SOLUTIONS MANUALFor Essential Foundations ofEconomics 7th Edition By Robin Bade Michael Parkin by digitaldownload87

Solutions Manual For Essential Foundations of Economics 7th Edition By Robin Bade Michael Parkin (All Chapters, 100% Original Verified, A+ Grade)

Part 1: Solutions Manual: Page 2-225 Part 2: Instructor's Manual: Page 226-558

Part 1: Solutions Manual Chapter

Getting Started ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

Provide three examples of scarcity that illustrate why even the 1,210 billionaires in the world face scarcity. The 1,210 billionaires might want to be able to eat unlimited meals without gaining weight; live to be at least 140 years old and enjoy perfect health everyday; be able to wake up in San Francisco and go to sleep in Paris after spending no more than 3 hours on a plane. None of these wants can be fulfilled given the present state of technology and resources available.

Label each entry in the list as dealing with a microeconomic topic or a macroeconomic topic. Explain your answer. • Motor vehicles production in China is growing by 10 percent a year. This entry is a microeconomic topic because individuals and businesses make decisions whether to buy or sell cars. •

Coffee prices rocket. This entry is a microeconomic topic because individuals and businesses make decisions whether to buy or sell coffee.

•

Globalization has reduced African poverty. This entry is a macroeconomic topic because globalization is the result of choices made by billions of people rather than an individual or business.

•

The government must cut its budget deficit. This entry is a macroeconomic topic because neither an individual nor a business makes decision to cut expenditures.

•

Apple sells 3 million iPhones a month. This entry is a microeconomic topic because individuals and Apple make decision whether to buy or sell iPhones.

Part 1 . INTRODUCTION

Use the following information to work Problems 3 to 6. The Social Network had world-wide box office receipts of $225 million. The movie had a production budget of about $70 million and additional marketing costs of about $50 million. Creating a successful movie brings pleasure to millions, generates work for thousands, and makes a few people rich. 3. What contribution does a movie like The Social Network make to coping with scarcity? When you buy a movie ticket to see a movie in a theater, are you buying a good or a service? Scarcity still exists but the amount of entertainment available in the economy increases. Buying a ticket to watch a movie is buying a service. 4.

Who decides whether a movie is going to be a blockbuster? How do you think the creation of a blockbuster movie influences what, how, and for whom goods and services are produced? The audience decides whether a movie will be a blockbuster because the audience decides whether to attend the movie. The “what” question is affected in three ways: First, one good or service that is produced is the blockbuster movie. Second, the people whose incomes are higher as a result of the blockbuster then buy an assortment of goods and services and so this assortment of goods and services is produced. Finally, the “what” question is influenced if the movie leads to spinoff goods (such as toys) or creates a series of sequels or similar films. 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 receive the profits of a blockbuster movie have higher incomes and so more goods and services are produced for them.

What are some of the components of marginal cost and marginal benefit that the producer of a movie faces? Some of the marginal costs the producer faces are the cost of an actor or actress, the costs of the crew for a day, the costs of a location, and the costs of advertising in a newspaper. The marginal benefits the producer enjoys are his or her salary and/or profit participation from the movie, royalties from the movie, the prestige resulting from a successful movie, and any awards given to the producer of the movie.

Suppose that Jesse Eisenberg had been offered a bigger and better part in another movie and that to hire him for The Social Network, the producer had to double Jesse’s pay. What incentives would have changed? How might the changed incentives have changed the choices that people made? The higher pay would have increased Mr. Eisenberg’s incentive to make The Social Network rather than the other movie and perhaps affected his

Chapter 1 . Getting Started

choice to make The Social Network rather than the other movie. The higher pay would have increased the incentive of the producer to decrease the expense of other aspects of the movie so the producer might have chosen to reduce the pay of the other stars in the movie. 7.

What is the social interest? Distinguish it from self-interest. In your answer give an example of self-interest and an example of social interest. The social interest looks at what is best for society as a whole; choices that are best for society as a whole are said to be in the social interest. The selfinterest looks at what is best for the individual; choices that are best for the individual making the choice are said to be in the self-interest. An example of a choice made in the self-interest is a student’s decision to take an economics class. An example of a choice made in the social interest is a firm’s decision to reduce its air pollution.

Pam, Pru, and Pat are deciding how they will celebrate the New Year. Pam prefers to take a cruise, is happy to go to Hawaii, but does not want to go skiing. Pru prefers to go skiing, is happy to go to Hawaii, but does not want to take a cruise. Pat prefers to go to Hawaii or to take a cruise but does not want to go skiing. Their decision is to go to Hawaii. Is this decision rational? What is the opportunity cost of the trip to Hawaii for each of them? What is the benefit that each gets? Pam, Pru and Pat’s decision to go to Hawaii is rational. All three of them considered the cost and benefit of various New Year’s plans. All three were at least willing to go to Hawaii while Pam and Pat were unwilling to go skiing and Pru was unwilling to go on a cruise. The opportunity cost of the trip for Pam is a cruise; for Pru, it is skiing; and for Pat, it is a cruise. The benefit each receives is the pleasure, the relaxation, excitement, and/or knowledge gained from the trip.

Label each of the entries in the list as a positive or a normative statement. • Low-income people pay too much for housing. The entry that low-income people pay too much for housing is a normative statement. •

The number of U.S. farms has decreased over the past 50 years. The entry about the number of farms is a positive statement.

•

Toyota expands parts production in the United States. The entry about Toyota expanding parts production is a positive statement.

•

Imports from China are swamping U.S. department stores. The entry about imports is a normative statement.

•

The population of rural United States is declining. The entry about the population in rural areas is a positive statement.

Part 1 . INTRODUCTION

Use the following information to work Problems 10 to 12. Hundreds line up for 5 p.m. Eminem ticket giveaway Eminem fans lined up all day to get a free ticket to his secret concert at which he will release his new album Relapse (his first in 5 years). Source: Detroit Free Press, May 18, 2009 10. With tickets free and the show to be held in the 1,500-seat Detroit theater, what is free and what is scarce? Explain your answer. The seats in the concert are scarce—there are only a limited number (1,500) available. Also scarce is the time the enthusiastic fans spent in line to acquire the tickets. The publicity that Eminem received is not free to him because he paid for the theater, hauling equipment to the theater, and so on. 11. What do you think Eminem’s incentive is to give a free show? Was his decision made in self-interest or in the social interest? Explain your answer. Eminem likely wants to allow his most enthusiastic fans the opportunity to see him in concert. He also has the incentive to promote his album by the publicity he gets from having the free concert and the resulting massive demand for tickets. This publicity will lead to increased sales of his album and increased income to him. Eminem’s decision to give a free concert had elements of both self-interest and social interest. To the extent that his decision was motivated by the free publicity and rise in album sales, the decision was motivated by selfinterest. However to the extent that a desire to allow his most enthusiastic fans the chance to see him perform, the decision also had elements of social interest. 12. Is the marginal benefit from the concert zero? Explain your answer. The marginal benefit from the concert was not zero. Regardless of the price paid for the concert, Eminem’s fans enjoyed the concert and therefore enjoyed a marginal benefit from it. 13. Read Eye on the Benefit and Cost of School on p. 15 and explain why both you and Clayton Kershaw made the right decision. Clayton Kershaw made the correct decision to skip college because the opportunity cost to him of attending college (which includes his forgone salary playing baseball) vastly exceeded the benefits to him of attending college. For most students, the opportunity cost of attending college is not so large, so for most students the benefits from attending college exceed the opportunity cost of attendance. For these students, attending college is the correct decision.

Chapter 1 . Getting Started

 Instructor Assignable Problems and Applications 1.

Which of the following are components of the opportunity cost of being a full-time student? The cost of: • Tuition and books The costs of tuition and books are part of the opportunity cost of being a full-time student because these expenses are paid only because the person is a student. •

Residence and a meal plan The costs of residence and a meal plan are not part of the opportunity cost of being a full-time student because expenses for housing and meals would be paid, perhaps by the student or perhaps by his or her family, even if the person was not a student.

•

A subscription to the New Yorker magazine If the subscription was required by a class and the individual subscribed only because of the class requirement, then the cost of the subscription is an opportunity cost of being a student. However if the person would have subscribed to the New Yorker even if he or she was not a student, then the cost of the subscription is not an opportunity cost of being a student.

•

The income a student will earn after graduating The income earned after graduation is not an opportunity cost of being a student.

Think about the following news items and label each as involving a what, how, or for whom question: • Today, most stores use computers to keep their inventory records, whereas 20 years ago most stores used paper records. Stores using computers for inventory records today versus paper 20 years ago answers the how question. •

Health-care professionals and drug companies recommend that Medicaid drug rebates be made available to everyone in need. Deciding whether to offer lower Medicaid drug rebates, which would lower the prices for drugs, is a for whom question.

•

A doubling of the gas tax might lead to a better public transit system. Deciding whether a better public transit system gets built answers a what question. Because not everyone will use the public transportation equally nor will everyone pay the same amount of taxes, there also is a for whom aspect of the headline.

On Friday May 3, 2013, the headlines in the list appeared in The Wall Street Journal. Classify each headline as a signal that the news article is about a mi-

Part 1 . INTRODUCTION

croeconomic topic or a macroeconomic topic. Explain your answers. • Job Gains Calm Slump Worries This entry is a macroeconomic topic because the slump concerns a turndown in the overall economy and neither an individual nor a business makes the decision to slow the aggregate economy. •

Washington Post’s Profit Falls This entry is a microeconomic topic because it concerns the profit outcome of one business, the Washington Post.

•

Overcapacity, Fuel Costs Hit Shipping This entry is a microeconomic topic. It describes the situation within one sector—shipping—which is being affected by overcapacity and a rise in the price of fuel.

•

Green Shoots in Greece? This entry is a macroeconomic topic because the “green shoots” mean that growth in different sectors is starting to grow. It is a sign that perhaps the overall Greek economy is starting to grow.

Your school decides to increase the intake of new students next year. To make its decision, what economic concepts would it have considered? Would the school have used the “economic way of thinking” in reaching its decision? Would the school have made its decision on the margin? The school would consider the extra revenue that each additional student would bring and compare that to the extra cost of providing each student with instruction and service. By comparing the extra revenue and the extra cost, the school is making its decision on the margin and is using the economic way of thinking. If the school compares the additional revenue to the additional cost, it makes its decision on the margin.

Provide two examples of a monetary incentive and two examples of nonmonetary incentive, a carrot and a stick of each, that government policies use to influence behavior. A monetary carrot that the students might answer because it is close to their lives is student aid, such as Pell grants. A monetary stick might be taxes on liquor. A non-monetary carrot is government support for youth sports, such as allowing little league teams to use a county park, and a non-monetary stick is jail terms for illegal drug or alcohol use.

Think about each of the items in the list and explain how they affect incentives and might change the choices that people make: • A hurricane hits Central Florida. The hurricane affects the people in Central Florida and the consumers who purchase the products produced in Central Florida, such as oranges or vacation services. Residents’ incentives change if they suffered

Chapter 1 . Getting Started

damage from the hurricane because they have the incentive to repair the damage. If the price of home repair rises, residents who specialize in home repair have an incentive to work longer hours to earn the higher price. If the hurricane raises the price of the goods and services produced in Central Florida, consumers have the incentive to buy less of these particular goods and services because they are more expensive. •

The World Series begins tonight but a storm warning is in effect for the area around the stadium. The report of the possible storm decreases fans’ incentive to attend the game. Some fans decide to stay at home and watch the game on television.

•

The price of a personal computer falls to $50. The fall in the price of a computer increases consumers’ incentive to buy a computer. More consumers decide to buy a computer. The fall in the price of a computer decreases producers’ incentives to produce computers. Fewer producers decide to produce computers.

•

Unrest in the Middle East sends the price of gas to $5 a gallon. The rise in the price of gasoline affects drivers’ incentives to buy gasoline and large gas-guzzling cars. Drivers decide to buy less gasoline and fewer large gas-guzzling cars. They also might decide to ride public transportation more often.

Does the decision to make a blockbuster movie mean that some other more desirable activities get fewer resources than they deserve? Is your answer positive or normative? Explain your answer. Making a blockbuster movie means that some other activities get fewer resources. But whether “more desirable” activities get fewer resources than they “deserve” is a normative answer for two reasons. First the question of whether an activity is more desirable or less desirable depends on the person’s judgment and values. Second the determination of whether an activity gets fewer resources than it deserves also involves the normative decision about the quantity of resources an activity deserves. So the answer to the question of whether making a blockbuster movie means that other more desirable activities get fewer resources than they deserve is a normative answer that depends on the student’s values.

Provide two examples of economics being used as a tool by each of a student, a business, and a government. Classify your examples as dealing with microeconomic topics and macroeconomic topics. Students might answer that they use economics as a tool when they budget their student aid and when they decided which college to attend based on the costs of their options. Both instances deal with microeconomics. A business uses economics as a tool when it decides the price it charges for its product and the salaries it pays its managers. Both instanc-

Part 1 . INTRODUCTION

es are microeconomic examples. The government use economics as a tool when it decides whether to increase taxes on cigarettes or lower the interest rate. The first example is microeconomic in nature and the second involves macroeconomics. Use the following news clip to work Problems 9 to 12. Obama will drive up miles-per-gallon requirements Obama’s revision of auto-emission and fuel-economy standards will require automakers to boost fuel economy to 35.5 miles per gallon by 2016, notching up 5% each year from 2012, to limit the amount of carbon dioxide cars can emit. Source: USA Today, May 18, 2009 9. What are two benefits of the new miles-per-gallon requirements? Are these benefits in someone’s self-interest or in the social interest? Two benefits of the new miles-per-gallon requirements are: (1) less gasoline will be used, and (2) carbon emissions will be lowered. Consumers benefit from the new mileage standards because their expenditure on gasoline will decrease which enables them to increase their consumption of some other goods and services. It is also in the social interest because more gasoline, or oil from which gasoline is made, is available for other uses. Lower carbon emissions are in the self-interest of everyone and in the social interest because these emissions cause global warming. 10. What are two benefits of the new auto-emission standards? Two benefits of the new auto-emission standards are: (1) a reduction in carbon emissions, which brings a decrease in the contribution of human activity to global warming and climate change, and (2) cleaner air, which contributes to improved health. 11. What costs associated with the new miles-per-gallon requirements arise from decisions made in self-interest and in the social interest? Automobile producers and buyers make their decisions in pursuit of their self-interest, but boosting gas mileage requires more costly engines, which in turn means the cost of producing automobiles and their prices will rise. President Obama’s decision to impose the new regulations is intended to serve the social interest, so all the costs associated with the new miles-pergallon regulation arise from this decision made in the social interest. 12. What costs associated with the new auto-emission standards arise from decisions made in self-interest and in the social interest? Automobile producers and buyers make their decisions in pursuit of their own self-interest but achieving new emission standards requires more costly engines and emission control technologies, which in turn means the cost of producing automobiles and their prices will rise. President Obama’s decision to impose the new regulations is intended to serve the social interest, so all the costs associated with the new emissions standard regulation arise from this decision made in the social interest.

Chapter 1 . Getting Started

 Multiple Choice Quiz 1.

Which of the following describes the reason why scarcity exists? A. Governments make bad economic decisions. B. The gap between the rich and the poor is too wide. C. Wants exceed the resources available to satisfy them. D. There is too much unemployment. Answer: C Answer C uses the definition of scarcity on page 2. 2.

Which of the following defines economics? Economics is the social science that studies ___________. A. the best way of eliminating scarcity B. the choices made to cope with scarcity, how incentives influence those choices, and how the choices are coordinated C. how money is created and used D. the inevitable conflict between self-interest and the social interest Answer: B Answer B uses the definition of economics on page 2. 3.

Of the three big questions, what, how, and for whom, which of the following is an example of a how question? A. Why do doctors and lawyers earn high incomes? B. Why don’t we produce more small cars and fewer gas guzzlers? C. Why do we use machines rather than migrant workers to pick grapes? D. Why do college football coaches earn more than professors? Answer: C Answer C describes how grapes are picked. 4

Which of the following is not a key idea in the economic way of thinking? A. People make rational choices by comparing costs and benefits. B. Poor people are discriminated against and should be treated more fairly. C. A rational choice is made at the margin. D. Choices respond to incentives. Answer: B Answer B is not part of description of the economic way of thinking on page 8.

Part 1 . INTRODUCTION

A rational choice is ___________. A. the best thing you must forgo to get something B. what you are willing to forgo to get something C. made by comparing marginal benefit and marginal cost D. the best for society Answer: C Answer C is part of description of a rational choice on pages 8 and 9. 6.

Which of the following best illustrates your marginal benefit from studying? A. The knowledge you gain from studying 2 hours a night for a month B. The best things forgone by studying 2 hours a night for a month C. What you are willing to give up to study for one additional hour D. What you must give up to be able to study for one additional hour Answer: C Page 10 shows that answer C is the marginal benefit from studying. 7.

The scientific method uses models to ___________. A. clarify normative disagreements B. avoid the need to study real questions C. replicate all the features of the real world D. focus on those features of reality assumed relevant for understanding a cause and effect relationship Answer: D Answer D uses the definition of an economic model on page 12.

Which of the following is a positive statement? A. We should stop using corn to make ethanol because it is raising the cost of food. B. You will get the most out of college life if you play a sport once a week. C. Competition among cell phone providers across the borders of Canada, Mexico, and the United States has driven roaming rates down. D. Bill Gates ought to spend more helping to eradicate malaria in Africa. Answer: C Answer C is a positive statement because it can, in theory, be tested.

Chapter

Appendix: Making and Using Graphs ANSWERS TO APPENDIX CHECKPOINT

 Study Plan Problems A

2002

803

2004

767

139

2005

620

586

2006

385

1,033

5 Draw a scatter diagram to show the relationship 6 between the quantities sold of compact discs and music videos. Describe the relationship. Figure A1.1 illustrates the relationship of the data from the spreadsheet between the quantities sold of compact discs and the quantities sold of music videos. Over all the period, there appears to be a positive or direct relationship; that is, when more compact discs are sold, more music videos are sold.

2010

226

1,162

2012

211

1,392

The spreadsheet in the table provides data on the U.S. economy: Column A is the year; the other columns are quantities sold in millions per year of compact discs (column B), music videos (column C), and singles downloads (column D). Use this spreadsheet to work Problems 1 and 2. 1.

Part 1 . INTRODUCTION

Draw a time-series graph of quantity of compact discs sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) increased the most, and (d) decreased the most. If the data show a trend, describe it. Figure A1.2 illustrates the time series of the quantity of compact discs sold using the data from the spreadsheet. a. b. c. d.

The quantity sold was the highest in 2002. The quantity sold was the lowest in 2012. The quantity sold never increased. The quantity sold decreased the most between 2006 and 2008 when it decreased by 235 million. Over the entire time period covered in the figure, there is a downward trend in the quantity of compact discs sold.

The following data shows the relationship between two variables x and y. x

Is the relationship between x and y positive or negative? Calculate the slope of the relationship when x equals 2 and when x equals 4. How does the slope change as the value of x increases? The relationship is negative: When x increases, y decreases. The slope of the relationship equals the change in y divided by the change in x along the tangent line; that is, the slope of the relationship at a point equals the slope of the tangent line at that point. When x equals 2, the slope of the tangent line equals –4, so the slope of the relationship equals –4. When x equals 4, the slope of the tangent line equals –8, so the slope of the relationship equals –8. The slope of the relationship increases in magnitude (the line becomes steeper) as x increases.

Appendix 1 . Making and Using Graphs

The table provides data on the Price price of a balloon ride, the tem(dollars perature, and the number of per ride) rides a day. Draw graphs to 5 show the relationship between 10 • The price and the number of 15 rides, when the temperature 20 is 70°F. Figure A1.3 illustrates the relationship between the price and the number of rides when the temperature is 70°F.

Balloon rides (number per day) 50°F

70°F

90°F

32 27 18 10

50 40 32 27

40 32 27 18

• The number of rides and the temperature, when the price is $15 a ride. Figure A1.4 illustrates the relationship between the number of rides and the temperature, when the price is $15 a ride.

Part 1 . INTRODUCTION

 Instructor Assignable Problems Use the information in the table to work Problems 1 and 2. Column A is the year; the other columns are quantities sold in millions per year of compact discs (column B), music videos (column C), and singles downloads (column D). 1.

2002

803

2004

767

139

2006

620

586

4 Draw a scatter diagram to show the relationship between quantities sold of music 5 videos and singles downloads. Describe the 6 relationship. Figure A1.5 illustrates the relationship of the data from the spreadsheet between the quantities sold of music videos and singles downloads. Over all the period, there appears to be a negative or indirect relationship; that is, when fewer music videos are sold, more singles are downloaded.

2008

385

1,033

2010

226

1,162

2012

211

1,392

Appendix 1 . Making and Using Graphs

Draw a time-series graph of the quantity of music videos sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) decreased the most, and (d) decreased the least. If the data show a trend, describe it. Figure A1.6 illustrates the time series of music videos sold using the data from the spreadsheet. a. The quantity sold was the highest in 2004. b. The quantity sold was the lowest in 2010. c. The quantity sold decreased the most between 2004 and 2006 and between 2006 and 2008, when it decreased by 10 million per period. d. Setting aside the periods during which the quantity increased, the quantity sold decreased the least between 2008 and 2010. There is a slight downward trend in the quantity of music videos sold.

Use the following data on the relationship between two variables x and y to work Problems 3 and 4. x

Is the relationship between x and y positive or negative? Explain. The relationship is positive: When x increases, y also increases.

Calculate the slope of the relationship when x equals 2 and x equals 4. How does the slope change as the value of x increases? The slope of the relationship equals the change in y divided by the change in x along the tangent line; that is, the slope of the relationship at a point equals the slope of the tangent line at that point. When x equals 2, the slope of the tangent line equals 4, so the slope of the relationship equals 4. When x equals 4, the slope of the tangent line equals 8, so the slope of the relationship equals 8. The slope of the relationship increases as x increases.

Part 1 . INTRODUCTION

The table provides data on Price the price of hot chocolate, the (dollars temperature, and the number per cup) of cups a week. Draw graphs to show the relationship 2.00 between 2.50 3.00 • The price and the number 3.50 of cups of hot chocolate, when the temperature is constant. Figure A1.7 illustrates the relationship between the price and the number of cups holding constant the temperature. Note that there are three relationships, one for each temperature.

Hot chocolate (number per week) 50°F

70°F

90°F

40 30 20 10

30 20 10 0

20 10 0 0

• The temperature and the number of cups of hot chocolate, when the price is constant. Figure A1.8 illustrates the relationship between the number of cups and the temperature, holding constant the price. Note that there are four relationships, one for each price.

The U.S. and Global Economies ANSWERS TO CHAPTER CHECKPOINT

 Study Plan Problems and Applications 1.

Explain which of the following items are not consumption goods and services: • A chocolate bar A chocolate bar is a consumption good. • A ski lift A ski lift is not a consumption good. It is capital that produces a service for skiers. • A golf ball A golf ball is a consumption good. 2. Explain which of the following items are not capital goods: • An auto assembly line An auto assembly line is a capital good. • A shopping mall A shopping mall is a capital good. • A golf ball A golf ball is not a capital good. It is a consumption good. 3. Explain which of the following items are not factors of production: • Vans used by a baker to deliver bread Vans used to deliver bread are capital, so they are factors of production. • 1,000 shares of Amazon.com stock 1,000 shares of Amazon.com stock are not a factor of production. The shares represent partial ownership of Amazon.com and therefore are financial capital. • Undiscovered oil in the Arctic Ocean Undiscovered oil is not a factor of production because it is not used to

Chapter

Part 1 . INTRODUCTION

produce goods or services. Once it is discovered, it will become a factor of production. Which factor of production earns the highest percentage of total U.S. income? Define that factor of production. What is the income earned by this factor of production called? Labor earns by far the largest percentage of total U.S. income, 69 percent of total income in 2011. Labor consists of the work time and the work effort that people devote to producing goods and services. The income earned by labor is a wage.

With more job training and more scholarships to poor American students, which special factor of production is likely to grow faster than in the past? As more people go to school and/or receive job training, the nation’s human capital will grow more rapidly. Human capital is the knowledge and skills people obtain from education, on-the-job training, and work experience. With more job training and more scholarships, human capital will grow more rapidly.

Define the factor of production called capital. Give three examples of capital, different from those in the chapter. Distinguish between the factor of production capital and financial capital. Capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that businesses now use to produce goods and services. Capital includes railroad engines and cars, servers, and ATMs. The factor of production “capital” is the actual good itself; “financial capital,” such as stocks and bonds, are the funds that provide businesses with their financial resources which can be used to acquire capital goods.

A Job Creation through Entrepreneurship Act, debated in the House of Representatives in 2009, would award grants to small business owners, some of which would be aimed at women, Native Americans, and veterans. The Act would provide $189 million in 2010 and $531 million between 2010 and 2014. Explain how you would expect this Act to influence what, how, and for whom goods and services are produced in the United States. The answer to the what question would change because more of the goods and services produced by the groups receiving the grants—small business owners, particularly women, Native Americans, and veterans—would be produced. If these groups of producers produced their goods and services using different technologies than the rest of the producers, then the question of how goods and services would change. For whom goods and services are produced would change because the producers receiving the © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

subsidies would have larger profits and therefore be able to buy more of the goods and services produced. 8.

Indicate on a graph of the circular flow model, the real and/or money flow in which the following items belong: • You buy a coffee at Starbucks. In Figure 2.1 the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors of production. If you buy a coffee at Starbucks, your expenditure is a money flow from households to the goods market, labeled a in the figure. • The government buys some computers. The purchase of computers by the government represents a flow of computers from the goods market to the government, labeled b in the figure. • A student works at Kinko. The student working at Kinko is a factor of production, so the flow is a flow of the services of factor of production from households to the factor markets, labeled c in the figure. • Donald Trump rents a Manhattan building to a hotel. Donald Trump’s building in Manhattan is a factor of production, so the flow is the services from this factor of production from households to the factor markets, labeled d in the figure. • You pay your income tax. Your income tax payment is a money flow from households to the government and is labeled e in the figure.

Part 1 . INTRODUCTION

For-profit colleges may face aid cuts The Obama administration proposes a new rule: Federal aid to for-profit colleges will be cut if students in vocational programs graduate without a degree. Millions of low-income students are borrowing heavily to attend colleges and too many of them are dropping out, and failing to get a job. Source: USA Today, June 2, 2011 How do you think the personal distribution of income would change if all graduates could obtain a well-paying job that uses their knowledge gained in college? The personal distribution of income would become more equal. As it is now, students who graduate from colleges with worthless degrees have little human capital and have low incomes. If these students had acquired more human capital and a worthwhile degree, their incomes would be higher. When the incomes rise of initially low-income people, the personal distribution of income becomes more equal. 10. Read Eye on the Dreamliner on p. 41 and then answer the following questions: • How many firms are involved in the production of the Dreamliner and how many are identified in the figure on p. 41? Over 400 firms are involved in the production of the Dreamliner. Only 15 of them are identified in the figure. • Is the Dreamliner a capital good or a consumption good? Explain why? The Dreamliner is a capital good because it will be used to produce services (airline travel) throughout many future years. • State the factors of production that make the Dreamliner and provide an example of each. All the factors of production—land, labor, capital, and entrepreneurship—are used to make the Dreamliner. The copper used for wiring is an example of the land used; the engineer who helped design the landing gear is an example of labor; the huge cranes that lift the various pieces of the Dreamliner to assemble them is an example of capital; and the creative and imaginative input of Boeing’s top managers who organize the resources used to produce the Dreamliner exemplify entrepreneurship. • Explain how the production of the Dreamliner influences what, how, and for whom, goods and services are produced. Dreamliner influences “what” goods and services are produced by creating a demand for components manufactured around the world. It influences “how: goods are produced because Boeing and the other © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

•

400 firms all determine the best way to produce each particular part of the Dreamliner. It influences “for whom” because factors of production employed to make the Dreamliner receive income from this production, thereby increasing the quantity of goods and services they can purchase. Use a graph to show where in the circular flow model of the global economy the flows of the components listed on p. 41 appear and where the sales of Dreamliners appear. Except for the components built in the United States, spending on the other components appear in the flow of expenditure on U.S. imports. Sales of Dreamliners appear in the flow of expenditure on U.S. exports.

Part 1 . INTRODUCTION

 Instructor Assignable Problems and Applications 1.

Boeing’s Dreamliner has had a rocky start. • Why doesn’t Boeing manufacture all the components of the Dreamliner at its own factory in the United States? Boeing wants to manufacture the Dreamliner at the lowest possible cost. It would be more expensive for Boeing to manufacture Dreamliners at its own factory in the United States because Boeing does not have the expertise possessed by its subcontractors and because the wages Boeing pays U.S. workers exceed the wages its subcontractors pays their workers. • Describe some of the changes in what, how, and for whom, that would occur if Boeing manufactured all the components of the Dreamliner at its own factories in the United States. If Boeing manufactured all the components of the Dreamliner at its own factories in the United States, more components would be produced in the United States and more capital would have been used in their production. U.S. workers and investors would have received higher incomes but the Dreamliner would cost more to produce so Boeing would have earned a lower profit. • State some of the tradeoffs that Boeing faces in making the Dreamliner. Boeing faced a huge number of tradeoffs. For example, when designing the plane, Boeing’s engineers had to make decisions about fuel economy and passenger load. Increasing the passenger load decreased fuel economy, so the engineers traded passenger load for fuel economy. Another example revolves around the construction of the Dreamliner. Boeing could have constructed the plane using just a few companies but instead it used over 400. Boeing was trading off the simplicity of dealing with just a handful of companies for the increased specialization by dealing with many specialized companies. • Why might Boeing’s decisions in making the Dreamliner be in the social interest? Building the Dreamliner itself advances the social interest because it increases the quantity of comfortable, rapid transportation. The amount of high-quality transportation available in the economy increases, which benefits society. The decisions in making the Dreamliner advance the social interest because they were designed to make the Dreamliner at low cost and thereby avoid wasting resources. 2. The global economy has three cell-phone users for every fixed line user. Two in every three cell-phone users lives in a developing nation and the © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

growth rate is fastest in Africa. In 2000, 1 African in 50 had a cell phone; in 2009, it was 14 in 50. Describe the changes in what, how, and for whom telecommunication services are produced in the global economy. What: As the number of cell phone users increases, the global economy has been producing more cell phone telecommunication services. More cell phones are produced, fewer land phones are produced, and presumably more cell phone frequencies are used. How: More telecommunication services are being produced using cell phones rather than fixed-line phones. For whom: While the amount of telecommunication services has been rising throughout the world, it definitely has been increasing rapidly in Africa. So more telecommunication services are being produced for residents of Africa as well as for residents in the rest of the world. 3.

Which of the entries in the list are conList sumption goods and services? Explain your An interstate highway choice. An airplane A pack of bubble gum and a movie are A school teacher consumption goods. They are purchased A stealth bomber by consumers. A garbage truck Which of the entries in the list are capital A pack of bubble gum goods? Explain your choice. President of the United States An airplane, a garbage truck, and an ATM A strawberry field are capital goods. All provide services to A movie produce other goods and services. The inAn ATM terstate highway and the stealth bomber also are capital goods. They also provide services (transportation and defense) that help produce other goods and services.

Which of the entries in the list are factors of production? Explain your choice. An interstate highway, an airplane, a school teacher, a stealth bomber, a garbage truck, the President of the United States, a strawberry field, and an ATM are factors of production. A school teacher and the President are labor; an interstate highway, an airplane, a stealth bomber, a garbage truck, and an ATM are capital; and, a strawberry field is land.

In the African nation of Senegal, to enroll in school a child needs a Birth Certificate that costs $25. This price is several weeks’ income for many families. Explain how this requirement is likely to affect the growth of human capital in Senegal. Human capital growth depends, in part, on the extent of schooling: More schooling means more human capital. Because of Senegal’s hefty fee for a © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

required Birth Certificate, fewer children will enroll in school, thereby decreasing Senegal’s human capital growth. 7.

China’s prosperity brings income gap The Asian Development Bank [ADB] reports that China has the largest gap between the rich and the poor in Asia. Ifzal Ali, the ADB’s chief economist, claims it is not that the rich are getting richer and the poor are getting poorer, but that the rich are getting richer faster than the poor. Source: Financial Times, August 9, 2007 Explain how the distribution of personal income in China can be getting more unequal even though the poorest 20 percent are getting richer. The distribution of income in China can be getting more unequal even when the poorest 20 percent are getting richer because the richest 20 percent are getting richer even faster. Because the rich are getting richer faster, the fraction of the nation’s total income received by the poorest 20 percent falls, which makes the personal distribution of income more unequal.

Compare the scale of agricultural production in the advanced and developing economies. In which is the percentage higher? In which is the total amount produced greater? Agricultural is a small part of total production in advanced economies. It is a much larger part in developing economies. Even though advanced economies devote only a small part of their total production to agriculture, they still produce about one third of the world’s total production of food. The remaining two thirds is produced in the developing nations.

Chapter 2 . The U.S. and Global Economies

On a graph of the circular flow model, indicate in which real or money flow each entry in the list belongs. • General Motors’ pays its workers wages. General Motors wage payment is a money flow that is a payment for use of the services of a factor of production and so flows out of the factor market to households (it flowed into the factor market from General Motors, a firm). In Figure 2.3 the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors. The flow of wage payments to households is labeled a in the figure in Figure 2.3. • IBM pays a dividend to its stockholders. IBM’s dividend payment is a money flow that is a payment for use of the services of a factor of production and so flows out of the factor market to households (it flowed into the factor market from IBM, a firm). The flow to households is labeled b in the figure. • You buy your groceries. Your purchase of groceries represents a money flow from households to the goods market, labeled c in the figure. • Chrysler buys robots. The robots are factors of production, so the flow is the services from these factors of production from the factor markets to firms, labeled d in the figure. • Southwest rents some aircraft. The aircraft are factors of production, so the flow is the services from

Part 1 . INTRODUCTION

these factors of production from the factor markets to firms, labeled e in the figure. • Nike pays Roger Federer for promoting its sports shoes. Roger Federer is a factor of production, so the flow is a money flow from the factor markets to households in exchange for Mr. Federer’s services of promoting the sports shoes. The flow is labeled f in the figure. Use the following information to work Problems 10 and 11. Poor India makes millionaires at fastest pace India, with the world’s largest population of poor people, also paradoxically created millionaires at the fastest pace in the world. Millionaires increased by 22.7 percent to 123,000. In contrast, the number of Indians living on less than a dollar a day is 350 million and those living on less than $2 a day is 700 million. In other words, there are 7,000 very poor Indians for every millionaire. Source: The Times of India, June 25, 2008 10. How is the personal distribution of income in India changing? If the number of millionaires is growing more rapidly than the number of other income groups, it will be the case that the personal distribution of income in India is becoming less equally distributed. 11. Why might incomes of $1 a day and $2 a day underestimate the value of the goods and services that these households actually consume? The people living on $1 and $2 a day probably grow a lot of their food and produce a lot of their clothing and shelter. If these goods and services are not taken into account, their share of goods and services is understated. Including them raises the value of the goods and services these households actually consume.

Chapter 2 . The U.S. and Global Economies

 Multiple Choice Quiz 1.

Which of the following classifications is correct? A. City streets are consumption goods because they wear out with use. B. Stocks are capital goods because when people buy and sell them they make a profit. C. The coffee maker in the coffee shop at an airport is a consumption good because people buy the coffee it produces. D. White House security is a government service because it is paid for by the government.. Answer: D Answer D is correct. 2.

Which of the following statements about U.S. production is correct? A. Construction accounts for a larger percentage of total production than does manufacturing. B. Real estate services account for 12.6 percent of the value of total production, larger than any other item of services or goods. C. Consumption goods and services represent 85 percent of U.S. production by value and that percentage doesn’t fluctuate much. D. The manufacture of goods represents more than 50 percent of total production. Answer: C Answer C is correct as the data on page 32 show. 3.

Which of the following items is not a factor of production? A. An oil rig in the Gulf of Mexico B. A ski jump in Utah C. A bank loan to a farmer D. An orange grove in Florida Answer: C Answer C is not a factor of production because it is financial capital; see page 35. 4.

What is human capital? A. Immigrant labor B. Someone who operates heavy equipment C. Your professor’s knowledge of the economy D. A car assembly line robot Answer: C Answer C uses the definition of human capital on page 35.

Part 1 . INTRODUCTION

Which of the following statements is correct? A. Labor earns wages and entrepreneurship earns bonuses. B. Land earns interest and capital earns rent. C. Entrepreneurship earns interest and capital earns profit. D. Capital earns interest and labor earns wages. Answer: D Page 37 shows that answer D is correct. 6.

How are goods and services produced in the global economy? A. Developing countries use less human capital but just as much physical capital as advanced economies. B. Emerging economies use more capital-intensive technology than do developing economies. C. Human capital in all economies is similar. D. Advanced economies use less capital than developing economies. Answer: B Developing countries have less capital than emerging economies. 7.

In the circular flow model, which of the following items is a real flow? A. The flow of government expenditures to firms for the goods bought B. The flow of income from firms to households for the services of the factors of production hired C. The flow of U.S. borrowing from the rest of the world D. The flow of labor services from households to firms Answer: D Answer D is a real flow because it is a labor service.

The Economic Problem

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

The table shows the quantities of corn and beef that a farm Corn can produce in a year. Draw a graph of the farm’s PPF. Mark (bushels) on the graph: 250 200 • An inefficient combination of corn and beef—label this 100 point A. 0 • An unattainable combination of corn and beef—label this point B. • An efficient combination of corn and beef—label this point C. The production possibilities frontier is illustrated in Figure 3.1. Any production point in the interior of the PPF, such as the point marked A, is an inefficient combination of corn and beef. Any production point beyond the PPF, such as the point marked B, is an unattainable combination of corn and beef. Any production point on the PPF, such as the point marked C is a production efficient combination of corn and beef.

Beef (pounds) and and and and

0 300 500 600

Part 1 . INTRODUCTION

Use the following information to work Problems 2 and 3. The people of Leisure Island have 50 hours of Entertainment labor a day that can be used to produce enterLabor (units) tainment and good food. The table shows the 0 0 or 10 20 or maximum quantity of either entertainment or 20 40 or good food that Leisure Island can produce 30 60 or with different quantities of labor. 40 80 or 50 100 or 2. Is an output of 50 units of entertainment and 50 units of good food attainable and efficient? With a production of 50 units of entertainment and 50 units of good food, do the people of Leisure Island face a tradeoff? Producing 50 units of good food and 50 units of entertainment is attainable. However, at this production point, Leisure Island’s resources are not fully employed or are misallocated. They are producing within their PPF. As a result, the people of Leisure Island do not face a tradeoff—they can produce more entertainment or good food at no opportunity cost. 3.

What is the opportunity cost of producing an additional unit of entertainment? Explain how the opportunity cost of producing a unit of entertainment changes as more entertainment is produced. If production is initially within the PPF, the opportunity cost of an additional unit of entertainment is zero. If production is on the PPF there is an opportunity cost of producing a unit of entertainment because good food must be forgone. At that point, the opportunity cost while moving along the PPF equals the loss in good food produced divided by the gain in entertainment produced. Once on the PPF, as more entertainment is produced, the opportunity cost of an additional unit increases.

Use the following information to work Problems 4 and 5. Malaria can be controlled The World Health Organization’s malaria chief says that it is too costly to try to fully eradicate the disease. He says that by using nets, medicine, and DDT it is possible to eliminate 90 percent of malaria cases. But to eliminate 100 percent of cases would be extremely costly. Source: The New York Times, March 4, 2008 4. Make a graph of the production possibilities frontier with malaria control on the x-axis and other goods and services on the y-axis. Figure 3.2 (on the next page) shows the PPF. 5.

Describe how the opportunity cost of controlling malaria changes as more resources are used to reduce the number of malaria cases. As more resources are used to control malaria, the opportunity cost increases. Indeed, the malaria chief indicated that the opportunity cost of eliminating the last 10 percent of malaria would have an extremely high © 2015 Pearson Education, Inc.

Good food (units) 0 30 50 60 65 67

Chapter 3 . The Economic Problem

opportunity cost. This conclusion is shown in the PPF diagram by the very steep PPF between 90 percent elimination and 100 percent elimination.

Explain how the following events influence U.S. production possibilities: • Some retail workers are re-employed building dams and wind farms. When these former retail workers are re-employed at their new occupations, more dams and wind farms are produced and fewer retail services are produced. The opportunity cost of the increased numbers of dams and wind farms is the forgone production of retail services. There is a movement along the PPF. • More people take early retirement. As more people retire, the quantity of labor available in the economy shrinks. As a result, the nation’s PPF shifts inward. • Drought devastates California’s economy. The nation’s PPF shifts inward as a result of the drought. The drought decreases the amount of productive land, thereby decreasing production of agricultural products and shifting the PPF inward. Use the following information to work Problems 7 and 8. Figure 3.3 (on the next page) shows Tom’s production possibilities and Figure 3.4 (on the next page) shows Abby’s production possibilities. Tom uses all his resources and produces 2 rackets and 20 balls an hour. Abby uses all her resources and produces 2 rackets and 40 balls an hour. 7. What is Tom’s opportunity cost of producing a racket? What is Abby’s opportunity cost of a racket? Who has a comparative advantage in producing rackets? Who has a comparative advantage in producing balls? If Tom increases his production by 1 racket, he forgoes 10 balls. So his opportunity cost of 1 racket is 10 balls ÷ 1 racket, or 10 balls per racket. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

If Abby increases her production by 1 racket, she forgoes 20 balls. So her opportunity cost of 1 racket is 20 balls ÷ 1 racket, or 20 balls per racket. Tom has the comparative advantage in producing rackets. Tom’s opportunity cost of a racket is 10 balls per racket and Abby’s opportunity cost of a racket is 20 balls per racket. Abby has the comparative advantage in producing balls. Tom’s opportunity cost of a ball is 0.10 rackets per ball and Abby’s opportunity cost of a ball is 0.05 rackets per ball. 8.

If Tom and Abby specialize and trade 15 balls for 1 racket, what are the gains from trade? Both Tom and Abby gain from their specialization and trade. Tom could produce 4 rackets and then trade 2 of the rackets for 30 balls. Tom would wind up with 2 rackets and 30 balls, 10 more balls than he had without the specialization and trade. Abby could produce 80 balls and then trade 30 of them for 2 rackets. Abby would wind up with 2 rackets and 50 balls, also 10 more balls than she had without the specialization and trade.

Read Eye on the Environment on p. 66 and describe a tradeoff faced when deciding how to generate electricity and whether to use wind power. Using wind power to generate electricity requires that the wind turbines be located in areas with wind which often are not near population centers. Long transmission lines are required which means transmissions losses are large. If other sources are used to generate power, long transmission lines are not necessary and smaller generating facilities are required because transmissions losses are less. If wind power is used to generate power, more resources are used and fewer other goods can be produced. © 2015 Pearson Education, Inc.

Chapter 3 . The Economic Problem

 Instructor Assignable Problems and Applications Use the following information to work Problems 1 to 4. Representatives Waxman of California and Markey of Massachusetts proposed a law to limit greenhouse gas emissions from electricity generation and require electricity producers to generate a minimum percentage of power using renewable fuels, with some emission rights to be auctioned. The Congressional Budget Office estimated that the government would receive $846 billion from auctions and would spend $821 billion on incentive programs and compensation for higher energy prices. Electricity producers would spend $208 million a year to comply with the new rules. (Think of these dollar amounts as dollars’ worth of other goods and services.) 1. Would the Waxman-Markey law achieve production efficiency? Production efficiency requires producing on the PPF. Use a PPF showing the tradeoff between electricity and clean air. Production efficiency requires producing on the PPF so that gaining more clean air means giving up some electricity. Before the new law, production might have been on the PPF if the producers had used the most efficient technologies and taken account of the pollution they created. After the law is in place, production might be within the PPF if the law requires more production of energy from renewable sources than is production efficient. 2.

Is the $846 billion that electricity producers would pay for the right to emit greenhouse gasses part of the opportunity cost of producing electricity? To the extent that the $846 billion pays for the cost that greenhouse gasses impose on society (by way of forgone production of other goods and services), the $846 billion is part of the opportunity cost of generating electricity.

Is the $821 billion that the government would spend on incentive programs and compensation for higher energy prices part of the opportunity cost of producing electricity? The incentive programs change what electricity providers buy in order to produce electricity with lower emissions. The goods and services forgone are the opportunity cost of these programs. Compensation for higher energy prices is a transfer payment from taxpayers to consumers. Nothing is forgone and so it is not an opportunity cost.

Is the $208 million that electricity producers will spend to comply with the new rules part of the opportunity cost of producing electricity? The $208 million is part of the opportunity cost of producing electricity because it represents the purchase of goods and services necessary to produce electricity.

Part 1 . INTRODUCTION

The people of Foodland have 40 hours of Bread labor a day to bake pizza and bread. The Labor Pizzas (loaves) 0 0 or 0 table shows the maximum quantity of 10 30 or 10 either pizza or bread that Foodland can 20 50 or 20 bake with different quantities of labor. 30 30 60 or Can Foodland produce 30 pizzas and 30 40 65 or 40 loaves of bread a day? If it can, is this output efficient, do the people of Foodland face a tradeoff, and what is the opportunity cost of producing an additional pizza? Producing 30 pizzas and 30 loaves of bread is attainable and efficient. There is a tradeoff because the nation is operating on its production possibilities frontier. As a result, if the production of pizza increases, less bread can be produced and if the production of bread increases, less pizza can be produced. For the nation to produce 20 more pizzas requires 10 more hours of labor devoted to making pizza, which means 10 fewer hours devoted to making bread. Foodland gives up 10 loaves of bread. The opportunity cost of another pizza equals the loaves of bread forgone, 10 loaves, divided by the pizzas obtained, 20 pizzas, or 10 loaves of bread ÷ 20 pizzas, or 1/2 of a loaf of bread per pizza. Use the table, which shows a farm’s production Soybean Chicken (bushels (pounds possibilities, to work Problems 6 and 7. per year) per year) 6. If the farm uses its resources efficiently, what is the 500

and

opportunity cost of an increase in chicken production 400 and from 300 pounds to 500 pounds a year? Explain your 200 and 0 and answer. If the farm expands chicken production from 300 pounds to 500 pounds, soybean production decreases from 400 to 200 bushels. The opportunity cost of the additional 200 pounds of chicken is 200 bushels of soybean, or 1 bushel of soybeans per pound of chicken. 7.

If the farm adopted a new technology, which allows it to use fewer resources to fatten chickens, explain how the farm’s production possibilities will change. Explain how the opportunity cost of producing a bushel of soybean will be affected. The farm’s PPF rotates outward; the maximum quantity of soybeans (500 bushels) does not change but the maximum quantity of chicken increases. The opportunity cost of a bushel of soybeans increases because more chicken must be given up to produce additional soybeans.

In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. Who has a comparative advantage in producing caps? If Sue and Tessa specialize and trade, who will gain? Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of pro© 2015 Pearson Education, Inc.

0 300 500 550

Chapter 3 . The Economic Problem

ducing one cap is (4 jackets) ÷ (40 caps) or 0.1 jackets per 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 jackets per cap. Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps. If Tessa specializes in caps and Sue specializes in jackets, both Sue and Tessa gain from trade. For instance, suppose they settle upon a price of 1 jacket for 15 caps. 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. Use the following information to work Problems 9 to 11. Cheap broadband’s a winner Inexpensive broadband access has created a new generation of television producers and the Internet is their native medium. Source: The New York Times, December 2, 2007 9. How has inexpensive broadband changed the production possibilities of video entertainment and other goods and services? Inexpensive broadband means that the production video entertainment increases when all resources are used for this purpose. It does not change the production of other goods and services when all resources are used for that purpose. 10. Sketch a PPF for video entertainment and other goods and services before broadband. As illustrated in Figure 3.5 by the production possibilities frontier labeled “Initial PPF,” the PPF has video entertainment on one axis and other goods and services on the other. The PPF is bowed outward as a conventional PPF. 11. Explain how the arrival of inexpensive broadband has changed the PPF. The arrival of inexpensive broadband shifts the PPF outward as shown by the change from the initial PPF to the new PPF in Figure 3.5. 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.

Part 1 . INTRODUCTION

 Multiple Choice Quiz 1.

The table shows the PPF of an island communiFish Berries ty. Choose the best statement. Possibility (pounds) (pounds) A. This community has enough resources to A 0 and 40 B 1 and 36 produce 2 pounds of fish and 36 pounds of C 2 and 30 berries. D 3 and 22 B. This community cannot produce 2 pounds of E 4 and 12 fish and 36 pounds of berries because this F 5 and 0 combination is inefficient. C. This community will waste resources if it produces 2 pounds of fish and 22 pounds of berries. D. This community can produce 2 pounds of fish and 30 pounds of berries but this combination is inefficient. Answer: C The production point is inside the PPF and so is inefficient. 2.

The table above shows the PPF of an island community. Choose the best statement. A. Suppose that this community produces 3 pounds of fish and 20 pounds of berries. If it decides to gather more berries, it faces a tradeoff. B. When this community produces 4 pounds of fish and 12 pounds of berries it faces a tradeoff, but it is inefficient. C. Suppose that this community produces 5 pounds of fish and 0 pounds of berries. If it decides to gather some berries, it will get a free lunch. D. If this community produces 3 pounds of fish and 22 pounds of berries, production is efficient but to produce more fish it faces a tradeoff. Answer: D The production point is on the PPF so production is efficient and there is a tradeoff when more fish are produced. 3.

The table above shows the PPF of an island community. This community’s opportunity cost of producing 1 pound of fish ______. A. is the increase in the quantity of berries gathered as the quantity of fish increases by 1 pound B. increases as the quantity of berries gathered increases C. is 10 pounds of berries if the quantity of fish increases from 2 to 3 pounds D. increases as the quantity of fish caught increases Answer: D Page 66 discusses why opportunity increases as production of the good increases. © 2015 Pearson Education, Inc.

Chapter 3 . The Economic Problem

The table above shows the PPF of an island community. Choose the best statement. A. When a drought hits the island, its PPF shifts outward. B. When the islanders discover a better way of catching fish, the island’s PPF shifts outward. C. When islanders reduce the time they spend gathering berries, the PPF shifts inward. D. If the islanders decide to spend more time gathering berries but continue to spend the same amount of time fishing, they face a tradeoff. Answer: B Page 68 shows that technological progress, such as exemplified in answer B, shifts the PPF outward. 5.

Mary makes 10 pies and 20 cakes a day and her opportunity cost of producing a cake is 2 pies. Tim makes 20 pies and 10 cakes a day and his opportunity cost of producing a cake is 4 pies. If Mary and Tim specialize in the good in which they have a comparative advantage ______. A. Mary produces pies B. Tim produces pies and cakes C. Mary produces cakes while Tim produces pies D. Tim produces cakes while Mary produces pies Answer: C Answer C is correct because Mary has the lower opportunity cost of making a cake.

Chapter

Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

Explain how each of the following events changes the demand for or supply of air travel. • Airfares tumble, while long-distance bus fares don’t change. A change in the price of airfares does not change either the demand for or the supply of air travel. (It changes the quantity demanded and the quantity supplied of air travel.) •

The price of jet fuel rises. The rise in the price of jet fuel decreases the supply of air travel because it raises the cost of producing air travel.

•

Airlines reduce the number of flights each day. The reduction in the number of flights decreases the supply of air travel.

•

People expect airfares to increase next summer. The current demand for air travel increases when people expect airfares to increase next summer because people fly now, when airfares are relatively cheaper, rather than next summer.

•

The price of train travel falls. Train travel is a substitute for air travel. So a fall in the price of train travel decreases the demand for air travel.

•

The price of a pound of air cargo increases. Transporting cargo by air is a substitute in production for transporting people by air. So the rise in the price of air cargo decreases the supply of air travel for people.

Use the laws of demand and supply to explain whether the statements in Problems 2 and 3 are true or false. In your explanation, distinguish between a change in demand and a change in the quantity demanded and between a change in supply and a change in the quantity supplied. 2. The United States does not allow oranges from Brazil (the world’s largest

Part 1 . INTRODUCTION

producer of oranges) to enter the United States. If Brazilian oranges were sold in the United States, oranges and orange juice would be cheaper. The statement is true. Allowing Brazilian oranges into the United States increases the supply of oranges and the supply curve shifts rightward. The equilibrium price of an orange falls and the equilibrium quantity increases. The quantity of oranges demanded increases and there is a movement down along the demand curve. Oranges are a resource used in the production of orange juice. When the price of an orange falls, it costs less to produce orange juice and the supply of orange juice increases. The quantity of orange juice demanded increases and there is a movement down along the demand curve. The equilibrium price of orange juice falls and the equilibrium quantity increases. 3.

If the price of frozen yogurt falls, the quantity of ice cream consumed will decrease and the price of ice cream will rise. The statement is false. Frozen yogurt and ice cream are substitutes for consumers. When the price of frozen yogurt falls, people substitute frozen yogurt for ice cream. The demand for ice cream decreases and the demand curve shifts leftward. The equilibrium quantity of ice cream decreases but the equilibrium price of ice cream falls. There is a change in the quantity of ice cream supplied and a movement down along the supply curve.

The table shows the demand and supPrice Quantity Quantity ply schedules for running shoes. What (dollars demanded supplied per pair) is the market equilibrium? If the price (pairs per day) 60 1,000 400 is $70 a pair, describe the situation in 70 900 500 the market. Explain how market equi80 800 600 librium is restored. If a rise in income 90 700 700 increases the demand for running 100 600 800 shoes by 100 pairs a day at each price, 110 500 900 explain how the market adjusts to its new equilibrium. The market equilibrium occurs at a price of $90 a pair and 700 pairs of running shoes a day. At the price of $90 a pair, the quantity demanded equals the quantity supplied. If the price is $70 a pair, the quantity demanded is 900 pairs and the quantity supplied is 500 pairs. There is a shortage of 400 pairs a day and the price rises. As the price rises, the quantity demanded decreases, the quantity supplied increases, and the shortage decreases. The price rises until the shortage disappears.

Chapter 4 . Demand and Supply

The table shows the new demand Price New Quantity Quantity schedule after the increase in income (dollars demanded supplied per pair) has increased the quantity demanded by (pairs per day) 60 1,100 400 100 pairs of shoes at each price. At the 70 1,000 500 original equilibrium price of $90 a pair, 80 900 600 there is a shortage and the price rises. 90 800 700 As the price rises, the quantity demand100 700 800 ed decreases, the quantity supplied in110 600 900 creases, and the shortage decreases. The price rises until the shortage disappears. The price rises to $95 a pair and the quantity increases to 750 pairs of running shoes a day. 5.

“As more people buy fuel-efficient hybrid cars, the demand for gasoline will decrease and the price of gasoline will fall. The fall in the price of gasoline will decrease the supply of gasoline.” Is this statement true? Explain. The first statement is correct. As more people buy fuel-efficient cars, the demand for gasoline will decrease. The price of gasoline will fall. The second statement is false. The demand for gasoline decreases and the demand curve shifts leftward. There is a movement along the supply curve and a decrease in the quantity of gasoline supplied but no change in supply.

OPEC deadlocked on oil production hike Oil prices exceeded the $100-a-barrel mark Wednesday after OPEC said it could not reach an agreement about raising crude production. Source: CNN Money, June 8, 2011 Suppose that OPEC members had agreed to increase production. Use a graph of the oil market to show the effect of this decision on the market equilibrium. The market initially is in equilibrium in Figure 4.1 with demand curve D and supply curve S0. The initial equilibrium price is $105 per barrel of oil and the initial equilibrium quantity is 120 million barrels per day. If OPEC agreed to increase the supply, the supply curve shifts rightward, as illustrated in Figure 4.1 by the shift from S0 to S1. In the figure the price of a barrel of oil falls from $105 per barrel to $90 per barrel and the quantity increases from 120 million barrels per day to 150 million barrels per day.

Part 1 . INTRODUCTION

Use the following information to work Problems 7 and 8. Pricier bread and cereal. Coming soon? Wheat and corn prices surged last week and could hit the items in your grocery basket by mid-summer. It’s a case of two extremes: drought in parts of the United States and in Europe have sparked fears of a supply crunch of wheat, while supplies of corn are being threatened by flooding and heavy rain in the Midwest. Source: CNN Money, May 19, 2011 7. Explain why the drought will lead to a rise in the price of bread. The drought decreases the supply of wheat. The price of wheat rises. Wheat is used to produce bread. The higher price of wheat increases the cost of producing bread. The supply of bread decreases, which raises the price of bread. 8.

Use graphs to show why the price of corn has risen and show its effect on the price of cereals. The drought decreases the supply of corn. In Figure 4.2, the supply curves shifts leftward from S0 to S1. The price of corn rises, in the figure from $5.90 per bushel to $6.10 per bushel. Corn is used to produce cereal. The higher price of corn increases the cost of producing cereal. The supply of cereal decreases, shown in Figure 4.3 by the leftward shift from S0 to S1. The price of cereal rises, in the figure from $2.30 per pound to $2.50 per pound.

Chapter 4 . Demand and Supply

Read Eye on Tuition on p. 1017 and explain how we know that tuition has risen because the demand for college places has increased and not because the supply has decreased? We know that the demand has risen because the quantity of students attending college has increased. If the higher tuition was the result of a decrease in supply, the number of students attending college would have decreased.

Part 1 . INTRODUCTION

 Instructor Assignable Problems and Applications 1.

Why can we be confident that the market for college education is competitive and that an increase in demand rather than the greed of college administrators is the reason for the ongoing rise in tuition? There are over 4,500 public, private, 2-year and 4-year schools in the United States. Even if college administrators were greedy, the fact that there are thousands of other colleges with whom they compete keeps their greed from affecting the tuition they charge. If one greedy administrator raised the tuition at his or her college, a large number of students would switch to other colleges whose administrators had not raised the tuition.

What is the effect on the equilibrium price and equilibrium quantity of orange juice if the price of apple juice decreases and the wage rate paid to orange grove workers increases? Apple juice and orange juice are substitutes for consumers, so the fall in the price of apple juice decreases the demand for orange juice. The demand curve for orange juice shifts leftward. The increase in the wage rate paid to orange grove workers raises the cost of producing oranges and thereby boosts the cost of producing orange juice. The supply of orange juice decreases and the supply curve of orange juice shifts leftward. The net effect of these events decreases the equilibrium quantity but has an undetermined effect on equilibrium price. If supply decreases by more than the demand decreases, the equilibrium price rises. If demand decreases more than the supply decreases, the equilibrium price falls. And if they decrease by the same amount, the equilibrium price does not change.

What is the effect on the equilibrium in the orange juice market if orange juice becomes more popular and a cheaper robot is used to pick oranges? Because orange juice becomes more popular, demand increases and the demand curve for orange juice shifts rightward. The cheaper picking robot lowers the production costs of orange juice, so the supply of orange juice increases and the supply curve of orange juice shifts rightward. The equilibrium quantity increases. But the effect on the equilibrium price is ambiguous. If the increase in supply is greater than the increase in demand, the equilibrium price falls. If the increase in demand is greater than the increase in supply, the equilibrium price rises. And if the increase is the same size, then the equilibrium price does not change.

4. Rain falls on wheat parade The price of wheat has fallen from $9 a bushel to $7 a bushel in the past seven months as rain and snow fell on the southern states. Source: The Wall Street Journal, February 12, 2013 Explain the effect of the fall in the wheat price on the market for cereals. Wheat is a key ingredient in many cereals. The fall in the price of wheat

Chapter 4 . Demand and Supply

means that the cost of producing cereal based on wheat has fallen. The fall in the cost increases the supply, thereby shifting the supply curve rightward. The price of cereal falls and the quantity increases. The table shows the demand and supply Price Quantity Quantity schedules for boxes of chocolates in an av(dollars demanded supplied per box) erage week. Use this information to work (boxes per week) 13.00 1,600 1,200 Problems 5 and 6. 14.00 1,500 1,300 5. If the price of chocolates is $17.00 a 15.00 1,400 1,400 box, describe the situation in the mar16.00 1,300 1,500 ket. Explain how market equilibrium 17.00 1,200 1,600 is restored. 18.00 1,100 1,700 At the price of $15.00 a box, the quantity supplied equals the quantity demanded. At a price of $17.00 a box, the quantity demanded is 1,200 boxes and the quantity supplied is 1,600 boxes. There is a surplus of 400 boxes a week and the price falls. As the price falls, the quantity demanded increases, the quantity supplied decreases, and the surplus decreases. The price falls until the surplus disappears. The market equilibrium occurs at a price of $15.00 a box and 1,400 boxes a week so the price falls to $15.00 a box. 6.

During Valentine’s week, more people buy chocolates and chocolatiers offer their chocolates in special red boxes, which cost more to produce than the everyday box. Set out the three-step process of analysis and show on a graph the adjustment process to the new equilibrium. Describe the changes in the equilibrium price and the equilibrium quantity. Starting with the demand side, Valentine’s week increases people’s preferences for boxes of chocolate so the demand for boxes of chocolate increases. The demand curve for chocolates shifts rightward, from D0 to D1 in Figure 4.4. Moving to the supply side, the fancy red box raises the cost of producing boxes of chocolate, which decreases the supply. The rise in the cost of producing boxes of chocolates shifts the supply curve leftward, from S0 to S1 in Figure 4.4. After these changes, at the initial price of a box of chocolate, $15.00, in Figure 4.4 there is a shortage of 600 boxes of chocolate per week. The shortage forces the price higher, so the equilibrium price of a box of chocolate rises, to $18.00 in the figure. The

Part 1 . INTRODUCTION

problem points out that people buy more boxes of chocolate during Valentine’s week. This result means that the change in demand exceeds the change in the supply, that is, the magnitude of the increase in demand exceeds that of the decrease in supply. Figure 4.4 illustrates this situation and in the figure the equilibrium quantity increases from 1,400 boxes per week to 1,500 boxes per week. 7.

After a severe bout of foreclosures and defaults on home loans, banks made it harder for people to borrow. How does this change influence: • The demand for new homes? The demand for homes decreases. •

The supply of new homes? The supply of new homes does not change.

•

The price of new homes? The price of new homes falls.

Illustrate your answer with a graphical analysis. Figure 4.5 shows the effect of making home loans more difficult to obtain. Before the change in difficulty, the demand curve is D0. In the figure the price of a new home is $350,000. After the increase in difficulty, the demand decreases and the demand curve shifts leftward, in the figure from D0 to D1. The supply curve does not shift. The price of a new home falls, in the figure from $350,000 to $275,000. 8. Alabama food prices jump in May Alabama Farmers Federation announced that food prices in May will increase. In previous unprofitable years, farmers reduced their herds with the result that in 2009 meat production will fall. Bacon is expected to rise by 32 cents a pound to $4.18 and steaks by 57 cents to $8.41 a pound. Source: The Birmingham News, May 21, 2009 Explain why the reduction of herds will lead to a rise in meat prices today. Draw a graph to illustrate. The reduction in herds decreases the supply of meat and shifts the supply curve of meat leftward. The demand for meat does not change. The decrease in supply raises the price of meat. In Figure 4.6 (on the next page), the leftward shift of the supply curve from S0 to S1 illustrates the decrease in supply. In the figure the equilibri-

Chapter 4 . Demand and Supply

um price of steak rises from its initial price $7.84 per pound to the new equilibrium price of $8.41 per pound. This rise of 57 cents per pound is the amount of the increase mentioned in the news clip.

“As more people buy cell phones, the demand for cell phone service increases and the price of cell service falls, which decreases the supply of cell service.” Is this statement true or false? Explain. The assertion that the demand for cell phone service increases as more people buy cell phones is true. However the claim that the increase in demand reduces the price of cell phone service is false; the increase in demand raises the price of cell phone services. The second sentence is false. Regardless of whether the price of cell phone service rises or falls, the supply of cell phone service does not change. Rather the change in price changes the quantity of cell phone service supplied.

10. Steel output set for historic drop Steel producers expect to cut output by 10 percent response to cancelled orders from construction companies and car and appliance producers. Source: Financial Times, December 28, 2008 Explain how the cancellation of orders change the market for steel. What happens to the equilibrium price of steel? The cancellation of orders decreases the demand for steel so that the demand curve for steel shifts leftward. The cancellation of orders does not change the supply of steel, so the supply curve of steel does not shift. As the demand curve shifts leftward, there is a movement down along the supply curve of steel and a decrease in the quantity of steel supplied. The equilibrium price falls.

Part 1 . INTRODUCTION

 Multiple Choice Quiz 1.

Which of the following events illustrates the law of demand: Other things remaining the same, a rise in the price of a good will ________ . A. decrease the quantity demanded of that good B. increase the demand for a substitute of that good C. decrease the demand for the good D. increase the demand for a complement of that good Answer: A The law of demand is the inverse relationship between the price of a good and the quantity demanded. 2.

In the market for jeans, which of the following events increases the demand for a pair of jeans? A. The wage rate paid to garment workers rises. B. The price of a denim skirt (a substitute for jeans) rises. C. The price of denim cloth falls. D. New technology reduces the time it takes to make a pair of jeans. Answer: B The other factors listed change the supply; only answer B increases the demand.

Other things remaining the same, a fall in the price of peanuts will ________. A. increase the supply of peanuts B. decrease the supply of peanut butter C. decrease the quantity supplied of peanuts D. decrease the supply of peanuts Answer: C A fall in the price of the good creates a movement along the supply curve and decreases the quantity supplied.

In the market for cell phones, which of the following events increases the supply of cell phones? A. New technology lowers the cost of making a cell phone B. Rise in the price of an e-book reader (a substitute in production) C. An increase in people’s incomes D. A rise in the wage rate paid to electronics workers Answer: A Answers B and D decrease the supply of cell phones; answer C affects the demand for cell phones.

Chapter 4 . Demand and Supply

When floods wiped out the banana crop in Central America, the equilibrium price of bananas ________ and the equilibrium quantity of bananas ________. A. rose; increased B. rose; decreased C. fell; increased D. fell; decreased Answer: B Figure 4.12(b) on page 102 illustrates this case of a decrease in supply. 6.

A decrease in the demand for chocolate with no change in supply will create a ________ of chocolate at today’s price, but gradually the price will ________. A. surplus; fall B. shortage; fall C. surplus; rise D. shortage; rise Answer: A Figure 4.11(b) on page 100 illustrates this case of a decrease in demand. 7.

Many Americans are selling their used cars and buying new fuel-efficient hybrids. Other things remaining the same, in the market for used cars, ________ and in the market for hybrids ________. A. supply increases and the price falls; demand increases and the price rises B. demand decreases and the price rises; supply increases and the price falls C. both demand and supply decrease and the price might rise, fall, or not change; demand increases and the price rises D. demand decreases, supply increases, and the price falls; supply increases and the price falls Answer: A Selling their used cars increases the supply of used cars. Buying new hybrids increases the demand for hybrids.

Chapter

Elasticities of Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications When the price of home heating oil increased by 20 percent, the quantity demanded decreased by 2 percent and the quantity of wool sweaters demanded increased by 10 percent. Use this information to work Problems 1 and 2. 1. Use the total revenue test to determine whether the demand for home heating oil is elastic or inelastic. When the price of home heating oil increased by 20 percent, the total revenue collected by sellers of home heating oil increased because the quantity demanded decreased by only 2 percent. Because the total revenue increased when the price rose, the total revenue test tells us that the demand for home heating oil is inelastic. (To check, the elasticity of demand is (2 percent) ÷ (20 percent), which is 0.10. Recall that when calculating the price elasticity of demand, we use absolute values or magnitudes and ignore the minus sign.) 2.

If the price of a wool sweater did not change, calculate the cross elasticity of demand for wool sweaters with respect to the price of home heating oil. Are home heating oil and wool sweaters substitutes or complements? Why? The cross elasticity of demand for wool sweaters with respect to home heating oil is:  Percentage change in quantity of sweaters demanded   10 percent   =     20 percent  = 0.50. Percentage change in price of heating oil     Home heating oil and sweaters are substitutes because as the price of home heating oil rises, you can stay warm by using less home heating oil and putting on a sweater. The cross elasticity of demand for a substitute is positive.

Part 2 . A CLOSER LOOK AT MARKETS

The figure shows the demand for movie tickets. Is the demand for movie tickets elastic or inelastic over the price range $7 to $9 a ticket? If the price falls from $9 to $7 a ticket, explain how the total revenue from the sale of movie tickets will change. Calculate the price elasticity of demand for movie tickets when the price is $8 a ticket. The percentage change in the quantity of movie tickets demanded equals  300 tickets − 100 tickets    × 100 , or 100  (100 tickets + 300 tickets) ÷ 2 )  percent. The percentage change in the price of a movie ticket equals  $9 a ticket − $7 a ticket    × 100 , or 25  ($9 a ticket + $7 a ticket) ÷ 2 )  percent. So the demand for movie tickets is elastic because the percentage change in the quantity demanded is larger than the percentage change in price. Because the demand is elastic, the fall in the price of a movie ticket increases the total revenue from the sale of movie tickets. When the price is $9 a ticket, the total revenue is $9 a ticket × 100 tickets, which is $900. When the price is $7 a ticket, the total revenue is $7 a ticket × 300 tickets, which is $2,100. So the total revenue increases by $1,200. The price elasticity of demand for movie tickets is the percentage change in the quantity of movie tickets demanded divided by the percentage change in the price of a movie ticket. The percentage change in the quantity of movie tickets  300 tickets − 100 tickets   × 100 , which is 100 perdemanded equals   (100 tickets + 300 tickets) ÷ 2 )  cent. The percentage change in the price of a movie ticket equals  $9 a ticket − $7 a ticket    × 100 , which is 25 percent. So the price elas ($9 a ticket + $7 a ticket) ÷ 2 )  ticity of demand for movie tickets at the price of $8 is 100 percent ÷ 25 percent, or 4.00.

The price elasticity of demand for Pete’s chocolate chip cookies is 1.5. Pete wants to increase his total revenue. Would you recommend that Pete raise or lower his price of cookies? Explain your answer. Because the price elasticity of demand for cookies is 1.5, Pete should lower the price of cookies to raise his total revenue. Because demand is elastic a decrease in the price of cookies will bring about a larger percentage increase in the quantity demanded than the percentage fall in price.

Chapter 5 . Elasticities of Demand and Supply

Use the following information to work Problems 5 and 6. The price of a plane ride rises by 10 percent. The price elasticity of demand for plane rides is 0.5 and the price elasticity of demand for train rides is 0.2. The cross elasticity of demand for train rides with respect to the price of a plane ride is 0.4. 5. Calculate the percentage changes in the quantity demanded of plane rides and train rides. The percentage change in the quantity demanded of plane rides equals the price elasticity of demand for plane rides multiplied by the percentage change in the price of a plane ride, which is (0.5) × (10 percent) = 5 percent. The percentage change in the quantity demanded of train rides equals the cross elasticity of demand for train rides with respect to the price of a plane ride multiplied by the percentage change in the price of a plane ride, which is (0.4) × (10 percent) = 4 percent increase. 6.

Given the rise in the price of a plane ride, what percentage change in the price of a train ride will leave the quantity demanded of train rides unchanged? From the previous answer, when the price of a plane ride rises 10 percent, the quantity of train rides demanded increases 4 percent. The price rise of a train ride necessary to decrease the quantity demanded by 4 percent is 20 percent because a 20 percent increase in the price of train ride decreases the quantity demanded by (0.2) × (20 percent) = 4 percent.

A survey found that when incomes increased by 10 percent, the following changes in the quantities demanded occurred: spring water up by 5 percent; sports drinks down by 2 percent; cruises up by 15 percent. Which demand is income elastic? Which is income inelastic? Which are normal goods? Because the percentage change in the quantity of cruises demanded increased by more than the percentage change in income, the demand for cruises is income elastic. Because the percentage change in the quantity of spring water demanded increased by less than the percentage change in income, the demand for spring water is income inelastic. The demand for cruises increases with income, so cruises are a normal good. The demand for spring water increases with income, so it is a normal good. The demand for sports drinks decreases with income, so it is an inferior good.

Use the following information to work Problems 8 and 9. Record U.S. corn crop, up 24%, is forecast The USDA reported that world corn production will be 9.9 percent greater than last year’s, while U.S. corn production will be 24 percent larger. The price of corn is expected to be 46 percent higher than last year’s price. Source: Bloomberg News, August 11, 2007 8. Calculate the U.S. price elasticity of supply of corn. Is this supply elastic?

Part 2 . A CLOSER LOOK AT MARKETS

The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The change in the U.S. quantity supplied is 24 percent and the change in the price is 46 percent. So for the United States, the price elasticity of supply equals 24 percent ÷ 46 percent, which is 0.5. The U.S. supply of corn is not elastic; it is inelastic. 9.

Calculate the world price elasticity of supply of corn. The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The change in the world quantity supplied is 9.9 percent and the change in the price is 46 percent. So the world price elasticity of supply equals 9.9 percent ÷ 46 percent, which is 0.2.

10. Read Eye on the Price of Gasoline on p. 121 and then explain why the demand for gasoline is more inelastic in the short run than in the long run. Which is likely to be more inelastic, the demand for premium gasoline or the demand for all grades of gasoline? The demand for gasoline is more inelastic in the short run because there are more substitutes for gasoline as more time elapses since the price changed. In particular, when the price of gasoline rises, as more time elapses consumers can switch to smaller, more fuel efficient cars. Consumers are less likely to make this substitution immediately because switching cars is expensive and they are more likely to make the substitution the longer the price of gasoline remains high. The demand for all grades of gasoline is more inelastic than the demand for premium gasoline. There are reasonably close substitutes for premium gasoline—mid-octane gasoline and low-octane gasoline—but there are very few substitutes for all grades of gasoline.

Chapter 5 . Elasticities of Demand and Supply

 Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. Why the tepid response to higher gasoline prices? Most studies report that when U.S. gas prices rise by 10 percent, the quantity purchased falls by 1 to 2 percent. In September 2005, the retail gasoline price was $2.90 a gallon, about $1.00 higher than in September 2004, but purchases of gasoline fell by only 3.5 percent. Source: The New York Times, October 13, 2005 1. Calculate the price elasticity of demand for gasoline implied by what most studies have found. The price elasticity of demand equals the percentage change in the quantity demanded, 1 or 2 percent, divided by the percentage change in price, 10 percent. Doing the division shows that most studies have found that the price elasticity of demand equals 0.1 or 0.2. 2.

Compare the elasticity implied by the data for the period from September 2004 to September 2005 with that implied by most studies. What might explain the difference? From September 2004 to September 2005, the price of gasoline increased by 41.67 percent (The percentage change equals ($2.90 − $1.90) ÷ $2.40, where $2.40 is the average of the September 2004 and September 2005 price). The quantity demanded decreased by 3.5 percent, so the price elasticity of demand over this year was 3.5 percent ÷ 41.67 percent, which is 0.08. The price elasticity of demand of demand for gasoline calculated over this year is slightly smaller than the conventional range. The price elasticity of demand over the year is probably smaller than normal because other factors that affected the demand for gasoline also changed. In particular, income increased. Gasoline is a normal good, which means that the increase in income increased the demand for gasoline and thereby increased the equilibrium quantity of gasoline. So the 3.5 percent change in the quantity reported in the news clip was composed of two parts: The decrease in the quantity demanded moving along the demand curve resulting from the higher price and the (offsetting) increase in the quantity resulting from higher income. The elasticity of demand should use only the decrease in the quantity demanded resulting from the price rise. Because the decrease in the quantity demanded from a higher price is offset by the increase from higher income, the reported 3.5 percent change in quantity is less than what would be the change resulting from only a higher price, so the computed elasticity of demand is smaller than the conventional range.

When heavy rain ruined the banana crop in Central America, the price of bananas rose from $1 to $2 a pound. Growers sold fewer bananas, but

Part 2 . A CLOSER LOOK AT MARKETS

their total revenue was unchanged. By what percentage did the quantity demanded of bananas change? Is the demand for bananas elastic, unit elastic, or inelastic? Because the total revenue did not change, the percentage change in bananas demanded equals the percentage increase in price. Using the midpoint method, the percentage increase in the price equals ($1.00 ÷ $1.50) = 66.67 percent. So the quantity of bananas demanded decreased by 66.67 percent. The demand for bananas is neither elastic nor inelastic; it is unit elastic because the percentage increase in the price equals the percentage decrease in the quantity of bananas demanded. 4.

The income elasticity of demand for haircuts is 1.5, and the income elasticity of demand for food is 0.14. You take a weekend job, and the income you have to spend on food and haircuts doubles. If the prices of food and haircuts remain the same, will you double your expenditure on haircuts and double your expenditure on food? Explain why or why not. Your expenditure on haircuts will more than double because the income elasticity of demand exceeds 1.0. Your expenditure on food will not double because the income elasticity of demand is less than 1.0. Only if the income elasticity of demand equals 1.0 will the expenditure on a good or service change proportionally with income.

Drought cuts the quantity of wheat grown by 2 percent. If the price elasticity of demand for wheat is 0.5, by how much will the price of wheat rise? If pasta makers estimate that this change in the price of wheat will increase the price of pasta by 25 percent and decrease the quantity demanded of pasta by 8 percent, what is the pasta makers’ estimate of the price elasticity of demand for pasta? If pasta sauce makers estimate that, with the change in the price of pasta, the quantity of pasta sauce demanded will decrease by 5 percent, what is the pasta sauce makers’ estimate of the cross elasticity of demand for pasta sauce with respect to the price of pasta? Rearranging the price elasticity of demand formula shows that the percentage change in the price of wheat equals the percentage change in the quantity demanded divided by the price elasticity of demand. The percentage change in the price of wheat is (2 percent) ÷ (0.5), or 4 percent. The estimated price elasticity of demand for pasta is equal to the percentage change in the quantity demanded of pasta divided by the estimated change in the price of pasta. So the estimated price elasticity of demand for pasta is (8 percent) ÷ (25 percent), which is 0.32. The estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is equal to the percentage change in the quantity demanded of pasta sauce divided by the estimated change in the price of

Chapter 5 . Elasticities of Demand and Supply

pasta. So the estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is −(5 percent) ÷ (25 percent), which is −0.2. 6.

“In a market in which demand is price inelastic, producers can gouge consumers and the government must set high standards of conduct for producers to ensure that consumers get a fair deal.” Do you agree or disagree with each part of this statement? Explain how you might go about testing the parts of the statement that are positive and lay bare the normative parts. Most of this statement is normative in nature. The terms “gouge,” “high standards of conduct,” and “fair deal” are all normative. To the extent that the statement can be interpreted as a positive statement, the first part might mean “in a market in which demand is price inelastic, producers can set a higher price than otherwise.” If this is the meaning of the first part, then it is testable by determining the extent to which the price elasticity of demand affects the equilibrium price in markets.

Use the following information to work Problems 7 and 8. Almonds galore! The quantity of almonds harvested in 2008–2009 was expected to increase by 22 percent, while total receipts of growers was expected to increase by 17 percent. Source: Almond Board of California 7. Was the price of almonds expected to rise or fall? Did a change in the supply of or demand for almonds bring about this expected change in the price? The price of almonds is expected to fall because the increase in the quantity of almonds exceeds the increase in growers’ receipts. Specifically, when the quantity increases by 22 percent, if the price does not change, growers’ receipts would also increase by 22 percent. Because growers’ receipts are expected to increase by only 17 percent, it must be the case that the price of almonds is expected to fall. If a change in demand is expected to lower the price of almonds, it must be the case that the demand for almonds is expected to decrease. But if the demand for almonds decreases, then the quantity of almonds decreases, which is not what is expected. If a change in supply is expected to lower the price of almonds, it must be the case that the supply of almonds is expected to increase. And if the supply of almonds increases, then the quantity of almonds increases, which is the outcome noted above. Consequently it is a change in supply, specifically an increase in supply, that is bringing about the expected fall in price.

Part 2 . A CLOSER LOOK AT MARKETS

If the price of almonds changed as a result of a change in the supply of almonds, is the demand for almonds elastic or inelastic? Explain your answer. The total revenue test indicates that the demand for almonds is elastic. The increase in the supply of almonds lowers the price but increases the total revenue. The total revenue test demonstrates that this outcome—the price and total revenue change in opposite directions—occurs when the demand is elastic.

Chapter 5 . Elasticities of Demand and Supply

 Multiple Choice Quiz 1.

When the price of ice cream rises from $3 to $5 a scoop, the quantity of ice cream bought decreases by 10 percent. The price elasticity of demand for ice cream is _______. A. 5 B. 0.2 C. 50 D. 2.5 Answer: B The percentage change in the price is equal to ($2/$4) × 100, which is 50 percent. The price elasticity of demand is equal to (10 percent) ÷ (50 percent), which is 0.2. 2.

In Pioneer Ville, the price elasticity of demand for bus rides is 0.5. When the price of a bus ticket rises by 5 percent, _______. A. the demand for bus rides increases by 10 percent B. the quantity of bus rides demanded increases by 2.5 percent C. the demand for bus rides decreases by 2.5 percent D. the quantity of bus rides demanded decreases by 2.5 percent Answer: D The quantity of bus rides demanded decreases by (0.5) × (5 percent), which is 2.5 percent.

The price elasticity of demand for a good is 0.2. A 10 percent rise in the price will _______ the total revenue from sales of the good. A. decrease B. increase C. decrease the quantity sold with no change in D. not change Answer: B The total revenue test on page 121 shows that a rise in the price increases the total revenue if demand is inelastic. 4.

If the price of a good falls and expenditure on the good rises, the demand for the good is _______. A. elastic B. perfectly elastic C. inelastic D. unit elastic Answer: A The total revenue test on page 121 shows that demand is elastic.

Part 2 . A CLOSER LOOK AT MARKETS

When the price of a good rises from $5 to $7 a unit, the quantity supplied increases from 110 to 130 units a day. The price elasticity of supply is _______. The supply of the good is _______. A. 60; elastic B. 10; elastic C. 0.5; inelastic D. 2; inelastic Answer: C The price elasticity of supply equals (20/120)÷($2/$6), which is 0.5; the price elasticity of supply is less than 1.0, so the supply is inelastic. 6.

The cross elasticity of demand for good A with respect to good B is 0.2. A 10 percent change in the price of good B will lead to a ____ percent change in the quantity of good A demanded. Goods A and B are _______. A. 2; substitutes B. 0.5; complements C. −2; complements D. −0.5; substitutes Answer: A The change in the quantity of good A demanded is computed as (0.2) × (10 percent), which is 2 percent; the cross price elasticity is positive, so the goods are substitutes. 7.

A 2 percent increase in income increases the quantity demanded of a good by 1 percent. The income elasticity of demand for this good is _______. The good is a _______ good. A. 2; normal B. –2; inferior C. 1/2; normal D. 2; inferior Answer: C The income elasticity of demand equals (1 percent) ÷ (2 percent); it is positive so the good is a normal good.

Chapter

Efficiency and Fairness of Markets ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications At McDonald’s, no reservations are accepted; at Panorama Restaurant at the St. Louis Art Museum, reservations are accepted; at Niche, reservations are essential. Use this information to work Problems 1 to 3. 1. Describe the method of allocating table resources in these three restaurants. All these restaurants use a first-come, first-serve system. McDonald’s uses this system directly. Niche 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. Panorama Restaurant uses a combination of the immediate first-come, first serve system and the reservation based first-come, first-serve system. 2.

Why do you think restaurants have different reservation policies, and why might each restaurant be using an efficient allocation method? 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. Niche 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 Niche refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Niche’s 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 Panorama Restaurant, the turnover rate of the tables is between that at Niche and McDonald’s, so it uses a combination of phone reservation first-come, first-serve and appear in person first-come, first serve. Each restaurant is using a different allocation method because of the rela-

Part 2 . A CLOSER LOOK AT MARKETS

tive costs. Each uses the method that has the lowest cost for the restaurant. 3.

Why don’t all restaurants use the market price to allocate their tables? 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 highly uncertain about the price they would need to pay and such uncertainty decreases the demand for meals from the restaurant. The decreased demand lowers the restaurant’s profit. Price Quantity Quantity The table shows the demand and supply (dollars per demanded supplied schedules for sandwiches. Use the table to sandwich) (sandwiches per week) work Problems 4 to 7. 0 400 0 4. Calculate the equilibrium price of a 1 350 50 sandwich, the consumer surplus, and 2 300 100 the producer surplus. What is the effi3 250 150 4 200 200 cient quantity of sandwiches? 5 150 250 The equilibrium quantity is 200 6 100 300 sandwiches and the equilibrium price 7 50 350 is $4 a sandwich. Figure 6.1 can be 8 0 400 used to calculate the consumer surplus. The consumer surplus equals the area of the light gray triangle above the price and below the demand curve. The area of the triangle is 1/2 × base × height, so the consumer surplus is 1/2 × (200 sandwiches) × ($4 a sandwich), which is $400. Figure 6.1 also can be used to calculate the producer surplus. The producer surplus equals the area of the dark gray triangle below the price and above the supply curve. This area is 1/2 × (200 sandwiches) × ($4 a sandwich), which is $400. The efficient quantity is 200 sandwiches. 5.

If the quantity demanded decreases by 100 sandwiches an hour at each price, what is the equilibrium price and what is the change in total surplus? If the quantity demanded of sandwiches decreases by 100 per hour at each price, the new equilibrium price of a sandwich is $3 and the new equilibrium quantity is 150. This consumer surplus equals the area of the

Chapter 6 . Efficiency and Fairness of Markets

triangle above the price and below the demand curve and so is equal to 1/2 × (150 sandwiches) × ($3 a sandwich), which is $225. The producer surplus equals the area of the triangle below the price and above the supply curve and so is equal to is 1/2 × (150 sandwiches) × ($3 a sandwich), which is $225. The total surplus equals the sum of the consumer surplus plus producer surplus. Before the change the total surplus is $400 + $400 = $800 and after the change the total surplus is $225 + $225 = $450, for a change of −$350. 6.

If the quantity supplied decreases by 100 sandwiches an hour at each price, what is the equilibrium price and what is the change in total surplus? If the quantity supplied of sandwiches decreases by 100 per hour at each price, the new equilibrium price of a sandwich is $5 and the new equilibrium quantity is 150. This consumer surplus equals the area of the triangle above the price and below the demand curve and so is equal to 1/2 × (150 sandwiches) × ($3 a sandwich), which is $225. The producer surplus equals the area of the triangle below the price and above the supply curve and so is equal to is 1/2 × (150 sandwiches) × ($3 a sandwich), or $225. Before the change the total surplus is $400 + $400 = $800 and after the change the total surplus is $225 + $225 = $450, for a change of −$350.

If Sandwiches To Go, Inc., buys all the sandwich producers and cuts production to 100 sandwiches an hour, what is the deadweight loss that is created? If Sandwiches To Go, Inc. rations sandwiches to two per person, by what view of fairness would the allocation be unfair? If only 100 sandwiches are produced, the deadweight loss equals the area of the darkened triangle in Figure 6.2. This area is 1/2 × (100 sandwiches) × ($4 a sandwich), which is $200. Rationing sandwiches might be fair based on the “fair results” principle because everyone has an equal number of sandwiches. However, because Sandwiches To Go, Inc. is restricting the number of sandwiches it produces, some customers might go without. If the “fair results” view incorporates these consumers into the picture, then the rationing is unfair because not every consumer has a sandwich. The “fair rules” approach is likely to consider the rationing fair, because all exchanges are voluntary. But, it is worth noting

Part 2 . A CLOSER LOOK AT MARKETS

that Sandwiches To Go, Inc. is restricting its production and so is creating a deadweight loss. Use the following information to work Problems 8 and 9. Quantity Quantity The table shows the dedemanded demanded mand and supply schedules Price during Quantity before for sandbags before and (dollars per flood supplied flood during a major flood. Durbag) (thousands of bags) ing the flood, suppose that 0 40 70 0 the government gave all 1 35 65 5 families an equal quantity 2 30 60 10 of sandbags. Resale of 3 25 55 15 4 20 50 20 sandbags is not permitted. 5 15 45 25 8. How would total sur6 10 40 30 plus and the price of a 7 5 35 35 sandbag change? 8 0 30 40 The effect on the producer surplus of the companies selling sandbags depends on the price the government paid. If the government paid the higher, post-flood price, the firms’ producer surplus is unchanged. If the government required the companies to sell the sandbags to the government at the lower, pre-flood price, the firms’ producer surplus decreased. If the government hands out the sandbags for “free,” so that everyone gets an equal share, the effect on the consumer surplus is ambiguous. The consumer surplus increases because the bags are available at a price of $0. But there are two factors that offset the increase in the consumer surplus: First, if the government buys only 20,000 bags—the equilibrium quantity before the flood—the consumer surplus will be reduced because fewer sandbags will be distributed. Second, even if the government buys 35,000 bags—the equilibrium quantity during the flood—the consumer surplus will be reduced because the government will distribute some bags to people with low marginal benefit (those who live on high ground) rather than concentrating on people with high marginal benefit (those who live on low ground). The effect on the price depends on whether the government pays the higher, during-flood price, or the lower, pre-flood price. 9.

Would the outcome be more efficient than if the government took no action? Explain. If the government took no action and the market was free to reach its equilibrium, then the outcome is efficient. If the government allows no resales, then the allocation is almost assuredly inefficient unless the government precisely duplicates the competitive market allocation.

Chapter 6 . Efficiency and Fairness of Markets

10. The winner of the men’s or women’s tennis singles at the U.S. Open is paid twice as much as the runner-up, but it takes two to have a singles final. Is this compensation arrangement efficient? Is it fair? Explain why it might illustrate the big tradeoff. 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. 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. This arrangement might illustrate the big tradeoff because if the winner was paid less and the loser was paid more, both the ultimate winner and the ultimate loser have an incentive to play less hard, that is, they may decrease the amount of tennis they produce. Use the following information to work Problems 11 and 12. eBay saves billions for bidders On eBay, the bidder who places the highest bid wins the auction and pays only what the second highest bidder offered. Researchers Wolfgang Jank and Galit Shmueli reported that purchasers on eBay in 2003 paid $7 billion less than their winning bids. Because each bid shows the buyer’s willingness to pay, the winner receives an estimated consumer surplus of $4 or more. Source: InformationWeek, January 28, 2008 11. What method is used to allocate goods on eBay? How does an eBay auction influence consumer surplus from the good? eBay is using market price to allocate the goods. The market price is the price established in the auction. If someone is willing and able to pay that price, the person will get the item. For the vast majority of auctions the winning bidder will enjoy a consumer surplus so eBay increases consumer surplus. For instance, if there are bidders on a unique item, the winning bidder—who sets the price for the good—will pay a price that is equal to the value of the item to the bidder with the second-highest valuation plus the minimum bid increment. The winning bidder has some consumer surplus as long as his or her value of the good exceeds the price that must be paid, which will almost always be the case. Indeed, a person chooses to buy on eBay rather than elsewhere if the person believes that his or her consumer surplus is largest by purchasing on eBay. 12. Read Eye on Price Gouging on p. 160 and explain why it was inefficient to stop Mr. Shepperson from selling his generators. After the hurricane the marginal benefit from a generator skyrocketed

Part 2 . A CLOSER LOOK AT MARKETS

and the demand for generators drastically increased. Potential consumers were willing to pay the price Mr. Shepperson was charging, which means that their marginal benefit from the generators equaled or exceeded the price Mr. Shepperson was setting. Additionally, Mr. Shepperson’s price exceeded his marginal cost. Consequently, the marginal benefit from Mr. Shepperson’s generators exceeded their marginal cost. Confiscating the generators prevented their sales. Forbidding the sales created a deadweight loss because the marginal benefit of these generators exceeded their marginal cost, which means that preventing the sales was inefficient.

Chapter 6 . Efficiency and Fairness of Markets

 Instructor Assignable Problems and Applications 1.

Panic in paradise: Are high fares the new reality for Hawaii? On March 31, 2008, Hawaii lost 15 percent of its air service as Aloha Airlines and the cheap-flight airline ATA suddenly shut down. Stranded travelers were offered flights to West coast cities at $1,000 one way. Within a month, the fare to west coast cities dropped to about $200 a round trip. Stranded travelers complained of price gouging. Source: USA Today, April 23, 2008 Under what conditions would the $1,000 fare be considered “price gouging”? Under what conditions would the $1,000 fare be an example of the market price method of allocating scarce airline seats? The stranded passengers believed that the surviving airlines had taken advantage of their emergency need for essential flights back to the mainland by sharply boosting the price much higher than normal, which is gouging. If $1,000 is the equilibrium price at which the quantity demanded of flights equaled the quantity supplied, then the $1,000 fare is an example of resources being allocated by the market price. The table shows the demand schedule for Price Quantity Quantity haircuts and the supply schedule for hair(dollars per demanded supplied cuts. Use the table to work Problems 2 and 3. haircut) (haircuts per day) 2. What is the quantity of haircuts 0 100 0 10 80 0 bought, the value of a haircut, and the 20 60 20 total surplus from haircuts? 30 40 40 The equilibrium quantity of haircuts 40 20 60 is 40 per day. The value of the 40th 50 0 80 haircut is $30. The total surplus is equal to the sum of the consumer surplus plus the producer surplus. Figure 6.3 helps in calculating the consumer surplus and producer surplus. The consumer surplus is equal to the area of the dark grey triangle. The consumer surplus equals 1/2 × 40 haircuts × $20 per haircut), or $400. The producer surplus is equal to the lighter grey area which is also $400 so total surplus is $400 + $400 = $800. 3.

Suppose that all salons agree to charge $40 a haircut. How do consumer surplus and producer surplus change? What is the deadweight loss created? If the price is $40 a haircut, the quantity of

Part 2 . A CLOSER LOOK AT MARKETS

haircuts is 20. The consumer surplus in Figure 6.4 is the dark triangle and is $100, so the consumer surplus has decreased by $300. The producer surplus in Figure 6.4 is the light grey area and is $500, so the producer surplus has increased by $100. The deadweight loss is $200. Note that the deadweight loss is equal to the gain in producer surplus minus the loss in consumer surplus.

In California, farmers pay a lower price for water than do city residents. Use this information to work Problems 4 to 6. 4. What is this method of allocation of water resources? Is this allocation of water efficient? Is this use of scarce water fair? Why or why not? This method of allocation is based on personal characteristics. Two otherwise identical people pay different prices for water if one is a farmer and the other is not. Water use is probably not efficient. Because farmers face a lower price, the quantity of water they consume is greater than the quantity of water consumed by otherwise identical non-farmers. As a result, the marginal benefit of farmers is less than the marginal benefit of otherwise identical nonfarmers. Presumably, however, the marginal cost of supplying water to the two groups is the same. So there is overuse of water in farm uses and underuse of water in other uses. By the “fair results” approach, the question of fairness depends on relative incomes of farmers and city dwellers. If farmers have lower incomes, the lower price for water is fair. If farmers have higher incomes, then the lower price of water is not fair. Under the “fair rules” approach, the different prices are fair because transactions are voluntary 5.

If farmers were charged the same price as city residents pay, how would the price of agricultural produce, the quantity of produce grown, consumer surplus, and producer surplus change? If farmers are charged the same price for water as city residents, farmers’

Chapter 6 . Efficiency and Fairness of Markets

costs increase. The increase in costs decreases the supply of agricultural products, so the price of agricultural produce rises and the quantity decreases. Consumer surplus decreases and producer surplus also decreases. 6.

If all water in California is sold for the market equilibrium price, would the allocation of water be more efficient? Why or why not? Water use would be more efficient. Prior to the change, farmers were paying less than the marginal cost and so there was overuse of water in farm uses. After the change farmers pay the marginal cost and so the marginal benefit equals the marginal cost.

Use the following information to work Problems 7 and 8. The world’s largest tulip and flower market Every day over 19 million tulips and flowers are auctioned at the Dutch market called “The Bloemenveiling.” These Dutch auctions match buyers and sellers. Source: Tulip-Bulbs.com In a Dutch auction, the auctioneer announces the highest price. If no one offers to buy the flowers, the auctioneer lowers the price until a buyer is found. 7. What method is used to allocate flowers at the Bloemenveiling? The auction uses the market price (as established by the auction) to allocate the flowers. 8.

How does a Dutch flower auction influence consumer surplus and producer surplus? Are the flower auctions at the Bloemenveiling efficient? A Dutch auction means there is little or no consumer surplus. If the buyers bid the moment the price reaches their value for the flower, then the successful buyers have no consumer surplus. The producers, however, likely have substantial producer surplus. As long as the price exceeds the marginal cost of producing the flowers, the producers have some producer surplus. The flower auctions are efficient because there are no obstacles (taxes, subsidies, monopoly, and so on) that prevent the market price from reaching allocative efficiency. The buyers pay a price equal to their marginal benefit and the sellers receive a price equal to their marginal cost.

Part 2 . A CLOSER LOOK AT MARKETS

New Zealand’s private forests In the early 1990s, the government auctioned half the national forests, converting these forests from public ownership to private ownership. The government’s decision was an incentive to get the owners to operate like farmers—that is, take care of the resource and to use it to make a profit. Source: Reuters, September 7, 2007 Was the timber industry efficient before the auction and did logging companies operate in the social interest or self-interest? What effect has private ownership had on efficiency of the timber industry? Probably before the auction the New Zealand timber industry was not operating efficiently. The forests were owned by the government and the government does not face the same incentives faced by private owners. Logging companies, operating in their self-interest, have the incentive to cut as much timber as economically possible to make the largest possible profit. They do not have the incentive to preserve any particular forest because they can switch to another forest if one becomes depleted. When logging companies negotiate how much timber and what price they must pay for the timber they will cut, private owners have the incentive to limit the amount of the harvest to insure that there will be timber to be cut in the future so that the owner can make a profit in the future as well as the present. With government ownership, however, the same incentive does not exist because the government is not trying to insure its profitability in the future. Logging companies were probably able to convince government officials to allow more than the efficient amount of logging, so the forests were likely over-logged when the government owned them. Since auction it is probable that the New Zealand timber industry has operated efficiently. The private forest owners have the incentive to limit the extent of logging so that the owner can sell logging rights throughout the future. With this institutional set up, logging companies have operated in their self-interest which has been the same as the social interest.

Chapter 6 . Efficiency and Fairness of Markets

 Multiple Choice Quiz 1.

The method of allocation that most stores use during Thanksgiving sales is: A. a combination of market price and lottery B. first-come, first-served C. a combination of contest and command D. a combination of market price and first-come, first-served Answer: D Market price is used until the store runs out the good, so the first to come who are willing to pay the price get the good. 2.

All of the following statements are correct except ______. A. the value of an additional unit of the good equals the marginal benefit from the good B. marginal benefit is the excess of value over the price paid, summed over the quantity consumed C. the maximum price willingly paid for a unit of a good is the marginal benefit from it D. price is what we pay for a good but value is what we get from it Answer: B Answer B defines consumer surplus not marginal benefit. 3.

Choose the best statement. A. An increase in the demand for a good increases producer surplus. B. If producers decrease the supply of the good, their producer surplus will increase. C. Producer surplus equals the total revenue from selling the good. D. Producer surplus is the excess of the value of the good over the market price, summed over the quantity produced. Answer: A The increase in demand raises the price and increases the quantity, both of which raise the producer surplus. 4.

The market for a good is efficient if ______. A. the marginal cost of producing the good is minimized B. the marginal benefit from the good is maximized C. the consumer surplus is maximized D. the total surplus is maximized Answer: D Figure 6.8 in the textbook shows that an efficient allocation of resources maximizes the total surplus.

Part 2 . A CLOSER LOOK AT MARKETS

When the marginal benefit from a good exceeds its marginal cost, ______. A. there is overproduction of the good B. a deadweight loss, which is the excess of marginal benefit over marginal cost, arises C. producer surplus decreases and consumer surplus increases D. total production increases and efficiency increases Answer: B Figure 6.9(a) on page 155 shows the deadweight loss when the marginal benefit exceeds the marginal cost. 6.

Market failure arises if ______. A. there is overproduction of the good but not if there is underproduction B. the deadweight loss is zero C. producer surplus exceeds consumer surplus D. total surplus is not maximized Answer: D When the total surplus is maximized, resource allocation is efficient; if it is not maximized, then resource allocation is inefficient and market failure occurs. 7.

The allocation of resources is fair ______. A. in the fair-rules view if everyone has equal opportunity B. in the fair-results view if most resources are distributed to the poorest people C. in the fair-rules view if owners of the resources are protected by property rights and all transfers of resources are voluntary D. in the fair-results view if resources are transferred voluntarily so that everyone has the same quantity Answer: C Page 159 discusses the rules view of fairness.

Chapter

Government Actions in Markets ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

In Florida, sunscreen and sunglasses are vital items. If the tax on sellers of these items is doubled from 5.5 percent to 11 percent, who will pay most of the tax increase: the buyer or the seller? Will the tax increase halve the quantity of sunscreen and sunglasses bought? Because sunscreen and sunglasses are necessities, the demand for them is inelastic. So, most of a tax imposed on them will be paid by the buyer. Even though the tax doubles, the quantity purchased is not halved because the demand is inelastic.

Suppose that the government imposes a $2 a cup tax on coffee. What determines by how much Starbucks will raise its price? How will the quantity of coffee bought in coffee shops change? Will this tax raise much revenue? The price elasticities of demand and supply determine how much more Starbucks charges for a coffee. The smaller the price elasticity of demand and the larger the price elasticity of supply, the more Starbucks will raise the price of a coffee. The quantity of coffee bought will decrease. The amount of revenue the government raises depends on the size of the tax and the size of the decrease in the quantity of coffee purchased. For a given tax, the government collects more revenue the smaller the price elasticities of demand and supply because the smaller these elasticities, the smaller the decrease in the quantity purchased.

3. The table illustrates the market for Internet service. What is the market price of Internet service? If the government taxes Internet service $15 a month, what is the price the buyer pays? What is the price the sell-

Price (dollars per month)

0 10 20 30 40

Quantity Quantity demanded supplied (units per month)

30 25 20 15 10

0 10 20 30 40

Part 2 . A CLOSER LOOK AT MARKETS

er receives? Does the buyer or seller pay more of the tax? The market price of an Internet service is $20 a month because that is the price at which the quantity demanded equals the quantity supplied. A figure is helpful to answer the questions about the tax incidence. If the government imposes a tax of $15 a month on Internet services, Figure 7.1 shows that the buyer pays $30 a month for Internet services. If the government imposes a tax of $15 a month on Internet services, the seller receives $15 a month for Internet services. The buyers pay more of the tax.

Use Figure 7.2, which shows the demand for oncampus housing, to work Problems 4 to 6. The college has 200 rooms to rent. 4. If the college puts a rent ceiling on rooms of $650 a month, what is the rent, how many rooms are rented, and is the on-campus housing market efficient? The equilibrium rent is $600 a month and the equilibrium quantity of rooms is 2,000 rooms. The rent ceiling of $650 a month is above the equilibrium rent and does not change the market equilibrium. The rent remains the equilibrium rent of $600 a month, the quantity of rooms rented remains 2,000 rooms, and the market remains efficient. 5.

If the college puts a strictly enforced rent ceiling on rooms of $550 a month, what is the rent, how many rooms are rented, and is the on-campus housing market efficient? Explain why or why not. The rent ceiling of $550 a month is below the equilibrium rent, so the rent is $550 a month. At this rent 2,250 rooms are demanded and the quantity supplied is only 2,000 rooms, so 2,000 rooms are rented. The on-campus

Chapter 7 . Government Actions in Markets

housing market is efficient because the supply is perfectly inelastic so the quantity remains equal to the efficient quantity. However, there is a shortage of rooms and students spend additional time searching for housing. 6.

Suppose that with a strictly enforced rent ceiling on rooms of $550 a month, a black market develops. How high could the black market rent be and would the on-campus housing market be fair? Explain your answer. The black market rent could be as high as $600 a month, which is the maximum rent someone is willing to pay for the 2,000th room. If a black market develops, using the “fair results” approach, the market is not fair because the poorest students cannot afford the higher black market rent. Using the “fair rules” approach, the market is not fair because the rent ceiling blocks some voluntary exchanges unless the buyers and sellers are willing to participate in the black market.

The table shows the demand and supWage rate Quantity Quantity ply schedules for student workers at (dollars per demanded supplied hour) on-campus venues. If the college in(student workers) 10.00 600 300 troduces a strictly enforced minimum 10.50 500 350 wage of $11.50 an hour, who gains and 11.00 400 400 who loses from the minimum wage, 11.50 300 450 and is the campus labor market effi12.00 200 500 cient or fair? 12.50 100 550 The workers who retain their jobs and are paid the higher wage rate gain from the minimum wage. The employer, the workers who lose their job, and workers who must undertake extensive search for a job lose from the minimum wage. The minimum wage of $11.50 an hour is not efficient. There is a surplus of workers and the marginal benefit to firms exceeds the marginal cost to workers. A deadweight loss is created. The minimum wage is unfair under the “fair results” approach because some student workers lose their jobs. The minimum wage is unfair under the “fair rules” approach because it blocks voluntary exchange.

Part 2 . A CLOSER LOOK AT MARKETS

The table shows the demand and Price (dollars per supply schedules for mushrooms. pound) Suppose that the government 1.00 introduces a price support for 2.00 mushrooms and sets the support price 3.00 at $6 per pound. Who gains and who 4.00 loses? What are the quantity of mush5.00 rooms produced, the surplus, and the 6.00 deadweight loss? If the government introduces a price support of $6 per pound, production rises to 4,500 pounds per week. Mushroom producers gain from the price support. Mushroom consumers and taxpayers lose from the price support. There is a surplus of 2,000 pounds per week. Figure 7.3 can be used to calculate the deadweight loss. The deadweight loss is the area of the darkened triangle. The area of a triangle is equal to 1/2 × base × height, so the deadweight loss is 1/2 × (1,000 pounds) × ($4 a pound), which is $2,000.

Quantity Quantity demanded supplied (pounds per week) 5,000 2,000 4,500 2,500 4,000 3,000 3,500 3,500 3,000 4,000 2,500 4,500

Use the following news clip to work Problems 9 and 10. Coal shortage at China plants The government of China has set price controls on coal and gasoline in an attempt to shield poor families and farmers from rising world energy prices. Chinese power plants have run short of coal, sales of luxury, gas-guzzling cars have increased, and gasoline consumption has risen. Oil refiners are incurring losses and plan to cut production. Source: CNN, May 20, 2008 9. Are China’s price controls price floors or price ceilings? Draw a graph to illustrate the shortages of coal and gasoline created by the price controls. China’s price controls are price ceilings. In the face of increased demand, China’s price controls have kept the price from rising to its equilibrium. As a result the quantity demanded exceeds the quantity supplied and shortages have resulted. Figure 7.4 (on the next page) illustrates the situation in the market for coal; the figures for gasoline is similar. In Figure 7.4 at the controled price of $550 per ton, the quantity of coal

Chapter 7 . Government Actions in Markets

demanded is 100 million tons per week, the quantity of coal supplied is 97.5 million tons per week so there is a shortage of 2.5 million tons per week. 10. Explain how China’s price controls have changed consumer surplus, producer surplus, total surplus, and the deadweight loss in the markets for coal and gasoline. Draw a graph to illustrate your answer. China’s price controls aim to keep the price from rising to the equilibrium level. A price ceiling decreases the quantity available to the quantity supplied at the price ceiling. In Figure 7.5, the quantity with the price control is 97.5 million tons of coal per week. Because the price and quantity decrease, producer surplus decreases. Because the quantity decreases and search costs are incurred, consumer surplus decreases. Because the quantity decreases and marginal benefit exceeds marginal cost, a deadweight loss arises. Figure 7.5 shows the changes in consumer surplus, producer surplus, and deadweight loss. With no price ceiling the consumer surplus is equal to area A + area B + area C. With the price ceiling consumer surplus is equal to area A. Search costs are area B + area E. The producer surplus without the price ceiling is equal to area E + area F + area G. With the price ceiling the producer surplus is equal to area G. Without the price ceiling there is no deadweight loss. With the price ceiling there is a deadweight loss equal to area C + area F and area B + area E are resources lost to search activity. 11. Read Eye on Price Regulation on p. 185 and explain why a mismatch between intention and outcome is inevitable if a price regulation seeks to block the laws of supply and demand. Price regulations have as their purpose the goal of changing the market outcome. For example, minimum wage laws raise the wage rate paid lower-skilled workers and rent controls lower the rent paid for apartments. In both instances, the law is designed to change the equilibrium

Part 2 . A CLOSER LOOK AT MARKETS

price (the wage for the minimum wage and the rent for rent controls) determined by supply and demand. Because the equilibrium price is the only price at which there is neither a shortage nor a surplus, a law that changes the price automatically creates either a shortage or a surplus. In the Eye on Price Regulation, the cap on executive pay would create a shortage of executives.

Chapter 7 . Government Actions in Markets

 Instructor Assignable Problems and Applications 1.

Suppose that Congress caps executive pay at a level below the equilibrium. • Explain how the quantity of executives demanded, the quantity supplied, and executive pay will change, and explain why the outcome is inefficient. Because the price cap is below the equilibrium salary, the executive pay falls. The quantity of executives demanded increases and the quantity of executives supplied decreases. There is a shortage of executives. The outcome is inefficient because the marginal benefit (to firms) exceeds the marginal cost (to executives). •

Draw a graph of the market for corporate executives. On your graph, show the market equilibrium, a pay cap, the quantity of executives supplied and the quantity demanded at the pay cap, and the deadweight loss created. Also show the highest pay that an executive might be offered in a black market. Figure 7.6 shows the market for executives. In the absence of a price cap, the equilibrium salary is $600,000 a year and the equilibrium quantity of executives is 60,000. With a price cap (which is the same as a price ceiling) of $550,000, the salary falls to $550,000 per year. At this salary, the quantity of executives demanded is increases to 65,000 per year and the quantity supplied decreases to 55,000 per year. There is a shortage of 15,000 executives. The price ceiling is inefficient. The deadweight loss is the darkened triangle. If a black market develops, the figure shows that firms are willing to pay $700,000 per year to hire an executive, so executives who participate in the black market can be paid as much $700,000 per year.

Use the following information to work Problems 2 and 3. The supply of luxury boats is perfectly elastic, the demand for luxury boats is unit elastic, and with no tax on luxury boats, the price is $1 million and 240 luxury boats a week are bought. Now luxury boats are taxed at 20 percent. 2. What is the price that buyers pay? How is the tax split between the buyer and the seller? What is the government’s tax revenue? Because the supply is perfectly elastic, the buyers pay all the tax: the price rises by the full amount of the tax and buyers pay $1.2 million per boat.

Part 2 . A CLOSER LOOK AT MARKETS

Because the supply is perfectly elastic, the buyers pay all the tax and the sellers pay none of the tax. The price rises 20 percent. The elasticity of demand is 1.0, so the quantity demanded decreases by 20 percent. Before the tax, 240 boats were bought, so the tax decreases the number of boats sold by (240 boats) × (20 percent), which is 48 boats. So after the tax, 192 boats are bought. The government collects a tax of 20 percent on each boat, so the government collects $200,000 tax on each. The total tax revenue the government collects is ($200,000 a boat) × (192 boats), which is $38.4 million. 3.

On a graph, show the excess burden of this tax. Is this tax efficient? The shaded area in Figure 7.7 is the excess burden of the tax. The tax is not efficient because a deadweight loss is created.

Chapter 7 . Government Actions in Markets

Figure 7.8 shows the demand for and supply of chocolate bars. Suppose that the government levies a $1.50 tax on a chocolate bar. What is the change in the quantity of chocolate bars bought, who pays most of the tax, and what is the deadweight loss? The initial price of a chocolate bar is $3.00 per bar and the initial quantity of chocolate bars is 6 million bars per year. Figure 7.9 shows the situation after the tax is imposed. As Figure 7.9 shows, the tax shifts the supply curve upward by $1.50 to the S + tax curve. Once the tax is imposed, including the tax consumers pay $4.00 a bar. Manufacturers must send $1.50 to the government as the tax, so after the tax is imposed, the suppliers receive $2.50. The equilibrium quantity of chocolate bars is 4 million bars per year. The quantity of chocolate bars decreases by 2 million bars per year. The amount that the consumer pays rises by $1.00 and the amount that the supplier receives falls by $0.50. Hence the consumers pay most of the tax. The deadweight loss is shown in Figure 7.9 as the area of the grey triangle. The area of a triangle is 1/2 × base × height. Hence the deadweight loss is equal to 1/2 × 2 million bars × $1.50 per bar, which is $1.5 million.

Use the following information to work Problems 5 and 6. Concerned about the political fallout from rising gas prices, suppose that the U.S. government imposes a price ceiling of $3.00 a gallon on gasoline. 5. Explain how the market for gasoline would react to this price ceiling if the oil-producing nations increased production and drove the equilibrium price of gasoline to $2.50 a gallon. Would the U.S. gasoline market be efficient? If the equilibrium price of gasoline is $2.50 a gallon, then a price ceiling of $3.00 a gallon has no effect on the market because it does not change the

Part 2 . A CLOSER LOOK AT MARKETS

equilibrium price. The market is efficient because at the equilibrium the marginal benefit equals the marginal cost. 6.

Explain how the market for gasoline would react to this price ceiling if a global shortage of oil sent the equilibrium price of gasoline to $3.50 a gallon. Would the U.S. gasoline market be efficient? If the equilibrium price of gasoline is $3.50 a gallon, then a price ceiling of $3.00 a gallon results in a shortage. The quantity of gasoline demanded at $3.00 a gallon exceeds the quantity supplied. A black market is likely to develop, in which consumers buy gasoline at prices higher than the price ceiling. In addition, a great deal of additional search activity arises as drivers look for gas stations that are open and willing to sell gasoline. The market is inefficient because the marginal benefit of a gallon of gasoline exceeds the marginal cost and so there is a deadweight loss.

Suppose the government introduced a ceiling on lawyers’ fees. How would the amount of work done by lawyers, the consumer surplus of people who hire lawyers, and the producer surplus of law firms change? Would this fee ceiling result in an efficient and fair use of resources? Why or why not? If the ceiling is set above the equilibrium fee, the ceiling has no effect on the amount of work, consumer surplus, or producer surplus. The market remains efficient. If the ceiling is set below the equilibrium fee, the quantity of work supplied decreases. There is a shortage and increased search. The consumer surplus decreases and the law firms’ producer surplus decreases. This ceiling results in an inefficient use of resources. The marginal benefit exceeds the marginal cost and a deadweight loss arises. Additionally, added resources are used as people increase their search activity to find an attorney. It also is unfair, by the “fair rules” view because it blocks voluntary exchange and by the “fair results” view unless the allocation mechanism allocates more law firm resources to poorer people, which is unlikely.

Use the following information to work Problems 8 and 9. Crop prices erode farm subsidy program High corn and soybean prices mean farmers are making the most money in their lives. At the same time, grain prices are far too high to trigger payouts under the U.S. primary farm-subsidy program’s “price support” formula. The market has done what Congress couldn’t do and that is “slash farm subsidies.” Source: The Wall Street Journal, July 25, 2011 8. Draw a graph to illustrate the soybean market when the soybean price was low. Show the quantity of soybeans produced, the subsidy farmers received, and the deadweight loss created. Figure 7.10 (on the next page) illustrates the market for soybeans. In the

Chapter 7 . Government Actions in Markets

absence of the price support, the equilibrium price is $12.00 per bushel and 2.9 billion bushels are produced. With a price support of $12.50 per bushel, 3.1 bushels are produced. The subsidy the farmers received is illustrated in the figure as the light grey rectangle (some of which lies behind the deadweight loss triangle). The deadweight loss is the dark grey triangle in the figure. 9.

In the market for corn with a price support, explain why the corn price has risen and ended up being too high to “trigger payouts.” The price of corn has risen because rising demand for corn has increased the price and because a poor growing season has decreased the supply, which has also boosted the price. The equilibrium price of corn exceeds the support price, so the support price has no effect on the market. At the equilibrium price, the quantity demanded equals the quantity supplied and there is no surplus that the government needs to purchase.

Part 2 . A CLOSER LOOK AT MARKETS

 Multiple Choice Quiz 1.

If a tax of $1 a can is imposed on the buyers of sugary drinks, the demand for sugary drinks ______ and the price that buyers pay ______. A. doesn’t change; doesn’t change B. doesn’t change; rises by $1 a can C. decreases; rises by more than $1 a can D. decreases; rises by less than $1 a can Answer: D Figure 7.1(a) illustrates this result. 2.

A tax on candy will be paid by ______. A. only buyers if the demand for candy is inelastic B. only sellers if the supply for candy is inelastic C. buyers and sellers if the demand for candy is elastic D. only buyers if the supply of candy is elastic Answer: C While sellers pay more of the tax if demand is elastic, both buyers and sellers part of the tax. 3.

A price ceiling imposed below the equilibrium price ______. A. creates a black market in which the price might equal or exceed the equilibrium price B. creates a black market in which the price equals the price ceiling C. leads to increased search activity, which reduces the shortage of the good D. increases the demand for the good, which makes the shortage even larger Answer: A The price in black markets lies between the ceiling price and the maximum price demanders will pay for the quantity produced. 4.

A price ceiling is ______ if it is set _____ the market equilibrium price. A. efficient and fair; below B. unfair but efficient; equal to C. efficient and unfair; above D. inefficient and unfair; below Answer: D A price ceiling set below the equilibrium price creates inefficiency and is unfair by both measures of fairness.

Chapter 7 . Government Actions in Markets

A price floor influences the outcome of a market if it is ______. A. set below the equilibrium price B. set above the equilibrium price C. an incentive for buyers to increase demand for the good D. an incentive for sellers to decrease supply of the good Answer: B If the price floor is set above the equilibrium price, it makes the equilibrium price illegal. 6.

A minimum wage set above the market equilibrium wage rate ______. A. increases both employment and the quantity of labor supplied B. decreases unemployment and raises the wage rate of those employed C. raises the wage rate of those employed and increases the supply of jobs D. increases unemployment and decreases employment Answer: D By raising the wage rate above the equilibrium wage rate, a minimum wage creates unemployment and decreases employment. 7.

A support price set above the equilibrium price ______. A. creates a shortage, increases farmers’ total revenue, and is efficient B. creates a surplus, which the government buys and dumps on the rest of the world to keep the U.S. market price equal to the price support C. is inefficient because farmers’ marginal cost exceeds U.S consumers’ marginal benefit D. is efficient because farmers’ marginal cost equals U.S. consumers’ marginal benefit Answer: B Price supports set above the equilibrium price require the government to purchase the surplus to maintain the price. 8.

Choose the best statement. A. A subsidy to peanut growers lowers peanut growers’ costs, lowers the market price of peanuts, and increases the demand for peanuts. B. A price support for peanut growers is a guaranteed price for peanuts, which increases the quantity of peanuts produced. C. A price support and a subsidy to peanut growers will make the peanut market more efficient if the support price is below the market price. D. For a support price set above the equilibrium price to increase peanut growers’ incomes, they must also receive a subsidy. Answer: B By guaranteeing a higher price, a price support increases the quantity producers supply.

Global Markets in Action ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications Use Figures 8.1 and 8.2 to work Problems 1 to 4. Figure 8.1 and Figure 8.2 show the markets for shoes if there is no trade between the United States and Brazil.

Which country has a comparative advantage in producing shoes? With international trade, explain which country would export shoes and how the price of shoes in the importing country and the quantity produced by the importing country would change. Explain which country gains from this trade. Brazil has the comparative advantage in producing shoes because, with no international trade, the price in Brazil is less than the price in the Unit-

Chapter

Part 3 . A CLOSER LOOK AT MARKETS

ed States. With international trade, Brazil will export shoes to the United States. The price of a pair of shoes in the United States will fall and the quantity of shoes produced in the United States will decrease. Both countries will gain from this trade. In Brazil producers of shoes gain (consumers of shoes lose, but the gain to the producers exceeds the loss to consumers) and in the United States consumers of shoes gain (producers of shoes lose, but the gain to the consumers exceeds the loss to producers). 2.

The world price of a pair of shoes is $20. Explain how consumer surplus and producer surplus in the United States changes as a result of international trade. On the graph, show the change in U.S. consumer surplus (label it A) and the change in U.S. producer surplus (label it B). The consumer surplus of U.S. consumers increases because the price U.S. consumers pay for a pair of shoes falls. As a result of the fall in price, U.S. consumers increase the number of shoes they buy. Consumer surplus increases because the price falls and because the quantity of shoes purchased increases. The producer surplus of U.S. producers decreases because of the fall in the price of a pair of shoes. As a result of the fall in price, U.S. producers decrease the quantity of shoes they produce. Producer surplus decreases both because the price falls and because the quantity of shoes produced decreases. Figure 8.3 shows the change in consumer surplus and the change in producer surplus. The increase in consumer surplus equals the area A + B (the part of the light colored gain that lies beneath area B is not visible). The loss of producer surplus equals the dark gray area B.

The world price of shoes is $20. Explain how consumer surplus and producer surplus in Brazil change as a result of international trade. Show the change in Brazil’s consumer surplus (label it C) and the change in Brazil’s producer surplus (label it D). The consumer surplus of Brazilian consumers decreases because the price Brazilian consumers pay for a pair of shoes rises. As a result of the rise in price, Brazilian consumers decrease the number of shoes they buy. Consumer surplus decreases both because the price rises and because the quantity of shoes purchased decreases. The producer surplus of Brazilian producers increases because of the rise in the price of a pair of shoes. As a result of the rise in price, Brazilian producers increase the quantity of shoes they produce. Producer surplus increases both because the price

Chapter 8 . Global Markets in Action

rises and because the quantity of shoes produced increases. Figure 8.4 shows the change in consumer surplus and the change in producer surplus. The decrease in consumer surplus equals the dark gray area C. The increase in producer surplus equals the area C + D (the part of the light colored gain that lies beneath area C is not visible). 4.

Who in the United States loses from free trade in shoes with Brazil? Explain. In the United States the losers from the trade in shoes are U.S. shoe producers. U.S. shoe producers lose because the price of a pair of shoes falls, so producers decrease the quantity of shoes they produce. The producer surplus of U.S. shoe producers decreases.

Use the following information to work Problems 5 to 7. 5. The supply of roses in the United States is made up of U.S. grown roses and imported roses. Draw a graph to illustrate the U.S. rose market with free international trade. On your graph, mark the price of roses and the quantities of roses bought, produced, and imported into the United States. Figure 8.5 shows a graph of the rose market. In the figure, the world price of roses is $10 per dozen and this is the price in the United States. In the United States, the demand curve shows that 400,000 dozen roses are purchased and sold per month. The supply curve shows that 100,000 dozen roses per month are produced in the United States. The difference, or 300,000 dozen roses per month, is imported into the United States. 6.

Who in the United States loses from this trade in roses and would lobby for a restriction on the quantity of imported roses? If the U.S. government put a tariff on rose imports, show on your graph the U.S. consumer surplus that is redistributed to U.S. producers and also the government’s tariff revenue. U.S. producers of roses lose from the international trade in roses and so they would lobby for a tariff on imported roses. If the government puts a

Part 3 . A CLOSER LOOK AT MARKETS

$10 per dozen tariff on rises, Figure 8.6 shows the consequences. The $10 per dozen tariff equals the length of the two-headed gray arrow. The price in the United States rises to $20 per dozen. The number of roses purchased in the United States decreases to 300,000 per month and the number of roses produced in the United States increases to 200,000 per month. The quantity of roses imported falls to 100,000 per month. The government’s tariff revenue is equal to the area of dark rectangle, $10 per dozen multiplied by 100,000 dozen imported, or $1,000,000 per month. The increase in producer surplus from the tariff equals the area of the medium grey trapezoid.

Suppose that the U.S. government puts an import quota on roses. Show on your graph the consumer surplus that is redistributed to producers and importers and also the deadweight loss created by the import quota. In Figure 8.7, the import quota is equal to the length of the light grey arrow, 100,000 dozen roses per month. With the import quota in place, the supply curve becomes S1 so that the equilibrium price in the United States is $20 per dozen and equilibrium quantity becomes 300,000 dozen. The consumer surplus is redistributed to producers (the area of the light grey trapezoid) and to importers (the area of the light grey rectangle). The deadweight loss is equal to the area of the two dark grey triangles.

Chapter 8 . Global Markets in Action

Use the following information to work Problems 8 to 10. U.S. expands China paper anti-dumping tariff The United States raised the tariff on glossy paper imports from China to 99.65 percent, as a result of complaints by NewPage Corp. of Dayton, Ohio. Imports from China increased 166 percent from 2005 to 2006. This glossy paper is used in art books, high-end magazines, and textbooks. Source: Reuters, May 30, 2007 8. Explain who, in the United States, gains and who loses from this tariff on paper. How do you expect the prices of magazines and textbooks to change? The U.S. producers of glossy paper (such as NewPage!) will gain. The U.S. government also will gain because it will receive additional tariff revenue. U.S. consumers of glossy paper will lose. The higher price of glossy paper increases the costs of magazine and textbook publishers. The supply of magazines and textbooks decreases so their price rises. 9.

What is dumping? Who in the United States loses from China’s dumping of glossy paper? Dumping occurs when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of glossy paper lose from China’s dumping of glossy paper.

10. Explain what an anti-dumping tariff is. What argument might NewPage Corp. have used to get the government to raise the tariff to a 99.65 percent? Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. NewPage might have argued that Chinese exporters of glossy paper were charging a price of (approximately) one half the cost of production. In this case a tariff of 99.65 percent will (approximately) double the U.S. price of the imported glossy paper, thereby raising the price to the (alleged) cost of production. 11. Read Eye on Globalization on p. 219 and draw two graphs to show how U.S. consumers gain from iPads manufactured in China and why Chinese workers also gain. Figure 8.8 shows the market for iPads in the United States. As the figure illustrates, U.S. consumers gain because they pay a lower price and consequently buy more iPads. In

Part 3 . A CLOSER LOOK AT MARKETS

the figure the price falls from $300 per iPad with no trade to $200 per iPad with trade. The lower price means that consumers increase the quantity of iPads they buy, in the figure from 75 million iPads per year to 100 million per year. Figure 8.9 shows that Chinese workers also gain. As the figure illustrates, Chinese workers gain because more iPads will be produced in China. Consequently more workers are employed and potentially their wage rate also rises. In the figure the price rises from $100 per iPad with no trade to $200 per iPad with trade. The quantity of iPads produced in China increases from 75 million with no trade to 100 million with trade.

Chapter 8 . Global Markets in Action

 Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. The future of U.S.–India relations In May 2009, Secretary of State Hillary Clinton gave a major speech covering all the issues in U.S.–India relations. On economic and trade relations she noted that India maintains significant barriers to U.S. trade. The United States also maintains barriers against Indian imports such as textiles. Mrs. Clinton, President Obama, and Anand Sharma, the Indian Minister of Commerce and Industry, say they want to dismantle these trade barriers. Source: www.state.gov 1. Explain who in the United States would gain and who might lose from dismantling trade barriers between the United States and India. Winners from increased trade are U.S. producers and Indian consumers from U.S. exports and U.S. consumers and Indian producers from Indian exports. Losers from increased trade are U.S. consumers and Indian producers from U.S. exports and U.S. producers and Indian consumers from Indian exports 2.

Draw a graph of the U.S. market for textiles and show how removing a tariff would change producer surplus, consumer surplus, and the deadweight loss from the tariff. Figure 8.10 shows the market for textiles. With the tariff the price of a unit of clothing in the United States is $20 while the world price is $10. When the tariff is removed, producers’ lose producer surplus equal to area A. This area is converted into consumer surplus. The deadweight loss with the tariff is equal to the sum of areas B. When the tariff is removed, the deadweight loss disappears—it becomes part of the consumer surplus. When the tariff is removed, consumer surplus increases by an amount equal to the sum of area A (which had been producer surplus with the tariff) plus both areas B (which had been the deadweight loss with the tariff) and area C (which was the amount of the tariff revenue).

Part 3 . A CLOSER LOOK AT MARKETS

The United States exports wheat. Draw a graph to illustrate the U.S. wheat market if there is free international trade in wheat. On your graph, mark the price of wheat and the quantities bought, produced, and exported by the United States. Figure 8.11 illustrates the situation. In the figure, without international trade, the price of a bushel of wheat in the United States is $2 per bushel and 20 billion bushels are grown and consumed. With international trade the price of a bushel of wheat in the United States rises to $6 per bushel. At this higher price, 10 billion bushels are consumed and 40 billion are produced. The difference between the quantity produced and the quantity consumed, which is 30 billion bushels, is exported by the United States.

Suppose that the world price of sugar is 20 cents a pound, Brazil does not trade internationally, and the equilibrium price of sugar in Brazil is 10 cents a pound. Brazil then begins to trade internationally. • How does the price of sugar in Brazil change? Do Brazilians buy more or less sugar? Do Brazilian sugar growers produce more or less sugar? With international trade, the price of sugar rises in Brazil. Brazilian consumers buy less sugar. Brazilian sugar growers produce more sugar. • Does Brazil export or import sugar and why? Brazil exports sugar. The world price of sugar is higher than the Brazilian price of sugar, so sugar will be exported from Brazil.

The United States exports services and imports coffee. Why does the United States gain from exporting services and importing coffee? How do economists measure the net gain from this international trade? The United States gains from exporting services because the United States receives a higher price for the services it produces than would otherwise be the case. For exports, producers gain increased producer surplus while consumers lose consumer surplus. But the increase in producer surplus is larger than the loss in consumer surplus. The United States gains from importing coffee because the United States pays a lower price for the cof-

Chapter 8 . Global Markets in Action

fee it consumes than would otherwise be the case. For imports, consumers gain increased consumer surplus while producers lose producer surplus. But the increase in consumer surplus is larger than the loss in producer surplus. Economists measure the net gain from international trade as the increase in the total surplus. Use Figure 8.12 and the following information to work Problems 6 to 8. Figure 8.12 shows the car market in Mexico when Mexico places no restriction on the quantity of cars imported. The world price of a car is $10,000. 6. If the government of Mexico introduces a $2,000 tariff on car imports, what will be the price of a car in Mexico, the quantity of cars produced in Mexico, the quantity imported into Mexico, and the government’s tariff revenue? If the Mexican government imposes a $2,000 per car tariff on cars imported into Mexico, the price of a car in Mexico rises from $10,000 to $12,000. At this price, 10 million cars per year will be purchased in Mexico and 6 million cars per year will be produced in Mexico. The difference, 4 million cars per year, will be imported. The Mexican government’s tariff revenue is $2,000 per car multiplied by 4 million cars imported, which is $8 billion per year. 7.

If the government of Mexico introduces an import quota of 4 million cars a year, what will be the price of a car in Mexico, the quantity of cars produced in Mexico, and the quantity imported? If the Mexican government imposes an import quota of 4 million cars a year, the price of a car in Mexico will rise from $10,000 to $12,000. At this new, higher price, the quantity of cars demanded in Mexico is 10 million; the quantity of cars produced in Mexico is 6 million. The difference between Mexican consumption and Mexican production, 4 million, is equal to the amount of the import quota and so is imported from abroad.

What argument might be used to encourage the government of Mexico to introduce a $2,000 tariff on car imports from the United States? Who will gain and who will lose as a result of Mexico’s tariff? The tariff might be imposed because the government gains revenue from the tariffs it imposes. It might also be imposed because of rent seeking, in particular, auto producers who profit from the tariff might lobby intensively to impose the tariff. They likely will suggest that the Mexican auto

Part 3 . A CLOSER LOOK AT MARKETS

industry is new (an infant) and therefore needs protection until it matures and can compete with the rest of the world. They might also argue that a tariff will save (actually, gain) jobs in Mexico because of the expansion of Mexican auto production. Mexican auto producers and the Mexican government gain from the tariff. The auto producers have more producer surplus and the Mexican government gains tariff revenue. Mexican consumers lose from the tariff. The consumers have less consumer surplus with the tariff. 9.

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument? Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods.

Chapter 8 . Global Markets in Action

 Multiple Choice Quiz 1.

The fundamental force driving international trade is comparative _______. A. advantage: a country exports those goods that have high prices B. abundance: the country that produces more than it needs exports the good C. advantage: the country with the lower opportunity cost of production exports the good D. cost: a country trades with other countries that produce cheaper goods Answer: C Trade according to comparative advantage maximizes the gains from trade. 2.

A country will export wheat if, with no international trade, ______. A. it produces a surplus of wheat B. its opportunity cost of producing wheat is below the world price C. its domestic price of wheat exceeds the world price D. other countries have a shortage of wheat Answer: B If the opportunity cost of producing wheat is below the world price, the country has a comparative advantage in wheat production. 3.

With free trade between the United States and Canada, the United States exports tomatoes and Canada exports maple syrup. U.S. consumers ______. A. of tomatoes gain and Canadian consumers of maple syrup lose B. of both tomatoes and maple syrup gain more than either producer C. of maple syrup gain more than U.S. producers of maple syrup lose D. of tomatoes gain more than U.S. producers of tomatoes lose Answer: C Figure 8.3 in the text shows that imports create a net gain in total surplus.

Part 3 . A CLOSER LOOK AT MARKETS

With free trade between China and the United States, the winners are ___________ and the losers are _______. A. U.S. consumers of U.S. imports; U.S. producers of the U.S. import good B. China’s consumers of China’s imports; China’s producers of its export good C. U.S. producers of the U.S. export good; U.S. consumers of U.S. imports D. China’s consumers of China’s export good; China’s producers of its imported good Answer: A Figure 8.3 in the text shows that the U.S. price of the imported good falls, so that U.S. consumers win and U.S. producers lose. 5.

The U.S. tariff on paper ____ the U.S. price of paper, _____ U.S. production of paper and _______the U.S. gains from trade. A. raises; increases; increases B. doesn’t change; increases; increases C. doesn’t change; doesn’t change; decreases D. raises; increases; decreases Answer: D Figure 8.6 in the textbook illustrates these results. 6.

If Korea imposes an import quota on U.S. oranges, losers include Korean _______ of oranges and U.S. ______ of oranges. A. consumers; consumers B. consumers; producers C. producers; consumers D. producers; producers Answer: B The import quote decreases U.S. exports of oranges to Korea, thereby harming U.S. producers, and raises the price of oranges in Korea, thereby harming Korean consumers. 7.

The people who support restricted international trade say that ______. A. protection saves jobs, in both the U.S. and foreign economies B. U.S. firms won’t be able to compete with low-wage foreign labor if trade is free C. outsourcing sends jobs abroad, which brings diversification and makes our economy more stable D. protection is needed to enable U.S. firms to produce the things at which they have a comparative advantage Answer: B This commonly encountered argument is flawed, because U.S. firms can compete when U.S. productivity is high.

Externalities: Pollution, Education, and Health Care

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications Price Quantity The first table shows the demand schedule for electricity (cents per demanded from a coal-burning utility. The second table shows the utilikilowatt) (kilowatts per day) ty’s cost of producing electricity and the external cost of the 4 500 pollution created. Use this information to work Problems 1 8 400 to 3. 12 300 1. With no pollution control, calculate the quantity of elec16 200 20 100 tricity produced, the price of electricity, and the margin24 0 al external cost of the pollution generated. With no pollution control, the quantity of elecQuantity Marginal Marginal tricity produced is the amount at which the (kilowatts cost external cost quantity demanded equals the quantity supper day) (cents per kilowatt) plied as determined by the marginal private cost 0 0 0 100 2 2 of producing electricity. In this case, the quanti200 4 4 ty is 400 kilowatts per day and the price is 8¢ per 300 6 6 kilowatt. At this quantity, the marginal external 400 8 8 cost is (also) 8¢ per kilowatt. 500 10 10 2. With no pollution control, calculate the quantity of electricity produced, the marginal social cost of the electricity generated, and the deadweight loss. With no pollution control, the quantity of electricity produced is the amount at which the quantity demanded equals the quantity supplied as determined by the marginal private cost of producing electricity. In this case, the quantity is 400 kilowatts per day. At this quantity the marginal external cost is (also) 8¢ per kilowatt so the marginal social cost is 16¢ per kilowatt. The deadweight loss equal to the area of the triangle whose height is the marginal external cost at the equilibrium quantity and whose base is the difference between the efficient quantity and the privatemarket equilibrium quantity. The efficient quantity is 300 kilowatts and at

100

Part 2 . A CLOSER LOOK AT MARKETS

the equilibrium quantity the marginal external cost is 8¢ per kilowatt. The difference between the efficient quantity and the equilibrium quantity is 100 kilowatts. So the deadweight loss equals 1/2 × 100 kilowatts × 8¢ per kilowatt, or $4.00. 3.

If the government levies a pollution tax such that the utility generates the efficient quantity of electricity, calculate the quantity of electricity generated, the price of electricity, the size of the pollution tax, and the tax revenue. The efficient quantity of electricity is the amount at which the quantity demanded (which reflects the marginal social benefit) equals the marginal social cost. The marginal social cost is the sum of the marginal cost and the marginal external cost. The efficient quantity is 300 kilowatts because at this quantity the marginal social cost, 12¢ per kilowatt, equals the price, also 12¢ per kilowatt. The pollution tax must equal the marginal external cost, 6¢ per kilowatt. The tax revenue equals 6¢ per kilowatt × 300 kilowatts, which is $18.00.

Use the following information to work Problems 4 and 5. Tom and Larry must spend a day working together. Tom likes to smoke cigars and the price of a cigar is $2. Larry likes a smoke-free environment. 4. If Tom’s marginal benefit from a cigar a day is $20 and Larry’s marginal benefit from a smoke-free environment is $25 a day, what is the outcome if they meet at Tom’s home? What is the outcome if they meet at Larry’s home? Larry is willing to pay Tom up to $25 to not smoke. Tom’s net benefit from smoking is $18 (the marginal benefit minus the price of the cigar). The Coase theorem says that in this case, with Tom and Larry meeting at Tom’s home, Larry pays Tom some amount between $18 to $25 not to smoke and Tom does not smoke. If Tom and Larry meet at Larry’s house, Tom is willing to pay up to $18 to be allowed to smoke. But Larry will accept nothing less than $25 to allow Tom to smoke. Tom cannot offer enough to Larry, so Tom does not smoke. In both questions, the efficient outcome, Tom not smoking, is attained regardless of who is given the property right, that is, regardless of who owns the house in which the meeting occurs. 5.

If Tom’s marginal benefit from a cigar a day is $25 and Larry’s marginal benefit from a smoke-free environment is $20 a day, what is the outcome if they meet at Tom’s home? What is the outcome if they meet at Larry’s home? Larry is willing to pay Tom up to $20 to not smoke. Tom’s net benefit from smoking is $23 (the marginal benefit minus the price of the cigar). When Tom and Larry meet at Tom’s house, Larry cannot offer enough to Tom to make Tom quit smoking, so Tom smokes. If Tom and Larry meet

Chapter 9 . Externalities: Pollution, Education, and Health Care

101

at Larry’s house, Tom is willing to pay up to $23 to be allowed to smoke. And Larry will accept anything more than $20 to allow Tom to smoke. So, Tom can offer Larry some amount between $20 and $23 and Tom smokes. As in Exercise 4, the efficient outcome (in this case, Tom smoking) is attained regardless of who is given the property right, that is, regardless of who owns the house in which the meeting occurs. Use the table and the following information to work Problems 6 to 8. The marginal cost of educating a college student is $5,000 a year. The table shows the marginal benefit schedule from a college education. The marginal external benefit from a college education is a constant at $2,000 per student per year. There are no public colleges. 6. With no government involvement in college education, how many students enroll, what is the tuition, and what is the deadweight loss created? Figure 9.1 illustrates the market for college education.

Students (millions per year) 1 2 3 4 5 6 7 8

Marginal private benefit (dollars per student per year) 5,000 3,000 2,000 1,500 1,200 1,000 800 500

With no public college and no government involvement, 1 million students enroll in college and the tuition is $5,000 a year. The efficient number of students is 2 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The deadweight loss is the grey area in Figure 9.1 and equals the area of a triangle with a height equal to the marginal external benefit at the unregulated equilibrium and a length equal to the difference between the efficient quantity and the equilibrium quantity. In this case the deadweight loss equals ½ × $2,000 per student × 1 million students, which is $1 billion. 7.

If the government subsidizes colleges and sets the subsidy so that the efficient number of students enroll, what is the subsidy per student, how many students enroll, and what is the cost to taxpayers? The efficient number of students is 2 million. The required subsidy is $2,000 a student, which leads to 2 million students enrolling. The cost to the taxpayers is $2,000 per student × 2 million students, which is $4 billion

102

Part 2 . A CLOSER LOOK AT MARKETS

If the government offers vouchers to students, what is the value of the voucher that will encourage the efficient number of students to enroll? If the government offers a $2,000 voucher, which is equal to the marginal external benefit, the efficient number of students, 2 million, enrolls.

Global solutions for local gridlock Gridlock in Toronto already costs the region $6 billion a year, with average commute times of 80 minutes, among the highest in North America. By 2031, commute times will increase by 27 minutes. Civic leaders are looking at the options: road tolls, a regional gas tax, and parking levies. Source: Toronto Star, June 24, 2011 With road tolls, a regional gas tax, and parking levies would Toronto roads become less congested? If the new charges cut commute times, would the Toronto road system be more efficient? Explain your answers. Road tolls, a regional gas tax, and parking levies all increase the cost of driving in Toronto. Therefore all would reduce the congestion on Toronto’s roads. Currently Toronto’s roads are over-utilized. Driving downtown imposes an external cost on other drivers because each additional car slows all the other cars. Imposing a road toll, a regional gas tax, or parking levies would increase the cost to each individual driver and decrease the number of drivers, thereby increasing the efficiency of Toronto’s road system.

10. Read Eye on Climate Change on p. 234 and then describe the government actions that could decrease carbon emissions and explain why the government is not using them more aggressively. Governments could decrease carbon emissions by using a cap-and-trade policy or by increasing the tax on gasoline. A cap-and-trade policy decreases carbon emissions because it sets a limit on the quantity of greenhouse gases that can be emitted. A gasoline tax decreases the consumption of gasoline consumed, thereby decreasing the emission of greenhouse gases. Governments have not moved aggressively to impose these policies. First, some people do not believe that emissions produce global warming. Second, the costs of limiting the emissions are incurred now but the benefits, if any, would come sometime in the future. And, third, in the future most of the greenhouse gas emissions will come from developing nations rather than developed nations. Consequently policies implemented by developed nations will impose costs on these nations but have an increasingly small benefit.

Chapter 9 . Externalities: Pollution, Education, and Health Care

 Instructor Assignable Problems and Applications 1.

The price of gasoline in Europe is about three times that in the United States, mainly because the European gas tax is higher than the U.S. gas tax. How would an increase in the gas tax in the United States to the European level change carbon emissions? Would this tax increase bring greater efficiency or would it increase deadweight loss? Burning gasoline while driving creates carbon emissions. The increase in the gas tax increases the cost of driving, which leads to less driving. Consequently raising the gasoline tax leads to less carbon emissions. The case for raising the gasoline tax asserts that the carbon emissions from driving contribute to global warming. These emissions are an external cost, so the marginal social cost of the carbon emissions from driving exceeds the marginal social benefit. The efficient amount of driving automobiles is the amount such that the marginal (social) benefit equals the marginal social cost. Increasing the tax makes the marginal private cost closer to (or, in an ideal world, equal to) the marginal social cost and decreases (potentially eliminates) the deadweight loss.

Polar ice cap shrinks further and thins With global warming of the planet, the polar ice cap is shrinking. As the Arctic Sea expands, more underwater mineral resources will be accessible. Countries are staking out territorial claims to parts of the polar region. Source: The Wall Street Journal, April 7, 2009 Explain how ownership of these mineral resources will influence the amount of damage done to the Arctic Sea and its wildlife. The Arctic Sea minerals might be privately owned or government owned. Regardless of who owns them, mining minerals creates pollution and disturbs marine life habitat, which have external costs. If the minerals are privately owned, then the quantity mined will be the amount that sets the marginal private cost equal to the marginal private benefit. This quantity will have a deadweight loss because the marginal social cost exceeds the marginal private cost. If the minerals are government owned, then their allocation will be by majority vote. Lobbyists will pressure elected officials to adopt their position in return for help with reelection. In this case, “green” lobbyists and “business” lobbyists likely will square off. If the greens prevail, there is a possibility that no minerals will be mined. This situation has a deadweight loss because less than the efficient quantity is mined. If the business groups prevail, then there might be significant amounts mined. This situation, similar, to the case of private ownership, has a deadweight loss because of overuse of the minerals. The outcome is either efficient or inefficient depending on the strength of the opposing lobby groups.

103

104

Part 2 . A CLOSER LOOK AT MARKETS

Use the following information to work Problems 3 and 4. Plans to curtail use of plastic bags, but not much action Last summer, Seattle approved a 20-cents charge on plastic shopping bags, which was intended to reduce pollution by encouraging reusable bags. Source: The New York Times, February 23, 2009 3. Explain how Seattle’s 20-cent charge will change the use of plastic bags and how the deadweight loss created by plastic bags will change. The charge increases the marginal cost of using plastic bags so the quantity of plastic bags used will decrease. Figure 9.2 illustrates the market for plastic bags. In the absence of any government intervention, the unregulated market equilibrium quantity of plastic bags is 400,000 per week. This quantity exceeds the efficient quantity of 200,000 per week and hence a deadweight loss—equal to the area of the grey triangle in the figure—is created. The tax of 20¢ a bag shifts the supply (and marginal private cost, S = MC) curve so that it becomes the same as the marginal social cost curve, MSC. The deadweight loss is eliminated because the tax decreases the production of plastic bags to 200,000 per week, the efficient quantity. 4. Explain why a complete ban on plastic bags would be inefficient. As Figure 9.2 illustrates, there is a marginal social benefit from use of plastic bags. If plastic bags were banned, the quantity of plastic bags would equal 0, which is less than the efficient quantity (200,000 per week in the figure). Because the quantity differs from the efficient quantity, there is a deadweight loss since the marginal social benefit exceeds the marginal social cost. Use the following information to work Problems 5 to 7. The marginal cost of educating a college student online is $3,000 a year. The table shows the marginal private benefit schedule from a college education. The marginal external benefit is 50 percent of the marginal private benefit. 5. With no government involvement in college education, how many students enroll and what is the tuition? Calculate the deadweight loss created. With no government involvement, 4 million stu-

Students (millions per year) 1 2 3 4 5 6

Marginal private benefit (dollars per student per year) 6,000 5,000 4,000 3,000 2,000 1,000

Chapter 9 . Externalities: Pollution, Education, and Health Care

dents enroll in college and the tuition is $3,000 a year. The efficient number of students is 5 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The deadweight loss equals the area of a triangle with a height equal to the marginal external benefit at the unregulated equilibrium and a length equal to the difference between the efficient quantity and the equilibrium quantity. In this case the deadweight loss equals ½ × $1,500 per student × 1 million students, which is $750 million. 6.

If the government subsidizes colleges so that the efficient number of students will enroll, what is the cost to taxpayers? The efficient number of students is 5 million. The required subsidy is $1,000 a student, which leads to 5 million students enrolling. Therefore the cost to taxpayers is $1,000 per student × 5 million students, which is $5 billion

If the government offers vouchers to students and values them so that the efficient number of students will enroll, what is the value of the voucher? If the government offers a $1,000 voucher, which is equal to the marginal external benefit, the efficient number of students, 5 million, enrolls.

U.S. environmentalists back EU emission plan The European Union requires any airline operating to or from an EU airport to participate in the EU cap-and-trade system under which 15 percent of pollution credits for airlines will be auctioned off and the other 85 percent of credits are being given without charge. Source: The Wall Street Journal, June 30, 2011 Explain the conditions under which a cap-and-trade system would reduce the amount of airline emissions to the efficient quantity. For a cap-and-trade system to be efficient, the government must determine the efficient quantity of airline travel. If the government can issue the appropriate number of permits, so that the efficient quantity of airline travel will be undertaken and therefore the efficient quantity of pollution will be emitted, then the cap-and-trade system will be efficient.

105

106

Part 2 . A CLOSER LOOK AT MARKETS

CBO report: the pros and cons of carbon tax A carbon tax would raise the cost of producing goods and services that create large carbon emissions, but it would encourage Americans to use less carbon-intensive goods and services, which could slow global warming. Source: The Wall Street Journal, May 22, 2013 Use a graph of the market for electricity produced from fossil fuel to show the “pro” and the “con” from a carbon tax. Figure 9.3 shows the market for electricity. When fossil fuel is used to produce electricity, there is an external cost because the marginal social cost, MSC, is greater than the marginal private cost, MC. The equilibrium quantity with no intervention is 400 million kilowatt hours but the efficient quantity is 200 million kilowatt hours. A pollution tax of 15¢ an hour shifts the supply and marginal cost curve so it becomes the same as the marginal social cost curve. The “pro” argument for the tax is that the tax eliminates the deadweight loss. The “con” argument for the tax is that it raises the price of electricity from 10¢ per kilowatt hour to 20¢ per kilowatt hour, thereby raising the cost and price of goods and services produced using electricity.

Chapter 9 . Externalities: Pollution, Education, and Health Care

 Multiple Choice Quiz 1.

Electricity has a negative production externality because _____. A. its marginal benefit decreases as more of it is consumed B. the marginal private cost of producing it increases as more of it is produced C. the marginal social cost of producing it exceeds the marginal private cost of producing it D. a marginal external cost lowers the marginal benefit from consuming it Answer: C MSC = MC + marginal external cost, so with an external cost present, MSC > MC. 2.

A steelmaking plant pollutes the air and water so __________ . A. the marginal social cost of producing steel exceeds the marginal private cost by the amount of the marginal external cost B. the marginal social cost of producing steel is less than the marginal private cost by the amount of the marginal external cost C. the marginal private cost of producing steel equals the marginal external cost plus the marginal social cost D. the marginal private cost of producing steel minus the marginal social cost equals the marginal external cost Answer: A MSC = MC + marginal external cost, so MSC − MC = marginal external cost. 3.

An unregulated paint factory that pollutes a river results in ______ and _____ . A. overproduction; a price that exceeds the marginal benefit from the good B. underproduction; a price that equals the marginal benefit from the good C. the efficient quantity produced; a marginal benefit equal to the marginal social cost D. an inefficient quantity produced; a marginal benefit below the marginal social cost Answer: D Figure 9.2 in the textbook shows that answer D is correct.

107

108

Part 2 . A CLOSER LOOK AT MARKETS

Steel production creates pollution. If a tax is imposed on steel production equal to the marginal external cost of the pollution it creates, ______. A. steel producers will cut pollution to zero B. the deadweight loss created by steel producers will be cut to zero C. the market price of steel will rise by the amount of the tax D. steel producers will continue to produce the inefficient quantity of steel Answer: B This tax makes the producers’ marginal cost equal to the marginal social cost and eliminates the deadweight loss. 5.

A good or service with a positive externality is one which ______. A. everyone wants to have access to B. is produced in the social interest C. the marginal social benefit exceeds the marginal private benefit D. the marginal external benefit exceeds the marginal private benefit Answer: C The definition of marginal social benefit shows that answer C is correct. 6.

Because education generates a positive externality, ______. A. everyone who wants a college education should get one B. graduates’ marginal benefit exceeds the society’s value of the education C. the quantity of education undertaken will achieve the social interest if it is free D. subsidies to colleges or vouchers to students are means of achieving the efficient number of graduates Answer: D Figures 9.9 and 9.10 show how subsidies and vouchers increase the number of students to be equal to the efficient number.

Chapter

Production and Cost ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

Joe runs a shoe shine stand at the airport. Joe has no skills, no job experience, and no alternative job. Entrepreneurs in the shoe shine business earn $10,000 a year. Joe pays the rent of $2,000 a year, and his total revenue is $15,000 a year. He borrowed $1,000 at 20 percent a year to buy equipment. At the end of one year, Joe was offered $500 for his business and all its equipment. Calculate Joe’s annual explicit costs, implicit costs, and economic profit. Joe’s explicit costs are the $2,000 rent and $200 in interest (the amount of interest equals the loan, $2,000, multiplied by the interest rate, 0.10), so the total explicit costs are $2,200. Joe’s implicit costs are $10,000 of normal profit and $500 depreciation for his capital equipment, the chair, polishes, and brushes. Joe’s total implicit costs are $10,500. Joe’s economic profit equals his total revenue minus his total opportunity costs. Joe’s total revenue is $15,000. His total opportunity costs are the sum of his explicit costs, $2,200, and his implicit costs, $10,500. Joe’s total opLabor Total product portunity costs are $12,700 so his economic profit is $15,000 (workers (body boards minus $12,700, or $2,300. per day) per day) Len’s body board factory rents equipment for shaping 0 0 boards and hires students. The table sets out Len’s total 1 20 product schedule. Construct Len’s marginal product and average product schedules. Over what range of workers do marginal returns increase? The table on the next page has Len’s total product, marginal product, and average product schedules. As the table there shows, marginal returns increase for the 1st and 2nd work

110

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

ers. After the second worker is hired, marginal returns decrease.

Labor 0

Total product 0

Average product xx

Marginal product 20 24 16 12

Use the following information to work Problems 3 to 6. Total product Labor Len’s body board factory pays $60 a day for equipment and $200 (workers (body boards per day) a day to each student it hires. The table sets out Len’s total prod- per day) 0 0 uct schedule. 3. Construct Len’s total variable cost and total cost schedules. 1 20 What does the difference between total cost and total varia2 44 ble cost at each output equal? The variable costs are the costs of labor; the fixed costs are 3 60 the costs of the equipment. The total cost schedules per day 4 72 are in the second table to right. Total cost equals the total variable cost plus the total fixed cost so the difference between total variable cost and total Total Total Total Total cost is total fixed cost. This product fixed cost variable cost cost (dollars) (dollars) difference, $60 for this Labor (body boards) (dollars) 0 0 60 0 60 problem, is the same at 1 20 60 200 260 each level of output. 2 44 60 400 460 3 60 60 600 660 4. Construct the average fixed 4 72 60 800 860 cost, average variable cost, and average total cost schedules and the marginal cost schedule. Labor 0

Total Average Average varproduct fixed cost iable cost (body boards) (dollars) (dollars) 0 xx xx

Average total cost (dollars) xx

3.00

10.00

13.00

1.36

9.09

10.45

1.00

10.00

11.00

.83

11.11

11.94

The average cost schedules and marginal cost schedule are in the table above.

Marginal cost (dollars) 10.00 8.33 12.50 16.67

Chapter 10 . Production and Cost

At what output is Len’s average total cost at a minimum? At what output is Len’s average variable cost at a minimum? For the output levels given in the table, Len’s average total cost is at a minimum at 44 body boards a day and Len’s average variable cost is at a minimum at 44 body boards a day. If more production levels were given, though, the average variable cost would occur at a lower level of output than would the average total cost.

Explain why the output at which average variable cost is at a minimum is smaller than the output at which average total cost is at a minimum. Though the output at which the minimum average total cost and average variable cost occur is the same in the table, we know that the average variable cost equals its minimum at a lower level of output than the average total cost. The average total cost equals the average variable cost plus the average fixed cost. The average fixed cost constantly falls as output increases. So as output increases after the average variable cost reaches a minimum and starts to rise, the average total cost continues to fall for a while because the average fixed cost falls and this fall dominates the rise in the average variable cost. Eventually the rise in the average variable cost is greater than the fall in the average fixed cost and at that level of output, the average total cost begins to rise as output increases.

The table shows the costs incurred at Pete’s peanut farm. Complete the table.

L 0

TP 0

TVC 0

105

140

L 0

TP 0

TC 100

AFC

AVC

ATC

TVC 0

TC 100

AFC xx

AVC xx

ATC xx

135

10.00

3.50

13.50

170

4.17

2.91

7.08

105

205

2.63

2.76

5.39

140

240

2.27

3.18

5.45

The completed table is above. Recall that when output (total product) equals zero, then the total cost (TC) equals the total fixed cost.

13.50 2.50 2.50 5.83

111

112

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Gap will focus on smaller scale stores Gap has too many 12,500 square-foot stores. The target store size is 6,000 to 10,000 square feet, so Gap plans to combine previously separate stores. Some Gap Body, Gap Adult, and Gap Kids stores will be combined in one store. Source: CNN, June 10, 2008 Thinking of a Gap store as a production plant, explain why Gap is reducing the size of its stores. Is Gap making a long-run decision or a short-run decision? Is Gap taking advantage of economies of scale? Gap 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) Gap can slide down its LRAC curve and decrease its average cost. Gap’s decision is a long-run decision because it involves the size of the firm’s plant. At 12,500 square feet Gap’s stores were too large and Gap was incurring diseconomies of scale. When Gap combines its separate Gap concept stores into a smaller space, Gap will use fewer resources, particularly less capital and less labor. Gap’s costs will be less as a result. Additionally Gap’s sales will be less but the proportionate decrease in cost will exceed the decrease in Gap’s production. In this case Gap’s average costs will decrease so that Gap can reap economies of scale it currently is not enjoying.

Read Eye On Retailers’ Costs on p. 273 and draw a graph to show how the retailers’ cost curves would change if they introduced cost-saving selfcheckouts. The substitution of capital—self-serve checkouts—for labor—clerks—increases 711’s and Wal-Mart’s average total costs at low levels of output. The substitution, however, decreases these costs at higher levels of output. These changes are illustrated in Figure 10.1. The initial average total cost curves for 7-11 and Wal-Mart are in grey; the curves after the substitution has been made are in black.

Chapter 10 . Production and Cost

 Instructor Assignable Problems and Applications 1.

If the ATC curves of a Wal–Mart store and a 7–Eleven store are like those in Eye on Retailers’ Costs on p. 273, and if each type of store operates at its minimum ATC, which store has the lower total cost? How can you be sure? Which has the lower marginal cost? How can you be sure? Sketch each firm’s marginal cost curve. The total cost equals ATC × q. For Wal-Mart the total cost equals $1.00 × 30,000 = $30,000 and for 7-11 the total cost equals $2.00 × 5,000 = $10,000. The MC equals the ATC at the minimum ATC. Because each store is operating at its minimum ATC, Wal-Mart’s MC is $1.00 per customer and 7-11’s MC is $2.00 per customer. Figure 10.2 shows the marginal cost curves. Sonya used to earn $25,000 a year selling real estate, but she now sells greeting cards. The return to entrepreneurship in the greeting cards industry is $14,000 a year. Over the year, Sonya bought $10,000 worth of cards from manufacturers and sold them for $58,000. Sonya rents a shop for $5,000 a year and spends $1,000 on utilities and office expenses. Sonya owns a cash register, which she bought for $2,000 with funds from her savings account. Her bank pays 3 percent a year on savings accounts. At the end of the year, Sonya was offered $1,600 for her cash register. Calculate Sonya’s explicit costs, implicit costs, and economic profit. Sonya’s explicit costs are $10,000 for cards, $5,000 for rent, and $1,000 for utilities. So Sonya’s explicit costs are $16,000. Sonya’s implicit costs are $25,000 in forgone income as a real estate agent, $14,000 normal profit, $60 in forgone interest, and $400 in economic depreciation on the cash register, for a total of $39,460. Sonya’s economic profit equals her total revenue, $58,000, minus her total opportunity costs or $55,460, which is the sum of her explicit and implicit costs. Sonya’s economic profit is $58,000 − $55,460, which equals $2,540.

Use the following information to work Problems 3 to 5. Yolanda runs a bullfrog farm. When she employs 1 person, she produces 1,000 bullfrogs a week. When she hires a second worker, her total product doubles. Her total product doubles again when she hires a third worker. When she hires a fourth worker, her total product increases but by only 1,000

113

114

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

bullfrogs. Yolanda pays $1,000 a week for equipment and $500 a week to each worker she hires. 3. Construct Yolanda’s marginal product and average product schedules. Over what range of workers does Yolanda’s experience increasing marginal returns? The marginal product and average Total Average Labor product product product schedules are in the table to 0 0 xx the right. Marginal returns increase for rd the 3 worker. 1 1,000 1,000

2,000

1,000

4,000

1,333

5,000

1,250

Marginal product 1,000 1,000 2,000 1,000

Construct Yolanda’s total variable cost and total cost schedules. Calculate Yolanda’s total fixed cost. The variable costs are the Total Total costs of labor; the fixed Labor Output fixed cost variable cost costs are the costs of the 0 0 1,000 0 1 1,000 1,000 500 equipment. The total cost 2 2,000 1,000 1,000 schedules are in the table 3 4,000 1,000 1,500 to right. Total fixed cost 4 5,000 1,000 2,000 always equals $1,000. At what output is Yolanda’s average total cost at a minimum? Though not necessary to Average Average answer the question, the Labor Output fixed cost variable cost table to the right has the 0 0 xx xx 1 1,000 1.00 .50 average cost schedules. 2 2,000 .50 .50 From the numbers in the 3 4,000 .25 .38 average cost table, 4 5,000 .20 .40 Yolanda’s average total cost is at a minimum when she produces 5,000 bullfrogs a week. The table shows some of the costs incurred at Bill’s Bakery. Calculate the values of A, B, C, D, and E. Show your work. A = $1,050. Calculate A using TVC = TC − TFC. Total cost is given in the row. For total fixed

Total cost 1,000 1,500 2,000 2,500 3,000

Average total cost xx 1.50 1.00 .63 .60

L 1

TP 100

TVC 350

TC 850

AFC C

AVC 3.50

ATC D

240

700

2.08

2.92

5.00

380

1,550

1.32

2.76

4.08

440

1,400

1,900

1.14

3.18

4.32

470

1,750

2,250

1.06

3.72

4.79

MC 2.50 E 5.83 11.67

Chapter 10 . Production and Cost

cost, TFC, note that TFC = TC − TVC. Use the information in the top row to get TFC = $500. So A = $1,550 − $500, which equals $1,050. B = $1,200. Calculate B by adding TVC + TFC, with TFC from the previous answer as $500. Then B = $700 + $500, which equals $1,200. C = $5. Calculate C by calculating TFC ÷ TP, which is $500 ÷ 100 = $5. D = $8.50. Calculate D by calculating TC ÷ TP, which is $850 ÷ 100= $8.50. E = $2.50. Calculate E as the change in TC divided by the change in TP, which is ($1,550 − $1,200) ÷ (380 − 240) = $2.50. 7.

Grain prices go the way of the oil price Rising grain prices have started to impact the price of breakfast for millions of Americans—cereal prices are rising. Source: The Economist, July 21, 2007 Explain how the rising price of grain affects the average total cost and marginal cost of producing breakfast cereals. When producing cereal, the grain crops used are a variable factor of production. An increase in the price of these crops boosts the firms’ average total cost and the firms’ marginal cost of producing cereal.

115

116

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

 Multiple Choice Quiz 1.

A firm’s cost of production equals ________. A. all the costs paid with money, called explicit costs B. the implicit costs of using all the firm’s own resources C. all explicit costs and implicit costs, excluding normal profit D. the costs of all resources used by the firm whether bought in the marketplace or owned by the firm Answer: D A firm’s costs include the opportunity costs of all the resources it uses. 2.

The average product of labor increases as output increases if _______. A. marginal product exceeds average product B. average product exceeds marginal product C. total product increases D. marginal product increases Answer: A The relationship between average and marginal product implies that the average product of labor increases when the marginal product of labor exceeds the average product of labor. 3.

Marginal returns start to decrease when more and more workers _______. A. have to share the same equipment and workspace B. produce less and less output C. require jobs to be too specialized D. produce less and less average product Answer: A With no more equipment or workspace, eventually as additional workers are employed, less additional output is produced. 4.

Average variable cost is at a minimum when ______. A. marginal cost equals average variable cost B. average total cost is at a minimum C. marginal cost exceeds average fixed cost D. average total cost exceeds average variable cost Answer: A Figure 10.6 in the textbook shows that A is the correct answer.

Chapter 10 . Production and Cost

An increase in the rent that a firm pays for its factory does not increase ______. A. total cost B. fixed cost C. marginal cost D. average fixed cost Answer: C Rent is a fixed cost, so an increase in the rent increases fixed cost, total cost, and average fixed cost. But it does not change the marginal cost because fixed costs have no influence on the marginal cost. 6.

An increase in the wage rate ______. A. shifts the average total cost curve and the marginal cost curve upward B. shifts the average fixed cost and average variable cost curve upward C. increases average variable cost but does not change marginal cost D. does not change average variable cost but increases average total cost Answer: A Wages are a variable cost, so an increase in the wage rate increases the average total cost and the marginal cost. 7.

When average variable cost is at its minimum level, marginal product _________. A. equals average product B. exceeds average product C. is less than average product D. is at its maximum level Answer: D Figure 10.7 in the textbook shows that D is the correct answer. 8.

In the long run, with an increase in the plant size, _____ . A. the short-run average total cost curve shifts downward B. the long-run average cost curve slopes downward C. the short-run average total cost curve shifts downward if economies of scale exist D. the average total cost of production rises Answer: C The fall in the short-run average total cost means that the long-run average total cost decrease, which is the case when there are economies of scale.

117

Chapter

Perfect Competition ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

In what type of market is each good or service in the following list sold? Explain your answers. • Wheat Wheat is sold in a perfectly competitive market because there are many producers, an identical product, and no barriers to entry or exit. • Jeans Jeans are sold in a monopolistically competitive market. There are many firms, no barriers to entry, and each firm produces a similar but slightly different type of jean. • Printer cartridges The printer cartridge market is likely an oligopoly. There are four major firms: Hewlett Packard, Cannon, Epson, and Lexmark. • Toothpaste The toothpaste market is monopolistically competitive with a large number of similar but not identical brands. • Gym membership in a town with one gym The membership is provided by a monopoly because there is only one firm in the market. 2. Explain why in a perfectly competitive market, the firm is a price taker. Why can’t the firm choose the price at which it sells its good? The firm cannot choose its price because it produces only a small portion of the entire market output and its good has perfect substitutes. If the firm increases its production, it has no impact on the market price. If the firm raises the price of its good above the market price, no one buys from it, switching instead to cheaper, perfect substitutes. And, if the firm lowers its price below the market price, the firm does not maximize its profit because it does not pick up any sales beyond what it could have gained

120

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

even if it did not lower its price. The firm’s horizontal demand curve shows it can sell as much output as it wants at the market price. The table to the right shows the demand schedule for Lin’s Fortune Cookies. Calculate Lin’s marginal revenue for each quantity demanded. Compare Lin’s marginal revenue and price. In what type of market does Lin’s Fortune Cookies operate? Lin’s marginal revenue equals the price, $50 a batch. Lin’s Fortunate Cookies operates in a perfectly competitive market because Lin can sell all the fortune cookies he produces at a price of $50 a batch.

Price Quantity (dollars per demanded batch) (batches per day) 50 0 50 1 50 2 50 3 50 4 50 5 50 6

The first table to the right shows the demand schedule for Lin’s Fortune Cookies. The second table to the right shows some cost data for Lin’s. Use this information to work Problems 4 to 7. (Hint: Make a sketch of Lin’s short-run cost curves.) 4. At a market price of $50 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run? For reference, Lin’s cost curves are in Figure 11.2 (on the

Price Quantity (dollars per demanded batch) (batches per day) 50 0 50 1 50 2 50 3 50 4 50 5 50 6

next page). Lin produces the quantity at which marginal revenue equals marginal cost. The marginal revenue is $50.00 a batch of cookies. So Lin produces 6.0 batches a day. Lin’s firm makes zero economic profit. 5.

Quantity (batches per day) 1

AFC

AVC ATC (dollars per batch)

84.0

51.00

135

42.0

44.00

28.0

39.00

At a market price of $35.20 a batch, 4 21.0 36.00 57 what quantity does Lin’s produce 5 16.8 35.20 52 and what is the firm’s economic profit in the short run? 6 14.0 36.00 50 Lin produces the quantity at which 7 12.0 39.00 51 marginal revenue equals marginal cost. The marginal revenue is 8 10.5 44.50 55 $35.20 a batch of cookies. So Lin produces 5 or 0 batches a day. Lin’s average total cost is $52, so Lin incurs an economic loss of $16.80 per batch of cookies, which means she incurs a total economic loss of $84.00.

37 29 27 32 40 57 83

Chapter 11 . Perfect Competition

Create Lin’s short-run supply schedule and make a graph of Lin’s shortrun supply curve. Explain why only part of Lin’s short-run supply curve is the same as its marginal cost curve. At a price of $35.20 a batch of cookies, Lin’s produces 5.0 batches; at a price of $40 a batch of cookies, Lin’s produces 5.5 batches; at a price of $57 a batch of cookies, Lin’s produces 6.5 batches; and, at a price of $83 a batch, Lin’s produces 7.5 batches. At any price less than $35.20 a batch, Lin’s produces no cookies because her minimum average variable cost is $35.20. Figure 11.1 shows Lin’s supply curve. Lin’s supply curve is the part of the marginal cost curve that is above minimum average variable cost. At prices below minimum average variable cost, Lin’s produces no cookies. For prices less than minimum average variable cost, $35.20 a batch, Lin’s incurs a smaller economic loss by shutting down and producing nothing than by remaining open. So, at these low prices, the firm’s supply curve runs along the vertical axis and the firm produces zero cookies.

At a market price of $83 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run? Do firms enter or exit the market and what is Lin’s economic profit in the long run? Lin produces the quantity at which marginal revenue equals marginal cost. The marginal revenue is $83 a batch of cookies. As Figure 11.2 shows, at this price Lin produces 7.5 batches a day. Lin makes an economic profit of $225. Firms enter the market. In the long run, Lin’s makes zero economic profit.

121

122

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Use the following information to work Problems 8 to 10. Maple-syrup makers strike gold Sugaring season in Vermont is going full blast. Vermont, the biggest U.S. syrup producer, produces about 500,000 gallons a year. In 2007, maple syrup cost an average of $35 a gallon; this year, the price is $45 a gallon. Canada is usually a huge producer, but with a poor season it has seen a 30 percent drop in production. As consumers turn to natural and organic products and buy locally made food, demand for maple syrup has rocketed. Source: USA Today, March 30, 2009 8. Draw a graph to describe the maple syrup market and the cost and revenue of one firm in 2007, assuming that all firms are making zero economic profit.

Figure 11.3 shows the market for maple syrup. The initial demand curve in 2007 is D0 and the initial supply curve is S0. The equilibrium price is $35 a gallon and the equilibrium (market) quantity is 4 million gallons of maple syrup a year. Figure 11.4 shows the situation for an individual producer. The firm’s marginal revenue curve is MR and the firm produces 4,000 gallons of maple syrup a year. 9.

Starting with the industry in long-run equilibrium, explain how the drop in the Canadian supply, other things remaining the same, affects the maple syrup market and an individual producer in the short run. The decrease in Canadian supply raises the market price of maple syrup and decreases the (market) quantity. The rise in price increases an indi-

Chapter 11 . Perfect Competition

vidual producer’s marginal revenue (so that the producer’s MR curve shifts upward). In response to the higher marginal revenue, the producer increases the quantity of maple syrup produced. Because the price rises, the producer makes an economic profit in the short run. 10. Starting with the industry in long-run equilibrium, explain how the increase in the demand for maple syrup, other things remaining the same, affects the maple syrup market and an individual producer in the short run. The increase in demand raises the market price of maple syrup and increases the (market) quantity. The rise in price increases an individual producer’s marginal revenue (so that the producer’s MR curve shifts upward). In response to the higher marginal revenue, the producer increases the quantity of maple syrup produced. Because the price rises, the price exceeds the average total cost so the producer makes an economic profit in the short run. 11. Read Eye on Record Stores on p. 298 and explain how Internet retailing of recorded music changed the constraints faced by small traditional record stores. Why did many record stores exit rather than shut down temporarily? The rise of Internet retailing drastically changed the market faced by small traditional record stores. Amazon entered the market for recorded music using a new technology, Internet marketing, which had much lower costs than the older, traditional format. Amazon made an economic profit and accordingly other firms entered the online music industry. The entry of the new firms increased the supply of pre-recorded music, so the market price of music fell. The small, traditional stores are price takers; the price is a constraint that they cannot change. As the price fell, it dropped below the traditional record stores’ minimum average variable cost. The stores’ owners realized that the price was never going to rise (and likely might drop still more!). Consequently the owners understood that whenever their store was open, it would incur an economic loss. Faced with the prospect of permanent economic losses, the owners permanently exited the business rather than temporarily closing down.

123

124

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

 Instructor Assignable Problems and Applications 1.

Why did Amazon enter the market for recorded music and why did independent record stores exit? Amazon entered because the entrepreneurs running Amazon realized that with their new, low-cost Internet technology, they could make an economic profit by selling recorded music. The entry of Amazon into the market lowered the price of recorded music. The independent record stores, using the old retail-store technology had higher average costs than did Amazon. The fall in the price of recorded music inflicted an economic loss on the traditional firms and so they exited the market.

How does competition among online music retailers influence economic profit? Competition among online music retailers lowers the price of recorded music. The fall in the price decreases the firms’ economic profit. Ultimately the price falls enough so that the firms make zero economic profit.

In what type of market is each of the following goods and services sold? Explain your answers. • Breakfast cereals The breakfast cereal market is an oligopoly because it is dominated by 4 large firms: Kellogg’s, General Mills, The Quaker Oats Company, and Post Cereals. • Cell phones The cell phone market is monopolistically competitive. There are many firms (LF, Apple, Nokia, Motorola, Panasonic, Sony Ericsson, Sanyo, Research in Motion, and others) each making a differentiated cell phone. There are no barriers to entry into the market. • The only restaurant in a small town The only restaurant in a small town is a monopoly because it is the only firm in the market. • Oranges Oranges are a perfectly competitive market. There are many orange growers, with no barriers to entry into the market, and each orange grower produces an identical product—oranges. • Cable TV in a town with one cable company The company is a monopoly because it is the only firm in the market. 4. Suppose that the restaurant industry is perfectly competitive. Joe’s Diner is always packed in the evening but rarely has a customer at lunchtime. Why doesn’t Joe’s Diner close—temporarily shut down—at lunchtime? Joe’s Diner doesn’t shut down because the price of a meal is greater than average variable cost. By staying open, even though Joe does not have

Chapter 11 . Perfect Competition

125

many customers, he can pay all of the variable costs of remaining open and some of his fixed cost. Use the following information to work Problems 5 to 7. Figure 11.5 shows the short-run cost curves of a toy producer. The market has 1,000 identical producers and the table shows the market demand schedule for toys. 5. At a market price of $21 a toy, what quantity does the firm produce in the short run and does the firm make a positive economic profit, a zero economic profit, or an economic loss? At a market price of $21 the firm will produce 2,000 toys per week because this is the quantity of toys for which the marginal revenue, $21, equals the marginal cost. At this price the firm makes a positive economic profit because the price exceeds the average total cost. 6.

At a market price of $12 a toy, how many toys does the Quantity firm produce and what is its economic profit in the Price demanded short run? How will the number of firms in the market (dollars per (thousands of toy) toys per week) change in the long run? 24 1,000 At a market price of $12 the firm will produce either 21 1,500 1,000 toys or 0 toys per week because this price equals 18 2,000 the firm’s shutdown point, the minimum of its average 15 2,500 variable cost. At this price the firm incurs an economic 12 3,000 loss because the price is less than the average total cost. The economic loss is equal to the firm’s fixed cost. Firms will exit the market so in the long run the number of firms decreases.

At what market prices would the firm shut down temporarily? What is the market price of a toy in long-run equilibrium? How many firms will be in the toy market in the long run? Explain your answer. At any market prices less than $12 per toy, the firm would shut down. The long-run price of a toy is $15. This price equals the firms’ minimum average total cost, so at this price there is no longer any incentive to enter or exit the market. When the price is $15 per toy, each firm produces 1,500 toys and the market quantity demanded is 2,500, 000 toys. To meet the market demand, there must be 2,500,000 toys ÷ 1,500 toys per firm, or 1,667 firms.

126

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Use the following information to work Problems 8 and 9. California plans to crack down on the use of fumigants by growers of strawberries. The biggest burden will fall on Ventura County’s growers, who produce about 90 percent of the nation’s crop. 8. Draw graphs of the U.S. strawberry market in long-run equilibrium before the pollution crackdown: one of the U.S. market and one of a California grower. Now show the short-run effects of the pollution crack down.

Figure 11.6 and Figure 11.7 show the initial U.S. market and a typical California grower. In Figure 11.6, the demand curve is D and the initial supply curve is S0. The initial (assumed) equilibrium price is $1 per pound and the initial equilibrium quantity is 600 tons per year. Figure 11.7 shows an individual producer of strawberries. The initial marginal cost curve is MC0, the initial average total cost curve is ATC0, and the initial marginal revenue curve is labeled MR0. The firm initially produces 5 tons per year and makes zero economic profit because the price, $1 per pound, equals the average total cost. The rise in costs shifts the firm’s average total cost and marginal cost curve upward, as shown in Figure 11.7 by the shift from ATC0 to ATC1 and from MC0 to MC1. In the market, Figure 11.6 shows that the market supply decreases and the market supply curve shifts leftward to S1. The new equilibrium price is $1.50 per pound. At this price, Figure 11.7 shows that the firm decreases its production to 2.5 tons per year, where the (new) marginal cost curve, MC1, intersects the new

Chapter 11 . Perfect Competition

marginal revenue curve, MR1. The firm incurs an economic loss because the price, $1.50 per pound, is less than its average total cost. 9.

On the graph, show the long-run effects of the pollution crackdown.

Figures 11.8 and 11.9 show what happens in the long run. In the short run the higher costs mean that the firms incur economic losses. These economic losses lead to some firms exiting the market. As firms exit, the market supply decreases. Eventually the market supply decreases so that the market supply curve becomes S2 in Figure 11.8. (In the long run, the market supply decreases so that the supply curve S0 shifts to the supply curve S2.) The price rises to $2 per pound. In Figure 11.9, which shows a firm in the market, the higher market price of $2 per pound shifts the firm’s marginal revenue curve upward to MR2. The firm produces where its marginal cost curve, MC1, intersects its (new) marginal revenue curve, MR2. In Figure 11.9, this firm produces 3 tons of strawberries in the long run. At this new equilibrium, the firm makes zero economic profit so there is no longer an incentive for firms to exit the market.

127

128

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Use the following information to work Problems 10 and 11. Big drops in prices for crops make it tough down on the farm Corn, soybean, and wheat prices have fallen roughly 50 percent from the historic highs of earlier this year. With better-than-expected crop yields, world grain production will rise nearly 5 percent this year. Grain prices have also become more closely tied to oil prices because of the growing corn-based ethanol industry. Source: USA Today, October 23, 2008 10. Why did grain prices fall in 2008? Draw a graph to show the short-run effect on an individual farmer’s economic profit. Grain prices fell in 2008 because the supply of grain increased. The increase in the supply of grain drives the prices of grain lower. Figure 11.10 shows the effect of the lower price on the economic profit of an individual farmer. The price of a bushel of grain falls from $4 per bushel to $2 per bushel. The firm’s marginal revenue curve therefore falls from MR0 to MR1. When the price was $4 per bushel, the firm produced 50,000 bushels per year and made an economic profit (because P > ATC). After the price falls to $2 per bushel, the firm produces 35,000 bushels per year and incurs an economic loss (because P < ATC).

11 Explain the effect of a fall in the oil price on the market for ethanol. If the price of oil remains low for some years, what will be the long-run effects on the market for ethanol and the number of ethanol producers? Oil and ethanol are substitutes. The fall in the price of oil decreases the demand for ethanol. The decrease in demand for ethanol lowers the price of ethanol. If the price of oil remains low, then the price of ethanol likewise will remain low. If the price of ethanol falls below the average total cost, ethanol producers incur an economic loss. In the long run some ethanol producers exit the market, which decreases the number of ethanol producers.

Chapter 11 . Perfect Competition

 Multiple Choice Quiz 1.

In perfect competition, all the following situations arise except ________. A. firms produce an identical good or service B. each firm chooses the price at which to sell the good it produces C. firms can sell any quantity they choose to produce at the market price D. buyers know each seller’s price Answer: B Firms in perfect competition are price takers so they “take” the price determined in the market. 2.

A firm that is producing the quantity at which marginal cost exceeds both average total cost and the market price will increase its economic profit by _______. A. producing a larger quantity B. raising the price to equal marginal cost C. producing a smaller quantity D. producing the quantity that minimizes average total cost Answer: C The market price equals the firm’s marginal revenue. When a firm’s marginal cost exceeds its marginal revenue, the firm’s profit increases if it decreases its production. 3.

A firm will shut down in the short run if at the profit-maximizing quantity, ___________. A. total revenue is less than total cost B. marginal revenue is less than average fixed cost C. average total cost exceeds the market price D. marginal revenue is less than average variable cost Answer: D The firm’s shutdown point is when price equals the minimum average variable cost.

In the short run, the profit-maximizing firm will ______. A. break even if marginal revenue equals marginal cost B. make an economic profit if marginal cost is less than average total cost C. incur an economic loss if average fixed cost exceeds marginal revenue D. incur an economic loss if average total cost exceeds marginal revenue Answer: D The firm’s marginal revenue equals its price, so answer D is correct because in the case described by answer D, the firm’s average total cost exceeds its price.

129

130

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

A firm’s short-run supply curve is the same as _____ if it produces the good. A. its marginal revenue curve B. the upward-sloping part of its marginal cost curve C. its marginal cost curve above minimum average variable cost D. its marginal cost curve above minimum average total cost Answer: C Figure 11.5 in the text illustrates that answer C is correct. 6.

A permanent increase in demand ______ economic profit in the short run and some firms will ____ in the long run. A. does not change; exit the market B. increases; enter the market C. increases; raise their price D. does not change; advertise their good Answer: B The increase in demand leads to a higher price, which increases the firms’ economic profit. The economic profit influences other firms to enter the market. 7.

Perfect competition is efficient because all the following conditions hold except ________. A. total product is maximized B. firms maximize profit and produce on their supply curves C. consumers get a real bargain and pay a price below the value of the good D. firms minimize their average total cost of producing the good Answer: A Although perfectly competitive firms produce at the minimum average total cost, that result does not mean that the firm’s total product is at its maximum. Each firm could produce more, albeit at a higher average total cost.

Chapter

Monopoly ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications Use the following information to work Problems 1 to 3. Elixir Spring produces a unique and highly prized mineral water. The firm’s total fixed cost is $5,000 a day, and its marginal cost is zero. The table shows the demand schedule for Elixir water. 1. On a graph, show the demand for Elixir water and Elixir Spring’s marginal revenue curve. What are Elixir’s profit-maximizing price, output, and economic profit? Elixir Spring’s marginal revenue curve and demand curve are illustrated in Figure 12.1. Also in the figure is Elixir’s marginal cost curve. The marginal cost curve runs along the horizontal axis because the marginal cost is zero. Elixir produces the quantity where the marginal cost curve intersects the marginal revenue curve, so Elixir produces 5,000 bottles a day. Elixir sets a price of $5 a bottle because that is the price at which 5,000 bottles a day is the quantity demanded. Elixir’s economic profit equals its revenue, which is $5 a bottle × 5,000, = $25,000 a day, minus its cost, which is its fixed cost of $5,000 a day. Elixir’s economic profit is $25,000 − $5,000, which is $20,000 a day. 2.

Price (dollars per bottle) 10 8 6 4 2 0

Compare Elixir’s profit maximizing price with the marginal cost of producing the profit-maximizing output. At the profit-maximizing price, is the demand for Elixir water inelastic or elastic? Elixir’s profit-maximizing price is $5 per bottle and Elixir’s profit-

Quantity (bottles per day) 0 2,000 4,000 6,000 8,000 10,000

132

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

maximizing output is 5,000 bottles per day. The price, $5, is well above the marginal cost, $0. At this price and quantity, the demand for Elixir water is unit elastic because the marginal revenue equals zero. 3.

Suppose that there are 1,000 springs, all able to produce this water at zero marginal cost and with zero fixed costs. Compare the equilibrium price and quantity produced with the price and quantity produced by Elixir water. In this (extreme) situation, the competitive outcome has price equal to marginal cost, $0. The quantity demanded at this price is 10,000 bottles a day, so the equilibrium quantity will be 10,000 bottles a day.

Blue Rose Inc. is the only flower grower to have cracked the secret of making a blue rose. Figure 16.2 shows the demand for blue roses and the marginal cost of producing a blue rose. What is Blue Rose’s profit-maximizing output? What price does Blue Rose charge and is it efficient? To work the question, it is handy to use Figure 12.3 which shows Blue Rose’s marginal cost curve as well as its demand curve, and marginal revenue curve. To maximize profit, Blue Rose produces the quantity where the marginal cost curve intersects the marginal revenue curve. Figure 16.3 shows that Blue Rose produces 2 roses a day, determined by the intersection of its marginal revenue and marginal cost curves. The demand curve shows that the price is $40 a (blue) rose because that is the price at which 2 roses per day is the quantity demanded. Blue Rose is not using its resources efficiently because Blue Rose is creating a deadweight loss.

Chapter 12 . Monopoly

Hawaii Cable Television is a natural monopoly. Sketch a market demand curve and the firm’s cost curves. Use your graph to work Problems 5 to 8. 5. If Hawaii Cable is unregulated and maximizes profit, show in your graph the price, quantity, economic profit, consumer surplus, and deadweight loss. Figure 12.4 illustrates the case of Hawaii Cable when it is unregulated. Hawaii Cable produces the quantity at which marginal revenue equals marginal cost, so it serves 20,000 households. The price is $60 a month. The economic profit, consumer surplus, and deadweight loss are illustrated in the figure.

If Hawaii Cable is unregulated and it gives householders a 50 percent discount for second and third connections, describe how its economic profit, consumer surplus, and deadweight loss would change. Hawaii Cable is price discriminating. Its economic profit increases because it will gain additional sales and, presumably, will charge a higher price for the first connection. Consumer surplus decreases as Hawaii Cable charges a higher price. The deadweight loss decreases because the quantity of cable connections increases.

If Hawaii Cable is regulated in the social interest, show in your graph the price, quantity, economic profit, consumer surplus, and deadweight loss. Figure 12.5 illustrates the situation when Hawaii Cable is regulated in the public interest. Hawaii Cable produces the quantity at which the marginal cost curve intersects the demand curve, so it serves 40,000 households. The price is $20 a month. The consumer surplus is the area under the demand curve and above the price, $20 a month. It is equal to the light grey triangle plus the part of the dark rectangle that lies under the demand curve. There is no deadweight loss. There also is no economic

133

134

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

profit. Instead, Hawaii Cable incurs an economic loss, shown by the dark grey rectangle. 8.

If Hawaii Cable is subject to a price cap regulation that enables it to break even, show in your graph the price, quantity, economic profit, consumer surplus, and deadweight loss. The price cap will be set at $40 per month. Figure 12.6 shows that with this price cap, Hawaii Cable serves 30,000 households and the price is $40 per month, the same as Hawaii Cable’s average total cost. There is no economic profit. The consumer surplus is equal to the area of the light grey triangle. The deadweight loss is equal to the area of the dark grey triangle.

Use the following information to work Problems 9 and 10. FCC planning rules to open cable market The Federal Communications Commission (FCC) will make it easier for independent programmers and rival videos services to lease access to cable channels. The FCC will also limit the market share of a cable company to 30 percent. Source: The New York Times, November 10, 2007 9. What barriers to entry exist in the cable television market? Are high cable prices evidence of monopoly power? The major barrier to entry is that the cable industry is a natural monopoly. Firms entering the market will have higher average total costs if the amount they produce and sell is less than that of the existing firm. High prices are not necessarily evidence of monopoly. Prices can be high in competitive markets if the costs are high. For instance, the luxury car market is competitive but these cars are quite expensive. 10. Draw a graph to illustrate the effects of the FCC’s new regulations on the price, quantity, consumer surplus, producer surplus, and deadweight loss. Presuming that the cable market was an unregulated monopoly before the FCC’s actions and that the market becomes competitive after the actions, Figure 12.7 (on the next page) shows what would happen. With the

Chapter 12 . Monopoly

cable television market a monopoly, 200 channels are provided and the price is $3 a channel. The consumer surplus is equal to area A, the producer surplus is equal to area B + area E, and the deadweight loss is equal to area C + area F. Once the market is competitive, 250 channels are provided and the price is $2.50 a channel. Consumer surplus increases to area A + area B + area C. Producer surplus decreases to area E + area F. There is no deadweight loss because the market is allocatively efficient.

11. Read Eye on Microsoft on p. 331 and explain how Window’s price, quantity, consumer surplus, producer surplus, and deadweight loss would change if Microsoft was able to sell ads that appear every time a user opens a program. Illustrate your answer with a graph. If Microsoft was able to sell ads, the situation will be similar to Google, which sells ads as people search. Microsoft’s ads would lead to a lower price for Windows, an increased quantity, and an increased consumer surplus. If the price falls to equal the marginal cost, zero, the deadweight loss is eliminated. Microsoft’s producer surplus increases. Figure 16.8 shows the market for ads. Presuming Microsoft can perfectly price discriminate, Microsoft’s producer surplus is equal to the area of the entire grey triangle.

135

136

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

 Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. Microsoft: We're not gouging Europe on Windows 7 pricing Regulators in the European Union have charged Microsoft with illegally tying Internet Explorer (IE) to Windows and mandated that a version of Windows be offered stripped of IE. A news report suggested that when Microsoft launches Windows 7, it will charge a higher price for the IEstripped version than the price for a full version that includes IE. Microsoft denied this report but announced that it would offer the full version of Windows 7 at a lower upgrade price. Source: computerworld.com 1. How does Microsoft set the price of Windows and would it be in the firm’s self-interest to set a different price for a version stripped of IE? Microsoft sets the price of Windows at the amount that maximizes its profit. Stripping IE increases Microsoft’s fixed costs but has no effect on its variable cost or its marginal cost. Microsoft will set different prices if the marginal revenue of the two Windows versions are different. 2.

Why might Microsoft offer the full version of Windows 7 to European customers at a lower upgrade price? Stripping IE increases Microsoft’s costs. Microsoft might set a lower price—the upgrade price—for the full version of Windows 7 than for the stripped version because Microsoft’s cost of the full version is less than its cost for the stripped version.

Use the following information to work Problems 3 and 4. Bobbie’s Hair Care is a natural monopoly. The Price Quantity Marginal cost (dollars per (haircuts (dollars per table shows the demand schedule (the first two haircut) per hour) hour) columns) and Bobbie’s marginal cost schedule 20 0 (the middle and third columns). Bobbie has 18 1 1 done a survey and discovered that she has four 16 2 4 types of customers each hour: one woman who is 14 3 8 willing to pay $18, one senior who is willing to 12 4 12 pay $16, one student who is willing to pay $14, 10 5 18 and one boy who is willing to pay $12. Suppose that Bobbie’s fixed costs are $20 an hour and Bobbie’s price discriminates. 3. What is the price each type of customer is charged and how many haircuts an hour does Bobbie’s sell? What is the increase in Bobbie’s economic profit that results from price discrimination? If Bobbie price discriminates, she charges the woman $18, the senior citizen $16, the student $14, and the boy $12. If Bobbie price discriminates, she sells 4 haircuts an hour. Bobbie’s economic profit is her total revenue minus her total cost. If she does not price discriminate, she produces the

Chapter 12 . Monopoly

137

quantity such that marginal revenue equals marginal cost. Bobbie’s marginal revenue when she produces 3 haircuts is equal to her marginal cost when she produces 3 haircuts. (Both are equal to $8.) So without price discrimination, Bobbie’s produces 3 haircuts an hour at a price of $14. In this case, her economic profit is her total revenue, $42, minus her total cost, $33 (the sum of the fixed cost plus the marginal costs), which is $9. If she price discriminates, her total revenue is $18 + $16 +$14 + $12, which is $60. Her total cost to produce 4 haircuts is $45, so her economic profit is $60 − $45, which is $15. So her economic profit increases by $6. Who benefits from Bobbie’s price discrimination? Is the quantity of haircuts efficient? When Bobbie price discriminates, Bobbie benefits because her economic profit is higher. Because Bobbie is perfectly price discriminating, Bobbie is producing the efficient quantity of haircuts. With price discrimination, the boy willing to pay $12 benefits because he now gets a haircut. Society benefits because the deadweight loss is eliminated.

Use the following information to work Problems 5 through 10. Big Top is the only circus in the nation. The Price Quantity Total cost table sets out the demand schedule for circus (dollars per (tickets (dollars per tickets and the cost schedule for producing ticket) per show) show) the circus. 20 0 1,000 18 100 1,600 5. Calculate Big Top’s profit-maximizing 16 200 2,200 price, output, and economic profit if it 14 300 2,800 charges a single price for all tickets. 12 400 3,400 Big Top’s total revenue and marginal 10 500 4,000 revenue schedules are in the second table 8 600 4,600 6 700 5,200 (on the next page), which is useful to an4 800 5,800 swer these questions. Big Top’s marginal cost is constant and equal to $6 per ticket. Big Top’s marginal revenue equals its marginal cost when the quantity of tickets is 350 tickets per show and the price is $13 per ticket. The total revenue is 350 tickets × $13, which is $4,550. The total cost of 350 tickets is $3,100. So the economic profit equals $4,550 − $3,100, which is $1, 450. 6.

When Big Top maximizes profit, what is the consumer surplus and producer surplus and is the circus efficient? Explain why or why not. The consumer surplus equals the triangular area under the demand curve and above the price. The height of this triangle is the price at which the quantity demanded is zero ($20) minus the equilibrium price and the base of the triangle is the equilibrium quantity. The consumer surplus equals

138

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

1/2 × ($20 − $13) × 350, which is $1,225. The producer surplus is the area above the marginal cost curve and below the price. Because the marginal cost curve is horizontal, this area is a rectangle equal to ($13 − $6) × 350, which is $2,450. When Big Top maximizes its profit, the circus is not efficient. At 350 tickets, the marginal cost of another ticket is $6 and the marginal benefit from another ticket (which is equal to the maximum a consumer is willing to pay) is $13. Marginal benefit is greater than marginal cost, so a deadweight loss exists.

Total Marginal Price Quantity revenue revenue (dollars per (tickets per (dollars (dollars per show) ticket) show) per show) 20

100

1800

200

3200

300

4200

400

4800

500

5000

600

4800

700

4200

800

3200

At the market equilibrium, no children under 10 years old attend the circus. Big Top offers children under 10 a discount of 50 percent. How will this discount change the consumer surplus and producer surplus? Will Big Top be more efficient by offering the discount to children? If Big Top offers a child discount, the consumer surplus increases because more children attend. Presumably the producer surplus increases (as Big Top’s production increases) because Big Top would be unwilling to offer a discount otherwise. Big Top sells more tickets and so it operates closer to the efficient level of output but it is unlikely to produce the efficient quantity.

If Big Top is regulated to produce the efficient output, what is the quantity of tickets sold, what is the price of a ticket, and what would be the consumer surplus? Big Top’s marginal cost is constant at $6 per ticket. To operate efficiently Big Top’s marginal cost must equal the price, so the price of a ticket is $6. At this price, the quantity of tickets sold will be 700 tickets per show. The consumer surplus equals 1/2 × ($20 − $6) × 700, which is $4,900.

If Big Top is regulated to charge a price equal to average total cost, what is the quantity of tickets sold, the price of a ticket, and economic profit? The quantity will be a bit more than 600 and the price will somewhat less than $8. Because the price equals the average total cost, the economic profit is zero. (Interpolation of the total cost and demand schedules shows that the “precise” quantity is 619 tickets and the “precise” price is $7.62. At this quantity, interpolation of the total cost schedule is $4,716 and so the average total cost is $7.62, equal to the price).

18 14 10 6 2 −2 −6 −10

Chapter 12 . Monopoly

10. Draw a graph to illustrate the circus market if regulators set a price cap that enables Big Top to break even. Show the deadweight loss in your graph. Figure 12.9 shows the situation if regulators set a price cap that allows Big Cap to break even. The price cap is a touch under $8 because this is the price at which the average total cost curve intersects the demand curve. The quantity of tickets sold is a bit more than 600. The deadweight loss is equal to the area of the grey triangle.

139

140

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

 Multiple Choice Quiz 1.

A firm is a natural monopoly if ________. A. it can produce the good at a price below its competitor’s price B. it can produce a larger quantity of the good than other firms could C. the government grants it a public franchise or patent D. it can satisfy the market demand at a lower average total cost than other firms can Answer: D Answer D is the definition of a natural monopoly. 2.

A monopoly ________. A. can choose its price and output and always has the option of price discriminating B. is a price taker and by offering a range of discounts can price discriminate C. that produces a good that cannot be resold might choose to price discriminate D. book store that offers a discount on Tuesdays is price discriminating Answer: C The monopoly has the potential of price discriminating only when the good cannot be resold. 3.

A single-price monopoly maximizes profit by producing the quantity at which _____. A. its total revenue will be as large as possible B. marginal revenue equals marginal cost and setting the price equal to marginal revenue C. marginal revenue equals marginal cost and setting the price equal to marginal cost D. marginal revenue equals marginal cost and setting the price equal to the most people are willing to pay for that quantity Answer: D Figure 12.4(b) illustrates that answer D is correct. 4.

A monopoly sets its price such that demand for the good produced is ______. A. unit elastic B. inelastic C. elastic D. either elastic or inelastic, but never unit elastic Answer: C To maximize profit, marginal cost must equal marginal revenue. Marginal cost is positive, so to maximize profit marginal revenue must also be positive. Only when the demand is elastic is marginal revenue positive.

Chapter 12 . Monopoly

A single-price monopoly is ______. A. inefficient because it converts consumer surplus to producer surplus B. inefficient because it produces too small an output and creates a deadweight loss C. efficient because buyers are paying a price equal to their willingness to pay D. efficient because it is the only producer of the good Answer: B The monopoly creates inefficiency by producing less than a competitive market to raise its price. 6.

A monopoly that price discriminates ______. A. benefits buyers because it offers the good at a variety of prices B. gains because it converts consumer surplus to economic profit C. uses resources more efficiently than would a competitive market D. enables buyers to maximize their consumer surplus Answer: B Price discrimination converts consumer surplus to economic profit. 7.

Governments regulate natural monopoly by capping the price at _____. A. marginal revenue and allowing the monopoly to maximize profit B. marginal cost so that the monopoly is efficient and makes zero economic profit C. average total cost, which allows the monopoly to be inefficient but make zero economic profit D. the buyers’ willingness to pay, which makes the monopoly operate efficiently Answer: C Figure 12.12 illustrates the effects of using an average cost pricing rule to regulate the natural monopoly.

141

Monopolistic Competition and Oligopoly

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 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.

•

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.

•

Ready-mix concrete The ready-mix concrete market is not an example of monopolistic competition.

144

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Use Figure 13.1, which shows the demand curve, marginal revenue curve, and cost curves of Lite and Kool, Inc., a producer of running shoes in monopolistic competition, to work Problems 2 to 4. 2. In the short run, what quantity does Lite and Kool produce, what price does it charge, and does it make an economic profit? Lite and Kool produces 200 pairs of shoes a week because this is the quantity at which marginal revenue equals marginal cost. Using its demand curve, Lite and Kool charges a price of $75 a pair of shoes. Lite and Kool’s price is $75 a pair of shoes and its average total cost is $35 a pair of shoes. So Lite and Kool makes an economic profit of $75 a pair of shoes − $35 a pair of shoes, which is $40 a pair of shoes. Lite and Kool produces 200 pairs of shoe a week, so its weekly economic profit is $40 × 200, which is $8,000 a week. 3.

In the short run, does Lite and Kool have excess capacity and what is its markup? Lite and Kool does not have excess capacity. Its efficient scale, where its average total cost is at its minimum, is less than 200, so Lite and Kool is producing beyond its efficient scale. Lite and Kool’s price is $75 a pair of shoes and its marginal cost is $50 a pair of shoes. So, Lite and Kool’s markup is $75 a pair of shoes − $50 a pair of shoes, which is $25 a pair of shoes.

Do you expect firms to enter the running shoes market or exit from that market in the long run? Explain your answer. Firms enter the market because the existing firms, of which Lite and Kool is one, are making an economic profit. Anytime there is an economic profit, if it is possible to enter an industry, new firms will do so. In the case of a monopolistically competitive industry, because there are no barriers to entry, it is possible for new firms to enter the market.

Chapter 13 . Monopolistic Competition and Oligopoly

Use the following information to work Problems 5 and 6. Isolated Island has two taxi companies, one owned by Ann and the other owned by Zack. Figure 13.2 shows the demand curve for taxi rides, D, and the average total cost curve of one of the firms, ATC. Suppose that Ann and Zack have two strategies: collude, fix the monopoly price, and limit the number of rides, or break the collusion, cut the price, and produce more rides. 5. Create a payoff matrix for the game that Ann and Zack play, and find the Nash equilibrium for this game if it is played just once. Do the people of Isolated Island get the efficient quantity of taxi rides? In perfect competition in the long run, price equals minimum average total cost. So if Ann and Zack produce as perfect competitors, the total quantity of rides is 30 a day, the price is $15 a ride, and both make zero economic profit. Ann and Zack have an incentive to collude and operate together as a monopoly. A monopoly produces where marginal revenue equals marginal cost. The marginal revenue curve goes through the point with price of $10 and quantity of 20 rides. Each firm’s marginal cost curve is “half” the market marginal cost curve. That means that at every marginal cost, the market marginal cost curve has twice the quantity of each firm’s marginal cost curve. So the market marginal cost also goes through the point with price $10 and quantity of 20 rides. Therefore the marginal revenue curve intersects the marginal cost curve at $10 and quantity of 20 rides, so each firm produces 10 rides. The price, from the market demand curve, is $20 per ride. At this quantity, the average total cost is $17, so the firms make an economic profit per ride of $20 − $17, or $3. Each firm sells 10 rides, so each firm’s economic profit is $30 for a total economic profit of $60, the same as the monopoly economic profit. Ann and Zack both have an incentive to break the cartel agreement by cutting their price below $20 a ride. For each, the marginal revenue of an additional taxi ride exceeds the marginal cost, so each knows that if it, and it alone cheated, its profit would increase. Calculating the profits when either Ann or Zack break the collusive cartel agreement is difficult and the answer to the question depends on these profits. Probably the most reasonable assumptions are that the “cheater,” that is, the player who does not collude, makes a larger economic profit and that the “victim,” that is the player who does collude, incurs an eco-

145

146

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

nomic loss because no one uses his or her higher-price rides. So, the cheater makes an economic profit that exceeds $30 (assumed to be $50 in the payoff matrix), the victim incurs an economic loss (assumed to be −$10 in the payoff matrix), and the sum of the profit plus the loss is less than $60, the total profit when both Ann and Zack comply with their agreement. A possible payoff matrix is to the right. In the payoff maAnn’s strategies trix, the entries are dollars of Collude Not collude economic profit. The Nash equilibrium is for Ann and $30.00 $50.00 Collude Zack to produce the same quantity of rides as would be produced in perfect competition. Both make $0 economic profit. The efficient quantity of taxi rides is produced. 6.

Zack’s strategies

−$10.00

$30.00

−$10.00 Not collude

If Ann and Zack play the game $50.00 $0.00 repeatedly, what additional strategies become available to them and how might the outcome change? If the game is played repeatedly, a tit-for-tat strategy becomes available. If both players use a tit-for-tat strategy, the Nash equilibrium is for Ann and Zack to produce the same quantity of rides as would be produced in monopoly. Both make an economic profit of $30 and an inefficient quantity of taxi rides is produced

Use the following information to work Problems 7 and 8. Cola wars: What’s your soft drink of choice? Soft drink sales have fallen for six straight years as consumers switched to healthier alternatives such as juices and cut back on spending in the recession. The two rivals have moved into bottled water, fruit juices, energy drinks, and sports drinks to try to maintain market share. Both companies saw decreased sales, but Pepsi had the greater loss. Overall, Coke product sales were down 0.5 percent while Pepsi saw a 2.6 percent decline. Source: CBC News, March 18, 2011 7. Describe the strategies in the game that Coca-Cola and PepsiCo play. With some assumed payoffs, create a payoff matrix for the game and find the equilibrium outcome. Coke and Pepsi are playing a product development game. In this prisoners’ dilemma game, both have two strategies: They can develop new products or not develop new products.

$0.00

Chapter 13 . Monopolistic Competition and Oligopoly

The payoff matrix to the right has some assumed payoffs. Pepsi’s dominate strategy is to develop new products. Similarly, Coke’s dominate strategy also is to develop new products. Consequently the equilibrium outcome is for both companies to develop new products.

Coke’s strategies Develop

Pepsi’s strategies

Do not develop

$20

Develop $20

$10 $90

$90 Do not develop

147

$10

$40 $40

Read Eye on Cell Phones on p. 348 and explain why cell-phone producers offer such a large variety of their products. Draw a graph of a firm’s cost and revenue curves if all cell phones are identical. Use your graph to illustrate the effects of the firm introducing a new, differentiated cell phone. Cell phone producers offer a huge variety because it is inexpensive to offer the variety and consumers want to buy a cell phone that is differentiated according to their tastes. When the firm produces a cell phone with the features that many consumers desire, the firm can temporarily make an economic profit. Figure 13.3 shows the situation in the cell phone market for one firm if all cell phones are identical. In this case, the market is effectively perfectly competitive and, as the figure shows, the demand curve, DSAME, is horizontal and equal to the marginal revenue curve. In this case the firm produces 1,000 cell phones a day and the price is $75 per cell phone. The firm makes zero economic profit. If, however, the firm creates a new, differentiated phone, the demand curve changes to DDIFF with the marginal revenue curve MRDIFF. Now the firm maximizes its profit by producing the quantity that sets MRDIFF = MC, which is 875 phones per day. The price is $175 per phone and the producer makes an economic profit.

148

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Read Eye On Cell-Phone Oligopoly on p. 363 and then explain the effects of economies of scale on the market for cell phones and illustrate it with a graph based on text Figure 13.1. Samsung and Apple together have about 50 percent of the market. This result suggests there are substantial economies of scale, as illustrated in Figure 13.4. In the figure, the efficient scale of the firm is 400 million cell phones, ¼ of the market at the price of $200 per cell phone. In this market, four firms could meet the market demand. In the actual cell phone market, however, the market has more than four firms because after Samsung's and Apple's 50 percent share, the remaining 50 percent is divided among several other firms.

Chapter 13 . Monopolistic Competition and Oligopoly

 Instructor Assignable Problems and Applications 1.

Washtenaw Dairy in Ann Arbor, Michigan, sells 63 flavors of Strohs Mooney’s ice cream. Ben and Jerry’s Web site also lists 63 different flavors of ice cream. These numbers are similar to the varieties of cell phones sold by Samsung, Nokia, and Motorola. Toyota makes only 16 varieties of vehicles and Boeing makes 16 varieties of airplanes. Why is there more variety in cell phones and ice cream than in automobiles and airplanes? There is more variety in cell phones and ice cream than in automobiles and airplanes because for cell phones and ice cream the marginal cost of producing additional varieties is lower relative to the marginal benefit of additional varieties. Cell phones can add or subtract features at low cost; new ice cream flavors can be developed with the addition of different flavors. The marginal benefit of these varieties easily exceeds the marginal cost. But producing different varieties of automobiles or airplanes is much costlier. Fewer varieties of automobiles and airplanes are produced because the marginal benefit from an additional variety does not cover the marginal cost of creating the variety.

Apple and Samsung have two pricing strategies: Set a high (monopoly) price or set a low (competitive) price. Suppose that if they both set a competitive price, economic profit for both is zero. If both set a monopoly price, Apple makes an economic profit of $100 million and Samsung of $200 million. If Apple sets a low price and Samsung sets a high price, Apple makes an economic profit of $200 million and Samsung incurs an economic loss of $100 million; if Apple sets a high price and Samsung sets a low price, Apple incurs an economic loss of $50 million and Samsung makes an economic profit of $250 million. • Create the payoff matrix for Samsung this game. High price Low price The payoff matrix is to the right. Each entry is in millions of dollars. •

What is the equilibrium of this game? The equilibrium is that each firm sets a high price. Each firm can determine that setting a high price is the best strategy for the other firm. And in that case, setting a low price when the other firm sets

High price

$200 $100

$250 - $50

Apple Low price

- $100 $200

$0 $0

149

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

150

a high price is a bad strategy because it decreases economic profit. •

Is the equilibrium efficient? The equilibrium is inefficient. When they set a high price, each makes an economic profit, which means there is a markup of price over marginal cost. Because the price equals the marginal benefit, the economic profit means that marginal benefit exceeds marginal cost.

•

Is this game a prisoners’ dilemma? The game is not a prisoners’ dilemma. A prisoners’ dilemma has a unique equilibrium, which is the worst outcome for the players. In a prisoners’ dilemma game, each firm knows that the other player will take a (selfinterested) action that damages their joint interest. This is not a feature of the Apple/Samsung game. There is no dilemma because each firm can work out what the other will do and the outcome is best for both firms.

Use the figure, which shows the demand curve, marginal revenue curve, and cost curves of La Bella Pizza, a firm in monopolistic competition, to work Problems 3 and 4. 3. In the short run, what is the quantity that La Bella Pizza produces, the price it charges, its markup, and its excess capacity? La Bella produces 150 pizzas a day because this is the quantity at which marginal revenue equals marginal cost. La Bella charges a price of $13 a pizza. La Bella has a price markup because its price exceeds its marginal cost. The price is $13 per pizza and the marginal cost is $10 per pizza. La Bella has a $3 per pizza markup. La Bella is producing less than its efficient scale, so La Bella has excess capacity. La Bella’s efficient scale of output is 210 pizzas, where the marginal cost curve intersects the average total cost curve. La Bella is producing only 150 pizzas, so it has excess capacity of 60 pizzas per day.

Chapter 13 . Monopolistic Competition and Oligopoly

In the long run, how will the number of pizza producers change? What are the excess capacity and the deadweight loss created? Explain your answer. Other firms will not enter the pizza industry because the firms, of which La Bella is one, are making zero economic profit. The excess capacity remains as it is in the short run, 60 pizzas per day. Figure 13.6 shows the deadweight loss as the area of the darkened gray triangular shaped area.

Which of the following items are sold by firms in monopolistic competition? Explain your answer. • 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.

•

PCs There are many firms that produce PCs and they produce many different varieties. PCs 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.

151

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

152

•

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.

Sparks fly for Energizer Energizer is gaining market share against competitor Duracell and its profit is rising despite the sharp rise in the price of zinc, a key battery ingredient. Source: www.businessweek.com, August 2007 In what type of market are batteries sold? Explain your answer. Batteries are an oligopoly. There are two companies with large market shares, Energizer and Duracell, and another company with a significantly smaller market share, Spectrum (which makes Rayovac).

Use the following information to work Problems 7 and 8. The United States claims that Canada Canada subsidizes its softwood Export Don’t export production and that imports of Canadian lumber damage the interests of U.S. producers. The $100 m $25 m No tariff United States has levied a tariff on Canadian imports to counter $100 m $50 m United the subsidy. Canada is thinking States of retaliating by refusing to $50 m $0 m export water to California. The Tariff table shows a payoff matrix for the game that the United States $125 m $75 m and Canada play. 7. What is the United States’ best strategy? What is Canada’s best strategy? What is the outcome of this game? Explain. The United States’ best strategy is to impose a tariff because regardless of whether Canada exports or does not export, the payoff to the United States is greater with a tariff than without. Canada’s best strategy is to export because regardless of whether the United States imposes a tariff or does not impose a tariff, the payoff to Canada is greater by exporting than by not exporting. The outcome of the game is for the United States to impose a tariff and for Canada to export. This equilibrium occurs because both the United States and Canada are using their best strategies.

Chapter 13 . Monopolistic Competition and Oligopoly

Is this game like a prisoners’ dilemma or different in some crucial way? Explain. Which country would benefit more from a free trade agreement? The equilibrium is a Nash equilibrium but it differs from the Nash equilibrium in the prisoners’ dilemma game because the equilibrium in this trade game is not a bad outcome for both players. In particular, in the Nash equilibrium for the trade game, the United States has its best possible outcome and receives its highest payoff of 125. Any other outcome would give the United States a lower payoff. In the Nash equilibrium for the prisoners’ dilemma game, neither player achieves his or her best outcome. A free trade agreement would prevent the United States from imposing a tariff. The outcome in this case is for the United States to not impose a tariff and for Canada to export. Compared to the outcome in which the United States imposes a tariff and Canada exports, the free trade agreement lowers the payoff to the United States (from 125 to 100) but raises it for Canada (from 50 to 100). So Canada would benefit more from a free trade agreement.

153

154

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

 Multiple Choice Quiz 1.

Monopolistic competition differs from ________. A. monopoly because firms cannot set their own price B. oligopoly because firms produce differentiated goods or services C. perfect competition because the goods or services produced are differentiated D. monopoly because the good produced by each firm has no close substitute Answer: C Answer C describes the key difference between perfect competition and monopolistic competition. 2.

A firm in monopolistic competition maximizes its profit by ________. A. differentiating its good and producing the quantity at which price equals marginal revenue B. producing the quantity at which marginal revenue equals marginal cost and then adding a markup C. raising its price and producing so that it always has excess capacity D. producing the quantity at which marginal cost equals marginal revenue and charging the highest price at which it can sell that quantity Answer: D Figure 13.1 shows how a monopolistically competitive firm maximizes its profit.

A firm in monopolistic competition that is maximizing profit ________. A. always makes a positive economic profit in the short run B. never needs to shut down because its price always exceeds minimum average variable cost C. might, in the short run, sell at a price that is less than average total cost D. shuts down temporarily if it incurs a loss equal to total variable cost Answer: C In the case of answer C, the firm incurs an economic loss. 4.

If one firm advertises and other firms in the market don’t, then ______. A. the demand for the advertised good becomes more elastic B. the profit-maximizing quantity of the advertised good decreases because total fixed costs increase C. the average cost of producing a small quantity of the advertised good rises but the average total cost of producing a large quantity might fall D. the economic profit made from the advertised good increases Answer: D If only one firm advertises, the demand for its good increases, which raises the economic profit the firm can make.

Chapter 13 . Monopolistic Competition and Oligopoly

The oligopoly dilemma is whether to ________. A. act together to restrict output and raise the price B. raise the price to the monopoly profit-maximizing price C. cheat on others in the cartel to take advantage of profit opportunities D. lower the price to the perfectly competitive price Answer: C Cheating on the others in the cartel will boost the cheater’s profit as long as the other participants also do not cheat. 6.

In the prisoners’ dilemma game, each player ________. A. consults the other player to determine his best action B. chooses the best outcome for the other player C. chooses the best outcome for himself D. chooses the best outcome for both players together Answer: C Each player maximizes his or her own well-being. 7.

A Nash equilibrium ______. A. is the outcome that delivers maximum economic profit B. is the outcome in which each player takes the best action given the other player’s action C. changes each time the game is played D. is the best possible outcome for the two players Answer: B Answer B is the definition of a Nash equilibrium.

155

GDP: A Measure of Total Production and Income ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

Figure 14.1 shows the flows of income and expenditure in an economy. In 2013, U was $2 trillion, V was $1.5 trillion, W was $7 trillion, X was $1.5 trillion, and Z was zero. Calculate total income, net taxes, and GDP. Total income (which is flow Q) equals total expenditure, the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports of goods and services. Flow U is government expenditure on goods and services, G; flow W is consumption expenditure, C; flow X is investment, I; and flow Z is net exports of goods and services, NX. Total expenditure equals $7 trillion + $1.5 trillion + $2 trillion + $0, which is $10.5 trillion, so total income also equals $10.5 trillion. Net taxes equal total income minus consumption expenditure and saving. Total income is $10.5 trillion. Consumption expenditure is $7 trillion. Saving is the flow into the financial markets (flow V) and equals $1.5 trillion. So net taxes equal $10.5 trillion − $7 trillion − $1.5 trillion, which is $2 trillion. Total income equals total expenditure which equals GDP, so GDP equals $10.5 trillion.

Use the following data to work Problems 2 and 3. The national accounts of Parchment Paradise are kept on (you guessed it) parchment. A fire in the statistics office destroys some accounts, leaving only the following data: • GDP (income approach) $2,900

Chapter

158

Part 4 . MONITORING THE MACROECONOMY

• Consumption expenditure $2,000 • Indirect taxes less subsidies $100 • Interest, rent, and profit $500 • Investment $800 • Government expenditure $400 • Wages $2,000 • Net factor income from abroad $50 • Net exports –$200 2. Calculate GDP (expenditure approach) and depreciation. For the expenditure approach, GDP equals the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. Fortunately, these data were saved from the fire. Hence GDP = C + I + G + NX = $2,000 + $800 + $400 − $200 = $3,000. From the income approach, GDP equals the sum of wages plus interest, rent, and profit plus indirect taxes less subsidies plus depreciation. The value of the income approach GDP survived the fire and is $2,900. The sum of wages plus interest, rent, and profit plus indirect taxes less subsidies equals $2,000 + $500 + $100 = $2,600. So depreciation equals $2,900 − $2,600 = $300. 3.

Calculate net domestic product at factor cost, the statistical discrepancy, and GNP. Net domestic product at factor cost equals the sum of wages, interest, rent, and profit. Once again, all these data were fortunately saved from the fire, so net domestic product at factor cost = $2,000 + $500 = $2,500. The statistical discrepancy equals GDP from the expenditure approach, $3,000 from problem 2, minus GDP from the income approach, $2,900. So the statistical discrepancy is $100. GNP equals GDP plus net factor income from abroad. From problem 2, GDP is $3,000. Net factor income from abroad is $50. So GNP equals $3,000 + $50 = $3,050.

Use the following information to work Problems 4 to 6. An economy produces only fun and food. The table shows the prices and the quantities of fun and food produced in 2013 and 2014. The base year is 2013. 4. Calculate nominal GDP in 2013 and 2014. Nominal GDP in 2013 is equal to (40 units of fun × $2) + (60 units of food × $3) = $260. Nominal GDP in 2014 is equal to (35 units of fun × $3) + (65 units of food × $2) = $235.

GDP data for 2013 Item Quantity Price Fun 40 $2 Food 60 $3 GDP data for 2014 Item Quantity Price Fun 35 $3 Food 65 $2

Chapter 14 . GDP: A Measure of Total Production and Income

Calculate the percentage increase in production in 2014. The percentage increase in production is equal to the percentage increase in real GDP. In the base year, real GDP equals nominal GDP, so real GDP in 2013 is $260. Using prices from 2013, real GDP in 2013 is $260 and real GDP in 2014 is $265. Using 2013 prices, real GDP grew [($265 − $260)/$260] x 100, or 1.9 percent.

If potential GDP was $270 in 2013 and it grew by 1 percent in 2014, in which phase of the business cycle is the economy? Explain. Between 2013 and 2014, real GDP grew so the economy is in the expansion phase of the business cycle.

Use the following information to work Problems 7 to 9. Expansion remains slow The Commerce Department reported that retail sales increased 1.3 percent in June. Net exports were up 0.8 percent in the first quarter and inventories held by businesses rose by 0.3 percent in June. Total sales by businesses rose 0.3 percent. Source: Commerce Department, 2013 7. Which component of GDP changed because retail sales increased? Which component of GDP changed because inventories held by businesses rise? The increase in retail sales means that consumption expenditure on goods and services increased. The increase in inventories held by businesses means that investment increased. 8.

Explain the effect of the rise in net exports on GDP. Because net exports is part of GDP, the rise in net exports means that GDP increases.

Does the statement that total sales by businesses were up 0.3 percent mean that GDP increased by 0.3 percent? Explain your answer. The statement “total sales by businesses” does not specify whether these sales include final goods and intermediate goods or just final goods. If it includes intermediate goods, then GDP is not up 0.3 percent. In this case GDP might be up by more than 0.3 percent because some components of GDP—net exports—rose by more than 0.3 percent.

10. Read Eye on the Booms and Busts on p. 550 and explain why the NBER reported that the 2008 recession began before real GDP had fallen for two successive quarters. The NBER dated the start of the 2008 recession before real GDP had fallen for two consecutive quarters because other relevant data, such as real personal income, real manufacturing, wholesale and retail sales, industrial production, and employment all peaked before real GDP had fallen for two successive quarters.

159

Part 4 . MONITORING THE MACROECONOMY

160

 Instructor Assignable Problems and Applications 1.

In France, real GDP was the same in 2012 as it had been in 2011, but in the last quarter of 2012 and the first quarter of 2013, France’s real GDP decreased. In the United States, real GDP increased in 2012, and in the first quarter of 2013, it was higher than in the last quarter of 2012. Based on this information, which country was in a recession at the beginning of 2013? What features of the information provided led you to your conclusion? France was in a recession because France’s real GDP had decreased for two successive quarters.

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 Target Banking services purchased by Target is an intermediate service. •

Security system bought by the White House The security system purchased by the White House is a final good. It is part of government expenditure on goods and services.

•

Coffee beans bought by Starbucks Coffee beans purchased by Starbucks are an intermediate good.

•

New coffee machines bought by Starbucks New coffee machines purchased by Starbucks are final goods. They are part of investment.

•

Starbuck’s grande mocha frappuccino bought by a student The student’s purchase is a final good. It is part of consumption expenditure on goods and services.

•

New battle ship bought by the U.S. navy The new battle ship purchased by the U.S. navy is a final good. It is part of government expenditure on goods and services.

Use the following information to work Problems 3 and 4. Mitsubishi Heavy Industries makes the wings of the new Boeing 787 Dreamliner in Japan. Toyota assembles cars for the U.S. market in Kentucky. 3. Explain where these activities appear in the National Income and Product Accounts of the United States. 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. If any U.S. factors of production are employed in Japan making these

Chapter 14 . GDP: A Measure of Total Production and Income

wings (say, a supervisor from Boeing or a Boeing engineer), their income is part of “net factor income from abroad” and will be counted as part of U.S. GNP but not 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. Finally, if any of the factors of production are foreign—say a Japanese citizen who supervises the production—the income of that factor is part of U.S. GDP but not part of U.S. GNP. 4.

Explain where these activities appear in the National Income and Product Accounts of Japan. 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. Finally, if any of the factors of production are foreign—say a U.S. citizen who supervises the production—the income of that factor is part of Japan’s GDP but not part of Japan’s GNP. 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. The production of these cars is included in Japan’s GNP if any Japanese-owned factors of production are used to produce the cars, such as a Japanese engineer sent from Japan to the United States to supervise the production. The income of these factors appears in the Japanese National Income and Product Accounts as “net factor income from abroad.”

161

162

Part 4 . MONITORING THE MACROECONOMY

Use the following data on the economy of Iberia to work Problems 5 and 6. • Net taxes $18 billion • Government expenditure $20 billion • Saving $15 billion • Consumption expenditure $67 billion • Investment $21 billion • Exports $30 billion 5.

Calculate Iberia’s GDP. Because the value of income equals the value of production, that is, the value of income equals GDP, Y = C + S + NT = GDP. So for Iberia, GDP = $67 billion + $15 billion + $18 billion, which is $100 billion.

Calculate Iberia’s imports of goods and services. GDP equals C +I +G +NX. Rearranging, NX = GDP − C − I − G. So Iberia’s net exports equal $100 billion − $67 billion − $21 billion − $20 billion, which is −$8 billion. Net exports equal exports − imports, so imports equal exports minus net exports. Iberia’s imports equal $30 billion − (−$8 billion), which is $38 billion.

Use the table, which shows an economy’s total production and the prices of the final goods it produced in 2013 and 2014, to work Problems 7 to 9. 7. Calculate nominal GDP in 2013 and 2014. Nominal GDP in 2013 is equal to (100 fish × $2) + (50 berries × $6) = $500. Nominal GDP in 2014 is equal to (75 fish × $5) + (65 berries × $10) = $1,025.

GDP data for 2013 Item Quantity Price Fish 100 $2 Berries 50 $6 GDP data for 2014 Quantity Price Item Fish 75 $5 Berries 65 $10

The base year is 2013. Calculate real GDP in 2013 and 2014. In the base year, real GDP equals nominal GDP, so real GDP in 2013 is $500. Real GDP in 2014 uses 2014 quantities and 2013 prices and so equals (75 fish × $2) + (65 berries × $6) = $540.

Calculate the percentage increase in production in 2014. The percentage increase in production equals the percentage increase in real GDP. Real GDP grew [($540 − $500)/$500] x 100, or 8.0 percent.

Use the following information to work Problems 10 and 11. Cash-paying vultures pick bones of U.S. housing market as mortgages dry up New-home sales fell to an annual pace of 250,000 in February, an all-time low in records dating to 1963, the Commerce Department reported March 23. Existing home sales dropped to a 4.88 million annualized pace in February, down 2.8 percent from a year earlier, the National Association of Realtors

Chapter 14 . GDP: A Measure of Total Production and Income

said, while the median price of existing homes fell to $156,100, the lowest since February 2002. Source: Bloomberg, March 29, 2011 10. Where do new-home sales appear in the circular flow of expenditure and income? Explain how a fall in new home sales affects real GDP. The purchase of a new home is counted as investment and so it appears with the rest of investment. A decrease in new home sales increases real GDP. 11. Where do sales of previously owned homes appear in the circular flow of expenditure and income? Explain how a fall in sales of previously owned homes affects real GDP. Sales of previously owned homes are sales of used goods; they were not produced in the current time period. For that reason they also do not appear in the circular flow of expenditure and income. Sales of previously owned homes have no direct impact on real GDP. (A real estate commission paid to sell a used home, however, does add to GDP because it is a part of current production.) 12. The road less traveled If we are right, this year is different and global growth will rise to an above trend pace during the second half of 2013. Source: J.P. Morgan Global Data Watch, May, 2013 Does this news mean that the 2008–2009 recession was expected to end in the second half of 2013? Does recession end only when real GDP growth rises above trend? Even if the news is correct, it does not indicate that the recession was ending only in the second half of 2013. A recession ends when GDP turns up and starts to increase not when GDP returns to potential GDP.

163

164

Part 4 . MONITORING THE MACROECONOMY

 Multiple Choice Quiz 1.

Gross domestic product is the market value of all the _______ in a given time period. A. goods and services bought by Americans B. goods and services produced by American companies in all countries C. final goods and services produced by all firms located in the United States D. U.S.-produced goods and services bought in the United States Answer: C Answer C is the definition of GDP. 2.

A ________ is a final good and ________ is an intermediate good. A. new car bought by a student; a used SUV bought by a dealer B. new textbook; used textbook C. new iPhone bought by a student; new computer bought by Wal-Mart D. tank of gasoline bought by you; jet fuel bought by Southwest Airlines Answer: D The gasoline has been purchased by its ultimate user, so it is a final good; the jet fuel purchased by Southwest Airlines will be used to help produce an service, airline flights, so it is an intermediate good. 3.

Saving equals ________. A. income minus consumption expenditure minus net taxes B. income minus net taxes C. total income minus total expenditure D. net taxes minus government expenditure Answer: A Saving is what is left from income after consumption expenditure and net taxes are paid. 4.

The expenditure approach to measuring U.S. GDP equals _________. A. the sum of U.S. consumption expenditure and U.S. investment B. U.S. government expenditure minus taxes paid by Americans C. all expenditure on final goods and services produced in the United States in a given time period D. all expenditure by Americans on goods and services produced in the United States in a given time period Answer: D Answer D is effectively the definition of the expenditure approach.

Chapter 14 . GDP: A Measure of Total Production and Income

When using the income approach to measure GDP at market prices, in addition to summing all factor incomes it is necessary to ________. A. subtract depreciation because profit is not reported as net profit B. add depreciation because capital depreciates when goods are manufactured C. add indirect taxes less subsidies to convert aggregate income from factor cost to market prices D. add a statistical discrepancy which is the sum of depreciation and indirect taxes less subsidies Answer: C The discussion on pages 375 and 376 of the text illustrate that answer C is correct. 6.

The following statements about the business cycle are correct except ______. A. it is a regular predictable cycle in real GDP around potential GDP B. from the peak to the trough, the economy is in a recession C. from the trough to the peak, the economy is in an expansion D. it is a periodic movement in economic activity including employment Answer: A The business cycle fluctuations around potential GDP are irregular and difficult to predict. 7.

Real GDP per person is not an accurate measure of the standard of living because it ______. A. includes the goods and services that governments buy B. omits the goods and services that people produce for themselves C. includes goods and services bought by firms D. omits the goods and services imported from other countries Answer: B In less developed nations, GDP is a poor measure of the standard of living because much of a person’s consumption is produced by the person themself.

165

Chapter

Appendix: Measuring Real GDP ANSWERS TO APPENDIX CHECKPOINTS

 Study Plan Problems An island economy produces 2012 2013 only bananas and coconuts. The Item Quantity Price Quantity Price table gives the quantities produced and prices in 2012 and Bananas 100 $10 110 $15 in 2013. Coconuts 50 $12 60 $10 1. Calculate nominal GDP in 2012 and nominal GDP in 2013. Nominal GDP in 2012 = ($10 × 100) + ($12 × 50) = $1,000 + $600 = $1,600. Nominal GDP in 2013 = ($15 × 110) + ($10 × 60) = $1,650 + $600 = $2,250. 2.

Calculate the value of 2013 production in 2012 prices and the percentage increase in production when valued at 2012 prices. Using 2012 prices, the value of 2013 production is ($10 × 110) + ($12 × 60) = $1,100 + $720 = $1,820. In 2012 prices GDP in 2012 is $1,600 so the value of production increased from $1,600 to $1,820, an increase of $220. The percentage increase is equal to ($220 ÷ $1,600) × 100, which is 13.75 percent.

Calculate the value of 2012 production in 2013 prices and the percentage increase in production when valued at 2013 prices. Using 2013 prices, the value of 2012 production is ($15 × 100) + ($10 × 50) = $1,500 + $500 = $2,000. In 2013 prices GDP in 2013 is $2,250 so the value of production increased from $2,000 to $2,250, an increase of $250. The percentage increase is equal to ($250 ÷ $2,000) × 100, which is 12.5 percent.

Use the chained-dollar method to calculate real GDP in 2012 and 2013. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2012 = $1,600. It is equal to nominal GDP because 2012 is the base year. To calculate real GDP in 2013 compute the growth rate of real GDP between 2012 and 2013. That growth rate is the average of the growth rates

168

Part 4 . MONITORING THE MACROECONOMY

between 2012 and 2013 using prices from 2012 and using prices from 2013. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 13.13 percent. This result means that real GDP in 2013 is 13.13 percent greater than real GDP in 2012. Real GDP in 2012 was $1,600, so real GDP in 2013 equals ($1,600) × (1.1313), which is $1,810.08. These real GDPs are in terms of 2012 dollars. 5.

Using the chained-dollar method, compare the growth rates of nominal GDP and real GDP in 2013. Between 2012 and 2013, nominal GDP increased from $1,600 to $2,250, an increase of $650. The growth rate of nominal GDP is ($650 ÷ $1,600) × 100, which is 40.6 percent. The growth rate of real GDP is 13.13 percent, so nominal GDP grew much more rapidly than did real GDP.

If the base year is 2013, use the chained-dollar method to calculate real GDP in 2012 and 2013. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2013 = $2,250. It is equal to nominal GDP because 2013 is the base year. To calculate real GDP in 2012 compute the growth rate of real GDP between 2012 and 2013. That growth rate is the average of the growth rates between 2012 and 2013 using prices from 2012 and using prices from 2013. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 13.13 percent. This result means that real GDP in 2013 is 13.13 percent greater than real GDP in 2012 so real GDP in 2012 equals ($2,250) ÷ (1.1313), which is $1,988.86. These real GDPs are in terms of 2013 dollars.

If the base year is 2013, compare the growth rates of nominal GDP and real GDP in 2013. From Problem 5, the growth rate of nominal GDP is 40.6 percent. From Problem 6, the growth rate of real GDP in 2013 dollars is 13.13 percent.

Appendix 14 . Measuring Real GDP

169

 Instructor Assignable Problems An economy produces only 2012 2013 food and fun. The table Item Quantity Price Quantity Price shows the quantities produced and prices in 2012 and Food 100 $2 75 $5 2013. Fun 50 $6 65 $10 1. Calculate nominal GDP in 2012 and nominal GDP in 2013. Nominal GDP in 2012 = ($2 × 100) + ($6 × 50) = $200 + $300 = $500. Nominal GDP in 2013 = ($5 × 75) + ($10 × 65) = $375 + $650 = $1,025. 2.

Calculate the value of 2013 production in 2012 prices and the percentage increase in production when valued at 2012 prices. Using 2012 prices, the value of 2013 production is ($2 × 75) + ($6 × 65) = $150 + $390 = $540. In 2012 prices, GDP in 2012 is $500 so the value of production increased from $500 to $540, an increase of $40. The percentage increase is equal to ($40 ÷ $500) × 100, which is 8.00 percent.

Calculate the value of 2012 production in 2013 prices and the percentage increase in production when valued at 2013 prices. Using 2013 prices, the value of 2012 production is ($5 × 100) + ($10 × 50) = $500 + $500 = $1,000. In 2013 prices, GDP in 2013 is $1,025 so the value of production increased from $1,000 to $1,025, an increase of $25. The percentage increase is equal to ($25 ÷ $1,000) × 100, which is 2.50 percent.

Using the chained-dollar method, calculate real GDP in 2012 and 2013. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2013 = $1,025. It is equal to nominal GDP because 2013 is the base year. To calculate real GDP in 2012 compute the growth rate of real GDP between 2012 and 2013. That growth rate is the average of the growth rates between 2012 and 2013 using prices from 2012 and using prices from 2013. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 5.25 percent. This result means that real GDP in 2013 is 5.25 percent larger than real GDP in 2012 so real GDP in 2012 equals ($1,025) ÷ (1.0525), which is $973.87. These real GDPs are in terms of 2013 dollars.

Using the chained-dollar method, compare the growth rates of nominal GDP and real GDP in 2013. Between 2012 and 2013, nominal GDP increased from $500 to $1,025, an increase of $525. The growth rate of nominal GDP is ($525 ÷ $500) × 100, which is 105 percent. The growth rate of real GDP is 5.25 percent, so nominal GDP grew much more rapidly than did real GDP.

170

Part 4 . MONITORING THE MACROECONOMY

If the base year is 2012, use the chained-dollar method to calculate real GDP in 2012 and 2013. In terms of what dollars is each of these two real GDPs measured? Real GDP in 2012 = $500. It is equal to nominal GDP because 2012 is the base year. To calculate real GDP in 2013 compute the growth rate of real GDP between 2012 and 2013. That growth rate is the average of the growth rates between 2012 and 2013 using prices from 2012 and using prices from 2013. Taking the average of the answers to Problems 2 and 3 gives an average percentage increase of 5.25 percent. This result means that real GDP in 2013 is 5.25 percent larger than real GDP in 2012. Based on this percentage growth rate, real GDP in 2013 equals ($500) × (1.0525), which is $526.25. These real GDPs are in terms of 2012 dollars.

If the base year is 2012, compare the growth rates of nominal GDP and real GDP in 2013. From Problem 5, the growth rate of nominal GDP is 105 percent. From Problem 6, the growth rate of real GDP in 2012 dollars is 5.25 percent. Nominal GDP (still) grew much more rapidly than did real GDP.

Chapter

Jobs and Unemployment ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications Use the following information gathered by a BLS labor market survey of four households to work Problems 1 and 2. • Household 1: Candy worked 20 hours last week setting up her Internet shopping business. The rest of the week, she completed application forms and attended two job interviews. Husband Jerry worked 40 hours at his job at GM. Daughter Meg, a student, worked 10 hours at her weekend job at Starbucks.

•

Household 2: Joey, a full-time bank clerk, was on vacation. Wife, Serena, who wants a full-time job, worked 10 hours as a part-time checkout clerk.

•

Household 3: Ari had no work last week but was going to be recalled to his regular job in two weeks. Partner Kosta, after months of searching for a job and not being able to find one, has stopped looking and will go back to school.

•

Household 4: Mimi and Henry are retired. Son Hank is a professional artist, who painted for 12 hours last week and sold one picture. Classify each of the 10 people into the labor market category used by the BLS. Who are part-time workers and who are full-time workers? Of the part-time workers, who works part time for economic reasons? Candy is employed because she worked for more than 15 hours at her family business. Jerry is employed because he worked full time at General Motors. Their 17-year old daughter, Meg, is employed because she worked for more than 1 hour as a paid employee. All three are in the labor force and in the working-age population. Joey is employed because he is temporarily absent from his job. Serena is employed because she worked for more than 1 hour as a paid employee. Both are in the labor force and in the working-age population.

172

Part 4 . MONITORING THE MACROECONOMY

Ari is unemployed because he is waiting to be recalled to his job. Ari is in the labor force and in the working-age population. Kosta is in the working age population but is not in the labor force so Kosta is a marginally attached worker. Mimi and Henry are in the working-age population but are not in the labor force. Hank is not in the labor force. He is not employed because he worked for less than 15 hours in the family business. And he is not unemployed because he made no effort to find employment and was not waiting to be recalled to a job. Hank is not in the labor force but he is in the working age population. Candy, Meg, and Serena are part-time workers. Jerry and Joey are fulltime workers. Candy and Serena are part time for economic reasons. 2.

Calculate the unemployment rate and the labor force participation rate, and compare these rates with those in the United States in 2013. The labor force is 6 people and 1 of the people is unemployed. The U-3 unemployment rate is (1 ÷ 6) × 100, which is 16.7 percent. The unemployment rate is higher than the U.S. unemployment rate, which was 7.6 percent in May, 2013. The labor force is 6 people and the working age population is 10 people. The labor force participation rate is (6 ÷ 10) × 10, which is 60 percent. The labor force participation rate is slightly less than the U.S. labor force participation rate, which was 63.4 percent in May, 2013.

Describe two examples of people who work part time for economic reasons and two examples of people who work part time for noneconomic reasons. Sam is an associate at JCPenney and would like to work 40 hours per week. However sales at JCPenney are slow and so he is scheduled to work only 25 hours per week. Maria is a server at Olive Garden and would like to work at least 40 hours per week. But Maria is scheduled for only 20 hours per week because Olive Garden’s sales are down. Both Sam and Maria work part time for economic reasons. Mike is a student who wants to work 20 hours per week at Cost Cutters hair styling so that he can attend class and study. Cost Cutters schedules him for 20 hours per week. Lorri is partially retired and wants to work only 15 hours per week at Walgreens so that she may spend most of her time with her spouse. Walgreens schedules Lorri for 15 hours per week. Both Mike and Lorri work part time for noneconomic reasons.

Chapter 15 . Jobs and Unemployment

Explain the relationship between the percentage of employed workers who have part-time jobs and the business cycle. When the economy goes into a recession, the percentage of workers who have part-time jobs for economic reasons rises. When the economy goes into an expansion, the percentage of workers who have part-time jobs for economic reasons falls. The percentage of workers who have part-time jobs for noneconomic reasons does not change through the business cycle. Because one component of part-time workers rises in a recession and falls in an expansion, the total percentage of workers who have part-time jobs rises in a recession and falls in an expansion.

Distinguish among the three types of unemployment: frictional, structural, and cyclical. Provide an example of each type of unemployment in the United States today. Frictional unemployment is unemployment that arises from normal labor turnover—from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. Structural unemployment is unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. And cyclical unemployment is the fluctuating unemployment over the business cycle that increases during a recession and decreases during an expansion. A college student graduating and entering the labor force to look for a job is frictionally unemployed. An assembly worker who is fired when the company moves production to Singapore is structurally unemployed. And an autoworker who is laid off when the economy contracts and Ford’s sales slump is cyclically unemployed.

Describe the relationship between the unemployment rate and the natural unemployment rate as the output gap fluctuates between being positive and being negative. When real GDP is less than potential GDP so that the output gap is negative, the unemployment rate is above the natural unemployment rate. When real GDP is greater than potential GDP so that the output gap is positive, the unemployment rate is below the natural unemployment rate. And, when real GDP equals potential GDP so that the output gap is zero, the unemployment rate equals the natural unemployment rate.

173

174

Part 4 . MONITORING THE MACROECONOMY

Use the following information to work Problems 7 and 8. U.S. unemployment rate lowest since 2008 The Labor Department said that the economy added 146,000 jobs in November, and the unemployment rate fell to 7.7% from 7.9% in October. But it fell mainly because workers dropped out of the labor force. Source: CNN Money, December 7, 2012 7. Explain how the new jobs change the labor force and the unemployment rate. If the new jobs were filled by workers moving from the ranks of the unemployed to being employed, then the labor force did not change. However if these workers entered the labor force by accepting the new jobs (such as college students who graduate and then immediately start work at a job they found while in college) then the labor force increased. In either case the unemployment rate falls, though it falls by more when the newly employed workers had previously been unemployed. New jobs decrease the unemployment rate if the jobs are filled by previously unemployed workers because the new jobs decrease the number of unemployed workers. New jobs also decrease the unemployment rate if the jobs are filled by workers entering the labor force because the new jobs increase the size of the labor force. 8.

Explain why workers dropping out of the labor force lowers the unemployment rate and why by more than new jobs do. Workers leaving the labor force decrease both the number of unemployed workers and the size of the labor force. The percentage change in the number of unemployed workers exceeds the percentage change in the labor force, so on net the unemployment rate falls. New jobs also lower the unemployment rate. But if the presence of new jobs motivates marginally attached workers or discouraged workers to reenter the labor force to look for work, new jobs increase the number of workers counted as unemployed and thereby offset some of their effect lowering the unemployment rate.

Read Eye on the Unemployed on p. 412. In which year, 2000 or 2013, was real GDP below potential GDP? How can you tell from the graph on p. 576? Real GDP was below potential GDP in 2013. The graph shows that in 2000, over 40 percent of the unemployed workers were unemployed for less than 5 weeks, a characteristic of unemployment when real GDP exceeds potential GDP. In contrast, in 2013 almost 40 percent of the unemployed workers were unemployed for more than 27 weeks, a characteristic of unemployment when real GDP is less than potential GDP.

Chapter 15 . Jobs and Unemployment

 Instructor Assignable Problems and Applications 1.

In the United States, • Compare the duration of unemployment in 2013 with that in 2000 and explain whether the difference was most likely the result of frictions, structural change, or the business cycle. The duration of unemployment was longer in 2013 than in 2000. In 2000, when real GDP exceeded potential GDP, the median duration of unemployment was only 6 weeks. In 2013 real GDP was below potential GDP, which increases the median duration of unemployment. Indeed, in 2013 when real GDP was below potential GDP, the median duration of unemployment was 16 weeks. Much of the difference is the result of a large increase in the number of workers who take 27 weeks or more to find a job: about 10 percent in 2000 versus about than 40 percent in 2010. The difference was the result of the business cycle because the United States was still recovering from a severe recession in 2013. • How does the unemployment of marginally attached workers influence the duration of unemployment in 2013 compared with that in 2000? When the economy moves into a recession, marginally attached workers exit the labor force, which makes the (measured) duration of unemployment shorter. Including the duration of the unemployment spells of marginally attached workers would increase the duration of unemployment because these workers take much longer to find a job. Because there are more marginally attached workers who have left the labor force in 2013 than in 2000, if they were included as unemployed, the duration of unemployment in 2013 would be even larger than in 2000.

The Bureau of Labor Statistics reported that in the second quarter of 2008 the working-age population was 233,410,000, the labor force was 154,294,000, and employment was 146,089,000. Calculate for that quarter the labor force participation rate and the unemployment rate. The labor force participation rate equals the number of people in the labor force divided by the working-age population, then multiplied by 100. (154,294,000 ÷ 233,410,000) × 100, which is 66.1 percent. The unemployment rate equals the number of unemployed workers divided by the labor force, then multiplied by 100. The number of unemployed workers equals the labor force minus the employment. So in the second quarter of 2008 the number of unemployed workers equaled 154,294,000 – 146,089,000, which is 8,205,000. Thus the unemployment rate equals (8,205,000 ÷ 154,294,000) × 100, which is 5.3 percent.

In July 2011, in the economy of Sandy Island, 10,000 people were employed and 1,000 were unemployed. During August 2011, 80 people lost

175

176

Part 4 . MONITORING THE MACROECONOMY

their jobs and didn’t look for new ones, 20 people quit their jobs and retired, 150 people who had looked for work were hired, 50 people became discouraged workers, and 40 new graduates looked for work. Calculate the change in the unemployment rate from July 2011 to August 2011. 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. To calculate the unemployment rate, the number of people unemployed and the number employed are needed. The number of people who are unemployed at the end of August equals the number unemployed in July plus people who lost their jobs and who stayed in the labor market, plus new workers entering the labor market, such as new graduates, minus people who were hired and people who stopped looking for work, that is, became discouraged workers. So the number of people unemployed equals 1,000 + 40 − 150 − 50, which is 840. Next the number of people who are employed at the end of August equals the number employed in July minus people who lost jobs plus people who were hired, so the number employed is 10,050. The unemployment rate equals the number unemployed expressed as a percentage of the labor force. The labor force equals the number employed plus the number unemployed, so 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. Between July and August, the unemployment rate fell by 1.4 percent from 9.1 percent to 7.7 percent. 4.

The BLS survey reported the following data in a community of 320 people: 200 worked at least 1 hour as paid employees; 20 did not work but were temporarily absent from their jobs; 40 did not have jobs and didn’t want to work; 10 were available for work and last week they had looked for work; and 6 were available for work and were waiting to be recalled to their previous job. Calculate the unemployment rate and the labor force participation rate. The number of employed people is 200 + 20, which is 220. The number of unemployed people is 10 + 6, which is 16. The labor force is 220 + 16, which is 236. So the unemployment rate is (16 ÷ 236) × 100, which is 6.8 percent. The total working age population is 200 + 20 + 40 + 10 + 6, which is 276. The labor force is 236. So the labor force participation rate is (236 ÷ 276) × 100, which is 85.5 percent.

Chapter 15 . Jobs and Unemployment

Describe the trends and fluctuations in the unemployment rate in the United States from 1949 through 2013. In which periods was the unemployment rate above average and in which periods was it below average? Between 1949 and 2013, the unemployment rate has fluctuated, falling in expansions and rising in recessions. It was generally lower than average from 1949 to 1958, though during recessions it rose. The unemployment rate fell again to below its average during the late 1960s but then generally rose above average in the 1970s and hit its post World War II peak, near 10 percent, in the 1982 recession. The unemployment rate, while falling through the 1980s, was generally above average. It rose again during the 1990-1991 recession but by the middle of the 1990s expansion it had fallen below its average. There was a slight rise around 2000, but the unemployment rate generally stayed near or a little below its average for most of the 2000s until 2008 when it rose well above its average during the most recent recession. Since 2009 the unemployment rate has fallen as the economy emerged from the 2008-2009 recession.

Describe how the labor force participation rate in the United States changed between 1960 and 2013. Contrast and explain the different trends in the labor force participation rates of women and men. Between 1960 through 2013, the labor force participation rate for men trended downward, from 83 percent to 70 percent. The labor force participation rate for women trended upward, from 37 percent to 60 percent in about 1999 and has fallen slightly since then. The overall labor force participation rate trended slowly upward, from 59 percent to about 67 percent in 1999 and has fallen slightly since then. The female participation rate increased for four reasons: more women pursued a college education and so increased their potential wages in the job market; technological change in the work place created a large number of white-collar jobs with flexible hours that women found attractive; technological change in the home increased the time available for paid employment; and, families wanted two incomes to balance tight budgets. The male labor force participation rate decreased for three reasons: some men retired early because of an increase in wealth; some men left the labor force because they lost jobs when they were older and finding a new job was difficult; and, more men remained in full-time education.

Explain why the natural unemployment rate is not zero and why the unemployment rate fluctuates around the natural unemployment rate. The natural unemployment rate includes frictional unemployment and structural unemployment. There are always people looking for work from just normal labor market turnover, so fictional unemployment is never zero. Similarly technological change and/or changes in international competition will always create some unemployment, so structural

177

178

Part 4 . MONITORING THE MACROECONOMY

unemployment is never zero. Because its components are never zero, the natural unemployment rate is never zero. Unemployment fluctuates around the natural unemployment because cyclical unemployment, which is included in the total unemployment but not in natural unemployment, fluctuates during the business cycle. Cyclical unemployment is negative during strong expansions and positive during recessions, so unemployment will sometimes be less than natural unemployment and sometimes more than natural unemployment. Use the following information to work Problems 8 and 9. Michigan unemployment tops 15% The U.S. Department of Labor reported that Michigan’s unemployment rate in June 2009 rose to 15.2%, becoming the first state in 25 years to suffer an unemployment rate exceeding 15%. Michigan has been battered by the collapse of the auto industry and the housing crisis and has had the highest unemployment rate in the nation for the past 12 months. Source: CNNMoney, July 17, 2009 8. Why is the reality of the unemployment problem in Michigan actually worse than the unemployment rate statistic of 15.2 percent? Michigan’s 15.2 percent unemployment rate does not reflect discouraged workers (workers who have left the labor force because their recent attempts to find work were unsuccessful), marginally attached workers (workers who have not recently looked for work but would do so if the labor market improved), and people who work part time for economic reasons (workers who want to have a full-time job but cannot find one because of the recession). If these workers were also counted as unemployed, Michigan’s unemployment rate would be significantly higher than 15.2 percent. 9.

Is this increased unemployment frictional, structural, or cyclical? Explain. The record setting unemployment rate for the state of Michigan is a combination of structural and cyclical unemployment. In part the unemployment rate reflects structural changes in the economy: Fewer vehicles will be produced by auto makers located in Michigan and more will be produced by those located elsewhere. As the Michigan-based automakers (GM, Ford, Chrysler) contract and lay off workers, these workers are structurally unemployed. However, in part the unemployment also reflects the deep recession of 2009. This recession has created a large amount of cyclical unemployment and the sales of vehicles decrease in the economic downturn. The point that Michigan’s unemployment rate is higher than any other state reflects structural change because all the states had cyclical unemployment in 2009.

Chapter 15 . Jobs and Unemployment

 Multiple Choice Quiz 1.

The BLS count Jody as being unemployed if she _______. A. had a job last month but not this month B. doesn’t have a job because the U.S. factory where she worked cannot compete with cheap Chinese imports C. wants a job and looked for a job last year but has now stopped looking D. wants a job and is willing to take a job but after searching last week cannot find a job Answer: D To be counted as unemployed, a person must be without a job, available for work, and made specific efforts to find a job within the past 4 weeks. 2.

A marginally attached worker is a person who ________. A. works part time for economic reasons B. works part time for noneconomic reasons C. doesn’t work, is available and willing to work, but hasn’t looked for job recently D. has no job but would like one and has gone back to school to retrain Answer: C Answer C is essentially the definition of a marginally attached worker. 3.

If the BLS included all marginally attached workers as being unemployed, the ________ would be __________. A. unemployment rate; higher B. labor force; unchanged C. labor force participation rate; lower D. unemployment rate; lower Answer: A Marginally attached workers are unemployed, so the unemployment rate would be higher. 4.

When the economy goes into recession, the biggest increase in unemployment is _________. A. structural because jobs are lost in most states B. cyclical because jobs are lost in many industries as they cut production C. frictional because the creation of jobs slows D. the combination of structural and frictional as few new jobs are created. Answer: B Cyclical unemployment is the unemployment resulting from a recession.

179

180

Part 4 . MONITORING THE MACROECONOMY

The economy is at full employment when all unemployment is ________. A. structural B. cyclical C. structural and cyclical D. structural and frictional Answer: D Answer D is the definition of when the economy is at full employment. 6.

Potential GDP is the value of real GDP when ______. A. the unemployment rate equals the natural unemployment rate B. there is no frictional unemployment C. there is no structural unemployment D. the unemployment rate is zero Answer: A When real GDP equals potential GDP, the unemployment rate equals the natural unemployment rate. 7.

When the unemployment rate _________ the natural unemployment rate, real GDP is _________ potential GDP and the output gap is _________. A. exceeds; below; negative B. is below; below; negative C. exceeds; above; positive D. is below; above; negative Answer: A When the unemployment rate exceeds the natural unemployment rate, the economy is in a recession with real GDP is less than potential GDP so the output gap is negative.

Chapter

The CPI and the Cost of Living ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

In Canada, the reference base period for the CPI is 2002. By 2012, prices had risen by 21.6 percent since the base period. The inflation rate in Canada in 2013 was 1.1 percent. Calculate the CPI in Canada in 2013. Because 2002 is the reference base period in Canada, in 2002 the CPI equaled 100. Between 2002 and 2012 prices rose by 21.6 percent. The formula for the percentage rise in prices is [(CPI in 2012 − 100) ÷ 100] × 100. So, [(CPI in 2012 − 100)] = 21.6 percent. Solving the formula for the CPI in 2012 shows that the CPI in 2012 is 121.6. Finally, with an inflation rate of 1.1 percent in 2013, the CPI in 2013 equals 121.6 × (1.011) = 122.9. In Brazil, the reference base period for the CPI is 2000. By 2005, prices had risen by 51 percent since the base period. The inflation rate in Brazil in 2006 was 10 percent, and in 2007, the inflation rate was 9 percent. Calculate the CPI in Brazil in 2006 and 2007. Brazil’s CPI in 2008 was 173. Did Brazil’s inflation rate increase or decrease 2008? Because 2000 is the reference base period for Brazil, the CPI in that year is 100. Between 2000 and 2005 prices rose by 51 percent. Over this period, the formula for the percentage rise in prices is [(CPI in 2005 − 100) ÷ 100] × 100. So, [(CPI in 2005 − 100)] = 51 percent. Solving the formula for the CPI in 2005 shows that the CPI in 2005 is 151. The price level in 2006 equals the price level in 2005, 151, multiplied by 1.10. (The 1.10 comes from the observation that the price level in 2006 equals the price level in 2005, which accounts for the “1,” plus the inflationary increase of 10 percent, which accounts for the “0.10.”) So the price level in 2006 equals (151 × 1.10), which is 166.1. The price level in 2007 equals the price level in 2006, 166, multiplied by 1.09. So the price level in 2007 equals (166.1 × 1.09), which is 181. The inflation rate in Brazil in 2008 equals [(173 − 181) ÷ 181] × 100, which is −4.4 percent. Brazil’s inflation rate decreased in 2008.

182

Part 4 . MONITORING THE MACROECONOMY

The table shows the Week 1 Week 2 quantities of the goods Price Price that Suzie bought and the Item Quantity (per unit) Quantity (per unit) prices she paid during Coffee 11 cups $3.25 11 cups $3.25 two consecutive weeks. Suzie’s CPI market DVDs 1 $25.00 3 $12.50 basket contains the goods Gasoline 15 gallons $2.50 5 gallons $3.00 she bought in Week 1. 1 ticket $95.00 Calculate the cost of Concert Suzie’s CPI market basket in Week 1 and in Week 2. What percentage of the CPI market basket is gasoline? Calculate the value of Suzie’s CPI in Week 2 and her inflation rate in Week 2. Susie’s CPI market basket contains 11 cups of coffee, 1 DVD, and 15 gallons of gasoline. The cost of her market basket in Week 1 is (11 cups × $3.25 a cup) + (1 DVD × $25 each) + (15 gallons of gasoline × $2.50 a gallon), which is $35.75 + $25.00 + $37.50, or $98.25. The cost of her market basket in Week 2 is (11 cups × $3.25 a cup) + (1 DVD × $12.50 each) + (15 gallons of gasoline × $3.00 a gallon), which is $35.75 + $12.50 + $45.00, or $93.25. Her market basket in Week 2 does not include concert tickets because she purchased no tickets in the base week. Gasoline accounted for $37.50 of her $98.25 market basket, which is ($37.50 ÷ $98.25) × 100 or 38.2 percent. Her CPI in Week 2 is equal to [$93.25 ÷ $98.25] × 100, which is equal to 94.9. The CPI in the base week is 100, so the inflation rate in week 2 equals ([94.9 − 100.0] ÷ 100) × 100, which is −5.1 percent.

Use the following information to work Problems 4 and 5. The GDP price index in the United States in 2000 was about 90, and real GDP in 2000 was $11 trillion (2005 dollars). The GDP price index in 2010 was about 111, and real GDP in 2010 was $13.1 trillion (2005 dollars). 4. Calculate nominal GDP in 2000 and in 2010 and the percentage increase in nominal GDP between 2000 and 2010. Nominal GDP in 2000 equals $11 trillion × 90 ÷ 100, which is $9.9 trillion. Nominal GDP in 2010 equals $13.1 trillion × 111 ÷ 100, which is $14.5 trillion. The percentage increase in nominal GDP is equal to ([$14.5 trillion − $9.9 trillion] ÷ $9.9 trillion) × 100, which is 46 percent. 5.

What was the percentage increase in production between 2000 and 2010, and by what percentage did the cost of living rise between 2000 and 2010? The percentage increase in production is equal to the percentage increase in real GDP. That percentage is {[$13.1 trillion − $11 trillion] ÷ $11 trillion} × 100, or 19 percent. The percentage increase in the cost of living is equal to the percentage increase in the GDP price index. That percentage is equal to ([111 − 90] ÷ 90) × 100, or 23 percent.

Chapter 16 . The CPI and the Cost of Living

The table shows the prices that Terry paid for some of his expenditures in June and July 2011. Explain and discuss why these prices might have led to commodity substitution or outlet substitution.

Item

Price in Price in June July (dollars per unit)

Steak Bread Bacon Milk Tomatoes Apples Bananas Chicken Lettuce

4.11 3.25 3.62 2.62 1.60 1.18 0.62 1.28 1.64

4.01 3.12 3.64 2.62 1.62 1.19 0.66 1.26 1.68

Terry will substitute other products, commodity substitution, or other locations to buy a product, outlet substitution, if the price rises. The larger the price increase, the greater the incentive for these substitutions. Bananas had the largest percentage price hike, so Terry could well have substituted other products (say apples, for which the price rise was a smaller amount) or have purchased his bananas at a different location to save on the price paid. Tomatoes and lettuce also had a large price hike. Terry might substitute apples for these (commodity substitution) or else purchased them at a less expensive location (outlet substitution). Steak and, to a lesser extent, chicken fell in price. Terry might have substituted these for bacon, which rose in price. 7.

In 2013, Annie, an 80-year-old, is telling her granddaughter Mary about the good old days. Annie says that in 1933, you could buy a nice house for $15,000 and a jacket for $5. Mary says that in 2013 such a house costs $220,000 and such a jacket costs $70. The CPI in 1933 was 16.7 and in 2013 it was 218.1. Which house and which jacket have the lower prices? The 2013 house price that is equivalent to $15,000 price in 1933 equals the CPI in 2013 divided by the CPI in 1930 and then multiplied by $15,000. So the 2013 house price is (218.1 ÷ 16.7) × $15,000, which is $195,898. The price for a house of $15,000 in 1933 is lower than its price in 2013. The 2013 jacket price that is equivalent to $5 in 1930 equals the CPI in 2013 divided by the CPI in 1933 and then multiplied by $5. So the 2013 jacket price is (218.1 ÷ 16.7) × $5, which is $65. So the $5 for a jacket in 1933 is the lower priced jacket.

Use the following information to work Problems 8 and 9. CPI: Inflation rate picks up in August The CPI rose 3.8% in August compared to a year earlier. Food prices rose 4.6% and clothing prices were up 4.2%, while new car prices rose 3.8% and medical care was up 3.2%. 8.

Source: CNN Money, September 15, 2011 What percentage change in the CPI during the year to August 2011 is ac-

183

184

Part 4 . MONITORING THE MACROECONOMY

counted for by the changes in the prices of food, clothing, and medical care? Figure 16.1 in the text shows that food (and beverages), clothing (apparel), and medical care account for 14.8 percent, 3.6 percent, and 6.6 percent of the CPI basket, respectively, for a total of 25 percent of the CPI basket. Therefore because food accounts for 14.8 percent of the CPI basket, its rise of 4.6 percent contributes (14.8 percent) × (4.6 percent) = 0.68 percentage points toward the change in the CPI. Similarly, since clothing accounts for 3.6 percent of the CPI basket, its rise of 4.2 percent contributes (3.6 percent × 4.2 percent) = 0.15 percentage points toward the change in the CPI. And finally, because medical care accounts for 6.6 percent of the CPI basket, its rise of 3.2 percent contributes (6.6 percent × 3.2 percent) = 0.21 percentage points toward the change in the CPI. 9.

Given the changes in the prices of food, clothing, and medical care, by what percentage did the prices of the other items in the CPI basket change? Food contributes 0.68 percentage points toward the change in the CPI; clothing contributes 0.15 percentage points toward the change in the CPI; and, medical care contributes 0.21 percentage points toward the change in the CPI. The total change accounted for by these components is 0.68 + 0.15 + 0.21, or 1.04 percentage point change. On net, the CPI rose by 3.80 percent, so the remaining factors must have contributed 2.76 toward the change. The remaining factors are 75 percent of the market basket, so they must have risen by 3.68 percent.

10. Read Eye on Box Office Hits on p. 438 and using BLS data for the CPI in 1982 and 1997, determine which movie had the greater real box office revenues, E.T.: The Extra-Terrestrial, which earned $435 million in 1982 or Titanic, which earned $601 million in 1997. From the BLS, the CPI in 1982 = 96.5 and the CPI in 1997 = 160.5. To convert the dollars earned by E.T.: The Extra-Terrestrial into 1997 dollars, multiply the 1982 dollars, $435 million, by the 1997 CPI and divide by the 1982 CPI. This procedure gives $435 million × 160.5 ÷ 96.5, which is $723 million. This result shows that E.T.: The Extra-Terrestrial had greater real box office than Titanic.

Chapter 16 . The CPI and the Cost of Living

 Instructor Assignable Problems and Applications 1.

Compare the method used by Box-Office Mojo to calculate real box-office receipts with the method used on p. 434 to calculate the real price of a postage stamp. Compare and contrast the real variables that each method calculates. The real price of a stamp was calculated using the CPI; Box-Office Mojo calculated the real box office receipts using the price of movie tickets. The formulas used are effectively the same: Multiply the product, the stamp price or box office revenue, by the current period price index and divide by the price index for the relevant period, that is, the period of the stamp price or box office revenue. The difference between the two methods revolves around what price index is used. Box-Office Mojo uses each year’s price of a movie ticket; that is, this calculation uses the price of one good. The textbook used the CPI, which incorporates the prices of 80,000 goods consumers purchase.

Pete is a student who spends 10 perItem Price in 2011 cent of his expenditure on books and Books and supplies 172.6 supplies, 30 percent on tuition, 30 Tuition 169.0 159.0 percent on rent, 10 percent on food Rent Food and drink 129.8 and drink, 10 percent on transporta115.4 tion, and the rest on clothing. The Transportation 92.9 Clothing price index for each item was 100 in 2000. The table shows the prices in 2011. What is Pete’s CPI in 2011? (Hint: The contribution of each item to the CPI is its price weighted by its share of total expenditure.) Did Pete experience a higher or lower inflation rate between 2000 and 2011 than the student whose CPI is shown on p. 429? Pete’s CPI in 2011 equals (0.10 × 172.6) + (0.30 × 169.0) + (0.30 × 159.0) + (0.10 × 129.8) + (0.10 × 115.4) + (0.10 × 92.9) = 149.5. Pete’s inflation is slightly lower than the inflation for the student on page 437. Pete spends less in sum on the items that have risen most rapidly—books and supplies, tuition, and rent—and more on the item that rose much less rapidly than inflation—clothing. Pete’s inflation rate has averaged about 3.7 percent per year, which the figure on page 437 shows is a bit less than the average inflation rate over the years of the student whose CPI is on page 437. The people on Coral Island buy only juice and cloth. The CPI market basket contains the quantities bought in 2010. The average household spent $60 on juice and $30 on cloth in 2010 when the price of juice was $2 a bottle and the price of cloth was $5 a yard. In the current year, 2011,

185

186

Part 4 . MONITORING THE MACROECONOMY

juice is $4 a bottle and cloth is $6 a yard. Calculate the CPI and the inflation rate in 2011. The average household on Coral Island spent $60 on juice and $30 on cloth. The price of juice was $2 a bottle, so the average household purchased 30 bottles of juice. The price of cloth was $5 a yard, so the average household purchased 6 yards. Hence the CPI market basket is 30 bottles of juice and 5 yards of cloth. In 2010, the CPI market basket cost $90 ($60 on juice and $30 on cloth). In 2011, the CPI market basket cost (30 bottles of juice × $4 a bottle) + (6 yards of cloth × $6 a yard) = $120 + $36 = $156. So the CPI in 2011 equals ($156 ÷ $90) × 100, which is 173.3. The inflation rate on Coral Island between 2011 and 2010 is equal to [(173.3 − 100) ÷ 100] × 100, which is 73.3 percent. 4.

The table shows the Week 1 Week 2 quantities of the goods Price Price Item that Harry bought and the Quantity (per unit) Quantity (per unit) prices he paid during two Coffee 5 cups $3.00 4 cups $3.25 consecutive weeks. 5 $1.00 10 $1.00 Harry’s CPI market basket iTune songs contains the goods he Gasoline 10 gallons $2.00 10 gallons $3.00 bought in Week 1. Calculate Harry’s CPI in Week 2. What was his inflation rate in Week 2? Harry’s CPI market basket contains 5 cups of coffee, 5 iTunes songs, and 10 gallons of gasoline. The cost of his market basket in Week 1 is (5 cups × $3.00 a cup) + (5 songs × $1.00 each) + (10 gallons of gasoline × $2.00 a gallon), which is $15.00 + $5.00 + $20.00, or $40.00. The cost of his market basket in Week 2 is (5 cups × $3.25 a cup) + (5 songs × $1.00 each) + (10 gallons of gasoline × $3.00 a gallon), which is $16.25 + $5.00 + $30.00, or $51.25. His CPI in Week 2 is equal to [($51.25) ÷ ($40.00)] × 100, which is 128.1. The CPI in the base week is 100, so the inflation rate equals ([128.1 − 100.0] ÷ 100) × 100, which is 28.1 percent.

Use the following information to work Problems 5 and 6. The base year is 2009. Real GDP in 2009 was $10 trillion (2009 dollars). The GDP price index in 2013 was 112, and real GDP in 2013 was $11 trillion (2009 dollars). 5. Calculate nominal GDP in 2009 and in 2013 and the percentage increase in nominal GDP from 2009 to 2013. In the base year, nominal GDP equals real GDP. So in the base year of 2009, nominal GDP = $10 trillion. In general, nominal GDP = real GDP × price level ÷ 100. So in 2013, nominal GDP = $11 trillion × 112 ÷ 100, which

Chapter 16 . The CPI and the Cost of Living

is $12.32 trillion. The percentage increase in nominal GDP is equal to [($12.32 trillion − $10 trillion) ÷ $10 trillion] × 100, which is 23.2 percent. 6.

What was the percentage increase in production from 2009 to 2013, and by what percentage did the cost of living rise from 2009 to 2013? The percentage increase in production equals the percentage increase in real GDP, [($11 trillion − $10 trillion) ÷ $10 trillion] × 100, which is 10 percent. The percentage increase in the cost of living equals the percentage increase in the GDP price index. In the base year, the GDP price index equals 100. So the percentage increase in the GDP price index equals [(112 − 100) ÷ 100] × 100, which is 12 percent.

In 1988, the average wage rate was $9.45 an hour and in 2008 the average wage rate was $18.00 an hour. The CPI in 1988 was 118.3 and in 2008 it was 215.3. Which real wage rate is higher? The 2008 wage rate that is equivalent to $9.45 in 1988 equals the CPI in 2008 divided by the CPI in 1988 and then multiplied by $9.45. So the 2008 wage rate is (215.3 ÷ 118.3) × $9.45, which is $17.20. The wage rate of $18.00 in 2008 is the higher wage rate.

Imagine that you are given $1,000 to spend and told that you must spend it all buying items from a Sears catalog. But you do have a choice of catalog. You may select from the 1903 catalog or from Sears.com today. You will pay the prices quoted in the catalog that you choose. Which catalog will you choose and why? Refer to any biases in the CPI that might be relevant to your choice. The 1903 catalog is attractive because prices quoted in the 1903 catalog are much lower than the prices quoted on Sears.com today. So the $1,000 buys more goods from the 1903 Sears catalog. Sears.com is attractive because the goods available on Sears.com are vastly improved and different from those available in the 1903 Sears catalog. The choice of whether to buy from the 1903 Sears catalog or from Sears.com will differ among students. However, two factors that play a role in this choice are, first, the quality of most goods today is higher than in 1903 and, second, the presence of a huge number of new goods available on Sears.com compared to the 1903 Sears catalog. These last two factors are the same as the corresponding two biases in the CPI: the quality change bias and the new goods bias.

187

188

Part 4 . MONITORING THE MACROECONOMY

Use the following information to work Problems 9 and 10. Money market funds are yielding almost nothing Last month, the interest rate on a money market fund averaged 0.08% a year and on 5-year CDs it was 2.6% a year. The inflation rate was 0.1% a year. Source: USA Today, August 12, 2009 9. Calculate the real interest rate on each of these financial assets. The real interest rate equals the nominal interest rate minus the inflation rate. So the real interest rate on a money fund was (0.08 percent) − (0.10 percent), which is −0.02 percent. The real interest rate on a 5-year CD was (2.60 percent) − (0.10 percent), which is 2.50 percent. 10. To maintain these real interest rates in the coming months, how will these nominal rates change if the inflation rate increases to 0.2 percent a year? If the inflation rate increases by 0.1 percentage points, then to maintain the same real interest rates, the nominal interest rates on these assets will rise by 0.1 percentage points.

Chapter 16 . The CPI and the Cost of Living

 Multiple Choice Quiz 1.

The CPI measures the average prices paid by __________ for _________. A. urban consumers; a fixed basket of consumption goods and services B. urban consumers; the average basket of goods and services they buy C. all consumers; housing, transportation, and food D. everyone who earns an income; the necessities of life Answer: A Answer A is the definition of the CPI. 2.

The BLS reported that the CPI in July 2010 was 226. This news tells you that _______. A. consumer prices during July were 226 percent higher than they were during the base year B. the CPI inflation rate in July was 26 percent a year C. consumer prices rose by 26 percent during the month of July D. the prices of consumption goods and services have risen, on average, by 126 percent since the base year Answer: D In the reference base period the CPI equals 100, so if it is 226 in July 2010, prices have risen, on average, 226 – 100, or 126 percent.

When the price level_______, the inflation rate ______. A. rises rapidly; increases B. rises rapidly; is high C. falls; is zero D. rises slowly; falls Answer: B When the price level rises rapidly, the inflation rate, which is the growth rate of the price level, is high. 4.

The CPI bias arises from all of the following items except ________. A. the introduction of new goods and services B. the improved quality of goods C. the goods and services bought by poor people D. consumers’ responses to price changes Answer: C The CPI’s biases do not include anything specific to the goods and services purchased by poor people.

189

190

Part 4 . MONITORING THE MACROECONOMY

Of the alternative measures of the price level, _________ overcomes the bias of the CPI and is a better measure of the cost of living because it _________. A. GDP price index; uses a current basket B. PCE price index; uses a current basket of all consumption goods C. PCE price index excluding food and energy; is less volatile D. GDP price index; includes all goods and services bought by Americans Answer: B The PCE is based on the current consumption bundle and thereby avoids the biases in the CPI. 6.

If nominal GDP increases by 5 percent a year and the GDP price index rises by 2 percent a year, then real GDP increases by ________. A. 7 percent a year B. 3 percent a year C. 2.5 percent a year D. 10 percent a year Answer: B Growth in nominal GDP can be separated into growth in the GPD price index plus growth in real GDP. 7.

When the CPI increases from 200 in 2010 to 210 in 2011 and the nominal wage rate is constant at $10 an hour, the real wage rate ______. A. increases by 10 percent B. increases to $15 an hour C. decreases by 5 percent D. is $10 an hour Answer: C The nominal wage rate falls from [($10 ÷ 200) × 100], which is $5.00, to [($10 ÷ 210) × 100], which is $4.76, a fall of 5 percent. 8.

When the price level is rising at ______ and the real interest rate is 1 percent a year, the nominal interest rate is 3 percent a year. A. 4 percent a year B. 3 percent a year C. 2 percent a year D. 1 percent a year Answer: C The nominal interest rate equals the real interest rate plus the inflation rate, so if the nominal interest rate is 3 percent a year and the real interest rate is 1 percent a year, the inflation rate must be 2 percent a year.

Potential GDP and Economic Growth

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications Use the following list of events, which occur in the United States one at a time, to work Problems 1 to 4. • Dell introduces a new supercomputer that everyone can afford. • A major hurricane hits Florida. • More high school graduates go to college. • The CPI rises. • An economic slump in the rest of the world decreases U.S. exports. 1. Sort the items into four groups: those that change the production function, those that change the demand for labor, those that change the supply of labor, and those that do not change the production function, the demand for labor, or the supply of labor. Say in which direction any changes occur. • The new supercomputers change the production function by shifting it upward. The hurricane changes the production function by shifting it (at least in Florida) downward. • The hurricane decreases the capital stock and thereby decreases the demand for labor. • If the new supercomputers increase workers’ productivity, the demand for labor increases. • The increased number of teenagers going to college has the immediate effect of changing the supply of labor by decreasing the supply of labor. • The CPI rising does not change the production function, the supply of labor, or the demand for labor. Similarly, the economic slump in the rest of the world does not change the production function, the supply of labor, or the demand for labor.

192

Part 5 . UNDERSTANDING THE MACROECONOMY

Which of the events increase the equilibrium quantity of labor and which decrease it? If the new supercomputers increase the demand for labor, the equilibrium quantity of labor increases. The increased number of teenagers in college has the immediate effect of decreasing the equilibrium quantity of labor. When a major hurricane hits Florida, the destruction of the capital stock decreases the demand for labor and decreases the equilibrium quantity of employment,

Which of the events raise the real wage rate and which lower it? If the new supercomputers increase the demand for labor, the equilibrium real wage rate rises. The increased number of teenagers in college has the immediate effect of increasing the equilibrium real wage rate. The hurricane decreases the demand for labor and thereby lowers the real wage rate.

Which of the events increase potential GDP and which decrease it? The new supercomputers increase potential GDP. The hurricane and the direct impact of more teenagers attending college decrease potential GDP. Production function Labor Real GDP hours (millions of (millions) 2009 dollars) 0 0 1 10 2 19 3 27 4 34 5 40

Labor market Real wage rate Quantity of Quantity of (dollars per labor demanded labor supplied hour) (millions of hours per year) 10 1 5 9 2 4 8 3 3 7 4 2 6 5 1

Use the information set out in the tables above about the economy of Athabasca to work Problems 5 and 6. 5. Calculate the quantity of labor employed, the real wage rate, and potential GDP. The real wage rate is $8 per hour, because that is the real wage that sets the quantity of labor demanded equal to the quantity of labor supplied. The equilibrium quantity of labor is 3 million hours per year. The production function shows that the potential GDP is $27 million. 6.

If the labor force participation increases, explain how employment, the real wage rate, and potential GDP change. If the labor force participation increases, the supply of labor increases. The increase in the supply of labor lowers the real wage and increases employment. The increase in employment increases potential GDP.

Chapter 17 . Potential GDP and Economic Growth

In 2005 and 2006, India’s real GDP grew by 9.2 percent a year and its population grew by 1.6 percent a year. If these growth rates are sustained, in what years would • Real GDP be twice what it was in 2006? Using the Rule of 70, India’s real GDP doubles in 70 ÷ 9.2 = 7.6 years. So starting from January 1, 2007 real GDP would be twice what it was on January 1, 2007 midway through the year 2014. • Real GDP per person be twice what it was in 2006? The growth rate of India’s real GDP per person equals 9.2 percent − 1.6 percent = 7.6 percent. Using the Rule of 70, India’s real GDP per person doubles in 70 ÷ 7.6 = 9.2 years. So starting from January 1, 2006 real GDP would be twice what it was on that date a little ways through the year 2015.

Explain how saving and investment in capital change labor productivity. Why do diminishing returns arise? Provide an example of diminishing returns. Use a graph of the productivity curve to illustrate your answer. Saving and investment in new physical capital increase labor productivity. Diminishing returns, however, occur: as capital per hour of labor rises, additional increases in capital per hour of labor raise labor productivity by smaller amounts. Diminishing returns arise because the first increases in capital boost labor productivity tremendously while, once more capital is accumulated, later increases have a smaller effect on labor productivity. For instance, when a wheat farm acquires its first combine, the workers’ productivity skyrockets higher because the wheat can be harvested in a much shorter time. But when the farm acquires its second combine, the increase in labor productivity is much smaller because the wheat already is being harvested efficiently. An increase in physical capital, which is the result of saving and investment, results in a movement along the productivity curve, as illustrated in Figure 17.1 by the arrow. The savings and investment has increased capital per hour of labor so there has been a movement along the productivity curve to a higher level of labor productivity.

193

194

Part 5 . UNDERSTANDING THE MACROECONOMY

Explain how advances in technology change labor productivity. Do diminishing returns arise? Provide an example of an advance in technology. Use a graph of the productivity curve to illustrate your answer. Advances in technology increase labor productivity. Technological advances allow producers to produce more goods and services without changing the quantity of resources utilized. Labor productivity is equal to (real GDP) ÷ (aggregate hours), so the technological advance that boosts real GDP without changing aggregate hours boosts labor productivity. Technological change is not subject to diminishing returns. For instance, the technological change in the production of computer chips has boosted the productivity of millions. An advance in technology results in an upward shift of the productivity curve, as illustrated in Figure 17.2 where the productivity curve shifts from PC0 to PC1. At any amount of capital per hour of labor, labor productivity PC1 is greater than labor productivity along PC0. Of course, along both productivity curves, increases in capital remain subject to diminishing returns.

10. What can governments in Africa do to encourage economic growth and raise the standard of living in their countries? Governments in Africa have to focus on increasing economic freedom within their countries. They need to end any wars in which they are involved to return to the rule of law and provide secure property rights. They also need to provide greater access to education to improve their citizens’ human capital as well as establish truly free markets. 11. Slowing down growth China’s GDP growth target for the 12th Five-Year-Plan period 2011–2015 is 7 percent a year. This largely symbolic goal (China’s average growth rate for the past five years was a whopping 11 percent a year) shows that the central government wants to fundamentally restructure the economy. Source: The Daily Telegraph, September 25, 2011 If China reduces its economic growth rate from 11 percent a year to 7 percent a year, how many additional years will it take for GDP to double? In what year will China’s GDP quadruple? Using the Rule of 70, if the growth rate is 11 percent, China’s GDP will double in 70 ÷ 11 = 6.36 years while if the growth rate is 7 percent, China’s GDP will double in 70 ÷ 7 = 10.00 years. Slowing the growth rate to 7 per-

Chapter 17 . Potential GDP and Economic Growth

cent means it will take 3.64 more years to double GDP. For China’s GDP to quadruple, it needs to double twice, so at a growth rate of 7 percent it will take China 20 years to quadruple its GDP. At this rate, GDP will quadruple from its level in 2013 in the year 2033. 12. Read Eye on Rich and Poor Nations on p. 473. Which nations are the richest and which are growing the fastest? What are the conditions that lead to higher incomes and faster growing incomes? The richest nations are the United States, Europe’s “Big 4” nations, Singapore, Hong Kong, and Taiwan. The nation growing the most rapidly is China, though Singapore, Hong Kong, Taiwan, and Korea have also grown rapidly in the recent past. Rapid economic growth requires three key factors: Economic freedom, secure property rights, and reliance upon free markets. Once these factors are in place, good incentives to save, invest, and innovate are important for speeding economic growth. Allowing for free international trade and creating a sound education system also help bring more rapid economic growth.

195

196

Part 5 . UNDERSTANDING THE MACROECONOMY

 Instructor Assignable Problems and Applications 1.

Distinguish between a low and high income and a low and high economic growth rate. What are the key features of an economy that are present when incomes are high or fast growing and absent when incomes are low and stagnating or growing slowly? Provide an example of an economy with a low income and slow growth rate, a low income and rapid growth rate, and a high income with sustained growth over many decades. The difference between low and high incomes versus low and high economic growth rates is important. A nation’s current income tells where it is now while the growth rate tells how rapidly its current income is changing. A nation with a high income or a fast-growing income will have met the preconditions for economic growth: economic freedom, secure property rights, and markets. These nations also frequently will have good incentive mechanisms to save, invest and innovate; government policies that encourage saving and research and development; free international trade; and, a high quality of education. Nations with low income or slow growth often need some of the necessary preconditions for growth. They also tend to lack good incentives to save, invest, and innovate; no government policies to encourage saving and research and development; restricted international trade; and poor schooling. Currently Zimbabwe is an economy with an extremely low income and an extremely slow growth rate; China is an economy with a relatively low income and a very high growth rate; and the United States is an economy that has enjoyed sustained growth over many decades.

Use the following information to work Problems 2 and 3. In Korea, real GDP per hour of labor is $22, the real wage rate is $15 per hour, and people work an average of 46 hours per week. 2. Draw a graph of the demand for and supply of labor in Korea and the United States. Mark a point at the equilibrium quantity of labor per person per week and the real wage rate in each economy. Explain the difference in the two labor markets. Figure 17.3 shows the labor market in Korea and also, based on data from the text, in the United States. The demand for labor in the United States exceeds the demand for labor in Korea because the quantity of capital per worker in the United States exceeds that in Korea and U.S. technology is generally more

Chapter 17 . Potential GDP and Economic Growth

productive than Korean technology. The U.S. supply of labor is less than the Korean supply of labor because of the income effect: U.S. income is higher than income in Korea, which increases the demand for leisure in the United States and thereby decreases the supply of labor in the United States. Draw a graph of the production functions in Korea and the United States. Mark a point on each production function that shows potential GDP per hour of work in each economy. Explain the difference in the two production functions. Figure 17.4 shows the two production functions. The information used for the U.S. production function is based on the data from the text. The U.S. production function is higher than the production function in Korea because the United States has more capital per worker than Korea and because U.S. technology is generally more advanced that Korean technology.

Use the following events that occur one at a time to work Problems 4 and 5. • The Middle East cuts supplies of oil to the United States. • The New York Yankees win the World Series. • U.S. labor unions negotiate wage hikes that affect all workers. • A huge scientific breakthrough doubles the output that an additional hour of U.S. labor can produce. • Migration to the United States increases the working-age population. 4. Sort the items into four groups: those that change the production function, those that change the demand for labor, those that change the supply of labor, and those that do not change the production function, the demand for labor, or the supply of labor. Say in which direction each change occurs. • The decrease in the supply of oil changes the production function by shifting it downward. The scientific breakthrough changes the production function by shifting it upward. • The decrease in the supply of oil decreases the demand for labor. The scientific breakthrough increase workers’ productivity so the demand for labor increases. • The increased migration increases the supply of labor.

197

198

Part 5 . UNDERSTANDING THE MACROECONOMY

•

The New York Yankees winning the World Series has no effect on the production function, the supply of labor, or the demand for labor. The union negotiation has no effect on the production function, the supply of labor, or the demand for labor. However it does increase the quantity of labor supplied and decrease the quantity of labor demanded. But these are movements along the curves and not shifts in the curves. Which of the events increase the equilibrium quantity of labor and increase potential GDP? The scientific breakthrough and the increased migration increase the equilibrium quantity of labor. They also increase potential GDP.

China’s growth rate of real GDP in 2005 and 2006 was 10.5 percent a year and its population growth rate was 0.5 percent a year. If these growth rates continue, in what year would real GDP be twice what it was in 2006? In what year would real GDP per person be twice what it was in 2006? Using the Rule of 70, China’s real GDP doubles in 70 ÷ 10.5 = 6.7 years. So starting from January 1, 2006, real GDP would be twice what it was on that date about two thirds of the way through the year 2012. The growth rate of China’s real GDP per person equals 10.5 percent − 0.5 percent = 10.0 percent. Using the Rule of 70, China’s real GDP per person doubles in 70 ÷ 10.0 = 7.0 years. So starting from January 1, 2006, real GDP would be twice what it was in 2006 in 2013.

Explain how an increase in physical capital and an increase in human capital change labor productivity. Use a graph to illustrate your answer. Saving and investment increase the amount of capital. The increase in the physical capital leads to an increase in labor productivity and a movement along a productivity curve. Formal education and training, as well as job experience, increase human capital. An increase in human capital increases labor productivity and shifts the productivity curve. Figure 17.5 illustrates this outcome by the shift in the productivity curve from PC0 to PC1. At any amount of capital per hours of labor, labor productivity (real GDP per hour of labor) is greater along productivity curve PC1 than along productivity curve PC0.

Chapter 17 . Potential GDP and Economic Growth

The table describes labor productivity in an economy. What must have occurred in this economy during year 1? Between year 1 and year 2, the output per hour of labor (labor productivity) increased for every level of capital per hour of labor. For this change to occur, there was either technological advances and/or growth in human capital.

Describe and illustrate in a graph what happened in the economy in the table if in year 1, capital per hour of labor was 30 and in year 2 it was 40. Figure 17.6 shows the productivity curves for the two years. PC1 is the productivity curve for year 1 and PC2 is the curve for year 2. The productivity curve shifted higher, as illustrated in the figure. This upward shift was the result of either technological advances and/or growth in human capital. The quantity of capital per hour of labor also increased because of saving and investment in new capital. With these changes the economy moved from point A in year 1 to point B in year 2.

Capital per hour of labor 10 20 30 40 50 60 70

Real GDP per hour of labor In year 1 In year 2 7 9 13 17 18 24 22 30 25 35 27 39 28 42

10. China invests almost 50 percent of its annual production in new capital compared to 15 percent in the United States. Capital per hour of labor in China is about 25 percent of that in the United States. Explain which economy has the higher real GDP per hour of labor, the faster growth rate of labor productivity, and which experiences the more severe diminishing returns. The United States has the higher real GDP per hour of labor because the U.S. productivity curve lies above the Chinese productivity curve and the United States has more capital per hour of labor than does China. China’s growth of productivity exceeds U.S. growth of productivity because China is increasing its capital per hour of labor more rapidly that the United States. The United States experiences more severe diminishing returns because the U.S. capital per hour of labor exceeds that in China.

199

200

Part 5 . UNDERSTANDING THE MACROECONOMY

 Multiple Choice Quiz 1.

U.S. potential GDP is the value of the goods and services produced in the United States ________. A. in the reference base year B. when the U.S. unemployment rate is zero C. when the U.S. economy is at full employment D. when the U.S. inflation rate is zero Answer: C Answer C is correct because it is the definition of potential GDP. 2.

The demand for labor curve shows the relationship between _________. A. the quantity of labor employed and firms’ profits B. all households’ willingness to work and the real wage rate C. the quantity of labor businesses are willing to hire and the real wage rate D. the labor force and the real wage rate Answer: C Answer C is the definition of the demand for labor curve. 3.

The supply of labor is the relationship between __________. A. the quantity of labor supplied and leisure time forgone B. the real wage rate and the quantity of labor supplied C. firms’ willingness to supply jobs and the real wage rate D. the labor force participation rate and the real wage rate Answer: B Answer B defines the supply of labor. 4.

Households’ labor supply decisions are influenced by all of the following except _______. A. the opportunity cost of taking leisure and not working B. the after-tax wage rate C. unemployment benefits D. the number of full-time jobs available Answer: D The number of full-time jobs available reflects firms’ demand for labor not households’ supply of labor.

Chapter 17 . Potential GDP and Economic Growth

If real GDP increases from $5 billion to $5.25 billion and the population increases from 2 million to 2.02 million, real GDP per person increases by ___ percent. A. 5.0 B. 1.0 C. 2.5 D. 4.0 Answer: D Real GDP grows by 5 percent and the population grows by 1 percent, so real GDP per person grows by 4 percent. 6.

If the population growth rate is 2 percent, real GDP per person will double in 7 years if real GDP grows by ______ percent per year. A. 7 B. 10 C. 12 D. 14 Answer: C For real GDP per person to double in 7 years, the growth rate of real GDP per person must be 10 percent. If the population growth rate is 2 percent, then real GDP must grow at 12 percent. 7.

All of the following increase labor productivity except _________. A. the accumulation of skill and knowledge B. an increase in capital per hour of labor C. an increase in consumption D. the employment of a new technology Answer: C An increase in consumption has nothing to do with changing labor productivity. 8.

An economy can achieve faster economic growth without ______. A. markets and property rights B. people being willing to save and invest C. incentives to encourage the research for new technologies D. an increase in the population growth rate Answer: D The other answers are necessary conditions for economic growth.

201

Money and the Monetary System ANSWERS TO CHAPTER CHECKPOINT

 Study Plan Problems and Applications 1.

What is money? Would you classify any of the following items as money? Money is any commodity or token that is generally accepted as a means of payment. • Store coupons for noodles Store coupons for noodles can act as a store of value but only at the store which honors them and usually only when presented with cash. They are not a widespread medium of exchange (only for noodles!) but if they are in dollars, the coupons are a unit of account. Store coupons are not money. •

A $100 Amazon.com gift certificate The $100 Amazon.com gift certificate acts as a store of value and a unit of account. It is a medium of exchange only at Amazon.com. The gift certificate is not money.

•

Frequent flier miles The frequent flier miles act as a unit of account. However, they might not serve as a store of value because they often have expiration dates. They are not money.

•

Credit available on your Visa card Credit available on your Visa card represents ability to borrow. It doesn’t share any of the characteristics of money, so it is not money.

•

The dollar coins that a coin collector owns The dollar coins that a coin collector owns are worth more than their face value of one dollar. Hence they will not be used as a means of payment so they are not money.

Chapter

Part 5 . UNDERSTANDING THE MACROECONOMY

204

What are the three functions that money performs? Which of the following items perform some but not all of these functions, and which perform all of these functions? Which of the items are money? Money acts as a medium of exchange; is a unit of account; and is a store of value. • A checking account at the Bank of America A checkable deposit at the Bank of America performs all three functions of money. It is money. •

A dime A dime performs all three functions of money. It is money.

•

A debit card A debit card represents a convenient way to access funds in account. The debit card is not a medium of exchange, a unit of account, or a store of value. (The funds in the account are the medium of exchange, unit of account, and store of value.) A debit card is not money.

Monica transfers $10,000 from her savings account at the Bank of Alaska to her money market fund. What is the immediate change in M1 and M2? M1 and M2 are left unchanged. The reason is that only the composition of M2 has changed but not the total amount of M2. M1 does not change because none of the components of M1 are affected.

Terry takes $100 from his checking account and deposits the $100 in his savings account. What is the immediate change in M1 and M2? M1 decreases by $100 and M2 remains unchanged.

Suppose that banks had deposits of $500 billion, a desired reserve ratio of 4 percent and no excess reserves. The banks had $15 billion in notes and coins. Calculate the banks’ reserves at the central bank. The banks’ total desired reserves equal $500 billion × 0.04, which is $20 billion. Of these $20 billion in desired reserves, banks have $15 billion in notes and coins, leaving $5 billion at the central bank.

Explain the Fed’s policy tools and briefly describe how each works. The Federal Reserve has four policy tools: changing the required reserve ratio, changing the discount rate, open market operations, and extraordinary crisis measures. The Fed can set the required reserve ratio, the fraction of deposits that banks must keep as reserves. If the Fed raises the required reserve ratio, banks are unable to make as many loans because they must keep more of their deposits as reserves. The Fed can change the discount rate, the interest rate it charges banks for loans of reserves. If the Fed raises the discount rate, banks will borrow fewer reserves. Open market operations are the purchase or sale by the Fed of government securities. If the Fed sells government securities, banks will have fewer re-

Chapter 18 . Money and the Monetary System

205

serves. Extraordinary crisis measures include quantitative easing, when the Fed increases banks’ reserves by large-scale open market operations, credit easing, when the Fed buys private securities or makes loans to financial institutions, and Operation Twist, when the Fed buys long-term government securities and sells short-term government securities in an effort to lower the long-term interest rate. 7.

The table shows a bank’s balance Assets Liabilities sheet. The bank has no excess re(millions of dollars) serves and there is no currency Reserves at the Fed 20 Checkable deposits 5 Savings deposits drain. Calculate the bank’s desired Cash in vault Securities 75 reserve ratio. Loans 100 The bank’s deposits are $200 million and its reserves, which are composed of the reserves at the Fed plus the cash in its vault, are $25 million. Therefore the desired reserve ratio equals ($25 million) ÷ ($200 million) = 0.125 or 12.5 percent. The Fed buys $2 million of securities from AIG. If AIG’s bank has a desired reserve ratio of 0.1 and there is no currency drain, calculate the bank’s excess reserves as soon as the open market purchase is made, the maximum amount of loans that the banking system can make, and the maximum amount of new money that the banking system can create. Excess reserves = actual reserves − desired reserves. The new reserves created by the Fed’s purchase are $2 million. Desired reserves have not changed, so the excess reserves are $2 million − $0.0 million, which is = $2.0 million. The maximum amount of loans that the banking system can make is equal to the increase in the quantity of money. To calculate the increase in the (1 + C / D) quantity of money, use the money multiplier, , where C/D ( R / D + C/D) is the currency drain ratio and R/D is the desired reserve ratio. In this case, the currency drain equals 0, so the money multiplier is 1 ÷ 0.10, or 10.0. So the total increase in the quantity of money is $2 million × 10.0, which is $20 million. Given the $20 million increase in the quantity of money, the total increase in loans is $20 million.

Use the following information to work Problems 9 and 10. If the desired reserve ratio is 5 percent, the currency drain ratio is 20 percent of deposits, and the central bank makes an open market purchase of $1 million of securities, calculate the change in 9. The monetary base and the change in its components. With the $1 million purchase of government securities, the monetary base increases by $1 million. Initially the component of the monetary base that

80 120

206

Part 5 . UNDERSTANDING THE MACROECONOMY

changes is banks’ deposits at the Fed, that is, banks reserves held at the Fed, increase. 10. The quantity of money, and how much of the new money is currency and how much is bank deposits. The change in the quantity of money equals (money multiplier) × (change (1 + C / D) in the monetary base). The money multiplier is , where C/D ( R / D + C/D) is the currency drain ratio and R/D is the desired reserve ratio. The money multiplier equals (1 + 0.2) ÷ (0.05 + 0.2) = 1.2 ÷ 0.25 = 4.8. So the change in the quantity of money equals (4.8) × ($1 million) = $4.8 million. One way to determine how much of the increase in money is in currency and how much is in deposits relies on two observations. First, note that c + d = $4.8 million, where c is currency and d is deposits. Then by rearranging, d = $4.8 million − c. Next, note that the entire $1 million increase in the monetary base must be held as either currency or reserves. Reserves equal the desired reserve ratio multiplied by the amount of deposits, or (0.05) × d. Thus $1 million = c + (0.05) × d. Now, use the first formula for d, namely d = $4.8 million − c, in the second formula to give $1 million = c + (0.05) × [($4.8 million) − c]. Multiply through by 0.05 to get $1 million = c + (0.05) × ($4.8 million) − (0.05) × (c). Simplify to obtain $1 million = 0.95 × c + $0.24 million. Solve this last formula for c and the result is c = $0.80 million. Because d = $4.8 million − c, with c = $0.8 million, d equals $4.0 million. Use this information to work Problems 11 and 12. South Korea: Bank reserves raised To rein in spending, the Bank of Korea raised the required reserve ratio to 7 percent from 5 percent—first time in almost 17 years. With higher required reserves, banks will have to cut the amount of loans they make. Source: The New York Times, November 24, 2006 11. Explain why a higher required reserve ratio means that banks will have to cut the amount of loans they can make. Banks are not free to use the reserves they hold as they choose because they must hold the amount they are required to hold, that is, they cannot loan these reserves. A higher required reserve ratio means that from their reserves, banks must increase the quantity they hold as required reserves. Banks excess reserves therefore decrease and it is these excess reserves that banks can loan. The decrease in excess reserves means that banks cannot loan as much and so they will decrease the amount of loans they make.

Chapter 18 . Money and the Monetary System

12. Assuming that the currency drain is zero and that the desired reserve ratio equals the required reserve ratio, calculate the change in the money multiplier that results from the increase in Korea’s required reserve ratio. (1 + C / D) The money multiplier is , where C/D is the currency drain ( R / D + C/D) ratio and R/D is the desired reserve ratio. If the currency drain is zero, then C = 0. When the desired reserve ratio is 5 percent, the money multiplier equals 1 ÷ 0.05 = 20.0. And when the desired reserve ratio is 7 percent, the money multiplier equals 1 ÷ 0.07 = 14.3. So the increase in the required reserve ratio lowered the money multiplier from 20.0 to 14.3. 13. Read Eye on Creating Money on pp. 502 –503. By how much did the monetary base increase and why didn’t M2 increase by the same percentage? The monetary based increased to four times its original amount, which means it increased by 300 percent. M2 did not increase by anywhere near the same amount because banks’ desired holdings of reserves relative to M2 deposits increased tenfold. Banks’ desired reserves increased so dramatically because of the significant increase in risk they perceived during and after the financial crisis. The huge increase in the ratio of reserves to M2 deposits more than halved the M2 money multiplier as it fell from about 9 to a bit more than 3. The drastic fall in the M2 money multiplier means that the ratio of M2 to the monetary base fell, so the rapid growth in the monetary base lead to much smaller growth in M2.

207

Part 5 . UNDERSTANDING THE MACROECONOMY

208

 Instructor Assignable Problems and Applications 1.

When the Fed increased the monetary base between 2008 and 2011, which component of the monetary base increased most: banks’ reserves or currency? What happened to the reserves that banks borrowed from the Fed? Banks’ reserves increased dramatically. There was a much smaller increase in currency. Borrowed reserves also temporarily skyrocketed but eventually returned to normal, an amount close to zero. 2. What happened to the money multiplier between 2008 and 2011? What would the money multiplier have been if the currency drain ratio had increased? What would the money multiplier have been if the banks’ desired reserve ratio had not changed? The money multiplier fell by an unprecedented amount. The money multiplier is (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the desired reserve ratio. Typically C/D is about 0.11 and R/D is about 0.01 so the money multiplier is 1.11/0.12, which is approximately 9. In 2008 the currency ratio hardly changed but the desired reserve ratio skyrocketed over 0.10 and still higher to about 0.20 in recent years. This drastic increase in banks’ desired reserve ratio lead to a huge fall in the money multiplier to less than 4.0. If the currency drain ratio had increased, the money multiplier would have fallen even more. If the desired reserve ratio had not changed, then because the desired reserve ratio has hardly changed, the money multiplier would not have changed; it would have remained equal to about 9. 3. What are the three functions that money performs? Which of the following items perform some but not all of these functions and which of the items are money? Money acts as a medium of exchange; is a unit of account; and is a store of value. • An antique clock An antique clock can serve as a store of value. But it is not a medium of exchange nor a unit of account, so it is not money. •

An S&L savings deposit The S&L saving deposit acts as a unit of account and a store of value. It is counted as part of M2 money.

•

Your credit card A credit card represents a convenient way to access an immediate loan. The credit card is not a medium of exchange, a unit of account, or a store of value, so a credit card is not money.

Chapter 18 . Money and the Monetary System

•

The coins in the Fed’s museum The coins in the Fed’s museum are worth more than their face value of one dollar. Hence they will not be used as a means of payment so they are not money. They are, however, a unit of account and a store of value.

•

Government securities Government securities can serve as a store of value. But they are not a medium of exchange nor a unit of account, so they are not money.

Naomi buys $1,000 worth of American Express travelers’ checks and charges the purchase to her American Express card. What is the immediate change in M1 and M2? M1 and M2 both rise by $1,000.

A bank has $500 million in checkable deposits, $600 million in savings deposits, $400 million in small time deposits, $950 million in loans to businesses, $500 million in government securities, $20 million in currency, and $30 million in its reserve account at the Fed. Calculate the bank’s deposits that are part of M1, deposits that are part of M2, the bank’s loans, securities, and reserves. The only deposits that are part of M1 are the checkable deposits of $500 million. The entire $1,500 million of deposits is part of M2. Total loans are $950 million. Reserves are deposits at the Fed plus currency = $30 million + $20 million = $50 million. Securities are $500 million.

What can the Fed do to increase the quantity of money and keep the monetary base constant? Explain why the Fed would or would not If the Fed decreases the required reserve ratio, banks can increase their lending, which increases the quantity of money. Reserves do not change and so the monetary base does not change. •

Change the currency drain ratio. The Fed has no control over currency drains.

•

Change the required reserve ratio. As outlined above, if the Fed lowers the required reserve ratio, the quantity of money increases and the monetary base does not change.

•

Change the discount rate. If the Fed decreases the discount rate, the banks pay a lower price for reserves that they borrow from the Fed. So banks are more willing to borrow reserves and increase their lending. The Fed would not do this action because it increases the monetary base.

•

Conduct an open market operation. The Fed cannot conduct an open market operation and increase the quantity of money while keeping the monetary base constant. Open market operations change the quantity of money by changing the monetary base.

209

210

Part 5 . UNDERSTANDING THE MACROECONOMY

It is impossible to use an open market operation to change the quantity of money while keeping the monetary base constant. Use the table, which shows a bank’s balAssets Liabilities ance sheet, to work Problems 7 and 8. (millions of dollars) The desired reserve ratio on all deposits Reserves at the Fed 25 Checkable deposits is 5 percent and there is no currency Cash in vault 15 Savings deposits Securities 60 drain. Loans 100 7. Calculate the bank’s excess reserves. If the bank uses all of these excess reserves to make a loan, what is the quantity of the loan and the quantity of total deposits after the bank has made the loan? The bank’s total deposits are $200 million, so the bank’s desired reserves are 0.05 × $200 million, which is $10 million. The bank’s reserves are the sum of its reserves at the Fed plus the cash in its vault, so the bank has $40 million in reserves. The bank’s excess reserves are $40 million − $10 million = $30 million. The bank can loan $30 million. When the bank has made the loan, the bank’s total deposits are $230 million, the sum of the initial demand deposits ($90 million) plus the deposit created by the loan ($30 million) plus the initial savings deposits ($110 million). 8.

If there is no currency drain, what is the quantity of loans and the quantity of total deposits when the bank has no excess reserves? The bank increases its loans by $30 million, so the total will be $130 million. Until the loan is spent, the bank’s total deposits are $230 million; after the loan is spent, the bank’s deposits are $200 million. System wide, the money multiplier is 20, so the total increase in deposits and loans is 20 × $30 million = $600 million.

Use the following information to work Problems 9 and 10. Inflation triggers more bank tightening To control inflation by limiting bank loans, the People’s Bank announced that it would raise the required reserve ratio for commercial banks from 21 percent to 21.5 percent. Source: South China Morning Post, June 15, 2011 9. Compare the required reserve ratio in China on June 15, 2011 and the required reserve ratio on checkable deposits in the United States today. The required reserve ratio is higher in China, 21.5 percent, then in the United States, where it is 3 percent on checkable deposits below a specified amount and 10 percent on checkable deposits above the amount.

90 110

Chapter 18 . Money and the Monetary System

10. If the currency drain ratio in China and the United States is 10 percent of deposits, compare the money multipliers in the two countries. (1 + C / D) The money multiplier is , where C/D is the currency drain ( R / D + C/D) ratio and R/D is the desired reserve ratio. In China, the money multiplier equals (1 + 0.10) ÷ (0.215 + 0.10), or 3.49. In the United States, using the higher required reserve ratio (that is, 10 percent on deposits) the money multiplier (1 + 0.10) ÷ (0.10 + 0.10), or 5.5. The higher required reserve ratio in China makes the Chinese money multiplier smaller than the U.S. money multiplier.

211

212

Part 5 . UNDERSTANDING THE MACROECONOMY

 Multiple Choice Quiz 1.

A commodity or token is money if it is ________. A. generally accepted as means of payment B. a store of value C. used in a barter transaction D. completely safe as a store of value Answer: A Answer A is the definition of money. 2.

Money in the United States today includes _______. A. currency and deposits at both banks and the Fed B. the currency in people’s wallets, stores’ tills, and the bank deposits that people and businesses own C. currency in ATMs and people’s bank deposits D. the banks’ reserves and bank deposits owned by individuals and businesses Answer: B Only currency outside of banks is part of money. 3.

Rick withdraws $500 from his savings account, keeps $100 as currency, and deposits $400 in his checking account. A. M1 increases by $400 and M2 decreases by $500. B. M1 does not change, but M2 decreases by $500. C. M1 does not change, but M2 decreases by $400. D. M1 increases by $500 and M2 does not change. Answer: D When the $500 was in the savings account, none of it was counted as M1 although all was counted as M2. When the funds are changed to currency and checkable deposits, all of it becomes part of M1 and hence all of it remains as M2. 4.

Commercial banks’ assets include ________. A. bank deposits of individuals and businesses and bank reserves B. loans to individuals and businesses and government securities C. bank reserves and the deposits in M2 D. government securities and borrowed funds Answer: B The discussion in the text about banks’ assets shows that banks’ assets include securities and loans.

Chapter 18 . Money and the Monetary System

The Fed’s policy tools include all the following except _______. A. required reserve ratio and open market operations B. quantitative easing C. discount rate D. taxing banks’ deposits at the Fed Answer: D Answer D is not a Fed policy tool. 6.

A commercial bank creates money when it does all the following except ______. A. decreases its excess reserves B. makes loans C. creates deposits D. puts cash in its ATMs Answer: D Currency inside of a bank is not money, regardless of whether the currency is in a teller’s till or is in an ATM. 7.

An open market _______ of $100 million of securities ______. A. purchase; increases bank reserves B. sale; increases bank reserves C. purchase; decreases the Fed’s liabilities D. sale; increases the Fed’s liabilities Answer: A When the Fed purchases government securities, it effectively pays for (at least part of) the purchasing by increasing banks’ reserves. 8.

The money multiplier _______. A. increases if banks increase their desired reserve ratio B. increases if the currency drain ratio increases C. is 1 if the desired reserve ratio equals the currency drain ratio D. decreases if banks increase their desired reserve ratio Answer: D If banks increase their desired reserve ratio, they will make fewer loans, which decreases the size of the money multiplier.

213

Aggregate Supply and Aggregate Demand ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

As more people in India have access to higher education, explain how potential GDP and aggregate supply will change in the long run. Increased access to higher education means that India’s labor force will be more highly educated and have more human capital. In the long run, this change will increase both India’s potential GDP and aggregate supply.

Explain the effect of each of the following events on the quantity of U.S. real GDP demanded and the demand for U.S. real GDP: • The world economy goes into a strong expansion. As the world economy goes into a strong expansion, U.S. exports increase. As a result, U.S. aggregate demand increases and the U.S. AD curve shifts rightward.

•

The U.S. price level rises. The rise in the U.S. price level decreases the quantity of U.S. real GDP demanded. There is a movement upward along the U.S. AD curve.

•

Congress raises income taxes. The tax hike decreases aggregate demand and shifts the AD curve leftward.

The United States is at full employment when the Fed cuts the quantity of money, other things remaining 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.

Chapter

216

Part 5 . UNDERSTANDING THE MACROECONOMY

The table sets out an economy’s aggrePrice level Real GDP Real GDP gate demand and aggregate supply (GDP demanded supplied price index) (billions of 2005 dollars) schedules. What is the macroeconomic 90 900 600 equilibrium? If potential GDP is $600 100 850 700 billion, what is the type of macroeco110 800 800 nomic equilibrium? Explain how real 120 750 900 GDP and the price level will adjust in 130 700 1,000 the long run. The macroeconomic equilibrium occurs at real GDP of $800 billion and a price level of 110. This price level is the only price level at which the quantity of real GDP demanded equals the quantity of real GDP supplied. If potential GDP is $600 billion, real GDP exceeds potential GDP. There is an inflationary gap. In the long run, the money wage rate rises. As the money wage rate rises, aggregate supply decreases so that real GDP decreases and the price level rises. Eventually aggregate supply decreases enough so that real GDP equals potential GDP, at which point adjustment stops.

Suppose that the U.S. economy has a recessionary gap and the world economy goes into an expansion. Explain the effect of the expansion on U.S. real GDP and unemployment in the short run. A global expansion increases exports and thereby increases U.S. aggregate demand so that the U.S. AD curve shifts rightward. In the short run, the increase in aggregate demand increases U.S. real GDP and lowers U.S. unemployment.

Explain the effect of the Fed’s action that increases the quantity of money on the macroeconomic equilibrium in the short run. Explain the adjustment process that returns the economy to full employment. An increase in the quantity of money increases aggregate demand. As shown in Figure 19.1, the AD curve shifts rightward from AD0 to AD1. The new short-run equilibrium occurs where the AS curve intersects the AD1 curve. The price level rises and real GDP increases. In Figure 19.1, the new short-run equilibrium occurs at the price level of 120 and real GDP of $16.5 trillion. This equilibrium reflects an inflationary gap. Full employment is restored as the money wage rate rises. Aggregate supply decreases and the AS curve shifts leftward. Eventually

Chapter 19 . Aggregate Supply and Aggregate Demand

aggregate supply decreases enough so that that real GDP returns to potential GDP and the economy is back at full employment. Use Figure 19.2 to work Problems 7 to 9. Initially, the economy is at point B. 7. Some events change aggregate demand from AD0 to AD1. Describe two possible events. What is the new equilibrium point? If potential GDP is $1 trillion, describe the type of macroeconomic equilibrium. Aggregate demand increases when the aggre-

gate 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 increases the quantity of money and lowers the interest rate; or if the U.S. foreign exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium real GDP is $1.1 trillion and the equilibrium price level is 105. The economy has an inflationary gap. Some events change aggregate supply from AS0 to AS1. Describe two possible events. What is the new equilibrium point? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no gap? Aggregate supply decreases when the aggregate supply curve shifts from

AS0 to AS1. 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 real GDP is $0.9 trillion and the equilibrium price level is 105. The economy is at an equilibrium with a recessionary gap. 9. Some events change aggregate demand from AD0 to AD1 and aggregate supply from AS0 to AS1. What is the new macroeconomic equilibrium? After the changes, equilibrium real GDP is $1.0 trillion and the equilibrium price level is 110. The economy is at a full-employment equilibrium. 10. Japan economic recovery under way as deflation eases Consumer prices excluding fresh food declined 0.4 percent from a year earlier—the smallest drop since 2009. The unemployment rate unexpectedly fell to 4.9 percent from 5.1 percent—the first decrease since

217

218

Part 5 . UNDERSTANDING THE MACROECONOMY

September. The economy will emerge from its slump “soon.” Source: Bloomberg, January 27, 2011 On an AS-AD graph show the macroeconomic equilibrium in Japan in 2010. Show why economic recovery is under way and deflation is easing. Figure 19.3 shows the situation in Japan. At the start of 2010, potential GDP was ¥565 trillion while real GDP was ¥550 trillion. Then aggregate demand increased, so the AD curve shifted rightward from AD0 to AD1 and aggregate supply also increased, so the AS curve shifted rightward from AS0 to AS1. The increase in aggregate supply was larger than the increase in aggregate demand. However, the increase in aggregate supply was only slighter larger than the increase in aggregate demand, so the price level fell by only 0.4 percent. Both the increase in aggregate demand and the increase in aggregate supply increase real GDP, so the unemployment rate fell to 4.9 percent. With both aggregate demand and aggregate supply increasing, the Japanese economy was heading back to potential GDP. And as the increase in aggregate demand picks up speed, eventually the price level will no longer fall so that Japan will no longer experience deflation. 11. Read Eye on the Business Cycle on p. 529. What caused the 2008–2009 recession and how do we know that a decrease in aggregate supply played a role? The financial crisis decreased the supply of loanable funds so that investment, particularly construction, decreased. The decrease in investment decreased aggregate demand. The decrease in aggregate demand was partially offset by an increase in government spending. Simultaneously, the rise in oil prices and in the money wage rate decreased aggregate supply. Accordingly, the recession was caused by the financial crisis, an increase in oil prices, and an increase in the money wage rate. We know that the recession involved a decrease in aggregate supply because if only aggregate demand decreased, the price level would have fallen. But the price level rose. The rise in the price level requires a decrease in aggregate supply.

Chapter 19 . Aggregate Supply and Aggregate Demand

 Instructor Assignable Problems and Applications 1.

What, according to the mainstream theory of the business cycle, is the most common source of recession: a decrease in aggregate demand, a decrease in aggregate supply, or both? Which is the most likely component of aggregate demand to start a recession? How does the aggregate demand multiplier influence a recession? According to mainstream theory, fluctuations in aggregate demand are the major source of recessions. Investment is the component of aggregate demand whose decrease starts recessions. The aggregate demand multiplier means that recessions will be deeper. An initial decrease in aggregate demand is reinforced by the aggregate demand multiplier so that the resulting decrease in real GDP (and increase in unemployment) is larger than would otherwise be the case.

Suppose that the United States is at full employment. Explain the effect of each of the following events on aggregate supply: • Union wage settlements push the money wage rate up by 10 percent. The higher money wage rate decreases U.S. aggregate supply and the U.S. AS curve shifts leftward.

•

The price level increases. The higher price level increases the quantity of real GDP supplied and there is a movement upward along the U.S. AS curve.

•

Potential GDP increases. The increase in potential GDP increases U.S. aggregate supply and the U.S. AS curve shifts rightward.

Suppose that the United States is at full employment. Then the federal government cuts taxes, and all other influences on aggregate demand remain the same. Explain the effect of the tax cut on aggregate demand in the short run. The tax cut increases aggregate demand and shifts the AD curve rightward. Aggregate supply does not change.

Use the following information to work Problems 4 and 5. Because fluctuations in the world oil price make the U.S. short-run macroeconomic equilibrium fluctuate, someone suggests that the government should vary the tax rate on oil, lowering the tax when the world oil price rises and increasing the tax when the world oil price falls, to stabilize the oil price in the U.S. market. 4. How would such an action influence aggregate demand? Raising the tax decreases disposable income, decreases consumption, and decreases aggregate demand. Lowering the tax has the opposite effects.

219

220

Part 5 . UNDERSTANDING THE MACROECONOMY

How would such an action influence aggregate supply? If the tax successfully stabilizes the price of oil, it would stabilize aggregate supply. If the tax does not fully stabilize but instead moderates fluctuations in the price of oil, then it would moderate fluctuations in aggregate supply.

The table sets out the aggregate dePrice level Real GDP Real GDP (GDP demanded supplied mand and aggregate supply schedules price index) (trillions of 2000 yen) in Japan. Potential GDP is 600 trillion 75 600 400 yen. What is the short-run macroeco85 550 450 nomic equilibrium? Does Japan have 95 500 500 an inflationary gap or a recessionary 105 450 550 gap and what is its magnitude? 115 400 600 125 350 650 The macroeconomic equilibrium oc135 300 700 curs at real GDP of ¥500 trillion and a price level of 95. This price level is the only price level at which the quantity of real GDP demanded equals the quantity of real GDP supplied Because potential GDP is ¥600 trillion, real GDP is less than potential GDP. There is a recessionary gap equal to real GDP minus potential GDP, which is ¥100 trillion.

Suppose that the world price of oil rises. On an AS–AD graph, show the effect of the world oil price rise on U.S. macroeconomic equilibrium in the short run. Explain the adjustment process that restores the economy to full employment. A rise in the world price of oil decreases aggregate supply. As Figure 19.4 shows, the AS curve shifts leftward from AS0 to AS1. The new short-run equilibrium occurs where the AS1 curve intersects the AD curve, at the price level of 120 and real GDP of $15.75 trillion. The economy is in an equilibrium with a recessionary gap. There is a surplus of labor because employment has decreased. This surplus gradually lowers the money wage rate. Full employment is restored as the money wage rate falls. Aggregate supply increases and the AS curve shifts rightward.

Chapter 19 . Aggregate Supply and Aggregate Demand

Explain the effects of a global recession on the U.S. macroeconomic equilibrium in the short run. Explain the adjustment process that restores the economy to full employment. As the world economy goes into recession, U.S. exports decrease so the U.S. aggregate demand decreases and the U.S. AD curve shifts leftward. Figure 19.5 illustrates this change, with the AD curve shifting leftward from AD0 to AD1. The new short-run equilibrium occurs where the AS curve intersects the AD1 curve. The price level falls and real GDP decreases. In Figure 19.5, the new short-run equilibrium occurs at the price level of 100 and real GDP of $15.5 trillion. The economy is in an equilibrium with a recessionary gap. There is a surplus of labor because employment has decreased. This surplus gradually lowers the money wage rate. In the long run, full employment is restored as the money wage rate falls. Aggregate supply increases and the AS curve shifts rightward. The increase in aggregate supply raises real GDP and employment so that the economy ultimately returns to potential GDP and full employment.

Use the following information to work Problems 9 and 10. House GOP changes course on infrastructure House Republicans abandoned plans to slash U.S. infrastructure spending and now say they are trying to find ways to pay for a multiyear highwayconstruction program, which will exceed $300 billion. Source: The Wall Street Journal, September 30, 2011 9. Explain the effect of the government’s increased expenditure on infrastructure on U.S. aggregate demand and aggregate supply. In the short run, the increased expenditure on infrastructure increases aggregate demand and has no effect on aggregate supply. In the long run, when the infrastructure is completed, expenditure on it drops to zero so there is no long-run effect on aggregate demand. However in the long run when the infrastructure comes on line, potential GDP increases, which increases aggregate supply.

221

222

Part 5 . UNDERSTANDING THE MACROECONOMY

10. The United States in 2011 has a recessionary gap. Use the AS-AD model to show the effect on U.S. real GDP as the new infrastructure is completed. In 2011 the U.S economy was at point A and potential GDP is $15.3 trillion, as shown by the Potential GDP0 line. The economy has a recessionary gap. As time passes and the infrastructure is completed, potential GDP increases, to Potential GDP1 and aggregate supply increases, to AS1. The economy moves to point B, with an equilibrium closer to potential GDP.

Chapter 19 . Aggregate Supply and Aggregate Demand

 Multiple Choice Quiz 1.

Aggregate supply increases when ________. A. the price level rises B. the money wage rate falls C. consumption increases D. the money price of oil increases

Answer: B

A fall in the money wage rate increases aggregate supply and shifts the AS curve rightward.

When potential GDP increases, _______. A. aggregate demand increases B. aggregate supply increases C. both aggregate demand and aggregate supply increase D. the price level rises

Answer: B

As Figure 19.2 in the text shows, an increase in potential GDP increases aggregate supply.

The quantity of real GDP demanded increases if _______. A. the buying power of money increases B. the money wage rate rises C. the price level falls D. the nominal interest rate falls

Answer: C

Changes in the price level bring movements along the AD curve and change the quantity of real GDP demanded.

An increase in expected future income increases ________. A. consumption expenditure, which increases current aggregate demand B. investment, which increases current aggregate supply C. the demand for money, which decreases current aggregate demand D. future consumption expenditure and has no effect on current aggregate demand

Answer: A

Consumption expenditure increases as consumers buy bigticket items now with the idea of paying for them in the future.

223

224

Part 5 . UNDERSTANDING THE MACROECONOMY

Macroeconomic equilibrium occurs when the quantity of real GDP _______ equals the quantity of _______. A. demanded; real GDP supplied B. demanded; potential GDP C. supplied; potential GDP D. demanded; real GDP supplied and potential GDP

Answer: A

Macroeconomic equilibrium occurs where the AD curve intersects the AS curve, which is the point at which the quantity of real GDP demanded equals the quantity of real GDP supplied.

If the economy is at full employment and the Fed increases the quantity of money, _______. A. aggregate demand increases, a recessionary gap appears, and the money wage rate starts to rise B. aggregate supply increases, the price level starts to fall, and an expansion begins C. aggregate demand increases, an inflationary gap appears, and the money wage rate starts to rise D. potential GDP and aggregate supply increase together and the price level does not change

Answer: C

An increase in the quantity of money can set off a demandpull inflation by increasing aggregate demand, thereby creating an inflationary gap.

Over the past decade, the demand for goods produced in China has brought a sustained increase in demand for China’s exports that has outstripped the growth of supply. As a result, China has experienced a _______. A. period of stable prices and sustained economic growth B. rising price level and demand-pull inflation C. rising price level and cost-push inflation D. rising price level and a falling real wage rate

Answer: B

Aggregate demand has increased far more than aggregate supply, so the price level has risen and the economy has had a demand-pull inflation.

Fiscal Policy and Monetary Policy ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

Suppose that in an economy, investment is $400 billion, saving is $400 billion, tax revenues are $500 billion, exports are $300 billion, and imports are $200 billion. Calculate government expenditure and the government’s budget balance. The circular flow shows that GDP = C + I + G + X − M. The circular flow also shows that Y = C + S + T. Because GDP = Y, these two equalities can be combined to give C + I + G + X − M = C + S + T. Rearranging this equality gives G = S – I + T + M – X. Using this formula shows G = $400 billion − $400 billion + $500 billion + $200 billion − $300 billion, or government expenditure = $400 billion. The government’s budget balance equals T − G, so the budget balance is $500 billion − $400 billion, or a $100 billion budget surplus. 2. Classify the following items as automatic fiscal policy actions, discretionary fiscal policy actions, or neither. • An increase in expenditure on homeland security Discretionary fiscal policy because the spending must be approved by an act of Congress. • An increase in unemployment benefits paid during a recession Automatic fiscal policy because no action of Congress was necessary for this increase to occur. • Decreased expenditures on national defense during peace time Discretionary fiscal policy because the spending change must be approved by an act of Congress. • An increase in Medicaid expenditure brought about by a flu epidemic Automatic fiscal policy because no action of Congress was necessary for this increase to occur.

Chapter

Part 5 . UNDERSTANDING THE MACROECONOMY

226

• 3.

A cut in farm subsidies Discretionary fiscal policy because an act of Congress was required. The U.S. economy is in recession and has a large recessionary gap. Describe what automatic fiscal policy might occur. Describe a fiscal stimulus that could be used that would not increase the budget deficit. One automatic fiscal policy that kicks in results from the point that the recession lowers people’s incomes, so induced taxes decrease. The other automatic stabilizer occurs because lower incomes increase needs-tested spending, such as unemployment benefits and food stamps. Both automatic stabilizers help to stabilize aggregate demand by decreasing the multiplier effect. A fiscal stimulus that could be used and that does not increase the budget deficit is a balanced budget increase in government expenditure and taxes. The balanced budget multiplier shows that when both government expenditure and taxes increase by the same amount, aggregate demand increases. The increase in aggregate demand can help decrease the recessionary gap. IMF reduces forecast for U.S. growth The IMF expects U.S. economic growth to slow to 2% in 2012 and 2.25% in 2013. That’s down from its earlier estimates of 2.15% in 2012 and 2.4% in 2013. Christine Lagarde, the IMF’s managing director, said that Congress should “promptly” raise the debt ceiling and adopt strong fiscal policies. Source: The New York Times, July 3, 2012 Explain the effects of strong fiscal stimulus if it is implemented well. The fiscal stimulus is designed to increase aggregate demand and offset the recessionary gap that existed. Mr. Blanchard suggested that such stimulus was needed soon because the sooner it was implemented, the sooner the recessionary gap would be closed. If it is implemented well, fiscal stimulus closes the recessionary gap without creating an inflationary gap by being too strong. The Canadian Prime Minister Stephen Harper warned on November 6, 2008, that if policy makers adopt too strong a fiscal stimulus then longterm growth might be jeopardized. Explain what he meant. Mr. Harper was concerned about the supply-side effects of the fiscal stimulus. If the fiscal stimulus consists of government expenditure increases that are large and permanent, then government tax revenues would need to increase to keep the budget deficit from rising and crowding out investment. If investment decreases, then the economic growth rate slows.

Chapter 20 . Fiscal Policy and Monetary Policy

Use the following information to work Problems 6 to 8. The figure shows the aggregate demand curve, AD, and the short-run aggregate supply curve, AS, in the economy of Artica. Potential GDP is $300 billion. 6. What are the price level and real GDP? Does Artica have an unemployment problem or an inflation problem? Why? The price level is 110 and real GDP is $400 billion. Artica has an inflation problem because real GDP exceeds potential GDP. 7.

What do you predict will happen if the central bank takes no monetary policy actions? What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action? If the central bank takes no action, then in the long run the money wage rate rises. Aggregate supply decreases so that the AS curve shifts leftward. In the long run, the economy returns to potential GDP of $300 billion and the price level rises to 120. If the central bank undertakes a policy action, the central bank should raise the federal funds rate and thereby decrease aggregate demand. If the central bank did so and was totally accurate, then real GDP would return to potential GDP of $300 billion and the price level would fall to 100.

Suppose that a drought decreases potential GDP in Artica to $250 billion. Explain what happens if the central bank lowers the federal funds rate. Do you recommend that the central bank lower the interest rate? Why? The central bank should lower the interest rate. If the central bank lowers the federal funds rate, aggregate demand increases. The price level rises. Real GDP increases and moves closer to potential GDP. Lowering the interest rate can move real GDP back to potential GDP. But if the central bank does not realize that potential GDP has decreased to $250 billion, it might lower the interest rate by too much and increase real GDP well beyond potential GDP. In that case inflation would result. Read Eye on Fiscal Stimulus on p. 546. How big was the fiscal stimulus package of 2008–2009, how many jobs was it expected to create, and how large was the multiplier implied by that expectation? Did the stimulus work? In February 2009, the total fiscal stimulus package passed by the Congress was $787 billion, though in the first year only about 20 percent of the stimulus, or $160 billion, had been spent. The stimulus was expected to

227

228

Part 5 . UNDERSTANDING THE MACROECONOMY

save or create 650,000 jobs by the summer of 2009. Government economists asserted that 650,000 jobs had been saved or created. Accordingly, $160 billion in fiscal stimulus created 650,000 jobs. The implied multiplier was only 0.4, far smaller than the administration predictions that the multiplier was 1.6. 10. Read Eye on the Fed in a Crisis on p. 554. What are the key differences in monetary policy between the Great Depression and the slow recovery from the 2008–2009 recession? The major difference in the Fed’s behavior between the Great Depression and the 2008-2009 recession was the vast increase in reserves in 2008-2009 and the following increase in the quantity of money. In the Great Depression, the Fed allowed the quantity of money to decrease by 35 percent; in the 2008-2009 recession, the Fed engineered an increase in the quantity of money of 37.5 percent.

Chapter 20 . Fiscal Policy and Monetary Policy

 Instructor Assignable Problems and Applications 1.

From the peak in 1929 to the Great Depression trough in 1933, government tax revenues fell by 1.9 percent of GDP and government expenditures increased by 0.3 percent. Real GDP fell by 25 percent. Compare and contrast this experience with the fiscal policy that accompanied the 20082009 recession. What did fiscal policy do to moderate the last recession that was largely absent during the Great Depression? In the 2008-2009, fiscal policy was used extensively to moderate the recession. During the Great Depression, however, fiscal policy was virtually not used. For instance, during the Great Depression, government expenditure increased by only 0.3 percent of GDP but during the recent recession government expenditure (including both automatic and discretionary expenditure) increased by 5 percent of GDP. Similarly during the Great Depression government tax revenues fell by only 1.9 percent of GDP while during the recent recession tax revenues (both automatic and discretionary) fell by 3.0 percent of GDP. The scale of the fiscal stimulus was much greater during the last recession and this fact might be a point why the recession was much less severe than the Great Depression.

In which episode, the Great Depression or the 2008–2009 recession, did the banks’ desired reserve ratio and the currency drain ratio increase by the larger amount and the money multiplier fall by the larger amount? Banks’ desired reserve ratio increased by much more in the 2008-2009 recession than during the Great Depression. The currency drain ratio increased by more during the Great Depression. The fall in the money multiplier was much larger during the 2008-2009 recession.

Suppose that the U.S. government increases its expenditure on highways and bridges by $100 billion. Explain the effect that this expenditure would have on aggregate demand and real GDP. Government expenditure is autonomous expenditure, so the increase in government expenditure increases autonomous expenditure. As a result, aggregate demand increases. The multiplier effect means that aggregate demand increases by more than the $100 billion increase in government expenditure. Real GDP increases because aggregate demand increases.

Suppose that the U.S. government increases its expenditure on highways and bridges by $100 billion. Explain the effect that this expenditure would have on needs-tested spending and the government’s budget surplus. Needs-tested spending decreases as the economy expands. The budget surplus will fall but by less than the increase in expenditure because the increase in GDP will induce some additional taxes and decrease needstested spending.

229

230

Part 5 . UNDERSTANDING THE MACROECONOMY

Describe the supply-side effects of a fiscal stimulus and explain how a tax cut will influence potential GDP. A tax cut increases people’s incentives to work and to save. Therefore a tax cut increases employment and investment in new capital. The increase in employment and capital increase potential GDP.

Use an aggregate supply–aggregate demand graph to illustrate the effects on real GDP and the price level of a fiscal stimulus when the economy is in recession. The fiscal stimulus increases aggregate demand and shifts the aggregate demand curve rightward, as illustrated in Figure 20.2. The increase in aggregate demand raises the price level, in Figure 20.2 from 110 to 120, and increases real GDP, in Figure 20.2 from $15.5 trillion to $16.0 trillion. The recessionary gap is decreased; indeed, in Figure 20.2, the recessionary gap is completely eliminated.

Use the following information to work Problems 7 and 8. CBO estimates $1.3 trillion deficit for 2011 The Congressional Budget Office (CBO) predicts that the federal budget deficit hit a near-record $1.3 trillion in the just-completed fiscal year. The 2011 deficit equaled 8.6% of GDP, a slight drop from the 8.9% of GDP in 2010. It’ll take some combination of new revenues and major spending cuts to get the deficit down to about 3% of GDP, the level that many analysts say is sustainable. Source: USA Today, October 8, 2011 7. If the plan to reduce the deficit includes a cut in transfer payments and a rise in taxes of the same amount, how will this policy influence the budget deficit and real GDP? The cut in transfer payments and rise in taxes both decrease the budget deficit. Ignoring the supply-side effects, they also both decrease aggregate demand, which decreases real GDP. If supply-side effects are taken into

Chapter 20 . Fiscal Policy and Monetary Policy

account, the tax hike decreases aggregate supply, which further decreases real GDP. 8.

If the plan to reduce the deficit includes an increase in taxes on the wealthy, explain how this policy might have serious supply-side consequences for both potential GDP and the growth rate of real GDP. If the tax rates on the wealthy are increased, there likely will be significant decrease in the supply of labor and a significant decrease in saving. The decrease in the supply of labor decreases employment and thereby decreases potential GDP. The decrease in saving decreases the supply of loanable funds. The equilibrium quantity of investment and capital accumulation decrease, which decreases the growth rate of real GDP.

Suppose that inflation is rising toward 5 percent a year, and the Fed, Congress, and the White House are discussing ways of containing inflation without damaging employment and output. The President wants to cut aggregate demand but to do so in a way that will give the best chance of keeping investment high to encourage long-term economic growth. Explain the Fed’s best action for meeting the President’s objectives. The Fed really cannot meet both the President’s objectives. On the one hand, to keep investment high, the policy must lower, or at the least, not raise the real interest rate. So the President’s goal is to decrease aggregate demand and lower (or not raise) the real interest rate. The rise in the federal funds rate means that the real interest rate rises. The rise in the real interest rate decreases aggregate demand, which is what the President wants. But it also decreases investment, which is incompatible with the President’s other goal. On the other hand, cutting the funds rate means that the real interest rate falls. The fall in the real interest rate increases investment, which is what the President wants. But it also increases aggregate demand, which is incompatible with the President’s other goal. 10. Compare and contrast the Fed’s monetary policy response to the surge in desired reserves and currency holdings in the Great Depression and the 2008–2009 recession. The Fed in the 2008-2009 recession attempted to avert the collapse in lending that occurred during the Great Depression by making its monetary policy much more accommodative than during the Great Depression. That is, the Fed met the increased demand for reserves in 2008-2009 by vastly increasing the quantity of reserves while in the Great Depression the Fed did very little. During the Great Depression M2 decreased by more than 30 percent while during the recent recession M2 grew by 8 percent.

231

232

Part 5 . UNDERSTANDING THE MACROECONOMY

 Multiple Choice Quiz 1.

The federal government’s major outlay in its budget is_______ and its major source of revenue is _______. A. debt interest; sales of government bonds B. expenditure on goods and services; taxes on goods and services C. Social Security and other benefits; personal income taxes D. subsidies to farmers; corporate taxes Answer: C Social Security payments are the major part of the government’s transfer payments, which is the largest outlay item. On the revenue side, personal income taxes slightly exceed Social Security taxes in revenue collected. 2.

U.S. national debt _______ when the federal government’s _______. A. increases; outlays exceed tax revenue B. decreases; outlays exceed tax revenue C. increases; tax revenue rises faster than outlays D. decreases; tax revenue rises faster than outlays Answer: A The national debt increases whenever the government’s outlays exceeds its tax revenues. 3.

Discretionary fiscal policy to stimulate the economy includes ________. A. lowering the tax rate paid by households with middle incomes B. raising the tax on gasoline C. the fall in tax revenue as the economy goes into recession D. the rise in tax revenue collected from businesses as their profits increase Answer: A Answer A is discretionary fiscal policy because it requires an act of Congress. It is an expansionary policy because it is designed to increase consumption expenditure and hence aggregate demand. 4.

Automatic fiscal policy ________. A. requires an action of the government B. is weak unless the government cuts its outlays to reduce the deficit C. operates as the economy moves along its business cycle D. reduces the deficit as the economy goes into recession Answer: C Answer C is essentially the definition of automatic fiscal policy.

Chapter 20 . Fiscal Policy and Monetary Policy

The Fed’s “dual mandate” is to achieve ________. A. a government budget surplus and low interest rates B. low inflation and maximum employment C. a stable quantity of money and stable prices D. zero unemployment and a stable means of payment Answer: B The Fed’s dual mandate reflects its major goals. 6.

When the Fed lowers the federal funds rate ________. A. aggregate demand increases the same day B. investment increases, but only after the economy’s growth rate rises C. the quantity of money and loans increase in the short term D. the inflation rate increases about two years later Answer: D Although few of the impacts of the Fed’s policy actions occur immediately, the impact on the inflation rate is particularly delayed. 7.

The Fed fights inflation by _______. A. lowering the federal funds rate, which lowers interest rates and decreases aggregate demand B. raising the federal funds rate, which raises interest rates and decreases aggregate demand C. decreasing the monetary base, which raises the interest rate and increases saving D. lowering the long-term real interest rate, which increases investment and spurs economic growth Answer: B By raising the federal funds rate, the Fed ultimately decreases aggregate demand, which slows the inflation rate. 8.

To fight unemployment and close a recessionary gap, the Fed ______. A. stimulates aggregate demand by lowering the federal funds rate, which increases the quantity of money B. stimulates aggregate supply by lowering the federal funds rate, which increases potential GDP C. increase employment, which increases real GDP D. increases bank reserves, which banks use to make new loans to businesses, which increases aggregate supply Answer: A By lowering the federal funds rate, the Fed ultimately increases aggregate demand, which increases real GDP and lowers unemployment.

233

Part 2: Instructor's Manual

Integrating Technology into the Principles Classroom* WELCOME! Today’s* economics instructors have an impressive array of tools to help their students master the discipline. Although “talk and chalk” will always be a viable method of instruction, technology tools are now expanding teaching and learning possibilities. Such tools often resonate with a generation used to playing video games and using smart phones. These students increasingly expect to use technology in many of their classes, including economics. The following remarks provide some suggestions on how to integrate various aspects of technology into your lesson plan, based on some of the experiences I have had in my own classroom. I also touch upon some of the potential pitfalls that can arise, along with suggestions for minimizing them, and I particularly discuss how I have used MyEconLab, the online homework and tutorial system packaged with all Foundations textbooks.

 Goals What are the goals we hope to achieve by using technology like MyEconLab in the classroom? The overriding one is to enhance student understanding and learning. A more immediate goal, however, is to generate enthusiasm and interest in economics by capturing a variety of student learning styles. The more senses that we can stimulate by using various technology components, the more students will be engaged in the learning process.

 Incentive Effect What are the benefits of using technology and in particular of using MyEconLab? The primary benefits that I have found with using a course-specific (text-specific) website is that it encourages and enforces student participation, even in the largest of classes, while providing coherence across the material presented in the book and on the website. My primary use of MyEconLab has been on the all-important homework side. With MyEconLab, I assign homework, my students submit it online, and they receive immediate feedback on their materials. In-progress grades (including exam grades) can be posted on the website. Feedback from assigned problems and the accessibility to these grades by the instructor afford a check on students who claim that they understand the material even though they have done poorly on exams–you can easily verify whether the problem set scores corroborate the claim or tell a different story. For those who are struggling, the online practice problems available for each chapter provide a straightforward solution for additional practice. Also encourage students to use the practice tests in

* This essay was originally written by Rebecca Neumann, University of Wisconsin – Milwaukee.

xiv

PREFACE 2

MyEconLab to work on the areas in which they are having difficulty. MyEconLab provides students with a Personalized Study Plan that directs them to additional exercises and step-by-step solutions, allowing them to shore up their weak spots. They will receive step-by-step explanations of solutions to the problems. They will also be able to draw and manipulate graphs via a powerful, automaticallygraded graphing tool. The Grapher tool can also be used interactively in class. You can display the Grapher on screen, give the mouse to a student, and ask the student to draw the graph needed to illustrate the point at hand. Other students can coach the (sometimes unfortunate) “mouser,” leading to an accurate and collaborative graph. Wrong paths are sometimes revealed through this participatory process and a powerful learning event can take place.

 A Coordination Tool For larger classes, the use of MyEconLab provides a unifying set of material, including homework and additional practice problems, for separate discussion sections with teaching assistants. In this way, you know that your teaching assistants have the same set of material and are covering the same types of questions in section. Having homework that is automatically graded reduces variation in grading and the acceptance of “almost correct” answers. It also allows for immediate feedback that does not depend on the timing of the discussion section relative to the main lecture. MyEconLab is also a superior coordination tool for smaller classes or for classes without teaching assistants. In these classes, the problem sets from MyEconLab can provide practice for students outside class or serve as a basis for discussion and practice within class. In my smaller classes, I often provide time in class to go over the assigned problems or have students complete additional, similar questions in small groups.

 Accommodating Variety in Learning Styles Utilizing multiple teaching tools helps in reaching students with different learning styles. My typical Principles class consists of a mixture of lectures and in-class application of material to problems similar to or a step beyond that on the homework. I use a fairly standard lecture style with an overhead projector. You may wish to use the PowerPoint lecture notes available with the text. I generally prefer to draw the graphs to show students how they can do the same to solve homework and/or exam problems. Mixing in some of the figures/tables from the book (using the PowerPoint slides) provides some visual relief from a pure lecture/notes format. For example, use the figures and tables to present real-world data and up-to-date applications. For larger classes, incorporate web pages and other visual and nonvisual aids to help capture attention. For smaller classes, there are more options for generating class discussion or assigning in-class work in small groups. I often use material from the Critical Thinking questions or the “Eye On” sections to generate in-class discussions or to assign a specific question for students to work on in groups for the last 20 minutes of class. I have them turn in one set of answers per group and count this as part of their participation grade for the day. Students who never speak in class are much more likely to ask a question if you are walking around the classroom offering assistance to individual groups. Don’t feel that you need to do this every week. But providing this type of individual attention two to three times during the term will help you to see how students are thinking and give students a more interactive feel to the class. If you have larger classes, this is a good tool for teaching assistants to use to generate discussion and class participation.

INTEGRATING TECHNOLOGY INTO THE PRINCIPLES CLASSROOM

 Sparking Creativity in Students Beyond homework and grading options, technology can be integrated in other ways to stimulate students’ interest and creativity. If your classroom has web access, utilize it during class time. For example, when presenting data on the macro economy, go to the website for the Bureau of Economic Analysis (www.bea.gov) and show students where they can access data. Similar to the BEA, MyEconLab has new real-time data problems. These problems load the latest available data from FRED, a comprehensive up-to-date data set maintained by the Federal Reserve Bank of St. Louis. Also, MyEconLab now has experiments that are a fun and engaging way to promote active learning of important concepts. Single-player experiments allow students to play anywhere they have an internet connection. Multiplayer experiments allow you to assign and manage a real-time experiment with your class. Pre and post-questions for each experiment are available for assignment in MyEconLab. There are additional suggestions for incorporating various websites in the Lecture Launchers for chapters included in this Instructor’s Manual. If you are going to utilize web pages in class, make sure you test them out ahead of time and know where you want to navigate. Ensure that the link is solid and that you can find the webpage quickly; otherwise, you will lose student attention as they wait for you to browse various pages.

 Being Creative Yourself Be creative in using technology. If you find interesting articles, pictures, or comics that can illustrate a point in class, don’t be afraid to try them out. I know one professor who uses music at the beginning of class. While students are filing in to class and taking their seats, he plays a clip or part of a song. He then figures out interesting ways to relate the songs to the material for the day. For example, if you are teaching a micro class, you can use the Barenaked Ladies song “If I had a Million Dollars” to illustrate normal and inferior goods. In it, they sing “If I Had $1000000, we wouldn't have to eat Kraft Dinner. But we would. Of course we would, we’d just eat more.”

 Set-Up Costs and Long-Term Benefits The incorporation of technology may require some front-end costs, but will likely reduce the number of usual problems later on. Take some time at the beginning of the term to explain why you are using MyEconLab. Students who do not purchase a new book sometimes question why they must purchase access to MyEconLab because they do not understand that it is different from using WebCT, Blackboard, or some other platform for web hosting. Explain that MyEconLab provides course content (including specific practice problems for this text), diagnostic quizzes, links to economic news and data, and the study guide and e-text chapters of the book. You may also want to take some time explaining the log-in procedure (if you have web access in class, show them exactly how to do this). I often assign a problem set early on (which I may subsequently drop from the grade) to compel students to access MyEconLab immediately in the term. Once registered, they begin to see how helpful it can be to their study and mastery of the subject.

 Bottom Line In general, incorporating technology in unique and creative ways can generate interest and enthusiasm for economics. As economics instructors, we want our students to catch our own fascination with and enthusiasm for the subject. For the best students in class, adding a technology component may do little for learning as these students will “get it” no matter what. The same may be said for the worst students in class, especially those who rarely attend class, since these students will likely ignore any homework or practice problems in any form. But for the vast majority of students in the middle, technology can help to enlighten and encourage. It is these students who will benefit most from the availa© 2015 Pearson Education, Inc.

xvi

PREFACE 2

bility of chapter-specific additional practice and from the quick feedback provided by the online problem sets. It is also these students who may find the greatest excitement from new and inventive ways of illustrating the ideas presented in Principles of Economics courses. They may even begin to think like economists!

Chapter

Getting Started CHAPTER OUTLINE I. Define economics and explain the kinds of questions that economists try to answer. A. Scarcity B. Economics Defined 1. Microeconomics 2. Macroeconomics C. What, How, and For Whom? 1. What? 2. How? 3. For Whom? D. Can the Pursuit of Self-Interest Be in the Social Interest? 1. Self-Interest and the Social Interest 2. Globalization 3. The “Information Age” 4. Climate Change 5. Government Budget Deficit and Debt 2. Explain the ideas that define the economic way of thinking. A. Economic Ideas B. A Choice Is a Tradeoff C. Cost: What You Must Give Up C. Benefit: What You Gain D. Rational Choice E. How Much? Choosing at the Margin 1. Marginal Cost 2. Marginal Benefit 3. Making a Rational Choice F. Choices Respond to Incentives G. Economics as Social Science 1. Economic Models 2. Check Models Against Facts 3. Disagreement: Normative versus Positive I. Economics as Policy Tool © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

1. Personal Economic Policy 2. Business Economic Policy 3. Government Economic Policy

CHAPTER ROADMAP

 What’s New in this Edition? The chapter has been slightly revised from the previous edition. “Can the Pursuit of Self-Interest Be in the Social Interest?” has been renamed and now includes an introduction to Adam Smith and the invisible hand. “Government Budget Deficits and Debt” is a renamed subheading. The six Economic Ideas have been reorganized and the section on Rational Choice has been significantly rewritten. Several other sections have been slightly rewritten and updated, but there are no major content changes.

 Where We Are In Chapter 1, we review definitions and address questions that economics helps answer. We also discuss how people make rational choices and preview the fact that these are the choices that individuals and firms make everyday.

 Where We’re Going After laying out the basic ideas of economics in this chapter, and some basic facts about the economy in the next, in Chapter 3 we’ll start building tools and models that help us understand how the economy works. These tools and models, such as the production possibilities frontier and the demand and supply framework, provide valuable insight into how the economy that we operate in each day works.

Chapter 1 . Getting Started

IN THE CLASSROOM  Class Time Needed You can complete this chapter in one session. As simple as the ideas might seem to you, covering the definitions and questions are important to your students, especially in the context of current events and topics. Thus do not shortchange this chapter. An estimate of the time per checkpoint is: •

1.1 Definitions and Questions—15 to 20 minutes

•

1.2 The Economic Way of Thinking—25 to 30 minutes

Classroom Activity: For the first week, have the students bring to class newspaper headlines that deal with stories about what goods and services are produced, how goods and services are produced, and for whom the goods and services are produced. When they bring their headlines to class, use the headlines to grab the students’ attention and raise a sense of excitement about learning this subject. Point out to them they will gain real insights into topics such as those in the headlines when they’ve completed their course. Classroom Activity: Help the students to appreciate the power of models as tools for understanding reality. The analogy of a model as a map is easy and convincing. Jim Peach, a fine economics teacher at the University of New Mexico, gets his students to make paper airplanes on the first day of class. After flying their paper planes around the classroom (and picking up the debris!) he gets them to talk about what they can learn about real airplanes from experimenting with paper (and other model) planes. Classroom Activity: You also can help your students appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedman’s pool hall example illustrates the point nicely: Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving tangents, cosines and a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It wouldn’t depict what we see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark, who relies on years of experience and the right “touch.” But constructed correctly, this mathematical model would predict exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can invent analogous examples from any sport.)

Part 1 . INTRODUCTION

CHAPTER LECTURE 1.1

Definition and Questions

Scarcity •

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants.

Forbes lists Bill Gates and Warren Buffet as the two wealthiest Americans. Do these two men face scarcity? According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world, but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time.

Economics Defined •

Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity, the incentives that influence those choices, and the arrangements that coordinate them. • Microeconomics is the study of the choices that individuals and businesses make and the way these choices interact and are influenced by governments. • Macroeconomics is the study of the aggregate (total) effects on the national economy and the global economy of the choices that individuals, businesses, and governments make.

Lecture Launcher: Students might not fully appreciate that economics is truly a science. They believe that economists are often incorrect in their predictions and assessments of the economy. Here is an opportunity for you to demonstrate humility and also show them (albeit charitably) the error in their conclusion. First, it is important to state honestly that many economists who have made forecasts have not only been wrong but sometimes spectacularly wrong. However, point out that being wrong doesn’t make their work unscientific. Remind the students that all science is constantly evolving. For instance, it was only five centuries ago that scientists believed the earth to be flat! No one claimed that these scientists were engaged in unscientific methods. Instead, when theories no longer fit the facts, they must either be reformulated or discarded in favor of new ones. Lecture Launcher: Maggy Shannon, who teaches at Gordon College in Georgia, tells her class a story from when she was an undergraduate: She telephoned her mother and in the course of her conversation, mentioned that “Dr. Thomas” had said she might have mono. Her mother was horrified, and didn’t calm down until she had managed to explain that Dr. Thomas was an anthropologist. The point is that some opinions carry more weight than others. And, what the students are preparing to learn is the “opinions” of economists—positive models—about how the economy works.

Chapter 1 . Getting Started

Lecture Launcher: To help students identify that economists often don’t make one definitive prediction about the future, but instead offer likely possible scenarios based upon the best available data, I always find it useful to quote President Harry S. Truman. Truman was actually quite fond of using economic advisors to help formulate policy, though he quickly recognized how economists liked to hedge their bets by offering a prediction and then the disclaimer, “but, on the other hand…” to account for other possible outcomes. An exasperated Truman famously proclaimed “Give me a one-armed economist!”. It is important to point out that economic forecasting is remarkably similar to weather forecasting – it is a scientific process based upon the best available data and models, but will always be subject to a margin of error.

What, How, and For Whom? • •

Goods and services are the objects (goods) and actions (services) that people value and produce to satisfy human wants. Societies must answer three very basic questions: • What?: What determines the quantities of the goods and services produced? • How?: How are goods and services produced? • For Whom?: For whom are goods and services produced?

Can the Pursuit of Self-Interest Be in the Social Interest? • • •

People make choices they are think are best for them, that is, choices in their self-interest. Choices that are the best for society as a whole are said to be in the social interest. A major question economists explore is “Could it be possible that when each of us makes choices in our self-interest, these choices are in the social interest?”

Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer listening to George Strait on an iPod and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of a below-average major-league baseball player?” (for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics. •

We can examine whether the self-interested choices serve the social interest for a variety topics: • Globalization: The acceleration of economic growth in the last two decades has made economic decision-making more complex as multinational concerns must be taken into account. Rational business decisions which bring a wider variety of lower-price choice to consumers may have negative side-effects on some producers. • The ”information age”: The Information Revolution, an economic restructuring comparable to the Agricultural Revolution and the Industrial Revolution, has brought about © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

•

1.2

new questions of social interest. Was the development of computers and of the Windows operating system by Microsoft in the social interest? Climate change: Climatologists agree that global warming is at least in part the result of economic activity. The warming may lead to large economic costs. How can individuals and nations satisfy their self-interested desire for goods and services while also protecting the social-interest of the environment? Government Budget Deficit and Debt: The U.S. government has been running a budget deficit every year since 2001. In approximately 2020 the deficit will come under increasing pressure because in that year payments for retirement and health-care entitlements will exceed tax revenue for those programs. Do our self-interested choices as voters conflict with the social interest? Do choices made by politicians and bureaucrats promote the social interest or only their self-interests?

The Economic Way of Thinking

Economic Ideas •

Six core ideas describe the economic way of thinking: • A choice is a tradeoff. • Cost is what must be given up to get something. • Benefit is what you gain from something. • People make rational choices by comparing costs and benefits. • Most choices are “how much” choices made at the margin. • Choices respond to incentives.

A Choice Is a Tradeoff •

Because we face scarcity, we must make choices and select from the available alternatives. A tradeoff is an exchange – giving up one thing to get something else.

Cost: What You Must Give Up • •

The opportunity cost of something is the best thing you must give up to get it. Choices have an opportunity costs; for example, the opportunity cost of attending college include goods and services forgone from paying for tuition and textbooks, and the goods and services forgone because the student does not have the income from a full-time job.

Benefit: What You Gain •

The benefit of something is the gain or pleasure it brings and is determined by personal preferences – by what a person likes and dislikes and the intensity of those feelings. Economists measure the benefit of something by what a person is willing to give up to get it.

Rational Choice •

A rational choice is one that uses the available resources to most effectively satisfy the wants of the person making the choice. Rational choices compare costs and benefits in order to maximize net benefit. Choices are made on the margin and respond to incentives. Some choices are all-or-nothing choices between two things, while most choices involve how much of an activity to do. © 2015 Pearson Education, Inc.

Chapter 1 . Getting Started

To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States. However, it takes many years to perform these tests, and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs.

How Much? Choosing at the Margin • •

•

Making choices at the margin means comparing all the relevant alternatives systematically and incrementally. People make choices at the margin by comparing the benefit from a one-unit change in an activity (which is the marginal benefit) to the cost of making a one-unit change in an activity (which is the marginal cost). If the marginal benefit of an action exceeds the marginal cost of the action, then the rational choice is to take the action.

Should Jim give up watching the Super Bowl game to take out his girlfriend Amy on her birthday? Jim will make his choice at the margin. Jim’s marginal benefit is that his relationship with Amy strengthens as they share a romantic birthday celebration together. His marginal cost is that he will miss watching the NFL championship game. If the marginal benefit of the dinner exceeds the marginal cost, then Jim will choose to take his girlfriend out on her birthday. If the marginal benefit is less than the marginal cost, then Jim will watch the Super Bowl (and might quickly find himself single!).

Choices Respond to Incentives • •

An incentive is a reward that encourages an action or a penalty that discourages an action. Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change. For example, if homework assignments are weighed more heavily in a class’s final grade, the marginal benefit of completing homework assignments has increased and more students will do the homework.

Economics as Social Science •

Economists try to understand and predict the effects of economic forces by using the scientific method – a commonsense way of systematically checking what works and what doesn’t work. • An economist begins with a question or a puzzle about cause and effect arising from some observed facts.

Part 1 . INTRODUCTION

•

An economist’s second step is to build an economic model, a description of some feature of the economic world that includes only those features assumed necessary to explain the observed facts. • The third step is to check the economic model against the facts by using: • A natural experiment: a situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal (or similar). • A statistical investigation: looking for a correlation – a tendency for the values of two variables to move together in a predictable and related way. • An economic experiment: puts people in a decision-making situation and varies the influence of one factor at a time to discover how they respond. • Economists sometimes disagree about assumptions, models, and policies. Disagreements that can’t be settled by facts are normative statements, statements about “what ought to be,” which are opinions and so are inherently not testable. Disagreements that can be settled by facts are positive statements, statements about “what is” and are testable. A positive statement is “Raising the tax on a gallon of gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on gasoline should be raised.”

 Land Mine: Students sometimes have difficulty sorting out economic facts from economic opinions. One way to cure this problem is to have them cut out articles from a newspaper (possibly U.S.A. Today, The Wall Street Journal, or the New York Times) or copy sections of articles from reliable sources from the Internet. Ask the students to label the headlines as either positive or normative economic statements. Make sure to tell them that one way of distinguishing the headlines is by asking themselves whether the statements represent testable propositions. If the headlines do not, then they are normative statements (that is, value judgments). Explain that some of the common buzzwords that are tip-offs to a normative statement are: should, must, or ought. Another problem that students have is with positive statements that are incorrect. Explain that the veracity of an economic statement is not the litmus test of whether an assertion is a positive statement or not. The litmus test is the testability! Of course, if the statement is incorrect, likely the person making the statement ought to change it! Indeed, one of the biggest problems recently is untangling opinions from prejudices. Opinions are founded in information, and can change as new information is acquired. Thus, after learning the information in Chapter One, a student’s answers to the Critical Thinking exercises should demonstrate that the student has learned Chapter One and incorporates this new information into his or her analysis of the questions posed. All too frequently, however, students seem to think that all opinions are created equal, that is, that no opinion can be

Chapter 1 . Getting Started

counted wrong. Point out that while it is not possible to prove that a normative statement is wrong, nonetheless they should be based on positive results.  Land Mine: Correlation is a tendency for the values of two variables to move together (either in the same direction or in opposite directions) in a predictable and related way. Correlation versus causation is an issue of logic that can represent a real challenge to students’ intuition. There is a natural human tendency to conclude that when two variables move together, or against one another, that there is causation. Point out that there is a difference between correlation and causation. Suppose economists found that there is a positive correlation between the level of education and worker health. We might conclude that the increase in education is the cause of the better health. But perhaps the higher income that workers enjoy as the result of their higher education allows them to purchase more health care. Or it could be that there are other intervening variables at work. Perhaps education and health move together because of characteristics that the two have in common. That is, it might be possible that talent, motivation, and work ethic, which help many people enjoy good health, are the same characteristics that help the same people earn a higher income.

Economics As Policy Tool • • • •

Economics is a tool which helps us make an endless array of decisions. Personal Economic Policy involves decisions about an individual’s need for shelter, transportation, and time management. Business Economic Policy involves decisions made at the margin to accomplish a business’s goals such as increasing sales, opening a new branch, or gaining market share. Government Economic Policy is perhaps the most controversial of the three types of economic policy. How should goals such as better education, military preparedness, and safe food be balanced against limited tax revenue and the desire of individual members of government to be reelected?

Part 1 . INTRODUCTION

USING EYE ON THE PAST 

Adam Smith and the Birth of Economics as a Social Science

Adam Smith used the example of pin making in his opus, The Wealth of Nations, to explain an elementary but profound point. It was an example to which people of his time could easily relate. Before introducing Smith’s work, you might want to consider asking students how productive one worker could be if he or she were the only one on duty at a local McDonald’s restaurant at noon time. The likely response is not very productive. The person would have to cook the burgers, fry the French fries, prepare the drinks, ring up the orders, and clean the dining area. Students will not find it difficult to accept that few customers will be served at this restaurant under these conditions! Next, ask how productivity would change if a second worker were asked to help out at this same restaurant and at the same time. Students will answer that the restaurant will be able to serve more customers. You can point out the gains from division of labor and specialization that are likely to be enjoyed by hiring the second worker. Explain that we owe this simple logic to the founding father of modern day economics, Adam Smith.

USING EYE ON THE BENEFIT AND COST OF SCHOOL 

Did You Make the Right Decision?

In order to help students get settled into the classroom, learn a few names, get engaged in the material, and reevaluate the purpose of taking the course, it can be useful to get into a small group activity that goes through this “Eye On” on the first day. While the explicit opportunity costs (tuition, fees, books, materials, etc) might be easier for students to quantify, you can help students quantify the implicit opportunity costs as well (foregone earnings or the value of their leisure time). If the students wouldn’t be working, then assigning a dollar value for the implicit cost is a bit more challenging, but not impossible…after all, leisure time is not “priceless” as many people will initially assume. Ask them what hourly wage they would require to get them to give up an hour of their leisure time – that is the value of an hour’s worth of leisure to them. Depending on the institution at which you teach, the implicit cost associated with your students’ higher education may far exceed the explicit cost. As for the benefits outlined in the “Eye On,” you may also want to suggest they estimate the value to them of a possible job with more desirable non-wage characteristics, having more knowledge, and being a more informed decision maker and voter. Hopefully your students end up with a cost-benefit comparison that tells them they are making a rational choice, or you may not see them again! © 2015 Pearson Education, Inc.

Chapter 1 . Getting Started

ADDITIONAL EXERCISES FOR ASSIGNMENT  Questions  Checkpoint 1.1 Definitions and Questions 1. Imagine a situation in which there is a device that can help improve productivity in any enterprise by as much as one thousand times. Assume that this device could be operated by anyone. Would this device eliminate scarcity?  Checkpoint 1.2 The Economic Way of Thinking 2. Assume your neighbor is a doctor. He complains bitterly about the overtime that he is putting in at the hospital each weekend. While the overtime is not required, he argues that by not taking it he would be sacrificing $1,000 each weekend. If he were to ask for your opinion about what to do, what would you advise him? 3.

Survey your classmates (or, a selected group of your classmates) regarding the opportunity cost of attending class. If you get different answers (which you will!), explain how these differences affect choices.

 Answers  Checkpoint 1.1 Definitions and Questions 1. Scarcity is not eliminated by this device. Scarcity is the inability of the available resources to satisfy all of everyone’s wants. The ability of each of us to satisfy our wants is limited by time and by the incomes we earn and the prices we pay for the things we buy. The device would expand the amount of goods and services available but it would not constrain our wants.  Checkpoint 1.2 The Economic Way of Thinking 2. You can advise your neighbor that the $1,000 each weekend that he would give up by not working is not his only opportunity cost. When he works he also incurs opportunity costs. For instance, by working he is giving up time he could be spending with his family. 3.

You will get a variety of answers. This fact shows that everyone faces different opportunity costs and, people make different choices. Students for whom the opportunity cost is too high simply were not present to participate in your survey! And, even though people have different opportunity costs, their choices remain rational.

Chapter

Appendix: Making and Using Graphs APPENDIX OUTLINE 1. Making and Using Graphs A. Basic Idea B. Interpreting Data Graphs 1. Scatter Diagram 2. Time-Series Graph 3. Cross-Section Graph C. Interpreting Graphs Used in Economic Models 1. Positive (or Direct) Relationship 2. Negative (or Inverse) Relationship D. The Slope of a Relationship E. Relationships Among More Than Two Variables 1. Ceteris Paribus

 What’s New in this Edition? The appendix is an updated version of the appendix in the sixth edition.

 Where We Are The appendix to Chapter 1 is a thorough review of the mathematics and geometry used in the text. There are no economic concepts introduced in it, only mathematical concepts.

 Where We’ve Been Chapter 1 introduced economics and presented information about important topics in the course.

Part 1 . INTRODUCTION

ered in this appendix. However, starting in Chapter 3, which presents the production possibilities frontier, most of the remaining chapters use various parts of the review in this appendix.

IN THE CLASSROOM  Class Time Needed Depending on your class’s mathematical sophistication, you might decide to make this appendix optional. If you cover it in class, you should spend no more than one class session on it. The topics most likely to need review are the different types of relationships (positive and negative), covered in the third section, and slope, covered in the fourth section. Ideally, you will present these sections together and spend no more than 30 minutes on them. Classroom Activity: An unfortunate number of students are “afraid” of mathematics. Do your best to convince them that math is a tool for them to use and, as such, it is their friend. Start by telling the students that many of them might have a fear of math, a math phobia. Then tell them that you do not understand why they would have this fear because math is just a tool and no one should have a phobia about a tool. Point out that a pen is a tool and that no one you know has a pen phobia. Take a pen and ask your students what it would be like to have a pen phobia. Start your hand shaking as you hold a pen and point out all the ways that pens can scare people: Some of them must be clicked to work, while others must have a cap removed. And then, the decision must be made as to which end of the pen to use! All in all, a pen is a lot more complicated than a pencil (?!) and so it is reasonable to think that some students will be deathly afraid of pens, just like some of them fear math! Then conclude by explaining to your students that math is just like a pen: It’s a tool to use and there is no more reason to fear it than to fear a pen! Classroom Activity: Almost all students know how to read graphs. Give them a graph from the newspaper, and they can tell you, yes, voter registrations are rising over time. But put the same chart on the board in an economics class, and whatever they knew flies out of their heads. What if you began by reminding them of the xy space and ordered pairs they worked with in junior high, then started in with price and quantity relationships, etc.? The idea is to link the skill Miss Chalkdust taught them so long ago to what we’re using now. My experience is that students learned math in a vacuum. They did it because they had to, without understanding that math is a tool for understanding far more important or interesting things. We want to point out to students that what they learned long ago has an additional payoff because it will help them learn an entirely different subject, economics.

Appendix 1 . Making and Using Graphs

CHAPTER LECTURE A1.1 Making and Using Graphs Basic Idea •

A graph presents a quantity as a distance. The vertical axis is the y-axis and horizontal axis is the x-axis. The vertical line is the y-axis and the horizontal line is the x-axis. Where they meet is the origin.

 Land Mine: Some students have persistent problems reading graphs, despite their exposure to graphs in middle and high school. They seem to fail to connect this basic tool of economics with what they’ve already learned. It helps to ask them to create their own graphs in xy space using graph paper. You also might use overheads that have light lines on them, and walk through counting across and down, especially in the early weeks of the course. It also seems to help if, at least at first, to label points on the graph as Miss Chalkdust did, that is, “A (5, $10); B (10, $3).”

Interpreting Data Graphs • •

•

A scatter diagram graphs the value of one variable against the value of another variable. A time-series graph measures time on the x-axis and the variable or variables of interest on the y-axis. • A time-series graph shows whether a variable has a trend, the general tendency for the value of the variable to rise or fall. A cross-section graph shows the values of an economic variable for different groups in a population at a point in time.

Interpreting Graphs Used in Economic Models •

•

When two variables move in the same direction, they have a positive, or direct relationship, as illustrated in the figure. A linear relationship is a special case of a positive relationship in which the function is graphed as a straight line.

Part 1 . INTRODUCTION

•

When two variables move in opposite directions, they have a negative, or inverse relationship, as illustrated in the figure. Some variables have a relationship in which there is a maximum or a minimum point. When two variables are unrelated, their graph is either a vertical or a horizontal line.

The Slope of a Relationship The slope of a relationship equals the change in the value of the variable measured on the y-axis divided by the change in the value of the variable measured on the x-axis or, in terms of a formula, the slope equals Δy ÷ Δx. • The slope of a straight line is the same at any point on the line. • The slope of a curved line at a point equals the slope of a straight line drawn so that it touches the curved line at only that point. In the figure, the slope of the curve at point A equals the slope of the straight line that is touching the curve at only point A.

 Land Mine: Slope is a concept that sometimes confuses students. In particular, students can think that slope equals the value of the variable on the yaxis divided by the value of the variable on the x-axis, that is, y ÷ x, rather © 2015 Pearson Education, Inc.

Appendix 1 . Making and Using Graphs

than the change in the value of the variable on the y-axis divided by the change in the value of the variable on the x-axis, that is, Δy ÷ Δx. Be sure to clearly explain to your students that slope involves changes. One way to stress that slopes are computed using changes is to present the slope as equal to “rise over run.” By expressing the slope as rise over the run, the students are reminded that they must calculate the “rise,” that is, the change in the value of the variable measured on the y-axis, as well as the “run,” the change in the value of the variable measured on the x-axis.

Relationships Among More Than Two Variables To graph a relationship among more than two variables, we must use the ceteris paribus assumption. • Ceteris paribus is the Latin phrase meaning “other things being equal.” • To graph a relationship among more than two variables, select the two of interest and then draw the relationship between the two, assuming that none of the other variables change (that is, use the ceteris paribus assumption). When one of the other variables changes, the entire graphed relationship shifts. This might be a good opportunity to explain that unrelated variables and exogenous forces are not depicted in these xy graphs. Such a seed planted now may help when students wrestle with the difference between changes in demand (supply) and changes in quantity demanded (supplied) in Chapter 4.

Part 1 . INTRODUCTION

ADDITIONAL EXERCISES FOR ASSIGNMENT  Questions 1. What is the difference between a time-series graph and a scatter diagram? Suppose you have data on the unemployment rate and the inflation rate between 1970 and 2013. To determine if there is a relationship between the two variables, which is the better diagram to use, a time-series graph or a scatter diagram? 2.

How is the slope of a straight line calculated? The slope of a curved line?

3a. Draw a curve with a positive and decreasing slope. 3b. Draw a curve with a positive and increasing slope.

 Answers 1.

A time-series graph plots time on the horizontal axis and the values of the variable or variables under examination on the vertical axis. A scatter diagram plots the value of one variable on the horizontal axis and the value of the other variable on the vertical axis. To determine if there is a relationship between any two variables, it is better to use a scatter diagram because a scatter diagram reveals a relationship, or lack of relationship, between two variables.

Slope is the change in the value of the variable measured on the vertical axis divided by the change in the value of the variable measured on the horizontal axis. The slope of a straight line is constant; that is, between any two points on the straight line, the slope is the same. To calculate the slope of a straight line, select two points on it. Then, measure the amount by which the variable on the vertical axis changes and the amount by which the variable on the horizontal axis changes. Divide the change in the value of the variable on the vertical axis by the change in the value of the variable on the horizontal axis, and the resulting quotient is the slope. The slope along a curved line is not constant. To compute the slope of a curved line, you must select the point at which the slope will be calculated. Then draw a straight line that touches the curved line at only that point. Calculate the slope of the straight line. The slope of the curved line at that point equals the slope of the straight line.

Appendix 1 . Making and Using Graphs

3a. A curve with a positive and decreasing slope is illustrated in the figure to the right.

3b. A curve with a positive and increasing slope is illustrated in the figure to the right.

The U.S. and Global Economies CHAPTER OUTLINE 1. Describe what, how, and for whom goods and services are produced in the United States. A. What Do We Produce? 1. Consumption Goods and Services 2. Capital Goods B. How Do We Produce? 1. Land 2. Labor 3. Capital 4. Entrepreneurship C. For Whom Do We Produce? 1. Rent 2. Wages 3. Interest 4. Profit (or Loss) 2. Describe what, how, and for whom goods and services are produced in the global economy. A. The People B. The Countries 1. Advanced Economies 2. Emerging Market and Developing Economies C. What in the Global Economy? 1. Where Is the Global Pie Baked? 2. Some Differences In What Is Produced 3. Some Similarities In What is Produced D. How in the Global Economy? 1. Human Capital Differences 2. Physical Capital Differences E. For Whom in the Global Economy? 1. Personal Distribution of Income 2. International Distribution 3. A Happy Paradox and a Huge Challenge © 2015 Pearson Education, Inc.

Chapter

Part 1 . INTRODUCTION

3. Explain the circular flow model of the U.S. economy and the global economy. A. Households and Firms B. Markets C. Real Flows and Money Flows D. Governments 1. Federal Government 2. State and Local Government E. Governments in the Circular Flow G. Circular Flows in the Global Economy 1. International Trade 2. International Finance

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 2 contains updated data, rewritten Eye On sections, and reorganized and rewritten content. The four groups of goods and services produced has been consolidated into just consumption goods and services and capital goods and the first two Eye On sections in 2.1 have been refocused and rewritten. The BRICS are now identified, the How in the Global Economy has been heavily streamlined, the Eye on the Dreamliner has replaced the iPhone example, and a new Eye on the Global Economy has been added in 2.2. Coverage of government expenditures and revenue has been heavily streamlined.

 Where We Are In Chapter 2, we describe what, how, and for whom goods and services are produced in the United States. Then we examine these same three questions in the global economy. Finally we use the circular flow model to provide a picture of how households and firms interact. We also describe the economic activities of governments in the United States.

 Where We’ve Been In the previous chapter, we covered the definition of economics and distinguished between microeconomics and macroeconomics. We described what economists do and some of the problems they encounter. In addition, we explored the four core ideas that define the way economists © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

think about macroeconomic questions. Finally, we explained why economics is worth studying.

 Where We’re Going In the next chapter, we develop our first economic model, the production possibilities frontier. We use the model to illustrate some of the concepts that have been developed in Chapters 1 and 2, such as the “what” question, the “how” question, and opportunity cost.

IN THE CLASSROOM  Class Time Needed The material in this chapter should be covered in no more than one class session. An estimate of the time per checklist topic is: •

2.1 What, How, and for Whom?—15 to 20 minutes

•

2.2 The Global Economy—15 to 20minutes

•

2.3 The Circular Flows—20 minutes

Classroom Activity: Part of this chapter focuses on the standard of living that we enjoy. As an icebreaker you might want to poll students by asking them what they believe are some of the most important achievements since 1900 that have helped raise the standard of living of Americans and people around the world. You could give students two minutes in class to compose a list of about ten items. Make sure to tell them that there really are no right or wrong answers. The only requirements are that the items were introduced (not necessarily invented) in the twentieth century and had some impact on our standard of living. When time is up, have students share with you their items and merge them with a list of your own. As an aid, here is a short list that might prove useful: Electricity, Automobile, Airplane, Radio, Television, Telephone, Air conditioning, Computer, Highways, Spacecraft, Internet, Refrigeration, Laser and fiber optics, Nuclear power Discussion of this list could center around a number of issues. First, it will allow you the opportunity to get students to question the mainstream view that an increase in the standard of living depends only on the quantities of goods and services produced and the number of people among whom those goods and services are shared. Point out that official measurements of standard of living around the world focus on average income earned per day. As a standard benchmark, these data are extremely useful, but they do hide some very important information, namely the quality of goods and services. You could pick any number of items on this list and ask students what kinds of advancements have occurred that make the good or service better. The automobile will likely be a favorite. Here is a short list of some of the advancements of the modern automobile: airbags, 5 m.p.h. bumpers, fuel injection (instead of © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

carburetors), safety glass, seat belts, window defrosters, global positioning systems, radio, television, compact disc players, Bluetooth, climate control systems, four-wheel drive, antilock braking systems, power steering, power brakes, power seats, power locks, daytime running lights, side crash severity sensors, and cruise control. Students will probably have a ball talking about all that has changed with the personal computer. Classroom Activity: You can generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2013, income per person in the United States was about $100 a day. In 1813 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2213 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $14 million!) Encourage a discussion of why scarcity is still present even at these large incomes. Classroom Activity: After introducing the factors of production, break students into small groups and ask them to select a specific good. Then ask them to brainstorm a detailed list of every factor of production they can identify that was used to produce that good and break this list into the 4 categories. This should help students apply their new understanding of the factors of production and become capable of distinguishing between the 4 categories of factors of production. Moreover, this exercise should also give students a better appreciation of the complexity of the factors of production for each good to which they are exposed. No matter how thorough they believe they are in identifying the factors of production for the good they chose, they will have undoubtedly left off various inputs that you can help them identify. But don’t fool yourself – even given a few minutes, you will likely just be scratching the surface of the factors of production for even the most “simple” of goods.

Chapter 2 . The U.S. and Global Economies

CHAPTER LECTURE 2.1

What, How, and For Whom?

What Do We Produce? Goods and services produced are divided into two categories: • Consumption goods and services are items that are bought by individuals and governments and are used up in the current period. Consumption goods and services account for about 85 percent of total production. • Capital goods are goods that are bought by businesses and governments to increase their productive resources to use over future periods to produce other goods and services. Capital goods account for about 15 percent of total production.

How Do We Produce? Goods and services are produced using four factors of production: land, labor, capital, and entrepreneurship. • Land is the “gifts of nature” or natural resources, which includes not only land in the everyday sense but also minerals, energy, water, air, wild plants, animals, birds and fish. • Labor is the work time and work effort that people devote to producing goods and services. Human capital is the knowledge and skills that people obtain from education, onthe-job training, and work experience. • Capital consists of the tools, instruments, machines, buildings, and other items that have been produced in the past and that businesses now use to produce goods and services. Capital does not include financial capital like money, stocks, or bonds. • Entrepreneurship is the human resource that organizes labor, land, and capital to produce goods and services. Entrepreneurs make business decisions and bear the risks that arise from these decisions. Lecture Launcher: To help make the idea of “factors of production” more tangible, ask the students to think about what home-based business they could start right now (baking, web site creation, cleaning houses, catering, babysitting, mowing lawns…). They should make a list of the factors of production they currently possess and classify them according to land, labor, capital, and entrepreneurship. For example, one student might suggest that “I could be a caterer.” This student could then list for the factors of production: 1. Land: I own the land my house is on, I could grow food products on it. 2. Labor: I own my own labor power 3. Capital: I own a kitchen, sink, refrigerator, phone, etc. I know how to cook (human capital) 4. Entrepreneurship: I know how to organize my efforts and promote them.  Land Mine: When you write the four productive resources on the board (land, labor, capital, and entrepreneurship) the greatest challenge is to get students to think “out of the box.” Students often take each of the terms too literally. For instance, when economists use the term land, it is important to © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

emphasize that this term encapsulates all natural resources, not just the obvious area of land in terms of acres or plots. “Land” also includes water, oil, and other important and strategic minerals. Labor refers to human labor. There is a natural tendency for students to think of the entire population and the labor force as synonymous. Take care to mention that the labor force includes not only people who are working but also people who are unemployed and actively seeking work. In addition, it is worth mentioning that the size of the labor force can change from increases in population and also from changes in demographics. Capital is usually not a concept that is difficult for students to grasp. However, it is sometimes confused with financial capital. Point out that unless economists specifically say “financial capital,” they are invariably referring to physical capital such as factories, machines, and equipment. Inform them that financial capital is a term that is used in business to refer to cash, loans, stocks, and bonds. Lastly is the term entrepreneurship. While the obvious icon here is that of a business person who is responsible for bringing together all the other factors of production, it is worth noting that the most important characteristic of an entrepreneur is that of being a risk taker. Explain that risk taking is a trait that is quite scarce in supply. If students ask for proof, merely ask them what most people do for a living. The answer is that they work for someone else. The very act of being an employee involves a certain implicit preference of risk aversion.

For Whom Do We Produce? • • •

•

2.2 • •

Rent is paid for the use of land, wages are paid for the services of labor, interest is paid for the use of capital, and entrepreneurs receive a profit or incur a loss. The functional distribution of income is the distribution of income among the factors of production. In the United States in 2011 labor received 69 percent of total income. The personal distribution of income is the distribution of income among household. In the United States in 2011 the richest 20 percent of households earned 51 percent of total income and the poorest 20 percent of households earned only 3 percent of total income. The distribution of income is constantly changing and is becoming increasingly unequal.

The Global Economy People: The world population was approximately 7.1 billion (approximately 315.8 million in the United States) as of May 9, 2013. Countries: The International Monetary Fund classifies the 176 economies into two broad categories: • Advanced economies. These are the 29 countries (or areas) that have the highest standard of living. Included in this list are the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada. Also included are the newly industrialized Asian © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

•

economies. Almost 1 billion people live in advanced economies. Emerging market and developing economies. The emerging market economies are the 28 countries in Europe and Asia that were, until the early 1990s, part of the Soviet Union or its satellites and today are moving toward market-based economies. The developing economies are the 119 countries in Africa, Asia, the Middle East, Europe, and Central and South America that have not achieved a high standard of living. Approximately 500 million people living in emerging market economies and more than 5.5 billion people live in developing economies. The BRICS (Brazil, Russia, India, China, and South Africa) comprise 42% of the global population and hold regular meetings to advance the issues of these nations and draw attention to development problems.

What in the Global Economy? •

•

Where is the global pie baked?: The advanced economies produce 50 percent of the world’s total production, including 19 percent in the United States. The BRICS account for 28 percent, including 15 percent in China. Some differences in what is produced: Developing economies have large and growing manufacturing industries. Agriculture accounts for a small percentage of total production within advanced economies and a large percentage of total production within developing economies. Even so, advanced economies produce about 33 percent of the world’s total agricultural output. The contrast between the share of production of agriculture and the total production results because total production is much larger in advanced economies. Some similarities in what is produced: Other advanced economies often have similar stores and brands as those in the United States. Services are the most rapidly growing sector in advanced economies, while agriculture and manufacturing are declining as a share of total production.

How in the Global Economy? • •

•

Goods and services are produced using land, labor, capital, and entrepreneurship, and the combination of these resources used are chosen to produce at the lowest possible cost. Human capital differences: Levels of education, training, and experience are higher in advanced economies than in developing economies, meaning human capital will play a more important role in production in advanced economies. Physical capital differences: The more advanced the economy, the greater are the amount and the level of sophistication of the capital equipment used in production. While select regions and industries in developing economies may have advanced technology and capital, it is not nearly as widespread as in advanced economies.

For Whom in the Global Economy? •

•

Personal distribution: The distribution of income in the global economy is quite unequal— the lowest-paid 20 percent of the world’s population receives 2 percent of world income and the highest-paid 20 percent receives 70 percent of world income. International distribution: The United States has an average income of $137 a day and the Euro area is $93 a day. Average incomes in China, India, and Africa are $25, $10, and $7 a day, respectively. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

•

A happy paradox and a huge challenge: Despite rising inequality within most countries, inequality in the world income has decreased during the past 20 years because incomes in China and India, both heavily populated and poor nations, have grown rapidly. Lifting Africa from poverty remains one of today’s biggest challenges.

Lecture Launcher: Students tend to think in terms of individuals when they think about standards of living. I recommend that you start there and then try to develop a kind of “national average” by making a list. Have students suggest things that they think are considered basic necessities to the “average” American family: air conditioning? Automobile? Electric refrigerator? Hot and cold running water? Indoor plumbing? Cell phone? Internet? From there, you can ask if these goods and services would be necessities in a developing economy.

2.3

The Circular Flows

The circular flow model is a model of the economy that shows the circular flow of expenditures and incomes that result from decision makers’ choices, and the way those choices interact to determine what, how, and for whom goods and services are produced. Lecture Launcher: Just as “no man is an island” neither is any economic actor. We are all touched by the actions of another. That’s the idea behind the circular flow model. So start by asking them what they’ve bought today—coffee, gasoline, breakfast sandwich, etc. How did they obtain them? Where did those things come from? How did the vendor get them? How does the vendor pay for them? For his employees? Another approach is to discuss how students pay their tuition. For example, in Georgia, state income taxes support the system of higher education, in addition to lottery profits which pay for scholarships and grants. Even if a student does not have a scholarship or grant, his or her education is being heavily subsidized. An otherwise unfunded college student in Georgia would have to pay approximately four times more in tuition without state support. That funding comes from all our taxes—so that I, the teacher, am being paid for out of their taxes as well as their tuition and expenses.

Households and Firms •

A household is an individual or a group of people living together. A firm is an economic unit that organizes the production of goods and services.

Markets •

A market is any arrangement that enables buyers and sellers to get information and to do business with each other. Goods markets are the markets in which goods and services are bought and sold; factor markets are the markets in which the services of factors of production are bought and sold.

Real Flows and Money Flows •

Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it. The real flows are the

Chapter 2 . The U.S. and Global Economies

•

goods and services and the factors of production. The money flows go in the opposite direction to the real flows Prices within markets coordinate firms’ and households’ decisions.

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

Governments in the Circular Flow •

•

The federal government has three major expenditure categories: public goods and services, social security and welfare payments, and transfers to state and local governments. It collects three main taxes: personal income taxes, corporate (business) income taxes, and social security taxes. The state and local governments have two major expenditure categories: goods and services, and welfare benefits. They collect three main taxes: sales taxes, property taxes, and state income taxes. In the circular flow, governments buy goods and services from firms. Households and firms pay taxes to, and receive transfers from, governments.

Circular Flows in the Global Economy • International Trade •

•

Imports are the good and services that we buy from households and firms in other countries. Exports are the goods and services that we sell to households and firms in other countries. International Finance • When firms, households, or governments want to borrow or lend money, they can compare interest rates in their economy to interest rates in other economies. They look for the lowest interest rate at which to borrow and the highest at which to lend • When the value of our imports exceeds the value of our exports, we must borrow from the rest of the world. When the value of our exports exceeds the value of our imports, we lend to the rest of the world. It is international trade and international finance flows that tie nations together in the global economy and through which global booms and slumps are transmitted.

USING EYE ON THE U.S. ECONOMY  What We Produce This Eye provides an overview of production in the U.S. according to the largest areas of production in terms of goods and services. This set of results sets the

Part 1 . INTRODUCTION

stage for discussing the U.S. economy as very consumption driven (because consumption goods and services account for nearly 85 percent of all domestic production) and very service oriented (as most of the largest areas of production are services, not goods). Students often lose sight of the fact that because they don’t see “Made in the U.S.A.” on everything they purchase, it doesn’t mean everything they buy was imported – it’s just that the domestically produced services they consume (such as health care or education) don’t have labels printed on them like the imported electronics, clothing, and toys they purchase!

USING EYE ON THE PAST  Changes in What We Produce This Eye provides an interesting example highlighting the transition of the U.S. economy from manufacturing to services. Point out to your students that we always hear of job losses in the manufacturing sector and these losses are always presented as “new” and “bad.” While the losses may or may not be “bad,” your students need to know that they are certainly not new: Manufacturing has shrunk in importance since at least 1950. Mention to your students that most likely they are going to be employed in the service sector—that is where the jobs are because that is what we produce. Indeed, over 80 percent of employment nowadays is in services! Moreover, service-oriented employment typically requires higher levels of education, so that is likely the career path they are heading down (if they aren’t already in a service-oriented job). If you ask how many of your students are going to college in order to get into shoe manufacturing, not many hands (if any) will go up.

USING EYE ON THE U.S. ECONOMY  Changes in How We Produce in the Information Economy After presenting students with the example of declining shoe manufacturing, you might want to ask them what fundamental changes in the economy have been underway in the United States. The likely response is that the goods and services that we produce today and will produce tomorrow are different than in decades past. This answer is basically correct. In the 1970s, manufacturing was a more dominant part of the economy. Technology has advanced tremendously over the last 50 years. Challenge your students to ask their folks if they used a computer at any point in their high school or college education. Many of your students’ folks will never have seen, much less used, a computer when they were in high school or college. Today, of © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

course, virtually all students have computers. It has been estimated that in 1965 there were 20,000 computers in the world. Today, if your college has more than 20,000 students, it is likely the case there are more than 20,000 computers associated with your college alone! This amazing fact really makes clear that how we produce goods and services has undergone massive changes.

USING EYE ON THE DREAMLINER  Who Makes the Dreamliner? Ask your students why Boeing chooses to have the components for the Dreamliner manufactured by more than 400 companies around the world, as opposed to producing everything themselves. For U.S. consumers and producers, what are the pros and cons associated with Boeing’s decisions to outsource production? It is important to identify here that the specialization of factors of production results in lower production costs, even after factoring in transaction and transportation costs. Also point out that often the least expensive way for domestic production to take place is not to rely solely on domestic producers, but to take advantage of factors of production in the global economy. Through this process, domestic producers become dependent upon foreign producers, just as foreign producers become dependent upon domestic producers. What are the advantages and disadvantages of this interdependence?

USING EYE ON THE GLOBAL ECONOMY  Differences in How We Produce This Eye can be used to draw parallels between production in current developing economies and the United States a century or two ago. While laundry is now done in the United States using machinery, clothing would have been hand washed a hundred years ago. While transportation is now heavily done using personal automobiles and commercial trucks on relatively well maintained highways, it might have been done on horseback or by covered wagon on open land or dirt trails two hundred years ago. Drawing the parallels between the current state of developing economies and the past conditions in the United States can allow you to have students picture global economic development like a long race that all countries are running in. Economies have perhaps started the race at different times, are moving at different speeds (and sometimes are even moving backwards or not moving at all) and are currently at different places in the race. Even the same economy might have these differences, such as the huge discrepancies seen in development between urban and rural China. While rural China © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

might be where the United States was in the race a century or two ago, urban China might only be a few decades behind.

USING EYE ON YOUR LIFE  The U.S. and Global Economies in Your Life This Eye discusses how your students will interact with international trade in their careers and as voters. Though not directly related to this topic, you can— and probably should—take the opportunity to explain to students what they can do with an economics major. Many students are interested in economics as a major but hesitate because they do not know about the careers they can follow with economics as their major. Point out to your students that economics is an excellent major for anyone considering advanced degrees in law or in the different public policy arenas. It also is a great background for anyone considering a career in politics. Additionally, economics is a wonderful major for students who plan to enter the workforce after obtaining their bachelor’s degrees. I contrast economics with degrees in finance and in marketing. I point out that all three degrees essentially prepare students for entry level management jobs. But they differ in their emphasis. A marketing degree will teach students what factors help sell products and about distribution networks. Marketing majors tend to find jobs in retail, in PR, and in similar areas. Finance majors learn a lot about a very important sector of the economy and very important part of running a firm. Finance majors tend to find jobs with banks, insurance companies, and other similar firms. Economics majors differ insofar as they do not learn so much about important sectors of the economy or important aspects of running firms. Instead they learn how to think quantitatively and logically about issues. In particular, they really learn how to use marginal analysis, introduced in Chapter 1, in all decision making processes. This method of thought is extremely powerful and so businesses are willing to pay a lot for students who have acquired it, which is why economics majors are, on the average, paid more than marketing majors and often more than finance majors. The average starting salary for a 2010 college graduate with an economics major was $51,698, which has the highest starting salary for a non-engineering major (business was $46,672 and the liberal arts majors was $35,508). The jobs economics majors take tend not to be as concentrated as with marketing and finance. For instance, it is uncommon, but still possible, for a marketing major to take a job with a bank and a finance major to take a job with a retail company. Economics majors, however, will take jobs with banks and retailing companies with about equal frequency. So you should reassure your students that if they are thinking of majoring in economics, that decision can be a wise choice. © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

USING EYE ON THE PAST  Growing Government The fact that the U.S. government buys more than 20 percent of total production is commonplace for our students. They have likely never lived in an era when the government took much less than 20 percent…or much more than 20 percent. The figure in this “Eye” can be used to good effect to point out to the students that until 1940, the federal government took much less than 20 percent of total production (other than during World War I) and in World War II, the fraction shot up to over 40 percent. You can point out to your students the trend from about 1930 to about 1984 for higher federal outlays as a percentage of total output. Ask them why this trend occurred. Was it good or bad? If the trend had not occurred, what would be different today? You can also use the huge spikes in World War I and World War II to point out that today’s War on Terror (as well as the war in Vietnam) had nowhere near the effects on the economy as did the two world wars. Ask your students what they think would be different if the War on Terror escalated so that the federal government was spending 40 percent of GDP. What trend do they predict for the next 10, 20, and 30 years?

USING EYE ON THE GLOBAL ECONOMY  The Ups and Downs in International Trade Ask your students why international trade has expanded so rapidly over the past few decades. How do changes in international trade patterns create winners and losers both in the U.S. and abroad? Do they personally feel like a winner or loser as a result of these changes in international trade? Students often believe that the U.S. is adversely impacted by trade, though they can quickly identify how they benefit tremendously from lower prices and a larger variety of imported goods. In fact, it is likely that they are draped (figuratively and literally) in the gains from international trade – with the clothes they are wearing, with the cell phone in their pocket, with the purse at their side, and with the automobile (and fuel for that automobile) that got them to class. In fact, without a global economy, they would likely not have the privilege of learning economics from this Foundations textbook written by Bade & Parkin (who live in Canada). Why does international trade slow down during a recession? Does this help an economy during a recession or magnify the problems an economy is experiencing? Does global economic interdependence provide more or less stability for an economy? Will international stay around its average growth rate of around 7 percent a year over the next few decades, or has the level of international trade reached a plateau for the foreseeable future? All of these questions are worthy of discussion! © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 2.1 What, How, and For Whom? 1. Identify each of the goods and services below as either capital goods or consumption goods and services. 1a. Restaurant meals 1b. Oven in a restaurant 1c. Oil rig 1d. Haircut 1e. Factory 1f. Dining room table in a house 1g. Table in a restaurant 1h. Golf course 1i. A round of golf 2.

Identify the payments that are made to each of the four factors of production.

Comment on the following assertion: “If the trends in schooling continue, at some point in the future, everyone will have a college degree and no one will be available to work as a janitor or garbage collector.” Critically evaluate this statement.

 Checkpoint 2.2 The Global Economy 4. Classify the following countries as advanced or developing countries: Australia, Chile, China, France, India, Indonesia, Hong Kong, Mexico, Nigeria, and Peru. 5.

Think about the trends in what and how goods and services are produced in the U.S. and global economies. Do you think that at some future time, there will be no jobs in the United States and all the jobs will be in developing economies? Explain your answers

 Checkpoint 2.3 The Circular Flows 6. In the goods market, households and firms both have a role to play. In the factor markets these roles are reversed. Why does the reversal occur?

Chapter 2 . The U.S. and Global Economies

1f. consumption good 1g. capital good 1h. capital good 1i. consumption service 2.

Wages are paid to labor, rent to land, interest to capital, and entrepreneurs receive a profit or incur a loss.

This statement exaggerates and is untrue. If the trend toward higher education continued unabated at the current rate, it would be well into 2100 before 100 percent of the population had college degrees. But the trend will not continue because many individuals do not have the necessary talents to graduate from college. And even if everyone possessed a college degree, if the pay offered as a janitor or garbage collector is sufficiently high, college graduates will accept these jobs.

 Checkpoint 2.2 The Global Economy 4. The advanced economies include Australia, France, and Hong Kong. The developing economies include Chile, China, India, Indonesia, Mexico, Nigeria, and Peru. 5.

We would not expect all jobs to move from the United States to other nations. Relative to the rest of the world, workers in the United States will remain highly skilled, and likely will increase their average skills even more. These highly skilled workers will be needed to produce goods and services that must be produced using skilled rather than unskilled labor.

 Checkpoint 2.3 The Circular Flows 6. Households are the buyers in the goods market and firms are the sellers. In this market, households pay firms money in exchange for goods and services. In the factor markets, the roles are reversed. Households are the sellers of labor, land, capital, and entrepreneurship and firms are the buyers. In this market, firms pay households money in exchange for the factors of production.

The Economic Problem

Chapter

CHAPTER OUTLINE 1. Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities frontier. A. Production Possibilities Frontier 1. Attainable and Unattainable Combinations 2. Efficient and Inefficient Production 3. Tradeoffs and Free Lunches 2. Calculate opportunity cost. A. The Opportunity Cost of a Cell Phone B. Opportunity Cost and the Slope of the PPF C. Opportunity Cost Is a Ratio D. Increasing Opportunity Costs Are Everywhere E. Your Increasing Opportunity Cost 3. Explain what makes production possibilities expand. A. Economic Growth 4. Explain how people gain from specialization and trade. A. Absolute and Comparative Advantage B. Comparative Advantage: An Example C. Achieving Gains from Trade

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 3 has been slightly revised for the seventh edition. The “Guns Versus Butter” Eye On has been removed and a new Eye On concerning expanding the PPF for the United States has been added. The introduction of absolute and comparative advantage has been reorganized.

 Where We Are In Chapter 3, we use the production possibilities frontier to illustrate the economic problem and calculate opportunity cost. We illustrate the effect of unemployed resources using

Part 1 . INTRODUCTION

the production possibilities frontier model. We study how technological change and capital accumulation increase production possibilities and lead to economic growth. Then we explain how specialization and trade expand production possibilities.

 Where We’ve Been In Chapter 2, we described what, how, and for whom goods and services are produced in the United States, thereby motivating the production possibilities frontier model developed in this chapter. In Chapter 2 we used the circular flow model to provide a picture of how households and firms interact. We described the economic activities of governments in the United States and included governments in the circular flow.

 Where We’re Going The next chapter introduces the supply and demand model. We will distinguish between quantity demanded and demand, and explain what determines demand. Likewise we will distinguish between quantity supplied and supply, and explain what determines supply. We will explore how demand and supply determine price and quantity in a market, and explain the effects of changes in demand and supply.

IN THE CLASSROOM  Class Time Needed The material in this chapter can be covered in up to two class sessions. An estimate of the time per checklist topic is: •

3.1 Production Possibilities—25 to 40 minutes

•

3.2 Opportunity Cost—15 to 20 minutes

•

3.3 Economic Growth—5 to 10 minutes

•

3.4 Specialization and Trade—25 to 40 minutes

Classroom Activity: You might like to get the students to realize how useful even a simple economic model, such as the PPF model, is for helping us understand and interpret important political events in history. For instance, the PPF model can be used to analyze real-world events such as an “Arms Race” between nations. Draw a PPF for military goods and civilian goods production. Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly arms © 2015 Pearson Education, Inc.

Chapter 3 . The Economic Problem

race. Each country picks a point on the PPF that produces an equal level of military output in absolute terms. What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country. What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post-Vietnam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. “What are the implications for the next fifty years?” China is currently the world’s second largest economy. It is predicted to surpass the U.S. to become the biggest economy in the nottoo-distant future. Ask your students how this development influences the strategic balance and the position of the United States? Classroom Activity: The PPF model can be used to analyze global environmental agreements between nations. This application of the PPF is a less hawkish and perhaps a more green perspective on a timely international policy issue. Compare a rich economy’s PPF to a poor economy’s PPF, each with the same degree of concavity. The production levels are now measured as output per person and the goods are “cleaner air” and “other goods and services.” What if the citizens of each country were required to make equal reductions in per-person greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curve. Show how the opportunity cost of requiring additional pollution reductions (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to try to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and the African nations).

Part 1 . INTRODUCTION

CHAPTER LECTURE 3.1

Production Possibilities

Production Possibilities Frontier •

•

The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot. Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right.

A B C D •

Books 0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable; production points on and within the PPF are attainable.

To make this model useful, it was necessary to simplify. By considering the case where production of all goods other than the illustrated two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. Meanwhile, all relevant results of model can be easily illustrated in the simple 2-D case.

Production Efficiency •

Production is efficient only on the frontier of the PPF. These points are production efficient, a situation in more of one good or service cannot be produced without producing less of something else. Points within the PPF, such as point Z, are inefficient.

Tradeoff Along the PPF •

Moving along the PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books. • These movements reflect a tradeoff, which is an exchange of giving up one thing to get something else. •

A free lunch is a gift, getting something without giving up something else. A movement from point Z to point C is free lunch because more of both books and movies are

Chapter 3 . The Economic Problem

obtained. When production is efficient – at a point on the PPF – then there will be no opportunity for a free lunch, as attempts to produce more of good requires a tradeoff.

3.2 • • •

Opportunity Cost The opportunity cost of an action is the best thing given up. If the economy is at a production efficient point on the frontier, then the opportunity cost of producing more books or movies is the tradeoff along the frontier. The magnitude of the slope of the PPF measures the opportunity cost of one more unit of the good measured along the horizontal axis. The opportunity cost equals the change in the quantity of the good forgone divided by the change in the quantity of the good that is gained.

Lecture Launcher: Students really do think that while some things are priceless, for everything else there’s MasterCard. Make sure they understand that even if one doesn’t give up money, one must give up something because many of them almost instinctively relate costs to monetary costs. To help them grasp the idea of opportunity cost while moving along the PPF, it is important to get students to realize very early on that thinking only of monetary costs is a narrow view and ignores the most important cost of all—opportunity cost. Demonstrate the fact that opportunity cost does not necessarily involve money by launching your lecture with an example that hits close to home. Ask your students to take a minute to write down a list of things that qualify as the opportunity cost to them of attending your economics class. Expect a fairly wide range of answers from the downright silly to the very thoughtful. Stress that the true opportunity cost of any endeavor is only the one next best thing forgone. The reason is because you can only perform one other activity in place of whatever it is you are doing at present. In other words, you will need to convince your students that even though they have come up with a fairly long list of items, the opportunity cost of attending your economics class can only be one of them. This one is the one that will rank above the others as the next best available alternative. Here might be some possible answers: by taking economics your students cannot take biology, physics or chemistry; they might have to give up overtime at work (if they are taking a night class); or the cost could be the forgone extra sleep they could have enjoyed if they are taking an 8:00 a.m. class!

Opportunity Cost Is a Ratio •

The opportunity cost of producing more of a product is the quantity of the product forgone divided by the quantity of the product gained. Hence the opportunity cost of a good or service is a ratio. Being a ratio, the opportunity costs for two goods will be the inverse of each other – the opportunity cost of producing good X in terms of good Y is the inverse of the opportunity cost of good Y in terms of good X.

Increasing Opportunity Cost •

As more of a product is produced, its opportunity cost increases. In the figure, moving from point A to point B to point C and so on, the opportunity cost of each additional book increases. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

3.3

•

Increasing opportunity cost is reflected in the bowed-out shape of the PPF.

•

Opportunity costs increase because resources are not equally productive in all activities. As resources are initially shifted into producing a good, the most productive resources for that good (and least productive for an alternative good) are chosen first – hence the low initial opportunity cost. As more of that good is produced, less productive resources for producing that good (and more productive resources for the alternative good) are shifted towards producing that good – hence the opportunity cost increases.

Economic Growth

Economic growth is the sustained expansion of production possibilities. Economic growth shifts the PPF outward.

The (Opportunity) Cost of Economic Growth •

•

3.4

Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth. This result demonstrates that economic growth is not “free.” Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster.

Specialization and Trade

Specialization of labor results in greater productivity. Absolute advantage occurs when one person (or nation) is more productive than another (needs fewer inputs or takes less time to produce a good or perform a production task). A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.  Land Mine: Absolute advantage and comparative advantage are concepts that give students trouble. It flies in the face of intuition to say that even though someone has the ability to produce something using fewer resources than someone else, nonetheless, it still pays for the two to trade. It is an especially difficult concept to grasp when you up the ante by saying that the same would still be true even if that person enjoyed an absolute advantage in everything over their trading partner! This might be a good opportunity to use a very concrete example that students should be able to compute right in the classroom. Lay out the following scenario: Assume Suzie, a computer consultant, is very good at repairing computers and also happens to be a very good house painter. In fact, she is so good that it turns out she is more productive at both things than her neighbor, Bob, who happens to paint houses for a livTime it takes Suzie Time it takes Bob 2 hours 24 hours ing. To the right is a table that Repair a computer Paint a house 30 hours 48 hours shows the amount of time it takes for Suzie and Bob to perform each of the two activities. In addition, © 2015 Pearson Education, Inc.

Chapter 3 . The Economic Problem

let’s assume that Suzie and Bob earn $100 per computer repaired and Bob and Suzie earn $960 per house painted. Ask the students to compute the opportunity cost for Suzie and Bob repairing a computer and painting a house. The new table to the right contains the opportunity costs. (To calculate these numbers, take Suzie’s opportunity cost of painting a house. In the 30 hours it takes her to paint a Opportunity cost Opportunity cost house, she could have repaired for Suzie for Bob $64 $480 15 computers, so the opportuni- Repair a computer Paint a house $1,500 $200 ty cost is 15 computers times $100 each, or $1,500.) The table reveals that Suzie has the lower opportunity cost of repairing computers and Bob has the lower opportunity cost of painting houses. What this example demonstrates so powerfully is that a person can have an absolute disadvantage in everything, as is the case for Bob, but still manage to have a comparative advantage in an activity. Point out to students that this logic applies between individuals and also across cities, states, and nations. •

The PPF shows opportunity cost of the goods. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers.

Achieving Gains from Trade •

•

When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, a total of 12 computers and 24 bushels of wheat are produced. Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own.

Part 1 . INTRODUCTION

Exchange is not a zero-sum game. If it is voluntary, both parties will believe they are better off, by definition (or else they would never agree to the trade in the first place). Imagine what would happen to your consumption if you couldn’t trade and had to be self-sufficient. How would selfsufficiency impact your level of consumption of food? Clothing? Transportation? Communications? Entertainment? Health care? Education? The gains from trade explain why an individual, a household, a city, a state, and even a country typically choose not to be entirely self-sufficient. A far greater amount of goods and services can be produced and consumed with specialization and trade than in isolation.

Chapter 3 . The Economic Problem

USING EYE ON YOUR LIFE  Your Production Possibilities Frontier The example of a student who must allocate his or her time between studying and other events illustrated in this Eye really strikes home for students and is a truly great example. However, economists generally do not analyze people’s decisions using the PPF. Instead, economists typically use utility functions or indifference curves. It’s probably wise to use this Eye to stress two points to the students: First, there are other ways of analyzing other people’s behavior. Second, the PPF deals with production so, as this Eye shows, we are looking at the production of grades. Students do not know the first point and it is easy for them to overlook the second, so both points are worthwhile.

 Your Comparative Advantage Ask your students what they envision for their future careers. Then ask them why they expect to be successful at this endeavor and tell them to use the concept of comparative advantage in their answer.

USING EYE ON THE ENVIRONMENT  Is Wind Power Free? Use this Eye to help students identify that alternative energy sources, often touted for their environmental friendliness and even as potential sources of economic growth by our elected officials, have opportunity costs associated with them. Relying too heavily on alternative energy sources (such as wind power), can result in an inefficient level of production. Inefficiency occurs if we must sacrifice other goods and services without gaining additional electricity when we increase our usage of these energy sources. It might be the case that increasing the usage of these “greener” sources of energy could lower our current standard of living and hinder overall production on the United States. One moral is to be wary of any politician who promises a cleaner environment and greater economic growth simultaneously. However, it still may be possible that a productively inefficient point of production now may still be desirable when longer term environmental consequences are factored into the costs associated with more traditional energy sources (coal, oil, gas). Ultimately, it comes down to a comparison between the value of the current tradeoffs made by switching to alternative energy sources to the potential future environmental benefits from using less polluting sources of energy. But, as is often the case, the devil is in the details – calculating those tradeoffs and the value of those environmental consequences is subject to considerable debate and large margins of error, therefore continuing to muddle the desirability of switching to greater usage of alternative energy. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

USING EYE ON THE U.S. ECONOMY  Expanding Our Production Possibilities This Eye can make an interesting combination with the Eye on the Environment in the previous section. While “green” energy sources such as wind, hydro, and solar are often touted, they require sacrifices in other areas of production in order to generate the same level of electricity as other energy sources (such as natural gas). While the environmental impact of fracking has become a matter of intense debate (and something your students may have strong opinions about), the production benefits associated with fracking technology have been tremendous. Technological advancements in fracking allow the United States to generate more electricity without having to cut back production in other areas. If it does turn out that fracking has severely negative environmental consequences though, it may result in a lower standard of living. Given what we see with the PPF in this Eye On, ask your students how it might be possible for the United States to expand electricity generation without compromising other areas of production and while still protecting the environment. Hopefully they should identify that technology is ultimately what will determine if “green” energy sources can meet our electricity needs in the future without requiring production sacrifices. If “green” technology can advance enough, it can unequivocally improve our standard of living by allowing greater production to take place while simultaneously maintaining a quality environment.

 No One Knows How to Make a Pencil Adapt this Eye as either in-class, small group work or an out-of-class research assignment (depending on what fits your course best). Select a good that is indicative of the region of the country in which your college is located. Ask students to identify all of the factors of production used to produce that good and try to trace those components back to their original sources. It should only take going through this process for one good for students to gain an understanding and appreciation for the astonishing power of specialization and trade.

USING EYE ON THE GLOBAL ECONOMY  Hong Kong’s Rapid Economic Growth This Eye makes an excellent launching pad for a discussion of the desirability of economic growth and its opportunity cost. Ask your students what—and how much—they are willing to sacrifice for more rapid economic growth. You can also engage them in a discussion of whether another nation’s rapid growth is good or bad for the United States.

Chapter 3 . The Economic Problem

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 3.1 Production Possibilities In the winter, both fish and fruit are harder to find and Robinson Crusoe can work only 5 hours a day. The table shows the quantities that Crusoe can produce in winter. Use this table for the next 4 problems.

Hours 0 1 2 3 4 5

Fish (pounds) 0 4 7 9 10 11

Use these numbers to make Crusoe’s PPF in winter.

Based on Crusoe’s PPF, Which combinations (pounds of each) are attainable and which are unattainable: (i) 9 fish and 13 fruit, (ii) 10 fish and 13 fruit, (iii) 7 fish and 18 fruit?

Which combinations (pounds of each) use all of Crusoe's available 5 hours a day: (i) 11 fish and 0 fruit, (ii) 10 fish and 7 fruit, (iii) 4 fish and 20 fruit?

Which combinations provide Crusoe with a free lunch and which confront him with a tradeoff when he increases fish by 1 pound: (i) 10 fish and 7 fruit, (ii) 4 fish and 2 fruit?

or or or or or or

Fruit (pounds) 0 7 13 19 24 28

 Checkpoint 3.2 Opportunity Cost The table shows Robinson Crusoe’s PPF in the winter. Use it for the next 4 problems. 5.

Calculate Crusoe’s opportunity cost of a pound of fruit. Make a table that shows Crusoe's opportunity cost of a pound of fruit as he increases the time he spends picking fruit and decreases the time he spends fishing.

If Crusoe currently catches 7 pounds of fish and picks 13 pounds of fruit a day, calculate his opportunity cost of a pound of fruit and of a pound of fish. Explain your answer.

If Crusoe increases the fish caught from 7 to 9 pounds and decreases the fruit picked from 19 to 13 pounds, what is his opportunity cost of a pound of fish? Explain your answer.

Does Crusoe's opportunity cost of a pound of fruit increase as he spends more time picking fruit? Explain why or why not.

Fish Fruit Possibility (pounds) (pounds) A 0 28 B 4 24 C 7 19 D 9 13 E 10 7 F 11 0

Part 1 . INTRODUCTION

and also is very good at typing. Bob's legal assistant Tom can prepare 1 legal brief in two hours and Bob can prepare 1 legal brief in one hour. In one hour Tom can type 6 pages and Bob can type 9 pages. Which person has the absolute advantage in preparing briefs and which has the comparative advantage in typing? Which person has the comparative advantage in preparing briefs and which in typing? 10. If you were seeking out a trading partner, would you choose someone whose tastes are similar to yours or different? Explain your answer.

 Answers  Checkpoint 3.1 Production Possibilities 1. Crusoe’s production possibilities frontier in the winter is given in the table to the right. The production possibilities frontier is illustrated in Figure 3.1. 2i. Attainable 2ii. Not attainable. After spending 4 hours producing

Fish Possibility (pounds) A 0 and B 4 and C 7 and D 9 and E 10 and F 11 and

10 fish, Crusoe has only one hour left to devote to picking fruit, which yields him 7 fruit, not 13. 2iii. Attainable 3i. The combination uses all Crusoe’s available 5 hours a day. 3ii. The combination uses all Crusoe’s available 5 hours a day. 3iii. The combination does not use all of Crusoe’s time. 4i. The combination of 10 fish and 7 fruit confront Crusoe with a tradeoff because it is a point on his production possibilities frontier. 4ii. The combination of 4 fish and 2 fruit gives Crusoe a free lunch because it is inside his production possibilities frontier. Crusoe could increase fish by 1 and simultaneously increase his fruit.

Fruit (pounds) 28 24 19 13 7 0

Chapter 3 . The Economic Problem

 Checkpoint 3.2 Opportunity Cost 5. Crusoe’s opportunity cost of a Increase in Decrease in Opportunity pound of fruit is the pounds of fruit picked fish caught cost of fruit fish he forgoes. To calculate the Move from (pounds) (pounds) (pounds of fish) F to E 7.0 1.0 0.14 opportunity cost, start by comE to D 6.0 1.0 0.17 puting the increase in fruit 6.0 2.0 0.33 D to C picked as he increases the time 5.0 3.0 0.60 C to B he spends picking fruit. Also B to A 4.0 4.0 1.00 calculate the decrease in the fish he catches. Then, divide the decrease in fish by the increase in fruit to get the opportunity cost per pound of fruit. The table shows the increase in pounds of fruit picked, the decrease in pounds of fish caught, and the opportunity cost as we move along the production possibilities frontier. 6. His opportunity cost of a pound of fruit and a pound of fish are both zero. The reason is that he is operating inside his production possibilities frontier. He could pick 6 more pounds of fruit without giving up any fish or alternatively catch 2 more pounds of fish without giving up any fruit. Crusoe is in a position to reap a free lunch. 7.

When Crusoe increases his fish caught by 2 pounds, from 7 pounds to 9 pounds, he decreases the quantity of fruit from 19 pounds to 13 pounds. His opportunity cost of a pound of fish is 6 pounds of fruit ÷ 2 pounds of fish, which is 3 pounds of fruit.

Crusoe’s opportunity cost of a pound of fruit increases as he spends more time picking fruit. This result is shown in the table above. As Crusoe spends more time picking fruit, so that he moves from spending no time at point F to one hour at point E to two hours at point D and so on, his opportunity cost of a pound of fruit rises from 0.14 pounds of fish to 0.17 pounds of fish to 0.33 pounds of fish, and so forth.

 Checkpoint 3.4 Specialization and Trade 9. Bob has an absolute advantage in preparing briefs and typing because he uses fewer resources than Tom for each. Comparative advantage is a different matter. When Bob prepares one brief in one hour, his opportunity cost is 9 pages of typing. When Tom prepares one brief in two hours, his opportunity cost is 12 pages of typing. Bob has the comparative advantage in preparing briefs because his opportunity cost is less. With regard to typing the opportunity costs are reversed. If Bob spends one hour typing he gives up one brief that he could have prepared. If Tom spends one hour typing he gives up only 1/2 of a brief he could have prepared. Tom has the comparative advantage in typing because his opportunity cost is less.

Part 1 . INTRODUCTION

10. Someone with different tastes would most likely have more experience in the production of different goods and services. And by specializing in the production of other goods and services they would most likely have a lower opportunity cost. So we could both benefit by specializing and trading the goods in which we have a comparative advantage.

Chapter

Demand and Supply CHAPTER OUTLINE 1. Distinguish between quantity demanded and demand, and explain what determines demand. A. Competitive Markets B. The Law of Demand C. Demand Schedule and Demand Curve D. Individual Demand and Market Demand E. Changes in Demand 1. Prices of Related Goods 2. Expected Future Prices 3. Income 4. Expected Future Income and Credit 5. Number of Buyers 6. Preferences F. Change in Quantity Demanded Versus Change in Demand 2. Distinguish between quantity supplied and supply, and explain what determines supply. A. The Law of Supply B. Supply Schedule and Supply Curve C. Individual Supply and Market Supply D. Changes in Supply 1. Prices of Related Goods 2. Prices of Resources and Other Inputs 3. Expected Future Prices 4. Number of Sellers 5. Productivity E. Change in Quantity Supplied Versus Change in Supply 3. Explain how demand and supply determine price and quantity in a market, and explain the effects of changes in demand and supply. A. Price: A Market’s Automatic Regulator B. Predicting Price Changes: Three Questions C Effects of Changes in Demand D. Effects of Changes in Supply © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

E. Effects of Changes in Both Demand and Supply 1. Both Demand and Supply Change In the Same Direction 2. Both Demand and Supply Change In Opposite Directions

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 4 is an updated version of the sixth edition. There is a new “Eye on the Global Economy” that focuses on solar panels, “Eye on the Price of Coffee” has been replaced by “Eye on Tuition,” and the “Eye on Your Life” has been greatly expanded. The introduction of changes to both demand and supply has been reorganized.

 Where We Are In Chapter 4, we create a tool (the supply-demand graph) to use in examining how a market operates. The chapter explains how to derive demand and supply curves. By combining the supply and demand curves, we see how the market determines market equilibrium. We also see how a change in supply, a change in demand, or a change in both affects the price and quantity in the market equilibrium.

 Where We’ve Been We’ve explored how scarcity and opportunity costs require us to make choices. We’ve also looked at the U.S. and global economies and established the basic idea that markets determine What, How, and Who.

 Where We’re Going Now that we’ve created a tool to examine how market prices and quantities are determined, we use it to see how market equilibrium responds to changes in prices. This responsiveness, or elasticity, plays a role in how taxes affect the market and the efficiency and fairness of government influences.

IN THE CLASSROOM 

Class Time Needed

Chapter 4 . Demand and Supply

Take as much time as possible on the differences between movements along the supply and demand curves versus shifts in the curves. Go over the reasons for the shifts and give several examples, always reinforcing the process of answering the 3 questions for analyzing changes in equilibrium. An estimate of the time per checkpoint is: • • •

4.1 Demand—60 to 75 minutes 4.2 Supply—60 to 75 minutes 4.3 Market Equilibrium—60 to 90 minutes

Classroom Activity: When it comes to introducing demand, pick an object that your students buy, say a bottle of Pepsi. Bring a bottle to class as a visual aid and simulate a market for this good in which the students are consumers and you are the seller. Set up a price range for this good (starting at $0.60 and going up to $1.60 in $0.20 increments). Then ask for 3-4 volunteers and ask them one at a time how many bottles of Pepsi they would be willing and able to buy right then at each price. From this you can set up a demand schedule for Pepsi on the board that illustrates the relationship between price and quantity demanded. Sum all of the individual demands together to calculate a market demand. This demand schedule can be used to set up the law of demand and to help students distinguish between quantity demanded and demand for individuals and for the market. Then draw the resulting market demand curve on the board. This market demand curve will illustrate the downward slope indicative of the law of demand and can further be used to distinguish between changes in quantity demanded and changes in demand - the difference between movements along the demand curve and shifts of the demand curve. You can also break students into groups and have them brainstorm a list of factors that could change the demand for Pepsi and shift the demand curve. Make sure they keep the product identical in their analysis and ask them to think about any factor, other than the price of Pepsi, which would change the amount of Pepsi that people would be willing and able to purchase. After allowing students time to brainstorm this list, you can use their ideas about what specifically causes a change in demand for Pepsi to create the list of what factors change demand in a market in general. Classroom Activity: It is best to do this next classroom activity on a different day from the demand experiment. To introduce the supply curve, tell the students you would like a Pepsi from a machine somewhere near the classroom and you want someone to get it for you. You are going to continue teaching while the student is out of the room and you will be giving hints about what is on the next test. Ask the students to raise their hand if they are willing to fetch one can of Pepsi if you pay, say $15.00. Write down the number. Lower the price you’re willing to pay in $1 increments until the number of students willing to fetch you the drink begins to decrease. Keep track of the numbers. Then lower the price you’re willing to pay in 25¢ increments until you get close to only having one student willing to fetch you the drink. Keep track of the numbers. Lower the price in smaller increments if necessary until just one student is willing to fetch you a drink. Now use the data to make a supply curve for Pepsi in your classroom today. You can use this curve to discuss the law of supply.

Part 1 . INTRODUCTION

CHAPTER LECTURE Lecture Launcher: Consider starting your introductory lecture of demand and supply by reaching back to an “Eye on the U.S. Economy” from chapter 3 and using a story made famous by Milton Friedman. Ask the class if someone has a regular pencil. Have a student hold up the pencil and ask the class to think about how that pencil got into this student’s hand: someone grew and harvested a tree, someone made the graphite center, someone grew the rubber that made the eraser, someone made the brass eraser holder, someone made the yellow paint, and someone assembled all these bits. Shippers, wholesalers, and a retailer all played a part in getting that pencil to your student’s hand. Emphasize that no one told anyone this student wanted a pencil. Markets did all this work. You can use this example of the power of the market to segue into the study of demand and supply.

4.1

Demand

Competitive Markets •

Markets vary in the intensity of competition. This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or seller can influence price. Also it is important to stress that no coordinated action on the part of government or any other central authority is required to make markets work efficiently.

 Land Mine: Students often have a difficult time accepting that all sellers are price takers, so be sure to point out that a competitive market is just one type of market structure and the other market structures will be analyzed in greater detail as the semester progresses. The idea is to start with the simplest market structure to work with and build in complexity from there, so that other market structures (where firms may have some price setting ability) will be addressed after students can work with a competitive market. You may even find it useful to introduce the terms monopoly, oligopoly, and monopolistic competition at this point as foreshadowing of where they will be building up to. However, they have to walk before they can run…

Law of Demand •

•

The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers are willing and able to buy during a given time period at a specified price. The law of demand states that other things remaining the same, if the price of a good rises, the quantity demanded of that good decreases; and if the price of a good falls, the quantity demanded of that good increases.

Chapter 4 . Demand and Supply

Demand Schedule and Demand Curve •

The demand for a good refers to the entire relationship between the price of the good and the quantity demanded of the good when all other influences on buying plans remain the same.

•

A demand schedule is a list of the quantities demanded at each different price when all other influences on buying plans remains the same. The table below gives the demand schedule for a good. Price (dollars) 1 2 3 4 5

•

Quantity demanded 50 40 30 20 10

A demand curve is a graph of the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. The figure illustrates the demand curve resulting from the demand schedule in the table.

Individual Demand and Market Demand •

The market demand is the sum of the demands of all the buyers in the market. At each price, add the quantity each buyer demands and the sum is the market quantity demanded.

Changes in Demand •

When any factor that influences buying plans other than the price of the good changes, there is a change in demand and the demand curve shifts. An increase in demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward. Five factors change demand: • Prices of Related Goods: A substitute is a good that can be consumed in place of another good (grape jelly and strawberry jelly) and a complement is a good that is consumed with another good (peanut butter and jelly). A rise in the price of a substitute or a fall in the price of a complement increases the demand for the good. • Expected Future Prices: A rise in the expected future price of a good increases the current demand for that good as consumers stockpile now in anticipation of buying less in the future at higher expected prices. A fall in the expected future price decreases current demand as consumers delay their purchases in anticipation of taking advantage of lower expected future prices. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

•

• •

Income: A normal good is a good for which demand increases when income increases and demand decreases when income decreases. An inferior good is a good for which demand decreases when income increases and demand increases when income decreases (such as generic goods, instant ramen noodles, canned meat) Expected Future Income and Credit: When income is expected to increase in the future or when credit is easy or inexpensive to get, the demand for some goods increases. This effect is especially evident with big ticket items. Number of buyers: The larger the number of buyers, the larger is the demand. Preferences: Preferences are an individual’s attitudes toward goods and services. If people “like” a good more, the demand for it increases.

Change in the Quantity Demanded Versus Change in Demand •

A change in price results in a movement along the demand curve, which is change in the quantity demanded. A change in other factors shifts the demand curve, which is a change in demand.

•

In the figure, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded. The shift of the demand curve from

•

D0 to the new demand curve D1 is a change in demand. Understanding the difference between change in demand versus change in the quantity demanded. It is crucial for your students to understand the difference between a “change in demand” and “change in the quantity demanded.” A useful exercise to get students to see the difference is to put a list of situations on the board and ask them to identify each as either a “change in demand” or a “change in the quantity demanded.” Before you do that there is a simple rule that you can impart that will help students solve the exercise much more easily. The rule is that the price of the good or service itself is the only factor that can cause a change in the quantity demanded. Anything else that affects demand is a change in demand.

Below is a quick list of scenarios you might wish to pose to ask if there is a change in demand (the demand curve shifts) or a change in the quantity demanded (a movement along the demand curve). •

The local gas station raises the price of its gasoline (change in the quantity demanded).

•

Chapter 4 . Demand and Supply

• Sales of Pepsi rise in the face of a price hike for Coke (change in demand for Pepsi and change in the quantity demanded of Coke). • Purchases of personal computers increase when retail stores slash prices (change in the quantity demanded).

4.2

Supply

Law of Supply •

•

The price of a good or service affects the quantity firms plan to sell. The quantity supplied of a good or service is the amount that people are willing and able to sell during a given time period at a specified price. The law of supply states that other things remaining the same, if the price of a good rises, the quantity supplied of that good increases; and if the price of a good falls, the quantity supplied of that good increases. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So the price must rise in order to induce firms to increase the quantity they produce.

Supply Schedule and Supply Curve • •

The supply is the relationship between the quantity supplied and the price of the good when all other influences on selling plans remain the same. A supply schedule is a list of the quantities supplied at each different price when all other influences on selling plans remain the same. The table below gives the supply schedule for a good. Price (dollars) 1 2 3 4 5

•

Quantity supplied 10 20 30 40 50

A supply curve is a graph of the relationship between the quantity supplied of a good and its price when all other influences on selling plans remain the same. The figure illustrates the supply curve resulting from the supply schedule in the table.

Individual Supply and Market Supply •

The market supply is the sum of the supplies of all the sellers in the market. At each price, add the quantity each seller supplies and the sum is the market quantity supplied.

Part 1 . INTRODUCTION

Changes in Supply •

When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. Five factors change supply: • Prices of Related Goods: A substitute in production is a good that can be produced in place of another good, such as Pepsi and Mountain Dew. A complement in production is a good that must be produced along with the initial good, such as wood and wood pulp. A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good. • Prices of Resources and Other Inputs: If the price of a resource used to produce the good rises, the cost of producing the good rises so the supply of the good decreases.

 Land Mine: Make sure to clearly distinguish between the terms “wage rates” and “income,” as students often treat these terms as synonyms. This creates tremendous confusion, as changes in income will change demand, but changes in wage rates will change supply. Remind students that changes in wage rates may not always translate to predictable changes in income. For example, if wage rates increase, firms may want to use less labor. So, some workers will be paid more per hour, though fewer hours are being worked – leaving the impact on total income brought home by workers potentially unchanged. Students need to accept that “wage rates” is just a term used for the price of an input (labor) and is not the same as income. This will be especially important for students in macroeconomics, as they will encounter this again when working with aggregate demand and aggregate supply. •

• •

Expected Future Prices: Expectations about future prices affect current supply. If the price of a good is expected to rise in the future, the current supply of the good decreases. Number of Sellers: If the number of suppliers increases, the supply increases. Productivity: Productivity is output per unit of input. An increase in productivity lowers costs and increases supply. Technological advances and increased capital raise productivity and thereby increase the supply. Natural disasters lower productivity and thereby decrease the supply.

Chapter 4 . Demand and Supply

Change in the Quantity Supplied Versus Change in Supply •

A change in price results in a movement along the supply curve, which is change in the quantity supplied. A change in other factors shifts the supply curve, which is a change in supply. •

In the figure, the movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

4.3 • •

Market Equilibrium An equilibrium is a situation in which opposing forces balance. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. In the figure, the equilibrium price is $3 and the equilibrium quantity is 30 per week.

There is an old joke in the economics profession: “If you can teach a parrot to say demand and supply you've taught the bird how to become an economist.” This is one occasion where reality mirrors humor rather than the other way around. Stress to students that demand and supply analysis is so powerful that a large number of questions can be answered in economics by relying on it. Remind them that if they have difficulty at first that they should not be embarrassed. After all, it took the economics profession about a hundred years before it finalized this model. Indeed, back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was the supply or the demand that determined the price and quantity of a good. Nowadays we know that these efforts were misguided. To borrow

Part 1 . INTRODUCTION

from the great economist Alfred Marshall, demand and supply curves are like the blades on a pair of scissors. It does not make sense to ask which blade does the cutting because the cutting takes both blades and occurs at the intersection of the two blades. Likewise, it takes both the demand and supply to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves.

Price: A Market’s Automatic Regulator •

The law of market forces states “When there is a shortage, the price rises; and when there is a surplus, the price falls. • Surplus (or excess supply): A situation in which the quantity supplied exceeds the quantity demanded. If the price is above the equilibrium price, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price. •

Shortage (or excess demand): A situation in which the quantity demanded exceeds the quantity supplied. If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below $3 and so the price is forced higher, toward the equilibrium price.

Classroom activity: The law of market forces is important, so you want your students to grasp why prices are driven to the equilibrium. You can choose a good, like concert tickets to the hottest band. Draw a demand-supply graph with a reasonable equilibrium price and quantity. Ask the students what would happen if the concert promoter decided to charge only $20 a ticket. Would students line up before dawn to buy them? Yes! Explain that this is a case of excess demand. Ask them what could the promoter do to get the crowds to go away? Hopefully they will answer, “Raise ticket prices!” Show them how the market pressures the price to rise to the equilibrium price and use the graph to show how the promoter and students move up their respective supply and demand curves. You can do the same thing for excess supply. Let the promoter try to sell tickets for $1,000 each. Again, move down along the supply and demand curves as the market pressures the price to fall. Market forces pushing towards the equilibrium can be compared to a buoy in the ocean. The natural state for the buoy is to point straight up (equilibrium), though sometimes forces act upon that buoy that cause it to rock to one side or the other. When this happens, the buoy tries to right itself to point straight up again (equilibrium). It’s not to say that a buoy (or markets) will always be at equilibrium, but when it deviates from equilibrium it will be pushed back towards it.

Predicting Price Changes: Three Questions To determine how an event affects the equilibrium, answer three questions: • Does the event affect the demand or the supply? • Does the event increase or decrease demand or supply? This question determines whether the demand or supply curve shifts rightward or leftward. • What are the new equilibrium price and quantity and how have they changed? © 2015 Pearson Education, Inc.

Chapter 4 . Demand and Supply

Effects of Changes in Demand •

•

If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price and the equilibrium quantity increase. If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price and the equilibrium quantity decrease. Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve. The figure illustrates an increase in demand. In the figure the demand curve shifts from D0 to D1. As a result, the equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30 to 40. The supply curve does not shift; there is a movement along the supply curve.

Effects of Changes in Supply •

•

If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases. If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases. Demand does not change and the demand curve does not shift. There is a change in the quantity demanded and a movement along the demand curve. The figure illustrates an increase in supply. In the figure the supply curve shifts from S0 to S1. As a result, the equilibrium price falls from $3 to $2 and the equilibrium quantity increases from 30 to 40. The demand curve does not shift; there is a movement along the demand curve.

Part 1 . INTRODUCTION

Effects of Changes in Both Demand and Supply Both Demand and Supply Change In the Same Direction • If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous. • If the increase in demand is greater than the increase in supply, the price rises. • If the increase in demand is the same size as the increase in supply, the price does not change. • If the increase in demand is less than the increase in supply, the price falls. • The figure illustrates an increase in both demand and supply: the de-

•

mand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium price does not change and the equilibrium quantity increases from 30 to 50. If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous. • If the decrease in demand is greater than the decrease in supply, the price falls. • If the decrease in demand is the same size as the decrease in supply, the price does not change. • If the decrease in demand is less than the decrease in supply, the price rises.

Chapter 4 . Demand and Supply

Both Demand and Supply Change In Opposite Directions • If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous. • If the increase in demand is greater than the decrease in supply, the quantity increases. • If the increase in demand is the same size as the decrease in supply, the quantity does not change. • If the increase in demand is less than the decrease in supply, the quantity decreases. • The figure illustrates an increase in demand and a decrease in supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from

•

S0 to S1. The shifts are the same size, so the equilibrium quantity does not change and the equilibrium price rises from $3 to $5. If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous. • If the decrease in demand is greater than the increase in supply, the quantity decreases. • If the decrease in demand is the same size as the increase in supply, the quantity does not change. • If the decrease in demand is less than the increase in supply, the quantity increases.

The entire chapter builds up to using the demand/supply model to predict changes in the equilibrium price and quantity. Students are remarkably ready to guess the consequences of some event that changes either demand, or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some event or events on a market has five steps: Step 1. Draw a demand-supply graph and label the axes with the price and quantity of the good or service in question. Step 2. Think about the event or events and decide whether they change demand, supply, both demand and supply, neither demand nor supply. If an event impacts demand or supply, students must always be able to identify one of the factors from the list of factors that change demand and supply. Students should make flash cards of these two lists to study and keep along side them while working on homework assignments. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

Step 3. Do the events that change demand or supply bring an increase or a decrease? Step 4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curve or curves in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—works OK for demand but is wrong for supply. Emphasize the leftward versus rightward shift.) Step 5. Find the new equilibrium and compare it with the original one. Walk them through the steps and have one or two students work some examples in front of the class. It is critical at this stage to return to the distinction between a change in demand and a change in the quantity demanded and between a change in supply and a change in the quantity supplied. You can now use these distinctions to describe the effects of events that change market outcomes. After working through some examples as a class, break students into smaller groups and have them practice examples– always verbalizing their thought process as they work through the steps. This group setting allows for the peer effect to take hold, as some students will pick up the model work very quickly, while others will take a bit longer. Once groups are able to work through these examples fairly quickly and accurately, have students try examples individually and you can walk around and monitor their progress. This can help you identify which students are still struggling and will need additional assistance and practice. For all students, there’s almost no way you can give them enough practice with this model. I tell my students that the supply and demand model is to economics what addition and subtraction are to math – without mastering that basic foundation, it’s impossible to move on and learn more complex material.

Chapter 4 . Demand and Supply

USING EYE ON YOUR LIFE 

Understanding and Using Demand and Supply

This Eye points out that students will encounter supply and demand throughout their life. You can mention to them that supply and demand is also highly relevant when it comes to investing. For instance, in 2004 the price of ethanol soared because of government initiatives for use of ethanol in fuel. These initiatives increased the demand for ethanol and thereby lead to dramatic price hikes ... and equally dramatic increases in the profits of ethanol producers and their stock prices. If a student had been able to “guess” in 2003 that the government was likely to respond to high oil prices by enacting policies that favored ethanol, that student could have made a killing in the stock market. Indeed, supply and demand are perhaps the real fundamental that underlies stock prices!

USING EYE ON TUITION 

Why Does Tuition Keep Rising

This Eye will be especially relevant to your students, as I’m sure rising tuition is a phenomenon with which they are familiar. Ask them if they think the rising price of attending college has led to a decrease in enrollment (as the law of demand would dictate). After identifying that both tuition (price) and enrollment (quantity) have been increasing over the past few decades, ask them to use the demand and supply framework to graphically illustrate and explain how that would be possible, making sure to accentuate that the law of demand only explains how the quantity demanded responds to price changes when other things remain the same. After they feel comfortable with the model, explain those factors identified in the Eye that have not remained the same and have been driving the rising demand. You can then have them consider other factors that are sometimes cited as causes of rising tuition, such as the expansion of financial aid (increase in demand) or rising college administration costs (decrease in supply). You can also ask them to consider the impact on the market if colleges were not allowed to raise tuition in the face of these changes (the creation of a shortage).

USING EYE ON THE GLOBAL ECONOMY 

The Market for Solar Panels

You can use this story to review the key fact that factors that shift the supply curve do not necessarily shift the demand curve. In particular, the falling price of silicon and advances in solar panel technology affected only the supply curve and had no effect on the demand curve. To demonstrate this point, ask your students © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

how many of them knew what was happening with the price of silicon from 2009-2013. Very few, if any, will know the recent trends in the price of this key resource used in the production of solar panels. This fact can serve as an excellent reminder of the point that the factors that affect supply do not affect demand. Ask your students how these changes could have affected demand if buyers didn’t know of them. Buyers pay attention to the price of a good or service that they purchase, but rarely are they aware of prices of the factors of production. The only factor that influenced buyer decisions was the lower price of solar panels, not the changes in silicon prices. So the change in the price of solar panels leads to a movement along the demand curve, not a shift of the demand curve.

Chapter 4 . Demand and Supply

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 4.1 Demand 1. The Internet was born in 1969. For the next 20 years, mainly scientists in universities and research laboratories used it. But in the 1990s, the use of Internet service increased dramatically and the price per hour of Internet service fell. 1a. Are there any substitutes for Internet service? If so, provide an example. 1b. Are there any complements of Internet service? If so, provide an example. 1c. What are the main developments that brought about the dramatic increase in the quantity of Internet service during the 1990s? 1d. Which developments that you identified in part (c) shifted the demand curve for Internet service rightward? 1e. Which developments that you identified in part (c) increased the quantity demanded of Internet service? 2. Answer and explain your answer for each of the events listed below. 2a. What happens to the demand curve for pumpkins in October? 2b. What happens to the demand curve for Gatorade in summer? 2c. What happens to the demand curve for gasoline if 20 percent of all new cars are required to be electric powered? 2d. What happens to the demand and the demand curve for beef if more people decide to become vegans? 2e. The price of a concert ticket increases. What is the effect on the demand curve for concerts? 2f. Because of concerns about terrorism, more firms want to buy metal detectors. What happens to the demand for metal detectors? 2g. More people decide to have a pet cat. What is the effect of this decision on the demand for cat food?  Checkpoint 4.2 Supply 3. In the market for SUVs, several events occur one at a time. Explain the influence of each event on the quantity supplied of SUVs and the supply of SUVs. Illustrate the effects of each event by either a movement along the supply curve or a shift in the supply curve and say which event or events illustrates the law of supply in action. The events are: 3a. The price of a truck rises. 3b. The price of an SUV falls. 3c. The price of an SUV is expected to fall next year. 3d. An SUV engine defect requires a huge and costly manufacturer's recall to replace the defective engines. 3e. A new robot technology lowers the cost of producing SUVs. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

4. Answer and explain your answer for each of the events listed below. 4a. What happens to the supply curve of new homes if the wage rate paid to carpenters falls? 4b. Companies can produce both cardigan sweaters and pullover sweaters. What happens to the supply curve of cardigan sweaters if the price of a pullover sweater increases?  Checkpoint 4.3 Market Equilibrium 5. Suppose a technological advance lowers the cost of producing computer memory chips. What is the effect of this change on the demand for memory chips, the supply of memory chips, the equilibrium price of memory chips, and the equilibrium quantity of memory chips? 6.

Suppose people read reports that eating oatmeal helps prevent heart disease. What is the effect of this change on the equilibrium price of oatmeal and the equilibrium quantity of oatmeal?

What happens to equilibrium price and the equilibrium quantity of each good described in the situations described below? Illustrate your answers. 7a. Sunnyvale is named the most livable city in the United States. At the same time, the wage rates of homebuilders, electricians, and plumbers in Sunnyvale increase. Describe what happens to the new home market in Sunnyvale. 7b. The price of airline fuel falls by 10 percent. At the same time, people’s incomes increase and they prefer to fly to their vacation destinations. Describe what happens to the market for airline travel. 7c. Installation costs for small satellite TV dishes fall by 10 percent. At the same time, network owners increase the cost of programming packages shown via satellite TV dish systems. Describe what happens in the market for small satellite TV dishes. 8. During 2004, orange growers in Florida experienced three hurricanes. As a result, the amount of oranges harvested in Florida was smaller than usual. Orange growers in other states experienced normal growing conditions. What was the effect of the smaller harvests in Florida? How do you think the price of oranges and the quantity bought and sold changed in early 2005? What do you predict happened to the price of frozen orange juice in early 2005? Use graphs of the orange market and the frozen orange juice market to illustrate your answers. 9.

The USA Today reported that in 2007, more than 25 percent of the corn crop could be used to produce ethanol, up from 20 percent in 2006 and 6 percent in 2000. USA Today also reported that farmers are expected to switch to corn from soybeans, wheat, and even cotton. One farmer, Leon Corzine of Assumption, Ill., said he plans to devote 90 percent to corn and 10 percent to soybeans in 2007. Four years ago he planted half corn and half soybeans. © 2015 Pearson Education, Inc.

Chapter 4 . Demand and Supply

Explain why farmers are switching to corn production and if most farmers agree with Leon Corzine, how will the price of soybeans change.

 Answers  Checkpoint 4.1 Demand 1a. There are five services provided by the Internet: e-mail, information on Web pages, home shopping services, information on fast breaking news, and entertainment. The only substitute for Internet e-mail service, if a person is interested in the speed of service, is the telephone. For bulky or unique items (like large documents, magazines, bills, photographs) or if you don’t mind waiting, postal services are substitutes. In terms of Web pages, some provide a great deal of information and others provide minimal, basic information on their firms. If you need the basic information and you want it fast, there are no real substitutes for the Internet. If you want detailed information, substitutes for the Internet are phone calls or literature sent from the firm. For home shopping, catalogs and home shopping channels on television are substitutes, though slower (in the case of catalogs) or generally without as much information (in the case of television home shopping channels). For information on fast breaking news, possibly radio or television is a substitute. For entertainment, substitutes abound. For instance, listening to music can be done by accessing an Internet radio station or, as substitutes, a local radio station or a CD. The Internet has cartoons, for which comic books and cartoons on television are substitutes. More generally, anything that provides entertainment substitutes for the Internet’s entertainment services, though some (watching a movie on a DVD) are not particularly close substitutes. 1b. The complements to the Internet are computers, phone lines, modems, cable modems, and DSL lines provided by the phone service. 1c. The main developments are quicker and cheaper computers and modems and more Internet providers supplying better service. Additionally, more people now own computers. 1d. The new, cheaper computers and modems, which are complements of Internet service have shifted the demand curve for Internet service rightward. More people now own computers, and this change in the number of buyers also shifts the demand curve rightward. 1e. The increase in quantity demanded occurs when the supply curve shifts. An increase in the number of providers and an increase in technology shift the supply curve rightward. When the supply curve shifts, rightward there is a movement down along the demand curve and an increase in the quantity demanded.

Part 1 . INTRODUCTION

2a. As people prepare for fall holidays, people increase their preferences for pumpkins. The demand curve for pumpkins shifts rightward. 2b. People exercise more in the summer and spend more time outside getting thirsty. There is an increase in the demand for Gatorade during the summer and the demand curve for Gatorade shifts rightward. 2c. As more cars are required to be electric powered, the demand for gasoline decreases. The demand curve for gasoline shifts leftward. 2d. As more people decide to become vegans, the demand for beef decreases and the demand curve for beef shifts leftward. 2e. There is a movement up along the demand curve for concerts. The demand curve does not shift because the only factor that change is the price. 2f. Firms have increased their preferences for metal detectors. The demand for metal detectors increases and the demand curve shifts rightward. 2g. Cat food and cats are complements. As more people decide they want a pet cat, the demand for cat food increases.  Checkpoint 4.2 Supply 3a. A truck is a substitute in production for an SUV. If the price of a truck rises, auto makers produce more trucks and fewer SUVs. The supply curve for SUVs shifts leftward from S0 to S1 as shown in Figure 4.1.

Chapter 4 . Demand and Supply

3b. When the price of an SUV falls, there is a movement down along the supply curve for SUVs. This outcome is shown in Figure 4.2 in which the price falls from P0 to P1, and the quantity supplied decreases from Q0 to Q1.

3c. If we expect the price of SUVs to fall next year, suppliers increase the current supply to take advantage of current higher prices. The supply curve shifts rightward from S0 to S1, as shown in Figure 4.3. 3d. To replace the defective engines, the auto maker incurs higher production costs. The cost hike decreases the supply and shifts the supply curve leftward, as in Figure 4.1. 3e. The new robot technology decreases production costs for SUVs. This change increases the supply of SUVs so the supply curve for SUVs shifts rightward, as in Figure 4.3. 4a. Carpenters help produce new homes, so they are a resource used in the production of new homes. As the wage rate paid to carpenters falls, the cost of producing housing decreases. The supply of new homes increases and the supply curve of new homes shifts rightward. 4b. Cardigan sweaters and pullover sweaters are substitutes in production. If the price of a pullover sweater increases, the supply of cardigan sweaters decreases. The supply curve of cardigan sweaters shifts leftward.  Checkpoint 4.3 Market Equilibrium 5. The technological advance has no effect on the demand for memory chips. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

The supply of memory chips increases. The equilibrium price of a memory chip falls and the equilibrium quantity of a memory chip increases. The reports increase people’s preference for oatmeal. The demand for oatmeal increases. The equilibrium price of oatmeal rises and the equilibrium quantity increases.

7a. As people hear how nice it is to live in Sunnyvale, the demand for new homes in Sunnyvale increases and the demand curve in Fig. 4.4a shifts rightward, from D0 to D1. At the same time, an increase in building costs decreases the supply of new homes, so the supply curve shifts leftward from S0 to S1. As Figures 4.4a, 4.4b, and 4.4c show, the equilibrium price of new homes increases, from P0 to P1 in the figures. What happens to the equilibrium quantity depends on which curve shifts the most. If the curves shift the same amount, as in Figure 4.4a, the equilibrium quantity does not change. If the demand curve shifts more than the supply curve, as in Figure 4.4b, the equilibrium quantity increases. If the supply curve shifts more than the demand curve, as in Figure 4.4c, the equilibrium quantity decreases. © 2015 Pearson Education, Inc.

Chapter 4 . Demand and Supply

7b. As the price of airline fuel falls, airlines’ costs fall. The supply of airline travel increases and the supply curve of airline travel shifts rightward in Fig. 4.5a from S0 to S1. At the same time, people decide to take more airline trips, so the demand curve for airline travel shifts rightward from D0 to D1. As figures 4.5a, 4.5b, and 4.5c show, the equilibrium quantity increases from Q0 to Q1. The figures also show that the effect on the price is indeterminate unless you know which curve shifts the most.

Part 1 . INTRODUCTION

7c. A decrease in installation costs is a decrease in production costs. The supply curve of satellite TV dishes shifts rightward in Fig. 4.6a from S0 to S1. At the same time, the price of programming, which is a complement of satellite TV dishes, increases. The demand curve for satellite dishes shifts leftward from D0 to D1. Figures 4.6a, 4.6b, and 4.6c each demonstrates that the equilibrium price of satellite dishes decreases from P0 to P1. But the effect on the quantity is ambiguous.

Chapter 4 . Demand and Supply

Figure 4.7 shows the effect of the smaller harvest of oranges. The equilibrium in the world market for oranges in a normal year has an (assumed) equilibrium price of a ton of oranges of $2,000 and an (assumed) equilibrium quantity of oranges is 60 million tons a year. Then the smaller harvest of oranges in Florida decreases the supply of oranges and the supply curve shifts leftward. In Figure 4.7, the supply curve of oranges shifts leftward from S0 to S1. The equilibrium price of a ton of oranges rises from $2,000 a ton to $2,100 a ton, and the equilibrium quantity of oranges decreases from 60 million tons to 55 million tons of oranges a year. The price of a ton of oranges rose and the quantity of oranges decreased. Oranges are an input used to produce frozen orange juice. The higher price of a ton of oranges means that the price of a resource used to produce frozen orange juice rises. The supply of frozen orange juice decreases so that the supply curve shifts leftward. Figure 4.8 illustrates this situation. The equilibrium in the market for frozen orange juice in a normal year has an (assumed) equilibrium price of $5,000 a ton and an (assumed) equilibrium quantity of 10 million tons a year. The hike in the price of oranges decreases the supply of orange juice and the supply curve shifts leftward. In Figure 4.8, the supply curve shifts leftward from S0 to S1. The equilibrium price of a ton of frozen orange juice rises from $5,000 a ton to $6,000 a ton, and the equilibrium quantity of frozen orange juice decreases from 10 million tons to 9 million tons.

Farmers are switching to corn production because the increase in the demand from ethanol producers has raised the price of corn. Farmers can now earn a larger profit producing corn rather than soybeans. If most farmers switch away from soybeans to corn, the supply of soybeans will decrease.

Part 1 . INTRODUCTION

The decrease in supply will lead to a higher price for soybeans, thereby increasing the profit of the farmers who continue to produce soybeans.

Chapter

Elasticities of Demand and Supply CHAPTER OUTLINE 1. Define and calculate the price elasticity of demand, and explain the factors that influence it. A. Percentage Change in Price 1. A Rise in Price 2. A Fall in Price 3. The Midpoint Method B. Percentage Change in Quantity Demanded C. Comparing the Percentage Changes in Price and Quantity D. Elastic and Inelastic Demand E. Influences on the Price Elasticity of Demand 1. Availability of Substitutes a. Luxury Versus Necessity b. Narrowness of Definition c. Time Elapsed Since Price Change 2. Proportion of Income Spent F. Computing the Price Elasticity of Demand G. Interpreting the Price Elasticity of Demand Number H. Elasticity Along a Linear Demand Curve I. Total Revenue and the Price Elasticity of Demand J. Applications of the Price Elasticity of Demand 1. Orange Prices and Total Revenue 2. Addiction and Elasticity 2. Define and calculate the price elasticity of supply, and explain the factors that influence it. A. Elastic and Inelastic Supply B. Influences on the Price Elasticity of Supply 1. Production Possibilities a. Time Elapsed Since Price Change 2. Storage Possibilities C. Computing the Price Elasticity of Supply

Part 2 . A CLOSER LOOK AT MARKETS

3. Define the cross price elasticity of demand and the income elasticity of demand, and explain the factors that influence them. A. Cross Elasticity of Demand B. Income Elasticity of Demand

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 5 is lightly updated from the sixth edition, with content for “A Rise in Price,” “A Fall in Price,” and “Comparing the Percentage Changes in Prices and Quantities” now separated into subheadings.

 Where We Are In this chapter we examine the price elasticity of demand, price elasticity of supply, cross elasticity of demand, and income elasticity of demand. The motivation for studying elasticity focuses on how elasticity can help make quantitative predictions about price and quantity changes. We study the total revenue test, which estimates the price elasticity of demand by observing the change in total revenue that results from a price change.

 Where We’ve Been We have now examined why we study economics and have built basic models, such as the production possibilities frontier and the demand and supply framework.

 Where We’re Going The next chapter continues to use the supply and demand framework to study the efficiency and fairness of markets. Consumer surplus and producer surplus will be introduced. We return to the concept of efficiency and study occasions when the market is inefficient. We discuss issues of fairness.

IN THE CLASSROOM  Class Time Needed You can complete this chapter in no more than three sessions. Take the time to explain the idea of percentage changes and explicitly go over each of the calculations in computing the elasticity. •

Chapter 5 . Elasticities of Demand and Supply

•

5.2 The Price Elasticity of Supply—20 to 25 minutes

•

5.3 Cross Elasticity and Income Elasticity—15 to 20 minutes

Classroom Activity: A Georgia professor begins the discussion of elasticity by passing around the class two rubber exercise bands. The green band is much harder to stretch than the pink band. Everybody has a great time pulling on the exercise bands. Some rubber bands, such as the green exercise band, don’t stretch very much. They are, comparatively, inelastic. And some rubber bands are quite stretchy. When the same amount of pressure is put on the pink exercise band as was placed on the green one, the pink band stretches much more. It, compared to the green band, is relatively elastic. What we’re really describing is how responsive the two exercise bands are to the same amount of force: the relatively elastic band responds a lot, while the relatively inelastic band responds less to the same amount of force. Similarly, when analyzing cause and effect relationships in economics, some causes have a greater effect on some variables than others. The greater the response, the more elastic the relationship. Therefore, if the price of gasoline (force) increases, people change their behavior only a little (less stretching) because they have few alternatives. The demand for gasoline is relatively inelastic. On the other hand, if the price of potatoes (more force) rises, people respond dramatically (more stretching), because there are plenty of alternatives. Demand for potatoes is relatively elastic. Classroom Activity: After introducing the influences on the price elasticity of demand, break students into small groups and give them a list of goods. Have students rank the price elasticities of demand for these goods by considering the various influences (but standardize the time elapsed for them). For example, you can give them salt, an automobile, filet mignon, beef, Grey Poupon Dijon Mustard, and a Hawaiian vacation (you can choose your own goods, just make sure they highlight the influences). Ask students to rank the demand for these goods from where demand would be most inelastic to most elastic. While there is a mathematically “correct” ranking, it is not important that you actually know what it is. The important thing is being able to support arguments about the relative price elasticities of demand based upon the influences. The actual correct ranking would be a far more advanced research project than any of your students (or you, for that matter) should be expected to undertake at this point. Remind students to consider all of the influences on the elasticity of demand when thinking about this list – whether the good is more of a luxury or necessity, whether the market is more narrowly or broadly defined, and whether the good would make up a fairly small or large proportion of a budget. Make sure to reinforce to students that it is the combination of these influences that ultimately determine the price elasticity of demand, not just one of the influences. When you bring the class back together, have each group volunteer their rankings and record them on the board. While it is unlikely every group will have the same rankings, there will be remarkable similarities. Use the trends you see in these rankings to review the influences and analyze how discrepancies can be explained by the assumptions made by different groups about how heavily to weigh these different influences. This exercise will get students practice interpreting the various influences on the price elasticity of demand and how the combination affects the price elasticity of demand for various goods. © 2015 Pearson Education, Inc.

Part 2 . A CLOSER LOOK AT MARKETS

CHAPTER LECTURE 5.1

The Price Elasticity of Demand

In general, elasticity measures responsiveness. The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is often useful for both businesses and governments.  Land Mine: Many students need a refresher and some practice at doing what seems too simple to bother with: calculating percentages and percentage changes. Don’t be afraid to start with this pre-elasticity warm up. Just toss out some numbers. Suppose that the campus book store increases the price of an economics text from $80 to $100. What is the percentage increase in price? Now suppose the campus book store cuts the price of an economics text from $100 to $80. What is the percentage decrease in price? You’re now set to have the students use the average of the original and new price to calculate percentages that are independent of the direction of change.  Land Mine: Many students have a hard time remembering whether quantity or price goes in the numerator of the elasticity formulas. Have the students create their own mnemonic. Suggest McDonald’s Quarter Pounder™ hamburgers. It’s silly, but it works, reminding the student that Q (quantity) appears before P (price) in the ratio of percentage changes. •

The price elasticity of demand is a measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of: Percentage change in quantity demanded . Percentage change in price

Percentage Change in Price and Quantity Demanded •

One method for calculating the percentage change in the price is:  New price − Initial price    × 100.   Initial price   However this method gives different percentage changes depending if the price rises or falls. For instance, the $2 change from $8 to 10$ is a 25 percent change whereas the $2 change from $10 to $8 is only a 20 percent change.

•

Economists use the midpoint method for calculating the percentage change in the price:  New price − Initial price     (New price + Initial price) ÷ 2  × 100.   This method gives the same percentage regardless of whether the price rises or falls. For instance, the $2 change from $8 to 10$ is a 22.2 percent change regardless of whether the price rises or falls.

Chapter 5 . Elasticities of Demand and Supply

•

Economists use the midpoint method for calculating the percentage change in the quantity:  New quantity − Initial quantity     (New quantity + Initial quantity) ÷ 2  × 100.   When calculating the price elasticity of demand, only the magnitude or absolute value is used when calculating the percentage changes so that any negative sign is ignored.

Elastic and Inelastic Demand •

• •

Demand is elastic if the percentage change in the quantity demanded exceeds the percentage change in price. • If the quantity demanded changes by a large percentage in response to a tiny price change, then the good is said to have perfectly elastic demand. The good’s demand curve is a horizontal line. Demand is unit elastic if the percentage change in the quantity demanded equals the percentage change in price. Demand is inelastic if the percentage change in the quantity demanded is less than the percentage change in price. • If the quantity demanded remains constant when the price changes, so that the percentage change in the quantity demanded is zero, then the good is said to have perfectly inelastic demand. The good’s demand curve is a vertical line.

Elasticity is a very practical concept. Businesses and governments are interested in elasticities. Businesses want to know the price elasticity of demand for their product because they want to know how a change in price affects their total revenue. Governments what to know the price elasticity of demand for various products, such as oil, because they want to predict the effect of a change in price on the quantity demanded (as this will play a key role in how a tax impacts market outcomes). You should point these facts out to your students because many students are eager to learn when they know what they are learning will have real-life applications. So your discussion of how elasticities are used in the real world can motivate your students.

Influences on the Price Elasticity of Demand •

The magnitude of the price elasticity of demand depends on: • The availability of substitutes: The more and the closer the substitutes for a good or service, the more elastic the demand for it. • A luxury good has more substitutes than a necessity, so the demand for luxuries is more elastic than the demand for necessities. • The more narrowly defined a good (for example, a Mountain Dew at 2 PM) has more substitutes than a more broadly defined good (for example, a soda sometime today). • The longer the time elapsed since the price of the good changed, the more elastic the demand for the good. • The proportion of income spent on the good: The greater the proportion of income spent on a good or service, the more elastic the demand for it. © 2015 Pearson Education, Inc.

Part 2 . A CLOSER LOOK AT MARKETS

Most people’s demand for salt is inelastic, largely because most people spend a miniscule amount of their income on salt. However large Northern cities’ demand for salt is significantly more elastic. These cities use salt to treat their roads after a snow storm. Salt is a significant fraction of their budgets. Because the proportion of their income they spend on salt is large, the price elasticity of demand for these cities is much larger than that of “ordinary” consumers. To practice applying the influences, have students compare the elasticity of demand for a few goods. Ask them which of the following would have a more elastic demand and why: ● Food or whole wheat bread ● Alcohol or Gatorade ● Gasoline one month after a price change or gasoline one year after a price change ● A yacht or milk ● Airfare for business travelers or airfare for leisure travelers

Computing the Price Elasticity of Demand •

The formula for the price elasticity of demand is the absolute value of: Percentage change in quantity demanded . Percentage change in price

•

The table to the right has two points on the dePrice Quantity mand curve for pizza from a pizza parlor. (dollars per demanded • The absolute value of the percent change in pizza) (pizzas per week) quantity demanded is 14 500 [(500 − 400) ÷ 450] × 100 = 22.2 percent. 16 400 • The absolute value of the percentage change in price is [($14 − $16) ÷ $15] × 100 = 13.3 percent. • Between these two points on the demand curve, the price elasticity of demand is 22.2% ÷ 13.3% = 1.67. If the price elasticity of demand is greater than 1, demand is elastic; if it is equal to 1, demand is unit elastic; if it is less than 1, demand is inelastic. If the price elasticity of demand is elastic, we can presume that the good probably has many substitutes and does not take up a large proportion of its buyers’ incomes. Pushing up the price a bit loses many customers but lowering the price a bit gains many customers.

• •

 Land Mine: Students sometimes wonder why we don’t just measure the slope of the demand curve to measure responsiveness. Point out to the students that the slope will change when the units change. For instance, you can compute the slope of a demand curve when the price is measured in dollars and then the slope of the exact same demand curve when the price is measured in cents. The slope with the price measured in cents is 100 times as large as the initial slope. Tell the students that it is not acceptable for the measure of responsiveness to change whenever the units of the price (or of the quantity) change. To show the importance of a units-free measure of © 2015 Pearson Education, Inc.

Chapter 5 . Elasticities of Demand and Supply

elasticity, you can calculate the slope of a demand curve when the vertical axis is measured in dollars and again when it is measured in cents. Draw a demand curve for tacos, such that when the price rises from $1.00 to $1.05, the quantity demanded decreases from 50 to 45 tacos. The slope of the demand curve with the price measured in dollars is −0.01. Then, draw the identical demand curve, only this time measure the price in cents. When the price rises from 100 cents to 105 cents, the quantity demanded decreases from 50 to 45 units. Now the slope is −1.00. Point out that having the slope of the identical demand curve change simply because the units of the price change is surely not a good feature. In addition, the slope changes when the quantity units change. For this reason, economists do not use the slope as their measure of sensitivity. They use elasticity because elasticity is calculated using units-free percentage changes. Elasticity does not change if the units of the price or the quantity are changed.

Elasticity Along a Linear Demand Curve •

•

With the exception of a vertical demand curve and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively) the price elasticity of demand changes when moving along a straight-line demand curve. As the figure illustrates, at points on the demand curve above the midpoint, the price elasticity of demand is elastic while at points below the midpoint, the price elasticity of demand is inelastic. At the midpoint, the price elasticity of demand is unit elastic.

Total Revenue and the Price Elasticity of Demand •

The total revenue is the total amount spent on a good and received by the seller. It equals the price of the good multiplied by the quantity sold. • If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. • If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change. • If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

Part 2 . A CLOSER LOOK AT MARKETS

•

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in price. • If a percent price cut increases total revenue, demand is elastic. And if a price hike decreases total revenue, demand is elastic. • If a percent price cut does not change total revenue, demand is unit elastic. And if a price hike does not change total revenue, demand is unit elastic. • If a percent price cut decreases total revenue, demand is inelastic. And if a price hike increases total revenue, demand is inelastic.

Applications of the Price Elasticity of Demand •

•

5.2 •

The price elasticity of demand can be used to predict the effect on the price of a change in the quantity. For instance, if the price elasticity of demand for oranges is 0.4 and the quantity of oranges decrease by 1 percent, then the price of oranges will rise by (1 percent) ÷ 0.4, which is 2.5 percent. The price elasticity of demand for many illegal drugs is very small, which shows that even substantial price hikes will not decrease the quantity consumed by much. In addition, the price elasticity of demand shows that the elasticity of demand for cigarettes by young people is larger than for established smokers. So although a tax will not have much of an effect on established smokers’ behavior, it will discourage smoking by younger people.

The Price Elasticity of Supply The price elasticity of supply measures how responsive the quantity supplied is to a change in the price a good when all other influences on sellers’ plans remain unchanged. The price elasticity of supply compares the percentage change in the quantity supplied to the percentage change in the price.

Elastic and Inelastic Supply •

• •

Supply is elastic if the percentage change in the quantity supplied exceeds the percentage change in price. • If the quantity supplied changes by a large percentage in response to a tiny price change, then the good is said to have perfectly elastic supply. Supply is unit elastic if the percentage change in the quantity supplied equals the percentage change in price. Supply is inelastic if the percentage change in the quantity supplied is less than the percentage change in price. • If the quantity supplied remains constant when the price changes, so that the percentage change in the quantity supplied is zero, then the good is said to have perfectly inelastic supply.

Influences on the Price Elasticity of Supply •

The magnitude of the elasticity of supply depends on: • Production possibilities: The more unique or rare are the productive resources used to produce the good, the smaller the elasticity of supply. The more common the produc© 2015 Pearson Education, Inc.

Chapter 5 . Elasticities of Demand and Supply

•

tive resources used to produce the good, the larger the elasticity of supply. • The time elapsed since the price change: The longer the amount of time producers have to adjust to a change in price, the more elastic will be the supply. Storage possibilities: If the good can be stored, its supply will be more elastic.

To practice applying the influences, have students compare the elasticity of supply for a few goods. Ask them which of the following would have a more elastic supply and why: ● ● ● ●

Fresh produce or canned produce Diamond rings or cubic zirconia rings Crude oil one month after a price change or crude oil one year after a price change Housing in Hawaii or housing in Kansas

Computing the Price Elasticity of Supply •

The price elasticity of supply is equal to: Percentage change in quantity supplied . Percentage change in price

•

The table to the right has two points on the supply curve for pizza from a pizza parlor. • The percentage change in the quantity supplied is [(400 − 300) ÷ 350] × 100 = 28.6 percent. • The percentage change in price is [($16 − $14) ÷ $15] × 100 = 13.3 percent. • Between these two points, the elasticity of supply is 28.6% ÷ 13.3% = 2.15.

5.3

Price (dollars per pizza) 14 16

Quantity supplied (pizzas per week) 300 400

Cross Elasticity and Income Elasticity

Cross Elasticity of Demand • •

The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or compliment, other things remaining the same. The cross elasticity of demand is equal to: Percentage change in quantity demanded . Percentage change in price of a substitute or complement

•

The cross elasticity of demand is positive for substitutes and negative for complements.

Use examples to show the students why the cross elasticity of demand is positive for substitutes and negative for complements. For instance, suppose the price of Coke rises. What effect does this price hike have on the demand for Pepsi? Students will immediately realize that the demand for Pepsi increases. So in this case the cross elasticity of demand for Pepsi with respect to the price of Coke is calculated by dividing one positive number by another, so the result will be positive. For complements, such as bowling balls and bowling shirts, a price hike for bowling balls © 2015 Pearson Education, Inc.

Part 2 . A CLOSER LOOK AT MARKETS

decreases the demand for bowling shirts. So in this case the cross elasticity of demand for bowling shirts with respect to the price of bowling balls is a negative number divided by a positive number, so the result will be negative.

Income Elasticity of Demand • •

•

The income elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the income, other things remaining the same. The income elasticity of demand is equal to: Percentage change in quantity demanded . Percentage change in income The income elasticity of demand is positive for normal goods and negative for inferior goods.

 Land Mine: Elasticity is a subject that can overwhelm students by the many details. Be sure to stress the common features of all the different elasticities. All elasticities measure how strongly people respond to a change in some factor; all elasticities use percentage changes; and all elasticities divide the percentage change in the quantity by the percentage change in the relevant factor. Of these features, the most important is the fact that elasticities measure responsiveness. Stress this fact and your students will find it significantly easier to comprehend all the myriad details.

Chapter 5 . Elasticities of Demand and Supply

USING EYE ON THE GLOBAL ECONOMY  Price Elasticities of Demand Often the relatively theoretical nature of economics takes students by surprise. They expect a typical business course in which only “practical, real-world” issues are studied. Elasticity is precisely the sort of “practical, real-world” concept that can appeal to this set of students. The price elasticities of demand in this “Eye on the Global Economy” can be used in test questions, to make the questions more realistic. You also can use them in a class discussion by asking your students about a few of the goods. For instance, you could ask them what they guess is more elastic, the demand for motor vehicles or clothing? The demand for furniture or food? The demand for metals or oil? Ask the students to explain their answers and then present them with the actual rankings from this Eye on the Global Economy.

USING EYE ON THE PRICE OF GASOLINE  What Do You Do When the Price of Gasoline Rises? As consumers with automobiles and very limited budgets (typically), the demand for gasoline is perhaps the first example that students think of when the price elasticity of demand is introduced. Most will identify their demand is highly inelastic. Indeed, some might assert it is perfectly inelastic. You can use the data provided in this Eye to give students practice calculating the price elasticity of demand and use these calculations to compare to the price elasticity of demand for other goods (as given in the Eye on the Global Economy on page 119). Although the time elapsed is not given for these other calculations so it is not quite ceteris paribus, the extremely inelastic demand for gasoline seen in this Eye can help illustrate how Americans have made gasoline such a necessity that it rivals the elasticity of demand for other life “essentials,” such as food, beverages, housing services, and clothing. Ask students to speculate about the price elasticity of demand for gasoline across different regions of the U.S. – why might it vary? Also, why might it vary around the world? Why might demand be more inelastic in the U.S. than in Europe, China, Canada, or Mexico? Is the highly inelastic demand for gasoline in the U.S. inevitable? Have students brainstorm a list of what changes could take place (both shorter term and longer term) that would make the demand for gasoline in the U.S. more elastic. Also, you can have students think about the impact that gas taxes have on gasoline consumption in the U.S. (though this will be more formally addressed in Chapter 8, introducing this concept now can get students thinking about the important role that elasticities play in market outcomes).

Part 2 . A CLOSER LOOK AT MARKETS

USING EYE ON YOUR LIFE  Your Price Elasticities of Demand This Eye presents an interesting discussion explaining how the students can determine if their demand for a good or service is elastic, inelastic, or unit elastic. You can point out to your students that this information is useful when they are thinking about public policies such as taxation. In particular, would they rather see a tax imposed on a product for which their demand is elastic or inelastic? Though this topic is handled more formally in a future chapter, you can point out to your students that almost surely they would prefer that the product with the more elastic demand be taxed. Why? When their demand is elastic, there are other goods which are close substitutes. As a result, if the price of the taxed product rises as a result of the tax, the students can readily find other products to take its place and thereby avoid paying most of the tax. On the other hand, if their demand for the good or service is inelastic, there are no close substitutes for the specific product. In this case, if the price of the product rises when the tax is imposed, the students will wind up buying some of it anyway and thereby are unable to escape the effect of the tax. By presenting this sort of intuitive, “realworld” discussion in this chapter you can be extremely helpful in conveying to students the basic intuition about tax incidence, which is studied more formally in an up-coming chapter.

Chapter 5 . Elasticities of Demand and Supply

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 5.1: The Price Elasticity of Demand 1. The price of spring water rises from $1.90 to $2.10 a bottle, and the quantity demanded decreases from 11 million to 9 million bottles a week. 1a. Calculate the percentage change in the price of spring water. 1b. Calculate the percentage change in the quantity demanded of spring water. 1c. Is the demand for spring water elastic or inelastic? 1d. Would the demand for Pepsi be more elastic or less elastic than the demand for spring water? Why? 1e. Calculate the price elasticity of demand for spring water. 1f. At what price is the price elasticity of demand for spring water equal to your answer in part (e)? 1g. What is the change in the total revenue of sellers of spring water? 1h. If the demand curve for spring water is a straight-line demand curve, is the price at which the demand for spring water is unit elastic a higher price or a lower price than your answer to part (f)? Why? 2.

Draw a straight-line demand curve and note three points on the curve. Point A should have an elasticity greater than 1, point B should have an elasticity equal to 1, and point C should have an elasticity less than 1.

What role does the presence or absence of substitutes play in determining the size of the price elasticity of demand?

Is the demand for a luxury likely to be more or less price elastic than the demand for a necessity? Why?

 Checkpoint 5.2: The Price Elasticity of Supply 5. The price of U.S.-produced long grain rice fell by 40 percent from January 1999 to January 2000. In response to the price fall, growers of U.S. long grain rice planted 17 percent less acreage in 2000. If the harvest also decreases by 17 percent: 5a. How would you describe the supply of U.S. long grain rice? 5b. How do you think production possibilities and storage possibilities influence the price elasticity of supply of long grain rice? 5c. Calculate the price elasticity of supply of U.S.-produced long grain rice. 5d. If the price of long grain rice remains the same, do you think the elasticity of supply will change over the coming years? Explain your answer. 6a. Suppose that Podunk University wins the 2002 college basketball championship. As a result, Podunk U’s fans increase their demand for tickets for the 2003 season. Podunk U. plays in an arena that seats 7,000 people. De-

Part 2 . A CLOSER LOOK AT MARKETS

scribe the supply of basketball tickets at Podunk U. and draw a supply curve for tickets. 6b. Podunk U.’s economist has calculated the price elasticity of demand for tickets to be 0.50. Podunk U.’s president is committed to increasing the total revenue collected by the university. To do so, should Podunk raise or lower its ticket prices? 7.

Once harvested, rice is storable but strawberries are not. As a result, which will be more elastic: The supply of rice or the supply of strawberries?

 Checkpoint 5.3: Cross Elasticity and Income Elasticity 8. Suppose that when the price of a burger decreases from $2.00 to $1.75 and other things remain the same, the quantity demanded of burgers increases from 200 an hour to 400 an hour and the quantity demanded of pizza decreases from 400 an hour to 200 an hour. At the same time, the quantity demanded of soda increases from 150 an hour to 300 an hour. 8a. Calculate the cross elasticity of demand for soda with respect to burgers. 8b. Are soda and burgers substitutes or complements? Why? 8c. Calculate the cross elasticity of demand for pizza with respect to burgers. 8d. Are pizza and burgers substitutes or complements? Why? 8e. Describe how the demand for soda and the demand for pizza have changed. 9.

When Jody's income increases by 10 percent and other things remain the same, Jody decreases the quantity demanded of macaroni and cheese by 20 percent and increases the quantity demanded of chicken by 5 percent. 9a. Calculate the income elasticity of demand for macaroni and cheese. 9b. Is macaroni and cheese a normal good or an inferior good? Why? 9c. Calculate the income elasticity of demand for chicken. 9d. Is chicken a normal good or an inferior good? Why? 9e. Is the demand for chicken income elastic or income inelastic?

 Answers  Checkpoint 5.1: The Price Elasticity of Demand 1a. The percentage change in price is 10 percent. The midpoint method shows  $2.10 − $1.90   × 100 , which is 10 percent. the percentage change is   ($2.10 + $1.90) ÷ 2 )  1b. The percentage change in quantity is 20 percent. The midpoint method  11 million − 9 million   × 100 , which is shows the percentage change is   ( ) 11 million 9 million) 2 + ÷   20 percent. 1c. The demand for spring water is elastic because the percentage change in quantity demanded is greater than the percentage change in price. © 2015 Pearson Education, Inc.

Chapter 5 . Elasticities of Demand and Supply

1d. The demand for Pepsi is probably less elastic than the demand for spring water because fewer close substitutes exist for Pepsi. Coke and perhaps R.C. Cola are very close substitutes, but other sodas, such as Mountain Dew, are less close substitutes. Any brand of water, for example Aquafina or Polar, or even plain tap water are substitutes for spring water. 1e. The price elasticity of demand equals 20 percent ÷ 10 percent, which is 2.0. 1f. The price at which the elasticity of 2.0 applies is the average price of $2.00 a bottle. 1g. The change in total revenue = −$2,000,000. This amount is the difference between the initial total revenue of $20,900,000 ($1.90 × 11 million bottles) and the new total revenue of $18,900,000 ($2.10 × 9 million bottles). So, the seller’s total revenue decreases by $2 million. 1h. The demand for spring water is unit elastic at a price lower than $2.00 a bottle. At $2.00 a bottle, the elasticity equals 2.00. Moving down along a linear demand curve, the elasticity falls in value. As we move down the demand curve, we will eventually reach the quantity at which the elasticity of demand is equal to 1. 2.

Although your students’ demand curves will be different from the demand curve in Figure 5.1, there are certain features that must be the same. First, point B, the point with the unit elasticity, must be at the midpoint of the demand curve. Second, point A, the point at which the elasticity exceeds 1.0, must lie above point B on the demand curve. And third, point C, the point at which the elasticity is less than 1, must lie below point B on the demand curve.

The more substitutes there are for a good or service, the more elastic is the demand for the good or service. So, the more substitutes, the larger is the price elasticity of demand.

The demand for a luxury is generally more price elastic than the demand for a necessity. There are many substitutes for a luxury, including going without. There are not as many substitutes for a necessity.

Part 2 . A CLOSER LOOK AT MARKETS

 Checkpoint 5.2: The Price Elasticity of Supply 5a. The supply of long grain rice is inelastic. The percentage change in the quantity supplied is less than the percentage change in the price. 5b. Once the seed has been planted, the supply of rice becomes fixed for that period making supply inelastic unless the price drops so low that farmers decide not to harvest the rice. Once harvested, rice is a storable good which makes supply more elastic. 5c. The price elasticity of supply equals 17 percent ÷ 40 percent, which is 0.425. 5d. If price remains low, fewer farmers raise rice. As the price stays low, some farmers leave the market. So, as more time passes, the quantity supplied decreases by more and supply becomes more elastic. 6a. The supply is perfectly inelastic because the number of seats can only be supplied in a fixed quantity. Figure 5.2 illustrates the supply curve. 6b. If the university wants to increase its total revenue, it should increase ticket prices. The elasticity of demand for tickets equals 0.5, so demand is inelastic. If ticket prices increase, the percentage decrease in the quantity of tickets demanded is less than the percentage increase in the price. Assuming Podunk U.’s economist is correct, raising ticket prices increase totals revenue.

The supply of rice is more elastic than the supply of strawberries. Suppose the price of each falls. Because rice can be stored, a fall in the price of rice leads to a large quantity being stored, so there is a large decrease in the quantity supplied. But strawberries cannot be stored, so a fall in the price of strawberries does not change the quantity supplied because the strawberries must be sold. So the fall in price results in only a small decrease in the quantity supplied.

 Checkpoint 5.3: Cross Elasticity and Income Elasticity 8a. The cross elasticity of demand of soda with respect to burgers is equal to (67 percent) ÷ (−13 percent), which is −5.15. The percentage changes are calculated using the midpoint method.

Chapter 5 . Elasticities of Demand and Supply

8b. Soda and burgers are complements because they are goods that are consumed together. The cross elasticity of demand for a complement is negative. 8c. The cross elasticity of demand of pizza with respect to burgers is equal to (−67 percent) ÷ (−13 percent), which is 5.15. The percentages changes are calculated using the midpoint method. 8d. Pizza and burgers are substitutes because they are foods that can be consumed in place of each other. The cross elasticity of demand for a substitute is positive. 8e. The demand for soda has increased and the demand curve has shifted rightward. The demand for pizza has decreased and the demand curve has shifted leftward. 9a. The income elasticity of demand for macaroni and cheese is equal to (−20 percent) ÷ (10 percent), which is −2.00. 9b. Macaroni and cheese is an inferior good because as Jody’s income increases, she consumes less of it. The income elasticity of demand for an inferior good is negative. 9c. The income elasticity of demand for chicken is equal to (5 percent) ÷ (10 percent), which is 0.50. 9d. Chicken is a normal good because as Jody’s income increases, she consumes more of it. The income elasticity of demand for a normal good is positive. 9e. The demand for chicken is income inelastic the percentage change in the quantity of chicken demanded is less than the percentage change in income.

Chapter

Efficiency and Fairness of Markets CHAPTER OUTLINE 1. Describe the alternative methods of allocating scarce resources and define and explain the features of an efficient allocation. A. Resource Allocation Methods 1. Market Price 2. Command 3. Majority Rule 4. Contest 5. First-Come, First-Served 6. Sharing Equally 7. Lottery 8. Personal Characteristics 9. Force B. Using Resources Efficiently 1. Efficiency and the PPF 2. Marginal Benefit 3. Marginal Cost 4. Efficient Allocation 2. Distinguish between value and price and define consumer surplus. A. Demand and Marginal Benefit B. Consumer Surplus 3. Distinguish between cost and price and define producer surplus. A. Supply and Marginal Cost B. Producer Surplus 4. Evaluate the efficiency of the alternative methods of allocating resources. A. Marginal Benefit Equals Marginal Cost B. Total Surplus Is Maximized C. The Invisible Hand D. Market Failure 1. Underproduction and Overproduction 2. Deadweight Loss

Part 2 . A CLOSER LOOK AT MARKETS

E. Sources of Market Failure 1. Price and Quantity Regulations 2. Taxes and Subsidies 3. Externalities 4. Public Goods and Common Resources 5. Monopoly 6. High Transactions Costs F. Alternatives to the Market 5. Explain the main ideas about fairness and evaluate the fairness of the alternative methods of allocating scarce resources. A. It’s Not Fair If the Rules Aren’t Fair B. It’s Not Fair If the Result Isn’t Fair C. Compromise

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 6 has been slightly revised from the sixth edition, with “Underproduction” and “Overproduction” being combined in one subheading, “Deadweight Loss” given its own subheading, and a revised “Eye on the U.S. Economy.”

 Where We Are We explore the conditions of market efficiency and whether market outcomes are fair. On the consumer side, we make the distinction between value and price. On the producer side, we make the distinction between cost and price. We mention factors that prevent efficiency from occurring.

 Where We’ve Been We’ve explored the motivation behind studying economics. We’ve developed the demand and supply model that helps us visualize how markets determine prices and quantities.

 Where We’re Going The next chapters continue to use the demand and supply framework to study government intervention in the market. Chapter 7 studies taxes, price ceilings, price floors, and price supports and demonstrates how these polices can lead to inefficiency. Chapter 8 looks at global markets. Chapter 9 concludes by studying externalities. Efficiency plays a key role in all these chapters.

Chapter 6 . Efficiency and Fairness of Markets

IN THE CLASSROOM  Class Time Needed You might be able to complete this chapter in two sessions, but because this material is so important, consider using three sessions and making sure that students understand why efficiency requires the equality of marginal benefit and marginal cost and why underproduction and overproduction lead to deadweight losses. Also, the more time spent introducing the obstacles to efficiency, the better students will understand where this course is moving towards later in the semester. An estimate of the time per checkpoint is: •

6.1 Allocation Methods and Efficiency—10 to 15 minutes

•

6.2 Value, Price, and Consumer Surplus—30 to 45 minutes

•

6.3 Cost, Price, and Producer Surplus—30 to 45 minutes

•

6.4 Are Markets Efficient?—30 to 45 minutes

•

6.5 Are Markets Fair?—10 to 15 minutes

Class Activity: Some years ago, Jim Tobin told Michael Parkin about a nice test of whether a person is a liberal or a conservative. It also generates a good classroom discussion. Here’s how it goes. Give the students the following scenario and question: You are at an oasis in a large desert and you have some ice cream in an unmovable refrigerator. (Ice cream is the only food available). The people in the next oasis some miles away have no ice cream (and no other food) and are too old and infirm to travel. You have plenty of ice cream and you can transport it to the next oasis, but on the journey, some of it will melt. Now the question: How much of the ice cream would have to survive the journey for it to be worth transporting to the next oasis? The most liberal would transport if only the smallest percentage survived the journey. The most conservative would want a large proportion to survive before undertaking the redistribution.

Part 2 . A CLOSER LOOK AT MARKETS

CHAPTER LECTURE 6.1

Allocation Methods and Efficiency

Lecture Launcher: Launch your lecture by drawing a demand curve and telling your students that this curve has two interpretations. The common interpretation, that the students have seen many times before, starts at a price, goes horizontally to the demand curve, and then down vertically to the quantity. The interpretation of this approach is the “standard” one: At the given price, the demand curve shows the quantity demanded. But then point out to the students that it is possible to pick a quantity, go vertically up to the demand curve, and then horizontally to the price. The interpretation of this method differs from the first. The interpretation here is that for the given quantity, the demand curve shows the maximum price for which someone is willing to buy the selected quantity. Point out that the maximum price equals the value to the consumer and that the value also equals the marginal benefit. Thus you have demonstrated to the students that the demand curve is the same as the marginal benefit curve. (Depending upon your student population, you may want to use actual numbers for the price and quantity, as it can make the otherwise abstract discussion more concrete and approachable.) Although done just with words and a diagram, this chapter explains the astonishing so-called “first fundamental theorem of welfare economics” that under appropriate conditions, a competitive equilibrium is Pareto efficient. Though the textbook does not discuss Pareto efficiency, if you choose you can provide your students with more background to this astonishing result. It begins with Adam Smith’s invisible hand conjecture. But Adam Smith’s conjecture did not receive formal proof until the 1950s. Sir John Hicks, Kenneth Arrow, and Gerard Debreu, are credited with the major contributions to welfare economics and all received the Nobel Prize in Economic Sciences for their work for Kenneth Arrow and Gerard Debreu. Lionel McKenzie is also credited with a major independent statement of the theorem and some economists refer to it as the Arrow-Debreu-McKenzie theorem. The A-D-M proof is deeper and more restricted that the arm waving words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter.) •

Because resources are scarce, they must be allocated. There are a variety of allocation methods that can be used: • Market price: The people who are willing and able to pay the price get the resource. • Command: A command system allocates resources by the order of someone in authority. Current examples are North Korea and Cuba. • Majority rule: A vote determines who gets the resource. Elected governments allocate some of our resources. • Contest: The winner gets the resource. Contests work well when the efforts of the players are hard to monitor and reward directly. An example is the contest of top executives to become the next CEO. © 2015 Pearson Education, Inc.

Chapter 6 . Efficiency and Fairness of Markets

•

First-come, first-served: National parks and tickets to college football games often are allocated using first-come, first-served. • Sharing equally: Works well with small groups, for example, roommates. • Lottery: The winner gets the resource. Landing slots at some airlines and some draft choices in the NBA are allocated using lotteries. • Personal characteristics: People with the right characteristics get the resource. This method can lead to discrimination. • Force: The strongest gets the resource. Theft is an example; so, too, is taxation. Allocative efficiency is achieved when the quantities of goods and services produced are those that people value most highly. The production possibilities frontier is the boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology. •

Allocative Efficiency and the PPF: • Allocative efficiency is achieved when the combination of goods and services produced on the PPF are those that are valued most highly. To know what combination of goods and services is most valued, we need to understand marginal cost and marginal benefit. • Marginal Benefit is the benefit people receive from consuming one more unit of a good or service. Preferences determine marginal benefit and we can measure the marginal benefit from a good or service by what people are willing to give up to get one more unit of it. • Marginal Cost is the opportunity cost of producing one more unit of a good or service and is measured by the slope of the PPF.

•

Books 0

200

400

600

Marginal cost of a book (movies per book) 0.5 1.0 1.5

•

An allocatively efficient use of resources requires that marginal benefit equal marginal cost. • In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up. © 2015 Pearson Education, Inc.

Part 2 . A CLOSER LOOK AT MARKETS

100

• •

6.2

When the allocatively efficient number of books, 200 per month, is produced, the PPF shows that the allocatively efficient number of movies is 500 movies per month. When marginal cost equals marginal benefit, the efficient allocation—the highestvalued allocation—has been achieved because it is impossible to make people better off by reallocating resources.

Value, Price, and Consumer Surplus

 Land Mine: The consumer surplus, producer surplus, and deadweight loss are all generally triangular in shape. Indeed, if you draw only linear demand and supply curves and do not make either curve vertical or horizontal, these surpluses and any deadweight loss are triangles. So, it is a good idea to remind your students of the formula for calculating the area of a triangle. Make sure to do several examples of the calculation for both consumer and producer surplus. Remind them that this area represents a dollar value. This reminder is especially useful when you quantify the deadweight losses created by monopolies, quotas, subsidies, etc. Many students just see the loss to society as a loss of jobs or less output, but you can create more intuition by putting the loss in dollar terms. It always helps to use colored chalk, overheads, or PowerPoint slides when dividing up the demandsupply graph into producer surplus, consumer surplus, and deadweight loss. By consistently using colored chalk or the other techniques, you can refer to area by color (“The green area shows consumer surplus and the red area shows the deadweight loss.”) The size of the areas are much more apparent. Additionally, you don’t need to go back to the screen or board to try to outline the area. Students easily associate green with growth (“go”) and red with deficit (as in “in the red.”)

Demand and Marginal Benefit •

The value of one more unit of a good or service is its marginal benefit. Marginal benefit is measured as the maximum price that people are willing to pay for another unit of a good or service.

•

The willingness to pay for a good or service determines the demand for it. So, as illustrated in the figure, a demand curve for a good or service is also its marginal benefit curve. •

Chapter 6 . Efficiency and Fairness of Markets

•

101

6,000,000th gallon of milk per month is $3, so $3 is the value and marginal benefit of this gallon. Consumer surplus is the marginal benefit from a good or service minus the price paid for it, summed over the units purchased. The figure illustrates the consumer surplus as the shaded triangle when the price is $3 per gallon.

6.3

Cost, Price, and Producer Surplus

Supply and Marginal Cost •

The cost of one producing more unit of a good or service is its marginal cost. Marginal cost is the minimum price that producers must receive to induce them to produce another unit of the good or service. And the minimum acceptable price determines the quantity supplied. So, as illustrated in the figure, a supply curve for a good or service is also its marginal cost curve. •

•

6.4

The supply curve in the figure shows that the minimum price a producer must receive to be willing to produce the 6,000,000th gallon of milk per month is $3, so $3 is the marginal cost of this gallon.

Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity produced. The figure illustrates the producer surplus as the shaded triangle when the price is $3 per gallon.

Are Markets Efficient?

Marginal Benefit Equals Marginal Cost •

A competitive equilibrium is the quantity at which the quantity demanded equals the quantity supplied. In the figure, the equilibrium quantity is 6 million gallons.

•

The efficient quantity is the quantity at which the marginal benefit of the last unit produced equals its marginal cost. In the figure, the efficient quantity is 6 million gallons.

•

Part 2 . A CLOSER LOOK AT MARKETS

102

same as the MC curve, the quantity that sets the MB equal to the MC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. The equilibrium quantity is, therefore, also the efficient quantity.

Total Surplus Is Maximized The total surplus from a good or service is the sum of the producer surplus plus the consumer surplus. As the figure shows, when the efficient quantity of milk is produced, the sum of the consumer surplus and producer surplus is maximized.

The Invisible Hand Adam Smith, in his 1776 book The Wealth of Nations, articulated how competition led selfinterested consumers and producers to make choices that unintentionally promote the social interest as if they were led by an “invisible hand.”

Market Failure •

A market failure is a situation in which the market delivers an inefficient market outcome.

•

If the market does not produce the efficient quantity, it will either produce less than the efficient quantity— underproduction—or produce more than the efficient quantity— overproduction.

•

In either case, a deadweight loss occurs. A deadweight loss is the decrease in the consumer surplus and producer surplus that results from producing an inefficient quantity of a good. The figure illustrates the deadweight loss from overproduction of milk and from underproduction.

Sources of Market Failure  Land Mine: Don’t get too hung up on the mechanics of how the sources of market failure work at this point. Just note at this stage that they bring either underproduction or overproduction and emphasize the deadweight loss that they generate. The list is a guide to what is coming with details coming in later chapters. •

The key obstacles to achieving an efficient allocation of resources in a market are: •

Price and Quantity Regulations: Price regulations include price ceilings (which sets the highest legal price, such as rent ceilings) and price floors (which set the lowest legal price, such as a minimum wage). If a price regulation makes the equilibrium price il© 2015 Pearson Education, Inc.

Chapter 6 . Efficiency and Fairness of Markets

• •

•

103

legal, it leads to inefficiency. Quantity regulations can limit the amount that can be produced and so lead to inefficiency. Taxes and Subsidies: Taxes and subsidies place a wedge between the prices consumers pay and the prices producers receive. Both can lead to inefficiency. Externalities: Externalities mean that the demand curve is not the same as the marginal benefit curve and/or the supply curve is not the same as the marginal cost curve. In these cases, the equilibrium quantity is not the same as the efficient quantity. Public Goods and Common Resources: A public good benefits everyone and no one can be excluded from its benefit. A public good leads to a free-rider problem, in which people do not pay for their share of the good, which can lead to inefficient underproduction. Common resources are owned by no one but used by everyone. They are over-used and lead to the tragedy of the commons. Monopoly: A monopoly is a firm that is the sole provider of a good or service. To maximize its profit, a monopoly produces less than the efficient quantity and so creates inefficiency. High Transactions Costs: The opportunity cost of buying and selling in a market is the transactions costs. If transactions costs become too high, the market might underproduce.

Alternatives to the Market •

When a market overproduces or underproduces, one of the alternative allocation methods might work better. • • •

6.5

Managers in firms issue commands and avoid the transactions costs of having to pay for each individual bit of work. First-come, first-serve is used in many instances, such as lines at the ATM, rather than buying a spot in the line. Sometimes, however, the deadweight loss is the result of a self-interested group taking advantage of majority rule to benefit themselves at a cost to everyone else.

Are Markets Fair?

It’s Not Fair If the Rules Aren’t Fair •

This perspective emphasizes equality of economic opportunity rather than equality of economic outcomes. Robert Nozick suggests governments should promote fairness by establishing property rights for individuals and allowing only voluntary exchange of these resources. If private property rights are enforced, if voluntary exchange takes place in a competitive market, and if there are none of the obstacles to efficiency listed before, then the competitive market is fair.

 Land Mine: Students generally expect to be graded based on their performance in the class. This scheme is a “fair rules” view of fairness. Discuss this observation with the class, and then ask if it would be fairer to grant everyone an A—a “fair results” view. How about automatically giving every student a C or a D or an F—would this be fair? If automatically giving © 2015 Pearson Education, Inc.

Part 2 . A CLOSER LOOK AT MARKETS

104

students an A is fair, why isn’t it equally fair to automatically give each student an F? Or, suppose on the final day of class, the rules of the course are changed so that regardless of a student’s previous scores, the student will be given an A—is this change fair? What if the student was automatically given an F—is this change fair?

It’s Not Fair If the Result Isn’t Fair • •

This principle argues that fairness requires equality of incomes, which requires that incomes be redistributed. Redistribution leads to the big tradeoff, the tradeoff between efficiency and equity. The tradeoff occurs because taxes decrease people’s incentives to work, thereby decreasing the size of the “economic pie.” In addition, taxes lead to administration costs that also decrease the economic pie.

 Land Mine: You could spend the rest of the course talking about and discussing equity, fairness, or distributive justice as it is sometimes called. The textbook contains a nice section laying out the basics needed to discuss fairness. This material is not standard and you’ll be hard pressed to find it in any other principles text. It is included here because students are very curious about what is fair - and the news media writes and talks of little else when it discusses economic issues.

Compromise •

The extremity of Nozick’s argument is alleviated in practice through taxes which redistribute income from the rich to the poor. Because the taxes are voluntarily agreed upon in democratic process, these income transfers may be considered fair. What constitutes a fair tax system will be examined further in Chapter 8.

Chapter 6 . Efficiency and Fairness of Markets

USING EYE ON THE U.S ECONOMY  The Invisible Hand and e-Commerce You can use this example to show consumer and producer surplus and how they differ for different individuals. Remind students that market demand curves are the addition of individual demand curves and therefore consumer surplus differs across people. (The same is true for supply curves.) As a result, as the cold drink vendor sells cold drinks, most people receive a consumer surplus from their purchase (the market price is less than the value they place on the drink). And the vendor is receiving producer surplus from selling cold drinks (the market price is greater than his marginal cost). That’s typically the end of the story. For the man on the bench though, it’s not the cold drink that provides the consumer surplus, but the umbrella, so he offers to buy the umbrella. Once the man on the bench makes the offer for the umbrella, the vendor realizes that he can realize a producer surplus from selling the umbrella, too. What price did the man offer for the umbrella? A price low enough to provide him some consumer surplus. What price was the vendor willing to accept? A price high enough to provide him some producer surplus. It’s always important to remind students that market transactions are not zero-sum games. It’s not that one side wins and the other loses – trade is mutually beneficial. The purchasing of the umbrella must have created gains for both the man on the bench (consumer surplus) and the vendor (producer surplus) or else the transaction never would have taken place.

USING EYE ON PRICE GOUGING  Should Price Gouging Be Illegal? You can use this Eye and Mr. Shepperson’s case explained in it to engage your students in an interesting debate surrounding the pros and cons associated with price gouging. Ask students to take a stance on whether Mr. Shepperson’s actions improved market efficiency and whether or not it was fair. While the efficiency associated with Mr. Shepperson’s actions is straightforward, whether or not his actions were “fair” can be argued in various ways. In this situation, the market price of generators rose significantly and this higher price encouraged Mr. Shepperson to purchase generators, rent a moving truck, and drive 600 miles to meet the increased demand. Those who can afford the higher price he charges will have a generator, thereby reducing the market shortage and deadweight loss. Those who cannot afford the higher price must do without power. The result is efficient, but is it fair? According to Nozick, it would be fair because all the affected people have equal access to the generators. Ask students if they personally think it was fair. Would their answer change if they knew that Mr. Shepper-

105

106

Part 2 . A CLOSER LOOK AT MARKETS

son was far poorer than the people to whom he sold the generators? Or if he was far wealthier? Or if he was just as well off as his customers? Obviously, the debate surrounding whether or not price gouging should be illegal is complicated by the different perspectives about its fairness. However, beyond the fairness debate, even defining what constitutes price gouging is not universally agreed upon. Ask your students to try to legally define price gouging. Attempts to define price gouging tend to be far too ambiguous to guide straightforward laws. Take the definition provided in this book: “selling an essential item for a much higher price than normal.” What items are unequivocally “essential”? Should our courts make a list of essential items that are subject to price gouging laws and anything else is fair game? Should this list be nationwide, statewide, or differ from county-to-county? Also, what is a good’s “normal” price? Wouldn’t that always be subject to changes in supply and demand? Finally, what exactly does “much higher” mean? Should a 10 percent price hike be considered price gouging? 50 percent? 100 percent? Attempts to define price gouging conjure up a statement made by Supreme Court Justice Potter Stewart in 1964 about pornography. He said that he couldn’t define pornography, “but I know it when I see it.” This case-by-case, subjective mindset is similar to the approach that most people take when trying to define price gouging. While this may work fine for people’s own perceptions, it’s not an ideal base for concrete laws.

USING EYE ON YOUR LIFE  Allocation Methods, Efficiency, and Fairness You can use this Eye to springboard to a discussion of many political issues. If you would like a controversial and timely issue, you can tackle health care. Challenge your students to think why healthcare ought not to be allocated strictly according to the market. Why do so many people believe that government intervention is necessary in the health care market? If students respond that health care is a matter of life or death, you can point out that for people living in the North, warm clothing is a matter of life or death but the government does not intervene in the clothing market. What exactly makes health care different? You probably should not take a dogmatic stand, but push your students to think deeply about these issues because issues of market allocation will be with them for all their lives.

Chapter 6 . Efficiency and Fairness of Markets

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 6.2 Value, Price, and Consumer Surplus 1. Figure 6.1 shows the demand for soft drinks. Use the figure to answer the following questions: 1a. What is the value of the 30th can of soft drink? 1b. What is the willingness to pay for the 10th can of soft drink? 1c. What is the consumer surplus on the 10th can of soft drink if the price is 50¢ a can? 1d. What are the quantity of soft drinks bought and the consumer surplus if the price is 50¢ per can? 1e. What is the total amount paid for the soft drinks in question (d)? 1f. What is the total benefit from the soft drinks bought in question (d)? 1g. If the price of a soft drink rises to $1.00 a can, what is the change in the consumer surplus?  Checkpoint 6.3 Cost, Price, and Producer Surplus 2. Figure 6.2 shows the supply of soft drinks. Use the figure to answer the following questions: 2a. What is the marginal cost of the 30th can of soft drink? 2b. What is the minimum supply price of the 10th can of soft drink? 2c. What is the producer surplus on the 10th can of soft drink if the price is $1.50 a can? 2d. What are the quantity of soft drinks produced and the producer surplus if the price is $1.50 a can? 2e. What is the total revenue from the soft drinks sold in question (d)? 2f. What is the cost of producing the soft drinks sold in question (d)? 2g. If the price of a soft drink falls to $1.00 a can, what is the change in the producer surplus? © 2015 Pearson Education, Inc.

107

108

Part 2 . A CLOSER LOOK AT MARKETS

 Checkpoint 6.4 Are Markets Efficient? 3. Figure 6.3 shows the market for soft drinks. Use the figure to answer the following questions: 3a. What are the equilibrium price and equilibrium quantity of soft drinks? 3b. In market equilibrium, what is the consumer surplus? 3c. In market equilibrium, what is the producer surplus? 3d. Is the market for soft drinks efficient? Why? 3e. If the government restricted producers to 10 cans of soft drinks a day, would the market for soft drinks be efficient? Why? 3f. In the situation described in part (e), what is the deadweight loss? 3g. If the government passed a law requiring producers of soft drinks to sell 20 cans a day, would the market for soft drinks be efficient? Why or why not? 3h. In the situation described in part (g), what is the deadweight loss? 4.

Figure 6.4 shows the market for carnations. In recent years, the U.S. government has removed a quantity regulation (a quota) on imported carnations. Suppose that in 1990, the United States only allowed florists to import 30 tons of carnations each week. As a result, the supply curve of carnations to the United States, which is not the same as the “supply=marginal cost” curve, was vertical at 30 tons. The price at that time was $400 a ton of carnations. Today, the regulations have been removed and florists now import 60 tons of carnations and the price is $300 a ton of carnations. 4a. What were the producer and consumer surplus while the quantity regulation was in effect? What was the deadweight loss? 4b. What is the producer and consumer surplus now that the regulation has been removed? 4c. Which outcome is efficient, with the regulation or without?

Chapter 6 . Efficiency and Fairness of Markets

 Checkpoint 6.5 Are Markets Fair? 5. Figure 6.5 shows the market for electrical generators before and after a hurricane, with the demand curves labeled “before” and “after.” 5a. What is the producer surplus and consumer surplus before the hurricane? 5b. What is the producer surplus and consumer surplus after the hurricane? 5c. What is the equilibrium price and quantity after the hurricane? Is this outcome efficient? 5d. Under which rule is the outcome after the hurricane fair?

A drought has drastically reduced the water available in a desert town. The only store decides to sell the bottled water it has at the highest price that people are willing to pay. 6a. Who gets to consume the water? 6b. Who receives the consumer surplus on water? 6c. Who receives the producer surplus on water? 6d. Is the outcome efficient? 6e. Is this outcome fair or unfair? 6f. By what principle of fairness is the outcome fair or unfair? 7.

Is it fair that Roger Federer wins so many tennis championships? Suppose the following rule were adopted: After three wins in a season, a professional tennis player is not permitted to compete for the rest of the season. Would this rule be fair? Explain why or why not.

Two roommates, Ratna and Sara, decide to cut their expenditure by buying one copy of the required math textbook and sharing it. 8a. What allocation methods do you think they would consider as feasible? 8b. What allocation method do you think would be more efficient? Would this allocation method be fair? Explain why or why not. 8c. In the last week of the semester, as the final exam approaches, how do you think the agreed allocation method would work out?

109

110

Part 2 . A CLOSER LOOK AT MARKETS

 Answers  Checkpoint 6.2 Value, Price, and Consumer Surplus 1a. The value of the 30th can of soft drink is $0.50. 1b. A consumer is willing to pay $1.50 for the 10th can of soft drink. 1c. The consumer surplus is the difference between the marginal benefit, which is what a consumer is willing to pay for the 10th can and the price paid for the can. The consumer’s marginal benefit from the 10th can is $1.50 and the price is $0.50, so the consumer surplus equals $1.00. 1d. 30 cans of soft drink are bought. The consumer surplus is the area below the demand curve and above the market price. The area of this triangle equals 1/2 × (the base) × (the height), so the consumer surplus equals ½ × (30 cans) × ($1.50), which is $22.50. 1e. The total amount paid = 30 cans × $0.50 = $15.00. 1f. The total benefit = $15.00 + $22.50 = $37.50. 1g. If the price of soft drinks rises to $1.00 per can, consumer surplus falls to $10. The change in consumer surplus is $10.00 − $22.50, which is −$12.50.  Checkpoint 6.3 Cost, Price, and Producer Surplus 2a. The marginal cost of the 30th can is $2.00. 2b. The minimum supply price of the 10th can is $1.00. 2c. Producer surplus is the price of a good minus the marginal cost of producing it, which is its opportunity cost. On the 10th can, the producer surplus is $1.50 − $1.00, which is $0.50. 2d. 20 cans of soft drinks are produced. The producer surplus is the triangular area above the supply curve and below the market price. The area of a triangle equals 1/2 × (base) × (height), which is 1/2 × (20 cans) × ($1.00)= $10.00. 2e. The total revenue is equal to 20 cans × $1.50, which is $30.00. 2f. The total cost can be calculated as the area under the supply curve. Alternatively, the cost equals the total revenue minus the producer surplus, which is $30.00 − $10.00 = $20.00. 2g. If the price falls to $1.00 a can, producer surplus decreases to $2.50. The change in producer surplus is $2.50 − $10.00, which is −$7.50.  Checkpoint 6.4 Are Markets Efficient? 3a. The equilibrium price and equilibrium quantity are $1.25 and 15 cans. 3b. At market equilibrium, consumer surplus = $5.63. 3c. Producer surplus = $5.63. 3d. The market is efficient because 15 cans are produced and this is the quantity at which marginal cost equals marginal benefit. Resources are efficiently used. © 2015 Pearson Education, Inc.

Chapter 6 . Efficiency and Fairness of Markets

3e. If output is limited to 10 cans per day, the market is not efficient because when 10 cans are produced, the marginal cost ($1.00) does not equal marginal benefit ($1.50). The market is underproducing. 3f. The deadweight loss equals $1.25. 3g. If the government requires 20 cans to be produced each day, the market is not efficient because at 20 cans, marginal cost ($1.50) does not equal marginal benefit ($1.00). The market is overproducing. 3h. The deadweight loss equals $1.25. 4a. While the quantity regulation is in effect, producer surplus is $9,750 and consumer surplus is $1,500. The deadweight loss is $3,750. 4b. With the regulation removed, producer surplus is $9,000 and consumer surplus is $6,000. 4c. The situation without the quantity regulation is efficient because without it marginal benefit equals marginal cost.  Checkpoint 6.5 Are Markets Fair? 5a. Before the hurricane, the producer surplus is $2,250 and the consumer surplus is $750. 5b. After the hurricane, the producer surplus is $4,000 and the consumer surplus is $1,000. 5c. The equilibrium price is $200 and the equilibrium quantity is 40 generators a week. The outcome is efficient because marginal benefit equals marginal cost. 5d. According to the “fair-rules” principle, the outcome is fair because there is voluntary exchange of private property. 6a. The people who value the water the most consume the water because they will be the people willing to pay a high price for the water. 6b. The consumers who drink the water are the consumers who receive the consumer surplus. 6c. If there are no resales of water from one buyer to another at a higher price than the store charges, the store selling the water receives the producer surplus. If there are resales, then the reselling purchasers also receive producer surplus. 6d. The outcome is efficient. 6e. The outcome is unfair based on the fair-results principle because poor people can’t afford to buy the water, so the water is shared unequally. The outcome is fair based on the fair-rules principle because the store’s property rights are enforced and there is voluntary exchange between the store and buyers. 6f. The outcome is fair based on the fair-rules idea and unfair on the fair results idea. © 2015 Pearson Education, Inc.

111

112

Part 2 . A CLOSER LOOK AT MARKETS

Under a fair rules approach, it is fair that Roger Federer wins as many championships as he does because he is earning his income using his private property—his tennis skills. If a rule limiting wins was enacted, the “fair-rules” principle is violated because Mr. Federer is unable to sell his private property. Under a fair results approach, it is unfair because Mr. Federer’s income soars well beyond that of any other competitor. A fair results proponent argues in favor of a rule limiting the number of times a player can win because a limit would help equalize incomes.

8a. It is likely that they will propose two allocation schemes: sharing equally and first-come, first-serve. 8b. Probably of the two, first-come, first serve is most efficient because that way the book won’t lie unused if either Ratna or Sara want it but it’s the other roommate’s time to use the book. Of the allocation methods, sharing equally is fair under the “fair results” view if Sara and Ratna are otherwise comparable. The first-come, first-serve allocation method is not necessarily fair under the “fair results” approach if either Ratna or Sara winds up with more time using the book. Under the “fair rules” approach, sharing equally and first-come, first-serve are both fair because both have equality of opportunity to use the book. 8c. In the last week of the semester, presumably both would like to use the book. In this situation, probably sharing equally will create fewer complaints than first-come, first-serve if one of the roommates would otherwise always be first. Of course, if the book is lying unused and it is the other roommates turn to use the book, presumably the roommate whose turn it is not will use the book (first come, first serve) but then give it up if the other roommate appears and wants the book (sharing equally).

Government Actions in Markets

Chapter

CHAPTER OUTLINE 1. Explain how taxes change prices and quantities, are shared between buyers and sellers, and create inefficiency. A. Tax Incidence B. Taxes and Efficiency C. Incidence, Inefficiency, and Elasticity D. Incidence, Inefficiency, and the Elasticity of Demand 1. Perfectly Inelastic Demand: Buyer Pays and Efficient 2. Perfectly Elastic Demand: Seller Pays and Inefficient E. Incidence, Inefficiency, and the Elasticity of Supply 1. Perfectly Inelastic Supply: Seller Pays and Efficient 2. Perfectly Elastic Supply: Buyer Pays and Inefficient 2. Explain how a price ceiling works and show how a rent ceiling creates a housing shortage, inefficiency, and unfairness. A. A Rent Ceiling 1. A Black Market 2. Increased Search Activity B. Are Rent Ceilings Efficient? C. Are Rent Ceilings Fair? D. If Rent Ceilings Are So Bad, Why Do We Have Them? 3. Explain how a price floor works and show how the minimum wage creates unemployment, inefficiency, and unfairness. A. The Minimum Wage 1. Increased Job-Search Activity 2. Illegal Hiring B. Is the Minimum Wage Efficient? C. Is the Minimum Wage Fair? D. If the Minimum Wage Is So Bad, Why Do We Have It? 4. Explain how a price support in the market for an agricultural product creates a surplus, inefficiency, and unfairness. A. How Governments Intervene in Markets for Farm Products © 2013 Pearson Education, Inc. Publishing as Addison Wesley

114

Part 2 . A CLOSER LOOK AT MARKETS

1. Isolate the Domestic Market 2. Introduce a Price Floor 3. Pay Farmers a Subsidy B. Price Support: An Illustration 1. Free Market Reference Point 2. Price Support and Subsidy 3. Effects on the Rest of the World

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 7 is updated from the fifth edition, with updated data for the Eye applications.

 Where We Are We use the demand and supply graph to study how the government can influence markets. Taxes, price ceilings, price floors, and price supports can prevent markets from efficiently allocating resources. Examples show how these actions impact consumers and firms, how equilibrium prices and quantities change, and how they create deadweight losses.

 Where We’ve Been We’ve developed the demand and supply model, a tool to use in examining how markets determine their equilibrium prices and quantities. The elasticities of supply and demand reflect how responsive quantities are to a change in price. These ideas play an important role in showing how market interventions create inefficiency and unfairness.

 Where We’re Going The next chapter examines how global markets work and looks at the effects of government policies such as tariffs and quotas.

IN THE CLASSROOM 

Class Time Needed

If you have only a little participation and questions from the class, you might be able to cover these topics in two sessions to two and one half sessions. However, © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 7 . Government Actions in Markets

115

it would be a tight fit. If you have class participation and examples you want to present, this material can stretch to three lectures, which might be appropriate because this chapter is a reward to the students for mastering the three preceding chapters—demand and supply, elasticity, and efficiency and fairness. And the chapter provides you with an opportunity to “sell” economics as a highly valuable perspective on the world. Be careful presenting the material dealing with how taxes shift the supply or demand curve. This material can take more time than expected because students need to understand why a tax shifts the supply curve or demand curve vertically by the amount of the tax. Once they grasp this point, the rest of the material goes more quickly. Later, if you cannot fit both the price ceiling and price floor sections in one session, at least try to mention price floors after you cover price ceilings because you want the students to see that the topics are closely related. Price supports are more straightforward for the students to grasp after they have studied price floors, so less time needs to be spent on this topic. An estimate of the time per checkpoint is: •

7.1 Taxes on Buyers and Sellers—40 minutes to 50 minutes

•

7.2 Price Ceilings—20 minutes to 45 minutes

•

7.3 Price Floors—20 minutes to 45 minutes

•

7.4 Price Supports in Agriculture—15 minutes to 20 minutes

Classroom Activity: As homework, prior to beginning this chapter, you can require your students to use MyEconLab to find news articles on the economic impact of taxation. At the beginning of class, students could share what they had learned. I would assign the students to provide a copy of the article and a short type-written summary of the article’s main points. By requiring the work typed, the instructor is assured that students don’t just bring in any article but actually have to do some thinking. Classroom Activity: You can divide the class into three groups (local, state, and federal) and have each group brainstorm a list of types of pertinent taxes and what things those taxes support. These lists could then be shared with the entire class. The idea is to show a) that we do get something for our tax money and b) lead toward understanding the difference between those who pay and those who benefit. Classroom Activity: The fairness issue can be explosive, as one professor from an impoverished area has reported. Students from a community which barely managed on minimum wages interpreted the whole explanation of fairness as “minimum wages are bad” and couldn’t be persuaded differently. They had had at least 18 years of seeing differently. The trick here is to help students move from thinking as workers and consumers (which comes naturally) to thinking from the perspective of producers.

Part 2 . A CLOSER LOOK AT MARKETS

116

CHAPTER LECTURE 7.1

Taxes on Buyers and Sellers

Lecture launcher: You can involve students in your lecture on tax incidence by drawing the demand-supply graph and asking them if a tax was imposed in this market, which curve would be affected? You can ask for a show of hands or a voice vote, but you’ll probably get more votes for the demand curve because students see themselves—the consumer—as always paying the entire tax. Of course, the fun part of the lecture is showing how consumers rarely pay the entire tax.

Tax Incidence Tax incidence is the division of the burden of a tax between the buyer and the seller. The buyers’ burden arises when the price paid by the buyers rises after the tax is imposed. The sellers’ burden arises when the price they receive falls after the tax is imposed. The tax incidence does not depend on whether the tax law imposes the tax on buyers or on sellers. •

A tax on sellers: • Imposing a tax on sellers decreases the supply because the tax is like a cost that sellers must pay. The supply curve shifts leftward and the vertical distance between the initial supply curve and the new supply curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases. • The figure shows the effect of a tax imposed on sellers. The initial price is $12 and the initial quantity is 10,000. When the tax is imposed, the supply curve shifts from S to S + tax. The length of the double headed equals the amount of the tax, $2. With the tax imposed, buyers pay $13, sellers receive $11, and the quantity decreases to 9,000.

 Land Mine: Students have difficulty envisioning why the supply curve shifts with imposition of a sales or excise tax, especially because they’ve always believed it’s the buyer that pays the tax. They don’t seem to realize that it’s the firms that are responsible for sending the tax into the government. Remind them that this fact is why it makes sense to shift the supply curve leftward (reflecting this added “cost” to the firm).  Land Mine: A related stumbling block in this chapter is the result that imposing a tax shifts the supply curve so that the vertical distance between the curve without the tax and the curve with the tax is equal to the amount © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 7 . Government Actions in Markets

117

of the tax. Remember that in previous chapters there was emphasis on the horizontal nature of the shift, that is, a decrease in supply is represented by the supply curve shifting leftward. Tell your students that in this case the supply curve has again shifted leftward—only you do not know by how much it has shifted. After this lead-in, explain to the students that the vertical shift equals the amount of the tax. This explanation is easiest if you use numbers. For instance, suppose that before any tax is levied, 1 million cans of soda are supplied if the price of a can of soda is 75¢. This assumption means that suppliers will produce 1 million cans of soda if they receive 75¢ a can. Now suppose the government imposes a 25¢ a can tax on soda. To have suppliers produce 1 million cans of soda now requires that the price, including the tax, be $1.00 a can because from the $1.00 the 25¢ tax is paid, leaving suppliers with 75¢. •

•

A tax on buyers: • Imposing a tax on buyers decreases the demand because the tax lowers the amount they are willing to pay to the sellers. The demand curve shifts leftward and the vertical distance between the initial demand curve and the new demand curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases. • The figure shows the effect of a tax imposed on buyers. The initial price is $12 per DVD and the initial quantity is 10,000 DVDs per month. When the tax is imposed, the demand curve shifts from D to D − tax. The length of the double headed equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per DVD, sellers receive $11 per DVD, and the quantity of DVDs decreases to 9,000 per month. The figures above confirm the general conclusion: Regardless of whether the tax is imposed on buyers or sellers, the tax leads to the same outcome in which the new equilibrium price and quantity are identical. The tax burden is split the same way regardless of who is responsible for paying the tax to the government.

Taxes and Efficiency •

Taxes place a wedge between the price buyers pay and sellers receive. It therefore puts a wedge between marginal benefit and marginal cost and creates inefficiency. The quantity produced is less than the efficient quantity. © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 2 . A CLOSER LOOK AT MARKETS

118

•

Taxes create an excess burden, which is the amount by which the burden of a tax exceeds the tax revenue received by the government—the deadweight loss from a tax.

Incidence, Inefficiency, and the Elasticity of Demand •

•

Perfectly Inelastic Demand: Buyer Pays and Efficient: The buyer pays the entire tax if demand is perfectly inelastic (so the demand curve is vertical). In general, the less elastic the demand, the larger the tax burden paid by the buyers. When demand is perfectly elastic, the outcome is efficient because marginal cost equals marginal benefit. Perfectly Elastic Demand: Seller Pays and Inefficient: The seller pays the entire tax if demand is perfectly elastic (so the demand curve is horizontal) In general, the more elastic the demand, the larger the tax burden paid by the sellers. Because marginal benefit exceeds marginal cost, the outcome is inefficient.

Describe the situation faced by smokers, as the recent hike in the federal tax on cigarettes impacted many of your students. First, the demand for cigarettes is highly inelastic. So, with the government’s hefty taxes placed on cigarettes, the price paid by buyers rises substantially. The incidence of the tax falls heavily on buyers. In addition, state governments have sued tobacco companies for past and future health care costs arising from smoking-related illnesses. Tobacco companies settled these suits, paying billions of dollars in penalties, which raised their costs and decreased their supply. But smokers’ very inelastic demand for cigarettes means that the tobacco producers were able to pass on most of these costs to smokers without bearing a significant decrease in the quantity sold.

Incidence, Inefficiency, and the Elasticity of Supply •

•

Perfectly Inelastic Supply: Seller Pays and Efficient: The seller pays the entire tax if supply is perfectly inelastic (so the supply curve is vertical). In general, the more inelastic the supply, the larger the tax burden paid by the sellers. When supply is perfectly elastic, marginal benefit equals marginal cost, so the outcome is efficient. Perfectly Elastic Supply: Buyer Pays and Inefficient: The buyer pays the entire tax if supply is perfectly elastic (so the supply curve is horizontal). In general, the more elastic the supply, the larger the tax burden paid by the buyers. Marginal benefit exceeds marginal cost, so the outcome is inefficient.

If either the demand or the supply is perfectly inelastic, there is no deadweight loss from the tax because the equilibrium quantity does not change. In all other cases, there is a deadweight loss.

7.2

Price Ceilings

Lecture Launcher: Ask the students if they saw the article in the day’s local paper that the local government plans to place a $400 limit on rents that landlords could charge for apartments near campus. (Of course this story wasn’t in the paper, but students are more likely to pay attention if they think you’re serious! Don’t tell them this yet though.) Ask them to participate in an informal vote by raising a hand in response to “Who thinks this is a good idea?”, “Who thinks this is a bad idea?”, and “Who doesn’t care?” (This last one always

Chapter 7 . Government Actions in Markets

119

catches a few honest students who like to chuckle as they raise their hands!) Then explain to the students that this limit is called a “rent ceiling” and cities across the country have them… so they must be good, right? However, further explain that in this lecture, they’ll find out several ways that the government intervenes in markets and that while the ideas might sound good, they create problems. At the end of the lecture, definitely be sure to tell the students that the local government isn’t really going to impose the rent ceiling. Lecture Launcher: After introducing the intention of a rent ceiling and the impact it has on quantity demanded and quantity supplied, break your students into groups to see if they can connect back to chapter 6 and identify the impact on consumer surplus, producer surplus, total surplus, and deadweight loss. From there, ask your students to think about other changes that may take place in this market after the rent ceiling is imposed. Make sure to remind students to think not only from a renter’s standpoint, but also from the perspective of a landlord. If you were a landlord in this situation, how might you respond to this new requirement? (And encourage them to think outside of an ethical, or even legal, framework thinking deviously tends to inspire greater student participation in this exercise...) Bring the class back together and use the ideas of the groups to compile a list of potential unintended consequences associated with a rent ceiling. Help students understand that these consequences start to chip away at the economic well-being of renters, economic fairness, and market efficiency, thereby really calling into question not just if this policy is good for the market (which it obviously is not), but even if it is good for the group it is intending to help – renters. •

A price ceiling is a government regulation that places an upper limit on the price at which a particular good, service, or factor of production may be traded.

A Rent Ceiling •

A rent ceiling is a price ceiling applied to a housing market. A rent ceiling is a regulation that makes it illegal to charge more than a specified rent for housing.

•

A rent ceiling set below the equilibrium rent creates a shortage. In the figure, the equilibrium rent is $800 per month and the equilibrium quantity is 3,000 units rented. If a $600 per month rent ceiling is imposed, the quantity of units demanded increases (to 4,000 units in the figure) the quantity of units supplied decreases (to 2,000 units in the figure) and a shortage emerges (of 2,000 units in the figure).

•

Part 2 . A CLOSER LOOK AT MARKETS

120

price ceiling or price floor, be sure to label all the prices, quantities, and the ceiling or floor. In the case of the price ceiling, clearly label and emphasize the shortage created. In the case of the price floor, clearly label and emphasize the surplus created. As you add more lines to the demandsupply graph, there is always the chance for confusion. Many times the students leave the labels off, and when they go back to study, they can’t remember what that extra line is. So, be sure that you label the lines and stress to your class that they should be doing the same. Use price ceilings and floors to remind students that any surplus or shortage is a horizontal distance. Some students want to look at vertical distances or areas of triangles as the measure of the surplus or shortage. •

Rent ceilings lead to the development of black markets and increased search activity. • A black market is an illegal market that operates alongside a government-regulated market. The price in a black market exceeds the legally imposed price ceiling. In a black market illegal arrangements are made between renters and landlords—often at effective rental rates that are higher than would be the case in an unregulated market. •

Search activity is the time spent looking for someone with whom to do business.

Are Rent Ceilings Efficient? Rent ceilings lead to inefficiency. In a competitive market, the equilibrium quantity is the same as the efficient quantity. In a housing market with a rent ceiling, the quantity of units is less than the equilibrium quantity and so is less than the efficient quantity. There is a deadweight loss.

Are Rent Ceilings Fair? • •

Using the “fair rules” criteria, blocking voluntary exchange is unfair. Using the “fair outcomes” criteria, rent ceilings are fair if they help the poor and disadvantaged. Some other allocative mechanism, such as a lottery, queuing, some form of discrimination is often used to allocate housing. These alternative allocation methods of distribution do not favor the poor and disadvantaged.

Point out to the students that replacing the market price as an allocative mechanism for the rental market conflicts with the stated goals of those who promote rent ceilings as a means to create affordable housing. Rent ceilings lead to a shortage, which means landlords have more ability to discriminate against renters who have a different color of skin, or have a different religion, or who have too many tattoos or too many pierced body parts. In addition, there is less incentive for landlords to make needed electrical or plumbing repairs, or perform maintenance on appliances. Builders have less incentive to build new housing units so that in the long run, the stock of available housing will not grow with the population, making the shortage worse.

If Rent Ceilings Are So Bad, Why Do We Have Them? •

Current renters gain from the presence of rent ceilings and so they lobby politicians to maintain the ceilings.

Chapter 7 . Government Actions in Markets

7.3 •

121

Price Floors A price floor is a government regulation that places a lower limit on the price at which a particular good, service, or factor of production may be traded.

Lecture Launcher: To launch your lecture on the minimum wage, ask the students about jobs around town. Sound them out to see if there are a lot of jobs that pay the minimum wage. (Do not ask a particular student his or her wage, because he or she may be embarrassed if the wage is the minimum wage!) Then, ask the students if they think jobs would be easier or harder to find without the minimum wage. You can easily segue from the students’ answers to your lecture on the minimum wage and you also can easily interweave their answers into your lecture. Lecture Launcher: Try a similar exercise to that suggested previously for introducing the unintended consequences associated with rent ceilings. After introducing the intention of a minimum wage and the impact it has on quantity demanded and quantity supplied, break your students into groups to see if they can connect back to chapter 6 and identify the impact on consumer (firm) surplus, producer (worker) surplus, total surplus, and deadweight loss. Make sure to remind students that in labor markets, workers are the suppliers and firms are the demanders, which likely requires a shift in their perspective of where they fit in this model. From there, ask your students to think about other changes that may take place in this market after the minimum wage is imposed. Make sure to remind students to think not only from a worker’s standpoint, but also from the perspective of an employer. Present the students with a problem: they are restaurant owners. They are paying their workers the minimum wage and then the minimum wage is hiked. In the short run, if they are compelled to pay their workers a higher wage, what choices will they make? They can’t reduce their rent, as that’s fixed by contract. Can they reduce their use of supplies or reduce the quality of the other inputs they purchase? Perhaps—but turning out lights, shrinking portion sizes, using lower quality ingredients, etc., may backfire. Can they raise their price? Perhaps. But the restaurant business is incredibly competitive. If they raise their price, they risk losing a lot of business. In the short run, what other choices do they have? Bring the class back together and use the ideas of the groups to compile a list of potential unintended consequences associated with minimum wage. Help students understand that these consequences start to chip away at the economic well-being of workers, economic fairness, and market efficiency, thereby really calling into question not just if this policy is good for the market (which it obviously is not), but even if it is good for the group it is intending to help – low-wage workers.

The Minimum Wage •

When a price floor is applied to labor markets, it is called a minimum wage. A minimum wage law is a government regulation that makes hiring labor for less than a specified wage illegal.

•

If a minimum wage is set below the equilibrium wage, it has no impact.

Part 2 . A CLOSER LOOK AT MARKETS

122

•

If a minimum wage is set above the equilibrium wage rate, the quantity of labor demanded is less than the quantity of labor demanded. The minimum wage creates unemployment because some workers who are willing to work at the minimum wage will not find a job. •

A minimum wage set above the equilibrium wage leads to increased job-search activity and illegal hiring of workers paid less than the minimum wage.

Is the Minimum Wage Efficient? •

The equilibrium quantity of workers is the efficient quantity because that is quantity at which the marginal benefit to firms equals the marginal cost to workers. A minimum wage decreases the quantity of workers employed, so there is a deadweight loss with less than the efficient quantity of workers are employed.

Is the Minimum Wage Fair? •

A minimum wage gives unfair results because only the people who find jobs benefit. It has unfair rules because it blocks voluntary exchange.

 Land Mine: In essence, efficiency means we have a system that produces as large a pie as possible. Fairness means everybody should get the same size slice of pie. Or does it? Some people think your size of pie ought to correspond to how much work you did to help bake the pie. Many students will be familiar with the fable about a chicken who planted, tended, harvested, milled, and baked wheat, all the time inviting the assistance of the other farm animals. The other animals having refused to help with the work are ultimately denied a share in the output by the hard-working chicken.

If the Minimum Wage Is So Bad, Why Do We Have It? •

Some supporters believe that not much unemployment results. Labor unions lobby for the minimum wage because a higher minimum wage puts upward pressure on all wages.

7.4

Price Supports in Agriculture

How Governments Intervene in Markets for Farm Products •

To support farmers government generally rely upon three elements: • The government isolates the domestic market from foreign competition by restricting imports. •

The government introduces a price support, which is a price floor in an agricultural market maintained by a government guarantee to buy any surplus output at that price.

•

Chapter 7 . Government Actions in Markets

Price Supports •

•

In the figure, the equilibrium price is $400 per ton and the equilibrium quantity is 3 million tons produced and consumed. If the government sets a support price of $500 per ton, then the quantity produced is 4 million tons and the quantity consumed is 2 million tons. There is a 2 million ton surplus, shown by the length of the arrow. To maintain the price at $500 per ton, the government must purchase the surplus. In this case, the government buys 2 million at $500 per ton and thereby gives the farmers a $1 billion subsidy. The farmers’ total revenue increases. There is, however, a deadweight loss, so society is worse off with the price supports.

123

124

Part 2 . A CLOSER LOOK AT MARKETS

USING EYE ON THE U.S. ECONOMY 

The Federal Minimum Wage

You can use this story to start a discussion about your students’ personal experience with the minimum wage. Ask if any of them have behaved as Card and Krueger suggest. For example, if they got a wage increase as a result of a minimum wage hike, did they work harder? Did the higher wage stop them from quitting? If any have been managers, ask if they worked to make the firm more efficient. Ask if any know of friends who studied less, took fewer classes, or actually quit high school or college to find a minimum wage job. You can also focus on the economic growth ideas proposed by Welch and Murphy. Ask students for the intuition behind their suggestion that a healthy economy caused a positive relationship between wages and employment.

USING EYE ON PRICE REGULATION 

Can the President Repeal the Laws of Supply and Demand?

This Eye serves as an excellent jumping off point into a discussion about the controversial issue of executive pay. Widely scapegoated by the general public and our elected officials as the greedy profiteers responsible for the recent economic collapse, high-income corporate executives have been made potential targets for federally mandated compensation limits. Ask students if they believe that companies should be allowed to determine how much to pay their workers, or if the federal government should get to decide? With the minimum wage fresh in their minds, most students will argue that companies should get to decide (though with some bottom limit, perhaps). Then ask them if the government should put limits on the highest paid employees – those greedy executives. Many will then take a stance that the government should set upper and lower limits on worker pay. For those students, ask them why not just fix all employee pay at the same level? That way no one is underpaid and no one is overpaid? Wouldn’t that be the fairest? Help students identify the consequences of government intervention in constraining executive pay and the usefulness of wage inequality as a motivator for productivity. Why are they going to college? Is it to get a better job with higher pay? Would they go to college if they knew their wage would be the same as everyone else? Should the same principle apply to your grading – everyone gets the same grade? Or a lower and upper limit on the grade they can earn? Or if the class doesn’t do well, those who did well on the previous exams will have their grade capped as a result, regardless of their performance? That approach would be similar to capping executive pay for poor performing companies. How does that inspire better performance in the future? Help students identify that if © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 7 . Government Actions in Markets

the government only limits compensation for companies that are struggling (as has been proposed), this decreases the willingness of talented workers to stay or join those companies – which only makes it more difficult to succeed. For those sports fans, you can compare this policy to only imposing salary caps on losing teams, while allowing winning teams to pay their players as they see fit. This would only ensure that losing teams will always be losing teams as they cannot attract and retain talented players.

USING EYE ON YOUR LIFE 

Price Ceilings and Price Floors

This Eye discusses instances in which students can run into price ceilings and price floors. One point you can make to your students is that even if they do not presently live in New York City (or another location with rent ceilings) nonetheless at some point in their careers they might face a move to New York. In this case, the existence of rent ceilings can have a huge impact on the quality of their life. Indeed, they might wind up living in New Jersey and face spending hundreds of hours a year commuting simply because of the existence of rent ceilings! One additional issue you can discuss with your students is the effect of price ceilings in the market for gasoline. You can ask them their opinion on price ceilings in this market. Given the high price of gasoline, many could be in favor. Then describe what the situation was like when price ceilings were last imposed in the 1970s: To help ration gasoline, drivers were allowed to buy gasoline only on certain days. If the car had an even numbered license plate, the driver could buy on even numbered days and vice versa for cars with odd numbered license plates. (On the 31st of a month, anyone could buy gasoline.) But gas stations sold gasoline for only a limited number of hours per day. The station would indicate it was selling gasoline by hoisting a green flag; when it stopped selling that day, the station showed a red flag. So even if it was “your” day to buy, you had to find a station with a green flag, get in line, which typically was around 60 minutes, and then hope that the red flag was not displayed until after you had purchased your gasoline. (If the red flag went out when you were line, the station stopped selling and even cars then in line were not able to buy.) Ask your students the next time they want to buy gasoline to spend, say, 50 minutes at the pump and then flip a coin. If the coin comes up heads, the station has put out its red flag so the student must then drive to another gas station and repeat the process. Obviously none of your students will undertake this endeavor, but the point to make is that with the gasoline price ceiling, this choice was not voluntary—everyone had to “play this game” in order to purchase gasoline.

125

126

Part 2 . A CLOSER LOOK AT MARKETS

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 7.1: Taxes on Buyers and Sellers 1. With the growth in telephone calls in recent years, the government decides to tax calls at 20¢ each. If the supply of telephone calls is perfectly elastic and the demand for telephone calls is elastic: 1a. How much of the tax would the buyer pay on a call? 1b. Would the tax reduce the number of calls? 1c. Would the market for telephone calls be efficient? 1d. What is the definition of the excess burden of the tax? 2.

Under what circumstances would the buyer pay all of a sales tax?

Your local government notes that 10,000 pizzas are delivered weekly. It imposes a $1 a pizza tax on the delivery of pizza and believes that it will collect $10,000 a week. Is this belief correct? Why or why not?

Suppose the government was considering imposing a sales tax on new cartridges used in ink jet printers. Would workers making and distributing ink jet cartridges be in favor of, or in opposition to, such a tax?

 Checkpoint 7.2: Price Ceilings 5. Figure 7.1 shows the demand for on-campus student housing at Fort Lewis College, Durango. The college has 1,400 rooms for rent. 5a. What are the equilibrium rent and the equilibrium quantity of rooms rented? 5b. If the city imposed a rent ceiling on on-campus housing of $100 a week, how would you describe the on-campus housing market? Would the allocation of housing be efficient? Would it be fair? 5c. If the rent ceiling of $100 a week was strictly enforced and there were no black market, who would gain and who would lose? 5d. If with the $100 a week rent ceiling a black market developed, what rent would be offered for a room? Would the allocation of housing be efficient? Would it be fair? 6.

To change the market outcome, a price floor must be set below the equilibrium price. Is this statement true or false?

Chapter 7 . Government Actions in Markets

 Checkpoint 7.3: Price Floors 7. Figure 7.2 shows a market for private math tutors in Madison organized by the Students’ Union. 7a. What is the wage rate that math tutors earn and how many are hired? 7b. If the Students’ Union sets the minimum wage for private math tutors at $8 an hour, how many tutors are employed and what wage rate do they earn? 7c. If the Students’ Union sets the minimum wage for private math tutors at $15 an hour, how many tutors are employed and what wage rate do they earn? 7d. Is the minimum wage of $15 an hour efficient? Is it fair? 7e. If a black market gets going and the Students’ Union cannot enforce the minimum wage, what wage rate might some unscrupulous tutors earn? 8.

Union members are generally paid significantly more than the minimum wage. Why, then, do unions support increases in the minimum wage?



Answers

 Checkpoint 7.1: Taxes on Buyers and Sellers 1a. When the government imposes a 20¢ tax on phone calls and the supply is perfectly elastic, the buyer pays all of the tax. 1b. The tax decreases the number of calls made because the rise in the price of a phone call decreases the quantity demanded. 1c. Because the tax creates a deadweight loss, the market with the tax is inefficient. 1d. The excess burden is the deadweight loss. 2.

When demand is perfectly inelastic or supply is perfectly elastic, the buyer pays all of a sales tax.

The belief is incorrect. Imposing a tax on pizza decreases the equilibrium quantity of pizza so that fewer than 10,000 pizzas a week will be delivered. The total tax revenue will be less than $10,000.

A tax on new ink jet cartridges would decrease the equilibrium quantity of new ink jet cartridges, as some people would refill old cartridges, others would print less, and still others would switch to laser printers. Because the © 2013 Pearson Education, Inc. Publishing as Addison Wesley

127

128

Part 2 . A CLOSER LOOK AT MARKETS

quantity of new ink cartridges decreases, firms will lay off or otherwise decrease the quantity of workers employed making these cartridges. So workers making the cartridges generally would oppose the tax because it could lead to some unemployment.  Checkpoint 7.2: Price Ceilings 5a. The equilibrium rent is $125 a week and the equilibrium quantity is 1,400 rooms rented. 5b. At a rent ceiling of $100 a week, the quantity of rooms demanded is 1,600 and there is a shortage of 200 rooms on campus. The allocation is efficient because the efficient number of rooms, 1,400, continue to be rented. But the college loses revenue (and some students might use some resources futility attempting to rent an on-campus room. The college can respond to the loss of revenue by increasing other fees or reducing maintenance of on-campus housing. The allocation is not fair because it prevents voluntary exchange and does not necessarily reallocate housing to the poorest students. 5c. The people who gain from the ceiling are those students who get the cheaper apartments on campus. Assuming the enrollment doesn’t change, the off-campus housing owners gain because the increased demand from students increases the rent charged off-campus. The losers include those students who are unable to rent on-campus at the $100 ceiling and the ofcampus renters who must pay the higher rent. The college also loses because it must charge a lower rent. 5d. If a black market develops, the maximum rent that someone would offer is $125 a week. This rent equals the willingness of someone to pay for the 1,400th room. The allocation is efficient because the efficient number of rooms continues to be rented. The black market is not fair because it does not provide rooms to those students most in need. 6.

The statement is false. A price floor sets the lowest price that can legally be charged. Prices cannot legally penetrate below the floor. To change the market outcome, the price floor must be set above the equilibrium price because in this case the equilibrium price becomes illegal.

 Checkpoint 7.3: Price Floors 7a. The equilibrium wage rate is $10 an hour and the equilibrium quantity is 200 tutors. 7b. An $8 an hour minimum wage has no effect because it is below the equilibrium wage. The equilibrium wage rate remains at $10 an hour and the equilibrium quantity remains 200. No tutors are unemployed. 7c. At a minimum wage of $15 an hour, only 100 tutors are hired and each receives $15 an hour. One hundred tutors are unemployed.

Chapter 7 . Government Actions in Markets

7d. The minimum wage rate of $15 an hour is inefficient because marginal benefit exceeds the marginal cost and there is a deadweight loss. The outcome is unfair. It benefits only the tutors who get the jobs and the unemployed tutors earn nothing. Students are unable to hire the tutors they want. 7e. If a black market develops and tutors can charge below the minimum wage, the supply curve shows that some are willing to tutor for as little as $5 an hour. 8.

Workers who are paid the minimum wage are generally low-skilled workers while union workers, who are paid more than the minimum age, are generally high-skilled workers. However, low-skilled and high-skilled workers are substitutes. An increase in the minimum wage will cause firms to decrease the quantity of low-skilled workers they demand and increase their demand for high-skilled, union workers. An increase in the minimum wage helps increase the employment and wages of union members.

129

Chapter

Global Markets in Action CHAPTER OUTLINE 1. Explain how markets work with international trade. A. International Trade Today B. What Drives International Trade? C. Why the United States Imports T-shirts D. Why the United States Exports Airplanes 2. Identify the gains from international trade and its winners and losers. A. Gains and Losses from Imports B. Gains and Losses from Exports 3. Explain the effects of international trade barriers. A. Tariffs 1. The Effects of a Tariff 2. Winners, Losers, and the Social Loss from a Tariff B. Import Quotas 1. The Effects of an Import Quota 2. Winners, Losers, and the Social Loss from an Import Quota C. Other Import Barriers 1. Health, Safety, and Regulation Barriers 2. Voluntary Export Restraints D. Export Subsidies 4. Explain and evaluate arguments used to justify restricting international trade. A. Three Traditional Arguments for Protection 1. The National Security Argument 2. The Infant-Industry Argument 3. The Dumping Argument B. Four Newer Arguments for Protection 1. Saves Jobs 2. Allows Us to Compete with Cheap Foreign Labor 3. Brings Diversity and Stability 4. Penalizes Lax Environmental Standards C. Why Is International Trade Restricted? © 2015 Pearson Education, Inc.

132

Part 2 . A CLOSER LOOK AT MARKETS

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 8 is updated with new data to reflect changes in international trade since the sixth edition.

 Where We Are Chapter 8 continues studying markets. We learn some history behind the role government plays in international trade, the factors that influence trade patterns, who gains and who loses from international trade, and examine trade’s political side.

 Where We’ve Been We’ve set up supply and demand analysis, comparative advantage, consumer surplus, producer surplus, and deadweight loss to understand the impact of trade on domestic markets.

 Where We’re Going Chapter 9 will analyze externalities, both external costs and external benefits, to further our study of the interaction of government and markets.

IN THE CLASSROOM 

Class Time Needed

This material can take more time than expected because students frequently resist the notion that protectionism is inefficient. Consequently at least two or three class sessions should be planned, so as to leave plenty of time for discussion. An estimate of the time per checkpoint is: •

8.1 How Global Markets Work—20 minutes to 25 minutes

•

8.2 Winners, Losers, and Net Gains from Trade—40 minutes to 60 minutes

•

8.3 International Trade Restrictions—20 minutes to 25 minutes

•

8.4 The Case Against Protection—45 minutes to 50 minutes

Classroom Activity: Ask your students to check the country of origin label on the items they purchase in an average week, and calculate the percentage of their expenditure taken up by non-American goods. If possible, ask them to compare the price of non-U.S. made articles to

Chapter 8 . Global Markets in Action

133

their imported counterparts. Which is higher? What motivates their purchasing decisions? Are they willing or able to change their buying habits to include more domestic goods? In a related note, students often have the impression that because they see so many “Made in…” labels that list other countries, that the U.S. doesn’t produce anything. Remind them that the biggest areas of production in the U.S. do not typically have labels attached to them (education, health care, housing, etc. – previously explored on textbook page 33). Given the high levels of human capital and physical capital, the U.S. specializes in the production of services and then imports consumer goods that require lower levels of human capital and physical capital. But just because they don’t see “Made in the USA” all that often, that of course does not mean that most of what they actually consume wasn’t produced in the U.S. – it’s just that many of the consumption goods weren’t produced domestically. Classroom Activity: Have students try to find a current news article that ignores or uses incorrectly the ideas behind comparative advantage. Examples abound of misguided reports regarding offshoring, outsourcing, and trying to convince people to “buy domestic.” One possibility is to ask students to bring the articles to class for discussion or have them email you the articles ahead of time – then pick a couple and talk about the issues underlying the article. Alternatively, have students write a one to two sentence summary of how the article ignores the potential gains from trade. This can help students solidify for themselves the idea that trade provides benefits, although these benefits may accrue unevenly. Don’t be afraid to spend more time on this issue as the benefits from trade is a key idea for students to grasp. Alternatively, pick a current trade argument in the news as the focus of discussion. Put the keys facts on the board or overhead and give students a chance to figure out who benefits and who loses from the restriction in trade. You might want to divide students into groups and ask some groups to come up with the benefits and others to come up with the costs. Then allow the students to present their arguments. Depending on where your school is, you may get strong arguments regarding protecting family farms or protecting manufacturing jobs. Be sensitive and take your students arguments seriously as some will have been affected directly by offshoring/outsourcing. But also point out that the loss of jobs may be due to a downturn in the U.S. economy and not to jobs moving out of the country. Try to get the students to convince each other that although there may be people in an economy who are adversely affected by trade, there are net gains as the benefits from trade outweigh the costs.

Part 2 . A CLOSER LOOK AT MARKETS

134

CHAPTER LECTURE 8.1

How Global Markets Work

International Trade Today • •

Imports are the goods and services that we buy from people in other countries. Exports are the goods and services that we sell to people in other countries. The U.S. is the world’s largest international trader, comprising 10 percent of the world’s exports and 12 percent of the imports in 2012. Total exports were about 14 percent of total U.S. production and total imports were about 17 percent of total U.S. expenditure.

What Drives International Trade? The fundamental force that generates international trade is comparative advantage. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. • The figure shows the market for airplanes in the United States. The world price of a plane, $80 million, exceeds the U.S. price, $60 million, which means that the United States has a comparative advantage in producing airplanes. • With no trade, the equilibrium price is $60 million per plane and 300 planes are produced. • When the United States trades with the world, the supply curve shows that it will produce 400 planes. Of these 400 planes, the demand curve shows that 200 will be purchased in the United States. The remaining planes will be exported to foreigners. • •

8.2

The number of planes produced in the United States increases but the number of planes consumed in the United States decreases.

If the world price of a good or service is less than the U.S. price, the United States does not have a comparative advantage in producing the good or service and so it will import the good or service from abroad. The amount of the good or service produced in the United States decreases but the number consumed in the United States increases.

Winners, Losers, and Net Gains from Trade

Chapter 8 . Global Markets in Action

• •

135

Winners see their surplus increase, while losers see their surplus decrease. The figure shows the market for pairs of pants in the United States. The world price of a pair of pants is less than the U.S. price, so the United States imports pants 200 million pairs of pants. • Consumer surplus increases and equals the sum of areas C + B + D. Of this amount, area B is lost by producers and gained by consumers. Area D is newly gained surplus resulting from the trade. • Producer surplus decreases and equals area A. Without trade, producer surplus would be the sum of areas A + B. • Because the total surplus increases by the amount of area D, the United States is better off with trade.

Gains and Losses from Exports The gains and losses from exports are likewise calculated by examining their effect on consumer surplus, producer surplus, and total surplus. • The figure shows the market for airplanes in the United States. The world price of an airplane exceeds the U.S. price, so the United States exports pants 200 airplanes. • Producer surplus increases and equals the sum of areas C + B + D. Of this amount, area B is lost by consumers and gained by producers. Area D is newly gained surplus resulting from the trade. • Consumer surplus decreases and equals area A. Without trade, consumer surplus would be the sum of areas A + B. • Because the total surplus increases by the amount of area D, the United States is better off with trade.

Part 2 . A CLOSER LOOK AT MARKETS

136

8.3

International Trade Restrictions

Governments restrict international trade to protect domestic industries from foreign competition.

Tariffs • •

•

A tariff is a tax on a good that is imposed when it is imported. A tariff raises the domestic price of the good. In the figure, the tariff is equal to $5 per pair of pants, the length of the grey arrow. As a result, the domestic price of a pair of pants rises from $10 to $15. • The higher price of a pair of pants decreases the quantity bought in the nation, from 500 million to 400 million in the figure. • The higher price of a pair of pants increases the quantity produced in the nation, from 100 million to 200 million in the figure. • The quantity of pants imported decreases, from 400 million (= 500 million demanded − 100 million supplied) to 200 million (= 300 million demanded − 200 million supplied) in the figure. • The government collects tariff revenue, $1,000 million (=$5 tariff per pants × 200 million pants imported) in the figure (which is also equal to area C). A tariff benefits producers and the government, harms consumers, and creates a deadweight loss. • Consumers lose consumer surplus, equal to area A + area B + area C + area D. • Producers gain additional producer surplus, equal to area A in the figure. • The government collects tariff revenue equal to area C in the figure. • There is a deadweight loss created from the lost consumer surplus. The deadweight loss is the sum of areas B and D. The deadweight loss indicates that the society is made worse off with the tariff.

Import Quotas •

An import quota is a quantitative restriction on the import of a particular good, which specifies the maximum amount of the good that may be imported in a given period of time. An import quota decreases the quantity of imports and thereby decreases the supply of the good. It raises the domestic price so domestic consumption decreases and domestic production increases. However the government does not gain any revenue; the person who has the right to import the good gains the revenue.

Chapter 8 . Global Markets in Action

•

137

An import quota benefits domestic producers and the importers, harms consumers, and creates a deadweight loss. • Consumers lose because the domestic price rises. • Producers gain producer surplus from selling a greater quantity at a higher price. • The importers earn profit from buying at the lower world price and reselling in the U.S. at the higher domestic price (importer profit would be the same amount as the government collects in tariff revenue with a comparable tariff). • There is a deadweight loss created from the lost consumer surplus. The deadweight loss indicates that the society is made worse off with the import quota. Provided that an import quota is set at the same level of imports that would result from a tariff, the impact on market outcomes is nearly identical, with one notable difference—a tariff creates government revenue while an import quota creates profit for the importer.

Other Import Barriers •

•

Health, safety, and regulation barriers: Imports of certain goods, such as food, pharmaceuticals, and toys may be regulated to ensure that they are safe from contaminants or produced under sanitary conditions. Voluntary export restraints resemble import quotas in that imports decrease, as with an import quota, but with voluntary export restraints the foreign exporter gets the profit from the gap between the good’s domestic price and its world price.

Export Subsidies Subsidies are payments by a government to a producer. An export subsidy is a subsidy paid to the producer of goods for export. Such subsidies stimulate production of goods and services and consequently make it difficult for other producers to compete. Export subsidies lead to global overproduction and deadweight loss.

8.4

The Case Against Protection

 Land Mine: You might have a student (or students) in class who claim to favor not “free” trade but “fair” trade. This phrase is not only a common refrain from those who favor free trade but it is also a common remark made by those who secretly are against free trade. You should tackle this head on in class because some students find compelling the argument that trade should only be free if it can be fair. In fact, many politicians say that the United States will bring down its tariffs, import quotas, and other barriers as soon as our trading partners do. Upon closer scrutiny, it can be seen that this argument does not hold up. If you are engaging in an activity that is making you worse off, why would you want to make sure that someone else stops doing the very same thing before you will stop? It’s like the person who defends high speeding on the freeway by saying “I’ll stop speeding as soon as the rest of these nuts stop speeding.” But if slowing down is a good thing on its own (saves lives, saves fuel, etc.), then you don’t have to wait for someone else to slow down before you are able to © 2015 Pearson Education, Inc.

Part 2 . A CLOSER LOOK AT MARKETS

138

enjoy the benefits. Free trade is no different. If one of our trading partners is able to sell products and services in our country free of trade restrictions then our consumers will be the beneficiaries. If that same country does not want to allow its own consumers to enjoy the same benefit, this refusal should have no bearing on our decision to keep the barriers down. In other words, this is an argument for unilateral free trade. The moral of the story: “beware of the wolf in sheep’s clothing.” The “not free trade but fair trade” argument is simply a pretext for restricted trade. •

Arguments for protection have varying degrees of credibility: •

The national security argument: There is an argument for protection of some industries, especially those associated with national defense, to make sure such industries are ready and able to operate in wartime. However, the argument is usually a veiled argument for more widespread protectionism because, in a time of war, there is no industry that does not contribute to national defense. It is more efficient to achieve higher production in target industries through the use of subsidies rather than trade barriers.

•

The infant-industry argument: The so-called infant-industry argument for protection is that it is necessary to protect a new industry to enable it to grow into a mature industry that can compete in world markets. The idea relates to changes in comparative advantages change over because of learning-by-doing. However, the infant industries argument only applies if the benefits of learning-by-doing spill over to other industries. Moreover, historical evidence indicates that protected industries have a difficult time developing into globally competitive industries.

•

The dumping argument: Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. Dumping might be used by a firm that wants to gain a global monopoly. However, it is difficult to measure the cost of production so whether dumping is taking place is difficult to determine. And charging a different export price than domestic price is not necessarily evidence of dumping because firms often sell goods and services for different prices in different markets.

•

Saves jobs: The argument that trade protection saves jobs is flawed. International trade changes the type of jobs in an economy, but it does not decrease employment in the aggregate because jobs lost in one sector are offset by jobs created in other sectors.

It is important to point out to students the magnitude of the costs associated with protecting domestic employment through trade restrictions in relation to how much those workers would actually earn (as textile workers didn’t get paid anywhere near the $221,000 a year it cost to save their jobs). Identifying how the cost of saving these jobs is greater than what these jobs actually pay may help reinforce how large the net gains from trade actually are. Moreover, Trade Adjustment Assistance could potentially be used to pay extended unemployment benefits and for the retraining and relocation of displaced workers and those subsidies would be far less than

Chapter 8 . Global Markets in Action

139

the net gains from importing in that market. Basically, the losers can be compensated and there would still be gains leftover for our economy.

An issue that might confront you in class is the idea that the effectiveness of free trade agreements is based on whether or not our country will be able to increase its exports. If it can’t or won’t then the agreement is judged a failure. But let’s hold on a moment. Americans can’t eat wheat we export to France, we can’t enjoy personal computers we send to Singapore, and we don’t get the benefits of a pharmaceutical that is sent half way around the world to South Africa! Imports on the other hand are the goods and services that our trading partner sells to us. We directly consume French wine and wear bathing suits made in Singapore and give our loved ones diamond jewelry that came from the mines of South Africa. The bottom line is that we export so we can import, not the other way around. •

Allows us to compete with cheap foreign labor: The argument that trade protection allows us to compete with cheap foreign labor is flawed. Differences in real wage rates generally reflect differences in productivity and to think about competitiveness, we must consider both differences in wages and differences in productivity.

•

Brings diversity and stability: The argument that trade protection brings diversity and stability is flawed. Big rich countries are already diversified. And smaller countries can use the proceeds to trade to invest in a variety of other nations and thereby increase diversity.

•

Penalizes lax environmental standards: The argument that trade liberalization leads to a “race-to-the-bottom” in environmental standards is weak. Many poorer countries have comparable environmental standards and should not be targeted. And environmental standards are positively related to income (they are a normal good). The best way to encourage improved environmental standards is to allow trade and the economic benefits it brings to poorer countries. But using free trade agreements such as CAFTA to help negotiate policies that avoid irreversible harm to resources such as rain forests might be useful.

Students might be somewhat familiar with the terminology of “exploitation” applied to international trade. Have the students think about what “exploitation” means in the context of voluntary trade. If I benefit from someone I trade with, did I exploit them? Did they exploit me? If trade is voluntary, how did I manage to exploit the person whom I traded with? Is it because I am smarter than the other person? This seems to be the condescending assumption of those who talk about exploitation of workers in developing countries. Indeed, representatives from many developing countries do not see trade as exploitation, but rather see it as a way to improve standards of living. When these representatives are upset at WTO meetings, it is usually about the trade restrictions rich countries place on imports from developing countries keeping developing countries poor. Perhaps the best way to improve the standard of living in developing countries is to open up the U.S. economy (the world’s largest importer) even more and by trading with them more freely. © 2015 Pearson Education, Inc.

140

Part 2 . A CLOSER LOOK AT MARKETS

Why Is International Trade Restricted? Despite arguments against protection, trade is still restricted because key economic interests benefit from protection. • Rent Seeking: Rent seeking is lobbying and other political activity that seek to capture the gains from trade. While the benefits from liberalized trade are large in the aggregate, they are widespread across all consumers. Meanwhile, the costs are concentrated on a smaller number of producers. It is in the interests of those who pay the costs of liberalized trade to undertake a large quantity of political lobbying to promote protection.

Chapter 8 . Global Markets in Action

USING EYE ON THE U.S. ECONOMY 

U.S. Exports and Imports

You can have the students brainstorm a list of goods and services that the United States exports. What do we do that other countries want to buy? Most of the time, students are stumped. They can think of a lot of things we import (especially goods, since goods tend to have country of origin labels), but not the other way round. Are they surprised by the list of U.S. exports? What general conclusions can they draw about the U.S. economy based on our exports? Is it desirable to be serviceoriented in our exports, or would we rather be larger exporters of goods?

USING EYE ON GLOBALIZATION 

Who Wins and Who Loses from Globalization

In this segment, we see that globalization seems to have brought benefits for almost everyone, though one exception is African farmers. Blocked from global food markets by trade restrictions, Africans cannot take part in the prosperity globalization has brought to the rest of the world. Many of the health crises such as AIDS, malnutrition, and even starvation are clearly linked to poverty. Moreover, many of Africa’s nations are politically unstable. If African farmers had better access to global markets, what would the implications be for African societies, nations, and economies?

USING EYE ON THE PAST 

The History of U.S. Tariffs

The story presents an interesting history of tariff rates in the U.S. Start off by reviewing what is meant by the “average tariff rate.” It is interesting to note that the Smoot-Hawley tariff (the first tariff shown) and the latest trade meetings (organized by the WTO) both generated controversy! Today, people from around the world greet any meeting of the WTO with solid protests, but for different reasons than those against Smoot-Hawley. Can you imagine people in the 1930s protesting human rights or the environment? Economists still disagree over the role the Smoot-Hawley tariff played in the depression. Some claim the tariff caused it, others say it exacerbated it, while others contend it played a much smaller role. The debate was relived recently as protectionist measures were proposed as economic stimulus in 2009 in response to the severe recession. Fortunately, much of those protectionist policies were

141

142

Part 2 . A CLOSER LOOK AT MARKETS

quickly shot down as the consensus amongst economists and many elected officials was that protectionism, while politically popular at the time, would likely deepen the recession and slow the recovery.

USING EYE ON YOUR LIFE 

International Trade

Using this example, you can help students see the wide range of areas in which economics affects their lives, and how they can use the knowledge gained in their course to make more considered judgments about their role as consumers, producers, and citizens. For example, given their experience evaluating their spending habits they may find that the typical poverty of the college student compels them to purchase imports, when their idealism stresses that they “buy American.” Their hearts may be moved when they consider the plight of factory workers in Southeast Asia, but have they considered the context in which these “underpaid” workers live? This is an opportunity to use cost-benefit analysis to make informed decisions. Is “patriotism” worth $5 more for a shirt? It’s something to consider.

Chapter 8 . Global Markets in Action

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 8.4 The Case Against Protection 1. Why is it that some economists are suspicious that some of those who claim they are for “free trade but fair trade” are not really championing the cause of free trade? 2.

Evaluate the following statement. “If we trade with China and they acquire all our technology, then we run the risk of exporting all of our jobs.”



Answers

 Checkpoint 8.4 The Case Against Protection 1. Economists realize that those who argue for free trade but only if it is fair are, in a sense, engaged in a stall tactic. The advantages of free trade are strong enough that we have no need to wait for our trading partners to embrace it. We can lead by example and enjoy the benefits ourselves. 2.

The statement ignores the fact that even if a country were to gain all of another nation’s technology, the gaining country still would not have a comparative advantage in everything. The United States would still benefit from trade with China because the United States would still command a comparative advantage in some areas.

143

Externalities: Pollution, Education, and Health Care CHAPTER OUTLINE I. Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome. A. Externalities in Our Daily Lives 1. Negative Production Externalities 2. Positive Production Externalities 3. Negative Consumption Externalities 4. Positive Consumption Externalities B. Private Costs and Social Costs 1. Valuing an External Cost 2. External Cost and Output C. Production and Pollution: How Much? D. Property Rights E. The Coase Theorem 1. Application of the Coase Theorem F. Government Actions in the Face of External Costs 1. Pollution Limits 2. Pollution Charges or Taxes 3. Marketable Pollution Permits (Cap-and-Trade) G. Switching to Clean Technologies 2. Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, and vouchers can achieve a more efficient outcome. A. Private Benefits and Social Benefits B. Government Actions in the Face of External Benefits 1. Public Provision 2. Private Subsidies 3. Vouchers C. Economic Problems in Health-Care Markets 1. Reasons for Underprovision in Health-Care Markets 2. A Reform Idea

Chapter

146

Part 2 . A CLOSER LOOK AT MARKETS

CHAPTER ROADMAP

 What’s New in this Edition? The emphasis on health care as an example of a product with an external benefit has been increased. The discussion of the health care market has been expanded, with a new section discussing asymmetric information in the health-care insurance market and a health-care reform proposal using vouchers. A new Eye on “Education Quality: Charter Schools and Vouchers” has been added.

 Where We Are We use the demand and supply curves to show how externalities affect the efficient use of resources. We see that external costs result in overproduction and that external benefits result in underproduction. By developing the marginal social cost curve and marginal social benefit curve, we incorporate these external costs and external benefits into the basic demand-supply graph. Finally, we investigate how the government intervenes in the market to promote efficient use of resources.

 Where We’ve Been We’ve explored the interactions of supply and demand that bring about the efficient use of resources by equating marginal benefit to marginal cost. We use the concept of efficiency in this chapter to discuss the deadweight loss from externalities and how government action can overcome the inefficiency.

 Where We’re Going After this chapter, the focus turns to exploring the supply curve in greater detail. The next chapter looks at a firm’s production choices. We also examine its costs and its cost curves in the short run and in the long run.

Chapter 9 . Externalities: Pollution, Education, and Health Care

IN THE CLASSROOM  Class Time Needed You can complete this chapter in two sessions. This chapter is particularly suitable to the use of current event examples. You can take one class period to cover the mechanics of the marginal social cost curve, marginal social benefit curve, and government intervention. Then you can spend the next class period discussing real world examples. An estimate of the time per checkpoint is: •

9.1 Negative Externalities: Pollution—50 minutes

•

9.2 Positive Externalities: Education and Health Care—50 minutes

147

Part 2 . A CLOSER LOOK AT MARKETS

148

CHAPTER LECTURE 9.1

Negative Externalities: Pollution

Externalities in Our Daily Lives •

An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer. A negative externality imposes an external cost and a positive externality creates an external benefit.

 Land Mine: To overcome potential language problems, be sure to relate the word “externality” to the more familiar phrase “side effect” or “3rd party effect.” Lecture Launcher: Launch your Chapter 9 lecture by asking your students if they have seen the movie Erin Brokovich. It’s a great (not necessarily in a review sense, but in an economic sense!) movie that shows how pollution creates external costs and how residents required Pacific Gas & Electricity (PG&E) to account for both private costs and external costs in the use of hexavalent chromium (chromium 6). PG&E used the chemical to clean its equipment. According to the movie, PG&E improperly discharged the chemical and polluted the ground and water, causing death and disease. The movie starts with PG&E recognizing there is a problem because it offers a homeowner $55,000 for his home and medical bills. The movie ends with this family receiving $5 million from PG&E. PG&E now claims that chromium 6 is not deadly if you drink it, only if you inhale it and that it presents no external costs. Still, PG&E settled the case for $330 million. •

There are four types of externalities: • Negative Production Externalities: noise from aircraft and trucks, polluted rivers and lakes, the destruction of native animal habitat, air pollution in major cities from auto exhaust. • Positive Production Externalities: honey and fruit production, in which fruit production gets an external benefit from locating bee hives next to a fruit orchard, where the bees pollinate the trees to boost fruit output and honey production gets an external benefit from the orchard trees that generate the pollen necessary for honey production. • Negative Consumption Externalities: smoking in a confined space and posing a health risk to others, or having noisy parties or loud car stereos that disturb others. • Positive Consumption Externalities, flu vaccination because everyone who comes into contact with the person benefits because they are less likely to catch the flu.

Lecture Launcher: Students quite often are surprised that economists have a lot to say about pollution. Many students think that pollution is a topic handled only by scientists, technicians, and engineers working in the field. You can point out to your students that in truth econo© 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 9 . Externalities: Pollution, Education, and Health Care

149

mists have had a lot of influence in the nation’s pollution policies. So, if a student is considering a career in a pollution related field, he or she might also want to consider economics as a potential major.

Private Costs and Social Costs •

A private cost of production is a cost that is borne by the producer. Marginal private cost (MC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service.

•

An external cost is a cost of producing a good or service that is not borne by the producer but is born by other people. A marginal external cost is the cost of producing an additional unit of a good or service that falls on people other than the producer.

•

Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost:

MSC = MC + Marginal external cost.  Land Mine: Have the students consider what is included in the idea of marginal external costs. Be sure that they understand that external costs are the costs of either cleaning up the damage caused by the polluting activity or the extra costs of having to take actions to avoid the damage in the first place. Emphasize that both actions require payment by people other than the producer or consumer, which is why the costs are considered external. This chapter tests students’ graphing abilities with the addition of the marginal social cost curve. Fortunately, students should be able to grasp this graphing ability more quickly given the similarities to the analysis of external benefits in Chapter 10. You may find it useful to do a similar exercise to that suggested in the previous chapter as well. Using colored chalk, colored markers on the overhead, or colored lines on your PowerPoint slides is very helpful in distinguishing these different lines. Draw the supply (MC) curve for a good, say electricity, that when produced creates pollution. Remind students that this curve represents the costs paid by the producers to produce one more unit of the good. Pick a point on the curve and say “To increase the production of electricity one more unit, the graph shows that the producer must incur a cost of $100 (or whatever price and quantity you have chosen). If I tell you that the utility is polluting the environment, do we as a society face a higher cost?” Most students will answer “yes” and you can plot a point higher on the graph at the same quantity. Do the same analysis for other production points and you now have a new supply curve, the marginal social cost (MSC) curve. Remind students that the distance between the curves is the added cost of the pollutants, which is the marginal external cost.

Part 2 . A CLOSER LOOK AT MARKETS

150

•

The figure shows the marginal private cost curve (MC) and the marginal social cost curve (MSC) for a good with an external cost. The vertical distance between the two curves is the marginal external cost. •

•

Because the marginal social cost includes the marginal external cost, the marginal social cost exceeds the marginal private cost (MSC > MC) for all quantities. The efficient quantity of output occurs where the marginal social cost equals marginal benefit, that is, where MSC = MB. In the figure, the efficient quantity is Q1. An unregulated market, however, produces where the MC = MB (which is equivalent to producing where S = D). In the figure, the unregulated market is at Q0. At this level of output, MSC exceeds MB so there is, as illustrated, a deadweight loss.

Production and Pollution: How Much? •

When an industry is unregulated, the amount of pollution it creates depends upon the market equilibrium price and quantity of the good produced. But it is an inefficient equilibrium (see the deadweight loss in the figure above). Therefore, reducing the amount of pollution and eliminating the deadweight loss brings potential gains. In an example of a factory which dumps waste chemical into a river, the people who live near the river experience a negative externality and a deadweight loss. How can the people who live by the polluted river get the chemical factories to decrease output of the chemical and thereby cause less pollution? Can a solution be found that benefits everyone? Solutions can be offered via property rights and the Coase Theorem.

Property Rights •

Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts. Assigning property rights can reduce the inefficiency arising from an externality.

The Coase Theorem •

The Coase theorem is the proposition that if property rights exist, if only a small number of parties are involved, and if the transactions costs are low, then private transactions are efficient. Transactions costs are the opportunity costs of conducting a transaction

Chapter 9 . Externalities: Pollution, Education, and Health Care

•

151

A remarkable feature of the Coase theorem is that it does not matter if the property right is given to the creators of the externality (the polluters) or to the victims. In either case, the result will be efficient. •

•

If the polluters value the benefits from the activity generating the pollution more highly than the victims value being free from the pollution, (that is, the cost of reducing the pollution exceeds the benefit from the reduction) then the efficient outcome is for the pollution to continue. If polluters are assigned the right to pollute, the victims are not able to pay enough to convince the polluters to stop. If the victims are assigned the property right to be free from pollution, then the polluters are able to pay the victims sufficient compensation to continue polluting. Either way, the pollution continues. If the victims value the benefits from being free from pollution more highly than the polluters value the benefits of the pollution, (that is, the benefit from reducing pollution exceeds the cost of the reduction) then the efficient outcome is for the pollution to stop. If the polluters are assigned the right to pollute, then the victims are willing to pay the polluters sufficient compensation to stop the pollution. If the victims are assigned the right to be free from pollution, then the polluters are not able to pay the victims enough to allow them to continue polluting. Either way, the pollution stops.

Government Actions in the Face of External Costs •

The government can use pollution limits to achieve an efficient outcome. A quantity limit on a polluting activity will cause the market price to rise, reducing the quantity demanded to an amount that balances MSC and MB. The higher price exceeds MC, which creates producer surplus. In reality, pollution limits are difficult to implement and monitor and the higher price encourages producers to increase their quantity beyond the limit.

•

The government can use pollution charges or taxes that seek an efficient outcome by making a polluter pay the marginal external cost of pollution. By charging or taxing an amount equal to the marginal external cost, the MSC curve becomes the same as the market supply curve. This moves the market to the efficient quantity and the government collects revenue from the charge or tax. In the figure above, the appropriate tax equals the length of the double headed arrow.

•

The government can use marketable pollution permits (or cap-and-trade), wherein pollution rights are assigned or sold to individual producers who are then free to trade permits with each other. The market in permits determines the price of a permit and firms will buy or sell permits until their marginal cost of pollution reduction equals the price of a permit.

•

All of these methods have the potential to achieve an efficient outcome if the marginal external cost is assessed correctly, though that is rarely possible. Moreover, some producers have a lower marginal cost of avoiding pollution than others, but pollution limits and pollution charges/taxes confront all producers with the same incentives to avoid pollution. Cap-and-trade ends up being a more effective government policy in practice because it provides the strongest available incentive to individual producers to find cost effective technologies that achieve pollution targets. © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 2 . A CLOSER LOOK AT MARKETS

152

9.2

Positive Externalities: Education and Health Care

Private Benefits and Social Benefits •

A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the benefit from an additional unit of a good or service that the consumer of that good or service receives.

•

An external benefit from a good or service is a benefit that someone other than the consumer receives. A marginal external benefit is the benefit from an additional unit of a good or service that people other than the consumer of that good or service enjoy.

•

Marginal social benefit (MSB) is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else who enjoys a benefit—and is the sum of marginal private benefit and marginal external benefit:

MSB = MB + Marginal external benefit. Draw the demand (marginal benefit) curve for a good, say education, that when consumed creates external benefits. Remind students that this curve represents the benefit received by consumers from one more unit of education. Pick a point on the curve and say “If a student increases their consumption of education by one more unit, the graph shows that the student will receive a private benefit equal to $500 (or whatever price and quantity you have chosen). If I tell you that the education is also benefitting that student’s coworkers, neighbors, and friends, do we as a society face a higher benefit?” Most students will answer “yes” and you can plot a point higher on the graph at the same quantity. Do the same analysis for other consumption points and you now have a new benefit curve, the marginal social benefit (MSB) curve. •

The figure shows the marginal private benefit curve (MB) and the marginal social benefit curve (MSB) for a good with an external benefit. The vertical distance between the two curves equals the marginal external benefit. For instance, the length of the arrow in the figure equals the marginal external benefit at the quantity Q1. • Because marginal social benefit includes marginal external benefit, the marginal social benefit exceeds the marginal private benefit (MSB > MB) for all quantities. • The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, •

Chapter 9 . Externalities: Pollution, Education, and Health Care

153

ducing where S = D). In the figure, the unregulated market equilibrium is Q0. At this level of output, MSB exceeds MC so there is, as illustrated in the figure, a deadweight loss.

Government Actions in the Face of External Benefits •

Public provision, which is when a public authority that receives its revenue from the government produces the good or service. (Public schools, colleges, and universities are examples.) In this case, the government can direct the authority to produce the efficient quantity.

•

A subsidy, is a payment that the government makes to a producer to cover part of the cost of production, can be used. If the government pays the producer a subsidy equal to the marginal external benefit, then the quantity produced by the private firm increases to that at which the marginal cost equals the marginal social benefit and an efficient allocation of resources occurs. In the figure, the correct subsidy is equal to the length of the double headed arrow.

•

A voucher, which is a token that the government provides to households to buy specified goods or services, can be used. Households receiving a voucher effectively have a greater income to be used for the specific good or service, which increases their demand and increases the quantity consumed.

•

Both public provision and private subsidies may fail to ultimately provide an efficient outcome due to bureaucratic cost padding and overprovision. Advocates of vouchers argue that giving financial resources to the consumer rather than the producer will produce a more efficient outcome as consumers may monitor performance more effectively than the government will.

To clarify the effects of the government’s options of using public provision, private subsidies, and vouchers to deal with external benefits, draw all three options as headings across the board at one time. Under each heading, start with identical demand and supply curves that result in underproduction. Add the MSB curve in each case. Start with the voucher case first because it is the simplest and show how the voucher increases demand so that it becomes the same as the MSB curve. You can then show how a subsidy shifts the supply curve creating the same outcome. Compare the value of the subsidy with the value of the voucher …it’s the same. Then draw the public provision case showing how the taxpayer pays the marginal external cost (the same amount in the two other cases) and produces the efficient amount. Review how each option produces the same outcome for the same “price” in theory and that it’s just the process to the efficient outcome that differs. After this is established, explore the argument that, in practice, vouchers may actually be more effective at producing the efficient outcome.

Economic Problems in Health-Care Markets •

Health care can be divided into two markets: the health-insurance care services market and the health-care insurance market. Problems in each lead to underprovision. •

Health-care services: Vaccination and public sanitation provide positive consumption

Part 2 . A CLOSER LOOK AT MARKETS

154

•

externalities. (For instance, flu vaccination protects the person receiving the shot but also protects all of the person’s friends from catching flu from the person.) With these external benefits, the marginal social benefit of health care exceeds the marginal private benefit, causing the unregulated market equilibrium to be inefficiently less than the efficient quantity. • Health-care insurance: Asymmetric information is a major problem in the health care market. People know more about their health than does the insurance company and doctors know more about the treatment that should be prescribed and the cost than does the insurance company. Asymmetric information means that an unregulated health-care insurance market equilibrium will have an inefficiently small quantity of health insurance. Currently, a mix of public provision and private subsidies are used to increase the quantity of health care in the U.S., though many people believe the level still falls short of the efficient quantity. These government actions may reduce deadweight loss, but are inadequate to eliminate it entirely. Health care reform aims to increase the quantity of services towards the efficient outcome and also increase equality of access to those services as well as control the costs of providing those services.

Chapter 9 . Externalities: Pollution, Education, and Health Care

USING EYE ON THE U.S. ECONOMY  U. S. Air Pollution Trends This article focuses on the three main types of pollution: air, water and land. The story notes that most types of air pollution have decreased over the past 30 years. These results show that the cost of reducing some contaminants (lead and sulfur dioxide) is lower than other contaminants (nitrogen dioxide and ozone). If the costs were equally low, we would see all types of pollution decrease by similar percentages. You can ask students when or how they think the most common types of pollutants will effectively be reduced. Their answers should contain intuition about comparing the opportunity cost of reduction versus pollution and the ability to assign property rights.

 Education Quality: Charter Schools and Vouchers This Eye introduces students to charter schools, which recently vaulted in notoriety after the award-winning 2010 documentary Waiting for Superman, which chronicles the success of some of the superior charter schools in the U.S. in contrast to the more traditional public schools. While not all charter schools produce high quality education, there is increasing evidence that charter schools can be a viable option for improving educational quality. How do charter schools promote competition in the public education system? Is this competition equally possible in all areas – urban, suburban, and rural? What are the advantages of having each school design its own educational policy, standards, and curriculum? What are the disadvantages of having each school design its own educational policy, standards, and curriculum? Ask your students to select and defend a stance: if they had a choice for themselves between a traditional public school, a charter school, a private school with a subsidy, or a private school with a voucher and they knew nothing else about the institution, which would they choose and why? If they had to choose for the entire country, which system would be best? Or should it be a combination? Why?

USING EYE ON CLIMATE CHANGE  How Can We Limit Climate Change? This Eye focuses on the most widely publicized environmental issue (global warming) and the debates surrounding the dangers of carbon emissions and policies used to reduce those emissions. Once your students understand that global warming is essentially a situation of pollution (CO2 emissions) and that global warming is an externality, ask them their suggested solutions to this issue. Be sure to keep them focused on how economists approach the problem by developing policies so that the marginal social cost equals the marginal benefit – but es© 2013 Pearson Education, Inc. Publishing as Addison Wesley

155

156

Part 2 . A CLOSER LOOK AT MARKETS

timating costs and benefits is the source of much debate. One point you might want to address in the class is the fact that the costs of global warming—and hence the benefits from preventing it—largely occur in the future and so must be discounted to make them equivalent to today’s costs of preventing global warming. There is no need to be formal about this issue. You can merely point out that money today is more valuable than money to be received in the future because money today can be saved and can reap interest, an option not available with money to be received in the future. In order to personalize the issue, ask students how much they are willing to pay for cleaner air, land, and water. For example, electricity deregulation is supposed to allow you to choose among various utility providers. Some providers will claim “clean” production of electricity, while others will offer electricity at the lowest price. Ask your students which provider they would pick. How many of those choosing the “green” provider are willing to pay higher prices? How much higher? Ask your students how many of them buy the “green” paper towels and napkins in the grocery store. They are usually higher priced and lower quality. How many of them are willing to give up their cars for public transportation? These choices represent the opportunity cost of reducing pollution. Obviously, in some cases, the costs are too high. To complicate the debate, point out that even if scientists, economists, and policymakers would agree on CO2 emissions’ negative effects and targeted environmental policy were adopted in the U.S., it still may have only a negligible impact on global warming. As long as developing countries’ governments subsidize the pollution, actions in the United States will account for a decreasing portion of the world’s total. Therefore, attempts to reduce pollution will have to focus more on these countries than on just the United States.

USING EYE ON YOUR LIFE  Externalities in Your Life This Eye has two interesting examples of government responses to externalities that occur in virtually every student’s life: the tax imposed on gasoline, which in part exists because of the external cost from gasoline use, and the subsidies granted college students, which in part exist because of the external benefit from education. But it is really important for your students to realize that not all taxes and not all subsidies exist as a result of externalities. It is easy to think of products that are taxed but have no external costs: clothing, cell phone service, and hair styling are immediate examples. It is similarly easy to think of products that are subsidized and have no external benefits: wheat, tobacco (!), and the 936 subsidies given to manufacturers who operate in Puerto Rico. Make sure that your

Chapter 9 . Externalities: Pollution, Education, and Health Care

students realize that taxes and subsidies are generally the result of the political equilibrium and not reflective of external costs and external benefits.

USING EYE ON HEALTH CARE  Does Health Care Need Fixing? This Eye should spark plenty of debate about the appropriate role of government intervention in the provision of health care. One way to promote debate is to break students into four groups and give them a health care structure to support – the current U.S. plan, the Obama plan, the Republican plan, and the UKCanada model. Allow the groups a few minutes to discuss the strengths associated with their plan (and the weaknesses associated with the competing plans) in terms of efficiency and equality and then pitch their case to the class. At the conclusion of the presentations, have students vote on which plan they believe would be best for the country.

157

158

Part 2 . A CLOSER LOOK AT MARKETS

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 9.1 Negative Externalities: Pollution 1. Figure 9.1 illustrates the unregulated market for pesticide. When the 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 dumped waste is equal to the marginal private cost of producing the pesticide, so the marginal social cost of producing the pesticide is double the marginal private cost. Suppose that the government issues marketable pollution permits that are just sufficient to enable the factories to produce the efficient output of pesticide. The permits are divided equally between the townspeople and the factories. 1a. What is the efficient amount of pesticide? 1b. What is the price of a marketable permit? 1c. Who buys permits and who sells permits? 1d. How would the outcome differ if all the permits were allocated to the factories? 1e. How would the outcome differ if all the permits were allocated to the townspeople? 2.

Figure 9.2 shows the marginal cost and marginal benefit curves facing a small scenic seaside village that has a water-polluting paper mill next to it. 2a. If property rights are not assigned and the market is unregulated, how much paper is produced and what is the price? 2b. If the transactions costs are low and property rights to the water are assigned, how much paper is produced? Does it matter whether the town or the factory is assigned the property rights? 2c. If the city wants to tax the factory to achieve the efficient amount of pollution, what must the tax be and what is the city’s total tax revenue from the tax?

Chapter 9 . Externalities: Pollution, Education, and Health Care

 Checkpoint 9.2 Positive Externalities: Education and Health Care 3. Obtaining a college education has a marginal external benefit. Figure 9.3 shows the market for college education. 3a. What is the efficient number of students? 3b. If the government decides to provide public colleges, what must the tuition equal to attain efficiency? How much of the cost of a student’s tuition will be funded by taxes and how much will be paid for by the student?



Answers

 Checkpoint 9.1 Negative Externalities: Pollution 1a. The efficient quantity is 20 tons a week because this quantity is where the marginal benefit curve intersects the marginal social cost curve, as shown in Figure 9.4. 1b. The price of the permit is $50, the marginal external cost when 20 tons a week are produced. 1c. The factory buys the permits and the town sells the permits. 1d. If the factory received all the permits, the factory would not sell any permits. The factory would use the permits to produce the efficient quantity of pesticide. 1e. If the townspeople received all the permits, the factory would buy the permits for $50 a ton.

2a. With no property rights and no government intervention, the quantity of paper is determined by the demand and supply curves and is 60 tons of paper at a price of $150 a ton.

159

160

Part 2 . A CLOSER LOOK AT MARKETS

2b. If property rights to the water are assigned, the efficient amount of paper is produced, which is 40 tons. The Coase theorem points out that it does not matter to whom the property rights are assigned. 2c. To attain efficiency, the tax must equal the marginal external cost at the efficient quantity, which is $100 a ton. With this tax, 40 tons of paper is produced, so the city collects ($100 a ton) × (40 tons), which equals $4,000 a week in tax revenue.  Checkpoint 9.2 Positive Externalities: Education and Health Care 3a. The efficient number of students is 12 million because that is the quantity at which the marginal social benefit, MSB, equals the marginal cost, MC. 3b. To have 12 million students enroll, the demand curve shows that the tuition must be $2,000 a student. The marginal cost when 12,000 students enroll is $6,000, so with each student paying $2,000, taxpayers must pay $4,000 a student.

Chapter

Production and Cost CHAPTER OUTLINE I. Explain and distinguish between the economic and accounting measures of a firm’s cost of production and profit. A. The Firm’s Goal B. Accounting Cost and Profit C. Opportunity Cost 1. Explicit Costs and Implicit Costs D. Economic Profit 2. Explain the relationship between a firm’s output and labor employed in the short run. A. The Short Run: Fixed Plant B. The Long Run: Variable Plant C. Total Product D. Marginal Product 1. Increasing Marginal Returns 2. Decreasing Marginal Returns E. Average Product 3. Explain the relationship between a firm’s output and costs in the short run. A. Total Cost B. Marginal Cost C. Average Cost D. Why the Average Total Cost Curve Is U-Shaped E. Cost Curves and Product Curves F. Shifts in the Cost Curves 1. Technology 2. Prices of Factors of Production

162

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

4. Derive and explain a firm’s long-run average cost curve. A. Plant Size and Cost 1. Economies of Scale 2. Diseconomies of Scale 3. Constant Returns to Scale B. The Long-Run Average Cost Curve 1. Economies and Diseconomies of Scale

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 10 is largely unchanged from the sixth edition.

 Where We Are In this chapter, we define economic costs and profits. We examine the relationship between inputs, costs, and production. This chapter lays the groundwork for the profitmaximizing decisions that are made by firms, which we study in the next several chapters.

 Where We’ve Been We defined what economics means in terms of scarcity, opportunity cost, choice, and efficient use of resources. We’ve explored the interactions of supply and demand that bring about the efficient use of resources and the role of government intervention in market efficiency. We’ve discussed the rationale behind the downward-sloping demand curve using marginal utility analysis.

 Where We’re Going After this chapter, we look at the demand and marginal revenue curves for firms in different industry structures. By combining cost, demand, and revenue curves, we will see the profit-maximizing operating decisions made by firms.

Chapter 10 . Production and Cost

163

IN THE CLASSROOM  Class Time Needed This chapter can be completed in two to three class sessions. However, this material lays a foundation for the next four chapters, so do not short change it. If you judge from your class’s reaction that you need more time, take it! An estimate of the time per checkpoint is: •

10.1 Economic Cost and Profit—15 to 20 minutes

•

10.2 Short-Run Production—40 to 60 minutes

•

10.3 Short-Run Cost—40 to 60 minutes

•

10.4 Long-Run Cost—30 to 40 minutes

Classroom Activity This chapter is one more place where an in-class experiment has a huge payoff and is definitely recommended. The experiment teaches students about the product curves, and a related assignment that we describe later teaches them about the short-run cost curves. Allow 30 to 40 minutes for this production experiment. This experiment motivates the students to go beyond memorizing the cost and productivity definitions by getting them directly involved with generating their own data and productivity and cost measures. This is a fun exercise that will illustrate the concept of diminishing returns to labor, as well as how short run productivity measures and cost measures are related. Students genuinely enjoy and learn from this exercise, even though it might seem childish. You have two inputs: Capital: A table (of which the class must have an unobstructed view), some tear-off scratch pads with about 500 sheets of paper, a fully loaded stapler, and a back-up stapler (also fully loaded). Labor: Provided by your students. The capital and labor are used to produce “widgets.” A widget is a piece of paper, torn from a pad, folded twice very carefully so that the corners of the paper align, and stapled. The first fold bisects the paper along its long side and the second fold is at right angles to the first. Once folded, a staple is used to hold the folds in place. A widget is fragile and breaks if it falls off the table. Start the experiment by hiring a manager from your class and appointing an auditor. Get the manager to hire a quality controller, an accountant, and some workers. Tell the manager that he or she must produce widgets as efficiently as possible and that he or she can discuss the process with his workers and with the class. Define a day as lasting 1 minute. Get the class to keep time. On day 1, have 1 worker produce widgets. On day 2, have 2 workers, and so on. You’ll probably run for 10 to 12 days before you get to almost zero marginal product. Record the inputs and outputs in a table on the board. Have some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and partly made widgets don’t get used in a subsequent day. Each day must start clean. © 2015 Pearson Education, Inc.

164

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Now comes the assignment (Stage 1): Get the students to calculate marginal product and average product from the total product numbers that you’re recorded on the board. Get them to make graphs of the total product, marginal product, and average product curves. Get them to describe the curves and to explain their similarities with and differences to the curves for smoothies in the textbook. If you want, you can extend the experiment with another assignment (Stage 2): Use the data from your widget production experiment. Tell the students the cost of the capital and the wage rate of a worker. (Make up the numbers. Any will do.) Tell the students to calculate total cost, marginal cost, and average cost. Get them to make graphs of the total cost, marginal cost, and average cost curves. Get them to describe the curves and to explain their similarities with and differences to the curves for smoothies in the textbook. This assignment and the previous one make an outstanding assignment for credit or extra credit.

Chapter 10 . Production and Cost

165

CHAPTER LECTURE 10.1

Economic Cost and Profit

Lecture Launchers: This chapter is incredibly important because it serves as the basis for the next four chapters. You know this fact, I know this fact, but your students don’t know this fact. You must tell them this fact because without it you will definitely lose some of the class. How so? They won’t realize that this chapter is critical until they are unable to grasp the next four chapters. At that point, several possibilities exist, all unpleasant: These students flunk the course, these students drop the course, or these students camp out in your office. Most likely no one would be happy with any of these outcomes, so launch your lecture by motivating your students with the important information that Chapter 10 is truly a key to Chapters 11, 12, and 13!

The Firm’s Goal •

The firm’s goal is to maximize profit.

Accounting Cost and Profit versus Opportunity Cost •

•

Accountants measure revenue and cost using accounting conventions in order to ensure that the firm pays the proper amount of tax and to give creditors information. But the costs as measured by accountants are the firm’s opportunity costs. The decisions the firm makes to maximize its profit respond to opportunity cost and economic profit. The opportunity cost of a firm’s use of resources is the highest-valued alternative forgone. Opportunity costs include both explicit costs and implicit costs. • An explicit cost is a cost paid in money. Explicit costs are opportunity costs. • An implicit cost is an opportunity cost incurred by a firm when it uses a factor of production for which it does not make a direct money payment. Implicit costs also are opportunity costs.

Normal Profit and Economic Profit •

•

A firm’s owner supplies entrepreneurship by organizing the business and bearing the risk of running it. • Normal profit is the return to entrepreneurship. The normal profit is part of a firm’s opportunity cost because it is the cost of persuading the entrepreneur of not running another business. Economic profit is a firm’s total revenue minus its total opportunity cost. An economic profit is a profit over and above the normal profit.

 Land Mine: Watch out for persistent confusion between economic profit and accounting profit. You can avoid some of this by thoroughly drilling them in opportunity cost, so that they understand that non-money cost is still cost.

166

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

10.2

Short-Run Production

A firm owner’s decisions can be categorized as short run decisions and long run decisions. • The short run is a time frame in which the quantities of some resources are fixed. The fixed resources include the firm’s management organization structure, level of technology, buildings and large equipment. These factors are called the firm’s plant. • The long run is a time frame in which the quantities of all resources can be varied. Longrun decisions are not easily reversed so usually a firm must live with the plant size that it has created for some time. Help the students to understand that the difference between the long run and short run is not related to calendar time. Compare the street vendor, who is a firm owner operating out of a food truck, to the giant automaker firm, Ford. Ask them how long it would take for the food vendor to double the size of his or her plant (truck, oven, etc.) versus Ford to double its plant size (factory buildings covering multiple blocks, sophisticated computerized assembly lines and robotics, etc.). They will realize that the length of time covered by the long run differs among firms. To increase its output in the short run, a firm must increase the quantity of labor employed. There are three relationships between the quantity of labor and the firm’s output.  Land Mine: If you do not create your own data using the experiment described in the Classroom Activities, be sure that when you draw the curves in this chapter you use numeric examples. Either make up your own numbers or use the table in the notes on the next page, but make sure to provide your students with two things: a preprinted table with the columns labeled (but not filled in) and preprinted handouts with graphs on which the axes are labeled. If you can, draw the points (not the actual curves) on the graphs that will correspond to the data in the tables. The table should provide a complete spreadsheet, with labor employment, capital employment, output, AP, MP, TC, TFC, TVC, ATC, AFC, AVC, and MC. Work through the first part of the table (capital and labor inputs, output, fixed, variable and total costs). Label and draw these graphs. Then turn back to the table, completing the data for the average and marginal cost columns. Finally draw and explain the graphs that relate to these data. This exercise allows students to listen to their intuition and follow the example without being distracted trying to get the layout of the table and graphs correct. You’ll also be able to cover more material this way because you won’t be waiting for students to catch up.

Chapter 10 . Production and Cost

167

Product Schedules • •

•

• •

The total product is the total quantity of a good produced in a given period. The marginal product (MP) of labor is the Total Marginal increase in total product that results from a Labor product product one-unit increase in the quantity of labor 0 0 employed with all other inputs remaining 10 the same. 1 10 The average product of labor is equal to the 20 total product of labor divided by the quanti2 30 ty of labor. 6 The table to the right has examples of these 3 36 product schedules.

Average product

10 15 12

The marginal product curve shows the additional output generated by each additional unit of labor. The figure shows a typical marginal product of labor curve (MP), with an upside-down U shape. The shape reflects the point that marginal product has increasing marginal returns initially and decreasing marginal returns eventually. • Increasing marginal returns occurs when the marginal product of an additional worker exceeds the marginal product of the previous worker. The marginal product curve has a positive slope. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows large gains from specialization. Eventually these gains become small or nonexistent and decreasing marginal returns set in. • Decreasing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker. The marginal product curve has a negative slope. The law of decreasing returns states that as a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes. The average product curve shows the average product that is generated by labor at each level of labor. The average product of labor curve (AP) has an upside-down U shape. As the figure shows, the marginal product curve and the average product curve are related: when the marginal product of labor exceeds the average product of labor, the average product of labor increases; when the marginal product of labor is less than the average

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

168

product of labor, the average product of labor decreases; and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum.

10.3

Short-Run Cost

Labor 0

Output 0

Fixed Variable Average Average Average Marginal cost cost Total cost fixed cost variable cost total cost cost (dollars) (dollars) (dollars) (dollars) (dollars) (dollars) (dollars) 50 0 50 10.00 50 100 150 5.00 10.00 15.00 5.00 50 200 250 1.66 6.67 8.33 16.67 50 300 350 1.39 8.33 9.72

The table above continues the previous product schedule table and shows different costs.

Total Cost •

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the cost of the firm’s fixed factors of production—the cost of land, capital, and entrepreneurship. Total variable cost (TVC) is the cost of the firm’s variable inputs—the cost of labor. Total cost is the sum of total fixed cost plus total variable cost:

TC = TFC + TVC. Marginal Cost and Average Costs •

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in output.

•

Average fixed cost (AFC) is total fixed cost per unit of output. The value of AFC falls as output increases.

•

Average variable cost (AVC) is total variable costs per unit of output. At low levels of output, AVC falls as output increases but at higher levels of output, AVC rises as output increases.

•

Average total cost (ATC) is the total cost per unit of output. ATC = AFC + AVC. At low levels of output, ATC falls as output increases but at higher levels of output, ATC rises as output increases.

•

Chapter 10 . Production and Cost

169

other additional important points about this figure: • The vertical distance between the AVC curve and the ATC curve is the AFC. Because the AFC decreases as output increases, these curves become closer to each other as output increases. • The MC curve intersects the AVC curve and ATC curve at their minimums. This chapter has a plethora of definitions. Students must learn the definitions, but the definitions are secondary to the concepts they define and the insights they bring. Focus on why productivity measures and cost measures are useful for decision making. Managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures and production cost measures they can use their understanding of this link to make inferences about how production costs might behave when the firm’s output must change to accommodate market changes.  Land Mine: The grade point average versus marginal grade example in the text is outstanding to use in class to describe how the marginal product and marginal cost curves relate to the average product and average cost curves. Once students can tell a story using the same intuition, they find drawing those curves much easier. While you have the curves drawn on the board or overhead, physically pull the average cost curves down (while marginal cost is below) or pull them up (when the marginal cost curve rises above). Use theatrics: raise your hands over your head and “pull down the curves.” If you have a more sports-oriented class, you can try using a batting average percentage and at-bat outcome example (if you had a .300 batting average and you struck out at your next at-bat [the marginal factor], your batting average is pulled down).

Cost Curves and Product Curves •

The shape of the cost curves is related to the shape of the productivity curves. • The shape of the AVC curve is determined by the shape of the AP curve. Over the range of output for which the AP curve is rising, the AVC curve is falling and over the range of output for which the AP curve is falling, the AVC curve is rising. • The shape of the MC curve is determined by the shape of the MP curve. Over the range of output for which the MP curve is rising, the MC curve is falling and over the range of output for which the MP curve is falling, the MC curve is rising.

Shifts in the Cost Curves •

The cost curves shift with changes in technology or changes in resource prices. • An increase in technology that allows more output to be produced from the same resources shifts the cost curves downward. If the technology requires more capital, a fixed input, then the average total cost curve shifts upward at low levels of output and downward at higher levels of output.

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

170

•

A fall in the price of the fixed factor of production shifts the AFC and ATC curves downward but leaves the AVC and MC curves unchanged. A fall in the price of a variable factor of production shifts the AVC, ATC, and MC curves downward but leaves the AFC curve unchanged.

 Land Mine: Students are introduced to more graphs in this chapter. When summing up the day’s lecture, the clearest way to show the differences (especially with respect to the variables on the axes) is to graph each of the curves on the board at the same time. Suggest that students practice graphing each of the curves many times noting the maximum points, minimum points, and intersections. Tell your students that it is important to draw the ATC curve and MC curve correctly, that is, so that the MC curve intersects the ATC curve when the ATC is at its minimum.

10.4

Long-Run Cost

In the long run, a firm can vary the quantity of both labor and capital, so in the long run all costs are variable costs.

Plant Size and Cost •

In the long run, when a firm changes its plant size, its average total cost might rise, fall, or not change •

•

Economies of scale are features of a firm’s technology that make average total cost fall as output increases. The main source of economies of scale is greater specialization of both labor and capital. Diseconomies of scale are features of a firm’s technology that make average total cost rise as output increases. Diseconomies of scale arise from the difficulty of coordinating and controlling a large business.

 Land Mine: Distinguish between decreasing marginal product in the short run versus diseconomies of scale in the long run. Decreasing returns occur when additional units of labor are combined with a fixed amount of capital. Diseconomies of scale do not occur for the same reason, because in the long run both labor and capital can change. Diseconomies of scale occur because of chaos, organizational overloads, etc. •

Constant returns to scale are features of a firm’s technology that keep average total cost constant as output increases. Constant returns to scale occur when a firm is able to replicate its existing production facility including its management system.

Chapter 10 . Production and Cost

171

The Long-Run Average Cost Curve •

In the long run, a firm can use different plant sizes. Each plant size has a different short-run ATC curve. Each short-run ATC curve is U-shaped and the larger the plant size, the greater is the output at which the average total cost is a minimum.

•

The figure illustrates three average total cost curves for three plant sizes. ATC1 pertains to the smallest plant size and ATC3 to the largest.

•

The long-run average cost curve, LRAC, is the curve that shows the lowest average total cost at which it is possible to produce each output when the firm has sufficient time to change both its plant size and labor employed. This curve is derived from the short-run average total cost curves. It shows the lowest average total cost to produce a given level of output. In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.

•

The LRAC slopes downward when the firm has economies of scale, is horizontal when the firm has constant returns to scale, and slopes upward when the firm has diseconomies of scale.

Point out to the students that the long-run average cost curve yields the lowest average cost of production possible when plant size is free to change. Once a firm commits to a specific plant size, it is locked into a specific short run cost curve configuration. Any significant departure from the range of output per period that best suits that configuration means the firm will incur higher short-run average total costs than it would have had it chosen a more appropriate plant size. If the firm’s competitors chose their plant size more wisely, the firm might have a tough time surviving! This observation explains why successful firms often spend much money on long run market analysis.  Land Mine: Before moving on to the next chapter, be sure that your students see the big picture. There are two big ideas: • First, a firm’s long-run production costs depend on the freedom to choose all inputs. Long-run flexibility enables firms to produce at a lower cost than is possible in the short run when some inputs are fixed. • Second, in the short run, with one or more fixed inputs, production costs vary with output in a predictable way because they are directly linked to input productivity. © 2015 Pearson Education, Inc.

172

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

USING EYE ON YOUR LIFE  Your Average and Marginal Grades Students generally see no purpose in solving for unknowns in high school algebra, but they find that skill handy when trying to determine what score they need on the final exam to achieve the desired outcome. Similarly, students will find it useful and insightful to use their knowledge of marginality to gauge their scholarly performance. Once again, here is an opportunity to demonstrate to your students that economics is not just textbook theory, but a way to understand everyday life.

USING EYE ON RETAILERS’ COSTS  Which Store Has the Lower Costs: Wal-Mart or 7-Eleven? The article provides interesting data and ATC curves for two retailers with dramatically different size stores. The story and curves clearly show why achieving lowest cost as a retailer is a function of not just the size of the retailer, but also the number of customers served. Large retailers require a large number of customers in order to achieve lowest cost, while small retailers need a smaller number of customers to achieve lowest cost. To introduce this discussion, ask students why Wal-Mart doesn’t build supercenters along interstates in isolated areas, whereas it’s common to see mini-marts attached to gas stations in these settings? And why are all Wal-Marts so large? Why don’t they build mini-Wal-Marts? Why does Wal-Mart have to be careful about spacing their stores at a decent distance, while 7- Elevens can be located in much closer proximity to one another?

Chapter 10 . Production and Cost

173

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 10.1 Economic Cost and Profit 1. In 2013, Roma was a schoolteacher and earned $40,000. But she enjoys creating cartoons, so at the beginning of 2014, Roma quit teaching and set to work as a cartoonist. She stopped renting out her basement for $5,000 a year and began to use it as her office. She used $5,000 from her savings account to buy a new computer, and she leased a printer for $150 a year. During 2010, Roma paid $1,250 for paper, utilities, and postage; the bank paid 5 percent a year on savings account balances; and Roma sold $50,000 of cartoons. Normal profit is $3,000 a year. At the end of 2014, Roma was offered $4,000 for her computer. For 2014, calculate Roma's: 1a. Explicit costs. 1b. Implicit costs. 1c. Economic profit.  Checkpoint 10.2 Short-Run Production 2. Lisa has a lawn-mowing business. Lisa hires Total product Labor students to mow the lawns. The table sets out (students per day) lawns cut per day) 0 0 Lisa's total product schedule. 1 20 2a. Calculate the marginal product of the fourth 2 44 student. 3 70 2b. Calculate the average product of four stu4 94 dents. 5 114 6 120 2c. Over what numbers of students does marginal product decrease? 2d. When marginal product decreases, compare average product and marginal product. 3.

Create some hypothetical short-run production data for a firm’s labor employment and output. Calculate the firm’s average product and marginal product schedule. Carefully graph the data. What happens at the minimum of the average product curve?

 Checkpoint 10.3 Short-Run Cost 4. Lisa has a lawn-mowing business. Lisa hires students at $40 a day to mow lawns. Lisa leases 5 lawn mowers for $200 a day. The table gives the daily output. 4a. Construct the total variable cost and total cost schedules. 4b. Construct the average fixed cost, average

Total product Labor (students per day) (lawns cut per day) 0 0 1 . 20 2 44 3 70 4 94 5 114 6 120

174

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

variable cost, and average total cost schedules. 4c. Construct the marginal cost schedule. 4d. Check that the gap between total cost and total variable cost is the same at all outputs. Explain why. 

Answers

 Checkpoint 10.1 Economic Cost and Profit 1a. Explicit costs are the $150 printer lease and $1,250 for paper, utilities, and postage, so total explicit costs are $1,400. 1b. Implicit costs are $40,000 in wages forgone, $5,000 in rent forgone, $3,000 in normal profit, $250 in forgone interest payments on the savings, and $1,000 in economic depreciation on the computer, so implicit costs are $49,250. 1c. Economic profit equals total revenue minus total opportunity cost, which is the sum of the explicit costs and implicit costs. So Roma’ economic profit is $50,000 − ($1,400 + $49,250), which equals −$650. Roma incurs an economic loss of $650 for the year.  Checkpoint 10.2 Short-Run Production 2a. The total product with 3 workers is 70 lawns mowed and the total product with 4 workers is 94 lawns mowed. So, the marginal product of the fourth student is 24 lawns. 2b. The average product of four students is (94 lawns) ÷ (4 students), which is 23.5 lawns. 2c. The marginal product decreases between 4 and 6 students. 2d. When marginal product decreases, eventually it become less than average product. Before it is less than average product (that is, when marginal product, though decreasing, exceeds average product) average product increases as more workers are hired. When marginal product is less than average product, average product decreases as more workers are hired. 3.

Students will have individual answers. Make sure their average product curve is U-shaped and that the marginal product curve intersects the average product curve at the minimum of the average product curve. Also make sure that the axes are labeled correctly.

Chapter 10 . Production and Cost

 Checkpoint 10.3 Short-Run Cost 4a. The total costs are in the table to the right.

4b. The average costs are in the table to the right.

Labor 0 1 2 3 4 5 6

Output 0 20 44 70 94 114 120

Total Total fixed cost variable cost 200 0 200 40 200 80 200 120 200 160 200 200 200 240

Average Average fixed cost variable cost xx xx 10.00 2.00 4.55 1.82 2.86 1.71 2.13 1.70 1.75 1.75 1.67 2.00

4c. The marginal cost is in the table to the right. 4d. The gap between total cost and total variable cost is the same at all levels of output because total cost minus total variable cost equals total fixed cost. Note in the answer to part (a), that the difference between total variable cost and total cost is always $200, the amount of total fixed cost.

Labor 0

Output 0

114

120

175

Total cost 200 240 280 320 360 400 440

Average total cost xx 12.00 6.37 4.57 3.83 3.50 3.67 Marginal cost 2.00 1.67 1.54 1.67 2.00 6.67

Chapter

Perfect Competition CHAPTER OUTLINE 1. Explain a perfectly competitive firm’s profit-maximizing choices and derive its supply curve. A. Perfect Competition B. Other Market Types 1. Monopoly 2. Monopolistic Competition 3. Oligopoly C. Price Taker D. Revenue Concepts E. Profit-Maximizing Output F. Marginal Analysis and the Supply Decision G. Temporary Shutdown Decision 1. Loss When Shut Down 2. Loss When Producing 3. The Shutdown Point H. The Firm’s Short-Run Supply Curve 2. Explain how output, price, and profit are determined in the short run. A. Market Supply in the Short Run B. Short-Run Equilibrium in Normal Times C. Short-Run Equilibrium in Good Times D. Short-Run Equilibrium in Bad Times 3. Explain how output, price, and profit are determined in the long run and explain why perfect competition is efficient. A. Entry and Exit 1. The Effects of Entry 2. The Effects of Exit B. Change in Demand C. Technological Change D. Is Perfect Competition Efficient? E. Is Perfect Competition Fair?

178

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 11 has slight revisions from the fifth edition.

 Where We Are In this chapter, we examine the profit-maximizing decisions made by a perfectly competitive firm in the short run and the long run. To do so, we use the groundwork on firms’ costs laid in the previous chapter.

 Where We’ve Been In Chapter 11 we use the foundation built in Chapter 10, which studied firms’ production and costs. The cost material covered in Chapter 10 remains important also in Chapters 12 and 13.

 Where We’re Going After this chapter, we continue studying firms’ behavior by looking at the demand and marginal revenue curves for monopolies, oligopolies and monopolistically competitive firms. We will see operating decisions faced by these firms and we can compare them with those made by perfectly competitive firms.

IN THE CLASSROOM  Class Time Needed This chapter is very important. Perfect competition is the standard against which other industries are compared, so do not rush through this material. You should plan on spending at least two and a half class sessions and possibly even three. An estimate of the time per checkpoint is: •

11.1 A Firm’s Profit-Maximizing Choices—60 to 80 minutes

•

11.2 Output, Price, and Profit in the Short Run—30 to 50 minutes

•

11.3 Output, Price, and Profit in the Long Run—30 to 40 minutes

Classroom Activity: For Chapters 11, 12, and 13 with your guidance your students can create a chart similar to the one below. For each market structure, have your students suggest realworld examples of industries that fit the market structure, tell how prices are set, what prob© 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 11 . Perfect Competition

179

lems and what benefits the consumer and producer face in each market structure, and what role the government might play in each market structure. You also can add other topics—is there an economic profit in the long run?; can the firm price discriminate?; are there barriers to entry?; is there product differentiation?; and so forth. The information can by put on the course web site, or assembled for a handout to be given at the end of presentation of Chapter 13. Perfect competition

Monopoly

Monopolistic competition

Examples Setting price Consumer advantages Consumer drawbacks Producer advantages Producer drawbacks Role of government

Oligopoly

180

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

CHAPTER LECTURE 11.1

A Firm’s Profit-Maximizing Choices

Lecture Launcher: Begin by drawing a spectrum of market types noting the four market structures to be studied in this and the next chapters. Let your students know that you will be comparing how a firm in each of these market structures chooses its equilibrium price and equilibrium quantity. Putting this diagram on the board provides a good foundation for the following chapters. Perfect competition exists when • Many firms sell identical products to many buyers • There are no restrictions on entry into the industry • Established firms have no advantage over existing ones • Sellers and buyers are well informed about prices Lecture Launcher: Once you discuss the characteristics that define perfect competition it is useful to give examples of perfectly competitive markets. The examples that always spring to mind are agricultural in nature. Often students, particularly those in urban areas, wonder why they will spend so much of their time studying agriculture. You need to combat the natural view that the model of perfect competition applies only to farms. There are two, complementary paths you can take: First, tell your students that although agriculture certainly meets all the requirements of perfect competition, a lot of other industries come close. If they live in an area with plenty of gas stations, the market for gasoline may be close to perfect competition – each station is selling virtually identical product in close proximity to competitors, which forces each station to be a price taker. If you have a mall near by, you can assign your students to walk through the mall and take note of the different types of businesses and list those that they think are closest to perfect competition. Businesses such as shoe stores, jewelry, toy stores, book stores, hair salons, and so forth are all commonly found in malls and are all relatively close to being in perfectly competitive markets. For instance, you can point out to the students that one jewelry store’s products aren’t identical to those of any other jewelry store, but they are very close substitutes. So, although the jewelry market does not exactly meet the definition of a perfectly competitive market, it is likely close enough so that if we want to understand the forces that affect firms within this industry, perfect competition is a reasonable starting point. Second, you can use a physical analogy. Ask your students how many of them have taken physics and encountered the assumption of a perfect vacuum. A perfect vacuum cannot exist and our world is not close to being a perfect vacuum. Yet physicists often use the model of a perfect vacuum to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 11 . Perfect Competition

181

will take a feather to make the same trip, you need a fancier model! Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition. Other market types are: • Monopoly, a market for a good or service that has no close substitutes and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms. • Monopolistic competition, a market in which a large number of firms compete by making similar but slightly different products. • Oligopoly, a market in which a small number of firms compete. Have the students consider the markets for goods for which they are familiar to see if any meet the strict criteria for perfect competition. The markets that come closest are agricultural markets, though others such as lawn service, laundromats, fishing, plumbing, and so on, come close. Students sometimes “worry” that these markets are not exact examples of perfect competition. Reassure them that the model of perfect competition gives us a great deal of understanding into the workings of extremely competitive real world markets and the real world firms in the markets. •

A firm’s objective is to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total cost of production. Part of the total cost is the normal profit.

 Land Mine: Every term you probably have students who ask, “Do firms really choose the output that maximizes profit?” To answer this question, perhaps before it is asked, it is useful to explain to your students that many big firms routinely make tables using spreadsheets of total revenue, total cost, and economic profit. But most firms, and certainly most small firms, don’t make such calculations. Nonetheless, they do make their decisions at the margin. They can figure out how much it will cost to hire one more worker and how much output that worker will produce. So they can figure out their marginal cost—wage rate divided by marginal product. They can compare that number with the price. They are choosing at the margin as our model of perfect competition assumes.

Price Taker •

Perfectly competitive firms are price takers, a firm that cannot influence the market price and so it sets its own price equal to the market price.

 Land Mine: Show what is meant by the term “price taker” by drawing the market supply and market demand curves and the resulting equilibrium price on the left side of the board and then draw the firm’s demand and © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

182

marginal revenue curves on a separate graph to the right of the first figure. Draw a dotted line across from the market graph to the firm graph. Really emphasize the fact that the market demand differs from the firm’s demand because the firm is such a small part of the market. Students consistently confuse the difference between the market demand and the firm’s demand, so the more time you spend clearly explaining this distinction, the better.

Revenue Concepts •

Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases. The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.

Profit-Maximizing Output • •

The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit. Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the marginal revenue (which remains constant with output) to the marginal cost (which changes with output) of producing different levels of output. • When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of producing one more unit, so the firm increases its output to increase its profit. • When MR < MC, then the extra cost of producing one more unit exceeds the extra revenue from selling one more unit, so the firm decreases its output to increase its profits. • When MR = MC, then the extra cost of producing one more unit equals the extra revenue from selling one more unit, so the firm’s profit is maximized at this level of output. In the figure, the firm maximizes its profit by producing q.

Marginal Analysis and the Supply Decision •

As output rises, MR is constant, but MC eventually increases. If MR exceeds MC, increasing output leads to increasing economic profit. But when MC is greater than MR, a decrease in economic profit will result from selling additional output.

Chapter 11 . Perfect Competition

183

Temporary Shutdown Decision: In the event that market prices fall so low that a firm cannot cover its costs, the firm must consider its options. These depend upon expectations of the duration of low prices. • Loss When Shut Down: If the firm stops production temporarily, it earns no revenue but there are no variable costs. Fixed costs constitute the only losses so the total economic loss equals the fixed cost. • Loss When Producing: If the firm carries on producing, it incurs both fixed and variable costs while gaining some revenue. The economic loss is revenue minus the sum of total fixed cost plus total variable cost. If total revenue is greater than total variable cost, the firm’s total economic loss is less than its fixed costs, so the firm stays open. But where total revenue is less than total variable costs, the firm’s economic losses exceed total fixed costs so the firm closes.  Land Mine: Students can have a hard time understanding why operating at an economic loss can be the best action. I use a story to help them see this point, Wally’s Wiener World hot dog cart. Wally has four costs: his variable costs for his hot dogs, buns, and mustard and his fixed cost for the interest he pays for the loan he used to buy his cart. (If you choose, you can make up numbers for each of these costs.) When price is greater than average variable cost, P>AVC, Wally can pay for his hot dogs, buns, and mustard, and part of the interest cost, his fixed cost. I show that because he can pay part of his fixed cost, he should stay open. But if P < AVC, Wally can’t even pay for all the dogs, buns, and mustard, much less pay for the interest on his loan. In this circumstance, Wally is better off by shutting down. •

The Shutdown Point: • If total revenue is less than variable costs, then P > AVC. In this case, the firm shuts down temporarily, thus limiting its losses to total fixed costs. • If total revenue equals variable costs, then P = AVC. In this case, the firm is indifferent between shutting down temporarily or carrying on, because in either case the economic loss will equal fixed costs.

 Land Mine: Explaining whether a firm exits, temporarily shuts down, or produces even though it has an economic loss is difficult because the last two topics are tough for the students to understand. Exit is the easiest for them to understand because they have seen firms fail throughout their life. But, temporary shutdown is harder to explain. You can help them by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Amusement parks significantly cut back on the days and hours they are open during the winter. Ski resorts don’t stay open during the summer. Why? Your students will easily figure out © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

184

that total revenue is less than total variable cost and equivalently that price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

The Firm’s Short-Run Supply Curve •

•

The firm will temporarily shut down in the short run when price falls below the price that just allows it to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the firm’s loss would be greater than if it shut down. The loss when the firm shuts down is equal to its fixed cost. As long as the firm remains open, it produces where MR = MC. So the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero.

 Land Mine: You will always have students asking why the firm bothers to produce the precise unit of output for which MR = MC. Indeed, it is simply amazing how many students “worry” about this one particular unit of output! Try the following: Draw the conventional upward-sloping MC curve and horizontal MR curve. Make sure to draw these so that the firm will produce a good deal of output. Then, starting at 0, move a bit to the right along the horizontal axis and stop at a point. Tell the students that this point measures 1 unit of output and ask them if this unit should be produced. The answer ought to be yes, because you have arranged matters so MR > MC. Pick some numbers—say, MR = $10 and MC = $1. Ask your students what the profit is for this unit and what the firm’s total profit is if it produces only 1 unit. The answers are $9 and $9. Below the x-axis, label two rows, one called “profit on the unit” and the other “total profit.” Put $9 and $9 in each space under your 1 unit of output. Then move your finger a bit more along the horizontal axis until you come to where you will define the second unit of output. Ask your students if this second unit should be produced. Again, the answer ought to be yes, because you have arranged matters so MR > MC. Pick another number for MC, say $2. Ask your students what the profit is on this unit and what the firm’s total profit is if it produces 2 units. The answers are $8 and $17. Stress that the total profit is what interests the firm and the total profit equals the sum of the profit from the first unit plus the profit from the second unit. Pick a couple of more units and use numbers until you feel it is safe to generalize that the firm produces a unit of output as long as MR > MC. Then, slide your finger to the right, stopping at closer and closer intervals, asking the class if that particular unit should be produced. Always stress that the firm’s total profit continues to increase, albeit more and more slowly. As you get closer to the magical MR© 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 11 . Perfect Competition

185

equal-to-MC point, make your stopping intervals even closer. Finally, when you reach MR = MC, tell the students that although this specific unit yields no profit, to have stopped anywhere before it means that the firm would have lost some profit. So, only by producing where MR = MC will the firm obtain the maximum total profit. Monday is typically the slowest day in the restaurant industry. So why do most restaurants stay open on Monday? The answer is that even if a restaurant incurs an economic loss on Monday, it still might increase its total profit by remaining open. The point is that as long as the restaurant can cover all its variable costs—the cost of the food, the cost of the servers, and so on—it likely will be able to pay some of its fixed costs using the revenue left over after paying its variable costs. As long as the restaurant can pay some of its fixed costs on Monday, its total profit by staying open exceeds what its total profit would be if it closed. So losing money on Monday might be good business!

11.2

Output, Price, and Profit in the Short Run

Market Supply in the Short Run •

The market supply curve in the short run shows the quantity supplied by the industry at each possible price when the number of firms is fixed. The quantity supplied in the industry at any price is the summation of all quantities supplied by each firm at that price.

 Land Mine: Students need repeated reminders that to determine whether a firm can increase profit by changing output, price and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion.

Short-Run Equilibrium in Normal Times •

In normal times, firms make zero economic profit. The figure to the right shows such a firm. The price is $3 per unit and the firm produces 3 units. P = ATC, so the firm has zero economic profit.

 Land Mine: Students are often skeptical that a zero economic profit is an acceptable outcome for an entrepreneur. The key is to reinforce the meaning of normal profit. A rational decision is one that is based on a weighing of the opportunity cost of each alternative against its full benefits. Opportunity cost © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

186

includes the benefits from forgone opportunities as well as explicit costs. One of these forgone opportunities for the entrepreneur is pursuing his or her next best activity. The value of this forgone opportunity is normal profit. So, when a firm makes zero economic profit, the entrepreneur earns normal profit and enjoys the same benefits as those available in the next best activity. There is no incentive to change to the next best activity.

Short-Run Equilibrium in Good Times •

• •

There are three possible profit outcomes—an economic profit, zero economic profit, and an economic loss. If the price exceeds the ATC, the firm makes an economic profit. The figure illustrates a perfectly competitive firm that is making an economic profit. The firm produces 4 units, has a price of $3 per unit, and makes an economic profit equal to the area of the darkened rectangle.

Short-Run Equilibrium in Bad Times • •

If the price is less than the ATC, the firm incurs an economic loss. The figure illustrates a perfectly competitive firm that is suffering an economic loss. The firm produces 3 units, has a price of $3 per unit, and incurs an economic loss is equal to the area of the darkened rectangle.

Chapter 11 . Perfect Competition

11.3 •

187

Output, Price, and Profit in the Long Run

If the price equals the ATC, the firm makes zero economic profit. In this case, the firm’s owners receive a normal profit.

Entry and Exit • •

Changes in market demand influence the output and the entry or exit decisions made by firms. An increase in market demand shifts the demand curve rightward and raises the market price. Each firm in the industry responds by increasing its quantity supplied.

•

The higher price now exceeds each firm’s minimum ATC and the firms in the industry make an economic profit. The economic profit motivates firms to enter the industry, thereby increasing the market supply. The market supply curve shifts rightward and the market price falls. Eventually the price falls to equal the minimum ATC for each firm in the industry. At this price, firms in the industry no longer make an economic profit.

•

The effects of a decrease in market demand are the opposite of those outlined above: The price falls, firms incur an economic loss, some firms exit thereby decreasing the supply and so the price rises until the surviving firms make zero economic profit.

Change in Demand •

When demand for a good increases, in the short run the existing firms in an industry make an economic profit.

•

The economic profit for the firms is a incentive for other firms to enter the industry in order to make an economic profit. As they do, the supply increases which drives down the price. Entry continues until in the long run the firms make zero economic profit.

Technological Change •

New, cost-saving technologies typically require new plant and equipment. So it takes time for new technology to spread throughout an industry.

•

Firms that adopt the new technology lower their costs and their supply curves shift rightward. The price of the good falls, so that firms using the old technology incur economic losses.

•

Old-technology firms either adopt the new technology or else exit the industry. In the long run, all the firms use the new technology and make zero economic profit.

Is Perfect Competition Efficient? •

• •

Resource allocation in a market is efficient when society values no other use of the resources more highly. Resource use is efficient when production is such that the marginal benefit of the good equals the marginal cost of the good. A firm’s supply curve for a good is its marginal cost curve and so the market supply curve for a good is the society’s marginal cost curve. The demand curve is the marginal benefit curve.

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

188

•

In a competitive equilibrium, the quantity demanded equals the quantity supplied. The demand curve is the same as the marginal benefit curve and the supply curve is the same as the marginal cost curve, so at the competitive equilibrium, the marginal benefit equals the marginal cost. Resource use is efficient. Because resources are used efficiently, at the competitive equilibrium there is no other allocation of resources that will generate greater net benefits to society. The figure shows this outcome, where resource use is efficient at the equilibrium quantity of 3,000 units.

Point out to your students that the entry (or exit) discussed when the demand changes really shows how the self-interested decisions by firms’ owners promote the social interest by using more resources to produce those goods that are more highly valued by society. This intuition helps reinforce the more technical definition of allocative efficiency.

Is Perfect Competition Fair? •

Perfect competition allows anyone to enter the market and the process of competition brings the maximum benefits for consumers. So fairness of opportunity and fairness as equality of outcomes are achieved in perfect competition in the long run.

Chapter 11 . Perfect Competition

USING EYE ON THE AUTO INDUSTRY  Why Did GM Fail? This Eye will help students understand why the failure of General Motors was not only the result of the economic downturn, but stemmed more from a cost structure established many years before. You can use the analysis and model on the first page of the Eye to help students grasp the economic loss in 2008, and then ask them to brainstorm a list of possible changes that could help GM reduce (or even eliminate) losses. Responses will likely revolve around lowering costs, raising prices, or increasing sales. For cost cutting, help students identify whether the costs are fixed or variable and how those lower costs shift the appropriate cost curves to reduce losses. For higher prices, help students identify that if GM is in a competitive global market, they are price takers – so what global market changes would have to occur for GM to charge higher prices? As for increasing sales, if costs and marginal revenue are held constant, does selling a greater quantity reduce losses or create larger losses? As for achieving these possible changes, what role can the federal government play in helping GM become profitable? Do your students believe that it is the role of the government to help businesses incurring losses? What are the arguments in favor of and against the government intervening in which businesses succeed and which are allowed to fail? Do they think the new GM will succeed? If it does, what does that mean for Ford?

USING EYE ON YOUR LIFE  The Perfect Competition that You Encounter With the advent of the Internet, we now have a much better example of perfect competition to offer our students. With a few keystrokes, we can learn the product offerings and prices charged by hundreds, even thousands of vendors. Some sites will do the searching automatically, and others will show photographs, descriptions, and prices from different vendors all on the same page, allowing for side-by-side comparison. The Internet has helped conquer the last difficulty in perfect competition: information. Yet some people lack access to computers. For them, some of the benefits of competition are unobtainable. You can ask your students what solutions might there be for these people?

189

190

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 11.1 A Firm’s Profit-Maximizing Choices 1. Roy is a potato farmer, and the world potato market is perfectly competitive. The market price is $25 a bag. Roy sells 40 bags a week, and his marginal cost is $20 a bag. 1a. Calculate Roy’s total revenue. 1b. Calculate Roy’s marginal revenue. 1c. Is Roy maximizing profit? Explain your answer. 1d. The price falls to $18 a bag, and Roy cuts his output to 25 bags a week. His average variable cost and marginal cost fall to $18 a bag. Is Roy maximizing profit? Is he making an economic profit or incurring an economic loss? 1e. What is one point on Roy’s supply curve?  Checkpoint 11.2 Output, Price, and Profit in the Short Run Quantity 2. Lisa’s Lawn Company is a lawn-mowing (lawns per hour) business in a perfectly competitive market for 0 lawn-mowing services. The table sets out Li1 sa’s costs. If the market price is $30 a lawn: 2 2a. How many lawns an hour does Lisa's Lawn 3 Company mow? 4 5 2b. What is Lisa’s profit in the short run? 6 3. In Exercise 2, if the market price falls to $20 a lawn: 3a. How many lawns an hour does Lisa's Lawn Company mow? 3b. What is Lisa’s profit in the short run?

Total cost (dollars per lawn) 30 40 55 75 100 130 165

4. In Exercise 2: 4a. At what market price will Lisa shut down? 4b. When Lisa shuts down, what will be her economic loss?  Checkpoint 11.3 Output, Price, and Profit in the Long Run 5. Lisa’s Lawn Company is a lawn-mowing Quantity business in a perfectly competitive market for (lawns per hour) lawn-mowing services. The table sets out Li0 1 sa’s costs. 2 5a. If the market price is $30 a lawn, what is Li3 sa’s economic profit? 4 5b. If the market price is $30 a lawn, do new 5 firms enter or do existing firms exit the indus6 try in the long run?

Total cost (dollars per lawn) 30 40 55 75 100 130 165

Chapter 11 . Perfect Competition

5c. What is the price of the lawn service in the long run? 5d. What is Lisa’s economic profit in the long run? 6.

A catfish farmer is operating in a perfectly competitive market. The market price of catfish is $5 a pound and each farmer produces 1,000 pounds a week. The average total cost is $7 a pound. 6a. What is a catfish farmer’s profit in the short run? 6b. What happens to the total number of farms in the long run? 6c. If technology reduces the cost of catfish farming while the demand for catfish increases, what happens to price in the long run? 

Answers

 Checkpoint 11.1 A Firm’s Profit-Maximizing Choices 1a. Roy’s total revenue equals the quantity multiplied by the price, which is 40 × $25 = $1,000. 1b. Roy is a perfect competitor, so his marginal revenue equals his price. Roy’s marginal revenue is $25 a bag. 1c. Roy is not maximizing profit because marginal cost, $20, is less than marginal revenue, $25. He should sell more bags until marginal cost rises to $25 because then his marginal cost equals his marginal revenue. 1d. If the price is $18, Roy’s marginal revenue is $18. Roy is maximizing profit by selling 25 bags because the marginal cost of the 25th bag is $18. Roy is incurring an economic loss because price is less than average total cost. 1e. One point on Roy’s supply curve is a price of $18 and a quantity of 25 bags.  Checkpoint 11.2 Output, Price, and Profit in the Short Run 2a. If the market price is $30 a lawn, the marginal revenue is $30 a lawn. Lisa mows 5 lawns because the marginal cost of mowing the fifth lawn is $30. 2b. Average total cost equals total cost divided by output, so Lisa’s average total cost is $130 ÷ 5, which is $26 a lawn. The economic profit per lawn is the price minus the average total cost, which is $30 a lawn − $26 a lawn = $4 a lawn. So Lisa’s total profit is $4 a lawn × 5 lawns, which is $20. 3a. If the market price is $20 a lawn, marginal revenue is $20 a lawn. Lisa mows 3 lawns because the marginal cost of mowing the third lawn is $20. 3b. Average total cost equals total cost divided by output, so Lisa’s average total cost is $75 ÷ 3, which is $25 a lawn. The economic “profit” per lawn is the price minus the average total cost, which is $20 a lawn − $25 a lawn = −$5 a lawn. Lisa incurs an economic loss of $5 a lawn. So her total economic loss is $5 loss per lawn× 3 lawns, which is $15. 4a. Lisa’s shutdown point is at $10 a lawn and 1 lawn mowed. Mowing 1 lawn has a marginal cost of $10, so when the price is $10, mowing 1 lawn sets marginal cost equal to marginal revenue. Lisa’s total variable cost at this © 2013 Pearson Education, Inc. Publishing as Addison Wesley

191

192

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

level of output is $10 because her total fixed cost is $30. (Her total fixed cost is her total cost when she mows zero lawns.) When Lisa mows 1 lawn, her average variable cost is $10 ÷ 1, which is $10. Lisa’s minimum average variable cost is $10, so when the price is $10, Lisa is at her shutdown point. 4b. When Lisa shuts down, her loss equals her total fixed cost, which is $30.  Checkpoint 11.3 Output, Price, and Profit in the Long Run 5a. If the market price is $30, marginal revenue equals $30. Lisa mows 5 lawns because that is the quantity for which marginal cost equals marginal revenue. The average total cost of cutting a lawn when 5 are cut is $26 so Lisa makes an economic profit of $4 a lawn. She cuts 5 lawns so her total economic profit is $4 × 5 = $20. 5b. Because firms are making an economic profit, new lawn-mowing firms enter the market. 5c. In the long run, the price is $25, which is the minimum of average total cost. 5d. In the long run, Lisa’s economic profit is zero. 6a. Because the price is less than average total cost ($5 versus $7), each farmer incurs an economic loss of $2 a pound and a total economic loss of $2,000. 6b. Because some firms are incurring an economic loss, they exit the market. Supply decreases and the market price rises. In the long run, the number of farms decreases. 6c. New technology shifts the cost curves downward. This effect decreases the price in the long run because in the long run price equals the minimum average total cost.

Chapter

Monopoly CHAPTER OUTLINE I. Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly. A. How Monopoly Arises 1. No Close Substitutes 2. A Barrier to Entry a. Natural Barrier to Entry b. Ownership Barrier to Entry c. Legal Barrier to Entry B. Monopoly Price-Setting Strategies 1. Single-Price 2. Price Discrimination 2. Explain how a single-price monopoly determines its output and price. A. Price and Marginal Revenue B. Marginal Revenue and Elasticity C. Output and Price Decision 3. Compare the performance of a single-price monopoly with that of perfect competition. A. Output and Price B. Is Monopoly Efficient? C. Is Monopoly Fair? D. Rent Seeking 1. Buy a Monopoly E. Create a Monopoly F. Rent-Seeking Equilibrium 4. Explain how price discrimination increases profit. A. Price Discrimination and Consumer Surplus 1. Discriminating Among Groups of Buyers 2. Discriminating Among Units of a Good B. Profiting by Price Discriminating C. Perfect Price Discrimination D. Price Discrimination and Efficiency © 2013 Pearson Education, Inc. Publishing as Addison Wesley

194

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

5. Explain why natural monopoly is regulated and the effects of regulation. A. Efficient Regulation of a Natural Monopoly B. Second-Best Regulation of a Natural Monopoly 1. Average Cost Pricing 2. Government Subsidy 3. And the Second-Best Is … 4. Rate of Return Regulation 5. Price Cap Regulation

CHAPTER ROADMAP

 What’s New in this Edition? The material in Chapter 12 is largely unchanged from the fifth edition, though the Eye applications have been updated and slightly rewritten.

 Where We Are In this chapter, we examine another market structure: monopoly. We discuss how monopoly arises and how a monopoly (single-price or price-discriminating) chooses its profit-maximizing output and price. Recognizing that monopoly creates a deadweight loss, we discuss whether monopoly is efficient and fair. The concept of rent seeking is examined and reveals that rent seeking is likely to extract all of the economic profit made by a monopoly. Finally, regulation of natural of monopoly is covered.

 Where We’ve Been The previous chapter studied perfectly competitive firms’ demand and marginal revenue curves. We combined them with the cost curve analysis in Chapter 14 to determine perfectly competitive firms’ profit-maximizing output and price decisions.

 Where We’re Going After this chapter we examine two more market structures: monopolistic competition and oligopoly in Chapter 13.

Chapter 12 . Monopoly

195

IN THE CLASSROOM  Class Time Needed Because the students are familiar with firm behavior in perfect competition, this chapter is somewhat easier to present. Even so, there is a lot of important material, so you should spend approximately three to four class sessions on this material. An estimate of the time per checkpoint is: •

12.1 Monopoly and How It Arises—15 minutes

•

12.2 Single-Price Monopoly—30 to 50 minutes

•

12.3 Monopoly and Competition Compared—20 to 30 minutes

•

12.4 Price Discrimination—30 to 40 minutes

•

12.5 Monopoly Regulation—30 to 40 minutes

Classroom Activity: After defining a monopoly, you can ask your students to discuss the economic factors which lead to the development of monopolies. To what extent are those conditions products of the free market? In which case, students can debate the role of government with regard to monopoly. If it is the result of natural coalescence in a free market, then is it equitable and/or efficient to intervene? Clearly there is no definitively correct answer to these questions, which is perhaps why they are so much fun to debate! There are many examples of government licensing. Licensing can protect consumers from fraud and abuse, but they can also hurt consumers by preventing competition from producing an efficient allocation of resources. Have the students debate the merits of the following licensing arrangements: 1) Doctors can receive a medical license to practice medicine only by graduating from an AMA approved medical program; 2) Lawyers can practice law only after passing an extensive Bar Exam; 3) Cab drivers in New York City can operate a taxi only if they have purchased a medallion from the city, of which there are a finite number; 4) Beauticians in many states cannot operate a beauty parlor without a state certification that requires training in sanitary practices as well as other courses completely unrelated to their profession (such as civics and history courses).

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

196

CHAPTER LECTURE 12.1

Monopoly and How It Arises

Lecture Launcher: Students love monopoly! Many of your students are taking an economics course because they think it will help them either get a better job or run a better business. Indeed, it is likely that many of your students are aspiring entrepreneurs. You’ve just had them slog through a heavy chapter on perfect competition, the bottom line of which is that the bottom line is miserable. Normal profit might be the best that many people can achieve but it is not very exciting. This chapter teaches the students how to make a serious entrepreneurial income. Innovate, create a monopoly that produces something that people value much more than the cost of producing it, and price discriminate as much as possible. Lecture Launcher: Explain that the monopoly model is a benchmark model - similar to the case of perfect competition. Although no real-world industry satisfies the full definition of a monopoly market, the behavior of firms in many real world industries can be predicted by using the monopoly model. Mention that this chapter examines the least competitive end of the spectrum of markets, just like Chapter 15 discussed the most competitive end. A monopoly has two key features: • No Close Substitutes: There are no close substitutes for the good or service. • Barriers to Entry: Legal or natural constraints that protect a firm from potential competition are called barriers to entry. Monopolies are protected by barriers to entry. • Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. •

When one firm owns all (or most) of a natural resource, it creates an ownership barrier to entry.

•

Legal barriers to entry create a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise (an exclusive right is granted to a firm to supply a good or service—the U.S. Postal Service has a public franchise to deliver first-class mail), a government license (when the government controls entry into particular occupations, professions and industries—a license is required to practice law), a patent (an exclusive right granted to the inventor of a product or service) or a copyright (exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work).

Monopoly Price-Setting Strategies • •

A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers. Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

Chapter 12 . Monopoly

12.2

197

Single-Price Monopoly

Price and Marginal Revenue •

•

The demand curve facing a monopoQuantity Total revMarginal ly firm is the market demand curve. Price demanded enue revenue Total revenue (TR) is the price (P ) $4 0 $0 multiplied by the quantity sold (Q ). $3 Marginal revenue (MR ) is the $3 2 $6 change in total revenue resulting $1 from a one-unit increase in the quan$2 4 $8 tity sold. The table shows the calcula−$1 tion of TR and MR. $1 6 $6 A key feature of a single-price monopoly is that MR < P at each quantity so, as illustrated in the figure below, the MR curve lies below the demand curve. MR < P because a single–price monopoly must lower its price on all units sold to sell an additional unit of output.

 Land Mine: Marginal revenue can be a sticking point for many students. Students find it easier to see the difference between the monopoly’s demand and marginal revenue curves if you take two steps. First develop a total revenue schedule using price and quantity data. Then add another column showing marginal revenue. Place the marginal revenue values between the quantity values. In the next step, draw the demand and marginal revenue curves. Again, emphasize that marginal revenue is plotted between two quantity levels. By explicitly graphing the data, you also have the framework for showing that the price of the good is always less than marginal revenue of a monopoly.

Marginal Revenue and Elasticity •

When demand is inelastic, fall in price decreases total revenue. A monopoly never profitably produces along the inelastic range of its demand curve because it could increase total revenue by raising the price and selling a smaller quantity.

Output and Price Decisions •

To maximize its profit, a monopoly produces the level of output where MR = MC. The monopoly then uses its demand curve to set the price at the maximum possible price for which it © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

198

•

will be able to sell the quantity it produces. In the figure, which uses the demand and MR schedules from the table above, the firm produces 200 units of output and sets a price of $160 per unit. The firm makes an economic profit if P> ATC, which is the case for the firm in the figure. The monopoly can make the economic profit even in the long run because the barriers to entry protect the firm from competition. However, a monopoly firm is not guaranteed an economic profit. In the short run and/or long run, it might make zero economic profit, (P = ATC) or in the short run, it might incur an economic loss (P > ATC ).

Lecture Launcher: The figure on the previous page, the classic monopoly diagram, provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book The Economics of Imperfect Competition, published in 1933 when she was just 30 years old. Women are still not attracted to economics on the scale that they’re attracted to most other disciplines. So the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk. Monopolizing the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time.

12.3

Monopoly and Competition Compared

Output and Price •

•

Perfect Competition: The market demand curve (D) in perfect competition is the same demand curve that the firm faces in monopoly. The market supply curve (S ) in perfect competition is the horizontal sum of the individual firm’s marginal cost curves. This supply curve also is the monopoly’s marginal cost curve, so in the figure above the supply curve is labeled MC. In a competitive market, equilibrium occurs where the quantity demanded equals the quantity supplied, which in the figure above is 250 units of output and a price of $140 per unit. Monopoly: The monopoly produces where MR = MC and sets its price using its demand curve. In the figure, the monopoly produces 200 units of output and sets a price of $160 per unit. Compared to a perfectly competitive industry, a single-price monopoly produces less output and sets a higher price.

Is Monopoly Efficient? •

A perfectly competitive industry produces the efficient quantity of output. Because a single-price monopoly produces less output, it creates a deadweight loss.

Chapter 12 . Monopoly

•

199

Though the monopoly creates a deadweight loss, the monopoly benefits its owners because it makes an economic profit. A monopoly benefits the owner because it redistributes some of the consumer surplus away from the consumer and to the monopoly producer.

It is important for students to recognize that the source of the inefficiency of a monopoly firm’s output and pricing decision arises from the absence of competition in the market, rather than any change in the behavioral assumptions about the firm owners. The intentions of a monopoly firm are the same as a competitive firm – maximize profit. So, “Mom and Pop,” the owners of a perfectly competitive firm, are maximizing their profit as surely as the owners of a monopoly.

Is Monopoly Fair? •

A monopoly redistributes gains from consumers to producers. According to the fair results standard, this is fair if the consumers are richer than the monopoly. According to the fair rules standard, this is fair if everyone is free to acquire the monopoly.

Rent Seeking •

•

The social cost of monopoly might exceed the deadweight loss it creates because of rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit. Rent seeking can occur when someone uses resources seeking the opportunity to buy a monopoly for a price less than the monopoly’s economic profit. Rent seeking also can occur when someone uses resources lobbying the government to restrict the competition faced by the lobbyist. The resources used up in rent seeking are a cost to society that adds to the monopoly’s deadweight loss. Because there are no barriers to entry in the activity of rent seeking, the resources used up can equal the monopoly’s potential economic profit. A person can become the owner of a monopoly in two ways: • Buy a monopoly: A person can buy a firm (or a right) that is protected by a barrier to entry. Competition to buy a monopoly will drive up the price to the point at which they make zero economic profit. • Create a Monopoly by Rent Seeking: A person can try to influence the political process to get laws that create legal barriers to entry. Rent-seeking equilibrium: Competition among rent seekers pushes up the cost of rent seeking until it leaves the monopoly making zero economic profit after paying rent-seeking costs. Rent seeking leaves consumer surplus unaffected but converts producer surplus into deadweight loss.

12.4

Price Discrimination

Price discrimination is the practice of selling different units of a good or service for different prices. Price discrimination converts consumer surplus into economic profit. To be able to price discriminate, a firm must: • Identify and separate different buyer types. • Sell a product that cannot be resold.

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

200

Students tend to find price discrimination very interesting, so take advantage of that by getting them to brainstorm examples and discuss those as a class. Outside of movie tickets (matinee pricing, student/senior/child discounts), air travel (14-day window for business/emergency vs. leisure travelers), and haircuts (age, gender?), here are some more examples to get the ball rolling: - Happy Hour: For most people, going out to eat dinner and drink during the mid-afternoon hours is undesirable. Restaurants and bars offer the lower prices during these times to allow buyers to separate themselves according to willingness to pay. Those with a lower willingness to pay get a deal by going to happy hour, while those with a higher willingness to pay have to pay more to go during “normal” times. This is similar to twilight rates at golf courses, movie matinees, and mid-week rates at hotels and theme parks. - Coupons: Finding, clipping, and keeping coupons can be a hassle. The only people willing to do it, are the ones who are most price sensitive. Coupons allow those with a lower willingness to pay to end up paying lower prices, while those not willing to go through the coupon hassle have to pay more. - Financial Aid: College students end up paying different amounts for their education as a result of financial aid. Many financial aid programs are income based, trying to target those with a lower willingness to pay as a result of lower income. In general, those with higher incomes (and higher willingness to pay) pay more for college, while those with lower incomes pay less after financial aid. In addition, scholarships can be a hassle to apply for. Those willing to go through the process (perhaps as a result of a lower willingness to pay), end up paying a lower price. - Hardcover Books: Dedicated followers of a particular writer are eager for the release of a new book and are willing to pay more for it. When the more expensive hardcover book sales slow down enough, publishers release a far cheaper paperback version for those readers who are more price sensitive.

Price Discrimination and Consumer Surplus •

Price discrimination occurs because of differences in willingness to pay for the good. A firm can charge the same buyer different prices for different units of a good or a firm can charge different prices to different groups of buyers. • Discriminating Among Groups of Buyers: A firm can charge different customers different prices for the product. Groups with a higher average willingness to pay are charged a higher price and groups with a lower average willingness to pay are charged a lower price. An example is airline travel, where business travelers who have a high average willingness to pay and often make last-minute reservations are charged a higher price than leisure travelers, who have a low average willingness to pay and often make advance reservations. • Discriminating Among Units of a Good: A firm can charge a higher price for the first units purchased and a lower price for later units purchased. An example is pizza delivery, where the second pizza is generally cheaper than the first.

Profiting by Price Discriminating •

Chapter 12 . Monopoly

201

crimination converts consumer surplus into economic profit.

Perfect Price Discrimination •

Perfect price discrimination occurs when a firm is able to sell each unit of output for the highest price that consumers are willing to pay for each unit. In this case, the price of each unit is the same as the unit’s marginal revenue, so the firm’s (downward sloping) demand curve becomes the same as its marginal revenue curve. Output increases to the point where the marginal revenue (demand) curve intersects the marginal cost and the efficient quantity is produced. The deadweight loss is eliminated. The firm’s economic profit is the largest possible. The firm captures the entire consumer surplus, however, so consumer surplus equals zero.

Price Discrimination and Efficiency •

12.5 •

•

With perfect price discrimination, the monopoly produces the identical output of perfect competition - an efficient outcome. In contrast to perfect competition, consumer surplus is zero and the total surplus is all producer surplus. However, these large producer gains encourage rent seeking, which can use up all of the producer surplus.

Monopoly Regulation Regulation consists of rules administered by a government agency to influence prices, quantities, entry, and other aspects of economic activity in a firm or industry. Conversely, deregulation is the process of removing regulation of prices, quantities, entry, and other aspects of economic activity in a firm or industry. The social interest theory of regulation is that the political and regulatory process relentlessly seeks out inefficiency and introduces regulation that eliminates deadweight loss and allocates resources efficiently. The capture theory of regulation is that the political and regulatory process gets captured by the regulated firm and ends up serving its self-interest, with maximum economic profit, underproduction, and deadweight loss. A natural monopoly is an industry in which one firm can supply the entire market at a lower price than two or more firms can. The figure below shows a natural monopoly. The definition of a natural monopoly means that the firm’s ATC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its ATC curve when the MC curve crosses the firm’s demand curve.

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

202

Efficient Regulation of a Natural Monopoly •

A marginal cost pricing rule sets price equal to marginal cost, P = MC. In the figure, the firm sets a price of Pmc and produces Qmc. • The rule leads to the efficient level of production in the industry, so it maximizes the total surplus in the industry. It is in the public interest. But the firm incurs an economic loss because P < ATC. • A government subsidy can be used to make a direct payment to the firm equal to its economic loss, though the government must use a tax to raise the revenue to pay the subsidy.

Second-Best Regulation of a Natural Monopoly •

•

An average cost pricing rule sets price equal to average total cost, P = ATC. In the figure, the firm sets a price of Patc and produces Qatc. • The rule leads to an inefficient level of production so there is a deadweight loss so this type of regulation is second-best. But the firm makes a normal profit because P = ATC. Implementing pricing rules is difficult because the regulator does not know the firm’s true costs. So regulators often use two practical pricing rules: • Rate of return regulation is regulation that sets the price at a level that allows the regulated firm to make a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities. • A price-cap regulation is a regulation that specifies the highest price that a firm is permitted to set—a price ceiling. Price cap regulation gives managers an incentive to minimize costs because if the firm decreases its costs and makes an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.

Chapter 12 . Monopoly

USING EYE ON THE U.S. ECONOMY  Airline Price Discrimination The Eye provides a good example of how airlines identify many buyer types. Charging different prices alone does not guarantee price discrimination. Airlines effectively price discriminate by requiring passengers to show identification. Before security scares, passengers could board a plane without showing identification so airlines could not prevent the resale of tickets. At that time, price discrimination was more difficult. You might see tickets advertised in the newspapers. There were businesses devoted to reselling low-priced tickets! For example, at that time, you could buy your grandmother’s ticket for which she paid a reduced senior citizen fare. Today, there are valid security reasons for showing identification, so it is much easier for airlines to prevent resale of tickets. You can no longer resell tickets and so airlines can more easily and more effectively price discriminate.

USING EYE ON MICROSOFT  Are Microsoft’s Prices Too High? Have students brainstorm ideas about how Microsoft could offer their operating system at a price equal to MC (zero), while still earning enough revenue to cover their fixed costs of development. One possibility is for Microsoft to charge more for another product they sell to recoup the lost revenue. However, they would need to make sure that consumers are buying this other product from them – which means they need to be a monopolist (or else consumers would buy from a competitor) or need to find a way to tie the operating system to the other product being offered. Tying their operating system with a free browser (Internet Explorer) is what brought about Microsoft’s well-publicized anti-trust cases in the United States. Perhaps Google could serve as their model – could Microsoft sell advertising space in their Windows 7 operating system to cover their fixed costs? As a user of Windows 7, what might be the disadvantages of this? Are there other options that students could come up with for how Microsoft could offer free operating systems? What would be the repercussions of a government subsidy to pay Microsoft for their losses in a marginal cost pricing rule? Are any of these proposed changes more desirable than simply having consumers buy the operating system? Obviously, there is no indisputably correct answer students can come up with to that question, but the thought process will help them explore various pricing scheme options available to a firm and also government regulation. Another exercise is to ask students to identify other examples where a firm provides customers with a “free” good or service – and what allows them to provide © 2013 Pearson Education, Inc. Publishing as Addison Wesley

203

204

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

it for free. For example, cell phone service providers often give subscribers free nights and weekends (and sometimes free mobile-to-mobile calls). The MC of providing this service is very low, but what are the fixed costs? How do cell service providers make up the lost revenue from free calling times and cover their fixed costs? Why do cell phone users get offered free phones if they sign a contract with a service provider? The MC of providing a phone is certainly not zero, so how do cell phone service providers not incur losses from giving away (or heavily reducing the price of) cell phones? Or why do most cable or satellite television service providers offer free installation, free receivers, and free satellite dishes?

USING EYE ON YOUR LIFE  Monopoly in Your Everyday Life The story provides a good example of how monopoly can help individuals. Here is another example in which the answer is also not so clear cut. It implicitly introduces the idea of “network externalities” by pointing out to the students how complicated their lives might be if there were many different operating systems, each with a wide range of applications. You can challenge your students to think of other instances where there might be “network externalities.” One example they might come up with is cellular phones. Think how much more difficult it would be if each brand of cellular phone used its own, proprietary technology. Of course, note that most monopolies have nothing to do with network externalities, but those that do can pose a problem for society. In particular, are we better off with a monopoly Microsoft or might we be better off with, say, 2 or 3 competitive operating systems?

Chapter 12 . Monopoly

205

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 12.1 Monopoly and How It Arises 1. Which of the following situations is a monopoly? 1a. The supermarket that stocks the best-quality products 1b. The supermarket that charges the highest prices 1c. The firm that has the largest share of the market sales 1d. The truck stop in the Midwest, miles from anywhere 1e. A firm that produces a good that has a perfectly inelastic demand 1f. The only airline that flies from St. Louis to Kansas City 2.

Which of the cases in Exercise 1 are natural monopolies and which are legal monopolies? Which can price discriminate, which cannot, and why?

 Checkpoint 12.2 Single-Price Monopoly 3. Dolly’s Diamond is a single-price monopoly. The first two columns of the table show the demand schedule for Dolly’s Diamond, and the middle and third column show the firm's total cost schedule.

Price Quantity Total cost (dollars per (carats per (dollars per carat) day) day) 2,200

2,000 1 3a. Calculate Dolly’s total revenue schedule and 1,800 2 marginal revenue schedule. 3b. Sketch Dolly’s demand curve and marginal 1,600 3 revenue curve. 1,400 4 3c. Calculate Dolly’s profit-maximizing output, 1,200 5 price, and economic profit. 3d. If the government places a fixed tax on Dolly’s Diamond of $1,000 a day, what are Dolly’s new profit-maximizing output, price, and economic profit? 3e. If instead of imposing a fixed tax on Dolly’s, the government taxes diamonds at $600 a carat, what are Dolly’s new profit-maximizing output, price, and economic profit?

800 1,600 2,600 3,800 5,200 6,800

206

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

 Checkpoint 12.3 Monopoly and Competition Compared 4. Figure 12.1 shows an industry. If the market is perfectly competitive, what is the equilibrium quantity that will be produced and the equilibrium price? If the market is a single-price monopoly, darken in the area of the deadweight loss.

 Checkpoint 12.4 Price Discrimination 5. What is price discrimination? Give some real-world examples of price discrimination. 6. Which of the following situations is price discrimination? 6a. The local drug store offers senior citizens a discount on all purchases made on Tuesdays. 6b. Domino’s offers “Buy 1 pizza for $15 and get a second one for only $1.” 6c. Farmers in Southern California pay a lower price for water than do the residents of Los Angeles. 6d. The U.S. Postal Service charges a lower price to mail a postcard than to mail a letter. 

Answers

 Checkpoint 12.1 Monopoly and How It Arises 1a. The supermarket that stocks only the best-quality products is not a monopoly. The statement does not say that no other markets stock these products. If indeed it is the only supermarket in the area that stocks these high-quality products, it still is not a monopoly because there are no barriers to entry to prevent other supermarkets from also stocking the best-quality products. 1b. A supermarket that charges the highest prices is not a monopoly. 1c. The firm with the largest market share is not necessarily a monopoly. 1d. A truck stop miles from anywhere is a monopoly. © 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 12 . Monopoly

207

1e. A firm producing a good with perfectly inelastic demand could be a monopoly. Inelastic demand implies that there are no close substitutes for the good (like insulin), but does not imply that other firms are prevented from entering the market. Unless there is a barrier to entry, the firm is not a monopoly. But, more generally, simply because the demand for a product is inelastic does not mean that the producer is a monopoly. 1f. An airline with the only service on a route has monopoly power on that route. 2.

Because the truck stop is in the middle of nowhere, the market demand for automobile and truck services is relatively small, so the truck stop is a natural monopoly. If two truck stops supplied the market, costs would be higher. (The truck stop could have a legal monopoly if it has purchased all surrounding land or if it lobbied the government to allow it to have the only building permit for the area.) The airline might be a legal monopoly if it has been awarded sole landing rights at one of the airports. The airline can price discriminate because the service cannot be resold.

 Checkpoint 12.2 Single-Price Monopoly 3a. The table showing Dolly’s total Total Marginal revenue and marginal revenue Price Quantity revenue revenue (dollars per (carats (dollars per (dollars per schedules is to the right. carat) per day) day) carat) 2,200

2,000

1,800

3,600

1,600

4,800

1,400

5,600

1,200

6,000

2,000 1,600 1,200 800 400

208

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

3b. Figure 12.2 illustrates Dolly’s demand and marginal cost curves. 3c. Dolly’s marginal cost equals marginal revenue at 2 1/2 carats a day, where both equal $1,200. From the demand curve, the price is $1,700. Total cost of 2 1/2 carats a day is $3,200. Dolly’s total revenue equals (2 1/2 carats) × ($1,700) = $4,250. Her total economic profit is $4,250 − $3,200 = $1,050. 3d. As a result of the tax, Dolly’s fixed cost changes, but her marginal cost does not. Her profit-maximizing level of output is still 2 1/2 carats and her price still equals $1,700. The tax eliminates all but $50 of Dolly’s economic profit. 3e. A $600 a carat tax increases Dolly’s marginal cost by $600 at every level of output. With the increase in her marginal costs, Dolly now sells 1 1/2 carats a day because at this quantity marginal cost equals marginal revenue, which is $1,600. From the demand curve, Dolly’s sets a price of $1,900 a carat. Her total profit equals her total revenue minus her total cost. Her total revenue is (1 1/2 carats) × ($1,900) = $2,850. Her total cost is $2,100 plus the tax of $600, which is $2,700. Dolly’s economic profit is $2,850 − $2,700 = $150.  4.

Checkpoint 12.3 Monopoly and Competition Compared If the market is perfectly competitive, 2 units are produced and the price is $30. The darkened triangle in Figure 12.3 shows the deadweight loss if the market is a single-price monopoly.

Chapter 12 . Monopoly

 Checkpoint 12.4 Price Discrimination 5. Price discrimination is a firm offering the same good for sale at different prices. Examples are a shoe store offering one pair of shoes for $50 and a second pair for half price. A restaurant that offers early bird specials for dinners before 6 pm or a movie theater that offers lower matinee ticket prices are engaging in price discrimination. 6a. The drug store is price discriminating. 6b. Domino’s is price discriminating. 6c. The residents might not face price discrimination. There could be higher costs to transport the water to Los Angeles. If the different prices are based on volume use or if the different prices are based on different types of users, then there is price discrimination. 6d. If the price difference is based on different costs of mailing a letter versus a postcard, then there is no price discrimination.

209

Chapter

Monopolistic Competition and Oligopoly CHAPTER OUTLINE I. Explain how a firm in monopolistic competition determines its price and quantity. A. Large Number of Firms 1. Small Market Share 2. No Market Dominance 3. Collusion Impossible B. Product Differentiation C. Competing on Quality, Price, and Marketing 1. Quality 2. Price 3. Marketing D. Entry and Exit E. Identifying Monopolistic Competition F. Output and Price in Monopolistic Competition G. The Firm’s Profit-Maximizing Decision H. Long Run: Zero Economic Profit I. Monopolistic Competition and Perfect Competition 1. Excess Capacity 2. Explain why advertising costs are so high in monopolistic competition. A. Innovation and Product Development 1. Cost Versus Benefit of Product Innovation 2. Efficiency and Product Innovation B. Marketing 1. Marketing Expenditures 2. Selling Costs and Total Costs 3. Selling Costs and Demand 4. Efficiency: The Bottom Line 3. Explain the dilemma faced by firms in oligopoly. A. Collusion B. Duopoly in Airlines 1. Competitive Outcome © 2013 Pearson Education, Inc. Publishing as Addison Wesley

212

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

2. Monopoly Outcome 3. Range of Possible Oligopoly Outcomes C. The Duopolists’ Dilemma 1. Boeing Increases Output to 4 Airplanes a Week 2. Airbus Increases Output to 4 Airplanes a Week 3. Boeing Increases Output to 5 Airplanes a Week 4. Use game theory to explain how price and quantity are determined in oligopoly. A. What Is a Game? B. The Prisoners’ Dilemma 1. Rules 2. Strategies 3. Payoffs 4. Equilibrium 5. Not the Best Outcome C. The Duopolists’ Dilemma 1. The Payoff Matrix 2. Equilibrium of the Duopolists’ Dilemma 3. Collusion Is Profitable but Difficult to Achieve D. Advertising and Research Games in Oligopoly 1. Advertising Game 2. Research and Development Game E. Repeated Games F. Is Oligopoly Efficient?

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 13 has been slightly revised.

 Where We Are In this chapter, we examine two more market structures, monopolistic competition and oligopoly. The profitmaximizing quantity and price for monopolistic competition is discussed. The chapter shows why firms in monopolist competition decide to advertise, use brand names, and develop new products. Then the chapter moves to oligopoly. It explains the oligopolists’ dilemma and then uses game theory to explore the behavior of oligopolists.

 Where We’ve Been The previous chapters studied perfectly competitive firms and monopoly firms. The material dealing with monopoly is

Chapter 13 . Monopolistic Competition and Oligopoly

213

used in this chapter because monopolistic competition is similar in some regards to monopoly.

 Where We’re Going The next chapter starts to study macroeconomics.

IN THE CLASSROOM  Class Time Needed You can complete this chapter in two and one half to three sessions. By this point the students are familiar with the diagrams illustrating how firms in monopolistic competition select their profit-maximizing price and quantity, so be sure to point out this similarity. Use three sessions if you have students who will be majoring in business disciplines because the material on advertising and brand names will be helpful to them. An estimate of the time per checkpoint is: •

13.1 What is Monopolistic Competition?—70 to 80 minutes

•

13.2 Product Development and Marketing—10 to 25 minutes

•

13.3 Oligopoly—40 to 50 minutes

•

13.4 Game Theory—50 to 70 minutes

Classroom Activity: Product differentiation is the heart of the difference between monopoly and competition. After listing the characteristics of monopolistic competition and securing suggested examples of firms in monopolistic competition, you can get your students to suggest how, if they ran a small coffee shop (or select a business of more interest in your particular region), they could attract more customers than their competition. Or, discuss more generally ways in which producers in a monopolistically competitive market can increase the demand for their product. Consider grocery stores: they have little latitude on prices as their markup is so small, so to build sales they attract customers in what ways? Some methods include friendliness, advertising loss-leaders, attractiveness of displays, free samples, speed, signage, perhaps even clean restrooms! Classroom Activity: The prisoners’ dilemma is a great way to start discussing oligopolies. Tell students they get to play a game and get two students to volunteer to be the “criminals.” Give the entire class the story and rules. Don’t use a payoff matrix at this point, just write the options on the board. Then send one of your volunteers out of the room. Ask the remaining student what strategy he or she will take. Get your class to help. It usually takes a few minutes for everyone to agree that confessing is the best strategy. Send the first student from the room and then call in the second student. Ask this student what he or she will do. Because the class already knows what the first student has done, encourage them not to tell. © 2013 Pearson Education, Inc. Publishing as Addison Wesley

214

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

Aid the students as they move toward choosing the equilibrium. Encourage students to remember this gaming strategy because it is the same material that you’ll use to describe a firm’s behavior.

Chapter 13 . Monopolistic Competition and Oligopoly

215

CHAPTER LECTURE 13.1

What is Monopolistic Competition?

Lecture Launcher: Students have no difficulty seeing monopolistic competition in the world all around them. Emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of monopolistic competition, as its name implies, is a mixture of both extremes. Some of what they learned in each of the two previous chapters survives and operates in the middle ground of monopolistic competition. Monopolistic competition is a market structure in which • A large number of firms compete. Each firm has a small market share and collusion is impossible. • Each firm produces a differentiated product. Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. Some people will pay more for one variety of a product, so the demand curve for the firm’s product is downward sloping. • Firms compete on product quality, price, and marketing. • Firms are free to enter and exit the market.

Identifying Monopolistic Competition There are two measures of market concentration used to help identify whether a market is competitive or dominated by a small number of firms: •

The four-firm concentration ratio is the percentage of the total revenue accounted for by the four largest firms in the industry. The four-firm concentration ratio ranges between near 0 (extremely competitive) to 100 (not very competitive).

•

The Herfindahl–Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. The HHI ranges between near 0 (extremely competitive) to 10,000 (a monopoly). • The U.S. Justice Department uses the HHI to classify markets: • Markets with an HHI of less than 1,000 are regarded as highly competitive • Markets with an HHI of between 1,000 and 1,800 are regarded as moderately competitive. • Markets with an HHI above 1,800 are regarded as concentrated.

Ford Motor Company advertises that it is the largest seller of pickup trucks in the United States. Should we be concerned that Ford might have too much market power in that area of the market? Ask the students to consider identifying what would be an appropriate definition for the “market” such that a proper market concentration measure might be calculated. Should only pickup trucks be included? Or should all cars and trucks be considered as possible substitutes? How about minivans and/or SUVs?  Land Mines: While students have gotten familiar with the demand, mar© 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

216

ginal revenue, and marginal cost curves over the past two chapters, still take the time to point out the curves as you draw them. Use actual numbers for quantity and price. Unlike the case of perfect competition, the demand curve for a firm’s differentiated product in monopolistic competition is downward sloping. Remind the students that along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, New Balance, K Swiss, Asics, and Reebok tennis shoes are constant. Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people prefer some other brand and will buy Nike only if its price is low enough. Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher the price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded.

The Firm’s Profit-Maximizing Decisions •

•

In the short run, a monopolistically competitive firm makes its output and price decisions just like a monopoly firm. The figure shows a monopolistically competitive firm’s downward sloping demand curve and the downward sloping MR curve that lies below the demand curve. The firm maximizes its profit by producing the quantity where MR = MC and using the demand curve to set the highest price at which people will buy the quantity it produces. In the figure, the firm produces 20 pizzas per hour and sets a price of $16 per pizza. The firm in the figure makes an economic profit because P > ATC. The amount of the economic profit is equal to the area of the darkened rectangle. If P < ATC, the firm incurs an economic loss. The firm will shut down if P < AVC, so the maximum loss the firm will incur is equal to its fixed costs.

Chapter 13 . Monopolistic Competition and Oligopoly

217

Long Run: Zero Economic Profit •

•

Unlike a monopoly, firms in monopolistic competition cannot make an economic profit in the long run. If the firms are making an economic profit, other firms enter the market. Entry continues as long as firms in the industry make an economic profit. As firms enter, each existing firm loses some of its market share. The demand for each firm’s product decreases and the firm’s demand curve shifts leftward. Eventually the demand decreases enough so that the firms make zero economic profit, where P = ATC. Entry then stops. This outcome is illustrated in the figure, in which the firm produces 13 pizzas per hour (where MR = MC ) and sets a price of $12 per pizza.

 Land Mine: Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. Part of the reason for this difficulty is because in perfect competition, entry and exit change the (market) supply. You can rule out this change for monopolistic competition by using a tennis shoes example. Explain that the demand for Nike tennis shoes changes and the demand curve for Nike tennis shoes shifts if other firms enter or exit. If Hollister and Abercrombie & Fitch started to make tennis shoes, some of Nike’s former customers would switch to these two new brands, the demand for Nike shoes decreases and the demand curve shifts leftward. But if Hollister and Abercrombie & Fitch start making tennis shoes, their decision does not increase the supply of Nike shoes— changes in the number of Nike shoes produced is Nike’s decision. So an increase in the number of firms does not affect the supply curve for Nike shoes. Of course, as a monopolistic competitor, Nike does not have a supply curve for its shoes, but the point you want to emphasize is that Hollister’s and Abercrombie & Fitch’s decisions affect the demand curve for Nike shoes.

Monopolistic Competition and Perfect Competition Because price exceeds marginal cost, monopolistic competition creates deadweight loss. Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity, monopolistic competition is efficient.

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

218

Unlike firms in perfect competition, firms in monopolistic competition have excess capacity: • Excess Capacity: A firm has excess capacity if it produces less than the quantity at which average total cost is a minimum. The quantity at which average total cost is a minimum is the efficient scale. A firm in perfect competition produces at the efficient scale but, as the figure above shows, a firm in monopolistic competition produces less than the efficient scale of output.

13.2

Product Development and Marketing

Innovation and Product Development Monopolistically competitive firms compete through product development and marketing. New product development allows a firm to gain a temporary competitive edge and economic profit before competitors imitate the innovation. A firm decides upon the extent of innovation and product development by comparing the marginal cost of innovation or product development to its marginal revenue.

Marketing •

•

Marketing and packaging allow a firm to differentiate its product. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product. Selling costs, such as advertising, are fixed costs that increase the ATC at any given level of output but do not affect the MC. The ATC curve shifts upward but the MC curve does not shift. Advertising efforts are successful if they increase demand, which can lead to increased profit. But if all firms advertise, more firms might survive and so the demand for any one firm is less than otherwise. Advertising and marketing names are expensive. To the extent that they provide the consumer with valuable information, they are a benefit of monopolistic competition. But in some instances it seems as if the cost exceeds the benefit. So, ultimately the total efficiency of monopolistic competition is ambiguous.

13.3

Oligopoly

Classroom Activity: The prisoners’ dilemma is another great way to start this lecture. Tell students they get to play a game and get two students to volunteer to be the “criminals.” Give the entire class the story and rules. Don’t use a payoff matrix at this point, just write the options on the board. Then send one of your volunteers out of the room. Ask the remaining student what strategy he or she will take. Get your class to help. It usually takes a few minutes for everyone to agree that confessing is the best strategy. Send the first student from the room and then call in the second student. Ask this student what he or she will do. Because the class already knows what the first student has done, encourage them not to tell. Aid the students as they move toward choosing the equilibrium. Encourage students to remember this gaming strategy because it is the same material that you’ll use to describe a firm’s behavior.

Chapter 13 . Monopolistic Competition and Oligopoly

219

Oligopoly is characterized by having a small number of firms competing and natural or legal barriers preventing the entry of new firms.

Collusion • •

•

Because there are a small number of firms, the firms are interdependent so that each firm’s actions influence the profits of the other firms. Because there are a small number of firms, the firms in an oligopoly might form a cartel. A cartel is a group of firms acting together to limit output, raise price, and increase economic profit. Cartels are illegal in the United States. A duopoly is a market with only two producers.

Range of Possible Oligopoly Outcomes An oligopoly might operate like a monopoly, like perfect competition, or somewhere between these two alternatives: • Competitive Outcome • A competitive outcome occurs when the firms produce the level of output determined by the intersection of the industry supply curve (the marginal cost curve) and the market demand curve. • The price is the lowest and the joint total profit is the smallest with this outcome. • Monopoly Outcome • The firms form a cartel in order to reach the monopoly outcome. A monopoly outcome occurs when the firms produce the same level of output as a single-price monopoly at the intersection of the marginal cost and marginal revenue curves. • The price is highest and the joint total profit is the largest with this outcome.

The Duopolists’ Dilemma •

If an oligopoly has formed a cartel that sets the monopoly price and quantity, then each firm has the incentive to cheat on the agreement by increasing its output and cutting its price because this action boosts the firm’s profit. If all the firms cheat, the cartel can break down and the outcome will be closer to, or the same as, the competitive outcome.

13.4

Game Theory

Game theory is a tool for studying strategic behavior—behavior that takes into account the expected behavior of others and the recognition of mutual interdependence. Games have rules, strategies, payoffs, and outcomes.

The Prisoners’ Dilemma •

Art (A) and Bob (B) have been caught stealing cars. Both men are scheduled to be sentenced to two years in jail for this crime. Both are suspected of committing a more serious crime for which the prosecutor has insufficient evidence for a conviction. The two men are each interrogated for the more serious crime in separate cells. Each prisoner is told that if he confesses and his partner denies, he will serve 1 year in jail and his partner will serve 15 years, while if both confess, both serve 4 years.

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

220

•

The game’s payoff matrix is to the right. In it are the payoffs from each man’s strategies, which are to confess or deny involvement in the serious crime. In general, strategies are all the possible actions of each player.

A’s strategies Deny

Confess 2 years

15 years

Confess B’s strategies

2 years

1 year

In the Nash equilibrium, player 4 years 1 year A takes the best possible action Deny given the action of player B and 4 years 15 years player B takes the best possible action given the action of player A. The Nash equilibrium for the prisoners’ dilemma is for both players to confess. This outcome is bad for them because both would be better off if each denied.

John Nash’s life makes for an interesting anecdote you can tell in class. Some of your students might have seen the movie A Beautiful Mind, which was the somewhat embellished story of Nash’s life. To recapitulate the story, Nash was an incredibly bright graduate student and assistant professor in the early 1950s. During this time he developed the concept of the Nash equilibrium. Tragically, he was taken severely ill with schizophrenia. He spent the next three decades in various places and wandering around the buildings at Princeton at night. Nash’s condition has improved in recent years. The Nobel Prize committee heard of his improving condition and called several of his friends to inquire if he would be able to accept the prize. He was and so the Nobel Prize was awarded to him in 1994. If you have the equipment and time, getting the DVD and showing the scene in A Beautiful Mind where Nash makes his discovery by analyzing the possible outcomes when a group of guys hit on a group of girls in a bar can be an entertaining way to generate student interest in game theory. (It’s your choice whether or not to tell your students that the incident in the bar is fiction.)  Land Mine: Determining the Nash equilibrium of a game is often difficult for students. I try to make the game more “practical” by pointing out to the students that in the real world, real firms are almost always doing ”what if” analyses and that game theory is well designed for answering these sorts of “what if” questions. In the Airbus/Boeing game in the text, the two companies are trying to determine how many airplanes they should produce if their competitor produces 3 airplanes or if their competitor produces 4 airplanes. You can illustrate the equilibrium by starting with Airbus and stating that Airbus wants to determine what it should do if Boeing produces 4 airplanes. Then, after determining that Airbus will produce 4 airplanes, do the next “what if” by looking what Airbus should do if Boeing produces 3 airplanes. In this case, Airbus again wants to produce 4 airplanes. Therefore Airbus’s “what if” analysis has led to the conclusion that regardless of Boe© 2013 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 13 . Monopolistic Competition and Oligopoly

221

ing’s decision, Airbus wants to produce 4 airplanes. You can conduct the same “what if” for Boeing’s choices and determine that Boeing, too, will produce 4 airplanes regardless of Airbus’s choice. Another way to keep track of decision making in a payoff matrix is to use arrows. For the player on the vertical axis, compare the payoffs in each row and draw an arrow towards the payoff that is more desirable to that player – do this for both columns. For the player on the horizontal axis, compare the payoffs in each column and draw an arrow towards the payoff that is more desirable to that player – do this for both rows. The directionality of the arrows will easily allow students to identify a dominant strategy (if both of a player’s arrows point in the same direction) and following the arrows for both players will lead to the Nash Equilibrium.

The Duopolists’ Dilemma •

Firms in an oligopoly can face a prisoners’ dilemma game. Suppose there are two firms, A and B. The firms could make a collusive (and illegal) agreement to jointly boost their price and decrease their output. Once the agreement is made, each firm must select its strategy: cheat on the agreement A’s strategies or comply with the agreement.

•

The payoff matrix is to the right. Each firm’s profit depends on its strategy and that of its competitor.

•

Comply

Cheat

−$1 million

$0 Cheat B’s

The Nash equilibrium for the strategies $5 million game is for both firms to cheat Comply on the agreement. The outcome is bad for them because both −$1 million would be better off if each complied with the agreement. Collusion is profitable but is difficult to maintain.

$5 million $3 million

$3 million

 Land Mine: The duopolist’s dilemma game in Checkpoint 13.3 and then revisited on pages 357–358 has been carefully designed to get the maximum payoff from the knowledge your students have of the perfect competition and monopoly results of the two preceding chapters and to introduce them to game theory in a setting that is as close to the previously studied settings as possible. Instead of asserting a payoff matrix on pages 357-358, the numbers in the matrix come directly from monopoly profit-maximizing and competitive outcomes calculated on the earlier pages. You need to do a bit of work to generate the payoff numbers, but the whole story hangs together so much better when the student can see where the numbers come from and can see the connection between the oligopoly set up and those of com© 2013 Pearson Education, Inc. Publishing as Addison Wesley

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

222

petition and monopoly. Start with Figure 13.5 and after you’ve explained the cost and demand conditions shown in the figure, ask the students what they think the price and quantity will be in this industry. There will be differences of opinion. This diversity of opinion motivates the need for a model of the choices the firms make.

Advertising and Research Games in Oligopoly •

Firms’ decisions about advertising and conducting research and development can be studied using game theory.

•

In an advertising game, two firms can advertise or not advertise. Advertising is costly but if one firm advertises and the other does not, the one not advertising loses market share and profit while the one advertising gains market share and profit. Both firms would be better if neither advertised but the Nash equilibrium is that both firms advertise.

•

In a research and development (R&D) game, two firms can conduct or not conduct R&D. Each firm’s strategies are to conduct the R&D or not conduct the R&D. A firm that conducts the R&D must pay for the R&D. Both firms would be better if neither firm conducted research and development but the Nash equilibrium is that both firms conduct research and development.

Repeated Games •

•

If a game is played repeatedly, it is possible for players of the game to cooperate and make and share the monopoly profit. Because the game is played repeatedly, a player can use a tit-for-tat strategy, in which the player cooperates in the current period if the other player cooperated in the previous period, but cheats in the current period if the other player cheated in the previous period. A tit-for-tat strategy used with the previous payoff matrix leads to a cooperative equilibrium.

Is Oligopoly Efficient? •

If the oligopoly can restrict its output, it is inefficient.

The OPEC oil cartel is an excellent example of how useful game theory can be to explain real world events. Use the prisoner’s dilemma game to illustrate the incentive each nation faces: whether to cheat on their agreement or comply with it. A tit-for-tat strategy makes all the nations (as a group) better off but the demand for oil fluctuates and it is difficult for each nation to determine whether the other nations are cheating on the agreement. This combination makes a cartel agreement difficult to monitor, which is why we see the price of oil fluctuate so much, even during peaceful times. Saudi Arabia is widely believed to be the market leader for the cartel. Its oil output decisions have waxed and waned significantly over time, so oil prices fall when its government needs the extra oil revenues (cheating) or rises when the political environment requires greater economic unity among the Arab nations (cooperating).

Chapter 13 . Monopolistic Competition and Oligopoly

USING EYE ON THE U.S. ECONOMY  Examples of Monopolistic Competition You can list several of the industries given in the figure on the board. Ask students to list them in order of competitiveness. You also can use these data to promote discussion on calculating the four-firm concentration ratio and the Herfindahl-Hirschman Index. Make sure to emphasize to students that monopolistic competition is likely the industry structure they participate in the most. In the U.S., approximately 75 percent of industries are competitive (ranging between perfectly competitive and monopolistically competitive). Oligopolies comprise about 20 percent of industries. Using a very loose definition of monopoly (one firm generating more than half of market revenue, which allows monopoly-like behavior), the remaining 5 percent are monopolies.

USING EYE ON CELL PHONES  Which Cell Phone? Ask your students with cell phones to make a list of the features that attracted them to that particular cell phone. Then, ask them to take out their cell phones and compare with the people sitting around them. (If you’re anything like me, this may be the one opportunity your students have to take out their cell phones without getting yelled at!) It’s entirely likely that while there may only be a few different brands of phones in the class, everyone has a different phone or at least different apps. Ask your students why there is so much variety? Why don’t cell phone makers only make one or two models? Why has the number of apps grown so rapidly over the past few years? This will help lead into a discussion about how firms weigh the costs and benefits of differentiation. While differentiating phones is fairly inexpensive to a point, tailoring each phone to each user would get far more costly, causing the marginal cost of differentiation to exceed the marginal benefit. This same discussion can also be used to discuss automobile models. While there are only be a handful of automobile brands to choose from, each manufacturer makes a number of models. For example, Ford and Toyota each make nearly 20 different models of consumer automobiles – GM makes over 30. And for each model, there are different series’ and features that consumers can choose from. Why so much variety? Also, while you have options, why don’t you get to select every single feature for your automobile? Why do auto manufacturers draw the line somewhere and mass produce a finite amount of combinations of features?

223

224

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

USING EYE ON YOUR LIFE  Some Selling Costs You Pay Ask your students their opinion of the price of shoes now that they have seen a breakdown of their costs of production. Does knowing how much of the purchase price goes towards selling the shoe to them cause them to rethink their buying habits? One thing you definitely should point out to your students is that none of these costs are “useless.” For instance, the $5.00 paid by Nike for “sales, distribution, and administration” is a necessary cost or else the shoes would pile up on the dock once they were imported. Similarly, Nike’s $6.25 of profit is necessary for Nike to stay in business. If Nike did not make a profit, your students definitely would not be wearing Nike shoes!

 A Game You Might Play Here the tools of economics are used to illustrate how entertainment decisions might be made within a loving relationship. Students will probably realize that it is unlikely that Jane and Jim will actually create the payoff matrix described in the Eye. Indeed, sometimes students have a lot of doubt about using game theory in any circumstance. While they might be right about Jane and Jim (though nonetheless game theory sheds light on how they will behave) they are likely wrong when it comes to businesses. Businesses often ask the “what if my competitor does this” question that is a key part of determining the proper strategy to follow. And definitely creating a payoff matrix is often the right way to think about issues oligopoly firms face. So even if the payoff matrix does not have a definite solution, it will help point to the best decision for the firm. The “lover’s dilemma” presented in this Eye is similar to a classic chicken game two players, no dominant strategies, and two Nash equilibriums. The difference being that in the lover’s dilemma the players want to do the same strategy, whereas in the chicken game each player has incentive to do the opposite of their opposing player (maybe if Jane and Jim were a dysfunctional couple…). If you have the time and want to go further into game theory, the chicken game is an easy game to present to the class. Two players driving straight at each other with 2 options – swerve or don’t swerve. If neither of them swerves, they both end up dead. If one swerves and the other doesn’t, the one who swerved is the chicken (loser) and the other player is the stud (winner). If they both swerve (assuming they swerve in opposite directions!), neither of them are studs, but they’re not viewed as much as a chicken as if one kept going straight – call them ½ chicken. The idea is to establish a ranking of payoffs in the following order: stud, ½ chicken, and chicken. With a payoff matrix, you can see 2 Nash Equilibriums – where each player does the opposite of the other. In a chicken game, a sequence of ac-

Chapter 13 . Monopolistic Competition and Oligopoly

tions or prior information can be very important factors in determining what the final outcome will actually be. For an entertaining way to introduce the chicken game, show the scene in the ‘80s movie Footloose as Kevin Bacon (the main character) goes head-to-head in tractors with the stereotypical, high school bully whose girlfriend Kevin Bacon has fallen for. Kevin Bacon ends up being the stud and the bully is the chicken, but only because Bacon’s strategy of not swerving is locked in by his shoelace getting caught in the brake pedal! While this example may not be the most immediately applicable to business decisions, the chicken game can be seen when two firms are deciding whether or not to enter into a market that is only large enough to support one profitable firm. If they both enter, they both won’t survive. However, if one enters and the other doesn’t, the one who enters will be profitable. Hence, each firm wants to do the opposite of the other firm. If one firm has information about which way the other firm is leading, this can be used to help make their decision. Or, if there is a sequence to action, the firm acting first wants to enter the market, knowing that no profitmaximizing firm would enter a market if they knew profits would be negative.

USING EYE ON THE CHIPS DUOPOLY  Are Two Computer Chip-Makers Two Too Few? This story provides a good example of how firms face a duopolist’s dilemma and how 2 firms competing doesn’t necessarily create a competitive outcome. While Intel is not technically a monopoly, it is similar to one in terms of its price setting ability. This Eye can also serve as a springboard to a discussion of how firms decide to advertise and innovate. In particular, for years Intel advertised “Intel inside,” and so consumers have come to prefer an Intel chip powering their computer. On the other hand, AMD’s chips are sometimes more cost effective for non-power users. Yet AMD still faces the handicap of consumers’ preference for the brand name recognition of “Intel inside.” You can highlight this competition on price and quality and let students speculate on how the firms will continue to compete. What will happen if Intel fails to innovate? Would the FTC allow a merger between Intel and AMD?

225

226

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 13.1 What is Monopolistic Competition? 1. How would a merger between Pizza Hut and Papa Johns affect the fourfirm concentration ratio for the home delivery pizza market? How would it affect the Herfindahl-Hirschman Index for the home delivery pizza market? 2. Draw an example of a firm in monopolistic competition that is incurring an economic loss. Be sure to label all the curves. Indicate the area that equals the firm’s economic loss.  Checkpoint 13.2 Product Development and Marketing 3. Explain how selling costs in monopolistic competition affect the efficiency of monopolistic competition.  Checkpoint 13.4 Game Theory 4. The equilibrium of a duopolists’ game can have both firms acting as competitors, so that they get the “worst” outcome possible. From the social standpoint of efficiency, how does this outcome compare to their best outcome, when they jointly act as a monopoly? 5. OPEC, the Organization of Petroleum Exporting Countries, was formed in Baghdad in 1960. Since its formation, this cartel has suffered from a major problem with respect to the quota (limit) of output it assigns each member nation. What is OPEC’s goal and what sort of quota do you think the cartel assigns? How and why do nations cheat on their quota? What happens when a nation cheats on its quota? 6. Both AMD and Intel spend billions of dollars a year on research and development. Why can’t they get together to decide to decrease their spending? 

Answers

 1.

Checkpoint 13.1 What is Monopolistic Competition? Pizza Hut and Papa Johns are two of the three largest firms in the home delivery pizza market. So a merger between Pizza Hut and Papa Johns would raise the four-firm concentration ratio and raise the HerfindahlHirschman Index.

Chapter 13 . Monopolistic Competition and Oligopoly

Figure 13.1 illustrates a firm in monopolistic competition that is incurring an economic loss. The economic loss equals the area of the gray rectangle.

 3.

Checkpoint 13.2 Product Development and Marketing The additional selling costs from product differentiation and marketing increase consumer choice by providing variety. This benefits society and weighs in favor of the efficiency of monopolistic competition. Selling costs increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly. Also, at times the product differentiation is more apparent than real. These factors harm society and count against the efficiency of monopolistic competition.

 4.

Checkpoint 13.4 Game Theory The outcome where both act as competitors is more efficient than the outcome when they act as monopolists. If they act as monopolists, they create a deadweight loss. If they act as perfect competitors, they will produce the efficient quantity and there will be no deadweight loss.

To keep the price of oil high, as has been the case since 2002, OPEC creates a target level of output designed to achieve a particular high price. OPEC’s goal is to set a price high enough so that its member nations make the maximum economic profit. Once the target output is set, OPEC assigns a production quota to each member. As long as each member adheres to its quota the price remains high. However, from time to time, individual nations cheat on the agreement by producing more oil than allowed. Nations cheat because if they alone cheat, the impact on oil prices will be slight but the impact on their profit will be large. The supply of oil increases and the price falls. Then, once prices begin to fall other members panic and start selling

227

228

Part 3 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

more oil to get the highest price they can before a collapse takes place. If every nation cheats, the supply will increase more than if just a few do and the collapse in price becomes a self-realizing prophecy. 6.

The problem faced by AMD and Intel is similar to any prisoners’ dilemma game: Neither can trust the other to actually cut back on their research and development spending. And, if one firm did cut back and the other did not, the one cutting back would run the risk of being driven from business.

GDP: A Measure of Total Production and Income

Chapter

CHAPTER OUTLINE 1. Define GDP and explain why the value of production, income, and expenditure are the same for an economy. A. GDP Defined 1. Value Produced 2. What Produced 3. Where Produced 4. When Produced B. Circular Flows in the U.S. Economy 1. Consumption Expenditure 2. Investment 3. Government Expenditure on Goods and Services 4. Net Exports of Goods and Services 5. Total Expenditure 6. Income C. Expenditure Equals Income 2. Describe how economic statisticians measure GDP and distinguish between nominal GDP and real GDP. A. The Expenditure Approach 1. Expenditures Not in GDP B. The Income Approach 1. Wage Income 2. Interest, Rent, and Profit Income 3. Net Domestic Product at Factor Cost 4. From Factor Cost to Market Price 5. From Net Product to Gross Product 6. Statistical Discrepancy C. GDP and Related Measures of Production and Income 1. Gross National Product 2. Disposable Personal Income D. Real GDP and Nominal GDP E. Calculating Real GDP F. Using the Real GDP Numbers

230

Part 4 . MONITORING THE MACROECONOMY

3. Describe the uses of real GDP and explain its limitations as a measure of the standard of living. A. The Standard of Living Over Time B. Tracking the Course of the Business Cycle C. The Standard of Living Among Countries D. Goods and Services Omitted from GDP 1. Household Production 2. Underground Production 3. Leisure Time 4. Environment Quality E. Other Influences on the Standard of Living 1. Health and Life Expectancy 2. Political Freedom and Social Justice

CHAPTER ROADMAP

 What’s New in this Edition? The data have been updated throughout Chapter 14 and the Income Approach section has been slightly revised with a new subheading for Net Domestic Product at Factor Cost.

 Where We Are In Chapter 14, we define GDP and explain why for the economy, the value of production equals income, which also equals expenditure. We describe how economic statisticians measure GDP. Next we distinguish between nominal GDP and real GDP. Lastly, we explain and describe the uses of real GDP and its limitations as a measure of the standard of living.

 Where We’ve Been After exploring how microeconomic decisions are made, this chapter is the first chapter that directly explores macroeconomics.

 Where We’re Going In the next two chapters, we will explore other major macroeconomic measurements. We will describe the labor market and explore measures and trends for employment, unemployment, and wage rates. We will also examine how the price level is measured and see how price indices are used to measure the cost of living and to calculate the inflation rate.

Chapter 14 . GDP: A Measure of Total Production and Income

231

IN THE CLASSROOM 

Class Time Needed

The material in this chapter can be covered in about two class sessions. An estimate of the time per checklist topic is: •

14.1 GDP, Income, and Expenditure—20 to 30 minutes

•

14.2 Measuring U.S. GDP—45 to 60 minutes

•

14.3 The Uses and Limitations of Real GDP—20 to 30 minutes

Classroom Activity: Suppose the economy is operating at full employment on the production possibilities frontier. Assume furthermore that GDP increases along the frontier, as depicted in the figure by the movement from point A to point B. Ask your students if this movement necessarily involves an improvement in this country’s standard of living. Granted, output has expanded, but it has come at the expense of a dirtier environment. Most students will respond by saying that it is difficult to say because it depends on just how badly the environment has deteriorated. That is to say, if the increase in GDP more than compensates for the reduction in the quality of the environment, then perhaps it is a welfare enhancing move and the standard of living has indeed gone up. Point out that this issue is the crux of the controversy—measuring something as elusive as a clean environment. You might consider asking students if there is any way out of this dilemma. One possible answer is that the standard of living could actually improve if there were developments that pushed the production possibilities frontier outward. In this case, we would be in the enviable position of being able to enjoy a higher GDP coupled with greater environmental quality. To wrap up the discussion you might want to make a connection with this lecture and the material covered in Chapter 4 on Demand and Supply. First, ask students what kind of a good they think the environment is. That is, ask them if it is a normal good or an inferior good. They might balk at first at the idea by questioning whether it is a good in the first place. Don’t let this problem derail you from your task. Explain that there are many things that we enjoy that are not necessarily bought and sold in markets that qualify as goods. A © 2015 Pearson Education, Inc.

232

Part 4 . MONITORING THE MACROECONOMY

clean environment is something that is in just as much demand as national defense, fire protection, or a safe workplace. With this discussion, someone is bound to say that the environment is a normal good. Refresh their memory by restating what it takes for a good to be a normal good. Now you can point out that we have an answer for our dilemma in the production possibilities frontier. That is, as a nation expands its national output there is, for a time, damage done to the environment. However, as a nation prospers it has a greater demand and preference for a cleaner environment. And, you can point out that this outcome is exactly what happened in Europe. When the richer West Germany reunited with the poorer East Germany in the late 1980s, observers were stunned by how environmentally dirty East Germany was, especially compared to West Germany!

Chapter 14 . GDP: A Measure of Total Production and Income

233

CHAPTER LECTURE 14.1

GDP, Income, and Expenditure

GDP Defined •

GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period • Value produced: The items in GDP are valued at their market values, that is, at their prices. If 1,000,000 slices of pizza are sold for $4 each, slices of pizza contribute $4,000,000 to GDP. • What produced: To avoid double counting, GDP includes only final goods and services. A final good or service is a good or service that is produced for its final user and not used as a component of another good or service. It contrasts with an intermediate good or service, which is a good or service that is used as a component of a final good or service. • Where produced: Only the goods and services produced within a country are counted. So a Toyota Tundra produced in Texas is counted in U.S. GDP and a Chevy Silverado produced in Silao, Mexico is not counted in U.S. GDP. • When produced: GDP measures production during a given period of time, typically a year.

Lecture Launcher: Try this exercise to get your students to focus on the elegance of the definition of GDP. From the text, GDP is defined as the market value of all the final goods and services produced within a country in a given time period. Reproduce the definition of GDP by writing it on the board. Ask your students to go through the definition and pull out the essential parts. You will get this list: market value, final goods and services, produced, within a country, and time period. Underline or draw a box around each key word. Explain that the words chosen in this definition were selected carefully. First, if the phrase “market value” had been left out, there would be room for lots of problems. Notice that when the government reports this figure, it doesn’t announce how many trains, planes, and automobiles the country has produced but rather it announces a monetary value. Using monetary values affords us the opportunity to be able to get around the problem of aggregation when the items in question are markedly different. We solve it by allowing the marketplace to determine the weights – and how markets determine value is what students learned back in Chapter 4. The second item on the list is “final goods and services.” The explanation here is straightforward: We are distinguishing between final products and intermediate products. Intermediate goods are goods that are bought by one firm to be used in the production of another good that will be ultimately consumed. If we include these intermediate goods, then we would double count the nation’s output. Now we come to the word “produced.” This word is to make clear that sales are not important. If we only counted sales, then the GDP figures would understate production because not all output is sold. Some of it became inventory. In addition, not all output that is sold is produced in that year. Testimony of this is the sale of an automobile that was actually produced in a previous year. Next is the phrase “within a country.” This phrase is to make clear that we don’t count output that wasn’t produced on a nation’s soil regardless © 2015 Pearson Education, Inc.

Part 4 . MONITORING THE MACROECONOMY

234

of who was responsible for producing it. Lastly, is the phrase “time period.” Here we want to make unambiguously clear that we are only talking about production that occurred in a certain period. This phrase leaves no doubt that production of a good or service produced in a previous time period (even if perhaps sold in the present time period) does not count in this period’s GDP.

Circular Flows in the U.S. Economy •

In the goods market, households, firms, governments, and foreigners buy goods and services. • Consumption expenditure, C, is the expenditure by households on consumption goods and services. This includes both durable goods (meant to last 3 or more years) and nondurable goods. • Investment, I, is the purchases of new capital goods (tools, instruments, machines, buildings, and other durable items), purchases of new homes by households, and additions to inventories. Investment does not include purchases of stocks and bonds, as these are not produced goods or services. • Government expenditures on goods and services, G, is the expenditures by all levels of the government on goods and services. • Net exports of goods and services, NX, is the value of exports of goods and services minus the value of imports of goods and services. Exports of goods and services are the items that firms in the United States produce and sell to the rest of the world. Imports of goods and services are the items that households, firms, and governments in the United States buy from the rest of the world.

Government transfer payments, such as Social Security payments, are not part of government expenditures on goods and services because these expenditures include only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures on goods and services.

Total Expenditure • •

Total expenditure equals C + I + G + NX. Households receive wages, capital, interest, rent, and profit as income. Some part of total income is not paid out to households by firms, but from an economic standpoint, this undistributed profit is income paid to households and then loaned back to firms.

Expenditure Equals Income •

Because firms pay out as income everything they receive as revenue from selling goods and services, total income, Y, equals total expenditure. So:

Y = C + I + G + NX. •

For a firm, the value of its production is the cost of the production, which equals the income generated by the production. So the value of production equals income equals expenditure, or

Chapter 14 . GDP: A Measure of Total Production and Income

•

235

Households use their income on consumption expenditure, saving, and paying net taxes. Therefore it is the case that Y = C + S + NT

 Land Mine: At an intuitive level, the equality between income and expenditure is not a difficult concept to get across. It makes sense to students that whatever someone spends must ultimately end up as income to someone else. The problem comes when we put this into practice. The reason has to do with the fact that there are two non-income charges against GDP (depreciation and indirect taxes less subsidies). If they are ignored, then when using the income approach the figure obtained will be less than the figure obtained using the expenditure approach. As always we are faced with a tradeoff. You can proceed immediately to introduce depreciation and indirect taxes less subsidies and do a comprehensive job. It will be accurate, but your simple and powerful point that income equals expenditure will be lost. The second alternative is to wait and let the intuitive equality sink in. This procedure has the benefit of preserving the expenditure/income equality without prematurely exhausting your students. The downside is that you delay the inevitable. You will eventually have to explain the discrepancy sometime.

14.2

Measuring U.S. GDP

The Expenditure Approach •

•

The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I, government expenditures on goods and services, G, and net exports of goods and services, ( X − M ). So GDP = C + I + G + ( X − M ) or, in the second quarter of 2013, annualized, and rounded to the nearest hundred billionth of dollars, $11.4 trillion + $2.6 trillion + $3.1 trillion + −$0.5 trillion = $16.7 trillion. Expenditures not in GDP include: • Used goods: Expenditures on used goods are not part of current GDP because these goods were part of GDP during the period in which they were produced. • Financial assets: The purchase of financial assets, such as stocks, is not part of GDP because these are not expenditures on goods and services.

The Income Approach •

The income approach measures GDP using several steps: • The income approach starts with the sum of wage income plus interest, rent, and profit income. This sum equals net domestic product at factor cost. • To change the measure from factor cost to market price, indirect taxes less subsidies are added because these are government taxes and transfers that affect market prices. • The next step adds depreciation, the decrease in the value of capital that results from its use and obsolescence.

Part 4 . MONITORING THE MACROECONOMY

236

•

If everything is measured correctly, adding depreciation would yield GDP. But there often is a statistical discrepancy, the difference between the expenditure approach and the income approach. The difference is measured as the expenditure approach minus the income approach, so any statistical discrepancy is added to the sum to yield the income approach GDP.

GDP and Related Measures of Production and Income •

•

Gross national product, (GNP) is the market value of all final goods and services produced anywhere in the world in a given time period by the factors of production supplied by the residents of the country. So pharmaceutical drugs produced in Ireland by a U.S. drug company is part of U.S. GNP but not part of U.S. GDP. • U.S. GNP equals U.S. GDP plus net factor income from abroad. Disposable personal income is the income received by households minus personal income taxes paid. It equals GNP minus depreciation minus any statistical discrepancy minus retained profits by businesses plus transfer payments minus personal income taxes.

Real GDP and Nominal GDP The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher.

Calculating Real GDP •

•

Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year expressed in terms of the prices in a base year. Nominal GDP is the value of the final goods and services produced in a given year expressed in terms of the prices in that same year.

Chapter 14 . GDP: A Measure of Total Production and Income

• •

Traditionally, real GDP is calculated using prices of the base year (the year in which real GDP equals nominal GDP). GDP Data for 2012 The top table to the right has data for 2012 for an economy that produces only books and coffee. In 2012, nominal GDP is $3,000. The second table to the right has data for 2013. In 2013, nominal GDP is $6,000.

•

Nominal GDP has doubled but what is real GDP between these years? To determine how real GDP changes, suppose that 2012 is the base year. Then real GDP equals nominal GDP in 2012. Now we need to determine real GDP in 2013.

Item

Quantity

Price

Market Value

Books

$25

$1,000

Coffee

1,000

$2,000

Nominal GDP

$3,000

GDP Data for 2013 Item

Quantity

Price

Market Value

Books

$30

$1,500

Coffee

1,500

$4,500

Nominal GDP

•

237

Real GDP in 2013 is calculated using the 2013 quantities and the 2012—the base year—prices. The table to the right shows these calculations.

2013 Quantities and 2012 Prices 2013 2012 Item Quantities Prices

Market Value

Books

$25

$1,250

Coffee

1500

$3,000

Real GDP (2012 dollars)

APPENDIX

$6,000

$4,250

The chained-dollar method for calculating real GDP is presented in the appendix. See the notes for the appendix for details.

14.3

The Uses and Limitations of Real GDP

Real GDP can be used to compare the standard of living over time, to track the course of the business cycle, and to compare the standard of living among countries.

The Standard of Living Over Time •

Standard of living is measured by the value of goods and services that people enjoy, on average. Real GDP per person can be used to measure and compare the standard of living. Real GDP per person is real GDP divided by the population. © 2015 Pearson Education, Inc.

Part 4 . MONITORING THE MACROECONOMY

238

•

In the United States in 2013, real GDP per person is 2.9 times larger than it was in 1960. Real GDP per person has doubled about every 30 years for the past 100 years, though its growth rate experiences short run fluctuations. Potential GDP is the value of real GDP when all of the economy’s factors of production – labor, capital, land, and entrepreneurship – are fully employed. When some factors are unemployed, real GDP is below potential GDP. When some factors are over-employed, real GDP exceeds potential GDP. Potential GDP grows over time, though not at a constant rate.

Tracking the Course of the Business Cycle •

Fluctuations in the growth of real GDP reflect business cycles. A business cycle is the periodic but irregular up-and-down movement of total production and other measures of economic activity. Business cycles have two phases and two turning points: • Expansion: The expansion phase is the period during which real GDP is increasing. • Recession: The recession phase is commonly defined as a period during which real GDP decreases for at least six months, though the NBER has a broader definition. • Peak: A peak is the highest level of real GDP yet attained. A peak is a turning point between an expansion and a recession. • Trough: A trough is the temporary low-point in real GDP. A trough is a turning point between a recession and an expansion.

Lecture Launcher: I find it useful to use a marathon metaphor to help students visualize the business cycle. I tell them to think of the U.S. economy as running in a marathon – always trying to move forward at a sustainable pace in a seemingly never-ending journey. Obviously, going backwards in a marathon is undesirable as we are moving farther away from where we are trying to get to – moving forward is the desired direction. But it’s not just about moving forward – we want to move forward at a relatively swift pace, not just walk (we’re better than that!). However, a marathon needs to be run at a sustainable pace. Trying to sprint a marathon is unsustainable and will lead to over-exhaustion and ultimately slow us down in the long run. A recession is going backwards in the marathon (with a negative real GDP growth rate), while an expansion is moving forward in the marathon (with a positive real GDP growth rate). A peak is when we stop moving forward and start to go backwards (turning point between positive and negative), while a trough is when we stop going backwards and start moving forward again (turning point between negative and positive). Our goal is for a sustainable pace for expansion, which is typically thought of as a real GDP growth rate of approximately 3 percent - that is the jogging pace that the U.S. economy has demonstrated it is capable of sustainably expanding at. Expanding more rapidly than that can only be done temporarily and trying to expand beyond that pace for an extended period will lead to “overheating” in the economy (ultimately revealed to be inflationary pressure) and an eventual backlash - a recession. Expanding less than that level is not living up to our potential. This is also an opportunity to introduce the non-technical term of “growth recession” – when the economy is growing (so it can’t technically be in recession), though growing so slowly there will still be some recession-like characteristics (such as rising or high unemployment). A growth recession © 2015 Pearson Education, Inc.

Chapter 14 . GDP: A Measure of Total Production and Income

239

is like walking in the marathon. While growth recession is not defined by the NBER or introduced in this textbook, it has grown in popularity in the media as it sometimes serves as a useful description of the seemingly “gray” area of the business cycle that is not a recession, but not a healthy expansion either. Growth recession sometimes precedes actual recession (a slowdown before GDP growth ultimately turns negative – such as the tail end of the expansions before the early 80s double-dip recession and the 2001 recession), follows a recession (GDP growth turns positive but is still lower than a healthy rate – such as the recoveries following the 1990-1991, 2001, and 2007-2009 recessions), or in the middle of an expansion (a slowdown that almost takes the place of an actual recession – such as the soft patch in the mid-90s). I find that the marathon metaphor helps students visualize the business cycle, what our goals are, and the purpose of fiscal and monetary policies (in order to either slow down or speed up our jogging pace).

The Standard of Living Among Countries To compare real GDP per person among countries, the real GDPs should be calculated using a common set of prices, called purchasing power parity prices. When this conversion is done (as the data in Chapter 2 show) U.S. real GDP per person is higher than in other advanced economies.

Goods and Services Omitted From GDP GDP measures the value of goods and services that are bought in markets, so it excludes: • Household Production: Household production is productive activities at the home that do not involve market transactions. As more services, such as childcare, meals and laundry are provided in the marketplace, the measured growth rate overstates development of all economic activity. • Underground Production: Underground production is the part of the economy that is hidden from the view of the government either because people want to avoid taxes and regulations or because the goods and services being produced are illegal. If the underground economy is a reasonably stable proportion of all economic activity, the growth rate will be accurate. • Leisure Time: Leisure time is an economic good that does not get measured in the official GDP figures. Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it. Increased output is not worth very much if we have little or no time to enjoy it. • Environmental Quality: Pollution does not directly lower the economic growth rate. If our standard of living is adversely affected by pollution, our GDP measure does not show this fact. The reason is that the devices that we produce to mitigate pollution count as part of GDP but the pollution itself is not subtracted. Lecture Launcher: A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn © 2015 Pearson Education, Inc.

240

Part 4 . MONITORING THE MACROECONOMY

(and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. Lecture Launcher: You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of illegal beer was not counted as part of GDP. But the day after prohibition ended, the production of now legal beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard but not impossible to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-forhire. The response, we hope, will be significantly different. Does such a “good” have any value?

Other Influences on the Standard of Living Omitted from GDP but important for the standard of living is: • Health and Life Expectancy: While obviously important factors determining the standard of people’s living, they are omitted from real GDP. Health and life expectancy have improved as infant deaths and death in childbirth have almost been eliminated. Life expectancy has increased from 70 years at the end of WWII to nearly 80 years today. These gains have been checked somewhat by AIDS and drug abuse, which take away from our standard of living. • Political Freedom and Social Justice: Political freedom and social justice are not measured by real GDP. A country might enjoy a very large GDP but have limited political freedom and social justice and hence have a lower standard of living.

Chapter 14 . GDP: A Measure of Total Production and Income

USING EYE ON THE U.S. ECONOMY 

Is a Computer Program an Intermediate Good or a Final Good?

This Eye presents a perfect opportunity to demonstrate to students that economic statistics are not perfect. After reading it, they might get the impression that economists are being arbitrary about the classification of software in the national income accounts. Remind them that the reason for the reclassification of software from an intermediate good to investment reflects the fact that software has many of the same characteristics as other types of investment. For instance, it has a life span just like capital and it helps improve productivity. In addition, it also depreciates just like capital. Students won’t need too much convincing for them to agree. But just in case, it wouldn’t hurt to mention that software eventually becomes obsolete as new software is developed to meet the changing needs of industry. Point out that the meaning of depreciation here comes with a bit of a twist because the software doesn’t actually get used up the way physical machinery tools or factories would but instead gets “used up” as it becomes obsolete. However, you can explain that this treatment of depreciation is not that much different than how physical capital equipment is treated in the sense that it too with the passage of time becomes obsolete as newer and more productive tools and equipment are introduced.

USING EYE ON THE BOOMS AND BUSTS 

How Do We Track the Booms and Busts of our Economy?

This Eye serves as an excellent way to introduce data lags in macroeconomics, to point out the usefulness of tracking a variety of macroeconomic measurements, and to reinforce the need to constantly try to improve upon our measurements. Our most recent recession was not formally identified until nearly a year after it had begun (and the 2001 recession wasn’t formally defined until it had actually ended – though the end wasn’t formally declared for almost another 2 years!). Ask students why it took so long? What are the repercussions of this lag between the actual beginning of a recession and the declaration of a recession? In addition, neither the 2001 recession nor the first few quarters of the recession that began in 2007 would have been defined as a recession if we strictly used real GDP growth as a guide. Why might focusing just on one measurement be too limiting? Ask you students what other measurements should be included in the determination of short run economic success and failure? You can use this discussion to serve as a preview of the importance to macroeconomic policy of being able to accurately and promptly measure a variety of economic indicators.

241

242

Part 4 . MONITORING THE MACROECONOMY

USING EYE ON YOUR LIFE 

Making GDP Personal

It’s useful here to focus on how a statistic like GDP can either understate or overstate are level of economic well-being. One exercise that can help students focus on this issue is by asking them what sorts of products or services do we consume more of today that were actually produced in greater volumes by the household in 1970. If your students have trouble making a list you could give them a jumpstart with the following list: childcare services, housecleaning services, fastfood restaurant meals and dry cleaning. Explain that part of the reason for the surge in production of these goods is simply explainable by the economic growth that the country has enjoyed. However, another significant explanatory variable is the change in the demographics of the labor force. In particular more women started to enter the workforce. As they did the demand for these types of services and goods in the marketplace intensified as women discovered that they needed a place to keep their children while they worked, have their house clean because they weren’t there to do it themselves and so on.

USING EYE ON THE GLOBAL ECONOMY 

Which Country Has the Highest Standard of Living?

Explain to students that economists have long wrestled with the inadequacies of using GDP to measure the standard of living. In fact, economists have never thought of it as a singular measure of social welfare for the reasons that are mentioned at the end of the chapter. The efforts by environmental economists and by the United Nations are steps in the direction to ameliorate some of these shortcomings. However, the trouble with the HDI is that it combines variables that are difficult to aggregate because they are measured in markedly different units. For instance, there is no obvious way to combine real GDP per person with life expectancy or literacy rates. Put your students into groups and have them develop their own standard of living measurement system. Ask them to brainstorm a list of what they believe are the factors that most influence standard of living. Then ask them to devise a way to measure each of those factors and assign weights to each factor that reflect their relative importance. In addition to the standard of living debate, this exercise can also segue into discussing the philosophy of measuring the value of human life and the value that people place on additional possible years of longevity. In lawsuits involving wrongful death, courts are often put in the position of valuing the years “taken” from a victim in terms of dollars in order to compensate widows and orphans. It’s a controversial area but it can prove a very interesting discussion for those who dare charter these waters. © 2015 Pearson Education, Inc.

Chapter 14 . GDP: A Measure of Total Production and Income

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 14.1: GDP, Income, and Expenditure 1. Identify each of the following as either included or not included in GDP. Make sure to give an explanation for those that you judge as not included. In addition, state whether each included item is consumption, investment, government expenditure, or net exports. 1a. The purchase of copy paper by Intel, which is used by the company staff. 1b. The purchase of an electronic handheld organizer by a sales manager to keep track of clients. 1c. The purchase of a new aircraft carrier by the Navy. 1d. An increase in Dell’s inventory of unsold personal computers. 1e. A family eating dinner at Taco Bell. 1f. The salary of the President of the United States. 1g. A Mom baking a birthday cake for her 8 year-old daughter. 1h. The sale of a used computer. 1i. Your donation of a used computer to a local elementary school. 1j. The purchase by a German resident in Germany of an American-made ceiling fan produced in the United States. 

Checkpoint 14.2: Measuring U.S. GDP Item Consumption expenditure Investment Government expenditure Exports Imports Depreciation

Dollars 800 400 200 50 75 100

Using the information in the table above, calculate GDP. Item Consumption expenditure Investment Government expenditure Net exports Wages Interest, rent, and profit Depreciation

Amount (trillions of dollars) 4.97 1.14 1.37 −0.08 4.20 1.68 0.89

The table above gives some of the items in the U.S. National Income and Product Accounts in 1995. Suppose the statistical discrepancy equals $0. 3a. Use the expenditure approach to calculate U.S. GDP in 1995. © 2015 Pearson Education, Inc.

243

244

Part 4 . MONITORING THE MACROECONOMY

3b. Use the income approach to calculate U.S. net domestic product at factor cost in 1995. 3c. Calculate GDP minus net domestic product at factor cost in 1995. 3d. Calculate indirect taxes less subsidies in 1995. 

Answers

 Checkpoint 14.1: GDP, Income, and Expenditure 1a. Not included because it is an intermediate good. 1b. Included as part of investment. 1c. Included as part of government expenditures. 1d. Included as part of investment. 1e. Included as part of consumption expenditure. 1f. Included as part of government purchases. 1g. Not included because it is household production. 1h. Not included because it was included in GDP in the year it was produced. 1i. Not included because it was included in GDP in the year it was produced. 1j. Included as part of net exports.  Checkpoint 14.2: Measuring U.S. GDP 2. GDP equals the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. So GDP = $800 + $400 + $200 + ($50 − $75), which is $1,375. The amount of depreciation is not used. 3a. Using the expenditure approach, GDP = C + I + G + NX = $4.97 trillion + $1.14 trillion + $1.37 trillion − $0.08 trillion = $7.40 trillion. 3b. Using the income approach, net domestic product at factor cost = Wages + Interest, rent, and profit = $4.20 trillion + $1.68 trillion = $5.88 trillion. 3c. GDP minus net domestic product at factor cost = $7.40 trillion − $5.88 trillion = $1.52 trillion. 3d. The difference between GDP and net domestic product at factor cost, $1.52 trillion, is equal to depreciation plus (indirect taxes minus subsidies). From the table, depreciation, $0.89 trillion. So indirect taxes minus subsidies = $1.52 trillion − $0.89 trillion = $0.63 trillion.

Chapter

Appendix: Measuring Real GDP APPENDIX OUTLINE 1. Real GDP A. The Problem With Base-Year Prices B. Value Production in the Prices of Adjacent Years C. Find the Average of the Two Percentage Changes D. Link (Chain) Back to the Base Year

APPENDIX ROADMAP

 Where We Are The appendix to Chapter 14 shows how the chained dollar real GDP is measured.

 Where We’ve Been Chapter 14 demonstrated the older base-year price method for calculating real GDP.

 Where We’re Going The next chapters examine the labor market, jobs, and unemployment. None of the technical material in this appendix is used in any of the following chapters.

Part 4 . MONITORING THE MACROECONOMY

246

CHAPTER LECTURE A14.1 Real GDP Lecture Launcher: Traditionally, real GDP is calculated using prices of the base year (the year in which real GDP=nominal GDP). But this method has been generally replaced with a new, chained-dollar method that uses the prices of two adjacent years to calculate the real GDP growth rate and then uses the growth rates to create a chain linking the base year real GDP to the real GDP in future years.

The Problem With Base-Year Prices When real GDP is computed using base year prices, the growth in real GDP from one year to the next depends upon which year was selected as the base year. This result occurs because goods with higher base-year prices have higher relative weights in real GDP than goods with lower base-year prices. The chained-dollar method of calculating real GDP uses prices from adjacent years—rather than just prices from one base year—to calculate real GDP’s growth rate.

The Chained-Dollar Method for Calculating Real GDP •

•

The top table to the right has data for 2012 for an economy that produces only books and coffee. In 2012, nominal GDP is $3,000. The second table to the right has data for 2013. In 2013, nominal GDP is $6,000. Nominal GDP has doubled but how much has real GDP changed between these years? To determine how real GDP changes, suppose that 2012 is the base year. Then the chained-dollar method for calculating real GDP determines the growth rate between 2012 and 2013 by calculating GDP in both years using 2012 prices and calculating GDP in both years using 2013 prices.

GDP Data for 2012 Item

Quantity

Price

Market Value

Books

$25

$1,000

Coffee

1,000

$2,000

Nominal GDP

$3,000

GDP Data for 2013 Item

Quantity

Price

Market Value

Books

$30

$1,500

Coffee

1,500

$4,500

Nominal GDP

$6,000

Appendix 14 . Measuring Real GDP

•

247

2013 Quantities and 2012 Prices Using 2012 prices, real GDP increases from $3,000 (the first taItem Quantity Price Market Value ble on the previous page) to $4,250 (the first table on this Books 50 $25 $1,250 page). Using 2012 prices, real GDP has grown by [($4,250 − Coffee 1500 $2 $3,000 $3,000) ÷ $3,000] × 100 = 41.7 percent. Real GDP $4,250 (2012 dollars) Using 2013 prices, real GDP increases from $4,200 (the second table on this page) to $6,000 (the 2012 Quantities and 2013 Prices second table on the previous page). Using 2013 prices, real Item Quantity Price Market Value GDP has grown by [($6,000 − $4,200) ÷ $4,200] × 100 = 42.9 perBooks 40 $30 $1,200 cent. Coffee 1,000 $3 $3,000 The average growth rate of real GDP is equal to (41.7 percent + Real GDP $4,200 42.9 percent) ÷ 2 = 42.3 percent. (2013 dollars) So real GDP between these years has grown by 42.3 percent. If 2012 is the base year, real GDP in 2013 is $3,000 × 1.423 = $4,269. The growth rate of real GDP between 2013 and 2014 is calculated similarly and then applied to real GDP in 2013, $4,269. Calculating the growth rates between adjacent years and then applying it to the previous year’s real GDP chains the real GDPs back to the initial base year.

248

Part 4 . MONITORING THE MACROECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Appendix: Measuring Real GDP 1. An island economy 2012 2013 produces only lobsters Item Quantity Price Quantity Price and crabs. The table gives the quantities Lobsters 100 $20 each 110 $25 each produced and the pricCrabs 25 $25 each 30 $30 each es in 2012, and the quantities produced and the prices in 2013. The base year is 2012. Calculate: 1a. Nominal GDP in 2012. 1b. Nominal GDP in 2013. 1c. The value of 2013 production in 2012 prices. 1d. Percentage increase in production when valued at 2012 prices. 1e. The value of 2012 production in 2013 prices. 1f. Percentage increase in production when valued at 2013 prices. 1g. Real GDP in 2012 and 2013. 

Answers

 Appendix: Measuring Real GDP 1a. Nominal GDP in 2012 = ($20 × 100) + ($25 × 25) = $2,000 + $625 = $2,625. 1b. Nominal GDP in 2013 = ($25 × 110) + ($30 × 30) = $2,750 + $900 = $3,650. 1c. Using 2012 prices, the value of 2013 production is ($20 × 110) + ($25 × 30) = $2,200 + $750 = $2,950. 1d. In 2012 prices, the value of production increased from $2,625 to $2,950, an increase of $325. The percentage increase is equal to ($325 ÷ $2,625) × 100, which is 12.38 percent. 1e. The value of 2012 production in 2013 prices is ($25 × 100) + ($30 × 25) = $2,500 + $750 = $3,250. 1f. In 2013 prices, the value of production increased from $3,250 to $3,650, an increase of $400. The percentage increase is ($400 ÷ $3,250) × 100, which is 12.31 percent. 1g. Real GDP in 2012 = $2,625. It is equal to nominal GDP because 2012 is the base year. To calculate real GDP in 2013 compute the growth rate of real GDP between 2012 and 2013. That growth rate is the average of the growth rates between 2012 and 2013 using prices from 2012 and using prices from 2013. Taking the average of the answers to parts (d) and (f) gives us an average percentage increase of 12.35 percent.

Appendix 14 . Measuring Real GDP

Real GDP in 2013 is 12.35 percent greater than real GDP in 2012. Real GDP in 2012 was $2,625, so real GDP in 2013 equals ($2,625) × (1.1235), which is $2,949.

249

Chapter

Jobs and Unemployment CHAPTER OUTLINE 1. Define the unemployment rate and other labor market indicators. A. Current Population Survey B. Population Survey Criteria C. Two Main Labor Market Indicators 1. The Unemployment Rate 2. The Labor Force Participation Rate D. Alternative Measures of Unemployment 1. Marginally Attached Workers 2. Part-Time Workers 2. Describe the trends and fluctuations in the indicators of labor market performance in the United States. A. Unemployment Rate B. The Participation Rate C. Alternative Measures of Unemployment D. A Closer Look at Part-Time Employment 3. Describe the sources and types of unemployment, define full employment, and explain the link between unemployment and real GDP. A. Frictional Unemployment B. Structural Unemployment C. Cyclical Unemployment D. “Natural” Unemployment 1. The Age Distribution of the Population 2. The Pace of Structural Change 3. The Real Wage Rate 4. Unemployment Benefits D. Unemployment and Real GDP

252

Part 4 . MONITORING THE MACROECONOMY

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 15 expands coverage of women in the labor force in the Eye application and features updated data for 2013 throughout the chapter.

 Where We Are In Chapter 15, we cover how the unemployment rate is calculated, review labor market indicators, trends and fluctuations in the labor market, explore the types of unemployment, define full employment, explore the influences on the natural unemployment rate, and explain the link between unemployment and real GDP using the output gap.

 Where We’ve Been In the previous chapter, we laid down the building block of how GDP and its components are measured. We continue by examining how labor market variables are measured and how they have evolved over time.

 Where We’re Going The next chapter concludes the descriptive part of the book by discussing and describing how the price level is measured. We will see how price indices are used to measure the cost of living and to calculate the inflation rate.

IN THE CLASSROOM  Class Time Needed The material in this chapter can be covered in approximately one and a half class sessions. If you mention current events, such as current labor market data, be sure to use the most current data available. You can check the Foundations and BLS Web sites for these data. An estimate of the time per checklist topic is: •

15.1 Labor Market Indicators—20 to 25 minutes

•

15.2 Labor Market Trends and Fluctuations—15 to 25 minutes

•

15.3 Unemployment and Full Employment—30 to 45 minutes

Chapter 15 . Jobs and Unemployment

253

CHAPTER LECTURE 15.1

Labor Market Indicators

Lecture Launcher: A good way to generate student interest and introduce the idea of unemployment is to start by pointing out to your students that less than half of the U.S. population is employed and ask them if that seems too high or too low? Ask them if everyone in our economy should be employed? Use their responses (and prompting from yourself) to brainstorm a list of people who, in your students’ opinions, probably should not be employed (children, retirees, students, stay-at-home parents, disabled, inmates, etc.). This will help you introduce the intention of the classification of unemployment. It’s an attempt to measure how an economy is doing at providing jobs for the people who want them, not just the percentage of people in an economy who are not employed. Lecture Launcher: A good way to introduce the idea that unemployment brings benefits is to think about the unemployment of things rather than people. Look around the campus and notice all the unemployed automobiles in the parking lots/stations. Notice the unemployed class rooms early in the morning and late at night. Notice the unemployed seats in Starbucks at peak lecture times. Look around the city and notice all the unemployed automobiles in the car sales lots. Try to make a reservation at any of the hotels in the city and notice that you can almost always get a room—hence, lots of unemployed hotel rooms. Now ask: does all this unemployment bring benefits? The students quickly see that it would be very costly to organize rental markets in which cars don’t sit idle all day, and so on. Move on by asking: do the same ideas apply to unemployed people? (Be sure to be compassionate about the misery that unemployment can bring. You are not claiming that it is not costly. You’re trying to identify the benefits, if any.) You’ll quickly get your students to see that imagining an economy without any unemployment is nearly impossible. If consumers are free to change their decisions about what they want to buy, some goods and services must fall out of favor when others come into favor. The firms making the products falling from favor fall on hard times and often their workers are fired or laid off. Sure, these laid off workers could start work right away, cleaning shoes, selling flowers at intersections. But they are better off (in their own opinion) being frictionally unemployed and searching for new jobs. To eliminate this source of unemployment we would need to forbid consumers from changing their buying plans or insist that no one remain idle and get on with doing any job even if it doesn’t earn a wage. Note that if this is how we ran our economy we’d still be using coal-fired stoves and the pony express, and we’d be wearing coonskin caps. There would be no McDonald’s, Federal Express, or Nike shoes.

Current Population Survey •

The U.S. Census Bureau measures the population, labor force, and level of employment. The working-age population is the total number of people aged 16 years and over who are not in jail, a hospital, or some other form of institutional care or in the U.S. Armed Forces. The labor force is the sum of the number of people employed and the number of people unemployed. © 2015 Pearson Education, Inc.

Part 4 . MONITORING THE MACROECONOMY

254

•

To be counted as unemployed, a person must not have a job and be available for work and must be either: • Without work but has made specific efforts to find a job within the previous four weeks • Waiting to be recalled back to a job from which he or she has been laid off

Two Main Labor Market Indicators •

The unemployment rate is the percentage of the people in the labor force who are un(Number of people unemployed) employed. It equals × 100. (Labor force)

Remember though that those counted in the numerator are people who are unemployed but at the same time are actively seeking employment. It’s important to stress that even though an individual may be without work this fact alone does not qualify the person to be classified as unemployed. The unemployed are a specific group of people who are not employed.  Land Mine: Perhaps the most difficult point in this chapter to get across to students is explaining the difference between the layperson’s definition of unemployment and unemployment as measured by the BLS. The layperson typically considers anyone who is not working as unemployed. It is worth reemphasizing that a person is only considered officially unemployed if the person is not working and also is actively seeking employment. Here is a good opportunity to ask students a direct question to which they will happily provide several answers. Why might someone be not working and not looking for work? Students will no doubt point to some of the most obvious answers: full-time student, homemaker, retired, disabled, etc. •

The labor force participation rate is the percentage of working-age population who are (Labor force) members of the labor force. It equals × 100. (Working - age population)

Alternative Measures of Unemployment •

A marginally attached worker is a person who does not have a job, is available and willing to work, has not made specific efforts to find a job within the previous four weeks, but has looked for work sometime in the recent past. A discouraged worker is a marginally attached worker who has not made specific attempts to find a job within the previous four weeks because previous unsuccessful attempts were discouraging. Other marginally attached workers differ from discouraged workers only in their reasons for not looking for jobs. Marginally attached workers are not included in the labor force participation rate or in the unemployment rate.

During the worst part of a very severe and protracted recession, some workers simply grow tired of looking for work and cease their job search efforts altogether, thereby lowering the unemployment rate. This means the unemployment rate may be underestimating the unemployment problem more during recessions than other phases of the business cycle because of this “hidden © 2015 Pearson Education, Inc.

Chapter 15 . Jobs and Unemployment

255

unemployment.” When the economy begins to recover, discouraged workers may resume their job search efforts which will then actually increase the unemployment rate. This is one reason why the unemployment rate tends to be a lagging indicator when tracking the end of a recession. •

Full-time workers are those who usually work 35 hours or more a week. Part-time workers are those who usually work less than 35 hours a week. People who work part time for economic reasons (also known as involuntary part-time workers) are people who work 1 to 34 hours per week but who are looking for full-time work and cannot find it because of unfavorable business conditions. These workers are not considered strictly unemployed, but are certainly underemployed – and, like unemployment, they indicate slack in the labor market.

15.2

Labor Market Trends and Fluctuations

Unemployment Rate •

Since 1929, the unemployment rate in the United States has averaged 7.2 percent. Since 1948, the average U.S. unemployment rate has been 5.8 percent, with much higher rates during the Great Depression and the 1973-1975, 1981-1982 and 2008-2009 recessions and lower rates during the expansions of the 1960s and 1990s.

The Labor Force Participation Rate •

Since 1960, the labor force participation rate for men has decreased and for women has increased, though in 2013 the labor force participation rate for men (about 70 percent) remains higher than that for women (less than 60 percent). The overall labor force participation rate has increased from about 59 percent in 1960 to about 67 percent in 1999 (though it has dropped below 64 percent by 2013). The cyclical fluctuations in the participation rate are small.

You might want to get students to explore the economic forces that lie behind the social attitudes and changes that have take place in the labor market. Get them to think about the technological advances that have contributed to more women being in the labor force. Many goods that were previously produced in the household are now mass-produced and available for purchase—most items of prepared food, for example. New appliances have increased productivity in the home enabling household production in less time—laundry, kitchen, and cleaning equipment for example. The market provides new goods and services that households want but can’t readily make at home—home entertainment equipment (TV, CD, DVD, etc) for example. These changes lead to many families deciding to have two income-earners rather than the older tradition of one. It is interesting to let students discuss what they think will happen to the labor force participation rates in the future and whether or not they think they will ever be equal—or unequal in the opposite direction!

Alternative Measures of Unemployment •

Because the unemployment rate does not include marginally attached workers and people who work part time for economic reasons, the BLS also now provides three broader measurements of unemployment (or underemployment). © 2015 Pearson Education, Inc.

Part 4 . MONITORING THE MACROECONOMY

256

•

• U-3 is the official unemployment rate. • U-4 is U-3 plus discouraged workers. • U-5 is U-4 plus other marginally attached workers. • U-6 is U-5 plus employed part time for economic reasons. The broader the measurement, the higher the rate at any given time period, though all of these measurements tend to have similar fluctuations over the course of the business cycle.

A Closer Look at Part-Time Employment •

Since 1980, the number of people who are part-time workers for noneconomic reasons has remained roughly constant at about 13 to 14 percent of total employment and changes very little over the business cycle. The number of people who work part-time for economic reasons (involuntary part-time workers), while consistently being much smaller than part-time for noneconomic reasons, experiences large swings over the business cycle, increasing during recessions and decreasing during expansions.

15.3

Unemployment and Full Employment

Types of Unemployment •

•

Frictional unemployment is the unemployment that arises from normal labor turnover as people enter and leave the labor force, quit jobs to find better ones, and from the ongoing creation and destruction of jobs. These workers are searching for jobs and unemployment related to this search process is a permanent phenomenon in a dynamic, growing economy. Frictional unemployment increases when more people enter the labor market or when unemployment benefits increase. Structural unemployment is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. Sometimes there is a mismatch between skills demanded by firms and skills provided by workers, especially when there are great technological changes in an industry. Structural unemployment generally last longer than frictional unemployment. Cyclical unemployment is the fluctuating unemployment over the business cycle. Cyclical unemployment increases during a recession and decreases during an expansion.

“Natural” Unemployment •

•

Full employment does not mean that there is no unemployment. Full employment occurs when there is no cyclical unemployment or, equivalently, when all the unemployment is frictional and structural. The unemployment rate at full employment is called the natural unemployment rate. The term “natural” refers to the idea that some positive level of unemployment is the outcome in any dynamic economy. The most important factors that influence the natural unemployment rate are: •

The Age Distribution of the Population: An economy with a young population has a large number of new job seekers and a high level of frictional unemployment.

Chapter 15 . Jobs and Unemployment

257

•

The Pace of Structural Change: An increase in the pace of technological change and international competition will lead to a higher level of structural unemployment.

•

The Real Wage Rate: A real wage rate higher than the equilibrium real wage rate (such as from minimum wage or efficiency wages) will create a surplus of labor and increases the natural unemployment rate.

•

Unemployment Benefits: Unemployment benefits lower the opportunity cost of job search and can increase the natural unemployment rate.

There are two controversies that surround the natural rate of unemployment. The first is the use of the term “natural,” which offends many who believe any unemployment is always a bad thing. From the perspective of an unemployed individual who has yet to find the job he or she wants, unemployment is bad. However, there is some level of unemployment that is good for society because it will help create more productive matches between firms and workers, allow for “creative destruction” as new firms replace unsuccessful firms, and allow for international trade and technological changes that lead to economic growth. The second controversy is what level of unemployment corresponds to the natural rate. Because this number is unobserved, it must be estimated. Some estimates imply the natural rate is stable and changes only slowly over time. Others imply that most of the fluctuations in unemployment are “natural”. These differences are important for macroeconomic policy because one of the typical goals of policy is to keep the unemployment rate from wide swings around the natural rate.

Unemployment and Real GDP •

•

The quantity of real GDP at full employment is called potential GDP. Potential GDP is the value of real GDP when all the economy’s factors of production—labor, capital, land, and entrepreneurial ability—are fully employed. When the economy is at full employment, the unemployment rate equals the natural rate of unemployment (no cyclical unemployment) and real GDP equals potential GDP. When the unemployment rate is less than the natural rate of unemployment (negative cyclical unemployment), real GDP is greater than potential GDP. And when the unemployment rate is greater than the natural rate of unemployment (positive cyclical unemployment), real GDP is less than potential GDP. Real GDP minus potential GDP expressed as a percentage of potential GDP is called the output gap.

Students often have an innate sense of an asymmetry in business cycle fluctuations around potential GDP because they often think that the economy is almost always below potential GDP. It is important for them to understand that it is possible for the economy to temporarily rise above potential GDP so that the unemployment rate is less than natural rate of unemployment. One (small) example of this state of affairs occurred in Silicon Valley in the late 1990s when workers who became dissatisfied with a job could quit and be assured of new job (often at higher pay!) within a few days. Indeed, firms paid for expensive radio advertisements “begging” for workers to apply for jobs.

258

Part 4 . MONITORING THE MACROECONOMY

USING EYE ON THE U.S. ECONOMY  The Current Population Survey Many students think that the government counts every unemployed person each month. To do this, every home in the country would have to be contacted—just as in the population census every 10 years. You might explain that this procedure would cost too much and take too long. One of the advantages of this measurement is that it can be calculated every month and is typically released the first Friday of the next month – making it a much more timely measurement than GDP, which is only calculated quarterly and goes through a nearly 3 month process of collecting and revising data after the quarter has ended before the final reading is reported. In addition, if the entire population were surveyed then people would soon grow tired of having a census taker come to their homes every month, year after year, to ask about job-related activities! Also you might wish to explain that because unemployment insurance records relate only to persons who have applied for such benefits, the government prefers to gather the data through a survey. Students might be skeptical that such a survey can actually work when only a very small fraction of the population is interviewed. You can respond by arguing that polls conducted on Election Day to project the winner are done in very much the same way. Usually, only a few hundred people are interviewed but typically the results are remarkably accurate because those who are chosen to participate come from an independent and random population. In other words, each member of the larger population had an equal chance of being chosen in the survey.

USING EYE ON THE GLOBAL ECONOMY  Unemployment Around the World It would be instructive for students to focus on the Japanese unemployment rate because it reveals a nation undergoing massive structural change. Until recently, how Japan’s economy and the U.S. economy made adjustments in the labor market over the business cycle were very different. In Japan, at least until recently, a substantial segment of the working population had unwritten “life time” employment contracts. In other words, there was a tacit understanding between many employers and workers that workers would remain on the payroll even during hard economic times. In addition, Japan made great use of a large contingent of part-time workers who were laid off during recession but did not actively seek work because they did not believe they would find it. But, because the Japanese have suffered through over a decade of very low growth, the Japanese labor market is changing and becoming more flexible, like the U.S. labor market. Now in Japan, there are fewer implied contracts so the adjustment process in the labor © 2015 Pearson Education, Inc.

Chapter 15 . Jobs and Unemployment

market falls more directly on full-time workers through layoffs during recessions. In addition, to these trends, it is interesting to illustrate the differences in cultural responses to unemployment–for example, in Japan large numbers of women who are temporary or casual workers withdraw from the labor force when they lose their jobs, rather than becoming unemployed. This action might be because they believe that their efforts to look for work will be in vain. Regardless of the reason, this withdrawal will lead to differences in the calculated unemployment rates based on the way in which unemployment is measured. This Eye also serves as an opportunity to point out the persistently higher rates of unemployment in Canada and the Eurozone than the U.S. Discuss how unemployment rates tend to be higher in countries with less flexible labor markets because firms are less willing to hire people if they are restricted in their ability to fire them later if needed. Higher unemployment benefits may also lead to higher unemployment rates as individuals take longer to find work.

 Women in the Labor Force As the figure demonstrates, labor force participation rates of women vary substantially across the nations surveyed. Here you might want to ask students what would be some of the cultural differences between the countries that might help explain the observed differences. In addition, you might wish to ask them how an overall increase in the number of women with a college degree across all the nations might bring about a convergence of these labor force participation rates. Also it might be useful to point out that part of the reason for the so-called “gender gap” (the wage rate differential between men and women) in some countries has to do with their delayed entry into the labor force and the greater propensity to exit and reenter the labor force and work part-time due to child rearing. By delaying entry, working part-time, and having interrupted stints in the labor force, women often do not have the same opportunity to have acquired the human capital levels that men have who have been more continuously active participants in the labor force. In the United States, the average full-time female worker has 40 percent less job experience than the average full-time male worker. In other words, because of this lack of experience, women tend to earn lower wages. But this lower wage is tied to their lower productivity.

USING EYE ON THE UNEMPLOYED  How Long Does it Take to Find a New Job? Use this Eye to highlight the fact that the headline-grabbing unemployment rate fails to capture how different groups of workers and different regions of the country experience unemployment in different ways and severities. In addition to differing durations of unemployment, unemployment rates are highly corre© 2015 Pearson Education, Inc.

259

260

Part 4 . MONITORING THE MACROECONOMY

lated with various worker characteristics, such as race, gender, age, region, and education level. For example, in July 2013 the national unemployment rate was 7.4 percent, though it was lower for Asians (5.7 percent) and whites (6.6 percent) and much higher for Hispanics (9.4 percent) and blacks (12.6 percent). The unemployment rate for males 7.7 percent, while for women it was only 7.0 percent. It was 23.7 percent for teenagers. North Dakota, South Dakota, and Nebraska had unemployment rates around 3-4 percent, while it was around 9 percent in Illinois, Michigan, Nevada, North Carolina, and Rhode Island. We also see dramatically different levels of unemployment for high school dropouts (11 percent), high school graduates with no college (7.6 percent), workers with some college or an associate’s degree (6.0 percent), and those with a bachelor’s degrees or beyond (3.8 percent)—an excellent reminder of why your students are probably sitting in your classroom! Current data can be found on the BLS Web site and should be presented to students to help them better understand how the national unemployment rate can fail to capture the experiences of groups within the U.S. at any given point in time. Also, you may find it helpful to select a few of the differentials and ask students to try to explain why the rates are higher or lower for these different groups. Analyzing how the duration of unemployment fluctuates with the business cycle can also generate discussion concerning controversial government assistance programs like unemployment benefits. As highlighted earlier in the chapter, one of the reasons the United States tends to have a lower rate of unemployment than Canada or the Eurozone is due to the relatively lower levels of U.S. unemployment benefits and the short duration in which workers are eligible to collect (typically capped at 26 weeks). The goal of unemployment benefits in the United States is to provide temporary income assistance to help workers who have lost their job take time to search for a new job that matches up with their skill sets. The benefits help so that workers aren’t forced into the first job that becomes available and promotes a better utilization of human capital. However, the fairly limited duration of eligibility is also used to push workers into getting back to work and not “milking the system.” Ask your students to explain the rationale behind extending unemployment benefits during recessions or having different durations of eligibility in different states (as our Congress typically does during a recession – eligibility was capped at 99 weeks in response to the 2008-2009 recession). Do they agree with basing the duration of eligibility for unemployment compensation off the amount unemployment, or does that only lead to higher rates of unemployment? If you really want to stir debate, ask those who agree with granting greater eligibility for states with higher levels of unemployment if they also agree with granting greater eligibility for groups with higher levels of unemployment? Should unemployment eligibility also be based off of race, gender, age, and education level, as unemployment rates are also correlated with these characteristics of workers? © 2015 Pearson Education, Inc.

Chapter 15 . Jobs and Unemployment

USING EYE ON YOUR LIFE  Your Labor Market Status and Activity Helping your students identify how the BLS would classify them can be a bit trickier (and more controversial) than it seems. If they are employed, that’s a pretty straightforward classification that supersedes their status as a student. If they are not employed and not seeking employment, then they are not in the labor force. If they are a part-time student looking for part-time or full-time employment, then they are unemployed since their part-time status makes them currently available for either type of employment. If they are a full-time student looking for part-time employment, then they are unemployed since they are available for part-time employment and are searching. However, if they are a fulltime student looking for full-time employment, then they are considered not in the labor force. The assumption is that full-time students are not available for full-time employment at that time, so the students searching for full-time employment are looking for the time after they are done being a full-time student— which means they are not currently available for work and so they are not counted as unemployed. I imagine you have a few students who may disagree with that last one… To practice identifying different types of unemployment, ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, seasonal or cyclical unemployment. Look at your local examples. If you live in a steel-producing area, for example, you can talk about local structural unemployment arising from the closing of a steel manufacturer due to international competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollment at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession the growth rate of full-time enrollment increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs.

261

262

Part 4 . MONITORING THE MACROECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 15.1 Labor Market Indicators 1. Assume the following people are interviewed by a representative of the Bureau of Labor Statistics. Classify each as either employed, unemployed, or not in the labor force. 1a. Nancy Lopez reported to the interviewer that last week she worked 30 hours as a sales manager for the Coca-Cola Bottling company. 1b. Bill Stevens lost his job when the local plant of Arco Steel Company was closed down. Since then, he has been visiting the personnel offices of the other factories in the town trying to find a job. 1c. Patricia Hunter is a homemaker. Last week, she was occupied with her normal household chores. She neither held a job nor looked for a job. Her 75-year old father, Jake Jackson, lives with her and has not worked nor looked for work because of a disability. 1d. Julie Simon is an autoworker. Last week she was not working because her union is on strike against the local automaker. 1e. Tom Nguyen is a personnel director. Last week he was not working because he had problems finding child care for his two small children. 2.

The BLS reported that in July 2000, the labor force was 140.4 million, employment was 134.7 million, and the working-age population was 209.8 million. Calculate for that month the: 2a. Unemployment rate. 2b. Labor force participation rate. 3.

Statistics Canada reported that in July 2000, the Canadian labor force was 15.95 million, Canadian employment was 14.87 million, and the Canadian working-age population was 24.31 million. Calculate for that month the Canadian: 3a. Unemployment rate. 3b. Labor force participation rate.  Checkpoint 15.3 Unemployment and Full Employment 4. Using the factors that influence the natural unemployment rate, explain what could cause the natural unemployment rate to increase. 

Answers

Chapter 15 . Jobs and Unemployment

1d. In spite of the fact that Julie was not working last week, she is still counted as employed because she was on strike. 1e. Tom also is considered employed because of the nature of his absence. 2a. Unemployment rate = (140.4 million – 134.7 million) ÷ 140.4 million × 100 = 4.1 percent. 2b. Labor force participation rate = (140.4 million ÷ 209.8 million) × 100 = 66.9 percent. 3a. Unemployment rate = (15.95 million – 14.87 million) ÷ 15.95 million × 100 = 6.8 percent. 3b. Labor force participation rate = (15.95 million ÷ 24.31 million) × 100 = 65.6 percent.  Checkpoint 15.3 Unemployment and Full Employment 4. A younger population that increases the number of job seekers would create more frictional unemployment and increase the natural unemployment rate. A more rapid pace of technological change or international competition would create more structural unemployment and increase the natural unemployment rate. Real wage rates higher than equilibrium as a result of higher minimum wage or efficiency wages will increase the natural unemployment rate. More generous unemployment benefits will increase the natural unemployment rate.

263

Chapter

The CPI and the Cost of Living CHAPTER OUTLINE 1. Explain what the Consumer Price Index (CPI) is and how it is calculated. A. Reading the CPI Numbers B. Constructing the CPI C. The CPI Market Basket D. The Monthly Price Survey E. Calculating the CPI F. Measuring Inflation and Deflation 2. Explain the limitations of the CPI and describe other measures of the price level. A. Sources of Bias in the CPI 1. New Goods Bias 2. Quality Change Bias 3. Commodity Substitution Bias 4. Outlet Substitution Bias B. The Magnitude of the Bias C. Two Consequences of the CPI Bias 1. Distortion of Private Contracts 2. Increases in Government Outlays and Decreases in Taxes D. Alternative Measures of the Price Level and Inflation Rate 1. GDP Price Index 2. Personal Consumption Expenditures (PCE) Price Index 3. PCE Price Index Excluding Food and Energy 3. Adjust money values for inflation and calculate real wage rates and real interest rates. A. Dollars and Cents at Different Dates B. Nominal and Real Values in Macroeconomics C. Nominal GDP and Real GDP D. Nominal Wage Rate and Real Wage Rate E. Nominal Interest Rate and Real Interest Rate

266

Part 4 . MONITORING THE MACROECONOMY

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 16 features updated data throughout and a new example for the Eye on the Box Office.

 Where We Are In Chapter 16, we explain what the Consumer Price Index (CPI) is and how it is calculated. We examine the limitations of the CPI as a measure of the cost of living. Next we look at alternative measures of the price level: the GDP price index, the PCE price index, and the PCE price index excluding food and energy. Finally we show how to adjust money values for inflation and calculate real wage rates and real interest rates.

 Where We’ve Been The previous chapters described other basic measurements in macroeconomics—GDP and the labor market. Chapter 21 described the basic facts about the macroeconomy, such as how U.S. GDP has changed over time. Chapter 22 discussed employment and unemployment and their changes over time.

 Where We’re Going This chapter is essentially the last descriptive chapter. The next chapter starts the more theoretical part of the course. It examines the economy at full employment and discusses potential GDP and the natural unemployment rate.

IN THE CLASSROOM  Class Time Needed The material in this chapter can be covered in one and a half to two class sessions. If you mention current events, such as the current inflation rate, be sure to use the most current data available. You can check the Foundations or BLS Web site for these data. An estimate of the time per checklist topic is: •

16.1 The Consumer Price Index—30 to 45 minutes

•

16.2 The CPI and Other Price Level Measures—30 to 40 minutes

•

16.3 Nominal and Real Values—20 to 30 minutes

Chapter 16 . The CPI and the Cost of Living

267

Class Activities: Ask your students to match their expenditure patterns with those in the CPI basket displayed below. The table presents a list of items and what the Bureau of Labor Statistics reported as the average expenditure in a typical market basket of goods for 2013. List the categories and leave the percentages blank. Next, ask your students to write down their own personal percentage expenditures for the list you have provided them. Remind them that they should make estimates of what percentage each item represents in terms of their annual income. After a couple of minutes or so, reveal the actual weights that the BLS reported for 2013. Then ask your students to place a check mark against each expenditure category in which he or she observes a substantial difference in relative weightings. In addition, you also can ask them to reveal if there are any items that are on their personal list that did not make it on the BLS list. The point of this activity is to demonstrate that although the CPI is a statistically sound measure of the average change in the cost of a bundle of goods; it does not measure each and every individual person’s average change in cost. Indeed, there is at least one item on this list that has a markedly different weight of importance than the figure that your students assigned to it. That item is education. Many students who are working their way through college are probably also paying their own tuition. It is likely that the percentage in this category is much higher than the BLS reported figure. This activity can be combined with the Eye on Your Life discussed at the end of this chapter.

Item

2013 Weight in CPI Market Basket (percent)

Housing

40.9

Transportation

17.2

Food and beverages

15.2

Medical care

7.2

Education and communication

6.7

Recreation

6.0

Apparel

3.6

Other goods and services

3.4

Part 4 . MONITORING THE MACROECONOMY

268

CHAPTER LECTURE 16.1

The Consumer Price Index

The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed market basket of consumer goods and services. The CPI is calculated monthly by the Bureau of Labor Statistics (BLS).

Reading the CPI Numbers • •

The CPI is defined to equal 100 for a period called the reference base period. The current reference base period is 1982-1984, so the average CPI during that period was 100. In May 2013, the CPI was 232.9. Thus, since 1982-84, prices have increased by 132.9 percent to May 2013.

Constructing the CPI •

The BLS conducts a survey of consumers (the Consumer Expenditure Survey) to determine the average market basket of goods and services purchased by urban household. Then each month the BLS records the prices of goods and services in the market basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices to determine the cost of the basket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in the current month to the cost in the base period, or (Cost of CPI basket at current period prices) (Cost of the CPI basket at base period prices)

× 100.

•

For example, suppose the initial survey shows that the CPI market basket is 2 books and 20 coffees. The initial base period prices and quantities are in the first table below. In this base period, say 2013, the cost of the CPI market basket is $100.

•

Next suppose that the BLS survey taken one month in 2014 reveals that the price of a book is $35 and the price of a coffee is $3. These 2014 prices and the initial base period quantities are in the table to the right. In this period the cost of the CPI basket is $130.

•

Using these data, the CPI equals ($130 ÷ $100) × 100, or 130. So between the base period and the current period, the CPI has risen by 30 percent.

Item Books Coffee Basket

Quantity 2 20

Price $30 $2

Cost (dollars) $60 $40 $100

Price $35 $3

Cost (dollars) $70 $60 $130

Lecture Launcher: Students might get the wrong idea in believing that the BLS blindly measures exactly the same quantities of goods from year to year. While true in general, it does smooth over some important details that are worth mentioning. One of them you could use for illustration in class is the treatment of college textbooks. Below is an example:

Chapter 16 . The CPI and the Cost of Living

269

College textbooks have a relatively high number of replacements (which occur when the book that has been followed is no longer sold in the outlet) and in many cases the replacement is not comparable to its predecessor. For example, over the one year time period from June 1998 to May 1999, the CPI priced a total of 948 quotes for the College textbook category. From this full year of quotes, 113 quotes (12 pe8rcent) were replacements. Of the 113 replacements, 40 quotes (35 percent) were deemed to be either comparable or able to be quality adjusted, and thus could be used in the CPI. The remaining 73 quotes (65 percent) were not comparable, and were deemed to be eligible for other processing where estimated price change is used based on price movement of comparable replacement items. Ultimately, this meant that 1 out of every 13 priced quotes in this item category over the course of a year were non-comparable replacements. These figures led to the conclusion that College textbooks more than qualified as a candidate for hedonic regression analysis.1 While you probably won’t want to get into the business of what a hedonic regression analysis is, you might still find the passage useful in demonstrating that the BLS goes to great pains to try to get the CPI right. 1Reese, Mike, “Hedonic Quality Adjustment Methods for College Textbook in the U.S. CPI.”

Measuring Inflation and Deflation •

The inflation rate is the percentage change in the price level from one year to the next. In  CPI in current year - CPI in previous year   × 100. a formula: Inflation rate =   CPI in previous year   •

Deflation is when the price level is falling and the inflation rate is negative.

 Land Mine: Be careful to explain the difference between calculating the CPI and calculating the inflation rate. Students easily confuse the two!

16.2

The CPI and Other Price Level Measures

The CPI is a cost of living index, which is a measure of the change in the amount of money that people need to spend to achieve a given standard of living. However, the CPI is not a perfect measure of the cost of living because it does not try to measure all the changes in the cost of living and the components that are measured are not always measured accurately.

Sources of Bias in the CPI •

The CPI has four biases that lead it to overstate the inflation rate. The biases are: • • • •

New Goods Bias: New goods are often more expensive than the goods they replace. Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation. Commodity Substitution Bias: Consumers substitute away from goods and services with large relative price increases. Outlet Substitution Bias: When prices rise, people use discount stores more frequently and convenience stores less frequently.

Part 4 . MONITORING THE MACROECONOMY

270

The Magnitude and Consequences of the Bias • • •

•

The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about 1.1 percentage points a year. Many contracts and payments are indexed to the CPI. If the CPI is biased, then these contracts are distorted because they incorrectly account for inflation. Many government outlays, such as Social Security payments, are linked to the CPI. If the CPI is biased upward, then government outlays increase more than what is required to offset inflation. Taxes are also indexed to the CPI so that the incomes for which tax rates rise are adjusted to take account of inflation. The upward bias means that adjustments are biased upward so that the government collects less tax revenues. To reduce the bias, the BLS has decided to undertake consumer spending surveys more frequently.

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent amounts to close to a trillion dollars in additional expenditures over a decade. Politically, it is hard to adjust Social Security payments for the bias, so the current plan is to reduce the measurement bias in the CPI, for instance by revising the basket more frequently to reflect new goods and substitution changes.

Alternative Measures of the Price Level and Inflation Rate

•

• •

The GDP price index (also called the GDP deflator) is an average of the current prices of all the goods and services in GDP expressed as a percentage of base-year prices. The GDP price index includes prices of all the goods and services in GDP: consumption expenditure, investment, government expenditure, exports, and imports. The GDP price index is broader than the CPI, but is not perfect because it still suffers from the CPI’s biases since the CPI is used to help construct real GDP. The PCE price index is an average of the current prices of the goods and services in the consumption expenditure part of GDP expressed as a percentage of base-year prices. The percentage change in the PCE price index excluding food and energy measures the core inflation rate. Food and energy prices fluctuate much more than other prices and their changes can obscure the underlying trends in prices. Students (and the media) often don’t understand why core inflation is a useful measurement and assume it is a way for the government or economists to trick people into thinking inflation is not as high by removing food and energy prices, which obviously do play a role in people’s expenditures. It is important to identify that food and energy prices can be extremely volatile, especially as a function of weather and global politics. Not only does this volatility complicate the analysis of other price changes, but from a policy perspective core inflation measurements may serve as a better guide than overall inflation. Food and energy price changes that are the result of changes in weather and global politics are largely outside of the influence of policies. Therefore, it may make sense to ignore them and focus on core inflation when designing policies, since it’s that underlying inflation that may be a reflection of the functioning of the economy and economic policies, as © 2015 Pearson Education, Inc.

Chapter 16 . The CPI and the Cost of Living

271

opposed to external factors which cannot be controlled. This is why policymakers (especially the Federal Reserve) tend to focus more on core inflation when designing policies.

•

Over time, the CPI and PCE indices move up and down in similar ways, but the previously discussed biases cause the CPI to rise slightly more rapidly than the PCE indices.

16.3

Nominal and Real Values

Dollars and Cents at Different Dates •

To compare dollar amounts at different dates, we need to know the CPI at those dates. To convert the price of a good in past dollars to its price in current dollars, multiply the earCPI in present year lier price by . CPI in earlier year

Nominal and Real Values in Macroeconomics The difference between nominal and real variables is important in macroeconomics. In macroeconomics, we generally use the GDP deflator rather than the CPI as our measure of the price level because we are dealing with economy totals, of which consumer spending is just one part. Real values seem to cause students confusion. Reiterate why we calculate real values and that the calculation of the real wage is just like the calculation of real GDP, only using a different set of variables. It may be helpful to show the real calculations side-by-side by writing out (real wage) = (nominal wage) ÷ (CPI) and real GDP = (nominal GDP) ÷ (GDP deflator). In other words, show your students the same general formula—real variable equals nominal variable divided by the price level—applies to all real variables except, of course, the real interest rate.

Nominal GDP and Real GDP •

Real GDP =

Nominal GDP × 100. GDP price index

Nominal Wage Rate and Real Wage Rate •

The nominal wage rate is the average hourly wage rate measured in current dollars and the real wage rate is the average hourly wage rate measured in dollars of a given reference base year. Nominal wage rate • The real wage rate = × 100. CPI •

The real wage rate is the quantity of goods and services that an hour’s work can buy.

•

Between 1981 and 2011 the nominal wage rate more than doubled but the real wage rate stayed roughly constant because the increase in the nominal wage rate just kept up with inflation.

Ask students to think about whether it is the real wage or the nominal wage that matters to them. You may want to use a numerical example to illustrate how an increase in prices without an increase in the nominal wage will reduce the amount of goods and services a student can buy. This procedure will help to cement the idea of the real wage. © 2015 Pearson Education, Inc.

Part 4 . MONITORING THE MACROECONOMY

272

Nominal Interest Rate and Real Interest Rate •

The nominal interest rate is the percentage return on a loan calculated by using dollars. The real interest rate is the percentage return on a loan calculated by using purchasing power; it’s the nominal interest rate adjusted for the effects of inflation. • Real interest rate = Nominal interest rate − Inflation rate. •

When the inflation rate was high, during the 1970s and early 1980s, the gap between the real interest rate and the nominal interest rate was large. The real interest rate was negative in the mid-to-late 1970s and very high in the early 1980s, but has shown no real upward or downward trend since 1971.

To be sure that your students understand that the real interest rate is similar to the real wage rate and real GDP insofar as it’s in real terms, mention that the calculation of the real interest rate also “deflates” the nominal interest rate. However, because the numbers are already percentages, we must subtract the percentage change in prices (the inflation rate) rather than divide by the price level.

Chapter 16 . The CPI and the Cost of Living

USING EYE ON THE PAST  700 Years of Inflation and Deflation Richard Gosselin once had a historian friend ask if he could provide him with inflation data for the past 200 years. Richard asked his friend why he wanted it and he explained that it was for a book he was writing and he wanted to include comparisons of the cost of living of the colonial period to that of today. Richard told him that he would see what he could do. After speaking with someone at the Federal Reserve Bank in Dallas, Richard had the answer. When he handed his colleague the figures, he explained to him that the numbers might not be very useful for comparing costs of living between such disparate time periods such as the colonial period and today. When he asked why, Richard responded by saying that it is difficult to measure changes in the cost of living between two time periods that in all likelihood do not even share 10 percent of the same goods in what would be a typical market basket of an average household. Richard thought he got the point until he noticed that he included the figures in his book anyway and gave him credit in the acknowledgement! No good deed goes unpunished. The point of this little story is that we have to be very careful with inflation data that is measured over long periods of time. It’s not that the people who computed the figures or gathered the data made a mistake. The problem is making standard comparisons of market baskets of goods where no meaningful comparison can be made.

 The Nominal and Real Wage Rates of Presidents of the United States As the section suggests, it is not always such a straightforward exercise to calculate real wage rates. Jobs change in terms of responsibility and the amount of physical and mental effort that must go into them. As a take-home exercise, you can ask your students to come up with a list of five professions whose responsibilities have not changed very much and five that have undergone marked change. Then ask them to research the salary of these professions going back 50 years and calculate the real wages at decade intervals. Invite them to share the results with the rest of their classmates at the next regularly scheduled class meeting. This assignment can provide for a lively discussion as some students will no doubt point to job characteristic differences that their classmates had not thought about. It leads to the even thornier issue of coming up with valuations of increased amenities on the job.

273

274

Part 4 . MONITORING THE MACROECONOMY

USING EYE ON THE U.S. ECONOMY  Deflating the GDP Balloon This segment might be best used if you introduce it before you actually present the discussion about the GDP price index. The GDP price index is one of these topics for which the underlying economic forces at work is often difficult to explain. The balloon metaphor is an excellent way to appeal to students’ intuitions, especially for visual learners.

USING EYE ON BOX OFFICE HITS  Which Movie Really Was the Biggest Box Office Hit? This Eye discusses how a price index can be used to compare the real value of money between time periods. If your students are anything like me, they have heard countless times the reminiscing of elderly relatives about how things were so much better when they were kids. You will, no doubt, have an ample supply of students who will tell you that their elders brag about the nickel Coca-Cola they enjoyed or the 50-cent movies they went to. Advise your students that when people often complain about the rising price of something they are nearly always speaking of nominal prices, not real prices. So, in today’s dollars, how much was that famous nickel Coca-Cola we’ve heard so much about? If we use 1939 as the starting year, a $.05 Coca-Cola would be the equivalent of paying $.84 in 2013 – which for a 12oz can purchased from a grocery store, would be a bit on the high side (especially if considering the per unit price of purchasing in bulk). What about a $.50 movie? A $.50 cent movie in 1939 (the year Gone with the Wind was first released), would be $8.40 in 2013 – which is about the same as the 2013 average ticket price. You might want to stress the opportunity cost element here. That is, if the price of a particular good is rising at a slower rate than other the prices of other goods, then the opportunity cost of acquiring that item has actually fallen. Perhaps the good ‘ole days weren’t as good as we’ve heard!

USING EYE ON YOUR LIFE  A Student’s CPI This Eye discusses how the CPI is not necessarily a reflection of how all consumers experience inflation. You can integrate the class activity previously suggested with this Eye. How does their personal market basket compare to that of the average American household? How does it compare to the student’s basket of © 2015 Pearson Education, Inc.

Chapter 16 . The CPI and the Cost of Living

goods created in this Eye? How might the market basket of a group near the opposite end of the age scale – senior citizens – compare to the student market basket and the average market basket used by the CPI? Given that college students and seniors may rely on more fixed incomes than most groups (financial aid and Social Security, respectively), why do these price trends pose more of a problem for these groups? Why might using CPI measurements for different groups (a student CPI, a senior CPI, etc) instead of just the general CPI be useful for targeted income assistance programs like financial aid and Social Security? How does the fact that the CPI tends to overstate the actual rate of inflation complicate this analysis?

275

276

Part 4 . MONITORING THE MACROECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 16.1 The Consumer Price Index 1 A Consumer Expenditure Survey in the city of Firestorm shows that people consume only firecrackers and bandages. In 2010, the year of the survey and also the reference base year, the average household spent $100 on firecrackers and $10 on bandages. The price of a firecracker in 2000 was $2, and the price of bandages was $1 a pack. In the current year, 2011, the price of a firecracker is $3 and the price of bandages is $1.25 a pack. Calculate: 1a. The CPI basket. 1b. The percentage of a household's budget spent on firecrackers in the base year. 1c. The CPI in 2011. 1d. The inflation rate in 2011. 2.

Assume a two-good world in which the market basket is 10 units of good A and 2 units of good B. Good A costs $4 and good B costs $1 in year 1. Furthermore, assume that in year 2 the prices rise to $5 and $2, respectively. Calculate the inflation rate in year 2. Will the choice of base year affect your answer?

 Checkpoint 16.2 The CPI and Other Price Level Measures 3. In Virtual Reality, time travel became 3001 3002 possible only in 3002. Economists in the Quantity Price Item Quantity Price Statistics Bureau decided to conduct a Games 10 $30 5 $35 Consumer Expenditure Survey in both Time 0 − 10 $4,000 3001 and 3002 to check the substitution Travel bias of the CPI. The table shows the results of the survey. It shows the items that consumers buy and their prices. The Statistics Bureau fixes the reference base year as 3001 and asks you to: 3a. Calculate the CPI in 3002 using the 3001 CPI basket. 3b. Calculate the CPI in 3002 using the 3002 CPI basket. I 3c. Explain whether there is any substitution bias in the CPI that uses the 3001 basket. 4. List the sources of bias in the CPI that are discussed in the text and give a brief explanation of each. 5.

Identify the consequences of the CPI bias mentioned in the text and discuss each.

Chapter 16 . The CPI and the Cost of Living



Answers

 Checkpoint 16.1 The Consumer Price Index 1a. The CPI basket is the quantities bought during the Expenditure Survey year, 2010. Households spend $100 on firecrackers at $2 a firecracker so the quantity of firecrackers bought was 50. Households spend $10 on bandages at $1 a pack so the quantity of bandages bought was 10 packs. The CPI basket is 50 firecrackers and 10 packs of bandages. 1b. In the reference base year, expenditure on firecrackers was $100 and expenditure on bandages was $10, so the household budget was $110. Expenditure on firecrackers was 90.9 percent of the household budget: ($100 ÷ $110) × 100 = 90.9 percent. 1c. To calculate the CPI in 2011, find the cost of the CPI basket in 2011 and 2010. In 2010, the CPI basket costs $110 ($100 for firecrackers and $10 for bandages). In 2011, the CPI basket costs $150 for firecrackers (50 × $3 a firecracker) plus $12.50 (10 packs of bandages × $1.25 a pack), which is $162.50. The CPI in 2011 equals ($162.50 ÷ $110) × 100 = 147.7. 1d. The inflation rate in 2011 is [(147.7 − 100.0) ÷ 100.0] × 100 = 47.7 percent. 2.

The cost of the basket in year 2 is $50 + $4 = $54. The cost of the basket in year 1, the base year is $40 + $2 = $42. The CPI for year 2 is $54 ÷ $42 × 100 = 128.5. The inflation rate in year 2 is [(128.5 − 100.0) ÷ 100.0] × 100.0 = 28.5 percent. It doesn’t make any difference which year is chosen as the base year. We get the same rate of inflation for year 2.

 Checkpoint 16.2 The CPI and Other Price Level Measures 3a. Using the 3001 CPI basket, the cost of the basket in 3001 is $300 and the cost of the basket in 3002 is $350. (Note that time travel does not enter into the cost in 3002 because it is not in the CPI basket.) The CPI in 3002 is ($350 ÷$300) × 100 = 116.7. 3b. Using the 3002 CPI basket, the cost of the basket in 3001 is $150. (Note that time travel does not affect the cost of this basket because its price is undefined in 3001.) The cost of 3002 CPI basket in 3002 is $40,175. (10 time travels × $4,000 + 5 games × $35). The CPI in 3002 is ($40,175 ÷ $150) × 100 = 26,783.3. 3c. There is not any commodity substitution bias but there is a huge new goods bias. In particular, the new good, time travel, is significantly more expensive than the good it is partially replacing, games. Some of the price increase caused by the introduction of time travel is not pure inflation but instead represents the higher quality of time travel as entertainment compared to games.

277

278

Part 4 . MONITORING THE MACROECONOMY

There are four biases: New goods bias — new goods replace old goods all the time. The problem rests in how to measure changes in the prices of goods when the goods themselves might no longer be directly comparable. Quality change bias — difficult to account for changes in the quality of a good across time. If a good is really better and costs more does it make sense to conclude that all the increase is attributable to inflation? Filtering out the two is not an easy job. Commodity substitution bias — because the CPI is based on a fixed basket, it does not take into account that consumers can and will make substitutions away from goods whose prices rise and toward relatively cheaper substitutes. If a consumer reduces his or her consumption of a particular good whose price has risen, his or her total expenditure on that item may not be any greater than before. Outlet substitution bias — the fact that consumers substitute from shopping at full service retail stores to discount stores when prices rise. This substitution is not taken into account when computing the CPI, which places an upward bias in the CPI measurement.

One consequence of the CPI bias is that it distorts contracts. Many private contracts use the CPI as a cost of living adjustment measure. If the figure is biased upward by one percentage point, the bias will lead employers to pay more for labor than the increase in the true CPI would suggest. A second consequence is increases in government outlays. Several federal government outlays tie benefits to the CPI. These include Social Security recipients, food stamps, and pensions paid to former military personnel and civil servants. Over many decades these outlays can add up to a trillion dollars. The third consequence is decreases in tax revenues. For some taxes, the levels of income at which higher tax rates are applied are linked to the CPI. Because the CPI is upward biased, these income levels rise more rapidly than does the cost of living and so the amount of tax revenue collected by the government is lower than would otherwise be the case.

Potential GDP and Economic Growth

Chapter

CHAPTER OUTLINE 1. Explain what determines potential GDP. A. The Three Main Schools of Thought 1. Classical Macroeconomics 2. Keynesian Macroeconomics 3. Monetarist Macroeconomics B. Today’s Consensus C. The Road Ahead D. Potential GDP E. The Production Function F. The Labor Market 1. The Demand for Labor 2. The Supply of Labor 3. Labor Market Equilibrium 4. Full Employment and Potential GDP 2. Define and calculate the economic growth rate, and explain the implications of sustained growth. A. Calculating Growth Rates B. The Magic of Sustained Growth 3. Explain the sources of labor productivity growth. A. Labor Productivity B. Saving and Investment in Physical Capital 1. Capital Accumulation and Diminishing Marginal Returns 2. Illustrating the Law of Diminishing Marginal Returns C. Expansion of Human Capital and Discovery of New Technologies 1. Illustrating the Effects of Human Capital and Technological Change D. Combined Influences Bring Labor Productivity Growth E. What Keeps Labor Productivity Growing? 4. Describe policies that speed economic growth. A. Preconditions for Economic Growth 1. Economic Freedom 2. Property Rights

280

Part 5 . UNDERSTANDING THE MACROECONOMY

3. Markets B. Policies to Achieve Faster Growth 1. Create Incentive Mechanisms 2. Encourage Saving 3. Encourage Research and Development 4. Encourage International Trade 5. Improve the Quality of Education C. How Much Difference Can Policy Make?

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 17 features updated data throughout, but no major content revisions.

 Where We Are First we preview different approaches to macroeconomics to give the students a grasp of where they are going and why. Then we explain the forces that determine potential GDP, which is the production function in combination with the labor market. We also explore economic growth, and what policies can be used to encourage more rapid growth. The technical models of economic growth—the classical model, the neoclassical model, and the new growth theory—are not included.

 Where We’ve Been The previous three chapters were essentially an introduction to macroeconomics. We explained basic concepts, such as GDP and the Consumer Price Index. We also examined data for the U.S. economy showing how GDP, the unemployment rate, and on the inflation rate have changed over time.

 Where We’re Going This chapter starts the study of the macroeconomy, culminating in Chapter 20 with an examination of fiscal and monetary policy.

IN THE CLASSROOM  Class Time Needed The material in this chapter can be covered in two and one half to three class sessions. Do not skimp on the very first material, discussing different approaches to

Chapter 17 . Potential GDP and Economic Growth

281

macroeconomics, because this material serves as a valuable introduction to the students that will help them throughout the entire section “Understanding the Macroeconomy.” An estimate of the time per checklist topic is: •

17.1 Potential GDP—50 to 100 minutes

•

17.2 The Basics of Economic Growth—20 to 30 minutes

•

17.3 Labor Productivity Growth—40 to 50 minutes

•

17.4 Achieving Faster Growth—30 to 40 minutes

Classroom Activity: Economic growth can be an exciting topic for students if the lecture is motivated by examples that students can relate to on a personal level. You can provide the table below indicating income per person (in 2000 dollars) starting in 1800. The 1800, 1900, and 2000 figures are actual data; obviously the 2100 and 2200 are hypothetical data and represent the incomes if economic growth continues at the same average pace as it has since 1800. Ask your class what kind of life people had in the year 1800 with an average income of $762 a year in current dollars. Answers will vary but many students are likely to respond that life was quite hard. Transportation was limited to horses, and meals were all prepared at home from scratch and cooked over an open fire. Medical care was quite meager (even the stethoscope was sixteen years away in the making) and entertainment was limited to books and song. In fact, very few people actually owned a book besides the Bible in 1800! By 1900 life was a bit better. The advent of the railroad made transportation much more practical and efficient. The potbelly stove was now available to cook meals and we had even conquered a few diseases along the way.

Year 1800 1900 2000 2100 2200

Average income (2000 dollars per person per year) 762 5,521 40,000 290,000 2,100,000

Part 5 . UNDERSTANDING THE MACROECONOMY

282

CHAPTER LECTURE Macroeconomic Approaches and Pathways There are three major approaches to macroeconomics: • Classical macroeconomics is a theory about how a market economy works and why it experiences economic growth and fluctuations. This theory started with Adam Smith, David Ricardo, and John Stuart Mill in the 18th and 19th centuries, though classical economists are still prevalent today. The view of this approach is that markets work well and, although the economy will fluctuate in business cycles, nothing the government can do will improve on the performance. • During the Great Depression the unemployment rate rose to 25 percent and economic growth was nonexistent. Classical macroeconomics fell into disrepute as it predicted that the Great Depression would end quickly, but it did not do so. •

Keynesian macroeconomics is a theory about how a market economy works that stresses its inherent instability and the need for active government intervention to achieve full employment and sustained economic growth. This theory started with John Maynard Keynes in the middle of the Great Depression in 1936 and argued that inadequate spending by households and businesses (private spending) that causes recession can be countered by increased government spending. Keynesian macroeconomics was the mainstream theory by the 1960s and 1970s. • Keynesian theory focused on the short run. But in the 1970s, long-run issues (such as economic growth) emerged as important.

•

Monetarist macroeconomics is the view that the market economy works well, that aggregate fluctuations are a natural consequence of an expanding economy, but expands on classical theory by arguing that fluctuations in the quantity of money also bring the business cycle. Milton Friedman was the most prominent monetarist. • While most economists agree that the quantity of money plays a role in economic fluctuations, few believe that it is the sole cause of the business cycle.

Today’s Consensus Today’s consensus combines insights and ingredients from the three schools of thought. • Classical macroeconomics describes the economy at (or close to) full employment, but fails to explain economic performance in the face of a major slump in spending seen during a recession or depression. • Keynesian macroeconomics explains economic performance in a recession or depression and offers policy options (increases in government spending and/or tax cuts) to help restore full employment. • Monetarist macroeconomics expands the Keynesian story by emphasizing that a contraction in the quantity of money brings higher interest rates, resulting in spending cuts that can create a recession. Increasing the quantity of money and lowering interest rates can help increase spending and restore full employment. Monetarists also argue that tying monetary growth to the growth of production possibilities can keep inflation in check.

Chapter 17 . Potential GDP and Economic Growth

•

Part of today’s consensus is that the long-term problem of economic growth is more important than the short-term problem of economic fluctuations. While the income lost during a recession is serious, because the losses are highly concentrated on those who are unemployed, that lost income is far less than the income lost from slower economic growth. This book is based on the new consensus. It starts by examining real factors, the forces that determine real GDP at full employment and the pace of economic growth. Then it studies money and the forces that bring inflation. Finally it looks at the ongoing debate about government macroeconomic policy.

17.1 •

283

Potential GDP

Potential GDP is value of real GDP when all the economy’s factors of production— labor, capital, land, and entrepreneurial ability—are fully employed. Potential GDP is the level of real GDP that the economy produces when it is at full employment. Actual real GDP fluctuates around potential GDP, so potential GDP is the sustainable upper limit of production. Fluctuations in real GDP around potential GDP is largely influenced by the quantity of labor employed.

The Production Function •

The production function is a relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain the same. The figure shows a production function. • The production function shows diminishing returns, the tendency for each additional hour of labor employed to produce a successively smaller additional amount of real GDP. The production function in the figure shows diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes. Diminishing returns occurs because along the production function each additional unit of labor works with the same amount of capital and other resources.

The Labor Market •

The quantity of labor demanded is the total labor hours that all the firms in the economy plan to hire during a given time period at a given real wage rate. The demand for la-

Part 5 . UNDERSTANDING THE MACROECONOMY

284

bor is the relationship between the quantity of labor demanded and the real wage rate when all other influences on firms’ hiring plans remain the same. • The real wage rate is the nominal wage rate divided by the price level. •

•

Firms maximize their profit by hiring the quantity of labor so that the real wage rate equals the extra output produced by an additional worker. Because of diminishing returns, the extra output diminishes as more workers are hired. As a result, there is a negative relationship between the real wage rate and the quantity of labor demanded and the demand for labor curve is downward sloping.

The quantity of labor supplied is the number of labor hours that all the households in the economy plan to work during a given time period at a given real wage rate. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same. • There is a positive relationship between the real wage rate and the quantity of labor supplied. The positive relationship arises because an increase in the real wage rate influences people to work more hours and also increases labor force participation. So the labor supply curve is upward sloping. •

Labor supply changes and the labor supply curve shifts when income taxes change (higher income taxes decrease the supply of labor and shift the labor supply curve leftward) and unemployment benefits (more generous unemployment benefits lead to longer job search, which decreases the supply of labor and shifts the labor supply curve leftward).

•

In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded. In equilibrium, the labor market is at full employment.

•

Potential GDP is the level of production produced by the full employment quantity of labor. • In the figure, the equilibrium quantity of employment is 200 billions of hours per year. In combination with the production function shown in the previous figure, potential GDP is $13 trillion.

Lecturer Launcher: Students sometimes understand the definition of potential GDP but have a hard time seeing it in practice. You may want to spend some time comparing the United States to the Eurozone using the Eye on the Global Economy and Eye on U.S. Potential GDP boxes. If you talked about global differences in unemployment in chapter 15, discussing

Chapter 17 . Potential GDP and Economic Growth

285

higher unemployment benefits and less flexible labor markets for France, Germany, and Italy, you can now use this information again to highlight how this determines differences in potential GDP. Use the Eye on the Global Economy box to describe the labor market differences. Mention that the higher unemployment benefits in Europe reduce the opportunity cost of job search. Together with differences in attitudes toward leisure, Europeans work an average of 30.5 hours per week compared to Americans’ 34 hours per week. Then link this discussion to the calculation of potential GDP. This will help to cement ideas that potential GDP is not some mythical number that is the same for each economy but that it depends on the underlying differences across countries, which include both labor market differences and productivity differences.

17.2

The Basics of Economic Growth

Lecture Launcher: Ask the students if the economy will grow dramatically differently if the growth rate is 3 percent or 5 percent. Students will probably say that it won’t make much difference. But, counter that over longer periods of time it can make a substantial difference. You can demonstrate this fact with a few simple calculations. Assume a hypothetical economy that starts off with real GDP of $100 billion. The numbers in the table below are the size of the economy in billions of dollars. What is instructive here is that small changes in the growth rate over short periods of time do not have much of an impact on the size of the economy. But small changes in growth rate over longer periods of time do. You can point out that the economy is almost at the same level at 5 percent growth after 10 years as it is at 3 percent after 20 years. In fact there is a very good historical example that you can point to that helps illustrate just how important small differences in economic growth can be. Since World War II the U.S. economy has grown at an average rate of approximately 3 percent a year. During the so-called slow down of the 1970s the growth rate dropped by as much as half of its historical rate. Economists have estimated that this slow down has cost our economy at least three trillion dollars in lost output! You can explain that this is output that is irretrievably lost. That is, we cannot get it back

Year 5 10 20 40

3 percent growth rate $115.92 $134.39 $180.61 $326.20

5 percent growth rate $127.63 $162.89 $265.33 $704.00

8 percent growth rate $146.93 $215.89 $466.10 $2,172.45

Calculating Growth Rates •

The economic growth rate is the annual percentage change of real GDP. The growth rate of real GDP equals: (Real GDP in current year - Real GDP in previous year) × 100. (Real GDP in previous year)

Part 5 . UNDERSTANDING THE MACROECONOMY

286

•

The standard of living depends on real GDP per person, which is real GDP divided by the population. The growth rate of real GDP per person equals:

Growth rate of real GDP per person = Growth rate of real GDP – Growth rate of population.

The Magic of Sustained Growth •

The Rule of 70 demonstrates the magic of economic growth. The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable. • Sustained growth of real GDP per person can transform a poor society into a wealthy one.

17.3

Labor Productivity Growth

Real GDP grows when the quantities of the factors of production grow or when persistent advances in technology make them increasingly productive. Our standard of living improves only if growth occurs because of increases in labor productivity.

Labor Productivity •

Labor productivity is the quantity of real GDP produced by one hour of labor.

•

Labor productivity = (Real GDP) ÷ (Aggregate hours). Rearranging, real GDP = (Aggregate hours) × (Labor productivity). Using the rearranged formula shows that growth in real GDP can be divided into growth in aggregate hours and growth in labor productivity.

•

The growth of labor productivity is influenced by saving and investment in physical capital, expansion of human capital, and discovery of new technologies.

Saving and Investment in Physical Capital •

More saving and investment in physical capital increases labor productivity.

•

The law of diminishing returns states that if the quantity of capital is small, an increase in capital brings a large increase in production; and if the quantity of capital is large, an increase in capital brings a small increase in production. This fact about capital means that saving and investment in additional capital will not bring sustained economic growth without an accompanying expansion of human capital and technological change.

•

The productivity curve shows how real GDP per hour of labor changes as the quantity of capital per hour of labor changes. As capital per hour of labor increases, labor productivity increases by ever smaller amounts and eventually stops rising.

•

Expansion of human capital: Human capital is the accumulated skills and knowledge of people. Human capital is the most fundamental source of economic growth because it directly increases labor productivity and is the source of the discovery of new technologies. Human capital comes from education and training, job experience, and health and diet.

Chapter 17 . Potential GDP and Economic Growth

287

•

Discovery of new technologies: New technologies increase labor productivity. Often these new technologies require new and better capital, such as personal computers replacing typewriters.

•

The expansion of human capital and the discovery of new technologies shift the productivity curve upward, as illustrated in the figure by the upward shift from PC0 to PC1. (Increases in capital per hour of labor lead to movements along the productivity curve.

17.4

Achieving Faster Growth

Preconditions for Economic Growth •

Three necessary preconditions for economic growth are: •

•

Economic freedom: Economic freedom is a condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets. • Property rights: Property rights are the social arrangements that govern the protection of private property. Clearly established and enforced property rights provide people with the incentive to work and save. • Markets: Markets enable people to trade and to save and invest. Markets cannot operate without property rights. These three preconditions for economic growth are necessary for growth but do not guarantee that economic growth will occur. For growth to occur and to persist, people need incentives to save and invest, to accumulate human capital, and to develop new technologies.

The three preconditions for growth—economic freedom, property rights, and markets are all essential to create acceptable levels of risk and low enough transactions costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, certain, and enforceable with reasonable cost—the concept of the rule of law. Most students

Part 5 . UNDERSTANDING THE MACROECONOMY

288

have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example.

Policies to Achieve Faster Growth •

Government policies to achieve economic growth must provide people with the incentives to save and investment, accumulate human capital, and develop new technologies. • •

•

• •

Create Incentive Mechanisms: Enforce property rights with a well-functioning legal system. Encourage Saving: Increased saving can increase the growth of capital and stimulate economic growth. East Asian countries have the highest growth rates and saving rates; some African economies have the lowest saving rates and the lowest economic growth rates. Encourage Research and Development: More research and development creates technological advances. Governments can direct public funds toward financing basic research. Encourage International Trade: International trade extracts all the available gains from specialization and exchange. Improve the Quality of Education: The social benefits of education go beyond the benefits accrued to the individuals who receive the education. The government can help by financing more basic education to raise skills in language, math and science.

Is there convergence or divergence in standards of living amongst nations? What is the role of economic growth for economic inequality? These are highly controversial questions. Most antiglobalization activists treat it as incontrovertible that economic growth creates higher inequality. But this view is likely incorrect. First, there has been a general convergence of standards of living for human beings over the past 50 years. This is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity. Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” in the sense becoming more integrated into global markets for goods and capital. The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are currently most practiced in countries that have grown the slowest. This result might not be a coincidence.

How Much Difference Can Policy Make? •

Change brings gains to some and losses to others. Because societies balance the interests of one group against the interests of another group, change is slow to occur and so changes that would increase the economic growth rate are slow to occur. And the government cannot simply dial up large changes in the economic growth rate.

Chapter 17 . Potential GDP and Economic Growth

USING EYE ON THE U.S. ECONOMY  The Lucas Wedge and the Okun Gap Most students are aware of the problems of recessions, especially if the economy happens to be in a recession when you teach the class. However, virtually no students are aware of the issues surrounding slower economic growth. This Eye is an outstanding chance to make clear to your students why an increasingly large number of economists are coming to believe that understanding what factors can lead to an increase in economic growth is significantly more important than understanding what factors can moderate business cycles. The Lucas wedge figure makes clear the tremendous “lost output” from slower economic growth. To make this potentially abstract figure more real, ask the students what they would do if they had an extra $406,000 (or since most of your students probably haven’t been around since 1970, if each of their parents had an extra $406,000)? What would they buy with the extra purchasing power? Then point out to them that this happy problem is what could have confronted them if real GDP per person in the U.S. economy had continued to grow at 2.8 percent per year rather than slowing to 2.0 percent per year. Confronted with this concrete example, most students immediately understand the importance of economic growth!

USING EYE ON THE GLOBAL ECONOMY  Potential GDP in the United States and European Union This Eye on the Global Economy can really springboard students to think deeply about cultural differences and how different cultures and different people have different values. As the Eye points out, the average work week in the major European economies is approximately 13 percent shorter than in the United States (4 hours less per week, which translates to 208 hours a year). For partially this reason, potential GDP in the United States is much greater than potential GDP in the Europe and so U.S. citizens consume more material goods than their European cousins. But European citizens enjoy more leisure hours per week. Clearly the United States and Europe have opted for different tradeoffs between consuming goods and services versus consuming leisure. You can ask you students why they think this difference exists? You also can ask your students which tradeoff they prefer: More goods and services and less leisure time or more leisure time and fewer goods and services? This exercise can serve as a reminder of the limitations of focusing too heavily on GDP as a measurement of standard of living in an economy. Finally, ask them if they think this difference will persist or will the United States become more like Europe or Europe more like the United States?

289

290

Part 5 . UNDERSTANDING THE MACROECONOMY

USING EYE ON U.S. POTENTIAL GDP  Why Do Americans Earn More and Produce More Than Europeans? Be sure to tie this Eye on U.S. potential GDP to the previous Eye on the Global Economy, “Potential GDP in the United States and the European Union.” The earlier Eye on the Global Economy asserted some facts about the labor markets in the United States and Europe. This Eye goes deeper to explain why these differences exist. Point out to the students that this enhanced understanding is the role of economics: Rather than merely recite data, economics endeavors to acquire a deeper understanding of the phenomena under study and these models your students are learning are the ones that are used to help organize and illustrate this understanding.

USING EYE ON THE PAST  How Fast Has Real GDP per Person Grown? A good motivator for the discussion of the data included in this study might be to ask students how these economists were able to measure economic variables, such as GDP one million years ago, when the United States has been collecting this information for less than a century! This question is a fair question. But students are not likely to be able to provide a ready answer. The answer is that economists have obtained these data with the help of historians and archeologists – a very multidisciplinary approach to answering economic questions. Historians can help us for the last few thousand years with the written word. However, archeologists are likely to be the people to turn to for information that goes back further than that. The information comes from evidence provided in archeological digs, which shed light on the type of implements and tools used by humans and the kinds of goods they consumed. While the margin of error for these data likely gets larger the further back we explore, we can still use these data to obtain a decent approximation for real GDP per person at time periods where it wasn’t actually being measured.

USING EYE ON THE U.S. ECONOMY  U.S. Labor Productivity Growth Since 1960 Students will no doubt be struck by the slow down in economic growth that took place in the 1970s. It is important to stress that there is still a lot of debate in the economics profession about what brought about the slowdown. However, there are a number of factors that most economists agree on that contributed to the

Chapter 17 . Potential GDP and Economic Growth

decline. First, a reason that is often pointed to is the Arab oil embargo against the United States following the Arab-Israeli War. It is asserted that a quadrupling in the price of crude from $3 to $12 created a ripple effect throughout the economy, forcing the costs of production for many manufacturing firms to rise. Firms devoted their investment spending to capital equipment that saved energy rather than capital equipment that increased productivity. Second, some observers assert that environmental protection laws also played a role, because firms invested in capital designed to decrease pollution rather than capital designed to increase productivity. Third, taxes and government regulation expanded in the late 1960s and 1970s, which weakened firms’ and workers’ incentives to work hard and efficiently. Finally, rapid inflation during this period distorted saving and investment decisions, leading to a decrease in long-term saving and investment. However, tell the students that not all economists agree with all the suggested reasons and the relative importance of the causes remains controversial. Identifying the relative importance of these causes is a crucial exercise though, as it can be used to help construct current and future policy. For example, your students may notice some similarities between the events that led to the productivity slowdown and recent events. 2008 also saw a dramatic increase in the price of oil, and while the price did drop considerably after peaking halfway through the year, that event might still weigh heavily on future business investment decisions. In addition, the democratically controlled Senate and President Obama have been more vocal about the need for greater environmental protection, stricter regulations in various areas of the economy, and higher taxes for high income earners. The only similarity to the 1970s that we haven’t seen is the rapid inflation, though given the unprecedented fiscal and monetary policies used recently, that event may also become a possibility in the not-to-distant future. Given these similarities, will we see a similar labor productivity slowdown in the 2010s, or will we actually see a different outcome in spite of similar events?

USING EYE ON YOUR LIFE 

How You Influence and Are Influenced by Economic Growth

An excellent way to stimulate discussion concerning new growth theory and how self-interested choices can improve not only an individual’s standard of living, but also improve the economic growth of the nation, is to play the Gordon Gekko famous (or infamous) “Greed is Good” speech from the movie Wall Street (which, not by coincidence, came out shortly after new growth theory rose to prominence). This speech proclaims that mankind has grown primarily because of human greediness. Help your students identify that they are likely in your class as a result of their own greed, in particular, their desire to earn greater income, to have more job security, to have a job they enjoy more, to have greater

291

292

Part 5 . UNDERSTANDING THE MACROECONOMY

knowledge, etc. But their greed has driven them to undertake an investment in themselves that just so happens to not only benefit themselves, but also the U.S. economy. In that respect, their greed is good for everyone. This movie clip can also provoke debate about if greed is always good. Certainly numerous examples from the past few years of greed that encourages an individual to cheat, steal, or manipulate (perhaps examples such as Bernie Madoff, Stanford Financial Group, Enron, questionable mortgage lending or credit card practices, etc) can be pointed to as counterexamples of the statement that greed is good. Greed is good when it causes people to undertake actions that earn (not simply take) greater rewards. Obviously, this is where the preconditions to growth come into play, complete with a slippery-slope discussion of how much government regulation is necessary to ensure that people’s greed is well directed towards productive outcomes. Another important discussion for your students involves recognizing that economic growth can have an impact on our standard of living that often doesn’t show up immediately in monetary terms, as money is obviously not the only determinant of happiness and the only reward that people direct their actions towards. For example, with economic growth our economy can “afford” a cleaner environment and because we are more productive we don’t have to work as long. We therefore have the opportunity to enjoy more leisure both during our working years and of course during retirement because we are able to retire earlier due to faster earnings growth.

USING EYE ON RICH AND POOR NATIONS  Why Are Some Nations Rich and Others Poor? Many students are dumbfounded to discover that there are countries that have a GDP that is less than one tenth the size of the U.S. economy but still manage to sport annual real GDP growth gains that exceed those of the United States. Students will often ask why. A good response is to make an analogy to firm size. Students enjoy talking about the stock market. Ask students if they know what is meant by the terms “large cap” and “small cap” when referring to company size. Someone is bound to respond that it refers to market capitalization. Now ask them why a company that is already billions of dollars in size (market capitalization, sales, or earnings) probably could not post gains in sales of twenty five to thirty percent per year. The response you are likely to get is that many of these companies have already experienced a large part of their growth. Smaller companies on the other hand are more nimble and are more likely to be able to make larger gains in growth. This logic not only applies to companies but it also applies to countries as well. Many countries like Hong Kong, Taiwan, Korea, and China have a lot of lost ground to make up and are doing so by growing quickly.

Chapter 17 . Potential GDP and Economic Growth

However, history tells us that this pace of growth will slow eventually to a pace that is more sustainable for a larger economy. On a side note for this Eye, make sure to point out that the scale on the vertical axis means that each gap is not the same dollar amount, but a quadrupling of the previous dollar amount. So, while it might first appear that China’s real GDP per person has grown to nearly 3/4th of that of the U.S. (since the line goes to approximately 3/4th up the vertical axis), it is actually less than 1/4th of the U.S. value.

293

294

Part 5 . UNDERSTANDING THE MACROECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT  Questions  Checkpoint 17.2 The Basics of Economic Growth 1. Assume that the U.S. real GDP is $13 trillion and grows at a 3 percent annual growth rate over the next several decades. How long would it take the economy to double in size? How long would it take for the economy to double in size if the growth rate is 2 percent? Why can a lower growth rate be considered an economic waste? 2.

Canada’s real GDP was $840 billion in 1998 and $880 billion in 1999. Canada’s population growth rate in 1999 was 0.8 percent. Calculate:

2a. Canada’s economic growth rate in 1999. 2b. The growth rate of real GDP per person in Canada in 1999. 2c. The approximate number of years it takes for real GDP per person in Canada to double if the 1999 economic growth rate and population growth rate are maintained. 2d. The approximate number of years it takes for real GDP per person in Canada to double if the economic growth rate rises to 6 percent a year but the population growth rate remains the same as it was in 1999.  Checkpoint 17.3 Labor Productivity Growth 3. The table provides some data Item on the U.S. economy in 1990 Aggregate hours (billions) and 1991. Real GDP (billions of 1996 dollars) 3a. Calculate the growth rate of

1990

1991

203.4

200.4

6,684

6,669

2000

2001

240.6

238.8

9,191

9,215

real GDP in 1991. 3b. Calculate labor productivity in 1990 and 1991. 3c. Calculate the growth rate of labor productivity in 1991. 4.

The table provides some data on the U.S. economy in 2000 and 2001.

Item Aggregate hours (billions)

Real GDP (billions of 1998 dollars) 4a. Calculate the growth rate of real GDP in 2001. 4b. Calculate labor productivity in 2000 and 2001. 4c. Calculate the growth rate of labor productivity in 2001.  Checkpoint 17.4 Achieving Faster Growth 5. List and discuss the three preconditions for economic growth.

Chapter 17 . Potential GDP and Economic Growth



Answers

 Checkpoint 17.2 The Basics of Economic Growth 1. Using the Rule of 70, with 3 percent annual growth, real GDP doubles in size in approximately 70 ÷ 3 or 23.3 years. It would take real GDP approximately 70÷ 2 or 35 years to double in size if the growth rate is only 2 percent. A lower growth rate is considered an economic waste because it results in irretrievably lost goods and services. The lower growth rate creates a permanent loss in the standard of living. 2a. Canada’s economic growth rate = ($880 billion – $840 billion) ÷ $840 billion × 100 = 4.8 percent. 2b. Canada’s growth rate of real GDP per person = 4.8 percent – 0.8 percent = 4.0 percent. 2c. Real GDP per person will double in approximately 70 ÷ 4.0 = 17.5 years. 2d. If the growth rate of real GDP rises to 6 percent and the population growth rate remains 0.8 percent, then the growth rate of real GDP per person is 6.0 percent – 0.8 percent, which is 5.2 percent. Real GDP per person will double in approximately 70 ÷ 5.2 = 13.5 years.  Checkpoint 17.3 Labor Productivity Growth 3a. Growth rate of real GDP in 1991 = [($6,669 billion – $6,684 billion) ÷ $6,684 billion] × 100 = –0.2 percent. The answer shows that the growth rate of real GDP was negative in 1991. 3b. Labor productivity in 1990 = $6,684 billion ÷ 203.4 billion hours = $32.86 an hour. Labor productivity in 1991 = $6,669 billion ÷ 200.4 billion hours = $33.28 an hour. 3c. The growth rate of labor productivity equals the change in labor productivity divided by the initial level and then multiplied by 100, which equals ($33.28 – $32.86) ÷ $32.86 × 100 = 1.28 percent. 4a. Growth rate of real GDP in 2001 = [($9,215 billion – $9,191 billion) ÷ $9,191 billion]× 100 = 0.3 percent. 4b. Labor productivity in 2000 = $9,191 billion ÷ 240.6 billion hours = $38.20 an hour. Labor productivity in 2001 = $9,215 billion ÷ 238.8 billion hours = $38.59 an hour. 4c. The growth rate of labor productivity equals the change in labor productivity divided by the initial level and then multiplied by 100, which equals [($38.59 – $38.20) ÷ $38.20] × 100 = 1.02 percent.

295

Part 5 . UNDERSTANDING THE MACROECONOMY

296

 Checkpoint 17.4 Achieving Faster Growth 5. There are three preconditions for economic growth: 1.

2. 3.

Economic freedom. There has to be a rule of law and an efficient legal system, which allows contracts to be enforced and protects private property. Property rights. Clearly established and enforced property rights provide people with the incentive to work and save. Markets. Markets enable people to trade, and to save and invest. Markets create a basis by which incentives are fostered.

Money and the Monetary System CHAPTER OUTLINE 1. Define money and describe its functions. A. Definition of Money 1. A Commodity or Token 2. Generally Accepted 3. Means of Payment B. The Functions of Money 1. Medium of Exchange 2. Unit of Account 3. Store of Value C. Money Today 1. Currency 2. Deposits 3. Currency Inside the Banks Is Not Money D. Official Measures of Money: M1 and M2 1. Are M1 and M2 Means of Payment? E. Checks, Credit Cards, Debit Cards, and E-Checks 1. Checks 2. Credit Cards 3. Debit Cards 4. E-Checks F. An Embryonic New Money: E-Cash 2. Describe the functions of banks. A. Commercial Banks 1. Bank Deposits 2. Profit and Risk: A Balancing Act 3. Reserves 4. Liquid Assets 5. Securities and Loans 6. Bank Assets and Liabilities: The Relative Magnitudes B. Thrift Institutions C. Money Market Funds

Chapter

298

Part 5 . UNDERSTANDING THE MACROECONOMY

3. Describe the functions of the Federal Reserve System (the Fed). A. The Structure of the Federal Reserve 1. The Chairman of the Board of Governors 2. The Board of Governors 3. The Regional Federal Reserve Banks 4. The Federal Open Market Committee B. The Fed's Policy Tools 1. Required Reserve Ratios 2. Discount Rate 3. Open Market Operations 4. Extraordinary Crisis Measures C. How the Fed's Policy Tools Work 4. Explain how the banking system creates money and how the Fed controls the quantity of money. A. Creating Deposits by Making Loans 1. The Monetary Base 2. Desired Reserves 3. Desired Currency Holding B. How Open Market Operations Change the Monetary Base 1. The Fed Buys Securities 2. The Fed Sells Securities C. The Multiplier Effect of an Open Market Operation D. The Money Multiplier

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 18 features updated data and has removed the key term designation for unit of account, store of value, banking system, commercial bank, central bank, and discount rate.

 Where We Are Chapter 18 studies money and its effects. This chapter defines money and describes its functions. It discusses the monetary system and introduces the Federal Reserve System. Then it explains how the Fed can change the quantity of money and the interest rate.

 Where We’ve Been The last chapter was the first chapter to help explain the factors that underlie the factors that affect the macroeconomy. It examined potential GDP and economic growth.

Chapter 18 . Money and the Monetary System

299

 Where We’re Going The next chapter introduces the workhouse model of macroeconomics, the AS-AD model. The final chapter uses the ASAD model to explore fiscal policy and monetary policy.

IN THE CLASSROOM  Class Time Needed Although it might be possible to cover the material in this chapter in under three class sessions, it is sufficiently important and interesting that spending at least two and possibly two and a half class periods is a good idea—especially if your students have questions about the Fed. An estimate of the time per checklist topic is: •

18.1 What Is Money?—20 to 40 minutes

•

18.2 The Banking System—20 to 30 minutes

•

18.3 The Federal Reserve System—20 to 30 minutes

•

18.4 Regulating the Quantity of Money—50 to 70 minutes

Part 5 . UNDERSTANDING THE MACROECONOMY

300

CHAPTER LECTURE 18.1 •

What Is Money?

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three functions: • Medium of exchange: A medium of exchange is any object that is generally accepted in exchange for goods and services. Money acts as a medium of exchange. As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services. Barter requires a double coincidence of wants.

There was a funny story back in 2001 about someone who printed up $200 dollar bills with George Bush’s picture on the front and then used this currency at a fast-food restaurant. This could make for a funny vignette about the fact that the clerk accepted this as currency and then made change for the food purchase (the customer paid for a $2 ice cream cone and received $198 in change!). Also note that this is not counterfeiting because it doesn’t replicate an existing bill; although the perpetrator would likely face a charge of theft by deception (of a very slow ice cream clerk!). (http://news.bbc.co.uk/1/hi/world/americas/1147246.stm). Thus, students could print their own currency as long as others will accept their declaration that it is now the medium of exchange (though I wouldn’t recommend this…). • •

Unit of account: Money serves as a unit of account, which is an agreed-upon measure for stating the prices of goods and services Store of value: Money serves as a store of value, which is any commodity or token that can be held and exchanged later for goods and services.

Money Today •

Fiat money refers to objects that are money because the law decrees or orders them to be money. Today’s fiat money consists of currency (the bills and coins that we use in the United States today) and deposits at banks and other depository institutions. Deposits are money because they can be converted into currency and because they are used to settle debts. • • • •

Currency in a bank is not counted as money; only currency held by individuals and businesses in any form is counted money. Credit cards are not money—they are IDs that allow an instant loan Checks, e-checks, and debit cards are not money—they are instructions to a bank to transfer money from one person to another. E-cash operates similarly to paper notes and coins, but doesn’t yet meet the definition of money. However, as it becomes more widely accepted it will likely gradually replace physical forms of currency.

 Land Mine: Checks and e-checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits. Debit cards also are not money. The old joke, “I must have money, I still

Chapter 18 . Money and the Monetary System

301

have checks left,“ is one that you can be sure your students have heard. Unfortunately for many Americans and perhaps for many of your students it is their reality. You can use this bit of humor to drive home a point about the difference between the instrument in the money process and money itself, a point that can really bedevil more than a few students. Checks aren’t money, unlike the deposits that they are drawn against. Ask your class if, when they write a check, have they created more money? The answer will be no. All that takes place is that the distribution of money changes but the absolute level of money (M1) remains the same. To give your students a quick chance to identify the difference between commodity money and fiat money, ask them if they know what item is used as money in prison (most students have seen enough movies to know that the answer is cigarettes). Are cigarettes in prison commodity money or fiat money? What about the tickets won playing games at Chuck-E-Cheese? Inside Chuck-ECheese, are those tickets commodity money or fiat money? What about outside of Chuck-ECheese?

Official Measures of Money: M1 and M2 •

M1 consists of currency held by individuals and businesses and traveler’s checks plus checkable deposits owned by individuals and businesses.

•

M2 consists of M1 plus savings deposits, small time deposits, and money market mutual funds and other deposits. M2 is much larger than M1, $10,600 billion versus $2,523 billion in June 2013. M2 includes liquid assets that are not means of payment.

18.2 •

The Banking System

The banking system consists of the Federal Reserve and the banks and other institutions that accept deposits. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.

Commercial Banks •

A commercial bank is a firm that is chartered by the Comptroller of the Currency or by a state agency to receive deposits and make loans. The number of commercial banks in the U.S. has shrunk dramatically in the past decade due to mergers and failures. • A commercial bank accepts checkable deposits, savings deposits, and time deposits. • A commercial bank tries to maximize their stockholders’ wealth by lending for long terms at high interest rates and borrowing from depositors and others. Banks must be careful to balance security for depositors and stockholders against high but risky returns from loans. To tradeoff between risk and profit a bank divides its assets into: • Reserves. A bank’s reserves are its currency in its vault plus the balance on its reserve account at a Federal Reserve Bank. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. • Liquid Assets. Liquid assets are short-term Treasury Bills and overnight loans to other banks – these assets how have low interest rates and low risk. The federal

Part 5 . UNDERSTANDING THE MACROECONOMY

302

•

funds rate is the interest rates on interbank loans and is the central target for monetary policy. Securities and loans. Banks buy securities issued by the U.S. government and large businesses. Some securities have low interest rates and low risk, while others have high interest rates and high risk. Banks also make loans to businesses and individuals. Loans tend to have higher interest rates and high risk and cannot be recalled until the agreed date.

Thrift Institutions The thrift institutions are savings and loan associations, savings banks, and credit unions. A saving and loan association (S&L) is a financial institution that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans. A savings bank is a financial institution that accepts saving deposits and makes mostly mortgage loans. A credit union is a financial institution owned by a social or economic group such as a firm’s employees that accepts savings deposits and makes mostly consumer loans.

Money Market Funds A money market fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills or short-term commercial debt. Shareholders can write checks of large amounts (for instance, a $500 minimum) on a money market fund account.

18.3

The Federal Reserve System

The central bank of the United States is the Federal Reserve System. A central bank is a public authority that provides banking services to banks and regulates financial institutions and markets.

The Structure of the Federal Reserve •

•

The Board of Governors has seven members who are appointed by the President and confirmed by the Senate to 14 year, nonrenewable terms. One of the members is appointed by the President to act as the Chairman (a 4 year, renewable position). There are 12 regional Federal Reserve banks.

Lecture Launcher: I find that students tend to know very little about the Fed coming into this section (very few will even know who the current Fed Chairman is), but they tend to become quite interested in learning about the structure and functions of the Fed. Take advantage of this interest, as some of the material pertaining to financial institutions and the upcoming formulas and model work can get a bit tedious. Ask them why it is important to have a central bank in place to regulate, supervise, and provide assistance to financial institutions? Also, start putting the pieces in place to separate monetary policy from fiscal policy by reinforcing the independence from politics that is intentionally built into the Fed. Identify that Fed officials are not voted on, that Board members long, nonrenewable term limits insulate them from Presidential pressure, and that they do not rely on Congressional funding – basically the Fed is set up to not have to worry about passing policies that are popular with voters, the President, or Congress. Also highlight that given their credentials, Board members have rela-

Chapter 18 . Money and the Monetary System

303

tively modest salaries ($170k and $190k for the Chairman at time of this printing) and don’t get to keep any profits generated - which means they don’t financially benefit from the policies they pass (no fat CEO bonuses or “Golden Parachutes” to be found at this bank…). The Fed is structured in this way so that the focus of their policies is on the long term health of the U.S. economy, not political gain (which tends to focus on shorter term goals due to election cycles) or personal gain. Setting this up will help when discussing monetary policy in greater detail in a few chapters. To break up the lecture, have students try to guess the Federal Reserve districts without looking in the book. You can have students just yell these out in class, which provides for a nice relief from lecture. They can usually name a good deal of them but might miss one or two of the smaller cities (e.g., Richmond is often forgotten in this exercise). If any of them have trouble tell them to pull out a one dollar bill and to look at the circle on the left side of the bill to see if they can read the name of the regional federal reserve bank (though not all notes now contain this feature). Then show the figure in the text with the District Banks to provide a visual picture of the districts. This exercise helps students remember where the locations are and illustrates that the cities are not all financial centers. Present this in the context of the separation of powers and the desire to set up a central bank that would be responsive to all and not just to specific groups. Thus, the district banks represent a variety of areas in an attempt to reflect the diversity of our economy (with regions that tend to be more specialized in agricultural, commercial, financial, or industrial activity). Students are often surprised that there are not more district banks on the west coast, but remind them that Fed was created nearly a century ago. It’s also fun to highlight that Missouri is the only state to house two district banks (in St. Louis and Kansas City). Also you can point out in which district your school resides. •

The Federal Open Market Committee (FOMC) is the Fed’s main policy-making committee that meets approximately every 6 weeks. It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks. The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four other regional Federal Reserve Banks, vote on monetary policy. In practice, the chairman has the largest influence on policy.

The Fed’s Policy Tools •

• •

Required reserve ratios: The minimum percentage of deposits that depository institutions must hold as reserves are the required reserve ratios. The Fed sets the required reserve ratios. Discount rate: The discount rate is the interest rate at which the Fed stands ready to lend reserves to depository institutions. Open market operation: An open market operation is the purchase or sale of government securities by the Federal Reserve System in the open market. The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures.

Part 5 . UNDERSTANDING THE MACROECONOMY

304

•

Extraordinary crisis measures: In response to the 2008 financial crisis, the Fed created new policy tools that can be grouped into two broad categories: •

• •

Quantitative easing: when the Fed creates bank reserves by a large scale open market operation at a low or possibly zero interest rate in the federal funds market. Credit easing: when the Fed buys private securities or makes loans to financial institutions to stimulate their lending. Operation Twist: when the Fed sells short-term securities and buys long-term securities in an attempt to lower long-term interest rates and stimulate long-term borrowing and investment.

How the Fed’s Policy Tools Work •

The monetary base is the sum of coins, Federal Reserve notes, and banks’ reserves at the Fed. It is by changing the monetary base that the Fed can change the quantity of money in the economy.

•

By increasing the required reserve ratio, the Fed forces banks to hold more reserves, which are part of the monetary base. This action decreases the quantity of money.

•

By raising the discount rate, the Fed discourages banks from borrowing reserves, which decreases the quantity of money.

•

By selling securities in the open market, the Fed decreases the monetary base, which decreases the quantity of money.

18.4

Regulating the Quantity of Money

Creating Deposits by Making Loans Commercial banks use their excess reserves to make loans to the public. When a borrower is granted a loan, the bank gives the borrowers the funds by creating a checkable deposit in the borrower’s name and depositing the amount loaned in the account. Therefore making loans is how banks create (deposit) money. • The monetary base limits the total quantity of money the banking system can create. The monetary base is held by the public as currency and as banks as reserves, so the monetary base limits the amount of banks’ reserves. •

A bank’s desired reserves are is the amount of reserves a bank wants to hold. Excess reserves equal actual reserves (currency in the bank’s vault plus its deposit at the Fed)— minus its desired reserves. Banks can lend their excess reserves, so excess reserves can be used for money creation.

•

The public holds some proportion of its money as currency. Currency held by the public cannot be used as reserves and hence is a leakage of reserves from the banking system. The ratio of currency to deposits is the currency drain ratio.

Chapter 18 . Money and the Monetary System

305

How Open Market Operations Change the Monetary Base •

•

When the Fed buys government securities in an open market operation, banks’ excess reserves increase. As a result, banks increase their lending and the quantity of money increases. To decrease the quantity of money, the Fed sells government securities in the open market. • Whether the Fed buys (or sells) from a bank or a member of the non-bank public makes no difference.

The Multiplier Effect of an Open Market Operation •

•

An open market purchase by the Fed of government increases banks’ reserves and also increases the monetary base (the sum of Federal Reserve notes plus banks’ reserves at the Fed) by the amount of the purchase. For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest. Excess reserves give a single bank the ability to make loans. When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan. After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank. As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves. A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again.

Round

Total reserves

Deposits

Desired reserves

Loans

Total increase in the quantity of money

$1,000

$100

$900

$1,000

900

810

1,810

810

729

2,539

•

The table above shows 3 rounds of the multiplier effect. The Fed makes an initial $1,000 purchase of government securities from a member of the nonbank public, which increases the bank’s total reserves by $1,000 and deposits by $1,000. The desired reserve ratio is 10 percent and the bank wants to hold no excess reserves. The currency drain is 0 percent. So in the first round the bank loans its excess reserves of $900, which are then the deposits of the second round. The third round is similar. The last column is running tally of the increase in the quantity of money. In the case in this table, the ultimate increase will be $10,000.

•

An increase in currency held outside the banks, the currency drain, decreases the amount of money that banks can create from a given increase in the monetary base.

Part 5 . UNDERSTANDING THE MACROECONOMY

306

The Money Multiplier •

•

The money multiplier is the number by which a change in the monetary base is multiplied to find the resulting change in the quantity of money. It determines the change in the quantity of money that results from a given change in the monetary base. • The currency drain is the ratio of currency kept outside of banks to deposits. The larger the currency drain, the smaller the money multiplier. The money multiplier equals (D + C)/(R + C) where D is the deposits, C is the currency, and R is the reserves. Dividing each item by D, gives: Money multiplier = (1 + C/D)/(R/D + C/D) •

C/D is the currency drain ratio and R/D is the desired reserve ratio. The larger the currency drain ratio and the larger the desired reserve ratio, the smaller is the money multiplier. The currency drain ratio and the desired reserve ratio are not constant, so the money multiplier is not constant.

Chapter 18 . Money and the Monetary System

USING EYE ON THE PAST 

The “Invention” of Banking

Even though gold perhaps no long carries the same mystique it did in the past, nonetheless students will be interested to know that the goldsmiths were really the founders of the first modern day equivalent of the banking system. You should point out to your class that initially these enterprises were not regulated by the government. Here is an interesting question to ask your class. What kept the goldsmiths from simply writing as many gold certificates as they desired? The answer is self preservation, often in its most basic sense! Not unlike modern banks today, goldsmiths in the past had to balance liquidity against profit. Too much emphasis on the latter and not enough concern over the former could result in a goldsmith or two being “tarred and feathered” and run out of town on a rail – a far worse fate than the Congressional tongue lashings or public chastisement that modern day heads of financial institutions receive when they fail!

USING EYE ON THE U.S. ECONOMY 

Commercial Banks Under Stress in the Financial Crisis

This Eye can be used to give students a precursory understanding of the tight credit conditions faced by households during the financial crisis and how this credit crunch magnified existing housing market problems, creating a cycle of problems. Lax lending conditions, low interest rates, and speculative buying “artificially” bid up home prices in the early-mid 2000s. However, as borrowers defaulted on loans they couldn’t afford (and as banks feared even more defaults), banks shifted towards reserves and liquid assets, thus restricting the availability of loans to consumers for new mortgages. Tighter credit conditions made it more difficult for homeowners to sell their houses, putting downward pressure on prices. Lower housing prices would normally stimulate more buying, but without available loans the prices just fell further. As prices fell, more and more homeowners fell “underwater” as they now had existing mortgages that were greater than the value of their house (especially given the proliferation of low(or zero) down mortgages and home equity loans). As underwater homeowners unable to afford their mortgages and unable to sell began to default on their loans, mortgage lending became even riskier—and banks further shifted assets away from loans, further magnifying the tight credit conditions and continuing the housing market decline.

307

308

Part 5 . UNDERSTANDING THE MACROECONOMY

USING EYE ON YOUR LIFE 

Money and Your Role in Its Creation

It’s often difficult for students to understand how their own individual behavior can have any impact on society as a whole. Idiosyncratic differences probably don’t, however, when there is a change in behavior by many households in the same direction the impact can be enormous. Ask your students what would happen to the money creating potential of the banking system if suddenly large numbers of people were to withdraw cash from their banks because of a real or perceived emergency. Obviously, it would be substantially reduced. In fact, because of the fear that many people had when the so-called Y2K crisis was looming there were fears that many people would make large withdrawals of cash at the end of the year out of concern that bank computers might fail when the clock turned to the year 2000. The Federal Reserve of course anticipated this and increased reserves for the banking system to prevent any problems.

USING EYE ON CREATING MONEY 

How Does the Fed Create Money and Regulate Its Quantity?

You can use this Eye to set up one of the major obstacles to effective monetary policy in a severe recession. The Fed flooded the banking system with reserves to expand the monetary base, but that didn’t translate into the desired increase in the quantity of money. Ask students why that money being pumped into the banking system wasn’t all coming out the other end in the form of greater loans and spending? Help students identify that the Fed can’t make banks lend money to households and businesses nor can they make households and businesses borrow that money—the Fed can only make it more attractive. Ultimately, the Fed is dependent upon lenders and borrowers responding “normally” to their policies, but during severely abnormal times (like the 2008 financial crisis) the Fed’s policies don’t always have the desired impact. Effectively, the Fed faced a bottleneck problem as they poured massive reserves into banks, but because banks wanted to hold the assets as reserves rather than make loans, loans only came trickling out the other end, thereby severely reducing the money multiplier.

Chapter 18 . Money and the Monetary System

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 18.1 What Is Money? 1. Sara has $5,000 in a Citibank time deposit. She withdraws her $1,000 from her savings deposit account, keeps $50 in cash, and deposits the balance in her checkable account at Citibank. What are the immediate changes in M1 and M2? 2.

In February 2001, currency held by individuals and businesses was $537.1 billion; traveler's checks were $8.0 billion; checkable deposits owned by individuals and businesses were $544.9 billion; savings deposits were $1,927.3 billion; small time deposits were $1,052 billion; and money market funds were $958.5 billion. 2a. What was M1 in February 2001? 2b. What was M2 in February 2001? 3.

In March 2004, currency held by individuals and businesses was $666.8 billion; traveler’s checks were $7.8 billion; checkable deposits owned by individuals and businesses were $651.1 billion; savings deposits were $3,279.1 billion; small time deposits were $802.7 billion; and money market funds and other deposits were $760.5 billion. Calculate M1 and M2 in March 2004.

 Checkpoint 18.2 The Banking System 4. A savings and loan association has $400 in checkable deposits, $1,390 in home loans, $856 in savings deposits, $634 in government securities, $806 in time deposits, $38 in currency, and no reserves at the Fed. Calculate: 4a. Total deposits 4b. Deposits that are part of M1 4c. Deposits that are part of M2 4d. Loans 4e. Reserves  Checkpoint 18.3 The Federal Reserve System 5. What power does the President of the United States have over the Federal Reserve? 6.

Suppose that at the end of December 2004, the monetary base in the United States is $650 billion, Federal Reserve notes are $600 billion, and coins are $20 billion. What are the commercial banks' reserves at the Fed?

Suppose that at the end of December 2005, the monetary base in Canada is $60 billion, Bank of Canada notes are $55 billion, and there is $2 billion of coins. What are the reserves of the Canadian banks at the Bank of Canada?

309

310

Part 5 . UNDERSTANDING THE MACROECONOMY

 Checkpoint 18.4 Regulating the Quantity of Money 8. If banks have a desired reserve ratio of 0.20, there is no currency drain, and Erin deposits $50 of cash in her bank, calculate 8a. The bank’s excess reserves as soon as Erin makes her deposit. 8b. The maximum amount of loans that the banking system can make. 8c. The increase in total deposits when the banks have no excess reserves. 

Answers

 Checkpoint 18.1 What Is Money? 1. M1 immediately rises by the full amount of the $1,000 withdrawal. The reason is that before, this $1,000 was only a part of M2 not M1. But, now because both cash and checkable accounts are part of M1, M1 rises by $1,000. However, because M2 includes everything that is a part of M1, M2 is left unchanged. 2a. M1 = currency + traveler’s checks + checkable deposits = $537.1 billion + $8.0 billion + $544.9 billion = $1,090 billion. 2b. M2 = M1 + savings deposits + small time deposits + money market funds = $1,090 billion + $1,927.3 billion + $1,052 billion + $958.5 billion = $5,027.8 billion. 3.

M1 = currency + traveler’s checks + checkable deposits = $666.8 billion + $7.8 billion + $651.1 billion = $1,325.7 billion. M2 = M1 + saving deposits + time deposits + money market funds = $1,325.7 billion + $3,279.1 billion + $802.7 billion + $760.5 billion = $6,168.0 billion.

 Checkpoint 18.2 The Banking System 4a. Total Deposits = checkable deposits + savings deposits + time deposits = $400 + $856 + $806 = $2,062. 4b. The only deposits that are part of M1 are the checkable deposits of $400. 4c. The entire $2,062 of deposits are part of M2. 4d. Total loans are $1,390. 4e. Reserves are deposits at the Fed plus currency. Because there are no reserves at the Fed, the reserves equal currency, which is $38.  Checkpoint 18.3 The Federal Reserve System 5. Subject to approval by the Senate, the President appoints the chairman of the Fed, who enjoys a four-year renewable term. The President also appoints the members of the Board of Governors. Once appointed these members serve 14-year terms, which go beyond the term served by the President. The president’s influence is limited, but the President can use the power and prestige of the office to bring about change. The Fed is not immune from public opinion.

Chapter 18 . Money and the Monetary System

The monetary base is the sum of coins, Federal Reserve notes, and banks’ reserves at the Federal Reserve. In the question, the monetary base is $650 billion, Federal Reserve notes are $600 billion, and coins are $20 billion. Banks’ reserves equal $30 billion, the monetary base minus Federal Reserve notes and coins.

The monetary base is the sum of coins, Bank of Canada notes, and banks’ reserves. The monetary base is $60 billion and Bank of Canada notes plus coins are $57 billion. So the reserves of the Canadian banks at the Bank of Canada equal $3 billion, the monetary base minus Bank of Canada notes and coins.

 Checkpoint 18.4 Regulating the Quantity of Money 8a. The bank’s excess reserves are $40. Excess reserves are equal to actual reserves minus desired reserves. The $50 deposit creates $50 of new reserves. With a desired reserve ratio of 20 percent, the bank holds 0.2 × $50, which is $10 as desired reserves. The remainder, $40, is excess reserves. 8b. The maximum amount of loans is $200. The maximum amount of loans that the banking system can make is equal to the increase in total quantity of money minus the initial deposit because all of the deposits except the initial deposit are created when a bank makes a loan. So, to determine the loans, calculate the increase in the quantity of money and then subtract the initial deposit. To calculate the increase in the quantity of money, the increase in (1 + C ) reserves is multiplied by the money multiplier, , where C is the ( R + C) currency drain ratio and R is the desired reserve ratio. If the currency drain is zero, then C = 0. When the desired reserve ratio is 20 percent, the money multiplier equals 1 ÷ 0.20 = 5.0. In this case, the quantity of money increases by 5 × $50 = $250. The maximum amount of loans equals $250 − $50, which is $200. 8c. The total deposits was calculated above as $250.

311

Aggregate Supply and Aggregate Demand CHAPTER OUTLINE 1. Define and explain the influences on aggregate supply. A. Aggregate Supply Basics 1. Why the AS Curve Slopes Upward a. Change in Output Rate b. Temporary Shutdowns and Restarts c. Business Failure and Startup B. Changes in Aggregate Supply 1. Change in Potential GDP 2. Change in Money Wage Rate 3. Change in Money Prices of Other Resources 2. Define and explain the influences on aggregate demand. A. Aggregate Demand Basics 1. The Buying Power of Money 2. The Real Interest Rate 3. The Real Prices of Exports and Imports B. Changes in Aggregate Demand 1. Expectations 2. Fiscal Policy and Monetary Policy 3. The World Economy C. The Aggregate Demand Multiplier 3. Explain how trends and fluctuations in aggregate demand and aggregate supply bring economic growth, inflation, and the business cycle. A. Macroeconomic Equilibrium B. Three Types of Macroeconomic Equilibrium 1. Adjustment toward Full Employment C. Economic Growth and Inflation Trends D. The Business Cycle E. Inflation Cycles 1. Demand-Pull Inflation 2. Cost-Push Inflation F. Deflation and the Great Depression

Chapter

314

Part 5 . UNDERSTANDING THE MACROECONOMY

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 19 is slightly updated from the sixth edition, featuring updated data for 2013 throughout the chapter.

 Where We Are Chapter 19 introduces the AS-AD model and then explains the influences on both aggregate supply and aggregate demand. It uses aggregate demand and aggregate supply to explain how fluctuations in them create the business cycle.

 Where We’ve Been This chapter moves away from long-run economic growth, covered in Chapter 17 to concentrate on economic fluctuations, the business cycle, and the AS-AD model.

 Where We’re Going The next chapter focuses on fiscal policy and monetary policy. It starts by describing the federal budget process and the supply-side effects of fiscal policy on employment and potential GDP as well as the demand-side effects of fiscal policy on employment and real GDP. Then it explores monetary policy and studies how it affects the economy and different monetary policy rules.

IN THE CLASSROOM  Class Time Needed Although it might be possible to cover the material in this chapter in two class sessions, it is sufficiently important and challenging that spending at least three class periods is a good investment. Depending on the current state of the economy, you can spend upwards of three or more class periods on it! An estimate of the time per checklist topic is: •

19.1 Aggregate Supply—40 to 50 minutes

•

19.2 Aggregate Demand—40 to 50 minutes

•

19.3 Explaining Economic Trends and Fluctuations—50 to 70 minutes

Classroom Activity: You might spend some time talking about the latest business cycle movements and the impact on real GDP, unemployment, and inflation. This is a good place to remind students of these three main economic aggregates on which we focus and how they fluctuate through time. You might visit the webpage of the NBER for any updates from

Chapter 19 . Aggregate Supply and Aggregate Demand

315

the Business Cycle Dating Committee (http://www.nber.org/cycles/main.html). Show students that this is where the news media are likely to get their information regarding recessions and expansions in the economy. Then explain that the AS-AD model can be used to explain the business cycle fluctuations in real GDP and the price level.

Part 5 . UNDERSTANDING THE MACROECONOMY

316

CHAPTER LECTURE 19.1

Aggregate Supply

The purpose of the AS-AD model is to explain how the price level and real GDP are determined. Real GDP depends on labor, capital, technology, land, and entrepreneurial talent. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP. When the quantity of labor demanded equals the quantity of labor supplied, there is full employment in the labor market and real GDP equals potential GDP.

Aggregate Supply Basics •

•

The aggregate supply is the relationship between the quantity of real GDP supplied and the price level when all other influences on production plans (the money wage rate, the prices of other resources, and potential GDP) remain constant. As illustrated in the figure, the AS curve is upward sloping. •

This slope reflects that a higher price level combined with a fixed money wage rate lowers the real wage rate, thereby increasing the quantity of labor employed and hence increasing real GDP.

•

The potential GDP line is vertical because moving along it both the price level and money wage rate and money prices of other resources change by the same percentage.

Why the AS Curve Slopes Upward Lecture Launcher: Remind your students that the AS curve used in this chapter is a short-run aggregate supply curve because it assumes product prices and resources prices do not move in lock step with one another. That is to say wages, materials prices, energy prices and the like move with a lag behind product prices. To launch your lecture, walk through this thought experiment with your students. Ask your class if firms are likely to be motivated to step up production if product prices rise. They will have no trouble responding in the affirmative. Now tell your students that the higher price is actually the result of an increase in the general price level. Ask them how quickly workers are likely to respond by asking for wage increases. The answer is that it will take time for workers to see the general price level has risen and their real wages are now lower. Eventually they will demand higher wages. Firms are forced to grant the wage hikes because the labor market is tight and if they did not raise wages, they would lose workers. But until workers realize their real wage has fallen, firms are in the position of receiving higher prices with no change in money wages, so they in-

Chapter 19 . Aggregate Supply and Aggregate Demand

317

crease their production. And with this result, you have demonstrated the upward-sloping aggregate supply curve! •

When the price level changes, three reactions create the positive relationship between the price level and quantity of real GDP supplied: • Changes in output rate: When the price level rises and the money wage rate doesn’t change, the quantity of labor demanded increases and production increases. • Temporary shutdowns and restarts: The price level relative to costs is an influence on temporary shutdown decisions. If the price level rises relative to costs, fewer firms will decide to shut down, so more firms operate and the quantity of real GDP supplied increases. • Business failure and startup: Real GDP changes when the number of firms in business changes. If the price level rises relative to costs, profits increase, the number of firms in business increases, and the quantity of real GDP supplied increases.

Changes in Aggregate Supply •

• •

When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the AS curve. The AS curve, however, does not shift. When potential GDP increases, aggregate supply increases and AS curve shifts rightward. The potential GDP line also shifts rightward. Short-run aggregate supply changes and the AS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the AS curve leftward. In this case, the potential GDP line does not shift.

19.2

Aggregate Demand

The quantity of real GDP demanded is the sum of consumption expenditure (C ), investment (I ), government expenditures (G ), and net exports (X − M ), or Y = C + I + G + (X − M ).

Aggregate Demand Basics •

The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded.

•

As the figure shows, the AD curve is downward sloping. Moving along the aggregate demand curve the only thing that changes is the price level.

Part 5 . UNDERSTANDING THE MACROECONOMY

318

Why the AD Curve Slopes Downward •

The negative relationship between the price level and the quantity of real GDP demanded, that is, the negative slope of the AD curve, reflects three factors: • The buying power of money: When the price level rises, the buying of money decreases and so people decrease consumption expenditure. • The real interest rate: When the price level rises, the demand for money increases, which raises the nominal interest rate. Because the inflation rate does not immediately change, the real interest rate also rises so that people decrease their consumption expenditure and firms decrease their investment. • The real price of exports and imports: When the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded.

Changes in Aggregate Demand •

Any factor that influences expenditure plans other than the price level changes aggregate demand and shifts the aggregate demand curve. Factors that change aggregate demand are: •

•

Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward. Fiscal policy and monetary policy: The government influences the economy by setting and changing taxes, making transfer payments, and purchasing goods and services, which is called fiscal policy. Tax cuts, increased transfer payments, or increased government purchases increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand. The world economy: Exchange rates and foreign income affect net exports (X − M ) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand.

The Aggregate Demand Multiplier •

An initial change in expenditure is magnified by the aggregate demand multiplier so that aggregate demand changes by a multiple of the initial change.

 Land Mine: Some of the same issues regarding change in demand versus change in the quantity demanded and change in supply versus change in the quantity supplied apply to the aggregate supply and aggregate demand curves as well as the microeconomic supply and demand model. Remind your students that a change in the price level does not shift the aggregate supply curve or aggregate demand curve. A change in the price level results in movements along the curves.

Chapter 19 . Aggregate Supply and Aggregate Demand

319

You can involve your students in the material and help solve the land mine above by asking them a few hypothetical questions. Ask your class what will happen to the aggregate demand curve in each of the following cases: a. b. c. d. e.

A cut in taxes. An increase in expected future profit. A cut in government expenditure. An increase in foreign income. A rise in the price level abroad.

Each of these examples give students practice shifting the aggregate demand curve rightward and leftward as well as understanding why it shifts in the direction it does. You should do a similar exercise that practices shifting the aggregate supply curve in isolation before putting the AD and AS curves together in equilibrium.

19.3

Explaining Economic Trends and Fluctuations

Macroeconomic Equilibrium •

Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the AS curve. • •

If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices. If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.

Point out to the students that to simplify analysis of the business cycle, economists typically abstract from growth in potential GDP. By fixing potential GDP when considering business cycle fluctuations, economists are looking at short-term movements around a slower moving long-run potential GDP level of output. Explain to the students that one reason to abstract from these longterm growth movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones. A second reason is the standard view that shortterm movements around potential GDP are driven by different economic forces than those that lead to growth in potential GDP. So abstracting from growth in potential GDP in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details.

Three Types of Macroeconomic Equilibrium •

A full employment equilibrium occurs when equilibrium real GDP equals potential GDP. When real GDP is below or above potential GDP, the money wage rate gradually changes to bring full employment.

•

A recessionary gap (or below full employment equilibrium) occurs when real GDP is less than potential GDP and that brings a falling price level.

Part 5 . UNDERSTANDING THE MACROECONOMY

320

•

A recessionary gap occurs when the AS curve and the AD curve intersect to the left of the potential GDP line, as illustrated in the figure to the left below. In the figure, potential GDP is $16 trillion but the actual real GDP is $15 trillion. In a recessionary gap, there is a surplus of labor and firms can hire new workers at a lower wage rate.

As the money wage rate falls, the AS curve shifts rightward and the price level falls and real GDP rises. The money wage rate falls until real GDP equals potential GDP. •

An inflationary gap (or above full employment equilibrium) occurs when real GDP exceeds potential GDP and that brings a rising price level. •

An inflationary gap occurs when the AS curve and the AD curve intersect to the right of the potential GDP line, as illustrated in the figure above to the right. In the figure, potential GDP is $16 trillion but the actual real GDP is $17 trillion. In an inflationary gap, there is a shortage of labor and firms must offer higher wage rates to hire the labor they demand. As the money wage rate rises, the AS curve shifts leftward and the price level rises and real GDP falls. The money wage rate rises until real GDP equals potential GDP.

Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the AS curve is not difficult. But the notion that the AS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the AS curve so that the students realize that wages and other input prices remain constant along an AS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of prices, the AS curve shifts leftward.

Chapter 19 . Aggregate Supply and Aggregate Demand

321

 Land Mine: The AS-AD model predicts a fall in the price level as the economy adjusts to an inflationary gap and a decrease in real GDP as the economy adjusts to a recessionary gap. But some students object by pointing out that the price level rarely, if ever, falls and real GDP infrequently decreases. These students are bothered by this apparent mismatch between the predictions of the model and the observed economy. The best way to handle this issue is to emphasize that in our actual economy, aggregate supply and aggregate demand almost always are increasing. When we use the model, we’re studying what happens relative to the trends in real GDP and the price level. Since a certain amount of inflation is to be expected in the U.S. economy, a fall in the price level in the model translates into a lower price level than would otherwise have occurred and a slowing of inflation (often referred to as “disinflation”). The story is similar for real GDP.

Economic Growth and Inflation Trends Economic growth results from a growing labor force and increasing labor productivity, which together make potential GDP grow. Inflation results when the quantity of money grows at a rate that outpaces the growth of potential GDP. • Using the AS-AD model, when the AD curve shifts rightward at a faster rate than the potential GDP curve, inflation occurs.

The Business Cycle The business cycle results from fluctuations in aggregate supply and aggregate demand. • Aggregate supply fluctuates because labor productivity grows at a variable pace, which brings fluctuations in the growth of potential GDP. A real business cycle results from fluctuations in the pace of growth of labor productivity and potential GDP. • Aggregate demand fluctuations are the main source of the business cycle, since swings in aggregate demand occur more quickly than changes in the money wage rate that change aggregate supply.

Inflation Cycles •

Demand-pull inflation is inflation that starts because aggregate demand increases. Demand-pull inflation can be started by any of the factors that increase aggregate demand, but can only be sustained by growth in the quantity of money. •

•

Starting at full employment, an increase in AD increases the price level and real GDP and creates an inflationary gap. The shortage of labor increases the money wage rate, which decreases AS and thereby increases the price level and decreases GDP back to potential GDP. If the quantity of money increases, AD will increase again, creating an inflationary gap. This process repeating itself results in an ongoing demand-pull inflation spiral.

Cost-push inflation is an inflation that begins with an increase in cost. The two main sources of cost increases are increases in the money wage rate and increases in the money

322

Part 5 . UNDERSTANDING THE MACROECONOMY

prices of raw materials such as oil. Cost-push inflation can be started by an increase in costs, but can only be sustained by growth in the quantity of money. •

Starting at full employment, an increase oil prices decreases the AS which increases the price level, decreases real GDP, and creates a recessionary gap. When the unemployment rate rises above the natural rate, the Fed increases the quantity of money to restore full employment. AD increases and returns real GDP back to potential GDP, but the price level rises further. Oil producers now see the price of everything else rising so they raise the price oil still higher and this process repeats in a cost-push inflation spiral.

•

The combination of recession (decreasing real GDP) and inflation (rising price level) is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks. Stagflation poses a dilemma for the Fed, because if they fail to increase the quantity of money the economy remains below full employment but if they increase the quantity of money it can create a cost-push inflation spiral.

Class activity: Use the AS-AD model to apply the theory students are learning to current events in the economy. For example, oil prices have increased due to Asian demand and every summer there is concern about hurricanes. Encourage students to think about the impact of these factors in the AS-AD model. How will higher oil prices affect the nation’s GDP and price level? Alternatively, if there have recently been significant changes to taxes, government spending, interest rates, exchange rates, events that may alter consumer or business confidence, etc. make sure you bring them into your discussion and use this opportunity to get practice applying the AS-AD model interpret the macroeconomic consequences of current events. This not only helps students master how to work with the model, but also demonstrates to them the practical applicability of this new tool. Also, be sure to remind your students that the upcoming chapters will be building on top of this model, so grasping the upcoming material will require understanding how to work with this important tool.

Deflation and Great Depression • In the Great Depression from 1929 to 1933, the price level fell by 22 percent and real GDP fell by 31 percent. In the 2008-2009 recession, the price level rose at a slow pace and real GDP fell by less than 4 percent. The 2008-2009 recession was much milder than the Great Depression for various reasons: • During the Great Depression, bank failures, a 25 percent contraction in the quantity of money, and inaction by the Fed resulted in a collapse of aggregate demand. Money wage rates and the price level were slow to adjust, resulting in huge decreases in real GDP and employment. • During the 2008 financial crisis, the Fed bailed out troubled financial institutions and doubled the monetary basis, which kept the quantity of money growing. Combined with increased government expenditure, the growing quantity of money limited the fall in aggregate demand, thus resulting in smaller decreases in employment and real GDP.

Chapter 19 . Aggregate Supply and Aggregate Demand

USING EYE ON THE U.S. ECONOMY  U.S. Economic Growth, Inflation, and the Business Cycle If you have young students in your class, most of them will have little or no knowledge of how our economy has evolved since the 1970s. This knowledge is vital because our experiences with economic growth, inflation, and the business cycle help shape policymakers’ decisions about what policies to pursue today. For instance, for those who lived through them, the 1970s and early 1980s with their high and volatile inflation rates are times that bring bad memories. So, policymakers today take actions to help avoid the roaring inflation that the U.S. economy experienced then. Indeed, some observers credit the Fed’s decisions in 2005 to continue raising interest rates in the face of oil price hikes as an attempt to avoid reliving the 1970s/early 1980s when the Fed eased in the face of oil price hikes and inflation skyrocketed. Use this Eye to help your students gain a more balanced, historical perspective because this view might well help them understand policymakers’ decisions today!

USING EYE ON YOUR LIFE  Using the AS-AD Model To have students actually use this “Eye on Your Life” in a meaningful way you should probably make this a required assignment. Additionally, to get them to pour over the data it might be useful to actually go through the release dates of important statistics so that students are working with “fresh” information. Typically, unemployment data is released the first Friday of the month for the previous month. CPI data are released about halfway through the month for the previous month. GDP is a bit more backward looking and while there is a preliminary update given approximately four weeks after the conclusion of the quarter, that measurement goes through 2 revisions over the following months until it becomes a final reading. Pinning down the release dates sends a cue to your students that you want the latest information on the economy. It might even be a good idea to provide your class with specific government websites and the precise information that can be found there. For instance if you want your students to grab the latest CPI and unemployment information you can direct them to www.bls.gov. GDP information can be found at www.bea.gov. You can even create data tables going back as far as you find to be relevant for these data to include in your course syllabus and have students update these tables throughout the semester as data are released. Of course if you believe at this point that students should already know where to look for this information then you can refrain from distributing the actual website addresses in class.

323

324

Part 5 . UNDERSTANDING THE MACROECONOMY

USING EYE ON BUSINESS CYCLE 

Why Did the U.S. Economy Go into Recession in 2008?

Use this Eye to help reinforce how the aggregate supply—aggregate demand model can be used to organize an analysis of real world macroeconomic fluctuations. Many times the models introduced in economics can seem too disconnected from reality to students to warrant appreciation. However, the AS-AD model works well to describe the 2008-2009 recession and the mix of a rising price level for the first part of the recession, and then a falling price level for the second part. You can add to the analysis presented in the Eye by presenting what happened when oil prices fell from their peak in July 2008 near $150 to the $30 range in early 2009. Breaking the 2008-2009 recession into two segments, you can demonstrate how the first portion of the recession saw a rising price level and the threat of stagflation as oil prices rose and aggregate supply decreased by more than aggregate demand. But then oil prices fell and aggregate demand continued to decrease, so the price level was pulled down and we saw deflationary pressure. You can gather data on the CPI from the BLS web site to help illustrate this shift as there is a stark divide in the monthly inflation reading before and after July 2008. In fact, while monthly readings on the CPI were high through July, the overall CPI saw a 1.5 percent decline from August 2008 to August 2009.

Chapter 19 . Aggregate Supply and Aggregate Demand

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 19.3 Explaining Economic Trends and Fluctuations 1. What effect does each of the following combinations have on real GDP and the price level? 1a. Increase in aggregate demand and a decrease in aggregate supply. 1b. Increase in aggregate demand and an increase in aggregate supply. 1c. Decrease in aggregate demand and a decrease in aggregate supply. 

Answers

 Checkpoint 19.3 Explaining Economic Trends and Fluctuations 1a. An increase in aggregate demand raises the price level and increases real GDP. A decrease in aggregate supply raises the price level and decreases real GDP. Combined, the price level definitely rises. But the effect on real GDP is ambiguous. If the aggregate demand effect is larger than the aggregate supply effect, real GDP increases, while if the aggregate supply effect is larger, real GDP decreases. If the two are the same magnitude, real GDP will not change. 1b. An increase in aggregate demand raises the price level and increases real GDP. An increase in aggregate supply lowers the price level and increases real GDP. When both occur simultaneously, definitely real GDP increases. The effect on the price level is uncertain. If the aggregate demand effect is larger, the price level rises and if the aggregate supply effect is larger, the price level falls. And if the two effects are the same magnitude, the price level does not change. 1c. A decrease in aggregate demand lowers the price level and decreases real GDP. A decrease in aggregate supply raises the price level and decreases real GDP. When both occur, real GDP definitely decreases. However, the effect on the price level is uncertain. If the aggregate demand effect dominates, the price level falls but if the aggregate supply effect dominates, the price level rises. And if the two effects are the same size, the price level does not change.

325

Fiscal Policy and Monetary Policy CHAPTER OUTLINE 1. Describe the federal budget process and explain the effects of fiscal policy. A. The Federal Budget 1. Budget Time Line B. Budget Balance and Debt 1. Surplus, Deficit, and Debt 2. A Personal Analogy 3. Types of Fiscal Policy a. Discretionary Fiscal Policy b. Automatic Fiscal Policy C. Discretionary Fiscal Policy: Demand-Side Effects 1. The Government Expenditure Multiplier 2. The Tax Multiplier 3. The Transfer Payments Multiplier 4. The Balanced Budget Multiplier D. A Successful Fiscal Stimulus E. Discretionary Fiscal Policy: Supply-Side Effects 1. Supply-Side Effects of Government Expenditure 2. Supply-Side Effects of Taxes 3. Scale of Government Supply-Side Effects 4. Supply-Side Effects on Potential GDP F. Limitations of Discretionary Fiscal Policy 1. Law-Making Time Lag 2. Shrinking Area of Discretion 3. Estimating Potential GDP 4. Economic Forecasting G. Automatic Fiscal Policy H. Cyclical and Structural Budget Balances I. Schools of Thought and Cracks in Today’s Consensus 2. Describe the Federal Reserve’s monetary policy process and explain the effects of monetary policy. A. The Monetary Policy Process 1. Monitoring Economic Conditions

Chapter

328

Part 5 . UNDERSTANDING THE MACROECONOMY

2. Decisions of the Federal Open Market Committee (FOMC) 3. Monetary Policy Report to Congress B. The Federal Funds Rate Target C. The Ripple Effects of the Fed’s Actions 1. Other Interest Rates Change 2. The Exchange Rate Changes 3. The Quantity of Money and Bank Loans Change 4. The Long-Term Real Interest Rate 5. Consumption Expenditure, Investment, and Net Exports Change 6. Aggregate Demand Changes D. Monetary Stabilization in the AS-AD Model 1. The Fed Eases to Fight Recession 2. The Fed Tightens to Fight Inflation 3. The Size of the Multiplier Effect E. Limitations of Monetary Stabilization Policy

CHAPTER ROADMAP

 What’s New in this Edition? Chapter 20 contains updated data, slightly revised and updated Eye On applications, a few slightly revised subheadings in 20.1. It also removes key terms designation for federal budget, fiscal year, fiscal stimulus, and needs-tested spending and replaces the key terms designations for balanced budget, budget surplus, and budget deficit with budget balance.

 Where We Are Chapter 20 uses material from the previous chapters. We describe fiscal policy, explain the difference between discretionary and automatic fiscal policy, and discuss the institutional details of fiscal policy. We discuss the multiplier effect on aggregate demand from changes in government expenditure, taxes, and from simultaneous changes in government expenditure and taxes. Then we use the AS-AD model from previous chapters to explore the effects of fiscal policy. The limitations of fiscal policy are discussed. A similar exploration of monetary policy is conducted, including using the AS-AD model to illustrate the effects of monetary policy.

 Where We’ve Been The previous chapter discussed business cycles and used the AS-AD model to explore factors that create business cycles

Chapter 20 . Fiscal Policy and Monetary Policy

329

and inflation. This chapter uses the same AS-AD model to explore how fiscal and monetary policy can be used to combat business cycle fluctuations.

 Where We’re Going This chapter is the last chapter in the book.

IN THE CLASSROOM  Class Time Needed This material is challenging and important. You probably can cover it in two class periods, but depending on your class’s ease with manipulating the AS-AD model, you might spend two and one half or slightly more periods on it. An estimate of the time per checklist topic is: •

20.1 The Federal Budget and Fiscal Policy—50 to 65 minutes

•

20.2 The Federal Reserve and Monetary Policy—50 to 65 minutes

Classroom Activity: After you have completed this chapter, ask your students to write down the type of fiscal and monetary policy they would recommend at the present time. Ask them to describe whether they would rely more on fiscal policy or monetary policy to attempt to influence the current position of the economy. For a smaller class, you can assign half the class to argue a fiscal policy response and half the class to argue a monetary policy response to the current economy and then allow the two sides to debate the issue. For a more extensive discussion, have the students do some basic research on current monetary and fiscal policy proposals reported in the press. Ask students to come to class prepared to defend their chosen policy. This could also be conducted as an in-class small-group exercise. Give the students about 20 minutes in small groups to decide on the fiscal or monetary policy they would implement–ask them to back this up with a graph of the effects of the chosen policy. Students can then either turn in their policy and graph or one person from each group can report on the chosen policy to the class.

Part 5 . UNDERSTANDING THE MACROECONOMY

330

CHAPTER LECTURE 20.1

The Federal Budget

Fiscal policy is the use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment.

The Federal Budget •

•

The federal budget is the annual statement of the expenditures and tax revenues of the government of the United States. The President proposes a budget to Congress in February. The Congress passes budget acts by September and the President either signs them or vetoes them. Budget balance = Tax revenues – Outlays • If tax revenues exceed outlays, the government has a budget surplus. • If outlays exceed tax revenues, the government has a budget deficit. In recent years the federal government has run a budget deficit. For the 2014 fiscal year, the projected U.S. budget balance is $3,000 billion − $3,627 billion = −$627 billion, that is, a budget deficit of $627 billion. • If tax revenues equal outlays, the government has a balanced budget. National debt – the amount of government debt outstanding that has arisen from past budget deficits.

Students often do not know the difference between a deficit and debt. Spend some time describing the national debt and how it is based on the accumulation of deficits over time. Linking this to the individual level as in the chapter can be very useful. Having students go find the current deficit (or projected deficit) and the national debt can be a useful (and eye-opening) exercise.

Automatic and Discretionary Fiscal Stimulus • •

Discretionary fiscal policy is a fiscal action that is initiated by an act of Congress. Automatic fiscal policy is a fiscal action that is triggered by the state of the economy.

Discretionary Fiscal Policy: Demand-Side Effects •

The government expenditure multiplier is the effect of a change in government expenditure on goods and services on aggregate demand. An increase in government expenditure on goods and services increases aggregate expenditure, which sets in motion the multiplier process.

•

The tax multiplier is the effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income and hence consumption expenditure, setting in motion the multiplier process. A decrease in taxes increases aggregate demand. •

•

The magnitude of the tax multiplier is less than the magnitude of the government expenditure multiplier because a $1 tax cut generates less than a $1 increase in consumption expenditure since only a fraction (equal to the MPC ) of the increase in disposable income is spent on consumption expenditure. The transfer payments multiplier is the effect of a change in transfer payments on aggregate demand. An increase in transfer payments increases disposable income and

Chapter 20 . Fiscal Policy and Monetary Policy

331

hence consumption expenditure, which sets in motion the multiplier process. An increase in transfer payments increases aggregate demand. •

The balanced budget multiplier is the effect on aggregate demand of a simultaneous change in government expenditures and taxes that leaves the budget balance unchanged. Because the government expenditure multiplier is larger than the tax multiplier, the balanced budget multiplier is positive, so a balanced budget increase in government expenditures and taxes increases aggregate demand.

A Successful Fiscal Stimulus Fiscal stimulus, a fiscal policy designed to increase aggregate demand (an increase in government expenditure or transfer payments, a decrease in taxes, or combination of all three) seeks to eliminate a recessionary gap. •

In the figure, the initial equilibrium is at real GDP of $15 trillion and a price level of 100. There is a recessionary gap because potential GDP ($16 trillion) exceeds real GDP.

•

The government can use expansionary fiscal policy. The initial increase in aggregate demand from the cut in taxes or hike in government expenditure or transfer payments is reinforced by the multiplier effect. The aggregate demand curve shifts rightward from AD0 to AD1. Real GDP increases so it equals potential GDP, $16 trillion, and the price level rises, to 110 in the figure.

Part 5 . UNDERSTANDING THE MACROECONOMY

332

Discretionary Fiscal Policy: Supply-Side Effects •

Some government services (law and order, public education) and some government capital infrastructure (highways, airports) increase production possibilities and thus increase potential GDP and aggregate supply. An increase in government expenditures of these types increases potential GDP and aggregate supply.

•

Taxes create a disincentive to work and save, so taxes decrease employment and capital, thereby decreasing potential GDP and aggregate supply. An increase in taxes decreases potential GDP and aggregate supply. •

•

If both government expenditure and taxes increase, the net effect on potential GDP is uncertain. So, a larger government might either increase or decrease potential GDP. A tax cut increases saving and investment, thereby increasing capital. As a result, as illustrated in the figure, the production function shifts higher. A tax cut increases labor supply, thereby increasing employment. As a result, there is a movement upward along the higher production function. On both counts, potential GDP and aggregate supply increase.

Limitations of Discretionary Fiscal Policy •

In practice, discretionary fiscal policy is hampered by four factors: • • •

•

Law-Making Time Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending. Shrinking Area of Law-Maker Discretion: An increasing large part of the budget (such as Medicare) is effectively off limits for shrinkage. Estimating Potential GDP: It is not easy to tell whether real GDP is below, above, or at potential GDP so it is not easy tell if a contractionary or expansionary policy is needed. Economic Forecasting: Fiscal policy must target forecasts of where the economy will be in the future. Economic forecasting has improved enormously in recent years, but it remains inexact and subject to error.

Automatic Fiscal Policy •

Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government. Induced taxes and needs-tested spending are automatic stabilizers.

Chapter 20 . Fiscal Policy and Monetary Policy

333

•

Induced taxes are taxes that vary with real GDP. In an expansion, induced taxes rise, helping to stabilize the economy and in a recession, induced taxes fall, helping to stabilize the economy. • Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits—benefits that vary with need and with the state of the economy. Induced taxes and needs-tested spending decrease the multiplier effects of changes in expenditure so they moderate both expansions and recessions and make real GDP more stable.

 Land Mine: The concept of automatic stabilizers is often difficult for students to grasp. For many students the possibility that something like an automatic stabilizer could exist appears to be incongruent with what they know to be true. To combat this confusion, I like to use the term “stability” as it is used in a physics class. In physics, stability is equated with maintaining an equilibrium position or resuming its original position after displacement. A simple analogy is in order. Ships are built in a way so as to provide for some measure of automatic stability. The shape of the hull is designed in such a way so that as wind pummels it from one side to the other, the ship will tip back in the opposite direction. In fact, the ballast in the ship assists in this way as well. Ballast is the heavy material that is placed in the hold of a ship to enhance stability. After giving this explanation, you can ask your students if the existence of the ballast and the shape of the hull guarantee that the ship will remain in an upright position. The answer is “no.” Heavy rains or gale force winds could tip the ship over with virtually no hope of righting itself! What the stability-enhancing characteristic of the shape of the hull and ballast provide is that the ship will not tip over in less than catastrophic conditions. This analogy holds true for the economy as well. Automatic stabilizers are not insulators from recession or depression but serve as devices that help the economy from reeling out of control when it is hit with less than catastrophic shocks By their nature, automatic stabilizers imply federal budget deficits in recessions as tax revenues fall and spending increases. By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabilizing fiscal policy. In the 2008-2009 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised. Such policies are the opposite of the policies that can be used to help stabilize the business cycle.

Cyclical and Structural Budget Balances •

The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and reflects the spending program and tax laws that Congress has created (the discretionary fiscal policy)

Part 5 . UNDERSTANDING THE MACROECONOMY

334

• •

The cyclical surplus or deficit is the budget balance that arises because revenues and outlays are not at their full-employment levels (the automatic fiscal policy) The actual budget balance equals the sum of the structural balance and cyclical balance.

Schools of Thought and Cracks in Today’s Consensus •

•

The Keynesian view is that fiscal stimulus – an increase in government outlays or a decrease in tax revenues – boosts real GDP and creates or saves jobs by increasing aggregate demand with a multiplier effect. The mainstream view is that Keynesians over-estimate the multiplier effects of fiscal stimulus and that these effects are small, short-lived, and incapable of working fast enough to be useful. Government stimulus “crowds out” private consumption expenditure and investment and ultimately leads to a bigger government, lower potential GDP, a slower real GDP growth rate, and a greater burden of government debt on future generations.

20.2

The Federal Reserve and Monetary Policy

The Monetary Policy Process •

The Beige Book is a report that summarizes current economic conditions in each Federal Reserve district and each sector of the economy. It serves as a background document for the members of the Federal Open Market Committee.

•

The FOMC meets eight times a year and makes the monetary policy decisions.

The Federal Funds Rate Target The Federal Reserve targets the federal funds rate. The federal funds rate is the interest rate in the federal funds market, that is, the market in which banks borrow and loan reserves. The Fed (the New York Fed actually carries out the actions) uses open market operations to influence the quantity of funds available. • If the Fed buys government securities, there are fewer funds (fewer reserves) available and so the federal funds rate rises. •

If the Fed sells government securities, there are more funds (more reserves) available and so the federal funds rate falls.

•

The Fed can adjust the federal funds rate to equal its target.

The Ripple Effects of the Fed’s Actions •

Suppose the Fed uses an open market operations purchase of government securities to lower the federal funds rate. The transmission mechanism is then: • •

•

Other interest rates rise. The effect on short-term interest rates is larger than the effect on long-term interest rates, but, in general, interest rates rise. The exchange rate rises: When interest rates in the United States rise, foreigners will want to buy U.S. dollars in order to earn the higher interest rate. The demand for the dollar on the foreign exchange rate market increases and the exchange rate rises. The quantity of money and bank loans: When the Fed raises the interest rate, it does so by decreasing banks’ reserves. As a result, banks can make fewer loans, so loans and deposits both decrease. The decrease in deposits decreases the quantity of money.

Chapter 20 . Fiscal Policy and Monetary Policy

• •

•

335

The long-term real interest rate: The change in bank loans affects the long-term real interest rate. The decrease in loans raises the long-term real interest rate. Consumption expenditure and investment: The higher real interest rate decreases consumption expenditure and investment.

•

Net exports: With the higher price of the dollar in the foreign exchange market, foreigners must now pay more for U.S.-made goods and services. So, U.S. exports decrease. Additionally, the higher exchange rate means that U.S. residents must pay less for imports. So, U.S. imports increase. As a result, U.S. net exports decrease.

•

Aggregate demand: The decrease in consumption expenditure, investment, and net exports all decrease aggregate demand.

If the Fed lowers the interest rate, the effects are reversed and aggregate demand increases.

Spend some time working through the steps of a Federal Reserve policy change. The chapter does a nice job explaining a change in the interest rate target and walks through the impacts in clearly, but students still have a hard time grasping the steps. Try to emphasize the intuition behind the effects. I often present only one of the policy directions in lecture (e.g., only a Fed loosening) and then break students into groups to have them try to work through the steps of the other direction (e.g., a Fed tightening). I then follow up and present that direction at the beginning of the next lecture.

Monetary Stabilization in the AS-AD Model •

The Fed tightens to fight inflation: •

If the Fed conducts an open market operation that increases the interest rate, there is a decrease in aggregate demand, which produces a decrease in real GDP and a fall in the price level.

•

The figure illustrates this case. The interest rate rises, which decreases consumption, investment, and net exports. The multiplier effect decreases aggregate demand and shifts the aggregate demand curve from AD0 to AD1. The price level falls, from 110 to 100 in the figure, and real GDP decreases, from $17 trillion to $16 trillion in the figure.

•

The Fed eases to fight recession: •

If the Fed conducts an open market operation that decreases the interest rate, there is an increase in aggregate demand, which produces an increase in real GDP and a rise in the price level.

336

Part 5 . UNDERSTANDING THE MACROECONOMY

Limitations of Monetary Stabilization Policy Monetary policy does not suffer from the law-making time lags. But monetary policy still has the problems of estimating potential GDP and forecasting economic activity in the future. And it suffers an additional limitation because its effects are indirect and depend on how private decisions respond to a change in the interest rate. Class Activity: Students can be left with the impression that policy is simple to implement. Be sure to give proper emphasis to the real-world difficulties mentioned in the text. It is dangerous to leave your students thinking that policy is trivial because we all know that policy is very difficult. Indeed, you might ask your students what they think is the proper policy for the Fed and/or the federal government to be pursuing. Assuming that the economy is not mired in the depths of a depression or inflation soaring out of sight, you likely will get a variety of answers, which you can use to point out to the students the non-trivial difficulty of determining the proper macroeconomic policy!

Chapter 20 . Fiscal Policy and Monetary Policy

USING EYE ON THE PAST 

Federal Tax Revenues, Outlays, Deficits, and Debt

Students are often surprised by the sheer magnitude of the government’s presence in the overall economy. This eye is a good opportunity to demonstrate that what is important is not the mere size of government expenditures and debt but its relation to the size of the economy in percentage terms. You might begin with a simple analogy. Ask your class who is likely to incur more debt: a rich person or a poor person. They should respond that the rich person will incur more debt. Just in case you have a reluctant student or two who is not convinced, it is worth settling this issue before proceeding forward. For instance, point out that the size of the house and the size of the mortgage is quite likely different between a rich and a poor person. The next question is to ask which person has a greater ability to pay or service the debt. Again the answer is the rich person. Explain that this set of questions and answers is not that much different than for the economy as a whole. When a nation’s economy is small in size, its ability to incur and pay back large amounts of debt is limited. However, when an economy matures and grows in size, the economy is better able to incur debt and pay it back. It is also worth pointing out to your students that the dramatic reduction of the debt to GDP ratio in the 1950s and 1960s was not really the result of paying down the debt, but of alternating between budget deficits and surpluses such that the budget was balanced on average and of having real GDP basically outgrow the debt. This can be useful to connect to our current debt, as the focus doesn’t necessarily need to be on paying down the debt, but on restoring the federal budget back towards a balance over time and having real GDP grow, thereby again reducing the debt to GDP ratio.

USING EYE ON THE U.S. ECONOMY 

A Social Security and Medicare Time Bomb

Most of your students will not appreciate the depth of the problems revolving around Social Security and Medicare. The Eye points out the four alternatives that can be used to “solve” these time bombs but it also points out the magnitude of the changes that these solutions require. Clearly there is no easy answer to these problems. However, they can make for an excellent class discussion focusing on what your students think would be the best answer(s). Make sure that the students are aware of the magnitude of the problems so that a simple “raise taxes on the rich” answer is not considered complete.

337

338



Part 5 . UNDERSTANDING THE MACROECONOMY

The U.S. Structural and Cyclical Budget Balances

This Eye can be used to “scare” your students…or, perhaps more positively, it can serve as a springboard to some very interesting discussions. Ask your students what, if anything, they should do about the deficit? Would they increase revenue? If so, what taxes would they adjust? Make certain that the suggestions are specific. For instance, the suggestion to “raise taxes on the rich” needs to be fleshed out. Who are the rich? By how much should their taxes be raised? How much revenue will this change collect? Or if the student thinks expenditures should be slashed, what should be decreased? By how much? You could even have them get into groups and ask them to discuss their proposals and see if they can get a majority of their classmates to agree to support their proposal. They should be able to quickly see why Congress struggles to get deficit reform passed, especially given that changes have to be passed through the House, the Senate (often with a filibuster-proof majority), and the President – and they would also have to worry about the response from their constituents and the media response in a 24-hour news cycle. This sort of discussion can really help demonstrate to the students the difficulty of some of the economic problems we face.

USING EYE ON FISCAL STIMULUS 

Can Fiscal Stimulus End a Recession?

This Eye can be used to emphasize how even seemingly enormous discretionary fiscal policy actions may only have small impacts on macroeconomic performance in the United State. For all of the political debate, assignment of blame, and claims of credit for success, it may be that discretionary fiscal policy takes a very distant back seat to automatic stabilizers when it comes to addressing the business cycle. However, make sure to discuss not only the short-term, but also the long-term effects of discretionary fiscal policy. This should help students distinguish between demand-side and supply-side effects of fiscal policy. While the demand-side impact of this discretionary stimulus is highlighted in the Eye, ask your students to think about the possible long-term supply-side effects of this stimulus package. If your students are unfamiliar with some of the particulars, inform them that this stimulus package consisted of a mixture of tax cuts and expansions of government expenditures on things like education, health care, infrastructure, energy efficiency, unemployment benefits, and other social welfare provisions. What are the demand-side and supply-side effects of these policies? Why are the demand-side effects felt sooner in an economy than the supply-side effects?

Chapter 20 . Fiscal Policy and Monetary Policy

USING EYE ON THE FED IN A CRISIS 

Did the Fed Save Us From Another Great Depression?

This Eye can serve as an excellent reminder of how far monetary policy has come since the Great Depression and how natural experiments and historical analysis have helped improve monetary policy. Undoubtedly, the Fed will continue to receive some blame for contributing to slipping into the 2008-2009 recession, but it should also receive credit for limiting the depth and duration of the recession in their response. It is important to emphasize to students that while monetary policy is not (and will likely never be) perfect, as economics as an academic discipline continues to advance, our policymakers will continue to get better at their jobs. The Fed’s response (or lack-there-of) to the money contraction that contributed to the Great Depression served as an excellent learning experience for economists and the Federal Reserve. Point out to your students that Ben Bernanke’s main area of expertise as an academic was the Great Depression – a study that he was able to bring with him in response to the threat of a similar situation in 2008. As the Eye explains, the Fed’s behavior in 2008 was drastically different than its behavior during the Great Depression. In the recent episode, the Fed accommodated banks’ vastly increased demand for (safe) reserves so that even though the money multiplier fell by more than in the Depression, the quantity of money actually increased! The 2008-2009 recession (like all recessions) will also serve as a learning experience for economists and policymakers. Perhaps our learning from this recent recession will lead to advances in economics and policy that will make future recessions milder and shorter, as has been the trend since the Great Depression.

USING EYE ON YOUR LIFE 

Fiscal Policy and Monetary Policy and How They Affect You

In motivating this “Eye on Your Life” it might be useful to talk about how and why people are likely to view inflation and recession differently in terms of their seriousness. President Truman was once asked what the difference is between a recession and a depression and his quick-witted answer was “a recession is when your neighbor doesn’t have a job, a depression is when you don’t have a job”. He meant this jokingly but the statement resonates at some level if you reflect on the simple fact that we are more likely to be concerned about economic issues that directly affect us personally even though other economic issues may be affecting other people even more acutely and are no less important. Individual assessments about the relative importance of economic issues are deeply influenced by personal circumstances.

339

340

Part 5 . UNDERSTANDING THE MACROECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT 

Questions

 Checkpoint 20.1 The Federal Budget and Fiscal Policy 1. It is often fashionable to blame Congress for large deficits and congratulate it when there are large surpluses. In what way is this blaming and congratulating somewhat unfounded?  Checkpoint 20.2 The Federal Reserve and Monetary Policy 2. In September, 2006 the overall CPI fell by 0.5 percent but the core CPI edged higher just enough to make inflation a concern. What is the Fed’s most likely response to a situation like this one? Will the Fed tighten or ease? Explain the Fed’s action and its consequences for real GDP and the inflation rate. 3.

If the inflation rate rises, what effect will the Fed’s decision to not change the federal funds rate have on the U.S. economy? If the economy slips into recession, what effect will the Fed’s no-change decision have on the economy?



Answers

 Checkpoint 20.1 The Federal Budget and Fiscal Policy 1. It is somewhat unfounded because Congress does not have direct control over the entire size of the deficit or surplus. The reason is that even though Congress can control government spending and tax rates, it does not have direct control over the state of the economy. So as the economy moves into recession, the government will incur larger deficits (smaller surpluses) even with no action of its own. The reason is that tax revenue will fall because income decreases. The same is true during an economic expansion. As the economy expands, tax revenue rises.  Checkpoint 20.2 The Federal Reserve and Monetary Policy 2. The Fed is more concerned with the core inflation rate than the overall inflation rate. The core inflation rate edged up enough to make inflation a concern. This result suggests that the Fed might be concerned about inflation increasing. If the Fed is concerned that inflation will rise, the Fed will respond by raising the federal funds rate. In this case, aggregate demand decreases. Real GDP decreases and the price level as well as the inflation rate fall. 3.

If the inflation rate increases, then the Fed’s decision to not cut the federal funds rate looks good. If the Fed had cut the federal funds rate, eventually the price level would have responded by rising more than otherwise, which would have aggravated the problem with inflation. However, if the econo-

Chapter 20 . Fiscal Policy and Monetary Policy

my slips into a recession, then the Fed’s decision looks bad. By not cutting the federal funds rate, the Fed will not have taken action that could have helped offset the problem of rising unemployment.

341