million and the bank’s reserves fall by $1 million. The amount of the bank’s assets does not change, though the composition changes (more securities, fewer reserves). The Fed’s assets and liabilities both fall by an equal amount ($1 million in this case).

17.

Set out the transactions that the Fed undertakes to increase the quantity of money. The Fed has three procedures by which it can increase the quantity of money:  The Fed could use an open market purchase of securities from banks. When the Fed buys securities, it pays for the purchase by increasing banks’ reserves. The increase in banks’ reserves increases the monetary base and allows banks to make more loans, which then increase the quantity of money.  The Fed could lower the discount rate and make a to a bank. When the Fed makes a loan to a bank, the bank’s reserves increase. The increase in reserves increases the monetary base and allows the bank to make more loans, which then increase the quantity of money.  The Fed could lower the interest rate it pays on reserves. By lowering this interest rate banks will be motivated to use more of their reserves to make loans, which then increases the quantity of money.

18.

Describe the Fed’s assets and liabilities. What is the monetary base and does it relate to the Fed’s balance sheet? The Fed has two main assets: U.S. government securities and mortgage-backed securities. The Fed also has two main liabilities, Federal Reserve notes and depository institution deposits (the reserves that depository institutions hold at the Fed). The monetary base is the sum of coins, Federal Reserve notes, and depository © 2023 Pearson Education, Inc.

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institution deposits at the Fed. Coins are only a small part of the monetary base. The two largest components of the monetary base, Federal Reserve notes and depository institutions deposits at the Fed, are the Fed’s two liabilities.

19.

Fed’s Mary Daly Says Tapering of Bond Purchases May Start This Year San Francisco Federal Reserve President Mary Daly says that with a strong recovery, the Fed will slow its asset purchases. The Fed has previously resisted calls to pull back on quantitative easing. Source: cnbc.com, July 13, 2021 a. What actions would the Fed pursue to “pull back on quantitative easing”? Quantitative easing refers to the Fed’s huge purchases of securities. To “pull back on quantitative easing” the Fed would start to decrease the quantity of securities it purchased during its quantitative easing.

b. How would the monetary base change, and how would bank reserves change? The Fed receives payments for these securities it sells by decreasing the reserve accounts held by the banks at the Fed. The monetary base ten decreases because it includes depository institution deposits, such as reserves, at the Fed.

20.

Banks in New Transylvania have a desired reserve ratio of 10 percent of deposits and no unplanned reserves. The currency drain ratio is 50 percent of deposits. Now suppose that the central bank increases the monetary base by $1,200 billion. a. How much do the banks lend in the first round of the money creation process? Banks loan $1,200 billion because the entire increase in reserves is unplanned reserves.

b. How much of the initial amount lent flows back to the banking system as new deposits? $800 billion flows back to the banks as new deposits. The currency drain, which is the percentage ratio of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited back in banks and 50 percent of the deposits, $400 billion, is kept as currency.

c. How much of the initial amount lent does not return to the banks but is held as currency? Currency increases by $400 billion. The currency drain, which is the percentage of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited and 50 percent of the deposits, $400 billion, is kept as currency.

d. Why does a second round of lending occur? A second round of lending takes place because the $800 billion flowing back to the banks as new deposits means that banks have unplanned reserves. Of the $800 billion flowing back to the banks, 10 percent, or $80 billion, is kept as reserves leaving $720 billion that will be loaned in a second round of lending.

21.

Explain the change in the nominal interest rate in the short run if a. Real GDP increases. The nominal interest rate rises. When real GDP increases, the demand for money increases. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises.

b. The money supply increases. The nominal interest rate falls. When the supply of money increases, the quantity of money increases. At the initial interest rate people are holding more money than the quantity demanded. People buy bonds to decrease the money they hold. The price of a bond rises and the nominal interest rate falls.

c. The price level rises. The nominal interest rate rises. When the price level rises, the demand for money increases. The supply of money does not change. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises. © 2023 Pearson Education, Inc.

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Figure 25.3 shows the demand for money curve. If the quantity of money decreases from $4 trillion to $3.9 trillion, explain how the price of a bond will change. If the Fed decreases the quantity of money to $3.9 trillion, the price of a bond falls. The decrease in the quantity of money means that at the initial interest rate, 4 percent, people are holding less money than the quantity they demand. In response people sell bonds to try to increase the quantity of money they hold. As people sell bonds, the price of a bond falls and the interest rate rises, in the figure from 4 percent to 6 percent.

23.

Use the data in Problem 7 to work this problem. The interest rate is 4 percent a year. Suppose that real GDP decreases from $20 billion to $10 billion and the quantity of money remains unchanged. Do people buy bonds or sell bonds? Explain how the interest rate changes. When real GDP decreases, the demand for money decreases. At the initial interest rate of 4 percent, the quantity of money people are holding exceeds the quantity of money they want to hold. People buy bonds to decrease the quantity of money they are holding. When people demand bonds, the price of a bond rises, and the interest rate falls. When the interest rate equals 3 percent a year, people are holding exactly the quantity of money that they want to hold so 3 percent is the new equilibrium interest rate.

24.

The table provides some data for the United States in the first decade following the Civil War. Source of data: Milton Friedman and Anna J. Schwartz, A

Monetary History of the United States 1867–1960 a. Calculate the value of X in 1869.

Quantity of money Real GDP (1929 dollars) Price level (1929 = 100) Velocity of circulation

1869 $1.3 billion $7.4 billion X 4.50

1879 $1.7 billion Z 54 4.61

Using the formula MV = PY gives ($1.3 billion  4.5) = (P  $7.4 billion) so that P equals 0.79, or, transformed to an index number, P = 79.

b. Calculate the value of Z in 1879.

Using the formula MV = PY gives ($1.7 billion  4.61) = (0.54  Y) so that Y equals $14.5 billion.

c. Are the data consistent with the quantity theory of money? Explain your answer. The quantity theory holds. The quantity theory predicts that the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity minus the growth rate of real GDP. The growth rate of velocity is approximately zero, so the inflation rate equals the growth rate of the quantity of money minus the growth rate of real GDP. The quantity of money grew by approximately 27 percent, real GDP grew by approximately 65 percent and the price level fell by approximately 38 percent. (These percentages are calculated using the average of the quantity of money, the price level, and real GDP as the base for the

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percentage.) The inflation rate, −38 percent (deflation) equals the growth rate of the quantity of money, 27 percent, minus the growth rate of real GDP, 65 percent.

25.

When he was the U.S. Federal Reserve chairman, Ben Bernanke said that financial innovation and the spread of U.S. currency throughout the world had broken down the relationships between money, inflation, and output growth, which made monetary aggregates less useful gauges for policy makers. Some other central banks use monetary aggregates as a guide to policy decisions, but Bernanke believed reliance on monetary aggregates would be unwise. He said that there are differences between the United States and Europe in terms of the stability of money demand. a. Explain how the debate surrounding the quantity theory of money could make “monetary gauges a less useful tool for policy makers.” The European Central Bank (ECB) policymakers believe that the quantity theory and its relationship between the monetary growth rate and the inflation rate are a useful guide for policy. As a result they pay greater attention to the quantity of money than does the Federal Reserve. Mr. Bernanke’s believes that velocity is less stable in the United States because of instability of the demand for money and financial innovation. Because velocity is less stable, Mr. Bernanke believes that the quantity theory, and emphasis on monetary aggregates, is less useful in the United States than in Europe. Indeed, Mr. Bernanke perhaps believes that ECB policymakers pay too much attention to monetary aggregates.

b. What do Ben Bernanke’s statements reveal about his view on the accuracy of the quantity theory of money? At the least Mr. Bernanke believes that velocity changes make the short-run tie between growth in the quantity of money and the inflation rate unreliable. The article, however, sheds no light on Mr. Bernanke’s views about the validity of the quantity theory in the long run.

Economics in the News 26. After you have studied Reading Economics in the News on pp. 614–615, answer the following questions. a. What changes in the Fed’s assets occurred between 2006 and 2021? Between 2006 and 2021 the total amount of the Fed’s assets increased almost ten-fold. The composition of the assets also changed. Before 2006 the Fed held only U.S. Treasury securities. In 2021 mortgagebacked securities and other securities were about one-half of the Fed’s assets.

b. How did M2 and its velocity of circulation change between 2006 and 2021? Between 2006 and 2021, M2 grew at about 10 percent per year until 2021 when its growth skyrocketed to 25 percent per year. Velocity, however, fell at about 10 percent per year until 2021 when it fell by approximately 25 percent per year.

c. How does the nominal interest rate influence the velocity of circulation and why? The nominal interest rate is the opportunity cost of holding money. When the nominal interest rises, the opportunity cost of holding money increases so people hold less money and velocity increases. When the nominal interest rate falls, the opportunity cost of holding money decreases so people hold less money and velocity decreases

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Mathematical Note 27.

In the United Kingdom, the currency drain ratio is 38 percent of deposits and the reserve ratio is 2 percent of deposits. In Australia, the quantity of money is $150 billion, the currency drain ratio is 33 percent of deposits, and the reserve ratio is 8 percent of deposits. a. Calculate the U.K. money multiplier. The money multiplier equals 3.45. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 38 percent and R/D = 2 percent, so the money multiplier equals (1 + 0.38)/(0.38 + 0.02), which equals 3.45.

b. Calculate the monetary base in Australia. The monetary base equals $46.2 billion. The monetary base equals the sum of currency and depository institution deposits at the central bank. The currency drain is 33 percent, so with the quantity of money equal to $150 billion, currency is $37.2 billion and deposits are $112.8 billion. The banks’ reserve ratio is 8 percent, so reserves are ($112.8  0.08), which is $9 billion. The monetary base equals $37.2 billion + $9.0 billion, or $46.2 billion.

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Answers to the Review Quizzes Page 630 1.

What are the influences on the demand for U.S. dollars in the foreign exchange market? The demand for U.S. dollars depends on four main factors: the exchange rate, the world demand for U.S. exports, the interest rate in the United State and other countries, and the expected future exchange rate.

What are the influences on the supply of U.S. dollars in the foreign exchange market? The supply of U.S. dollars depends on four main factors: the exchange rate, the U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate.

How is the equilibrium exchange rate determined? The equilibrium exchange rate is the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. At the equilibrium exchange rate there is neither a shortage nor a surplus of U.S. dollars.

What happens if there is a shortage or a surplus of U.S. dollars in the foreign exchange market? If there is a shortage of U.S. dollars, the quantity of U.S. dollars demanded exceeds the quantity supplied. As long as there is a shortage, this upward pressure on the price automatically forces the price higher to its equilibrium. If there is a surplus of U.S. dollars, the quantity of U.S. dollars demanded is less than the quantity supplied. As long as there is a surplus, this downward pressure on the price automatically forces the price lower to its equilibrium.

What makes the demand for U.S. dollars change? Three factors change the demand for U.S. dollars: the world demand for U.S. exports, the interest rate in the United States and other countries, and the expected future exchange rate. If world demand for U.S. exports increases, the demand for U.S. dollars increases. If the interest rate in the United States rises relative to interest rates in other countries, the demand for U.S. dollars increases. And if the expected future exchange rate rises, the demand for U.S. dollars increases.

What makes the supply of U.S. dollars change? Three factors change the supply of U.S. dollars: U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate. If U.S. demand for imports increases, the supply of U.S. dollars increases. If the interest rate in the United States falls relative to interest rates in other countries, the supply of U.S. dollars increases. And if the expected future exchange rate falls, the supply of U.S. dollars increases.

What makes the U.S. dollar exchange rate fluctuate? Changes in the demand for U.S. dollars and the supply of U.S. dollars lead to fluctuations in the U.S. dollar exchange rate. Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large.

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Page 634 1.

What is arbitrage and what are its effects in the foreign exchange market? Arbitrage is seeking to profit by buying in one market and selling for a higher price in another market. Arbitrage has several effects:  Law of one price: At any one time, an exchange rate is the same in all markets.  No round-trip profit: It is impossible to make a profit by using currency A to buy currency B and then selling currency B to buy currency A. It is impossible to make a profit if even longer chains of currency are used.  Interest rate parity: For risk-free transactions, the rate of return earned by a unit of currency is the same in different nations.  Purchasing power parity: Purchasing power parity occurs when a unit of money buys the same amount of goods and services in different nations.

What is interest rate parity and what happens when this condition doesn’t hold? Interest rate parity occurs when, for risk-free transactions, the rate of return earned by a unit of currency is the same in different nations. If the rate of return for the U.S. dollar is higher than that for, say, the Japanese yen, interest rate parity does not hold. In this case people will expect the value of the dollar to fall against the yen (that is, the U.S. dollar is expected to depreciate over time) so that interest rate parity is restored because the rate of return earned by a unit of currency is the same in both nations.

What makes an exchange rate hard to predict? The exchange rate depends on the expected future exchange rate. The expected future is volatile. For example, the U.S. expected future exchange rate changes when news occurs that changes the future demand and/or supply of U.S. dollars. Consequently the current demand and supply of U.S. dollars changes, thereby changing the U.S. exchange rate.

What is purchasing power parity and what happens when this condition doesn’t hold? Purchasing power parity means equal value of money. If prices of goods and services are higher in the United States than the (exchange rate adjusted) prices of goods and services in, say, Japan, purchasing power parity does not occur because a unit of currency buys less in the United States than in Japan. The demand for U.S. dollars decreases and the supply of U.S. dollars increases so that the value of the dollar falls against the yen to restore purchasing power parity.

What determines the real exchange rate and the nominal exchange rate in the short run?

What determines the real exchange rate and the nominal exchange rate in the long run?

The real exchange between the United States and Japan, RER, equals E  P/P* where P is the U.S. price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar. In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate because the price levels in Japan and the United States do not adjust instantly to a change in the nominal exchange rate. In the short run, the nominal U.S. exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. In the long run, the real exchange rate is determined by demand and supply in the markets for the millions of goods. Identical goods in the United States and Japan sell for the same price once adjusted for the (nominal) exchange rate. The relative prices of goods that are not identical are determined by the supply and demand for them and so the relative price levels in different countries are determined by supply and demand. These relative price levels determine the real exchange rate. In the long run, changes in the real exchange rate and changes in the price levels change the nominal exchange rate. In the long run, the price level is determined by the quantity of money. So changes in the

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U.S. or the Japanese quantity of money change the price level and also bring an offsetting change in the nominal exchange rate.

Page 637 1.

What is a flexible exchange rate and how does it work? A flexible exchange rate policy is an exchange rate that is determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. In this arrangement, the forces of supply and demand with no direct central bank intervention are the only factors that influence the exchange rate.

What is a fixed exchange rate and how is its value fixed? A fixed exchange rate policy is an exchange rate that is pegged at a value decided by the government or central bank. The central bank directly intervenes in the foreign exchange market to block the unregulated forces of supply and demand from changing the exchange rate away from its pegged value. For instance, if a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling. If the demand for its currency increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising.

What is a crawling peg and how does it work? A crawling peg exchange rate policy selects a target path for the exchange rate and then uses direct central bank intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate except that the central bank changes the target value of the exchange rate in accord with its target path.

How has China operated in the foreign exchange market, why, and with what effect? From 1997 until 2005, the People’s Bank of China fixed the Chinese yuan exchange rate. Over this time, the demand for the yuan increased, so the People’s Bank of China supplied additional yuan to keep the exchange rate constant. By supplying yuan, the People’s Bank acquired large amounts of foreign currency. In addition, by fixing its exchange rate China essentially pegged its inflation rate to equal the U.S. inflation rate. Since 2005 the yuan has been on a crawling peg exchange rate policy. The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to U.S. inflation.

Page 643 1.

What are the transactions that the balance of payments accounts record? The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest income paid abroad, and net transfers abroad (such as foreign aid payments). The capital and financial account records foreign investment in the U.S. minus U.S. investment abroad. Any statistical discrepancy is also recorded in the capital account. The official settlements account records the change in U.S. official reserves.

Is the United States a net borrower or a net lender? Is it a debtor or a creditor nation? The United States is a net borrower and is a debtor nation.

How are net exports and the government sector balance linked? Net exports is the value of exports of goods and services minus the value of imports of goods and services. Net exports are equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit. The government sector balance is equal to net taxes minus government expenditure on goods and services. If the government sector balance is negative, then the government sector has a deficit, that is, a budget deficit. Because net exports equals the sum of the government sector balance plus private sector balance, if the government budget deficit increases and the private sector balance does not change, the value of net exports becomes more negative.

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3. The U.S. dollar exchange rate increased from $1.24 Canadian in June 2015 to $1.29 Canadian in June 2016, and it decreased from 121 Japanese yen in June 2015 to 108 yen in June 2016. 1. Did the U.S. dollar appreciate or depreciate against the Canadian dollar? Did the U.S. dollar appreciate or depreciate against the yen? The U.S. dollar appreciated against the Canadian dollar and it depreciated against the yen.

What was the value of the Canadian dollar in terms of U.S. dollars in June 2015 and June 2016? Did the Canadian dollar appreciate or depreciate against the U.S. dollar over the year June 2015 to June 2016? One Canadian dollar was worth 81 U.S. cents in June 2015 and 78 U.S. cents in June 2016. The Canadian dollar depreciated against the U.S. dollar.

What was the value of 100 yen in terms of U.S. dollars in June 2015 and June 2016? Did the yen appreciate or depreciate against the U.S. dollar over the year June 2011 to June 2012? One hundred yen was worth 83 U.S. cents in June 2015 and 93 U.S. cents in June 2016. The yen appreciated against the U.S. dollar.

On June 23, 2016, the U.S. dollar was trading at 0.68 U.K. pounds per U.S. dollar on the foreign exchange market. On June 25, 2016, the U.S. dollar was trading at 0.76 U.K. pounds per U.S. dollar. a. What events could have brought this change in the value of the U.S. dollar? The rise in the U.S. exchange rate is the result of an increase in the demand for U.S. dollars and/or an decrease in the supply of U.S. dollars. Factors that increase the demand for U.S. dollars include an increase in the U.K. demand for U.S. exports; a rise in the U.S. interest rate relative to the U.K. interest rate; and, a rise in the expected future exchange rate. Factors that decrease the supply of U.S. dollars include a decrease in the U.S. demand for U.K. imports; a rise in the U.S. interest rate relative to the U.K. interest rate; and, a rise in the expected future exchange rate.

b. Did the events you’ve described change the demand for U.S. dollars, the supply of U.S. dollars, or both demand and supply in the foreign exchange market? An increase in the U.K. demand for U.S. exports leads to only an increase in the demand for U.S. dollars. An increase in the U.S. demand for U.K. imports leads only to a decrease in the supply of U.S. dollars. The other factors, a rise in the U.S. interest rate relative to the U.K. interest rate and a rise in the expected future exchange rate, change both the demand for U.S. dollars and the supply of U.S. dollars.

Colombia is the world’s biggest producer of roses. The global demand for roses increases and at the same time Colombia’s central bank increases the interest rate. In the foreign exchange market for Colombian pesos, what happens to a. The demand for pesos? The demand for the peso increases because the Colombian interest rate differential increases and because the demand for Colombia’s export, roses, increases.

b. The supply of pesos? The supply of the pesos decreases because the Colombian interest rate differential increases.

c. The quantity of pesos demanded? The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new demand curve, so along the new demand curve for pesos, the quantity of pesos demanded decreases.

d. The quantity of pesos supplied? The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new supply curve, so along the new supply curve of pesos, the quantity of pesos supplied increases. © 2023 Pearson Education, Inc.

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e. The peso-U.S. dollar exchange rate? The U.S. exchange rate depreciates (and the Columbian exchange rate appreciates) because the demand for Colombian pesos increases and the supply decreases.

If a euro deposit in France earns 4 percent a year and a yen deposit in Japan earns 0.5 percent a year, other things remaining the same, what is the exchange rate expectation of the Japanese yen against the E.U. euro? For interest rate parity to hold, the Japanese yen must be expected to appreciate by the difference in the interest rates. So the Japanese yen must be expected to appreciate by 4.0 percent minus 0.5 percent, or 3.5 percent.

The U.K. pound is trading at 1.50 U.S. dollars per U.K. pound and purchasing power parity holds. The U.S. interest rate is 1 percent a year and the U.K. interest rate is 3 percent a year. a. Calculate the U.S. interest rate differential. The U.S. interest rate differential equals 1 percent minus 3 percent, or 2 percent per year.

b. What is the U.K. pound expected to be worth in terms of U.S. dollars one year from now? For interest rate parity to hold, the U.K. pound must be expected to depreciate 2 percent per year. Therefore next year the U.K. pound is expected to be equal to 0.98  1.50 U.S. dollars per U.K. pound, which is 1.47 U.S. dollars per U.K. pound.

c. Which country more likely has the lower inflation rate? How can you tell? The U.S inflation rate is likely to be lower than the U.K. inflation rate. The U.K. pound is expected to depreciate by 2 percent, that is, fall in value by 2 percent. For purchasing power parity to hold, prices in the United Kingdom must grow by 2 percent more than prices in the United States. If U.K. prices grow by less than 2 percent more than U.S. prices, goods and services will be cheaper to buy in the United Kingdom than in the United States and if they grow by more than 2 percent more, goods and services will be cheaper to buy in the United States than in the United Kingdom. The inflation rate measures the growth rate in prices, so the U.S. inflation rate is expected to be 2 percentage points than the U.K. inflation rate.

The U.S. price level is 115, the Japanese price level is 92, and the real exchange rate is 98.75 Japanese real GDP per unit of U.S. real GDP. What is the nominal exchange rate? The real exchange rate equals (E × P)/P* in which E is the nominal exchange rate, P is the U.S. price level, and P* is the Japanese price level. Rearranging this formula gives E = (real exchange rate × P*)/P. Using the rearranged formula, the nominal exchange rate equals (98.75 × 92)/115 = 79.0 yen per dollar.

With the strengthening of the yen against the U.S. dollar, Japan’s central bank did not take any action. A Japanese politician called on the central bank to take actions to weaken the yen, saying it will help exporters in the short run and have no long-run effects. a. What is Japan’s current exchange rate policy? Japan’s current exchange rate policy is a flexible exchange.

b. What does the politician want the exchange rate policy to be in the short run? Why would such a policy have no effect on the exchange rate in the long run? The politician wants the exchange rate to be a crawling peg by lowering it over a period of time. This policy has no effect on the exchange rate in the long run because in the long run the real exchange rate is determined by supply and demand for the nation’s goods. In addition, the nominal exchange rate adjusts to make the ratio of the nations’ price levels equal to the real exchange rate.

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The table gives some information about the U.S. international transactions in 2015. a. Calculate the balance on the three balance of payments accounts.

Item Imports of goods and services Foreign investment in the United States Exports of goods and services U.S. investment abroad Net interest income Net transfers Statistical discrepancy

Billions of U.S. dollars 2,764 502

The current account balance equals exports of 2,264 goods and services ($2,264 billion) minus 175 imports of goods and services ($2,764 billion) 193 plus net interest income ($193 billion) plus −127 net transfers ($127 billion). So the current 101 account balance is $434 billion. The capital and financial account balance equals foreign investment in the United States ($502 billion) minus U.S. investment abroad ($175 billion) plus the statistical discrepancy ($101 billion). So the capital and financial account balance is $428 billion. The official settlements account balance equals  current account balance ($434 billion)  capital and financial account balance ($428 billion). So the official settlements account balance is $6 billion. Because the official settlements account is positive, U.S. official reserves are decreasing.

b. Was the United States a net borrower or a net lender? Explain your answer. The United States was a net borrower because foreign investment in the United States exceeded U.S. investment abroad.

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Answers to Additional Problems and Applications 11.

Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 0.75 euros per U.S. dollar and today the U.S. dollar is trading at 0.80 euros per U.S. dollar. Which of the two currencies (the U.S. dollar or the euro) has appreciated and which has depreciated today? The U.S. dollar appreciated because its exchange rate rose. The euro depreciated because its exchange rate fell (from 1.33 U.S. dollars per euro to 1.25 U.S. dollars per euro).

12.

Suppose that the exchange rate fell from 80 yen per U.S. dollar to 70 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to buy in the foreign exchange market? The fall in the exchange rate increases the quantity of U.S. dollars that people plan to buy in the foreign exchange market.

13.

Suppose that the exchange rate rose from 80 yen per U.S. dollar to 90 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to sell in the foreign exchange market? The rise in the exchange rate increases the quantity of U.S. dollars that people plan to sell in the foreign exchange market.

14.

Today’s exchange rate between the yuan and the U.S. dollar is 6.40 yuan per dollar and the central bank of China is buying U.S. dollars in the foreign exchange market. If the central bank of China did not purchase U.S. dollars would there be excess demand or excess supply of U.S. dollars in the foreign exchange market? Would the exchange rate remain at 6.40 yuan per U.S. dollar? If not, which currency would appreciate? In the absence of the purchases by the central bank of China there would be an excess supply of U.S. dollars in the foreign exchange market. Without these purchases, the exchange rate would fall from 6.40 yuan per dollar to something lower. The Chinese yuan would appreciate (and the U.S. dollar would depreciate).

15.

Yesterday, the current exchange rate was $1.05 Canadian per U.S. dollar and traders expected the exchange rate to remain unchanged for the next month. Today, with new information, traders now expect the exchange rate next month to fall to $1 Canadian per U.S. dollar. Explain how the revised expected future exchange rate influences the demand for U.S. dollars, or the supply of U.S. dollars, or both in the foreign exchange market. The revision in the expected future exchange rate lowers the expected profit from holding U.S. dollars and thereby affects both the demand for U.S. dollars and the supply of U.S. dollars. The fall in the expected profit from holding dollars decreases the demand for U.S. dollars because people would rather hold more profitable currencies. It also increases the supply of U.S. dollars as people supply dollars in order to buy other, more profitable currencies.

16.

In 2016, the exchange rate changed from 108 yen per U.S. dollar in April to 104 yen per U.S. dollar in May, and to 109 yen per dollar in June. What information would you need to determine the factors that caused these changes in the exchange rate? Which factors would change both demand and supply? The factors that influence the U.S. exchange rate include the Japanese demand for U.S. exports; the U.S. demand for Japanese imports; the U.S. interest rate relative to the Japanese interest rate; and, the expected future exchange rate. Changes in any of these factors will change the U.S. exchange rate. Changes in the U.S. interest rate differential and the excepted future exchange rate change both demand and supply.

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Australia produces natural resources (coal, iron ore, natural gas, and others), the demand for which has increased rapidly as China and other emerging economies expand. a. Explain how growth in the demand for Australia’s natural resources would affect the demand for Australian dollars in the foreign exchange market. The growth in demand for Australia’s natural resources increases the demand for Australian dollars.

b. Explain how the supply of Australian dollars would change. Absent any change in the expected future exchange rate, the supply of Australian dollars does not change (there is a change in the quantity supplied).

c. Explain how the value of the Australian dollar would change. The increase in demand for Australian dollars raises the value of the Australian dollar.

d. Illustrate your answer with a graphical analysis. Figure 26.1 illustrates the effect of the increase in demand for Australian dollars. The demand curve for Australian dollars shifts rightward, from D0 to D1. The supply curve does not shift. The exchange rate rises from 90 yen per Australian dollar to 95 yen per Australian dollar.

Use the following news clip to work Problems 18 and 19. Rio’s Foreign Property Investors Score Deals on Currency Woes For foreign investors, a 21% fall in the Brazilian real since the start of 2020 has encouraged the purchase of real estate. Before the 2016 Summer Olympics, Rio’s real estate market was compared to that of New York or Paris. After the games, property prices fell and the real depreciated nearly 37%. Now real estate in Rio is heating up after a slash in interest rates. Source: Bloomberg.com, June 4, 2021 18. Explain why the depreciation of the Brazilian real has led to foreign investment in Rio’s real estate. The fall in the real makes it less expensive for foreigners to acquire reals and thereby makes buying real estate in Rio less expensive. Accordingly, more foreign investors have purchased property in Rio.

19.

What is the effect of a slash in interest rates on foreign investment in Rio? The decrease in Brazilian interest rates decreased the demand for Brazilian reals and increased the supply of reals. Consequently, the Brazilian exchange rate fell, which made foreign investment in Rio less expensive and thereby increased foreign investment in Rio.

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Use the following information to work Problems 20 and 21. Is the Loonie Going Up or Down? The price of a Big Mac is $C6.88 in Toronto and $5.71 in New York. The exchange rate is $C1.36 per U.S. dollar. The 3-month interest rate is 0.17 percent in Canada and 0.10 percent in the United States. Source: The Economist, The Federal Reserve System, and the Bank of Canada, June 2020 20. Does purchasing power parity hold? If not, does PPP predict that the $C (loonie) will appreciate or depreciate against the U.S. dollar? Explain. Purchasing power parity (PPP) does not hold because a Big Mac is more expensive in New York than in Canada. In Canada it takes ($C6.88) ÷ ($C1.36 per U.S. dollar) = $US5.05 to buy a Big Mac. PPP predicts that the Canadian dollar will appreciate against the U.S. dollar. Appreciation will increase the number of U.S. dollars it takes to buy a Canadian dollar and thereby increase the number of U.S. dollars it takes to purchase a Big Mac in Canada back to equality with the number of dollars it takes to purchase a Big Mac in New York.

21.

Does interest rate parity hold? If not, why not? Will the Canadian dollar depreciate further or appreciate against the U.S. dollar if the Fed raises the interest rate while the Canadian interest rate remains at 0.17 percent a year? Interest rate parity holds. The difference in the interest rates is offset by the expected appreciation of the US dollar, so the U.S. dollar is expected to appreciate by (0.17 percent)  (0.10 percent) = 0.07 percent a year. If the Fed raises the U.S. interest rate, interest rate parity will continue to hold. Because the U.S. interest rate is now higher, the demand for dollars increases and the supply decreases, so the dollar immediately appreciates which means the Canadian dollar immediately depreciates. However, because the interest rate differential is now smaller (perhaps even negative), the Canadian dollar is expected to depreciate less (and even appreciate if the interest rate differential is negative) in the future.

22.

Over- or Undervalued The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued. In June 2020, the price of a Big Mac was $5.71 in New York, 21.70 yuan in Beijing, and 6.50 Swiss francs in Geneva. The exchanges rates were 6.9 yuan per U.S. dollar and 0.94 Swiss francs per U.S. dollar. Source: www.economist.com, Jun 2020 a. Was the yuan undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in China into U.S. prices shows that the Chinese Big Mac has a dollar price of 21.70 yuan ÷ 6.9 yuan per dollar which is $3.14. The yuan was undervalued relative to purchasing power parity.

b. Was the Swiss franc undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in Switzerland into U.S. prices shows that the Swiss Big Mac has a dollar price of 6.50 francs ÷ 0.94 francs per dollar which is $6.91. The Swiss franc was overvalued relative to purchasing power parity.

c. Do Big Mac prices in different countries provide a valid test of purchasing power parity? The price of a Big Mac is the price of only one good. Purchasing power parity applies to national price levels not to the price of an individual good. Using an individual good means that local supply and demand conditions might lead the price to diverge from purchasing power parity.

Use the following news clip to work Problems 23 to 25. U.S. Says China Is No Longer a Currency Manipulator China’s designation as a currency manipulator has been officially removed by the Trump © 2023 Pearson Education, Inc.

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administration. As part of a new trade deal, China and the United States agree they will not devalue their currencies to achieve trade advantages. Source: nytimes.com, January 13, 2020 23. What was the exchange rate policy adopted by China until July 2005? Explain how it worked. Draw a graph to illustrate your answer. The actions in the foreign exchange market of the People’s Bank allowed China to maintain a fixed exchange rate with the United States. If, at the fixed exchange, there was shortage of yuan (which means there is a surplus of dollars), the People’s Bank bought dollars using yuan. Without this action by the People’s Bank, the shortage of yuan would have appreciated the yuan and depreciated the dollar; with this action by the People’s Bank, the exchange rate stayed fixed. Figure 26.2 shows the foreign exchange market. At the fixed exchange of 0.10 dollar per yuan, there is a shortage of 0.2 billion yuan. If the market is allowed to reach its equilibrium exchange rate, the yuan would appreciate to 0.12 dollar per yuan, which means that the dollar would depreciate. But the People’s Bank provided the 0.2 billion yuan shortage by purchasing dollars and paying with yuan and thereby kept the exchange rate pegged at 0.10 yuan per dollar. By fixing its exchange rate in order to keep the yuan from appreciating, the People’s Bank accumulated U.S. dollars.

24.

What was the exchange rate policy adopted by China after July 2005? Explain how it works. After July 2005 China has not allowed a truly flexible exchange rate. Instead China uses a crawling peg policy, in which the Chinese government intervenes in the market for foreign exchange so as to allow the Chinese exchange rate to make only small changes.

25.

Explain how fixed and crawling peg exchange rates can be used to manipulate trade balances in the short run, but not the long run. Changes in fixed and crawling peg exchange rates can affect the trade balance in the short run because these changes affect the relative price of the domestically-produced good and the foreign good. But changes in fixed and crawling peg exchange rates cannot affect the trade balance in the long run because the trade balance is (ultimately) determined by the real exchange rate. In the long run, the price levels will adjust to create a real exchange rate that balances trade.

26.

Hong Kong’s Central Bank Is Keeping Its Currency Peg Hong Kong’s central bank intervened 40 times in 2020 to keep its currency pegged to the U.S. dollar at 7.8 Hong Kong dollars per U.S. dollar. The U.S. dollar dropped sharply in 2020, due in part to low interest rates. To date, Hong Kong’s central bank has bought 152 billion Hong Kong dollars ($19.6 billion) this year. Source: businessinsider.com, September 3, 2020 a. What is Hong Kong’s exchange rate policy? Hong Kong’s exchange rate policy is a fixed exchange rate policy.

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b. Is the Hong Kong central bank trying to raise or lower the value of the Hong Kong dollar? How do you know? Hong Kong is trying to raise the value of the Hong Kong dollar. We can determine that Hong Kong is trying to raise the value of its dollar because the central bank is buying Hong Kong dollars, thereby increasing the demand for Hong Kong dollars, which raises the value of the Hong Kong exchange rate.

c. What is happening to Hong Kong’s official reserves? As Hong Kong buys Hong Kong dollars, it pays for these purchases with its official reserves. Accordingly, Hong Kong’s official reserves are decreasing.

Use the table to work Problems 27 and 28. The table gives some data about the U.K. economy: 27.

Calculate the private sector and government sector balances.

Item Consumption expenditure Exports of goods and services Government expenditure Net taxes Investment Saving

The private sector balance equals saving (£162 billion) minus investment (£181 billion), which is £19 billion. The government sector balance is equal to net taxes (£217 billion) minus government expenditures on goods and services (£230 billion), which is £13 billion.

28.

Billions of U.K. pounds 721 277 230 217 181 162

What is the relationship between the government sector balance and net exports? The government sector balance plus the private sector balance equals net exports. Therefore the net exports equals the private sector balance (£19 billion) plus the government sector balance (£13 billion), which is £32 billion. The U.K. had a net export deficit of £32 billion.

Economics in the News 29. After you have studied Economics in the News on pp. 644–645, answer the following questions. a. In which year or years did the Swiss National Bank not intervene in the foreign exchange market to lower the franc exchange rate? How can you tell? Switzerland did not intervene to lower the franc exchange rate in 2018. Additionally, in 2013 and 2014 any attempts to lower the franc exchange rate were small. We can determine when the Swiss intervened to lower the franc exchange rate by determining the change in Switzerland’s U.S. dollar reserves. When the Swiss National Bank intervenes to lower the franc exchange rate, it does so by buying U.S. dollars using Swiss francs (which increases the supply of Swiss francs and lowers the exchange rate) thereby raising Switzerland’s U.SD. dollar reserves. In 2018, Switzerland’s U.S. dollar reserves fell and in 2013 and 2014, the increase in Switzerland’s U.S. dollar reserves was quite small.

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b. What did the Swiss National Bank do in 2018? Make a graph like Fig. 3 on p. 645 to illustrate your answer. In 2018 the Swiss National Bank did not want the franc exchange rate to fall, so it sold $30 billion U.S. dollars by purchasing Swiss francs. As Figure 26.3 shows, the Swiss National Bank’s action purchases the surplus of Swiss francs (1,015 billion francs ─ 985 billion francs) and thereby kept the exchange rate at 1.02 U.S. dollars per franc rather than falling to 1.00 U.S. dollars per franc.

c. The news article identifies Vietnam as a country that might be a currency manipulator. What data would you need to check that claim? If Vietnam is manipulating its currency, it is trying to keep its exchange rate from appreciating, which would decrease the quantity of its exports. Vietnam achieves this goal by buying foreign currency, thereby increasing the quantity of its currency supplied and preventing its exchange rate from appreciating. However, Vietnam might intervene in the foreign exchange market for other reasons, such as to maintain its inflation rate at a desired target. Consequently, to determine if Vietnam is a currency manipulator, we need data on the amount of Vietnam’s U.S. dollar reserves and the rationale behind Vietnam’s intervention in the foreign exchange market.

d. In 2021, Vietnam’s foreign exchange reserves increased by $18 billion and the dong (Vietnam’s currency) depreciated from 43 to 42 U.S. cents per 10,000 dongs. What made that happen? Vietnam’s central bank likely purchased dollars and sold Vietnamese dongs on the foreign exchange market. By selling Vietnamese dongs, the central bank increased the supply of dongs and depreciated the dong exchange rate.

e. Make a graph like Fig. 3 on p. 645 to illustrate the effect of the $18 billion increase in Vietnam’s foreign exchange reserves and depreciation of the dong in 2021. In 2021 the Vietnamese Central bank did not want the dong exchange rate to rise, so it sold $18 billion Vietnamese dongs by purchasing U.S. dollars. As Figure 26.4 shows, the central bank’s action increased the quantity of Vietnamese dongs from 998 hundred trillion to 1,002 hundred trillion and thereby lowered the exchange rate from 0.43 U.S. dollars per 10,000 dongs to 0.42 U.S. dollars per 10,000 dongs.

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Answers to the Review Quizzes Page 657 1.

If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied and a movement occurs up along the LAS curve.

If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level rises and the money wage rate remains constant the quantity of real GDP supplied increases and the economy moves along the SAS curve.

If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve? If potential GDP increases both long-run aggregate supply and short-run aggregate supply increase and the LAS curve and SAS curve shift rightward.

If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve? If the money wage rate rises and potential GDP remains the same there is a decrease in short-run aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward and the LAS curve is unchanged.

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What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve? The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same. When there is a movement along the aggregate demand curve, the price level changes and other factors such as expectations, fiscal and monetary policy, and the world economy remain the same.

Why does the aggregate demand curve slope downward? The aggregate demand curve slopes downward because of the wealth effect and two substitution effects. First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect. Second, a rise in the price level raises the interest rate, which decreases borrowing and spending—an intertemporal substitution effect as people decrease current spending in favor of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect.

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How do changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve? Aggregate demand increases and the AD curve shifts rightward if: expected future income, expected future inflation, or expected future profits increase; government expenditure increases or taxes are cut; the quantity of money increases and the interest rate is cut; the exchange rate falls; or foreigners’ income increases. The reverse changes decrease aggregate demand and shift the AD curve leftward.

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Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Economic growth results from increases in long-run aggregate supply. Economic growth occurs because the quantity of labor increases, capital is accumulated and there are technological advances over time. All three of these factors increase potential GDP and shift the LAS curve rightward.

Does inflation result from increases in aggregate demand, short-run aggregate supply, or longrun aggregate supply? Inflation results from increases in aggregate demand that exceed the increase in long-run aggregate supply. As the aggregate demand curve shifts rightward the price level rises. Increases in AD that exceed increases in LAS produce inflation.

Describe three types of short-run macroeconomic equilibrium. Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. There are three types of short-run equilibrium: below full-employment equilibrium where a recessionary gap exists with real GDP less than potential GDP; above fullemployment equilibrium where an inflationary gap exists with real GDP greater than potential GDP; fullemployment equilibrium where no gap exists and real GDP equals potential GDP.

How do fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP? Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP. For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap. In the long run the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy returns to its full employment equilibrium. Starting from full employment, a decrease in shortrun aggregate supply decreases real GDP and raises the price level. The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation.

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What are the defining features of classical macroeconomics and what policies do classical macroeconomists recommend? Classical macroeconomists believe that the economy is self-regulating and always at full employment. Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change.

What are the defining features of Keynesian macroeconomics and what policies do Keynesian macroeconomists recommend? Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment. To achieve and maintain full employment the economy needs active help from fiscal and monetary policy. Aggregate demand fluctuations combined with a very sticky money wage rate are the major sources of the business cycle. Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies.

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What are the defining features of monetarist macroeconomics and what policies do monetarist macroeconomists recommend? Monetarists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady. The major source of business cycle fluctuations are similar to the Keynesian view, that is, changes in aggregate demand combined with a sticky money wage rate. However, according to monetarists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the Federal Reserve. Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth.

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Answers to the Study Plan Problems and Applications 1.

Explain the influence of each of the following events on the quantity of real GDP supplied and aggregate supply in India and use a graph to illustrate.  U.S. firms move their call handling, IT, and data functions to India. Moving call-handling, IT, and data functions to India increases short-run and long-run aggregate supply because it increases the amount of employment at full employment and (probably) also increases the capital stock. As Figure 27.1 shows, both the short run aggregate supply curve and long-run aggregate supply curve shift rightward, from SAS0 to SAS1 and from LAS0 to LAS1.



Fuel prices rise. The rise in fuel prices raises firms’ costs. Short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Long-run aggregate supply does not change. Figure 27.2 shows the leftward shift of the short-run aggregate supply curve from SAS0 to SAS1.



Walmart and Starbucks open in India. When Starbucks and Walmart open in India, short-run and long-run aggregate supply increase. When these stores open, employment at full employment increases and India’s capital stock increases. Both the short-run and long-run aggregate supply curves shift rightward, as illustrated in Figure 27.1.



Universities in India increase the number of engineering graduates. Increasing the number of engineering graduates increases India’s human capital. Both the short-run and long-run aggregate supply increases, as shown in Figure 27.1 by the rightward shifts in the short-run and long-run aggregate supply curves. © 2023 Pearson Education, Inc.

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The money wage rate rises. An increase in the money wage rate increases firms’ costs. Short-run aggregate supply decreases but longrun aggregate supply does not change. Long-run aggregate supply does not change because in the long run the price level rises by the same percentage the money age rate increased, so in the long run employment does not change. This situation is illustrated in Figure 27.2, in which the short-run aggregate supply curve shifts leftward and the long-run aggregate supply curve does not change.



The price level in India increases. In the short run, an increase in the price level increases the quantity of real GDP supplied. In the long run, the money wage rate rises by the same percentage so in the long run there is no change in the quantity of real GDP supplied. These results are illustrated in Figure 27.3 by the grey arrows showing the movement along the short-run aggregate supply curve, SAS, and the movement along the long-run aggregate supply curve, LAS.

Labor productivity is rising at a rapid rate in China and wages are rising at a similar rate. Explain how a rise in labor productivity and wages in China will influence the quantity of real GDP supplied and aggregate supply in China. The rise in labor productivity increases potential GDP and increases aggregate supply. The short-run and long-run aggregate supply curves shift rightward. The rise in the money wage rate in China decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward. It has no effect on potential GDP or on the long-run aggregate supply curve.

Canada trades with the United States. Explain the effect of each of the following events on Canada’s aggregate demand.  The government of Canada cuts income taxes. Cutting income taxes increases aggregate demand because it increases people’s disposable incomes.



The United States experiences strong economic growth. Strong growth in the United States increases U.S. demand for Canadian exports. Canadian exports are a component of Canada’s aggregate demand so the increase in demand for Canada’s exports means that Canada’s aggregate demand increases.



Canada sets new environmental standards that require power utilities to upgrade their production facilities. To upgrade their facilities, power utilities must increase their investment. Investment is a component of aggregate demand so an increase in investment means that Canada’s aggregate demand increases.

The Fed cuts the quantity of money and all other things remain the same. Explain the effect of the cut in the quantity of money on aggregate demand in the short run. A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward. By © 2023 Pearson Education, Inc.

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cutting the quantity of money, the interest rate rises, so firms decrease their investment and households cut back their expenditure on new homes, new cars, and other big-ticket items. The decrease in consumption expenditure and investment both decrease aggregate demand.

Gross Domestic Product for the Second Quarter of 2021 In the second quarter of 2021, personal consumption expenditures, exports, and imports increased. Investment and government expenditure decreased. Real GDP increased by 6.5 percent following a 6.3 percent increase in the first quarter. Source: Bureau of Economic Analysis, July 29, 2021 Explain how the items in the news clip influence U.S. aggregate demand. The increase in consumption expenditures and exports increase U.S. aggregate demand. The increase in imports and the decrease in investment and government spending all decrease U.S. aggregate demand.

Use Figure 27.4 to work Problems 6 to 8. Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0. 6.

Some events change aggregate demand from AD0 to AD1. Describe two events that could have created this change in aggregate demand. What is the equilibrium after aggregate demand changed? If potential GDP is $1 trillion, the economy is at what the type of macroeconomic equilibrium? Aggregate demand increases when the aggregate demand curve shifts from AD0 to AD1. Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed lowers the interest rate; or if the U.S. exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium is at point C: real GDP is $1.1 trillion and the price level is 105. The economy is at an above full-employment equilibrium with an inflationary gap.

Some events change aggregate supply from SAS0 to SAS1. Describe two events that could have created this change in aggregate supply. What is the equilibrium after aggregate supply changed? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no output gap? Aggregate supply decreases when the aggregate supply curve shifts from SAS0 to SAS1. Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise. After the change, equilibrium is at point A: real GDP is $0.9 trillion and the price level is 105. The economy is at a below full-employment equilibrium with a recessionary gap.

Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS0 to SAS1. What is the new macroeconomic equilibrium? After the changes, equilibrium is at point D: real GDP is $1.0 trillion and the price level is 110. The economy is at a full-employment equilibrium.

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Describe the policy change that a classical macroeconomist, a Keynesian, and a monetarist would recommend for U.S. policymakers to adopt in response to each of the following events: a. Growth in the world economy slows. Classical economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

b. The world price of oil rises. Classical and monetarist economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

c. U.S. labor productivity declines. Classical economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

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Answers to Additional Problems and Applications 10.

Explain for each event whether it changes the quantity of real GDP supplied, short-run aggregate supply, long-run aggregate supply, or a combination of them.  Automotive firms in the United States switch to a new technology that raises productivity. When firms switch to a new technology, both the short-run aggregate supply and the long-run aggregate supply increase.



Toyota and Honda build additional plants in the United States. Building new plants in the United States increases the U.S. capital stock and thereby increases both the short-run aggregate supply and the long-run aggregate supply.

 

The prices of auto parts imported from China rise. The increase in the price of auto parts imported from China decreases the short-run aggregate supply because the cost of producing automobiles increases. There is no effect on the long-run aggregate supply.

Autoworkers agree to a lower money wage rate. The lower money wage rate increases short-run aggregate supply because the cost of producing automobiles falls. There is no effect on the long-run aggregate supply.



The U.S. price level rises. The increase in the price level increases the short-run quantity of real GDP supplied. It has no effect on the long-run quantity of real GDP supplied.

11.

Explain for each event whether it changes the quantity of real GDP demanded or aggregate demand in the United States.  U.S exports to the European Union boom. The increase in U.S. exports increases U.S. aggregate demand.



U.S. firms build new gas-fuel utilities. Building new plants in the United States increases U.S. aggregate supply, which brings a change in the quantity of real GDP demanded. Building the new plants also increases investment, which increases aggregate demand.



U.S. inflation rate is expected to rise next year.



The U.S. price level rises.

The increase in the expected inflation rate increases aggregate demand. The rise in the U.S. price level leads to a change in the quantity of real GDP demanded.

12.

Inventory Investment Decreases When real GDP increased in the second quarter of 2021, consumption expenditure, exports, and imports increased. Fixed investment decreased, which included a decrease in business inventory investment. Source: Bureau of Economic Analysis, July 29, 2021 Explain how a fall in inventories influences aggregate demand. Inventories are a component of investment and investment is a component of aggregate demand. When inventories decrease, investment decreases so that aggregate demand decreases.

13.

Exports and Imports Increase Real exports of goods and services increased 6 percent in the second quarter of 2021, compared with a decrease of 2.9 percent in the first quarter of 2021. Real imports of goods and services increased 7.8 percent in the second quarter of 2021, and by 9.8 percent in the first quarter of 2021. Source: Bureau of Economic Analysis, July 29, 2021 a. Explain how the changes in exports and imports reported here influence the quantity of real © 2023 Pearson Education, Inc.

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GDP demanded and aggregate demand. Net exports is part of aggregate demand, which means that an increase (decrease) in net exports increases (decreases) aggregate demand. Net exports equals exports minus imports, so an increase in exports increases aggregate demand while an increase in imports decreases aggregate demand. Consequently, the increase in exports in the second quarter of 2021 increased aggregate demand and the decrease in exports in the first quarter of 2021 as well as the increases in imports in the second quarter of 2021 and in the first quarter of 2021 all decreased aggregate demand.

b. In which of the two quarters reported did exports and imports make the greater contribution to aggregate demand growth? In the first quarter of 2021, both the decrease in exports and (large) increase in imports decreased aggregate demand growth. In this quarter, because these two effects reinforced each other, the effect on aggregate demand growth was the largest.

Use the following information to work Problems 14 to 16. The following events have occurred at times in the history of the United States:  The world economy goes into an expansion.  U.S. businesses expect future profits to rise.  The government increases its expenditure on goods and services in a time of war or increased international tension. 14. Explain for each event whether it changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them. The expansion in the world economy increases U.S. exports and increases aggregate demand. The expectation of higher profits in the future increases investment and increases aggregate demand. An increase in government expenditure on goods and services increases aggregate demand.

15.

Explain the separate effects of each event on U.S. real GDP and the price level, starting from a position of long-run equilibrium. The expansion in the world economy increases U.S. exports and increases aggregate demand, which increases real GDP and raises the price level. The expectation of higher profits in the future increases investment and boosts aggregate demand, which increases real GDP and raises the price level. The increase in government expenditure on goods and services increases aggregate demand, which increases real GDP and raises the price level.

16.

Explain the combined effects of these events on U.S. real GDP and the price level, starting from a position of long-run equilibrium. The combined effect of an expansion in the world economy, the expectation of higher profits in the future, and an increase in government expenditures increase aggregate demand, which increases real GDP and raises the price level.

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Use the following information to work Problems 17 and 18. In Japan, potential GDP is 600 trillion Real GDP Real GDP supplied in yen. The table shows the aggregate demanded the short run demand and short-run aggregate supply Price level (trillions of 2009 yen) schedules. 75 600 400 17. a. Draw a graph of the aggregate 85 550 450 demand curve and the short-run 95 500 500 aggregate supply curve. 105 450 550 Figure 27.5 shows the aggregate 115 400 600 demand curve and the short-run 125 350 650 aggregate supply curve. 135 300 700 b. What is the short-run equilibrium real GDP and price level? Equilibrium real GDP is ¥500 trillion and the price level is 95. Short-run macroeconomic equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate supply curve.

18.

Does Japan have an inflationary gap or a recessionary gap and what is its magnitude? Equilibrium real GDP is less than potential GDP, so Japan has a recessionary gap. The recessionary gap equals the difference between potential GDP and real GDP, which is ¥100 trillion.

Use the following information to work Problems 19 and 20. Gen Z, the Pandemic, and How They Pay A 2018 study estimated Gen Z’s spending power to be significant. Is this still the case? The pandemic destroyed many of the jobs that Gen Z seek, so like other predictions coming out of the pandemic, we’re waiting to see how the new reality affects Gen Z financially in the long term. Source: forbes.com, January 21, 2021 19. Suppose that Gen Z comes strongly out of the pandemic. Explain the effect of a rise in expenditure by Gen Z on real GDP and the price level in the short run. Figure 27.6 shows the effect from the increase in consumption expenditure by Gen Z. Consumption expenditure is one of the components of aggregate demand, so an increase in consumption expenditure increases aggregate demand and shifts © 2023 Pearson Education, Inc.

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the aggregate demand curve rightward. In the figure the aggregate demand curve shifts from AD0 to AD1. Because aggregate demand increased, equilibrium real GDP increases (in Figure 10.6 from $21 trillion to $23 trillion) and the price level rises (in the figure from 117 to 119).

20.

Describe the macroeconomic equilibrium after an increase in spending by Gen Z: a. If the economy had been operating below full-employment equilibrium. If the economy had been operating below full-employment equilibrium before the increase in consumer expenditure, after the increase equilibrium real GDP will be closer to potential GDP and possibly even exceed it. Ideally real GDP will equal potential GDP.

b. If the economy had been operating at a full-employment equilibrium. Starting from a full-employment equilibrium, a rise in spending by Gen Z moves U.S. equilibrium real GDP above potential GDP. The economy moves to an above full-employment equilibrium. To restore the long-run equilibrium, the money wage rate rises which decreases short-run aggregate supply and eventually decreases equilibrium real GDP back to potential GDP.

c. Explain and draw a graph to illustrate how the economy adjusts in the two situations described in parts a and b. Figure 27.7 shows how the economy can adjust to its long-run equilibrium. If the economy starts at point A, a below fullemployment equilibrium, then an increase in aggregate demand from AD0 to AD1 moves the economy to point B. This point also is the long-run equilibrium because it is where the aggregate demand and short-run aggregate supply curves intersect and at that point real GDP equals potential GDP, $23 trillion. If the economy starts at point B, a full-employment equilibrium, then an increase in aggregate demand from AD1 to AD2 moves the economy to point C. In the short run, real GDP exceeds potential GDP. Employment exceeds full employment. The tight labor market means that the money wage rate starts to rise. As the money wage rate rises, short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Real GDP and employment decrease. Even though employment is decreasing, as long as employment exceeds full employment, the money wage rate continues to rise and the short-run aggregate supply continues to decrease. The process ultimately ends when real GDP has decreased back to equal potential GDP and employment equals full employment. Short-run aggregate supply has decreased and the short-run aggregate supply curve has shifted from SAS0 to SAS1. At this point the price level has risen (to 121 in Figure 27.7) and real GDP has returned to potential GDP ($23 trillion).

21.

Suppose that the E.U. economy goes into an expansion. Explain the effect of the expansion on U.S. real GDP and unemployment in the short run. When the E.U. economy moves into an expansion, U.S. exports to the E.U. increase. The increase in U.S. exports increases U.S. aggregate demand, thereby increasing U.S. real GDP and lowering U.S. unemployment.

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Explain why changes in consumer spending and business investment play a large role in the business cycle. Changes in consumer spending play a large role in business cycles because consumption expenditure is by far the largest part of GDP. A small percentage change in consumption expenditure is a large change in aggregate demand which can lead to a large change in real GDP. Changes in investment spending are also important because investment spending is quite volatile and subject to large changes. Consequently a decrease in investment often leads to a large decrease in aggregate demand and a recession while an increase frequently results in a large increase in aggregate demand and an expansion.

23.

Federal Reserve Slashes Interest Rates to Zero The Fed is dropping its interest rate to zero percent. The Fed wants to keep borrowing costs as low as possible as it sees the economy falling into recession. This announcement follows a previous interest rate cut less than two weeks ago. Source: washingtonpost.com, March 15, 2020 a. Describe the process by which the Fed’s action in the news clip flows through the economy. A decrease in the interest rate makes loans less costly. The lower interest rate leads businesses to increase their investment and households to increase spending on new homes and other consumer durables. All these effects increase aggregate demand and thereby raise real GDP.

b. Draw a graph to illustrate the state of the economy that prompted the Fed to take the action described in the news clip. Figure 27.8 shows the state of the economy. Real GDP of $19 trillion (determined by the intersection of AD0 and SAS0) is less than potential GDP of $20 trillion. There is an recessionary gap.

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c. Draw a graph to illustrate the Fed’s action and its effect. Figure 27.9 shows how the Fed’s action increases aggregate demand, shifting the aggregate demand curve rightward from AD0 to AD1. Real GDP increases from $19 trillion to potential GDP of $20 trillion. In the figure, the Fed’s action perfectly removes the recessionary gap but the Fed’s action might simply reduce it (if the increase in aggregate demand is less than what is illustrated) or even create an inflationary gap (if the increase in aggregate demand exceeds what is illustrated).

24.

Cut Taxes and Boost Spending? Raise Taxes and Cut Spending? Cut Taxes and Cut Spending This headline expresses three views about what to do to get the U.S. economy growing more rapidly and contribute to closing the recessionary gap. Economists from which macroeconomic school of thought would recommend pursuing policies described by each of these views? The first policy, cut taxes and boost spending, would be endorsed by the Keynesian and new Keynesian schools. The second policy, raise taxes and cut spending, is endorsed by no school of thought. The third policy, cut taxes and cut spending, would be endorsed by the classical and new classical schools.

Economics in the News 25. After you have studied Economics in the News on pp. 262–263 (670–671 in Economics), answer the following questions. a. What were the main features of the U.S. economy in the first quarter of 2020? Did the United States have a recessionary gap or an inflationary gap? How do you know? The main feature of the U.S. economy was a small recessionary gap because actual GDP was below potential GDP.

b. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that occurred in the second quarter of 2020. Figure 27.10 shows the changes in the second quarter of 2020. Starting from a small recessionary gap, in that quarter stay-at-home orders and restrictions on social interactions created large decreases in both aggregate demand and short-run aggregate supply. As shown in the figure, both the aggregate demand curve and the © 2023 Pearson Education, Inc.

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short run aggregate supply curve shifted left, from AD1 to AD2 for aggregate demand and from SAS1 to SAS2 for short-run aggregate supply. Real GDP fell from $19.0 trillion to $17.3 trillion and the price level fell from 113.4 to 112.8. A large recessionary gap was opened.

c. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that occurred in the third quarter of 2020. Figure 27.11 shows what occurred. In the third quarter the events in the second quarter reversed. As the federal government introduced expansionary Covid policies and the restrictions on social interaction and stay-at-home orders eased, both aggregate demand and short-run aggregate supply increased. In Figure 27.11 the aggregate demand curve shifted rightward from AD2 to AD3 and the short-run aggregate supply curve shifted rightward from SAS2 to SAS3. Equilibrium real GDP increased to $18.6 trillion and the price level rose to 113.8. Real GDP remains below potential GDP.

d. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would have occurred without the federal government’s Covid stimulus. Without the Covid stimulus, the increase in aggregate demand would have been smaller. Figure 27.12 shows what would occurred. In it the increase in the short-run aggregate supply, illustrated by the shift of the SAS curve from SAS2 to SAS3, is assumed to be the same as in Figure 27.11. But aggregate demand now increases by less, so the shift of the AD curve from AD2 to AD3 is smaller than in Figure 27.11. Consequently, the increase in equilibrium real GDP is smaller, to only $18,2 trillion. The rise in the price level is also smaller, to only 113.

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e. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the federal government’s stimulus was exactly the right size to restore full employment. If the government’s stimulus was exactly the correct size to restore full employment, Figure 27.13 shows the result. Assuming the increase in the short-run aggregate supply is the same as actually occurred, this is illustrated by the shift of the SAS curve from SAS2 to SAS3. But aggregate demand now increases by more than before, so the shift of the AD curve from AD2 to AD3 is larger than in Figure 27.11. Consequently, the increase in equilibrium real GDP is larger, to $19.5 trillion which equals potential GDP. The rise in the price level is also larger, to 115.5.

Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the federal government’s stimulus was too large and brought an inflationary gap. Show the short-run and the long-run effects.

If the Covid stimulus was too large, the increase in aggregate demand would have been larger than that in Figure 27.13. Figure 27.14 shows what would have occurred. In it, the initial increase in the short-run aggregate supply, illustrated by the shift of the SAS curve from SAS2 to SAS3, is assumed to be the same as in Figure 27.13. But aggregate demand now increases by more, so the shift of the AD curve from AD2 to AD3 is larger than in Figure 27.13. Consequently, in the short run the increase in equilibrium real GDP is larger, to $20.0 trillion which exceeds potential GDP of $19.5 trillion. The rise in the price level is also larger, to 116.5. The economy has an inflationary gap. In the long run, the inflationary gap will be eliminated. For simplicity, presuming that neither potential GDP nor aggregate demand change, the tight labor market leads to increases in the money wage rate. As the money wage rate rises, firms’ costs increase. © 2023 Pearson Education, Inc.

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The short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Figure 27.15 illustrates this change. Eventually aggregate supply decreases so that the short-run aggregate supply curve has shifted to SAS4. With this change, the economy is back to full employment: Equilibrium GDP equals potential GDP, $19.5 trillion, and the price level equals 117.0.

26.

Eurozone Out of Recession After Economy Grows 2% The Eurozone economy grew 2 percent in the second quarter of 2021, moving the economy out of recession. Consumer expenditure made a large contribution to the growth of the economies of France, Germany, and Spain. Eurozone real GDP remains down 3 percent from its pre-pandemic level in 2019. Source: bbc.com, July 30, 2020 a. Assuming that the Eurozone was at full employment prior to the pandemic, explain its current macroeconomic equilibrium. If the Eurozone was at full employment prior to the pandemic, the result that it remains down 3 percent from the pre-pandemic level of real GDP means that the Eurozone is in a below-full-employment equilibrium.

b. Draw a diagram to illustrate the state of the Eurozone economy in the second quarter of 2021. Figure 27.16 illustrates the situation in the Eurozone. Potential GDP is $5.0 trillion but the actual level of real GDP, determined by the intersection of the AD and SAS curves, is only $4.85 trillion, 3 percent below full employment.

C h a p t e r

EXPENDITURE MULTIPLIERS

Answers to the Review Quizzes Page 681 1.

Which components of aggregate expenditure are influenced by real GDP? Consumption expenditure and imports are influenced by real GDP. Both increase when real GDP increases.

Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save. The marginal propensity to consume is the proportion of an increase in disposable income that is consumed. In terms of a formula, the marginal propensity to consume, or MPC, can be calculated as C/YD, where  means “change in.” The marginal propensity to save is the proportion of an increase in disposable income that is saved. In terms of a formula, the marginal propensity to save, or MPS, can be calculated as S/YD.

How do we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import? The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import. In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income. Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP.

Page 685 1.

What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure? Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP.

How does equilibrium expenditure come about? What adjusts to achieve equilibrium? Equilibrium expenditure results from adjustments in real GDP. For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories are below their targets. In response, firms increase production to meet their inventory targets, As production increases, real GDP increases. The increase in real GDP increases aggregate planned expenditure but by less than the increase in real GDP. Eventually real GDP increases sufficiently so that it equals aggregate planned expenditure and, at that point, equilibrium expenditure occurs.

If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are less than their equilibrium levels, an unplanned decrease in inventories occurs. The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels. The increase in production increases real GDP.

If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? © 2023 Pearson Education, Inc.

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If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs. The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels. The decrease in production decreases real GDP.

Page 690 1.

What is the multiplier? What does it determine? Why does it matter? The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP. A change in autonomous expenditure changes real GDP by an amount determined by the multiplier. The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP.

How do the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier? The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier. The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger.

How do fluctuations in autonomous expenditure influence real GDP? Fluctuations in autonomous expenditure bring business cycle turning points. When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next. For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease and, as a result, the economy enters the recession phase of the business cycle.

Page 695 1.

How does a change in the price level influence the AE curve and the AD curve?

If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why?

A change in the price level shifts the AE curve and creates a movement along the AD curve.

A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve. The AE curve shifts by an amount equal to the change in autonomous expenditure. The multiplier determines the magnitude of the shift in the AD curve. The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier.

How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the short run, an increase in aggregate expenditure increases real GDP. However, the increase in real GDP is less than the increase in aggregate demand because the price level rises. The more the price level rises (the steeper the SAS curve) the smaller the increase in real GDP.

How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change. The change in real GDP—zero—is less than the change in aggregate demand. The change in real GDP is nil because, in the long run, the economy returns to its full-employment equilibrium. In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP.

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Page 701 In an economy, autonomous consumption expenditure is $50 billion, investment is $200 billion, and government expenditure is $250 billion. The marginal propensity to consume is 0.7 and net taxes are $250 billion. Exports are $500 billion and imports are $450 billion. Assume that net taxes and imports are autonomous and the price level is fixed. a. What is the consumption function? The consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same. In this case the consumption function is C = 50 + 0.7(Y – 250) where the “50” is $50 billion and the “250” is $250 billion.

b. What is the equation of the AE curve? The equation of the AE curve is AE = 375 + 0.7Y, where Y is real GDP and the 375 is $375 billion. Aggregate planned expenditure is the sum of consumption expenditure, investment, government purchases, and net exports. Using the symbol AE for aggregate planned expenditure, aggregate planned expenditure is AE = 50 + 0.7(Y – 250) + 200 +250+ 50 AE = 50 + 0.7Y – 175 + 200 + 250 + 50 AE = 375 + 0.7Y

c. Calculate equilibrium expenditure. Equilibrium expenditure is $1,250 billion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 375 + 0.7Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $1,250 billion.

d. Calculate the multiplier.

The multiplier equals 1/(1  the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.7. So the multiplier is 1/(1  0.7), which is 3.333.

e. If investment decreases to $150 billion, what is the change in equilibrium expenditure? Equilibrium real expenditure decreases by $166.67 billion. From part d the multiplier is 3.333. The change in equilibrium expenditure equals the change in investment, $50 billion, multiplied by 3.333.

Describe the process in part (e) that moves the economy to its new equilibrium expenditure. When investment decreases by $50 billion, aggregate planned expenditure is less than real GDP. Firms find that their inventories are accumulating above target levels. As a result, they decrease production to reduce inventories. Real GDP decreases. The decrease in real GDP decreases disposable income so that consumption expenditure falls. In turn, the decrease in consumption expenditure leads to a further decrease in aggregate planned expenditure. Real GDP still exceeds aggregate planned expenditure though by less than was initially the case. Nonetheless unwanted inventories are still accumulating and firms continue to cut production, further reducing real GDP. This process continues until eventually real GDP will decrease enough to equal aggregate planned expenditure.

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Answers to the Study Plan Problems and Applications 1.

In an economy, when income increases from $400 billion to $500 billion, consumption expenditure changes from $420 billion to $500 billion. Calculate the marginal propensity to consume, the change in saving, and the marginal propensity to save. The marginal propensity to consume is the fraction of a change in disposable income that is consumed. In this economy, when income increases by $100 billion per year, consumption expenditure increases by $80 billion per year. The marginal propensity to consume equals $80 billion ÷ $100 billion, or 0.8. Saving equals disposable income minus consumption expenditure. Therefore from the $100 billion increase in income, consumption expenditure increased by $80 billion, leaving a $20 billion increase in saving. The marginal propensity to save is the fraction of a change in disposable income that is saved. In this economy, for the increase in income of $100 billion, saving increases by $20 billion, so the marginal propensity to save is $20 billion ÷ $100 billion, which is 0.2.

Use Figure 28.1 to work Problems 2 and 3. Figure 28.1 illustrates the components of aggregate planned expenditure on Turtle Island. Turtle Island has no imports or exports, no incomes taxes, and the price level is fixed. 2. Calculate autonomous expenditure and the marginal propensity to consume. Autonomous expenditure is $2 billion. Autonomous expenditure is expenditure that does not depend on real GDP. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. The marginal propensity to consume is 0.6. When the country has no imports or exports and no income taxes, the slope of the AE curve equals the marginal propensity to consume. When income increases from zero to $6 billion, aggregate planned expenditure increases from $2 billion to $5.6 billion. That is, when real GDP increases by $6 billion, aggregate planned expenditure increases by $3.6 billion. The marginal propensity to consume is $3.6 billion ÷ $6 billion, which is 0.6.

3. a. What is aggregate planned expenditure when real GDP is $6 billion? Figure 28.1 shows that aggregate planned expenditure is $5.6 billion when real GDP is $6 billion.

b. If real GDP is $4 billion, what is happening to inventories? Firms’ inventories are decreasing. When real GDP is $4 billion, aggregate planned expenditure exceeds real GDP, so firms sell all that they produce and more. As a result, inventories decrease.

c. If real GDP is $6 billion, what is happening to inventories? Firms are accumulating inventories. That is, unplanned inventory investment is positive. When real GDP is $6 billion, aggregate planned expenditure is less than real GDP. Firms cannot sell all that they produce and inventories pile up.

Explain the difference between induced consumption expenditure and autonomous consumption expenditure. Why isn’t all consumption expenditure induced expenditure? Induced consumption expenditure is consumption expenditure that changes when disposable income changes. Autonomous consumption expenditure is consumption expenditure that would occur in the short run even if disposable income was zero. Not all consumption expenditure is induced consumption © 2023 Pearson Education, Inc.

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expenditure because, in the short run, even if someone has no income they still will have some (autonomous) consumption expenditure, if for nothing else, for food.

Explain how an increase in business investment at a constant price level changes equilibrium expenditure. Investment is a component of autonomous aggregate expenditure. An increase in investment increases aggregate expenditure so the AE curve shifts upward. Equilibrium expenditure increases.

Use the following data to work Problems 6 and 7. An economy has a fixed price level, no imports, and no income taxes. MPC is 0.80, and real GDP is $150 billion. Businesses increase investment by $5 billion. 6. Calculate the multiplier and the change in real GDP.

With no imports and no income taxes, the multiplier equals 1/(1  MPC). So the multiplier is 1/(1  0.8), which is 5.0 Then the $5 billion increase in investment increases real GDP by 5.0 × $5 billion, which is $25 billion.

Calculate the new real GDP and explain why real GDP increases by more than $5 billion. Real GDP was initially $150 billion. The increase in investment increased real GDP by $25 billion, so real GDP increases to $175 billion. Real GDP increases by more than the initial increase in investment because the increase in investment increases disposable income which induces additional increases in consumption expenditure. So real GDP increases both because investment increases and also because of induced increases in consumption expenditure.

An economy has a fixed price level, no imports, and no income taxes. An increase in autonomous expenditure of $2 trillion increases equilibrium expenditure by $8 trillion. Calculate the multiplier and explain what happens to the multiplier if an income tax is introduced. The multiplier is defined as the change in equilibrium expenditure divided by the change in autonomous expenditure. In this problem the multiplier equals $8 trillion ÷ $2 trillion which is 4.0. If an income tax is introduced, the multiplier decreases in value. With an income tax, at each spending round less disposable income is created leading to smaller increases in induced expenditure.

Use the following data to work Problems 9 to 13. Suppose that the economy is at full employment, the price level is 100, and the multiplier is 2. Investment increases by $100 billion. 9. What is the change in equilibrium expenditure if the price level remains at 100? The initial change in equilibrium expenditure is $200. The initial effect of the increase in investment increases equilibrium expenditure by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the initial change in equilibrium expenditure is $200 billion.

10. a. What is the immediate change in the quantity of real GDP demanded? The quantity of real GDP demanded increases by $200 billion. The increase in investment shifts the aggregate demand curve rightward by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the aggregate demand curve shifts rightward by $200 billion.

b. In the short run, does real GDP increase by more than, less than, or the same amount as the immediate change in the quantity of real GDP demanded? In the short run, real GDP increases by less than $200 billion. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the price level will rise and real GDP will increase but by an amount less than the shift of the AD curve.

11.

In the short run, does the price level remain at 100? Explain why or why not. In the short run, the price level rises. Real GDP is determined at the intersection of the AD curve and the © 2023 Pearson Education, Inc.

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SAS curve. In the short run, the increase in aggregate demand means that the price level will rise as the economy moves along its upward-sloping SAS curve.

12. a. In the long run, does real GDP increase by more than, less than, or the same amount as the immediate increase in the quantity of real GDP demanded? In the long run, real GDP equals potential GDP, so real GDP does not increase. Real GDP is determined at the intersection of the AD curve and the SAS curve. After the initial increase in investment, money wages increase, the SAS curve shifts leftward, and in the long run, real GDP moves back to potential GDP.

b. Explain how the price level changes in the long run. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the long run, money wages increase so the SAS curve shifts leftward, raising the price level by more than it rose in the short run.

13.

Are the values of the multipliers in the short run and the long run larger or smaller than 2? The multiplier in the short run is less than the multiplier of 2 because the short-run increase in real GDP is less than $200 billion. The long-run multiplier is even smaller. It equals zero.

14.

Use the data in the Worked Problem on p. 702. Calculate the change in equilibrium expenditure when investment decreases by $150 billion. The multiplier equals 4. Consequently the change in equilibrium expenditure equals (4) × (−$150 billion), or a decrease of $600 billion.

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Answers to Additional Problems and Applications Use the following data for the Australian economy to work Problems 15 and 16. 15. Calculate the marginal propensity to save. The marginal propensity to save is the fraction of a change in disposable income that is saved. In Australia, when disposable income increases by $100 billion per year, saving increases by $25 billion per year. The marginal propensity to save is $25 billion ÷ $100 billion, which is 0.25.

16.

Disposable income Saving (billions of dollars per year) 0 0 100 25 200 50 300 75 400 100

Calculate consumption at each level of disposable income. Calculate the marginal propensity to consume. The table to the right shows Australia’s consumption expenditure schedule. Consumption expenditure equals disposable income minus saving. For each increase in disposable income of $100 billion, consumption expenditure increases by $75 billion. The marginal propensity to consume is 0.75. The marginal propensity to consume plus the marginal propensity to save equals 1. Because the marginal propensity to save equals 0.25, the marginal propensity to consume equals 0.75.

Disposable Consumption income expenditure (billions of dollars per year) 0 0 100 75 200 150 300 225 400 300

Use the following news clip to work Problems 17 to 19. U.S. Household Wealth Jumps to Record $136.9 Trillion U.S. household wealth grew to $136.9 trillion in the first quarter of 2021. Rising stock prices added $3.2 trillion to household financial assets and rising real estate values added $1 trillion. Sources: reuters.com, June 10, 2021 17.

Explain why higher stock prices and higher real estate values are equivalent to saving. Saving adds to a household’s wealth. Because higher stock prices and higher real estate values add to the household’s wealth, they are equivalent to saving.

18.

Explain how a rise in household financial assets would be expected to influence consumption expenditure and saving and how the consumption function and the saving function would change. Consumption expenditure increases so the consumption function shifts upward. Savings decreases so the saving function shifts downward.

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Draw a graph to illustrate how a rise in household financial assets would change the consumption function and the saving function.

Figure 28.2a shows the effect of an increase in financial assets on the consumption function and Figure 28.2b shows the effect on the saving function. Consumption expenditure increases so the consumption function shifts upward from CF0 to CF1 while saving decreases so the saving function shifts downward from SF0 to SF1.

A 1 2 3 4 5 6 7

A B C D E F

B Y 100 200 300 400 500 600

C C 110 170 230 290 350 410

D I 50 50 50 50 50 50

E G 60 60 60 60 60 60

F X 60 60 60 60 60 60

G M 15 30 45 60 75 90

Use the spreadsheet above, which lists real GDP (Y ) and the components of aggregate planned expenditure in billions of dollars, to work Problems 20 and 21. 20. Calculate autonomous expenditure. Calculate the marginal propensity to consume. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. Because the spreadsheet does not list GDP of zero, we must extrapolate to calculate the value of consumption expenditure and imports when GDP equals zero. From the spreadsheet, consumption expenditure falls by $60 billion for every $100 billion decrease in GDP. So when GDP equals zero, autonomous consumption expenditure is $50 billion. Similarly, from the spreadsheet, imports decrease by $15 billion for every $100 billion decrease in GDP. So when GDP equals zero, imports equal zero. Autonomous expenditure is $50 billion (consumption expenditure) plus $50 billion (investment) plus $60 billion (government expenditure) plus $60 billion (exports), which equals $220 billion.

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The marginal propensity to consume is 0.6. When income increases from $100 billion to $200 billion, consumption expenditure increases from $110 billion to $170 billion. A $100 billion increase in GDP increases consumption expenditure by $60 billion. So the marginal propensity to consume is $60 billion ÷ $100 billion, which is 0.6.

21. a. What is aggregate planned expenditure when real GDP is $200 billion? Aggregate planned expenditure is $310 billion. Aggregate planned expenditure is the sum of consumption expenditure ($170 billion) plus planned investment ($50 billion) plus government expenditure ($60 billion) plus exports ($60 billion) minus imports ($30 billion), which is $310 billion.

b. If real GDP is $200 billion, explain the process that moves the economy toward equilibrium expenditure. Inventories are decreasing so that the unplanned inventory change is negative. When real GDP is $200 billion, aggregate planned expenditure is $310 billion. Because aggregate planned expenditure exceeds real GDP, firms sell all that they produce and even more so that inventories are decreasing. Firms then increase their production, to restore their inventories, and real GDP increases.

c. If real GDP is $500 billion, explain the process that moves the economy toward equilibrium expenditure. Firms are accumulating inventories so that the unplanned inventory change is positive. When real GDP is $500 billion, aggregate planned expenditure is $445 billion. Firms cannot sell all that they produce so that unplanned inventories increase. Firms respond by decreasing their production, to lower their inventories, and real GDP decreases.

22.

U.S. Wholesale Inventories Rise Solidly The Commerce Department reports that U.S. wholesale inventories rose 0.8% in March with businesses replenishing stocks to meet pent-up demand. Source: reuters.com, June 9, 2021 Explain why an increase in inventories might bolster economic growth, while a fall in inventories might be a sign of recession. In your explanation, distinguish between planned and unplanned changes in business inventories. Inventories are part of investment. If the increase in inventories reflects an increase in planned inventories, then planned investment increases which increases aggregate expenditure and real GDP. If, however, the increase is unplanned, it could reflect a decrease in aggregate expenditure, which could lead to a decrease in real GDP. Similarly, if a fall in inventories reflects a decrease in planned inventories, then planned investment decreases, which lowers aggregate expenditure and real GDP. Alternatively, if the fall in inventories is unplanned, it might indicate an increase in aggregate expenditure which would then lead to an increase in real GDP.

23.

South Korea Plans $29-Billion Virus Stimulus The government of South Korea announced a $29 billion (35.3 trillion won) fiscal stimulus package. The goal is to create 550,000 new jobs and boost social safety nets. Source: asiatimesfinancial.com, June 3, 2020 If the slope of the AE curve is 0.7, calculate the immediate change in aggregate planned expenditure and the change in real GDP in the short run if the price level remains unchanged. The increase in government expenditure will have a multiplier effect on aggregate expenditure and real GDP. The multiplier equals 1/(1  the slope of the AE curve). The slope of the AE curve is 0.7 so the multiplier is 1/(1  0.7), which is 3.3. With this multiplier, the $29 billion increase in government expenditure increases aggregate expenditure by 3.3 × $29 billion, or $95.7 billion (or, 3.3 × 35.3 trillion won, which is 116.5 trillion won). In the short run, when the price level is constant, real GDP increases by the same amount, $33 billion (116.5 trillion won).

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Japan Mulls New Cash Handout for Needy Households As Pandemic Drags On In 2020, Japan’s government gave ¥100,000 each to its 126 million residents to ease the effects of the Covid-19 pandemic. Now the government is considering another similar program. Source: japantimes.co.jp, May 26, 2021 Suppose Japan changes its stimulus payments from all cash handouts to half as cash payments and half as investment in infrastructure projects. Which of these expenditures would have the larger effect on equilibrium expenditure, other things remaining the same? The spending on infrastructure projects will have the larger effect on equilibrium expenditure. The effect on equilibrium expenditure is larger from the infrastructure spending because in the first round all of the increased infrastructure expenditure increases aggregate expenditure. Some of the cash handouts, however, will be saved so the first round only part of the cash handouts is spent so only part goes to increase aggregate expenditure. Because the multiplier effect applies only to the funds that are spent, the effect on equilibrium expenditure from the infrastructure spending will be larger than that from the cash handouts.

Use the following news item to work Problems 25 to 27. The BEA reported that in the second quarter of 2021 U.S. exports increased by $141 billion. 25.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium expenditure in the short run. The increase in exports increases aggregate expenditure because exports is a component of aggregate expenditure. As shown in Figure 28.3, the aggregate expenditure curve shifts upward from AE0 to AE1. Because aggregate expenditure has increased, real GDP increases, In Figure 28.3 the increase in aggregate expenditure increases real GDP from $19.0 trillion to $19.4 trillion.

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389

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the short run. Presuming the economy was in its long-run equilibrium at the start of the second quarter of 2021, the increase in exports increases aggregate expenditure and creates an increase in the aggregate demand. Figure 28.4 illustrates the effect on real GDP. The aggregate demand curve shifts rightward, from AD0 to AD1. The price level rises and equilibrium real GDP increases from $19.0 trillion to $19.2 trillion. The economy is in an above full-employment equilibrium.

27.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the long run. In the short run, the economy is in an above fullemployment equilibrium. As time passes, the money wage rate rises, which decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward. Eventually the short-run aggregate supply decreases enough so that the economy returns to full employment. In Figure 28.5, this analysis means that the shortrun aggregate supply curve eventually shifts from SAS0 to SAS1 and the economy returns to full employment, with real GDP of $19.0 trillion and a price level of 122.

28.

Compare the multiplier in the short run and the long run and explain why they are not identical. The long-run multiplier is zero, which means that the short-run multiplier is larger than the long-run multiplier. The long-run multiplier equals zero because in the long run the economy returns to full employment. For example, in the short run an increase in aggregate demand increases real GDP, which means that the short-run multiplier is positive. But the economy is at a greater than full-employment © 2023 Pearson Education, Inc.

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equilibrium. Therefore the money wage rate starts to rise. The rise in the money wage rate decreases shortrun aggregate supply and thereby decreases real GDP. The short-run aggregate supply continues to decrease until the economy reaches full employment, at which point it stops decreasing. But the ultimate change in real GDP is zero, which means the long-run multiplier is zero.

Use the following news clip to work Problems 29 to 31. U.S. Exporters Struggle to Gain Ground as Global Recession Remains Severe U.S. imports are recovering thanks to the $2 trillion rescue package passed by Congress. But lagging foreign demand is hurting U.S. exports. Source: washingtonpost.com, October 4, 2020 29.

Are U.S. exports part of U.S. induced expenditure or autonomous expenditure? Are U.S. imports part of U.S. induced expenditure or autonomous expenditure? U.S. induced expenditure changes with changes in U.S. disposable income. Exports do not change when U.S. disposable income changes, so exports are part of autonomous expenditure. Imports do change when U.S. disposable income changes, so imports are part of U.S. induced expenditure.

30.

Other things remaining the same, what is the effect of a decrease in exports on the U.S. price level in the short run? What is the effect of this change in the price level on the AE curve? A decrease in U.S. exports decreases U.S. aggregate demand and thereby lowers the U.S. price level. The fall in the price level increases real wealth and makes buying goods and services today cheaper than purchasing them in the future. These effects increase aggregate expenditure and shift the AE curve upward.

31.

Draw a diagram to illustrate a decrease in exports and the change in the U.S. price level in the short run. The decrease in exports decreases aggregate expenditure and thereby decreases aggregate demand and shifts the demand curve leftward, from AD0 to AD1 in Figure 28.6. Consequently, the price level falls, which offsets some of the initial decrease in aggregate demand so that in Figure 28.6, the ultimate shift in the aggregate demand curve is from AD0 to AD2. This decrease in aggregate demand results in the U.S. price falling from 126 to 124.

32.

U.S. Business Investment Drops 3% in Third Quarter Amid Trade War Uncertainty Business investment for the third quarter dropped 3%, after falling 1% in the previous quarter. Source: cnbc.com, October 30, 2019 If the United States was in a long-run equilibrium in 2019, describe the change in real GDP that occurs in the long run as a result of the decrease in business investment. The fall in investment decreases aggregate demand and shifts the AD curve leftward. Real GDP and the price level both fall. In the short run, the economy is in a below full-employment equilibrium. The labor force is less than fully employed so that, in the long run, the slack in the labor market decrease the money © 2023 Pearson Education, Inc.

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wage rate. The fall in the money wage rate lowers firms’ costs, which increases short-run aggregate supply and shifts the SAS curve rightward. In the long run, the money wage rate and price level fall by the same percentage, at which time real GDP is again equal to potential GDP. So, the long run result is a fall in the price level but no change in real GDP which means the long-run multiplier is zero.

Economics in the News 33. After you have studied Economics in the News on pp. 696–697, answer the following questions about the second quarter of 2020. a. What was the planned change in inventories when the unplanned change in inventories was $400 billion ($0.4 trillion)? According to the figure, the total change in inventories was ─$1.4 billion. If the unplanned change was $0.4 billion, then the planned change was ─$1.4 billion ─ $0.4 billion, or ─$1.8 billion.

b. The BEA data show that exports of goods and services decreased by $568 billion and imports of goods and services decreased by $645 billion. Were these changes in exports and imports changes in autonomous expenditure or changes in induced expenditure, and how do they influence the magnitude of the multiplier? Changes in exports are autonomous expenditure and changes in imports are induced expenditure. Changes in exports have no effect on the magnitude of the multiplier. Changes in the marginal propensity to import affects the size of the multiplier. The smaller the quantity of imports that are induced by a change in income, the larger the multiplier.

c. Using the assumptions made in Fig. 2 on p. 697, what is the value of the autonomous expenditure multiplier? The autonomous expenditure multiplier equals 1/(1 – slope of AE line). In the figure, the slope of the AE curve is equal to 0.74. So the autonomous expenditure multiplier equals 1/(1 – 0.74) = 3.8.

34.

In an economy with a fixed price level, autonomous spending is $20 trillion and the slope of the AE curve is 0.6. a. What is the equation of the AE curve? The equation of the AE curve is AE = 20 + 0.6Y, where Y is real GDP and the 20 is $20 trillion.

b. Calculate equilibrium expenditure. Equilibrium expenditure is $50 trillion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 20 + 0.6Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $50 trillion.

c. Calculate the multiplier.

The multiplier equals 1/(1  the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.6. So the multiplier is 1/(1  0.6), which is 2.5.

d. Calculate the equilibrium expenditure if investment increases by $1 trillion Because the price level is fixed, the change in equilibrium expenditure is equal to the shift of the aggregate demand curve. The shift of the aggregate demand curve equals the multiplier multiplied by the change in investment, or 2.5 × $1 billion, which is $2.5 billion. Consequently, equilibrium expenditure increases by $2.5 billon.

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A 1 2 3 4 5 6 7 35.

A B C D E F

B Y 100 200 300 400 500 600

C C 110 170 230 290 350 410

D I 50 50 50 50 50 50

E G 60 60 60 60 60 60

F X 60 60 60 60 60 60

G M 15 30 45 60 75 90

The spreadsheet above lists real GDP (Y) and the components of aggregate planned expenditure in billions of dollars. Calculate the slope of the AE curve and the multiplier. Aggregate expenditure is the sum of the components of aggregate planned Y AE expenditure. Using the data in the spreadsheet, the table to the right shows 100 265 aggregate expenditure for the different values of income, Y. The slope of 200 310 the AE curve is equal to (change in aggregate expenditure)/(change in 300 355 income). The AE curve is linear, so its slope is the same between any two 400 400 points. Accordingly, calculating the slope of the AE curve between Y of 200 500 445 and 100 shows that the slope equals (310 ─ 265)/(200 ─ 100) = (45)/(100) 600 490 = 0.45. The multiplier equals 1/(1  the slope of the AE curve). The slope of the AE curve is 0.45. So the multiplier is 1/(1  0.45), which is 1.8. .

C h a p t e r

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

Answers to the Review Quizzes Page 712 1.

Explain the mainstream theory of the business cycle. Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth. According to the mainstream view, potential GDP grows steadily and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP. When aggregate demand grows more slowly than potential GDP, the inflation rate is low and, because money wages are sticky and do not adjust to the lower the inflation rate, the economy slides into a recessionary gap so that real GDP is less than potential GDP. When aggregate demand grows more rapidly than potential GDP, the inflation rate is high and the economy moves into a strong expansion accompanied by inflation.

What are the four special forms of the mainstream theory of the business cycle and how do they differ? The four special forms of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory. These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand. Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence. The monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money. New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand. As a result, only unexpected changes in aggregate demand growth lead to business cycles. Finally, new Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past. As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles.

According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change? Real business cycle (RBC) theory says that economic fluctuations are caused by technological change that makes productivity growth fluctuate. Fluctuations in the rate of technological change are the impulse that creates the business cycle.

According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labor, the supply of labor, employment, and the real wage rate? According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labor. The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate. Via the intertemporal substitution effect, the lower real interest rate decreases the supply of labor. Because both the demand for labor and the supply of labor decrease, employment © 2023 Pearson Education, Inc.

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decreases. The real wage rate also falls because the decrease in the demand for labor exceeds the decrease in the supply of labor.

What are the main criticisms of RBC theory and how do its supporters defend it? Critics of the real business cycle theory level three criticisms at it: 1) the money wage rate is sticky; 2) the intertemporal substitution effect is small so that the small changes in the real wage rate cannot account for large changes in employment; and, 3) measured productivity shocks are likely to be caused by changes in aggregate demand so that business cycle fluctuations cause the measured productivity shocks. Real business cycle supporters respond that 1) the real business cycle theory is consistent with the facts about economic growth and it explains the facts about business cycles; and 2) real business cycle theory is consistent with a wide range of microeconomic evidence about labor supply, labor demand, investment demand, and the distribution of income between labor and capital.

Page 718 1.

How does demand-pull inflation begin? Demand-pull inflation begins with an increase in aggregate demand. The increase in aggregate demand increases real GDP and the price level.

What must happen to create a demand-pull inflation spiral? When the economy is at an above full-employment equilibrium, the money wage rate rises which decreases the short-run aggregate supply. The decrease in the short-run aggregate supply decreases real GDP and raises the price level. If nothing else changes, the price level eventually stops rising. To create a demandpull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.

How does cost-push inflation begin? Cost-push inflation begins with an increase in the money wage rate or an increase in the money prices of raw materials, which decreases short-run aggregate supply. The decrease in short-run aggregate supply raises the price level and decreases real GDP.

What must happen to create a cost-push inflation spiral? If the Fed responds to each decrease in short-run aggregate supply by increasing the quantity of money, aggregate demand increases and freewheeling cost-push inflation ensues.

What is stagflation and why does cost-push inflation cause stagflation? Stagflation occurs when real GDP decreases and the price level rises. Cost-push inflation causes stagflation when short-run aggregate supply decreases because a decrease in short-run aggregate supply raises the price level and decreases real GDP.

How does expected inflation occur? Expected increases in aggregate demand or expected decreases in short-run aggregate supply create expected inflation because they change the expected price level. For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise. With the correct expectation, real GDP remains equal to potential GDP and unemployment remains at its natural rate.

How do real GDP and the price level change if the forecast of inflation is incorrect? If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected and real GDP exceeds potential GDP. If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected and real GDP is less than potential GDP.

Page 721 1.

What is deflation?

What is the distinction between deflation and a one-time fall in the price level?

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Deflation is a persistently falling price level; that is, the price level continually falls. A one-time fall in the price level occurs when the price level falls but thereafter starts to grow once again.

What causes deflation? Deflation occurs if aggregate demand increases at a persistently slower rate than aggregate supply. This situation typically occurs when the quantity of money grows slowly so that aggregate demand also grows slowly.

How does the quantity theory of money help us to understand the process of deflation? The equation of exchange shows that the growth rate of the price level equals the money growth rate plus the rate of change of velocity minus the growth rate of real GDP. The quantity theory adds two assumptions to the equation of exchange: The trend rate of change of velocity does not depend on the money growth rate and the trend growth rate of real GDP equals the growth rate of potential GDP, which also does not depend on the money growth rate. With these assumptions, the quantity theory predicts that a nation’s deflation (or inflation) rate equals the money growth rate plus the trend growth in velocity minus the trend growth in real GDP. The situation in Japan illustrates that this prediction is close to what occurred.

What are the consequences of deflation? Unanticipated deflation means that workers who have long-term wage contracts receive a higher real wage rate. But firms respond to the higher real wage by hiring fewer workers, so employment and output fall. The reduction in output decreases profits. Firms respond by decreasing investment, which reduces the growth rate of the capital stock, thereby slowing growth in potential GDP. The deflation also lowers the nominal interest rate, which increases the quantity of money people hold, which decreases the velocity of circulation, further adding to deflation.

How can deflation be ended? Deflation can be ended by increasing the money growth rate. In particular, the money growth rate must be changed to equal the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation.

Page 723 1.

How would you use the Phillips curve to illustrate an unexpected change in inflation? An unexpected change in inflation results in a movement along the short-run Phillips curve. In particular, an unexpected increase in the inflation rate lowers the unemployment rate and an unexpected decrease in the inflation rate raises the unemployment rate.

If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change? A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points. (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips curve directly below it). A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve.

If the natural unemployment rate increases, what happens to the short-run Phillips curve and the long-run Phillips curve? An increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate.

If actual inflation departs from the expected inflation rate, how is the labor market changing? If actual inflation exceeds expected inflation, the unemployment rate is less than the natural unemployment rate. If actual inflation is less than expected inflation, the unemployment rate is more than the natural unemployment rate.

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Answers to the Study Plan Problems and Applications 1.

Debate on Causes of Unemployment Two economists are debating the cause of a high unemployment rate. One economist argues that there is not enough government spending. The other says high unemployment is a structural problem—people who can’t move to take new jobs because they are tied down to burdensome mortgages or firms that can’t find workers with the skills they need to fill job openings. a. Which business cycle theory would say that the first economist is correct and why? It is likely that most of the mainstream business cycle theories would say that the first economist is correct. Most of the mainstream models believe high unemployment is the result of a business-cycle recession. These models, especially the Keynesian cycle theory and new Keynesian cycle theory, agree that a recession can be combatted by an increase in government spending, so these theories say that the high unemployment results because there is not enough government spending to lower it.

b. Which business cycle theory would say that the second economist is correct and why? The real business cycle theory would say the second economist is correct. It regards all unemployment as natural unemployment and so it would assert that the rise in the unemployment rate reflects a rise in the natural rate because of a rise in structural unemployment.

Higher Gas, Energy Prices Boost Consumer Inflation Over half of the increase in inflation has been driven by gasoline, electricity, and natural gas prices. And with the decrease in the number of coronavirus cases, restrictions have eased and household spending has increased. Source: wsj.com, March 20, 2021 Explain what type of inflation the news clip is describing and provide a graphical analysis of it. The news clip is describing “over half” the inflation as a cost-push inflation in which aggregate supply decreases and the SAS curve shifts leftward. Rising household spending increase aggregate demand and the AD curve shifts rightward. Figure 29.1 illustrates this case. In it the aggregate supply curve has shifted leftward, from SAS0 to SAS1 and the aggregate demand curve has shifted rightward, from AD0 to AD1. The price level has risen from 122 to 126.

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Use Figure 29.2 to answer Problems 3 to 5. The economy starts out on the curves labeled AD0 and SAS0. 3. Some events occur and the economy experiences a demand-pull inflation. What might those events have been? Describe their initial effects and explain how a demand-pull inflation spiral results. Anything that increases aggregate demand can be the factor that starts a demand-pull inflation. For instance, an increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of a demand-pull inflation. To sustain the inflation, the quantity of money must keep increasing. Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Aggregate demand increases and the AD curve shifts rightward to AD1. The new equilibrium is at the intersection of AD1 and SAS0, so the price level rises and real GDP increases. There is an inflationary gap. Starting at the intersection of AD1 and SAS0, there is an inflationary gap so the money wage rate rises and short-run aggregate supply decreases. The SAS curve starts to shift leftward toward SAS1. The price level keeps rising, but real GDP now decreases. If the central bank responds with persistent increases in the quantity of money, the process repeats: AD shifts to AD2, an inflationary gap opens again, the money wage rate rises again, and the SAS curve shifts toward SAS2.

Some events occur and the economy experiences a cost-push inflation. What might those events have been? Describe their initial effects and explain how a cost-push inflation spiral results. Anything that decreases short-run aggregate supply can set off a cost-push inflation. For instance, an increase in the money wage rate or an increase in the money price of raw materials could be the start of a cost-push inflation. But to sustain such an inflation, the quantity of money must keep increasing. Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Short-run aggregate supply decreases and the SAS curve shifts leftward to SAS1. The price level rises and real GDP decreases. There is now a recessionary gap. Starting out at the intersection of AD0 and SAS1, there is a recessionary gap so real GDP is below potential GDP and unemployment is above the natural rate. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD1. Real GDP returns to $16 trillion and the price level rises to 160. A further cost increase occurs, which shifts the shortrun aggregate supply curve to SAS2 and a recessionary gap opens up again. The economy is again below potential GDP. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD2. Real GDP returns to $16 trillion and the price level rises to 200.

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Some events occur and the economy is expected to experience inflation. What might those events have been? Describe their initial effects and what happens as an expected inflation proceeds. Anything that increases aggregate demand can set off an expected inflation as long as the event is expected. For instance, an expected increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of an expected inflation. But to sustain such an expected inflation, the quantity of money must keep increasing along its expected path. Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Aggregate demand increases, and the AD curve shifts rightward to AD1. The increase in aggregate demand is expected so the money wage rate rises and the SAS curve shifts to SAS1. The price level rises, and real GDP remains equal to potential GDP. Starting at the intersection of AD1 and SAS1, a further expected increase in aggregate demand occurs. The AD curve shifts to AD2, and because the increase in aggregate demand is expected, the money wage rate rises again and the SAS curve shifts to SAS2. Again, the price level rises and real GDP remains equal to potential GDP.

Suppose that the velocity of circulation of money is constant and real GDP is growing at 3 percent a year. a. To achieve an inflation target of 2 percent a year, at what rate would the central bank grow the quantity of money? To achieve a target inflation rate, the growth rate of the quantity of money must equal the inflation target plus real GDP growth minus growth in velocity. In the situation at hand, the growth in the quantity of money should equal 2 percent a year plus 3 percent a year minus 0 percent, or 5 percent a year.

b. At what growth rate of the quantity of money would deflation be created? Deflation occurs if the inflation rate is less than zero. Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate. The rate of velocity change is zero and the real GDP growth rate is 3 percent a year. So the inflation rate is negative when the money growth rate is less than the real GDP growth rate, which is 3 percent a year.

Federal Reserve Moves to Keep Stock Market Elevated During the last 20 years, Japan had low growth and low inflation. So did the European Union over the past decade. In the last expansion, the Fed was surprised to see falling unemployment with no increase in inflation. Source: seekingalpha.com, August 3, 2020 a. What does the Phillips curve model say about the relationship between the unemployment rate and the inflation rate? The Phillips curve model says that if the expected inflation rate and the natural unemployment rate do not change, then in the short run an increase in the inflation rate results in a decrease of the unemployment rate. So, with constant expected inflation and constant natural unemployment, unemployment is low when inflation is high.

b. Given the information in the news clip, what is happening to the short-run and long-run Phillips curves? If the natural unemployment rate is decreasing and/or the expected inflation rate is falling, then the shortrun Phillips curve shifts leftward and the long-run Phillips curve does not change. As the short-run Phillips curve shifts leftward, the unemployment rate can fall and remain low with no rise in the inflation rate.

From the Fed’s Minutes Inflation is soaring and employment is beginning to show sustained improvement. The unemployment rate is 6 percent, compared to its 3.5 percent rate prepandemic. The CPI grew © 2023 Pearson Education, Inc.

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5.4 percent in June, and the Fed raised its inflation expectations for 2021 from 2.2 percent to 3.0 percent. Source: FOMC Minutes, July 27–28, 2021 Is the Fed suggesting that the U.S. economy is moving along a short-run Phillips curve or that the short-run Phillips curve is shifting during 2021? Explain. The Fed is suggesting that the U.S. economy will move upward along short-run Phillips curve with higher inflation and lower unemployment as employment increases. However, the Fed also expects that the shortrun Phillips curve is shifting upward as inflation expectations rise.

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Answers to Additional Problems and Applications Use the following information to work Problems 9 to 11. Suppose that the business cycle in the United States is best described by RBC theory and that a new technology increases productivity. 9.

Draw a graph to show the effect of the new technology in the market for loanable funds. The advance in technology makes investment in industries that can utilize the new technology more profitable. Investment demand increases, which increases the demand for loanable funds. As Figure 29.3 shows, the increase in the demand for loanable funds shifts the demand for loanable funds curve rightward from DLF0 to DLF1. The increase in the demand for loanable funds raises the equilibrium real interest rate and increases the equilibrium quantity of loanable funds. In Figure 29.3 the real interest rate rises from 4 percent a year to 5 percent a year and the quantity of loanable funds increases from $2.5 trillion to $2.7 trillion.

10.

Draw a graph to show the effect of the new technology in the labor market. The advance in technology directly increases the demand for labor as firms look to hire more workers to exploit the technology. In addition, the supply of labor increases as workers respond to the higher real interest rate. The increase in the supply of labor, however, is less than the increase in the demand for labor. As Figure 29.4 shows, the demand for labor curve shifts rightward from LD0 to LD1 and the supply of labor curve shifts rightward from LS0 to LS1. Both changes increase the equilibrium quantity of employment. In Figure 29.4 employment increases from 300 billion hours to 330 billion hours. The effect on the real wage rate is ambiguous, but if, as illustrated in the figure, the increase in demand exceeds the increase in supply, then the net effect raises the real wage rate. In Figure 29.4 the real wage rate rises from $20 per hour to $30 per hour.

11.

Explain the when-to-work decision when technology advances. The when-to-work decision is an important part of the real business cycle theory. The increase in technology raises the real interest rate. Changes in the real interest rate create an “intertemporal substitution effect,” which is the “when-to-work” decision. If the real interest rate rises, the return to © 2023 Pearson Education, Inc.

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current work increases because any funds saved reap a higher real interest rate. (The effect is called “intertemporal” because in the future the increased saving influences people to work less.) As a result, a higher real interest rate increases the current supply of labor, which shifts the supply of labor curve rightward and increases equilibrium employment.

12.

IT Job Wages Are No Longer ‘Exceptional’ Information technology jobs were among the fastest rising during the 1990s, bolstered by the dot-com boom. But now, wage growth in IT jobs is relatively moderate. Although IT wages remain high relative to many other occupations, they are no longer “exceptional.” Source: forbes.com, February 16, 2021 Explain the relationship between wages and technology in this news clip in terms of real business cycle theory. The real business cycle theory focuses on the effects from technological changes. If technological change is particularly large, as it was in the 1990s particularly in the technology sector, labor productivity in the affected sectors rises. When the productivity of labor rises, the demand for labor increases, which, by itself, leads to an increase in the real wage rate, as occurred in the technology sector during the 1990s. However, as time progressed labor productivity growth slowed in the technology sector and more workers gained the skills necessary to work in this sector. The slower increase in the demand for labor combined with the fast increase in the supply of labor resulted in lower relative wages in the technology sector.

Use the following information to work Problems 13 and 14. Inflation Should Be Feared Economist John H. Cochrane thinks the Fed must be careful not to over-stimulate the economy. He thinks inflation remains a danger because U.S. debt is skyrocketing, with no visible plan to pay it back. For the moment, foreigners are buying that debt. But they are buying out of fear that their governments are worse. They are short-term investors, waiting out the storm, not long-term investors confident that the United States will pay back its debts. If their fear passes, or they decide some other haven is safer, the Fed must watch out. For in that situation, inflation will come with a vengeance. It’s not happening yet: Interest rates are low now. But if inflation takes off, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity. 13. What type of inflation process does John Cochrane warn could happen? Explain the role that inflation expectations would play if the outbreak of inflation were to “happen with little warning.” Mr. Cochrane is concerned that a cost-push inflation could occur. Mr. Cochrane worries that if foreigners decide to sell their U.S. government securities, the U.S. exchange rate will fall as foreigners try to sell dollars to purchase their currency. With the fall in the U.S. exchange rate, the costs of goods imported into the United States will rise, thereby starting a cost-push inflation. If the inflation starts with little warning, people’s inflation expectations will not change so that inflation expectations will play a small role in the inflation.

14.

Explain why the inflation that John Cochrane fears would “bring stagnation rather than prosperity.” Mr. Cochrane is fearful of a cost-push inflation. In a cost-push inflation, real GDP decreases and the unemployment rate rises, being “stagnation rather than prosperity.”

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Eurozone Slides Into Deflation For the First Time in Four Years Deflation occurred in 12 of the 19 eurozone countries in August. Analysts blamed the fall in part on lower oil prices and the delay of heavily discounted summer clothing sales in France, Italy, and Belgium from July until August, Source: ft.com, September 1, 2020 a. Explain the process by which deflation occurs. Deflation occurs when aggregate demand persistently grows more slowly than aggregate supply. This situation occurs when the money growth rate grows too slowly, which leads to slower growth in aggregate demand.

b. How might Europe boost its aggregate demand? Might the boost to aggregate demand create demand-pull inflation? Europe can persistently boost aggregate demand by persistently increasing the growth rate of the quantity of money. If this growth rate is raised too high, then the boost to aggregate demand runs the risk of creating a demand-pull inflation.

Use the following data to work Problems 16 and 17. An economy has an unemployment rate of 4 percent and an inflation rate of 5 percent a year at point A in Figure 29.5. Then some events occur that move the economy from A to B to D to C and back to A. 16.

Describe the events that could create this sequence. Has the economy experienced demand-pull inflation, cost-push inflation, expected inflation, or none of these? First the inflation rate increases from 5 percent a year to 15 percent a year and the unemployment rate does not change. Then the unemployment rate increases from 4 percent to 8 percent and the inflation rate does not change. Next the inflation rate falls from 15 percent a year to 5 percent a year and the unemployment rate does not change. Finally the unemployment rate falls from 8 percent to 4 percent and the inflation rate does not change. This set of changes could be the result of an expected increase in the inflation rate from 5 percent to 15 percent, followed by an increase in the natural unemployment rate from 4 percent to 8 percent, followed by an expected fall in the inflation rate from 15 percent to 5 percent, finally followed by a decrease in the natural unemployment rate from 8 percent to 4 percent.

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Draw in the figure the sequence of the economy’s short-run and long-run Phillips curves. Figure 29.6 shows these short-run and longrun Phillips curves. The initial increase in the expected inflation rate moves the economy up its (stationary) long-run Phillips curve LRPC0 from point A to point B. The short-run Phillips curve shifts upward from SRPC0 to SRPC1 and intersects the long-run Phillips curve at point B. Then the increase in the natural unemployment rate shifts both the long-run and short-run Phillips curves rightward to LRPC1 and SRPC2 so that they intersect at point D. Next the fall in the expected inflation rate moves the economy along its (stationary) new long-run Phillips curve LRPC1 from point D to point C. The short-run Phillips curve shifts downward from SRPC2 to SRPC3 and intersects the long-run Phillips curve at point C. Finally, the fall in the natural unemployment rate shifts both the long-run and short-run Phillips curves leftward back to LRPC0 and SRPC0 so that they intersect at point A.

Use the following information to work Problems 18 and 19. The Reserve Bank of New Zealand signed an agreement with the New Zealand government in which the Bank agreed to maintain inflation inside a low target range. Failure to achieve the target would result in the governor of the Bank (the equivalent of the chairman of the Fed) losing his job. 18. Explain how this arrangement might have influenced New Zealand’s short-run Phillips curve. The Reserve Bank of New Zealand’s arrangement with New Zealand’s government affected the short-run Phillips curve because it affected people’s expectations of the inflation rate. In particular, since the agreement was credible and had significant sanctions for the governor of the Reserve Bank of New Zealand, the public likely kept their expected inflation rates lower than might otherwise have been the case. As a result, the short-run Phillips curve was lower than it otherwise would have been and, in addition, was probably less likely to shift higher if the inflation rate temporarily rose.

19.

Explain how this arrangement might have influenced New Zealand’s long-run Phillips curve. The long-run Phillips curve is independent of the inflation rate and of people’s inflationary expectations, so the arrangement probably had little direct effect on the long-run Phillips curve. The only way in which the long-run Phillips curve could have been affected was if the arrangement affected the natural unemployment rate. If the agreement lowered the natural unemployment rate, the long-run Phillips curve shifted leftward.

20.

The Fed Abandons the Idea Low Unemployment Stokes Inflation The long-held view is that we can’t have a tight labor market without wage growth and rising prices. This relationship encourages central bankers to hike interest rates in the expectation that inflation will appear with labor market strength. But today’s Phillips Curve is flat because wage growth is weak. Source: ft.com, September 3, 2020 a. Evaluate the claim that the Phillips curve has gone flat. This claim is likely incorrect. Inflation has been low and that has lowered the expected inflation rate. The short-run Phillips curve shifts downward if the expected inflation rate falls. Because the short-run Phillips © 2023 Pearson Education, Inc.

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curve has shifted downward, low unemployment rates are associated with lower inflation rates, which is the experience described in the clip.

b. How does the Phillips curve model account for the facts reported in the news clip? The low inflation rate has lowered the expected inflation rate. When the expected inflation rate falls the short-run Phillips curve shifts downward so that low unemployment rates are associated with lower inflation rates than before, which is what has occurred.

Use the following information to work Problems 21 and 22. Because the Fed doubled the monetary base in 2008 and the government spent billions of dollars bailing out troubled banks, insurance companies, and auto producers, some people are concerned that a serious upturn in the inflation rate will occur, not immediately but in a few years time. At the same time, massive changes in the global economy might bring the need for structural change in the United States. 21. Explain how the Fed’s doubling of the monetary base and government bailouts might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? The doubling of the monetary base might lead to significant inflation at some point in the future. If the inflation is unexpected, it will not change either the short-run Phillips curve or the long-run Phillips curve. But if at some point the inflation becomes expected, the short-run Phillips curve will shift upward. In either case, however, the long-run Phillips curve is not affected. The government bailouts probably decreased the amount of cyclical unemployment that otherwise would have occurred. In this case they forestalled a movement downward along the short-run Phillips curve. As long as the bailed out companies operate efficiently, the bailouts by themselves did not affect the natural unemployment rate and thereby did not change the long-run Phillips curve.

22.

Explain how large scale structural change might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? Large-scale structural changes increase structural unemployment, thereby increasing the natural unemployment rate. The long-run and short-run Phillips curves shift rightward, worsening the tradeoff between unemployment and inflation.

Economics in the News 23. After you have studied Economics in the news on pp. 724–725, answer the following questions. a. Why is there no consensus among economists about the likelihood of a sustained high inflation? There is no consensus among economists about the likelihood of a sustained high inflation because there is no consensus among economists about the proper way to view the economy. Among economists are Keynesians, monetarists, new Keynesian proponents, new classical economists, ad real business cycle theorists. Until macroeconomists achieve more unanimity about the correct model of the economy, there will be disagreements about issues such as the likelihood of sustained high inflation.

b. Why do some economists worry that government stimulus will bring inflation? Some economists believe that the government stimulus could start a demand-pull inflation.

c. What happened to U.S inflation in the 1970s that alarms some economists? In the 1970s the United States experienced high inflation. These economists are concerned that this might recur so that the United States once again has high inflation.

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d. Use the AS-AD model and the Phillips curve to explain why inflation has remained so low when unemployment has also been low.

Figure 29.7(a) shows that if the SAS curve is close to flat, then as long as the AD curve intersects it along the nearly flat part, changes in aggregate demand have little effect on inflation. Figure 29.7(b) shows that similarly, if the Phillips curve has an almost flat region, then changes in unemployment, such as illustrated by points A and B, that stay in this virtually flat region bring very small changes in the inflation rate.

e. Use the AS-AD model and the Phillips curve to show why inflation is an expectations game.

Figure 29.8(a) shows that when inflation is expected to increase, money wages rise more rapidly so that firms’ costs increase and the SAS curve shifts leftward so that inflation occurs with the rising price level. Figure 29.8(b) shows that when inflation is expected to increase, the short-run Phillips curve shifts upward so even if the unemployment rate does not change, the inflation rate increases. © 2023 Pearson Education, Inc.

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Britain’s New Record: A Recession Worse Than in Europe and North America Britain is experiencing a deep recession. The U.K. depends heavily on consumer spending. In the second quarter, spending on accommodations and food services fell 87 percent. Britain’s recovery will need consumers to feel confident enough to spend. Source: nytimes.com, August 12, 2020 a. How does a decrease in consumption expenditure influence Britain’s aggregate demand, aggregate supply, unemployment, and inflation? A decrease in consumption expenditure decreases Britain’s aggregate demand. There is no immediate impact on aggregate supply. The decrease in aggregate demand lowers the price level and decreases real GDP. The fall in the price level means that the inflation rate falls; the decrease in real GDP means that unemployment rises.

b. Use the AS-AD model to illustrate your answer to part (a). Figure 29.9 illustrates this situation. Aggregate demand decreases and the aggregate demand curve shifts leftward, from AD0 to AD1. The economy moves from point A to point B. Real GDP decreases and the price level falls.

c. Use the Phillips curve model to illustrate your answer to part (a). In part (a) the inflation rate fell and the unemployment rate increased. People’s inflation expectations likely did not change so the British economy moved along its short-run Phillips curve. Figure 29.10 shows the effect of the decrease in consumption as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The inflation rate falls and the unemployment rate rises.

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d. What does the news clip mean by “Britain is experiencing a deep recession”? The report that “Britain is experiencing a deep recession” means that the fall in real GDP and ensuing rise in unemployment are very large and have lasted for at least two consecutive quarters.

e. Use the AS-AD model to illustrate your answer to part (d). In Figure 29.9 the decrease in real GDP is severe, falling 33 percent from $3.0 trillion to $2.0 trillion.

Use the Phillips curve model to illustrate your answer to part (d). In Figure 29.10 the increase in unemployment is large, rising from 5 percent to 20 percent.

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Answers to the Review Quizzes Page 739 1.

What is fiscal policy, who makes it, and what is it designed to influence? Fiscal policy is the use of the federal budget to achieve macroeconomic objectives. Fiscal policy is made by the president and Congress. It is designed to influence employment, economic growth, and price level stability.

What special role does the president play in creating fiscal policy? Each year the president proposes the budget that Congress amends and enacts.

What special roles do the Budget Committees of the House of Representatives and the Senate play in creating fiscal policy? Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how it should be modified. Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed.

What is the timeline for the U.S. federal budget each year? When does a fiscal year begin and end? Consider the budget for 2018 as an example in answering this question. In February 2017 the president proposes a budget to Congress. Then, from February until October 1, 2017, the Congress debates the budget, amends it, and eventually passes the necessary budget bills. The president then signs or vetoes the budget bills that were presented to him. When the president vetoes bills, the Congress may over-ride the veto or pass other bills acceptable to the president. Fiscal year 2018 begins on October 1, 2017 and runs until September 30, 2018. During this year the Congress may pass—and the president may sign— supplementary bills. Then, after the fiscal year ends, accounts are prepared and the “official” amounts of outlays, receipts, and budget deficit or surplus are reported.

Is the federal government budget today in surplus or deficit? Currently, the U.S. federal government is running a (large) budget deficit.

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How does a tax on labor income influence the equilibrium quantity of employment? A tax on labor income drives a wedge between the after-tax wage rate of workers and the before-tax wage rate paid by firms. The tax on labor income decreases the supply of labor. That is, for each before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers their after-tax wage. The decrease in labor supply raises the before-tax wage rate, even though the after-tax wage rate received by workers falls. The decrease in labor supply also means that the quantity of employment at full employment (i.e., equilibrium employment in the labor market) falls.

How does the tax wedge influence potential GDP? By decreasing employment, the tax wedge lowers potential GDP.

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A tax on consumption raises the price paid for consumption goods and services and so is equivalent to a cut in the real wage rate from the perspective of workers.

Why are income taxes on capital income more powerful than those on labor income? Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans. In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy.

What is the Laffer curve and why is it unlikely that the United States is on the “wrong” side of it? The Laffer curve is the relationship between the tax rate and the amount of tax revenue collected. The amount of tax revenue collected increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall. When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve. It is unlikely that the United States is on the wrong side of the Laffer curve because U.S. tax rates are among the lowest in the industrial world and past changes in U.S. tax rates have produced changes in tax revenues in the same direction.

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What is a present value? A present value is the amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

Distinguish between fiscal imbalance and generational imbalance. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation continues to enjoy the current levels of taxes and benefits.

How large was the estimated U.S. fiscal imbalance and how does it divide between current and future generations? In 2014, the fiscal imbalance was estimated to be $68 trillion. The generational imbalance estimates suggest that the current generation will pay 83 percent and future generations will pay 17 percent of the fiscal imbalance.

What is the source of the U.S. fiscal imbalance and what are the painful choices that we face? The source of the fiscal imbalance is the social security and, especially, the Medicare obligations made under current law. The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending.

How much of U.S. government debt is held by the rest of the world? U.S. government debt held by the rest of the world is $7.0 trillion.

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What is the distinction between automatic and discretionary fiscal policy? Automatic fiscal policy is triggered by the state of the economy with no need for any government action. Discretionary fiscal policy, however, requires an act of Congress to either change government spending and/or change taxes.

How do taxes and needs-tested spending programs work as automatic fiscal policy to dampen the business cycle? Taxes, such as income taxes, and needs-tested spending programs both work as automatic fiscal policy because they decrease the effect a change in income has on aggregate expenditure. For instance, when income decreases, consumption expenditure and aggregate expenditure decrease. But with the fall in income, income taxes decrease and needs-tested spending increase so that disposable income does not fall © 2023 Pearson Education, Inc.

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as much as does income. The smaller fall in disposable income means that the fall in consumption expenditure is smaller, so that the fall in aggregate expenditure is likewise smaller.

How do we tell whether a budget deficit needs discretionary action to remove it? A budget deficit needs discretionary government action to remove it when the deficit is a structural deficit. If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain. However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear.

How can the federal government use discretionary fiscal policy to stimulate the economy? If the economy has a recessionary gap, the government can increase its expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP.

Why might fiscal stimulus crowd out investment? Fiscal stimulus, such as an increase in government expenditure or a decrease in taxes, increases the budget deficit. The increase in the budget deficit increases the (government’s) demand for loanable funds, thereby raising the real interest. The higher real interest rate decreases—crowds out—investment.

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Answers to the Study Plan Problems and Applications Use the following news clip to work Problems 1 and 2. U.S. Budget Deficit Hits $1.7 Trillion in the First Half of the Fiscal Year In the first half of fiscal 2021, the U.S. government spent $3.4 trillion, giving it a deficit of $1.7 trillion. Source: nytimes.com, April 12, 2021 1. What were tax revenues in the first half of fiscal 2021? How much did U.S. government debt change in the first half of fiscal 2021? The deficit equals outlays minus receipts (government spending minus tax revenues). In the first half of fiscal 2021, the government spent $3.4 trillion and had a deficit of $1.7 trillion, meaning that its tax revenues equal $3.4 trillion minus $1.7 trillion, or $1.7 trillion. The total amount of U.S. government debt increased by the amount of the deficit, $1.7 trillion.

What would Congress do if it wanted to stop the government’s debt from increasing? Congress can stop the debt from increasing by raising tax revenue and/or cutting government expenditure.

The government is considering raising the tax rate on labor income. Explain the supply-side effects of such an action and use appropriate graphs to show the directions of change, not exact magnitudes. What will happen to: a. The supply of labor and why? The supply of labor will decrease. As shown in Figure 30.1, the supply of labor curve shifts leftward from LS0 to LS1. The supply of labor decreases because at each real wage rate, the hike in the tax rate on labor income lowers the aftertax wage rate received by workers.

b. The demand for labor and why? The demand for labor will remain the same so in Figure 30.1 the demand for labor curve remains LD. The demand for labor depends on the productivity of labor, which does not change after the increase in the tax rate on labor income.

c. Equilibrium employment and why? As Figure 30.1 shows, the equilibrium level of employment decreases. In the figure, employment decreases from 310 billion hours per year to 300 billion hours per year.

d. The equilibrium before-tax wage rate and why? As Figure 30.1 shows, the equilibrium before-tax wage rate increases from $34 per hour to $35 per hour. The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve.

e. The equilibrium after-tax wage rate and why? The equilibrium after-tax wage rate decreases. The tax wedge in the figure is $2 per hour, so the after-tax wage rate falls from $34 per hour to $33 per hour. The increase in the tax rate on labor income increases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate increases but not by as much as the increase in tax. So the after-tax wage rate decreases.

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Potential GDP? Potential GDP decreases. The equilibrium level of employment is full employment. So as full employment decreases, potential GDP decreases along the aggregate production function. Figure 30.2 shows this change as the movement along the aggregate production function, PF, from point A, with 310 billion hours of employment and potential GDP of $16.2 trillion, to point B, with 300 billion hours of employment and potential GDP $16.1 trillion.

What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work. A decrease in the tax on capital income will increase investment and thereby increase economic growth. A decrease in the tax on capital income increases the supply of loanable funds. The real interest rate falls and investment increases. The increase in investment increases economic growth.

Suppose that instead of taxing nominal capital income, the government taxed real capital income. Use appropriate graphs to explain and illustrate the effect that this change would have on: a. The tax rate on capital income. The nominal interest rate is the (nominal) income from capital. If the government changes the tax code to subtract the inflation rate from the (nominal) interest rate before taxes are imposed, the true tax rate on capital income falls because the part of the capital income—the inflation rate—that is received in compensation for inflation is no longer taxed.

b. The supply of and demand for loanable funds. With a lower tax rate on capital income, the supply of loanable funds increases as the after-tax real interest rate rises. This change is illustrated in Figure 30.3 by the rightward shift of the supply of loanable funds curve from the initial supply of loanable funds curve, SLF0, to SLF1. The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not necessarily change when the tax code changes. In Figure 30.3, the demand for loanable funds curve does not shift. © 2023 Pearson Education, Inc.

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c. Investment and the real interest rate. As shown in Figure 30.3, the increase in the supply of loanable funds shifts the supply of loanable funds curve rightward. This change leads to a lower real interest rate and a higher amount of loanable funds and investment.

Under current policies, a plausible projection is that U.S. public debt will reach 250 percent of GDP in 30 years and 500 percent in 50 years. a. What is a fiscal imbalance? How might the U.S. government reduce the fiscal imbalance? The fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. To reduce the fiscal imbalance, the government needs to decrease its benefit payments—both its present payments and those promised in the future—and increase its tax revenue—both its current tax revenue and tax revenue in the future. While the annual government budget deficit is not the fiscal imbalance, it is related because, in general, the larger the budget deficit the larger the fiscal imbalance. Additionally, the larger the budget deficit, the larger the accumulated public debt becomes.

b. How would your answer to part (a) influence the generational imbalance? The generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits. The changes in part (a) of cutting benefits and raising taxes will affect the generational imbalance if the reduction in benefits and/or the hike in taxes affects the current generation. In that case the generational imbalance would change so that more of the fiscal imbalance is paid by the current generation and less by future generations.

The economy is in a recession, and the recessionary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. Fiscal policy that increases government expenditure or decreases taxes would boost aggregate demand. In terms of automatic fiscal policy, needs-tested spending increases in recessions and tax revenue falls. Congress might also use discretionary policy by passing a new spending bill or a cut in tax rates.

b. Describe a discretionary fiscal stimulation package that could be used that would not bring an increase in the budget deficit. An increase in government expenditure with an offsetting increase in tax rates to boost tax revenue would not bring a budget deficit and would increase aggregate demand because the increase in government expenditure increases aggregate demand by more than the increase in taxes decreases aggregate demand.

c. Explain the risks of discretionary fiscal policy in this situation. The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

An economy is in a recession with a large recessionary gap and a government budget deficit. a. Is the government budget deficit a structural deficit or a cyclical deficit? Explain. We know that at least some of the budget deficit in a recession is a cyclical deficit as needs-tested spending is higher and tax revenue is lower than at potential GDP. However, some of the budget deficit might be a structural deficit. The structural deficit is the deficit that would exist if real GDP equaled potential GDP and the economy was at full employment.

b. Explain how automatic fiscal policy is changing the output gap? Automatic fiscal policy is decreasing the output gap relative to what it would be otherwise in a recession because they increase aggregate demand relative to what it would be otherwise in a recession. That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needstested spending and the decrease in tax revenue that produce the cyclical deficit.

c. If the government increases its discretionary expenditure, explain how the structural deficit might change. A discretionary increase in government expenditure, if not reversed following the end of the recession, © 2023 Pearson Education, Inc.

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moves the budget balance toward a structural deficit.

Use the following news clip and fact to work Problems 9 to 11. The Trump Tax Cut Wasn’t Just For the Rich Suppose the Trump tax cuts remain in place. Compared to a situation with no tax change, the Tax Policy Center estimates that after-tax incomes of households in the bottom fifth will rise 0.4%; the second fifth, up 0.9%; the middle fifth, up 1.3%; fourth fifth, up 1.4%; and the top fifth up 2.3%. Source: Bloomberg.com, October 27, 2020 Fact: Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes. 9. a. Explain how the income tax cut influences aggregate demand. Draw a graph to illustrate the intended effect. The goal of the income tax cuts is to increase consumption expenditure, which increases aggregate demand. Figure 30.4 shows the intended effect of this policy where, including the multiplier effect, the aggregate demand curve shifts rightward from AD0 to AD1. As a result, real GDP increases, in the figure from $20.7 trillion to $20.9 trillion. In the figure real GDP remains below potential GDP but the recessionary gap becomes smaller.

b. Explain why the effect of tax cuts depends on who receives them. The effect of this fiscal policy depends on the size of the impact on aggregate demand. The more of the tax cut that is spent (which means the less that is saved) the larger the magnitude of the effect on aggregate demand. If the tax rebates go to people who spend more of the rebate, that is, middle and low-income earners, the effect of this fiscal policy is larger.

10.

What would have a larger effect on aggregate demand: tax cuts to everyone; to the middle-class only; or to high-income earners only? Compare each alternative with no tax cuts but an equivalent increase in government expenditure. Extending the income tax cuts to everyone will have the largest effect on aggregate demand. Low and middle-income tax payers will spend most of the tax cut while high-income tax payers will spend only a small fraction of the tax cut.

11.

Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services. According to the aggregate demand/aggregate supply model, the government expenditure multiplier exceeds the tax multiplier, so government expenditure has a larger impact on real GDP. Some economists, such as Robert Barro and Harald Uhlig disagree and assert that the tax multiplier exceeds the government expenditure multiplier because taxes affect aggregate demand and aggregate supply. In this case the decrease in taxes has a larger impact on real GDP.

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Answers to Additional Problems and Applications 12.

U.S. Economy Shrank 5% In the First Quarter The Commerce Department reported that gross domestic product fell at an annual rate of 5% in the first quarter. Source: cnbc.com, May 28, 2020 How does an unexpected decrease in the economic growth rate influence federal government (a) outlays and (b) revenues? The decrease in economic growth increases federal government outlays because transfer payments increase. It decreases revenues because tax revenues depend on the level of income.

Use the following information to work Problems 13 and 14. Suppose that investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion. 13. Calculate the amount of tax revenue and the government budget balance. Tax revenue equals $1,200 billion. From the circular flow of expenditure and income, we know that I = S + T – G + M – X. Rearranging the equation gives T = I– S + G + X – M, which equals $1,200 billion.

14. a. Explain the impact of the government budget balance on investment. The government has a budget deficit. It is exerting a negative influence on investment by increasing the demand for loanable funds, which increases the real interest rate and crowds out investment.

b. What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work. A decrease in the budget deficit by increasing taxes or decreasing government expenditure decreases the demand for loanable funds, which lowers the real interest rate and increases investment. The increase in investment increases economic growth.

15.

Suppose that capital income taxes are based (as they are in the United States) on nominal interest rates. If the inflation rate increases by 5 percent a year, explain and use appropriate graphs to illustrate the effect of the rise in inflation on: a. The tax rate on capital income. The increase in the inflation rate increases the true tax rate on capital income because the interest income that is received in compensation for inflation is larger so that the tax paid on capital income increases.

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b. The supply of loanable funds. With a higher tax rate on capital income, the supply of loanable funds decreases and the aftertax real interest rate falls. This change is illustrated in Figure 30.5 by the leftward shift of the supply of loanable funds curve from the initial supply of loanable funds curve SLF0 to the new supply, SLF1, when the inflation rate is higher.

c. The demand for loanable funds. The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not change when the tax code changes.

d. Equilibrium investment. As illustrated in Figure 30.5, when the supply of loanable funds decreases, the supply of loanable funds curve shifts leftward from SLF0 to SLF1. The real interest rate rises from 4 percent a year to 5 percent a year, and the equilibrium quantity of loanable funds deceases from $2.5 trillion to $2.4 trillion. Investment decreases.

e. The equilibrium real interest rate. The decrease in the supply of loanable funds leads to a higher equilibrium real interest rate. In the figure the real interest rate rises from 4 percent to 5 percent.

Use the following data to work Problems 16 and 17. Fiscal Policy Changes When Congress passed a Job Creation Act following the 2008–2009 recession, it increased the level of unemployment benefits and lowered the Social Security payroll tax by 2 percentage points. These temporary measures expired after three years. 16.

Explain the supply-side effects of allowing unemployment benefits and the Social Security payroll tax cut to expire. Allowing emergency unemployment benefits to expire decreases job search by making unemployed workers more likely to accept employment offers, thereby boosting employment. Allowing the Social Security payroll tax cuts to expire increases the income tax on labor, which decreases the supply of labor, thereby decreasing employment.

17. a. Explain the potential demand-side effects of extending unemployment benefits and not increasing the Social Security payroll tax. Compared to the situation of allowing these policies to expire, extending unemployment benefits will increase the income of unemployed workers who cannot find jobs. Extending the Social Security payroll tax cut increases the income of employed workers. The increase in income for both classes of workers boosts their consumption expenditure higher than what it would be if the policies expired, so aggregate demand increases from what it would be otherwise.

b. Explain the potential supply-side effects of the fiscal policy actions in part (a). Compared to the situation of allowing these policies to expire, extending emergency unemployment benefits increases job search by making unemployed workers less likely to accept employment offers, thereby reducing employment. Allowing the Social Security payroll tax cuts to continue continues the © 2023 Pearson Education, Inc.

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decreases the income tax on labor, which means that the supply of labor will not decrease and hence employment will not decrease.

c. Draw a graph to illustrate the combined demand-side and supply-side effect of the fiscal policy actions in part (a). Figure 30.6 shows the combined effects of these policies compared to what the situation would be if the policies were allowed to expire. Aggregate demand unambiguously increases, so the aggregate demand curve shifts rightward from AD0 to AD1. The effect on aggregate supply is ambiguous. Continuing the unemployment benefits decreases aggregate supply; continuing the Social Security payroll tax cuts increases aggregate supply. Presuming that the effects from extending the unemployment benefits and Social Security payroll tax cuts just offset each other, aggregate supply does not change so the aggregate supply curve does not shift. In Figure 30.6 the shift of the aggregate demand curve increases real GDP, in the figure from $15.4 trillion to $15.8 trillion, and the price level rises, in the figure from 122 to 126.

Use the following news clip to work Problems 18 and 19. The Value-Added Tax Brings in Billions For Other Countries Value-added tax (VAT) is a tax on goods and services at every stage of the production process rather than a single tax at the end. VATs are not used in the United States but they are the third-largest revenue producer for countries in the Organisation for Economic Cooperation and Development. Source: cnbc.com, June 21, 2021 18. Explain the potential supply-side effects of a VAT on the U.S. economy. A VAT is a tax on a producer’s total revenue minus the cost of inputs purchased from other producers. The final price paid by consumers includes the VAT paid by all the firms that have had a hand in producing the good. A VAT effectively lowers the tax on business income. By decreasing the tax on profits, business’s demand for investment increases, which increases the nation’s capital stock. Aggregate supply and potential GDP both increase.

19.

How do the effects of a VAT depend on which side of the Laffer curve the U.S. economy lies? Explain your answer. The effect on the government’s tax revenue from imposing a VAT depends on which side of the Laffer curve the U.S. economy lies. If the tax rate lies beyond the rate that maximizes U.S. tax revenue, then adding a VAT will increase government tax revenue but if the tax rate is less than the rate that maximizes U.S tax revenue, then government tax revenue will decrease.

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Budget of the U.S. Government In Fiscal 2021, mandatory spending on the three entitlement programs—Social Security, Medicare, and Medicaid—was 11.1 percent of GDP. This expenditure was projected to rise to 12.6 percent of GDP by 2031. Over that same period, discretionary expenditure on national defense was projected to fall from 3.4 percent of GDP to 2.5 percent of GDP. The deficit was projected to fall from 14.9 percent of GDP to 4.7 percent of GDP. Source: whitehouse.gov, Fiscal Year 2022 If politicians continue to avoid legislating changes that lower the projected increases in the three big entitlement programs, how do you think the fiscal imbalance will change? If Congress introduced changes that slowed the growth of expenditure on the three entitlement programs, who would benefit and who would pay? If politicians avoid tackling spending from the three big entitlement programs, the fiscal imbalance will increase because their scheduled spending will skyrocket. If Congress introduces changes that slow the growth of expenditures on the three entitlement programs, the current generation would pay because they do not receive the benefit from any growth in the programs. The future generation would benefit because they do not have to pay higher taxes.

21.

The economy is in a boom and the inflationary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. Fiscal policy that decreases expenditure or increases taxes would decrease aggregate demand. In terms of automatic fiscal policy, need-tested spending decreases in expansions and tax revenue increases. Congress might also use discretionary policy by cutting spending programs or increasing tax rates.

b. Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects. A decrease in government expenditure with an offsetting decrease in autonomous taxes would not bring a change in government saving and so would not change investment and the growth of real GDP.

22.

The economy is growing slowly, the inflationary gap is large, and there is a budget deficit. a. Do we know whether the budget deficit is structural or cyclical? Explain your answer. The economy is at an above full-employment equilibrium because there is an inflationary gap. Real GDP exceeds potential GDP. There is a budget deficit, but with potential GDP greater than real GDP there is a cyclical surplus. The structural deficit is larger than the total budget deficit because the cyclical surplus offsets some of structural deficit. So the budget deficit is composed of a structural deficit and a cyclical surplus.

b. Do we know whether automatic stabilizers are increasing or decreasing aggregate demand? Explain your answer. We know that automatic stabilizers are decreasing aggregate demand relative to what it would be otherwise in an inflationary gap.

c. If a discretionary decrease in government expenditure occurs, what happens to the structural budget balance? Explain your answer. A discretionary decrease in government expenditure decreases the structural deficit. Following the change in fiscal policy, government outlays would be smaller even when the economy returned to full employment.

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Use the following news clip to work Problems 23 to 25. Struggling Americans Blast Stimulus Bill as Too Little, Too Late People are expressing deep disappointment with the $600 Covid relief checks approved by Congress. The help is too little, too late, say Americans who are having difficulty paying their bills during the pandemic. Source: cnn.com, December 23, 2020 23.

Are the Covid relief checks discretionary fiscal stimulus or automatic fiscal stimulus? The Covid relief checks are discretionary fiscal stimulus. These checks do not happen automatically. It depends on whether the government officials want to make this spending or not.

24.

Do the Covid relief checks have a similar effect on aggregate demand as a tax cut? What has a greater effect on aggregate demand—issuing Covid checks or government expenditure of the same amount? Explain your answer. The Covid checks are very similar to tax cuts insofar as both increase consumers’ disposable income and so both should have the same effect on aggregate demand. An increase in government expenditure of the same amount as the Covid checks will have a larger effect on aggregate demand because some part of the Covid checks will be saved and consequently will not increase aggregate demand.

25.

What are the fiscal policy time lags evident in the news clip? The time lags are the recognition lag (the time it took for the government to realize that the checks were needed), the law-making lag (the time it took for Congress to pass the laws necessary for the Covid checks, and the impact lag (the time it took for the checks to reach the public).

Economics in the News 26. After you have studied Economics in the News on pp. 752–753, answer the following questions. a. What was the scale of federal government expenditure on Covid relief programs? The scale of the Covid relief programs was large, $3.18 trillion or about 15 percent of GDP.

b. How did the Covid pandemic change aggregate demand and aggregate supply? Draw a graph to illustrate your answer. As Figure 30.7 shows, taken by itself the Covid pandemic decreased both aggregate demand, from AD0 to AD1, and also decreased aggregate supply, from SAS0 to SAS1. Aggregate supply decreased as mandated social distancing and closure of businesses decreased production. Aggregate demand decreased because consumption and investment fell. Consumption fell as a result of the rise in unemployment and consequently the decrease in income from business closures. Consumption of services also fell because of social-distancing requirements. Investment decreased because of massive uncertainty about the future course of the pandemic.

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c. How did the fiscal policy response to Covid change aggregate demand and aggregate supply? Draw a graph to illustrate your answer. The fiscal policy response to Covid increased both aggregate demand and aggregate supply. In Figure 30.8, the aggregate demand curve shifts from AD1 to AD2 and the aggregate supply curve shifts from SAS1 to SAS2.

d. As the economy recovered from the Covid recession in 2021, what happened to aggregate demand and aggregate supply, and how can we tell? Draw a graph to illustrate your answer. As the economy recovered from the Covid recession, aggregate demand continued to increase but aggregate supply decreased. Figure 30.9 illustrates these changes. In it, the aggregate demand curve shifts from AD2 to AD3 and the aggregate supply curve shifts from SAS2 to SAS3. Aggregate demand increased as a result of further stimulus and fall in unemployment while aggregate supply decreased because firms’ costs were rising. We can tell these changes occurred because: 1) the decrease in aggregate supply decreases real GDP, 2) the increase in aggregate demand increases real GDP and, 3) because real GDP actually increased, the change in aggregate demand must exceed that in aggregate supply.

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More Fiscal Stimulus Needed? In New York Times articles and in blogs, economists Paul Krugman and Joseph Stiglitz say there is a need for more fiscal stimulus in both the United States and Europe despite the large federal budget deficit and large deficits in some European countries. a. Do you agree with Krugman and Stiglitz? Why? Students who agree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy will not return to full employment rapidly without further government stimulus. Students who disagree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy is on track to return to full employment.

b. What are the dangers of not engaging in further fiscal stimulus? If the economy is not returning to full employment, fiscal stimulus might be necessary. In this situation, if there is no fiscal stimulus, the economy will remain mired in a recessionary gap and unemployment will exceed natural unemployment.

c. What are the dangers of embarking on further fiscal stimulus when the budget is in deficit? The fiscal stimulus will further increase the budget deficit. The rise in the deficit increases the government’s demand for loanable funds and thereby raises the real interest rate. The higher real interest rate decreases—crowds out—investment. The net effect on aggregate demand is uncertain: The fiscal stimulus increases aggregate demand; however, the decrease in investment expenditure decreases aggregate demand. If aggregate demand does not change, there is no immediate effect on real GDP. But the decrease in investment lowers the future capital stock, which means that aggregate supply does not increase as much as otherwise so that U.S. economic growth will be slower.

28.

U.S. Senate Passes Biden’s $1T Bipartisan Infrastructure Plan The infrastructure plan includes funding to rebuild roads and bridges, shore up coastlines, modernize the electric grid, and update public transit, airports, and freight rail. There is also $65 billion allocated to expand broadband and make it more affordable. Source: globalnews.ca, August 10, 2021 a. Explain how $1 trillion of infrastructure spending could be paid for. The $1 trillion of spending can be financed by either increasing taxes and/or cutting other spending.

b. Explain the effects of $1 trillion in infrastructure spending on employment and unemployment. In the short-run, an increase in infrastructure increases aggregate demand, which increases real GDP and thereby increases employment and decreases unemployment. In the longer-run, an increase in infrastructure spending increases the nation’s productive resources, which increases potential GDP and short-run aggregate supply. The increase in short-run aggregate supply increases employment and decreases unemployment.

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Answers to the Review Quizzes Page 762 1.

What are the objectives of monetary policy? As set out in law, the objectives of monetary policy are to achieve “maximum employment, stable prices, and moderate long-term interest rates.”

Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run? The monetary policy goals are essentially in harmony for the long run. In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible. In the short run, however, the monetary policy goals might conflict with each other. In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession. The Fed’s policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate.

What is the PCEPI inflation rate and how does it differ from the CPI inflation rate? The PCEPI inflation rate is the rate of increase in the personal consumption expenditure price index (PCEPI). The PCEPI is a monthly, chain-linked index, so it is free of the (upward) bias in the CPI and therefore free of the (upward) bias in the CPI inflation rate.

Who is responsible for U.S. monetary policy and what are the roles of the Fed, Congress, and the President? The Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) are responsible for the conduct of U.S. monetary policy. The President’s formal role is to appoint the members and the chair of the Board of Governors. Some Presidents, however, have also tried to influence Fed decisions. The Congress plays no direct role but the Fed must make two reports about its monetary policy to Congress each year.

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What are the Fed’s monetary policy instruments? The Fed’s monetary policy instruments are the quantity of reserves, and three interest rates: The federal funds rate, the discount rate, and the interest on reserves rate. The federal funds rate is the interest rate on overnight loans of reserves that commercial banks make to each other. The discount rate is the interest rate the Fed charges banks for the loan of reserves. The interest on reserves rate is the interest rate the Fed pays banks on reserves held at the Federal Reserve.

What are the main influences on the FOMC federal funds rate decision? Though the Federal Reserve does not use an explicit formula to determine changes in its targeted federal funds rate, the Fed responds to the inflation rate and the unemployment rate when determining its federal funds target rate. © 2023 Pearson Education, Inc.

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How is the federal funds rate determined in the market for bank reserves? The federal funds rate is determined by equilibrium in the reserve markets. The federal funds rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied. The equilibrium federal funds rate is bounded by the discount rate above and the interest rate on reserves below.

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Describe the channels by which monetary policy ripples through the economy and explain how each channel operates. When the Federal Reserve lowers the federal funds rate target, other short-term interest rates also fall. As a result, the exchange rate falls because investors decrease their demand for U.S. dollars since the interest yield on dollars is lower. When the Federal Reserve lowers the federal funds rate it does so by using quantitative easing, that is, buying securities and thereby increasing bank reserves. With the increase in reserves, banks have excess reserves. Because banks have excess reserves, they loan the excess. Loans increase and a multiple expansion of the quantity of money results. The supply of loanable funds increases so that the long-term real interest rate falls and consumption and investment increase. Net exports increase because of the lower exchange rate. All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase.

How do the Fed’s actions influence real GDP and the inflation rate and how long does it take for these targets to respond to the Fed’s actions? The Fed’s actions affect real GDP and the inflation rate by changing expenditure plans. For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure and investment. Both of these changes boost aggregate demand so that real GDP growth and the inflation rate increase. The effects are far from immediate because there are time lags in the process. Real GDP and the inflation rate initially respond about two years after the policy is initiated.

How does inflation targeting work? If the Fed followed a policy of inflation rate targeting, it would make a public commitment about its inflation rate target and would explain how its policy actions will achieve its goal. Inflation rate targeting gives the public guidance about what the central bank expects the inflation rate will be. This will help anchor and manage inflation expectations.

How would using the Taylor rule have changed the Fed’s interest rate setting? From 2002 to 2005, the actual federal funds rate was lower than what the Taylor rule called for. Then, in 2006 and 2007 the Taylor rule called for 1 to 2 percentage point lower interest rate than the Fed actually set. But the major difference occurs from 2010 onward. Since 2010 the Taylor rule suggests that the Fed should have raised the federal funds rate to near 4 percent while the Fed kept the federal funds rate near 0 percent. And, even as the Fed started to raise the federal funds rate in 2016, the Taylor rule would have set the federal funds rate about 3 percentage points higher.

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What are the three ingredients of a financial and banking crisis? A financial and banking crisis occurs when there is a widespread fall in assets prices, a significant currency drain, and a run on banks. When these events occur, banks and other financial institutions face incipient failure and so they drastically decrease their lending activities.

What are the policy actions taken by the Fed and the U.S. Treasury in response to the financial crisis of 2007-2008? The Fed and the U.S. Treasury have undertaken eight policies designed to combat the financial crisis. The Fed conducted massive open market operations to provide liquidity to banks. To provide liquidity to money market funds, the Fed also created an asset-backed commercial paper money market mutual fund liquidity facility. To provide liquidity to other financial institutions, the Fed allowed created programs that allowed term auction credit and also primary dealer and other broker credit. The U.S. Treasury engaged in © 2023 Pearson Education, Inc.

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two Troubled Asset relief Programs, TARP 1 and TARP 2. TARP 1 was designed to give banks more liquidity. Under it banks were to sell troubled assets to the U.S. Treasury in exchange for U.S. government assets. This program did not work well and was replaced by TARP 2. Under TARP 2 the U.S. Treasury directly purchased stock in financial institutions, thereby increasing their solvency and making their failure less likely. Finally, accounting rules were changed to allow financial institutions to use fair value accounting rather than mark-to-market accounting to value assets. This change also increased their solvency and made failure less likely.

Why was the recovery from the 2008–2009 recession so slow? The recovery from the recession was slow because investment did rebound. Investment remained low because of uncertainty about the future.

What is macroprudential regulation and how does is contrast with microprudential regulation? Macroprudential regulation is financial regulation designed to lower the risk that the financial system will collapse, thereby leading to severe macroeconomic issues. Microprudential regulation aims to lower the risk that individual financial institutions fail. Macroprudential regulation focusses on the interconnections among individual financial institutions because it is these interconnections that can cause the entire system to fail. For example, a macroprudential regulation might require banks to increase the ratio of their net worth to loans when the economy is in a recession thereby making each individual firm—and hence the entire system—less likely to fail.

What are the main provisions of Dodd–Frank? The Dodd-Frank Act, passed in 2010, has two main provisions: the Volcker Rule, and the Orderly Liquidation Authority. The Volcker Rule limits the amount of funds a bank can invest in hedge funds and private equity funds to a maximum of 3 percent of the bank’s capital. This rule essentially separates commercial banking and investing banking insofar as one bank cannot do both. The Orderly Liquidation Authority allows the Financial Stability Oversight Council to determine if the liquidation of a financial institution is necessary for the macro-stability of the financial system. If a forced liquidation is necessary, the Federal Deposit Insurance Corporation can use an Orderly Liquidation Fund to manage it.

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Answers to the Study Plan Problems and Applications 1.

“Unemployment is a more serious economic problem than inflation and it should be the focus of the Fed’s monetary policy.” Evaluate this statement and explain why the Fed’s primary policy goal is price stability. The Fed’s primary goal is price stability because price stability helps the Fed reach all three of its goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability directly meets the second goal of price stability. And because price stability means that the inflation rate is low, it helps keep nominal long-term interest rates close to the long-term real interest rate. Finally price stability helps consumers and businesses make better decisions about saving and investment and thereby keep unemployment close to the natural rate.

“Monetary policy is too important to be left to the Fed. The President should be responsible for it.” How is responsibility for monetary policy allocated among the Fed, the Congress, and the President? The Fed has primary responsibility for the nation’s monetary policy. It is the FOMC that decides upon monetary policy. The Congress plays, at best, a minor role. Each year the Fed must make two reports to Congress about its monetary policy and the Fed chairman testifies before Congress at these times. The President’s role is limiting to appointing the members and the chairman of the Board of Governors, though Presidents have tried to influence the Fed’s decisions.

Fed to Announce QE Taper in Aug or Sept on Rising Inflation Concerns The Fed is making monthly purchases of $80 billion in Treasuries and $40 billion in mortgage-backed securities. With rising consumer prices and the unemployment rate forecast to fall, the Fed is expected to announce a strategy for reducing its bond-buying program. Source: reuters.com, June 10, 2021 a. What does the Federal Reserve Act of 2000 say about the Fed’s control of the quantity of money? The Federal Reserve Act of 2000 says that the Fed “shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

b. How can changes in the Fed’s bond-buying program be reconciled with the Federal Reserve Act of 2000? The Fed is charged with setting monetary growth to “promote effectively the goal(s) of maximum employment, stable prices, …” The QE taper is an effort to head off potential high inflation rates, thereby helping to achieve the goal of stable prices.

Describe each of the Fed’s monetary policy instruments. The Fed’s monetary policy instruments are the quantity of reserves, the federal funds rate, the discount rate, and the interest on reserves rate. The quantity of reserves is the amount of reserves the Fed provides. The federal funds rate is the interest rate on overnight loans of reserves that commercial banks make to each other. The discount rate is the interest rate the Fed charges banks for the loan of reserves. The interest on reserves rate is the interest rate the Fed pays banks on reserves held at the Federal Reserve.

How does the interest rate corridor limit the movement of the federal funds rate? The interest rate corridor is bounded above by the discount rate and below by the interest rate on reserves. The federal funds rate will lie within this corridor. It will never be above the discount rate because at federal funds rates above the discount rate banks who are borrowing reserves will borrow from the Fed and pay the discount rate, so the quantity of reserves demanded at federal funds rates above the discount rate is zero. And the federal funds rate will never be below the interest rate on reserves because banks loaning

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reserves will retain the reserves rather than loan them in order to collect the higher interest on reserves rate, so the quantity of reserves supplied at federal funds rates below the interest rate on reserves rate is zero.

Explain how the FOMC determines whether to raise or lower its federal funds rate target. Why doesn’t the FOMC respond symmetrically to inflation and unemployment risks? The Fed changes in the federal funds rate based on its forecasts of the inflation rate and the unemployment rate. If the inflation rate is forecasted to rise or the unemployment rate is forecasted to fall, the Fed might be concerned about inflation and push the federal funds rate up. If the inflation rate is forecasted to fall or the unemployment rate is forecasted to rise, the Fed might be concerned about unemployment and push the federal funds rate down. Because the Fed responds to whichever issue is most pressing at the time, the response will vary and therefore will not be symmetric. Generally when the FOMC is concerned about inflation, it raises the federal funds target rate in small steps over several months but when it is concerned about recession, it slashes the federal funds rate target quickly in large steps.

Use the following news clip to work Problems 7 and 8. Risks Rise to Both the Fed’s Inflation and Employment Goals The Fed’s mandate is in trouble. Unemployment remains close to 6% and inflation is at its highest level in 29 years. Inflation is expected to stay above 3 percent through the remainder of the year. Source: wsj.com, June 15, 2021 7. Explain why the Fed’s mandate is in trouble. The Fed’s mandated policy goals include maximum employment and stable prices. In order to lower unemployment, the Fed follows an expansionary policy that risks increasing the inflation rate, which is already high. Additionally, in order to lower the inflation rate, the Fed follows a contractionary policy that risks increasing the unemployment rate, which also is already high. Consequently, it appears that the Fed’s mandate might be in trouble in the short run but not necessarily in the long run.

Why might the Fed (a) lower and (b) raise the federal funds rate in 2022? The Fed might decide to cut the federal funds rate in 2022 if it believed that unemployment is a larger problem than inflation. However, the Fed also might decide to raise the federal funds rate in 2022 if it believed that inflation is a larger problem than unemployment.

Use the following data to work Problems 9 to 11. The Bureau of Economic Analysis reported that business investment in the second quarter of 2017 was $2.3 trillion—$0.1 trillion more than in 2015. 9. Explain the effects of the Fed’s low interest rates on business investment and use a graph to illustrate your explanation. The low interest rates are achieved by increasing banks’ reserves, which leads to an increase in the supply of loanable funds. Then, as illustrated in Figure 31.1, the increase in the supply of loanable funds lowers the real interest rate, in the figure from 5 percent per year to 3 percent per year. The fall in the real interest rate increases firms’ purchase of investment items, such as factories, plants, machine tools, and so forth, because it makes their purchase less expensive.

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Explain the effects of business investment on aggregate demand. Would you expect it to have a multiplier effect? Why or why not? The increase in investment increases aggregate demand as illustrated in Figure 31.2. It is likely that the increase in investment has a multiplier effect. The initial increase in investment increases real GDP and consumers’ disposable income. In turn the increase in disposable income induces additional consumption expenditure, which serves to further increase aggregate demand and real GDP.

11.

What actions might the Fed take to stimulate business investment even more? The Fed might commit to keeping the inflation rate low by stating that it will raise the interest rate at some specified point in the future if inflation starts to pick up. This commitment would help dispel fears of inflation. It would also make clear that buying investment goods will be cheaper at the present time, when the interest rate is low, then in the future, when the interest rate rises. This belief would lead firms to increase their investment at the present time.

Use the following news clip to work Problems 12 to 14. IMF to Keep 2021 Global Growth Forecast at 6% The IMF projected a global growth rate of 6% in 2021, the highest rate since the 1970s, as vaccine availability increased and economies reopened with intense stimulus, especially in the United States. Source: reuters.com, July 21, 2021 12. If the IMF forecast turns out to be correct, what would most likely happen to the output gap and unemployment in 2021? The increase in global economic activity means that the output gap will decrease, and the unemployment rate will fall.

13. a. What actions taken by the Fed in 2020 would you expect to have influenced real GDP growth in 2021? Explain how those policy actions would transmit to real GDP. In 2020 the Fed slashed the federal funds rate. The Fed’s policy was strongly expansionary because the Fed’s goal was to increase aggregate demand in order to avoid the possibility of high unemployment, so the Fed’s policy helped contribute to higher real GDP in 2021. By cutting the federal funds rate, other interest rates fall, which increase consumption expenditure and investment. Both of these changes then boost aggregate demand and raise real GDP.

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b. Draw a graph of aggregate demand and aggregate supply to illustrate your answer to part (a). Figure 31.3 shows the outcome described in part (a). In the absence of the Fed’s policy, economic growth would have been slow so that the aggregate demand curve would be AD0 and the aggregate supply curve would be SAS. The Fed’s expansionary policies raised economic growth by increasing aggregate demand, so the aggregate demand curve shifts to AD1. In the absence of the Fed’s policies, real GDP would be $19.0 trillion and the price level would be 120. The Fed’s policies have raised the price level to 122 and thereby increased inflation. The policy also increased economic growth by raising real GDP to $20.0 trillion.

14.

What further actions might the Fed take in 2021 to influence the real GDP growth in 2022? The time lags in the operation of monetary policy suggest that any policy the Fed takes in 2021 likely will have a small effect in 2022. If, early in 2021 the Fed decided to undertake further expansionary policy by continuing or even increasing its purchases of assets, there might be a small positive impact on real GDP and employment in late 2022. Alternatively, if the Fed sticks to its plan to reduce its purchases of securities and start to unwind the monetary stimulus, there might be a small negative impact on real GDP and employment in late 2022.

15.

Federal Banking Agencies Ease Volcker Rule Restrictions Looser restrictions on the Volcker Rule will free up billions of dollars that banks can now use. Sen. Jeff Merkley, D-Oregon says “Re-opening the Wall Street casino is the wrong path forward, one that puts all Americans’ financial stability at risk.” Source: apnews.com, June 25, 2020 What is the Volcker Rule? Why would it be considered to be a part of macroprudential regulation? Why does Senator Jeff Merkley oppose easing it? The Volcker Rule is part of the Dodd-Frank Bill. It prohibits banks from investing more than 3 percent of their capital in hedge funds and private equity funds. In essence, it prohibits banks from combining commercial banking and investment banking, that is, taking an ownership position in a business. This rule is a macroprudential regulation because it attempts to limit the potential harm a recession might inflict on the financial sector and thereby reduce the severity of the recession. Senator Merkley opposing easing it because he worries that banks will invest more in risky businesses and that could lead to another financial crisis.

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Answers to Additional Problems and Applications Use the following information to work Problems 16 to 18. The Fed’s mandated policy goals are “maximum employment, stable prices, and moderate long-term interest rates.” 16. Explain the harmony among these goals in the long run. In the long run, stable prices bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low— perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible.

17.

Explain the conflict among these goals in the short run. In the short run, the monetary policy goals might conflict with each other. In the short run, during a recession the Federal Reserve lowers the federal funds rate and increases the growth rate of the quantity of money to combat the recession. The Fed’s policy increases employment and real GDP but at the cost of also increasing the price level and, eventually, the inflation rate and the nominal interest rate. Conversely in an expansion the Fed raises the federal funds rate to decrease inflation but at the cost of decreasing employment and real GDP.

18.

Explain how the Fed pursues “flexible average inflation targeting.” The Fed first selects the price level measure it will use, a target inflation rate, and the time period over which to average inflation. The Fed then aims to keep the average inflation over the time period equal to its goal.

19.

How successful has the Fed been with its operational price stability goal since 2000? The Fed has been reasonably successful in reaching its price stability goal of approximately 2 percent average inflation, though prior to 2008 the inflation was above the goal more often than not and after 2008 it has more frequently been below the goal. But, in general, the inflation rate has been within or at least close to the Fed’s comfort zone for inflation.

20.

Suppose Congress decided to strip the Fed of its monetary policy independence and legislate interest rate changes. How would you expect the policy choices to change? Which arrangement would most likely provide price stability? If interest rates are determined by Congress, there would be a bias toward persistently increasing monetary growth to keep the interest rate low and help the re-election prospects of legislators. While this policy is successful in the short run, in the long run the higher monetary growth leads to higher inflation. In turn, the higher inflation rate leads to a higher nominal interest rate. Keeping the Fed independent of Congress is most likely to provide price stability.

Use the following CBO report to work Problems 21 to 23. U.S. Deficit to Hit $3 Trillion in 2021, Then Fade as Stimulus Relief Expires The federal deficit will hit $3 trillion in 2021, primarily due to the government response to the pandemic. The deficit is slightly lower than last year but is triple that of 2019. Source: washingtonpost.com, July 1, 2021 21. How does the federal government get funds to cover its budget deficit? How does financing the budget deficit affect the Fed’s monetary policy? The federal government borrows the funds. Borrowing, by selling government securities, is how the federal government funds its budget deficit. When the government borrows to fund its deficit, the increased demand for loanable funds raises the real interest rate. The budget deficit has no direct impact on the Federal Reserve’s monetary policy. But the budget deficit might exert an indirect effect. For its monetary policy, the Federal Reserve targets the federal funds rate © 2023 Pearson Education, Inc.

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and uses open market operations to meet the target. When government borrowing raises the real interest rate, the federal funds rate rises. The rise in the federal funds rate might affect the Fed’s assessment of the level at which to target the federal funds rate.

22.

How was the budget deficit of 2021 influenced by the Fed’s low interest rate policy? The Fed’s low interest rate policy lowered the interest payments the federal government had to make on its debt. Therefore the low interest rate policy decreased the amount of government spending and hence decreased the size of the government budget deficit.

23. a. How would the budget deficit change in 2022 and 2023 if the Fed moved interest rates up? If the Fed boosts interest rates, the government payments on its debt will increase. The higher payments increase the amount of government spending and therefore increase the size of the budget deficit.

b. How would the budget deficit change in 2022 and 2023 if the Fed’s monetary policy led to a rapid depreciation of the dollar? A rapid depreciation of the dollar can have two effects on the budget deficit. First it can increase the U.S. inflation rate. With the increase in the inflation rate, inflation expectations would increase, thereby increasing interest rates. The increase in the interest rate increases the budget deficit because the government must increase the interest payments it makes on its debt. Second, a rapid depreciation of the dollar can also increase U.S. net exports which decreases the U.S. unemployment rate. A decrease in unemployment decreases the needs-based expenditure the government must make and thereby lowers the budget deficit.

24.

The Federal Reserve Act of 2000 instructs the Fed to pursue its goals by “maintain[ing] longrun growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production.” a. Has the Fed followed this instruction? The Fed would argue that it has tried to follow this instruction. The Fed would point to the relatively low inflation rate as evidence that it did not let the growth rate of the quantity of money get out of hand. And the Fed would argue that the financial crisis and ensuing recession is not the fault of its monetary policy.

b. Why might the Fed increase money by more than the potential to increase production? During a recession the Fed increases the quantity of money by more than the “long-run potential” in an effort to conduct a monetary policy that moves real GDP back to its “long-run potential.”

25.

Looking at the federal funds rate since 2000, identify periods during which, with the benefit of hindsight, the rate might have been kept too low. Identify periods during which it might have been too high. Some analysts assert that the federal funds rate was too low during the period from 2001 to 2005. During this period house prices skyrocketed. It was the following rapid fall in house prices, starting in 2006, that helped lead to the financial crisis. These analysts say that if the Fed had raised interest rates earlier, then demand for housing would have not been as strong, thereby limiting the rise in house prices. According to the Taylor rule, the interest rate was also too low from 2009 to 2019. Some observers believe that the Fed kept interest rates too high at the start of in 2000 and in 2006-2007. In both periods the economy was poised to enter a recession. These observers say that if the Fed had lowered the interest rate before the economy entered the recession, the following recession would have been milder and might have been avoided all together.

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Now that the Fed has created $4 trillion of bank reserves, how would you expect a further open market purchase of securities to influence the federal funds rate? Why? Illustrate your answer with an appropriate graph. The Fed’s immense creation of $4 trillion of bank reserves might mean that further open market operations would have no effect on the federal funds rate. The $4 trillion of reserves has sent the federal funds to 0 percent, so there is little room for it to fall further. At this exceedingly low federal funds rate, banks might be willing to hold any quantity of additional reserves. In this situation, as Figure 31.4 illustrates, the demand curve for reserves, the thick dark line, is horizontal. If the demand curve for reserves is flat, then increasing the quantity of reserves has no effect on the federal funds rate because banks merely hold the additional reserves. Banks hold the reserves because the opportunity cost of holding them rather than loaning them in the federal funds market is so low.

27.

The federal funds rate target range is 2.25 to 2.50 percent a year, when the United States suddenly enters a recession. The Fed decides to lower the federal funds rate target range to 0.50 to 0.75 percent a year. What actions does the Fed take? The Fed will lower the discount rate to 0.75 percent a year and the interest on reserves rate to 0.50 percent a year. The Fed will also increase banks’ reserves by purchasing securities so that the federal funds rate falls within the range.

To work Problems 28 to 30, use the information that during 2017 the inflation rate increased slightly but remained in the “comfort zone” and the unemployment rate was low. 28. Explain the challenge that low inflation and low unemployment poses for the Fed. Low inflation and low unemployment pose a challenge for the Fed because the Fed believes that these two outcomes are unlikely to persist together for long. The Fed believe that low inflation brings high unemployment and that low unemployment brings high inflation. So if the Fed fears higher inflation, the Fed must raise the interest rate and decrease growth in the quantity of money. But this policy raises the unemployment rate. However, if the Fed fears high unemployment the Fed needs to lower the interest rate and increase the growth rate of the quantity of money. But this expansionary policy raises the inflation rate.

29.

Why might the Fed decide to raise interest rates in this situation? The Fed might raise the interest rate if it perceives that inflation will rise outside of its comfort zone and if it perceives the rising inflation as a larger problem than the high unemployment.

30.

Why might the Fed decide to try to lower interest rates (or stimulate in other ways) in this situation? The Fed might lower the interest rate because it perceives high unemployment as a larger problem than inflation because inflation, while increasing, was in the “comfort zone.”

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Use the following information to work Problems 31 to 33. From 2009 through 2017, the long-term real interest rate paid by the safest U.S. corporations fell from 5.5 percent a year to 4 percent a year. During most of that period, the federal funds rate was roughly constant at 0.25 percent a year. 31. What role does the long-term real interest rate play in the monetary policy transmission process? The long-term real interest rate plays an important part in the monetary transmission process. Both consumption expenditure and investment respond to the long-term real interest rate. When the long-term real interest rate falls, consumption expenditure and investment both increase. The increase in consumption expenditure and investment increase aggregate demand and thereby increase real GDP and the price level.

32.

How does the federal funds rate influence the long-term real interest rate? The long-term interest rate is an expected average of short-term interest rates. People can either borrow or save by making a long-term commitment or by making successive short-term commitments. Adjusted for risk, the average of the interest rates on the short-term commitments must equal the long-term interest rate. If they were not equal one method of borrowing would be more or less expensive than the other. People would stream to borrow using the less expensive method, pushing that interest rate higher, back toward equality. Simultaneously other people would stream to save using the method with the higher return, pushing that interest rate lower, back toward equality. When the Fed lowers the federal funds rate, other short-term interest rates also fall. This fall makes borrowing by using a series of short-term loans less expensive and saving using a series of short-term commitments less profitable. The demand for long-term loans falls, which lowers the long-term interest rate and the supply of long-term saving commitments rises, which also lowers the long-term interest rate. So a fall in the federal funds rate lowers the long-term real interest rate.

33.

What do you think happened to inflation expectations between 2009 and 2017 and why? Inflation expectations probably increased. The expected inflation rate equals the nominal interest rate minus the real interest rate. Over this time period, the federal funds rate did not change, so the nominal interest rate did not change. But the real interest rate fell. Therefore inflation expectations increased.

34.

Uruguay Lifts Key Rate to 5% With Inflation Above Target With the pandemic easing and inflation above its target range, the central bank has started to raise its key interest rate. Source: bloomberg.com, August 11, 2021 a. When the central bank raises its key interest rate, what are the effects on Uruguay’s economy through the next days, weeks, and months? Very quickly other short-term interest rates will rise. Long-term bond interest rates will also start to rise but they will rise by less than do short-term rates. The quantity of money will decrease quickly, as will banks’ reserves. The decrease in banks’ reserves will eventually lead to a decrease in the loans banks make.

b. When the central bank raises its key interest rate, what is the effect on aggregate demand and when does this effect occur? Explain. When a central bank raises its key interest rate, ultimately aggregate demand decreases because consumption and investment both decrease. This effect does not happen immediately or even quickly. It may take upwards of two years before aggregate demand decreases.

c. Given the rise in Uruguay’s key rate in August 2021, when do you anticipate a change in the inflation rate, other things remaining the same? The lag before monetary policy affects the aggregate economy is approximately two years. Accordingly, the inflation rate in Uruguay may start to decline in mid-2023.

35.

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the official cash rate (its equivalent of the federal funds rate) at 4 percent a year. If the inflation rate in New Zealand is 2 percent a year, what is its output gap? The Taylor rule sets the official cash rate according to CASH = 2 + INF + 0.5(INF  2) + 0.5GAP. So the with a cash rate of 4 percent and an inflation rate of 2 percent, the Taylor rule is that 4 = 2+ 2 + 0.5(2 – 2) + 0.5GAP, or 4 = 4 + 0.5GAP. The last equation shows that the output gap is 0 percent.

Use the following news clip to work Problems 36 and 37. Bernanke on Inflation Targeting Inflation targeting promotes well-anchored inflation expectations, which facilitate more effective stabilization of output and employment. Thus inflation targeting can deliver good results with respect to output and employment as well as inflation. Source: Federal Reserve Board, remarks by Ben Bernanke to the National Association of Business Economists 36. What is inflation targeting and how do “well anchored inflation expectations” help to achieve more stable output as well as low inflation? Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve a specific inflation rate goal. Inflation rate targeting helps “anchor expectations” because the public has a good idea of hat the inflation rate will be. There are fewer gyrations in inflation expectations which lead to fewer changes in the real interest rate and, accordingly fewer changes in investment and consumption expenditure. Because aggregate demand is more stable, so, too, is output.

37.

Explain how inflation targeting as described by Ben Bernanke is consistent with the Fed’s dual mandate. The Fed’s dual mandate is to maintain stable prices and maximum employment. By setting a low inflation rate target, the Fed directly helps achieve its goal of stable prices , which is the best environment for households and firms to make the saving and investment decisions. By limiting fluctuations in aggregate demand, the Fed can keep real GDP growing at a rate that more closely approximates its long-term trend.

38.

If the Fed had adopted inflation targeting and used the Taylor rule to hit its target, how would the course of the federal funds rate have been different from the course that it did take? How would inflation and the output gap have been different? Before the recession of 2007-2008, according to the Taylor rule the federal funds rate was raised too high in response to the recession of 2000, kept too low during the expansion of 2001 to 2005, and then kept significantly too low after 2010 until the start of the Covid pandemic. On average, the federal funds rate set according to the Taylor rule is higher than the federal funds rate that actually occurred, which means that the inflation rate would have been lower and would have had smaller fluctuations if the Taylor rule had been followed. According to proponents of the Taylor rule, the Fed’s actions led to the boom and bust of the past decade, so setting the federal funds rate according to the Taylor rule would have resulted in smaller output gaps.

39.

Fed’s Kashkari Opposed to Rate Hikes at Least Through 2023 Minneapolis Federal Reserve President Neel Kashkari wants interest rates near zero so the labor market can return to its pre-pandemic strength. “Americans want to work, and I want to give them the chance to work,” Kashkari said. Kashkari is in the minority. With rising inflation, most Fed policymakers support interest rate hikes. Source: cnbc.com, June 18, 2021 a. Why is Neel Kashkari concerned? Mr. Kashkari is concerned because if interest rates are hiked too soon, the recovery from the Covid pandemic created by the expansion in aggregate demand might be nipped in the bud. If this were to occur, the unemployment rate would persist at a level higher than otherwise. © 2023 Pearson Education, Inc.

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b. Could keeping interest rates low damage the Fed’s credibility? Why or why not? Keeping interest rates low might cause people to doubt the Fed’s commitment to price level stability. The low interest rates are achieved by keeping banks’ reserves high and if banks loan these reserves, the money supply could expand significantly and with it the price level and inflation rate might jump higher.

Economics in the News 40. After you have studied Economics in the News on pp. 778–779, answer the following questions. a. What was the state of the U.S. economy in the summer of 2021 when the Fed made the decision to keep the federal funds rate at near zero and to keep buying bonds? The economy had not yet fully recovered from the Covid recession. Employment was still below full employment. But inflation was starting to be an issue with some indication that it was rising about 2 percent.

b. What was the FOMC majority expectation about future employment, real GDP, and inflation in July 2021? The FOMC believed that the economy was on track to reach full employment and potential GDP at some point in the future. However, there was worry about the progress of the pandemic, because the Delta virus variant was spreading and adversely affecting the labor market and economic growth. Additionally, there also was some worry about inflation because there were signs that inflation might be pushing above 2 percent a year.

c. How would an earlier and faster rise in interest rates influence aggregate demand, the output gap, and inflation? An earlier and faster rise in interest rates would lead to an earlier and stronger restraint on the growth of consumption expenditure and investment and, thereby, an earlier and stronger restraint on the growth of aggregate demand. Accordingly, the output gap would be closed more slowly but the inflation rate would rise less.

41.

The Fed Is About to Wind Down Its Emergency Economic Stimulus To balance the threat of Covid with the current economic recovery, Fed chair Jerome Powell suggested the Fed will start pumping the brakes before the end of the year. Source: cnn.com, August 27, 2021 a. What actions did the Fed take to stimulate the economy during the Covid-19 pandemic? The Fed immediately lowered its discount rate and the interest on reserves rate. The Fed also made massive purchases of securities under its Covid QE to drive the federal funds rate to virtually 0 percent a year.

b. Why is the Fed deciding to “start pumping the brakes”? The Fed is concerned that the expansionary policies it undertook during the pandemic are leading to higher inflation. In order to lower the inflation rate, the Fed is “starting to pump the brakes,” that is, reduce its expansionary policies.

c. What are the risks from the decision to “start pumping the brakes”? If the Fed stops its expansionary policy prematurely, then the unemployment rate might remain at persistently high levels.

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