SOLUTIONS MANUAL For Economics (Micro+Macro) Fourth Canadian Edition. Glenn Hubbard Anthony Patrick by StudyGuide

Part 1: Microeconomics Contents Chapter 1: Economics: Foundations and Models.................................................

Chapter 2: Trade-offs, Comparative Advantage, and the Market System .......

Chapter 3: Where Prices Come From: The Interaction of Supply and Demand

Chapter 4: Economic Efficiency, Government Price Setting, and Taxes ...........

Chapter 5: Externalities, Environmental Policy, and Public Goods .....................

Chapter 6: Elasticity: The Responsiveness of Demand and Supply.....................

Chapter 7: Comparative Advantage and the Gains from International Trade

Chapter 8: Consumer Choice and Behavioural Economics ...............................

Chapter 9: Technology, Production, and Costs ....................................................

Chapter 10: Firms in Perfectly Competitive Markets ............................................. 110 Chapter 11: Monopolistic Competition: The Competitive Model in a More Realistic Setting ........................................................................................................... 127 Chapter 12: Oligopoly: Firms in Less Competitive Markets................................... 141 Chapter 13: Monopoly and Competition Policy ................................................... 151 Chapter 14: The Markets for Labour and Other Factors of Production .............. 167 Chapter 15: Public Choice, Taxes, and the Distribution of Income .................... 183

CHAPTER 1 | Economics: Foundations and Models SOLUTIONS TO END-OF-CHAPTER EXERCISES 1.1

Three Key Economic Ideas Learning Objective: Explain these three key economic ideas: People are rational; people respond to incentives; and optimal decisions are made at the margin.

Review Questions 1.1 “People are rational” is the assumption that decision makers explicitly or implicitly weigh the benefits

and costs of each action and then choose an action only if the benefits are expected to outweigh the costs. “People respond to incentives” means that consumers and firms consistently respond to economic incentives. “Optimal decisions are made at the margin” means that most decisions are not “all or nothing” but involve doing a little more or a little less of an activity. Therefore, the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.

1.2 Scarcity is the situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices consumers, business managers, and government officials make to attain their goals. Scarcity is central to the study of economics because scarcity requires people to make choices about how to use their resources to best fulfill their wants.

Problems and Applications 1.3 As noted in the chapter, the economic incentive to banks is clear—it is less costly to put up with bank

robberies than to take these additional security measures. The marginal cost of adding the additional security is greater than the expected marginal benefit.

1.4 a. Students face scarcity of time, like everyone else, and respond to the incentives of the teacher’s grading system. Students have more incentive to direct their efforts into the parts of the course that have the most weight in the grading system. b. Too little weight on outside readings or the like gives students little incentive to read and master the material. Students will put less effort into the parts of the course that have little effect on their grades. c. Quizzes over assigned readings would give students an incentive to come to class having read the upcoming material. Some teachers give preparation assignments where students have to read and answer questions about the upcoming material, and over the course of the semester students have to successfully complete a certain percentage of the preparation assignments to qualify for an A, or B, or other grade in the course. 1.5 The carbon price and the subsequent increase in the price of gasoline (and other carbon-intensive products) will encourage people to use less gasoline. If people respond to the negative incentive of higher gas prices by using less gas, maybe by taking the bus or buying a more fuel-efficient car, we will emit fewer greenhouse gases and do less damage to the environment. Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models

1.6 a. In deciding whether or not to go to the gym on a specific day, most people aren’t comparing the benefits of an active lifestyle and the cost of the gym membership. They’re comparing what they stand to miss out on and the relatively small benefit any single workout will have on their overall health. By implementing a simple payment system, the researchers increase the benefit of a small number of trips to the gym. Further thought: The benefits of going to the gym tend to materialize over a long time after the decision to go to the gym is made. Some of those benefits will be received years into the future. By offering cash payments in the relatively near term, the researchers offer a benefit that can be received in the same time frame as the costs of going to the gym are paid. b. Those who do not respond to the monetary incentive to go to the gym clearly value their other options more than the health benefits and monetary reward received by going to the gym. Consider a student who is working to pay for their education. The payment received by going to the gym is likely less than the payment received by going to work. In short, the incentive isn’t big enough.

1.7 Jill is correct. The difference between the grade before and after watching an extra episode is exactly the same as knowing the change in the grade.

1.8 Your friend is failing to think at the margin. It doesn’t matter how much time your friend has already

spent studying psychology. What matters is the marginal benefit to be received from studying psychology relative to the marginal cost, where cost is measured as the opportunity cost of lower grades in other subjects. If the course is required to graduate, that may raise the marginal benefit associated with completing the course.

The Economic Problems All Societies Must Solve 1.2 Learning Objective: Discuss how a society answers these three key economic questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Review Questions 2.1 Scarcity implies that every society and every individual faces trade-offs because wants are unlimited, but the ability to satisfy those wants is limited. Societies and individuals cannot have everything they want, so they have to make choices about what to have and what not to have.

2.2 The three economic questions that every society must answer are: (1) What goods and services will

be produced? (2) How will the goods and services be produced? (3) Who will receive the goods and services produced? In a centrally planned economy, the government makes most of these decisions. In a pure market economy, almost all these decisions are made by the decentralized interaction of households and firms in markets. In a mixed economy, most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role in the allocation of resources.

2.3 Productive efficiency occurs when a good or service is produced at the lowest possible cost. Allocative efficiency means that what is produced reflects consumer preferences—every good or service is produced up to the point at which the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

CHAPTER 1 | Economics: Foundations and Models

2.4 Efficiency is concerned with producing the goods and services that people want at the lowest cost. Equity is “fairness,” a concept that can differ from person to person. Government policymakers often want to make economic outcomes “fairer,” but doing so usually involves redistributing income from one group to another. Redistributing income usually (but not always) hampers efficiency because it reduces incentives to produce and drives up production costs.

Problems and Applications 2.5 Yes, even Bill Gates faces scarcity because his wants exceed his resources. First, Gates has established a foundation with billions of dollars to spend on worthy causes like eradicating malaria and reducing homelessness. However, there are an unlimited number of worthy causes that Gates can fund, so even he faces scarcity. Second, even Gates has only 24 hours in a day, so he must make choices about how to spend his scarce time. Everyone faces scarcity, because human desires are virtually unlimited. Because the world’s resources are limited, the only way not to face scarcity would be to reduce your wants to be fewer than what your resources can accomplish.

2.6 a. It is doubtful that centrally planned economies have been less efficient purely by chance. The

underlying reason seems to be that centrally planned economies don’t provide as strong incentives for hard work and innovation as market economies do. In addition, the people running centrally planned economies cannot make the most efficient decisions because they don’t have the information that is in the minds of all the decentralized decision makers in a market economy.

b. You might still prefer having a centrally planned economy if you considered it to be more equitable. (Also, you might prefer a centrally planned economy if you were in charge.)

2.7 A complete explanation for the connection between majoring in economics and succeeding in business

or government leadership would involve many factors. But we can say that economics teaches us how to look at the trade-offs involved in every decision we make. Those who cannot understand the costs of an action and weigh them against its benefits are unlikely to make good decisions. Climbing the corporate or governmental ladder requires making a wider and wider array of such decisions.

2.8 a. The groups of students most likely to try to get the tickets will be those for whom the expected marginal benefit of going to the athletic department’s office on Monday morning is greater than the expected marginal cost. These would include students who have a relatively low opportunity cost of their time, such as those who have no Monday-morning classes. Other students who are likely to stand in line are those who would have a large benefit from getting the tickets: those who love hockey and those who hope to sell their tickets (“scalpers”). b. The major opportunity cost of distributing the tickets this way is the cost to those students who attempt to get the tickets: the costs of missing out on the activities that cannot be done while standing in line, and the costs to those people who try to get tickets but don’t arrive soon enough to do so. There’s also the cost of the lost revenue to the college from giving away the tickets instead of selling them. c. This isn’t an efficient way to distribute the tickets because it wastes a lot of time. It would be more efficient to sell the tickets to those willing to pay the highest prices. d. Equity is hard to define. Some people will see this way of distributing tickets as equitable because students with low incomes can still get tickets, provided they are willing to pay the opportunity cost of waiting in line. Some people will see this way of distributing the tickets as equitable because only those with the greatest desire to watch the game in person will put up with the hassle of getting the tickets. Some people might argue that this system is equitable because students are more deserving than non-student recipients of the tickets. Others may disagree, saying that people with a strong desire to obtain the tickets, but who are unable to be at the athletic Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models department’s office at the designated time, would have no chance to get the tickets. Still others could argue that the system is not equitable because no revenue is received for the tickets— revenue that could be used to cover some of the costs of administering the university’s athletic programs.

1.3

Economic Models Learning Objective: Understand what economic models are and aren’t, and why they are a good idea.

Review Questions 3.1 Economists use models for the same reason that any other scientist (and indeed everyone else) does— to make a complicated world simple enough that it can be understood and analyzed, so that questions about it can be usefully answered. Useful models will generate testable predictions. If these predictions are consistent with economic data, then the model isn’t rejected and can be used to understand the economy. Testing models with data can be very difficult, however, because the economy is always changing, and it is difficult to conduct controlled economic experiments. 3.2 In arriving at a useful economic model, these five steps are followed: (1) decide the assumptions to be used; (2) formulate a testable hypothesis; (3) use economic data to test the hypothesis; (4) revise the model if it fails to explain the economic data; and (5) retain the revised model to help answer similar economic questions in the future. 3.3 Positive economic analysis concerns what is; that is, it deals with how the economy actually behaves. Normative economic analysis concerns what ought to be. Economics is mainly concerned with positive analysis—conceptualizing and measuring the costs and benefits of different courses of action. Decision makers (including voters and government officials) can use the trade-offs and costs and benefits identified by positive economic analysis in normatively deciding what course of action should be taken.

Problems and Applications 3.4 The economist should revise the model in light of its failure to explain or predict real-world events. 3.5 The problem with Dr. Strangelove’s theory is that it cannot be tested unless we can devise a way to measure the emission of these subatomic particles, which seems to be impossible because they don’t exist in our universe. Because we cannot test the model’s predictions, it is not very useful to us; even though it might be true, we have no way of knowing. 3.6 The positive elements of debate would be the costs of the policy (people who were harmed and how much they were harmed) and the benefits of the policy (people who were made better off and how much better off they were). The economic data that would be most useful would be to identify those who are unemployed due (largely) to the increase in the minimum wage and to identify those who are able to enjoy the improved income resulting from increased wages. Understanding the number and nature of those who lose and those who gain can help us understand the positive side of the issue. Unfortunately, this data will not resolve the normative side of the data debate, as the normative side of the debate requires people to make an assessment of which group is more important.

CHAPTER 1 | Economics: Foundations and Models

3.7 a. Tim Hortons and other coffee shops will likely respond to the reduction in the amount of coffee available by increasing the price they charge their customers. b. Centrally planned economies tend to deal with shortages in two different ways. First, when goods are scarce in centrally planned economies, the central planning committee rations the scarce resource by either issuing a small share to each person or restricting the amount any one person is allowed to buy at a time. Second, consumers are often required to wait in long lines to get the scarce goods. By requiring that someone wait in line for hours in order to receive their ration of coffee, central planners are effectively raising the cost of coffee to consumers—some consumers will choose to give up their coffee rather than wait in line. 3.8. a. and c. are positive statements; b. and d. are normative statements.

1.4

Microeconomics and Macroeconomics Learning Objective: Distinguish between microeconomics and macroeconomics.

Review Questions 4.1 Microeconomics is the study of how households and firms make choices, how they interact in specific markets, and how the government influences their choices. Micro means small, and microeconomics deals with individual decision makers. Macroeconomics is the study of the economy as a whole. Macro means large, and macroeconomics deals with economy-wide outcomes, such as the inflation rate, the unemployment rate, and the economic growth rate. 4.2 No, because many economic situations have both a microeconomic and a macroeconomic aspect. For example, the level of total consumption spending by households helps to determine how fast the economy grows—which is a macroeconomic issue. But to understand the amount of consumption spending by households, we have to analyze the incentives and constraints individual households face—which is a microeconomic issue.

Problems and Applications 4.3 a. and d. are microeconomic issues; b. and c. are macroeconomic issues. 4.4 You should disagree with the assertion. Microeconomics deals with individual decision makers, while macroeconomics deals with economy-wide outcomes. Because the unemployment rate in any one city would be an issue for the economy of the entire city and not an individual, it is a macroeconomic issue rather than a microeconomic issue. The effect of an increase in the taxes on alcohol on underage drinking concerns underage individuals who drink alcohol, so it is a microeconomic issue rather than a macroeconomic issue.

Suggestions for Critical Thinking Exercises CT1.1 Clearly, answers to this question will vary substantially and will depend on the background of the student. The main point is not correctness but to help students connect the chapter to their prior knowledge. This is difficult for an instructor to evaluate. By connecting to their prior knowledge, students should be able to learn this topic more deeply. Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models

CT1.2 The key here is what incentive(s) you need to put in place to encourage yourself and your team to train harder or more often. Also, keep in mind that this article suggests that the training is already in progress, so it is also about additional training, or marginal analysis. Simply put, what can you do to make sure you train for an extra hour or session, or to make sure you work a little bit harder in your next previously scheduled training session?

SOLUTIONS TO CHAPTER 1 APPENDIX A-1

Using Graphs and Formulas Learning Objective: Review the use of graphs and formulas

Problems and Applications 1A.1 a. The relationship is negative because as price decreases, the quantity of pies purchased increases. b.

The slope = ∆y/∆x = rise/run = −1/1 = –1.

CHAPTER 1 | Economics: Foundations and Models

1A.2

1A.3

Answers will vary somewhat depending on the values determined from the time-series graph. The calculations below use Ford sales rounded to the nearest million as shown in the table below. Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Ford’s Auto Sales (in millions of dollars) 6.8 6.6 6.6 5.4 4.9 5.5 5.7 5.7 6.3 6.3 6.6 6.7 Percentage Change [(6.6 – 6.8)/6.8] × 100 = −2.9% [(6.6 – 6.6)/6.6] × 100 = 0.0% [(5.4 – 6.6)/6.6] × 100 = −18.2% [(4.9 – 5.4)/5.4] × 100 = −9.3% [(5.5 – 4.9)/4.9] × 100 = 12.2% [(5.7 – 5.5)/5.5] × 100 = 3.6% [(5.7 – 5.7)/5.7] × 100 = 0.0% [(6.3 – 5.7)/5.7] × 100 = 10.5% [(6.3 – 6.3)/6.3] × 100 = 0.0% [(6.6 – 6.3)/6.3] × 100 = 4.8% [(6.7 – 6.6)/6.6] × 100 = 1.5%

We can conclude that sales fell at the highest rate in 2008.

CHAPTER 1 | Economics: Foundations and Models

1A.4

Percentage change in real GDP: [($16 397 billion − $15 982 billion)/$15 982 billion] × 100 = 2.6% The percentage change in real GDP from one year to the next is the economy’s growth rate.

1A.5 a.

b. At $2.50 per bottle, the total revenue equals rectangles A + B = $250 000 (because $2.50 × 100 000 = $250 000). At $1.25 per bottle, the total revenue equals rectangles B + C = $250 000 (because $1.25 × 200 000 = $250 000). 1A.6

The triangle’s area = 0.5 × 60 000 × $0.75 = $22 500.

1A.7

The slope is calculated using the formula: = Slope

∆ y Rise Change in value on the vertical axis = = . Change in value on the horizontal axis ∆ x Run

At point A: rise = 300 − 175 = 125, run = 7 − 5 = 2. Therefore, the slope = 125/2 = 62.5. At point B: rise = 900 − 700 = 200, run = 14 – 12 = 2. Therefore, the slope = 200/2 = 100.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System SOLUTIONS TO END-OF-CHAPTER EXERCISES Production Possibilities Frontiers and Opportunity Costs 2.1 Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.

Review Questions 1.1 Scarcity is the situation in which wants exceed the limited resources available to fulfill those wants. There are some things that are available in such abundance that they exceed our wants. For example, for most people there is enough oxygen in the atmosphere that the amount they want to inhale would not exceed the available amount—so oxygen isn’t scarce for them. Another example might be something undesirable, such as weeds in your garden—unlike tomato plants, the number of weeds available exceeds the number you desire. 1.2 The production possibilities frontier (PPF) is a curve showing all the attainable combinations of two products that may be produced with available resources and existing technology. Combinations of goods that are on the frontier are efficient because all available resources are being fully utilized, and the fewest possible resources are being used to produce a given amount of output. Points inside the production possibilities frontier are inefficient, because the maximum output is not being obtained from the available resources. A production possibilities frontier will shift outward (to the right) if more resources become available for making the products or if technology improves so that firms can produce more output with the same amount of inputs. 1.3 Increasing marginal opportunity costs means that as more and more of a product is made, the opportunity cost of making each additional unit rises. It occurs because the first units of a good are made with the resources that are best suited for making that good, but as more and more of the product is made, resources must be used that are better suited for producing something else. Increasing marginal opportunity costs implies that the production possibilities frontier is bowed out—the slope gets steeper and steeper as you move down the production possibilities frontier.

Problems and Applications 1.4 a. The production possibilities frontiers in the figure are bowed to the right from the origin because of increasing marginal opportunity costs. The drought causes the production possibilities frontier to shift to the left (see the graph part (b)). b. The genetic modifications would shift the maximum soybean production to the right (doubling it), but not the maximum cotton production.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

1.5 Increased size will decrease range, as shown in the figure below. Trade-offs can be between physical goods, such as cotton and soybeans in Problem 1.4, or between less tangible features, such as size and range.

1.6 You would still have an opportunity cost represented by the next best use of your time.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 11 1.7 a.

If you spend all five hours studying for your economics exam, you will score a 95 on the exam; therefore, your production possibilities frontier will intersect the vertical axis at 95. If you devote all five hours to studying for your chemistry exam, you will score a 91 on the exam; therefore, your production possibilities frontier will intersect the horizontal axis at 91. b. The points for choices C and D can be plotted using information from the table. Moving from choice C to choice D increases your chemistry score by four points but lowers your economics score by four points. Therefore, the opportunity cost of increasing your chemistry score by four points is the four-point decline in your economics score. c. Choice A might be sensible if the marginal benefits of doing well on the chemistry exam are low relative to the marginal benefits of doing well on the economics exam—for example, if the chemistry exam is only a small portion of your grade but the economics exam is a large portion of your grade; or if you are majoring in economics and don’t care much about chemistry; or if you have already achieved an A in chemistry but want the economics professor to replace your low exam grade in economics with this exam grade. 1.8 Your report should focus on the opportunity costs of spending more money on research to find a cure for heart disease. While heart disease kills thousands of Canadians every year, you need to consider what else could be done with the government resources your minister is considering spending. These same resources could be spent on preventative programs, promotion of the arts, road maintenance, or other things. You also need to consider the impact the additional spending is likely to have on heart disease treatments. These factors make many government decisions very difficult to make. 1.9 The government should consider whether the costs involved in either of the two programs exceed the benefits received from the programs. If the government decides that the costs of Sport A exceed its benefits, it may decide that the funds would be better spent on Sport B. Sport A will allow four more students to participate than Sport B, but at an extra cost of $812.5 per participant. Although this would be a difficult trade-off to consider, spending less—even though four fewer students can participate— would save resources that could be used for other purposes.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

Comparative Advantage and Trade 2.2 Learning Objective: Understand comparative advantage and explain how it is the basis for trade.

Review Questions 2.1 Absolute advantage is the ability to produce more of a good or service than competitors using the same amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than competitors. It is possible to have a comparative advantage in producing a good even if someone else has an absolute advantage in producing that good (and every other good). Unless the two producers have exactly the same opportunity costs of producing two goods—that is, the same trade-off between the two goods—one producer will have a comparative advantage in making one of the goods and the other producer will have a comparative advantage in making the other good. 2.2 The basis for trade is comparative advantage. If each party specializes in making the product for which it has the comparative advantage, they can arrange a trade that makes both of them better off. Each party will be able to obtain the product made by its trading partner at a lower opportunity cost than without trade.

Problems and Applications 2.3 In Figure 2.4 the opportunity cost of 1 kilogram of apples is 1 kilogram of cherries to you and 2 kilograms of cherries to your neighbour. Any price of apples between 1 and 2 kilograms of cherries will be a fair trading price, and because 10 kilograms of apples for 15 kilograms of cherries is the same as 1 kilogram of apples for 1.5 kilograms of cherries, it falls within this range. We could take any other value in this range to complete the table. Let’s take, for example, 1.25 kilograms of cherries per kilogram of apples. We will keep the kilograms of apples traded as before at 10. The completed table will now be as follows: Summary of the Gains from Trade You Production and consumption without trade Production with trade Consumption with trade Gains from trade (increased consumption)

Your Neighbour

Apples (kilograms)

Cherries (kilograms)

Apples (kilograms)

Cherries (kilograms)

8 20

9 0

12 0 10 × 1.25 = 12.5

42 60 60 − 12.5 = 47.5

12.5 − 12 = 0.5

47.5 − 42 = 5.5

Note: Both you and your neighbour are better off after trade than before trade. Also, this rate of trading cherries for apples is better for your neighbour than the original rate of trading and worse for you.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 13 2.4 a. Canada has a comparative advantage in making lumberjack boots. Canada’s opportunity cost of making one boot is giving up one shirt. In the United States, the opportunity cost of making one boot is giving up three shirts. The United States has a comparative advantage in making shirts. In the United States, the opportunity cost of making one shirt is giving up one-third boot, but Canada’s opportunity cost of making one shirt is one boot. b. Neither country has an absolute advantage in making both goods. The United States has an absolute advantage in making shirts, but Canada has an absolute advantage in making boots. Remember, both countries have the same amount of resources. If each country puts all of its resources into making shirts, then the United States makes 12 shirts, but Canada makes only 6 shirts. If each country puts all of its resources into making boots, then Canada makes 6 boots, but the United States makes only 4 boots. c. If each country specializes in the production of the good in which it has a comparative advantage and then trades with the other country, both will be better off. Let’s use the case in which each country trades half of what it makes for half of what the other makes. The United States will specialize by making 12 shirts and Canada will specialize by making 6 boots. Because each gets half of the other’s production, they both end up with 6 shirts and 3 boots. They are better off than before trading because they end up with the same number of boots but twice as many shirts. Other trades will also make them better off. 2.5 Yes, Canada can still benefit from trade with developing countries like Vietnam, despite Canada having an absolute advantage in all goods. Vietnam will still have a comparative advantage in some goods, typically goods that are labour-intensive to produce (such as clothes), so Canada can specialize in goods in which it has a comparative advantage and Vietnam can do the same. After trade, both Canada and Vietnam will both be better off. 2.6 a. When France produces one more bottle of wine, it produces two fewer kilograms of schnitzel. When Germany produces one more bottle of wine, it produces three fewer kilograms of schnitzel. Therefore, France’s opportunity cost of producing wine—two kilograms of schnitzel—is lower than Germany’s—three kilograms of schnitzel. When Germany produces one more kilogram of schnitzel, it produces 0.33 fewer bottles of wine. When France produces one more kilogram of schnitzel, it produces 0.50 fewer bottles of wine. Therefore, Germany’s opportunity cost of producing schnitzel —0.33 bottles of wine—is lower than that of France—0.50 bottles of wine. We can conclude that France has the comparative advantage in making wine and that Germany has the comparative advantage in making schnitzel. b. We know that France should specialize where it has a comparative advantage and Germany should specialize where it has a comparative advantage. If both countries specialize, France will make four bottles of wine and zero kilograms of schnitzel, and Germany will make zero bottles of wine and fifteen kilograms of schnitzel. After both countries specialize, France could then trade three bottles of wine to Germany in exchange for seven kilograms of schnitzel. This will give France the same amount of wine as they initially had but an extra one kilogram of schnitzel. Germany will have three bottles of wine and eight kilograms of schnitzel—that is, the same amount of wine but more schnitzel. Other mutually beneficial trades are possible as well. 2.7 An individual or a country cannot produce beyond its production possibilities frontier. The production possibilities frontier shows the most that an individual or country can produce for a given amount of resources and technology. Without trade, an individual or country cannot consume beyond its production possibilities frontier, but with specialization and trade, an individual or country can consume beyond its production possibilities frontier. In Figure 2.5, both you and your neighbour were

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System able to consume beyond your production possibilities frontiers, and in Solved Problem 2.2, both Canada and the United States were able to consume beyond their production possibilities frontiers.

2.8 Colombia could have a comparative advantage in producing coffee if Nicaragua has an even larger absolute advantage relative to Colombia at producing another product. Say Nicaragua can produce four times more cashews than Colombia can using the same resources. Then Colombia will have a comparative advantage in producing coffee. 2.9 Specialization and trade are about standard of living, not jobs. In both cases, individuals and countries have jobs. You have a job if you produce everything yourself and do not trade with others, and you have a job if you specialize and trade with others. But your standard of living will be higher if you specialize and trade. 2.10 Importing only products that cannot be produced here would result in Canada producing—rather than importing—many goods for which it does not have a comparative advantage. These products would be produced at a higher opportunity cost than if they had been imported.

2.3

The Market System Learning Objective: Explain the basic idea of how a market system works.

Review Questions 3.1 A circular-flow diagram illustrates how participants in markets are linked. It shows that in factor markets, households supply labour and other factors of production in exchange for wages and other payments from firms. In product markets, households use the payments they earn in factor markets to purchase the goods and services produced by firms. 3.2 The two main categories of market participants are households and firms. Households as consumers are of greatest importance in determining what goods and services are produced. Firms make a profit only when they produce goods and services valued by consumers. Therefore, only the goods and services that consumers are willing and able to purchase are produced. 3.3 A free market is one with few government restrictions on how goods or services can be produced or sold, or on how factors of production can be employed. Economic decisions are made by buyers and sellers in the market. In a centrally planned economy, the government—rather than households and firms—makes almost all the economic decisions. Free market economies have a much better track record of providing people with rising standards of living. 3.4 Private property rights are the rights that individuals or firms have to the exclusive use of their property, including the right to buy or sell it. If individuals and firms believe that property rights are not well enforced, they will be reluctant to risk their wealth by opening new businesses. Therefore, the enforcement of property rights and contracts is vital for the functioning of the economy. Independent courts are crucial because property rights and contracts will be enforced only if judges make impartial decisions based on the law rather than decisions that favour powerful or politically connected individuals.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 15

Problems and Applications 3.5 a. An auto purchase takes place in the product market. The household (George) demands the good and the firm (Toyota) supplies the good. b. The labour market is a factor market. Households supply labour and the firm demands labour. c. The labour market is a factor market. The household (George) supplies the factor of production (labour), while the firm (McDonald’s) demands it. d. The land market is a factor market. The household (George) supplies the factor of production (land) and the firm (McDonald’s) demands it. 3.6 Adam Smith was making the “invisible hand” argument that, in pursuing their self-interest, business people end up producing the goods and services most desired by consumers. 3.7 Adam Smith realized—as economists today realize—that people’s motives can be complex. But in analyzing people in the act of buying and selling, economists have concluded that in most instances, the motivation of financial reward provides the best explanation for the actions people take. Moreover, being self-interested—looking out for your own well-being and happiness—and being selfish—caring only about yourself—are not exactly the same thing. Many successful business people are, in fact, generous: donating to charity, volunteering for activities, and otherwise acting in a generous way. This is not inconsistent with making business decisions that maximize profits for their companies. 3.8 a. “Psychic rewards” refers to the psychological benefits of, in this case, buying lottery tickets, which provide the excitement of playing the lottery and the chance of winning big. b. An entrepreneur might receive the psychic rewards of creating and running their own business along with the chance of making large profits. c. Answers will vary here. Elements of being an entrepreneur do appear to be similar to buying a lottery ticket, with the psychic rewards of playing the game along with the possibility of large returns. Other elements may differ, such as the probability of success. 3.9 Weak property rights force resource owners to spend additional resources defending their property and/or reduce the incentive to invest in ways to make their property more productive and valuable. Finally, weak property rights make it very difficult for someone to use the property as collateral for a loan to start or expand a business.

Suggestions for Critical Thinking Exercises CT2.1

There are very few (if any) companies that make things without purchasing inputs from others. We couldn’t think of any. This is a great illustration of comparative advantage. Companies are able to specialize in what they do well (have a comparative advantage) and make gains from trade.

CT2.2. Most economists would consider this method of production highly inefficient. This person is not exploiting any specialization that would increase their productivity. Even adding just one more person would create opportunities for specialization and the large gains that accompany it. Such gains are one of the advantages a group has over individuals.

CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand SOLUTIONS TO END-OF-CHAPTER EXERCISES 3.1

The Demand Side of the Market Learning Objective: Discuss the variables that influence demand.

Review Questions 1.1 A demand schedule is a table showing the relationship between the price of a product and the quantity of the product demanded. A demand curve is a curve that shows the relationship between the price of a product and the quantity of the product demanded. 1.2 Ceteris paribus means “all else equal”—that is, holding everything else constant when examining the relationship between two variables. 1.3 A “change in demand” refers to a shift of the demand curve, while a “change in quantity demanded” refers to a movement along the demand curve as a result of a change in the product’s price. 1.4 The law of demand states that, holding all else constant, when the price of a product falls, the quantity demanded of the product will increase (and when the price of a product rises, the quantity demanded of the product will decrease). An increase in the price of a product raises the price of the product relative to other products, causing consumers to substitute away from the higher-priced product. The increase in the price of the product also causes a decrease in the real incomes of consumers and, assuming that the product is a normal good, leads consumers to buy less of the product. 1.5 The main variables that will cause a demand curve to shift include (1) changes in the prices of related goods—substitutes or complements, (2) changes in income, (3) changes in tastes, (4) changes in population or demographics, and (5) changes in expected future prices. Examples of substitute goods are Coca-Cola and Pepsi, and examples of complementary goods are hot dogs and hot dog buns. The impact of a change in income depends on the nature of the good: normal or inferior. An example of a normal good may be a name brand product, like Coca-Cola. An example of an inferior good may be a store brand product, like PC Cola. An example of a change in tastes would be the increasing popularity of organic produce. An example of a change in population or demographics would be an increase in the number of people over the age of 65 leading to an increase in the demand for health care services. An example of a change in expected future prices would be the prices of hybrid vehicles expected to come down in the future, causing today’s demand to decrease.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 17

Problems and Applications 1.6 a. Substitutes b. Complements c. Probably unrelated d. Substitutes 1.7 Assuming that premium bottled water and carbonated soft drinks are substitutes, then a tax on soft drinks will increase the price of soft drinks and increase the demand for premium bottled water. 1.8 a. Because the price of a substitute good has declined, the demand curve for Quarter Pounders will shift to the left from D1 to D2 in the following graph.

b. The coupon results in a cut in the price of Quarter Pounders, so there will be a movement down the demand curve for Quarter Pounders in the following graph.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply c. Because for many people Quarter Pounders and french fries are complements, an increase in the price of french fries will shift the demand curve for Quarter Pounders to the left from D1 to D2 in the following graph.

d. If McDonald’s made this switch, it would expect there to be an increase in the demand for Quarter Pounders (demand would shift from D1 to D3 in the following graph), but until the switch is made the effect on the demand for Quarter Pounders is uncertain.

e. The demand curve for Quarter Pounders will shift. If Quarter Pounders are an inferior good, the demand curve will shift to the left from D1 to D2 in the following graph. If Quarter Pounders are a normal good, the demand curve will shift to the right from D1 to D3.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 19

1.9 The demand for Allbirds shoes decreased from 2019 to 2020, which could be caused by the following: a decrease in the price of leather shoes, which are a complementary good (Allbirds shoes are made from wool and other plant materials); a decrease in national income assuming Allbirds shoes are normal goods; a decrease in the taste (preference) for Allbirds shoes as a result of a campaign against using wool; or any other factors decreasing demand. 1.10 The student’s reasoning is flawed. Whether a good is normal or inferior depends on how your demand changes when your income changes. If this person were to buy less lobster when their income increased, then they’d be correct. Just because you don’t like something doesn’t make it an inferior good. 1.11 a. Music downloads, SAT test prep services, text messaging services b. Diapers, developmental toys, child-care services c. English language courses, prepaid phone cards, foreign-language newspapers 1.12 The data does not indicate that the demand curve for Priuses is upward sloping. It is likely that factors such as income, fuel prices, and the prices of other hybrid vehicles have changed during these three years. Therefore, the data is likely to represent points from three different demand curves. 1.13 As given by the reporter, Posner’s statement confuses a change in demand and a change in quantity demanded. The reduction in the cost of books—the price of books—will increase the quantity demanded of books. It will not cause the demand curve to shift outward. 1.14 a. Factors that have caused a decline in sales of carbonated beverages include the following: increases in demand for substitutes, such as bottled water; health concerns among consumers regarding sugar and other ingredients found in carbonated beverages; and increases in taxes on sugary drinks. It is likely that these factors will continue to affect demand for carbonated beverages in the future. b. Sales of bottled water might decline during a recession because consumers can use tap water as a substitute for bottled water. Because the price of premium bottled water is higher than the price of regular bottled water, sales of premium bottled water are likely to decline more than regular bottled water during a recession.

3.2

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

The Supply Side of the Market Learning Objective: Discuss the variables that influence supply.

Review Questions 2.1 A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve is a curve that shows the relationship between the price of a product and the quantity of the product supplied. 2.2. A “change in supply” refers to a shift of the supply curve, while a “change in quantity supplied” refers to a movement along the supply curve as a result of a change in the product’s price. 2.3 The law of supply states that, holding everything else constant, an increase in price causes an increase in the quantity supplied (and a decrease in price causes a decrease in the quantity supplied). The main variables that will cause a supply curve to shift include (1) changes in the prices of inputs used to make the product, (2) technological change, (3) changes in the prices of substitutes in production (other things that the producers could be making), (4) changes in expected future prices, and (5) changes in the number of firms. An example of a change in price of input used would be if the price of hybrid engines increases, the supply of hybrid cars will decrease. An example of technological change would be an improvement in the technology of producing iPhones leading to an increase in the supply of iPhones. An example of changes in the prices of substitutes in production would be if Sony is producing both plasma and LED flat-screen televisions, and the price of LED televisions increases, the supply of plasma televisions will decrease. An example of changes in expected future prices would be if Toyota believes that the price of the Prius hybrid will increase in the future, it will decrease supply today and increase it in the future. An example of changes in the number of firms would be as more firms enter the flat-screen television market, the supply of flat-screen televisions will increase.

Problems and Applications 2.4

a. Change in quantity supplied: A movement up the supply curve. b. Change in supply: The supply curve shifts to the right. c. Change in demand: The demand curve shifts to the left.

2.5 The supply of Allbirds shoes decreased from 2021 to 2022. The supply decrease could be caused by an increase in the price of wool (or any other material used in the production of these shoes) or an increase in the price of the machines used to assemble the shoes, an increase in the price of other types of shoes that the makers of Allbirds could produce, or any of the other factors identified in the text. 2.6 Not necessarily. Firms may have different costs of producing tablet computers and, therefore, supply different quantities at the same price. 2.7 The increase in the quantity supplied is likely to be larger the longer the time period being considered. Over time, new firms can enter the market and existing firms can better adjust their mix of products by increasing the quantity they supply of the good whose price has increased.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 21

3.3

Market Equilibrium: Putting Buyers and Sellers Together Learning Objective: Use a graph to illustrate market equilibrium.

Review Questions 3.1 Market equilibrium is the situation in which the quantity demanded equals the quantity supplied. 3.2 A shortage is a situation in which the quantity demanded is greater than the quantity supplied, and a surplus is a situation in which the quantity demanded is less than the quantity supplied. 3.3 If the current price is above equilibrium, the quantity supplied will be greater than the quantity demanded, and there will be a surplus. A surplus causes the market price to fall toward equilibrium. If the current price is below equilibrium, the quantity demanded will be greater than the quantity supplied, and there will be a shortage. A shortage causes the market price to rise toward equilibrium.

Problems and Applications 3.4 You should disagree. If there is a shortage, firms will raise the prices they charge. The quantity supplied will increase, the quantity demanded will decrease, and equilibrium will be reached at a higher price. 3.5 Begin by drawing two demand curves. Label one “Demand for diamonds” and the other “Demand for water.” Make sure that the water demand curve is much farther to the right than the diamond demand curve. Based on the demand curves you have just drawn, think about how it might be possible for the market price of water to be lower than the market price of diamonds. The only way this can be true is if the supply of water is much greater than the supply of diamonds. Draw on your graph a supply curve for water and a supply curve for diamonds that will result in an equilibrium price of diamonds that is much higher than the equilibrium price of water.

3.6 No. It only means that those willing to pay the equilibrium price received the goods. They would have been happier paying less. And there are likely to be consumers who want the good but are not willing (or able) to pay the market price. Similarly, on the supply side, sellers would be happier to receive a higher price than the equilibrium price, and there may be sellers who are only willing to sell at a higher price and, therefore, do not participate in the market.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

3.7 a. A supply chain is a series of processes or steps in a production process involved in the production and distribution of good, often involving several different firms. A breakdown in the supply chain suggests reduction in supply at every given price so that at the prior equilibrium price quantity demanded will exceed quantity supplied. b. The reduced supply will put upward pressure on prices, causing the equilibrium price to rise. c. The rising prices will make empty shelves less likely. As prices rise, all else equal, quantity demanded will fall until the price has risen sufficiently to cause quantity demanded to be equal to quantity supplied.

The Effect of Demand and Supply Shifts on Equilibrium 3.4 Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

Review Questions 4.1 When the demand curve shifts to the right, the equilibrium price and equilibrium quantity both rise. The first graph that follows illustrates this case. When the supply curve shifts to the left, the equilibrium price rises, but the equilibrium quantity falls. The second graph that follows illustrates this case.

4.2 If the demand curve shifts to the right more than the supply curve does, the equilibrium price will rise. Figure 3.11(a) illustrates this case. If the supply curve shifts to the right more than the demand curve, the equilibrium price will fall. Figure 3.11(b) illustrates this case.

Problems and Applications 4.3 You should agree. The increase in demand for athletic shoes would cause the demand curve to shift to the right along an unchanged supply curve. By itself, this shift in the demand curve would result in an increase in the price of athletic shoes. But an increase in the number of firms producing athletic shoes would result in an increase in supply—the supply curve will shift to the right—and a lower price—if demand remained unchanged. The relative size of the shift of the demand curve and the supply curve will determine whether the equilibrium price rises or falls. The following graph illustrates this

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 23 uncertainty. For a given increase in demand—from D1 to D2—an increase in supply from S1 to S2 results in an increase in the equilibrium price from P1 to P2, but an increase in supply from S1 to S3 results in a decrease in the equilibrium price from P1 to P3.

4.4

c. The falling demand for renewable diesel means the price of a substitute in the production for cooking oil falls. As a result of a decrease of the price of a substitute in production, the supply curve for the product in question shifts to the right. Thus, if the price of renewable diesel falls, the supply of cooking oil will shift to the right. 4.5 Because demand is falling, and the exit of some smaller firms will cause supply to fall, the equilibrium quantity will definitely decrease. You cannot tell for certain if the new equilibrium price will be higher or lower than the old equilibrium price. If the decrease in demand is greater than the decrease in supply, the new equilibrium price will be lower. If the decrease in demand is less than the decrease in supply (as is shown on the graph), the new equilibrium price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.6 a. The following graph illustrates an increase in the demand for coffee from D1 to D2 due to the millennials’ “unquenchable thirst” for coffee. The supply curve shifts to the left from S1 to S2 as the result of dry weather in Brazil and Asia. The shifts in demand and supply would each increase the equilibrium price of coffee, but an increase in demand by itself would increase the equilibrium quantity while a decrease in supply by itself would cause the equilibrium quantity to decrease. The graph shows that the equilibrium quantity of coffee will increase from Q1 to Q2 if the increase in demand is greater than the decrease in supply.

b. The quantity of coffee sold over time is a result of changes in both demand and supply. The quantity of coffee sold can increase due to an increase in supply even if demand hasn’t increased. 4.7 Draw a demand and supply graph showing the market equilibrium in the winter, label both the demand and supply curves “winter,” and label the equilibrium price created by these curves as “winter.” Add to your graph the demand curve for summer, making sure it is to the right of the winter demand curve. Look at the graph to see how the equilibrium price in the summer could be lower than the equilibrium price you have established for the winter. The only way for this to happen is for the summer supply

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 25 curve to shift to the right by enough to cause the equilibrium price to be lower in the summer than it is in the winter. The demand for watermelons does increase in the summer compared with in the winter, but the increase in the supply of watermelons in the summer is even greater, so the equilibrium price falls.

4.8 The demand will be greater if the season is moved, and therefore price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.9 The student’s analysis is correct. The decrease in demand will decrease the equilibrium price and the equilibrium quantity. The increase in supply will decrease the equilibrium price and increase the equilibrium quantity. The equilibrium price, therefore, will definitely decrease, but the equilibrium quantity could increase or decrease, depending on which change is larger—the decrease in demand or the increase in supply. The graph shows changes in demand and supply of equal magnitude, so the equilibrium quantity does not change.

4.10 The student’s reasoning is incorrect. He should have said, “Increased production leads to a lower price, which increases the quantity demanded. There is a movement along the demand curve, but the demand curve does not shift.” 4.11 The student’s analysis is incorrect—the shift from D1 to D2 will not happen. There will be a movement along the demand curve, D1, due to the price change, but the demand curve will not shift. 4.12 a. Scenario a. is shown in Graph 1. The demand for premium bottled water rises because a decrease in the supply of sports drinks will increase the price of sports drinks, which are substitutes for premium bottled water. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. b. Scenario b. is shown in Graph 4. The demand for premium bottled water falls when incomes fall, assuming premium bottled water is a normal good. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. c. Scenario c. is shown in Graph 3. An improvement in technology reduces the cost of producing premium bottled water and shifts the supply curve for premium bottled water to the right. d. Scenario d. is shown in Graph 2. A rise in an input’s price shifts the supply curve for premium bottled water to the left.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 27

4.13 The rising costs will cause the supply curve to shift to the left, from S1 to S2, while the improvement in quality will cause the demand curve to shift to the right from D1 to D2. Because we don’t know if the demand curve shifts to the right more than the supply curve shifts to the left, we don’t know if the equilibrium quantity purchased will increase or decrease. If the shift in the supply curve is greater, as shown in the figure, the equilibrium quantity will fall. We do know that the equilibrium price of childcare services will rise as a result of the regulation.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.14 The graph with the vertical demand curve is more likely to represent the market for the cancer-fighting drug. If the price of this good rises, patients are unlikely to reduce the quantity they demand, but if the price of the BMW rises, households will reduce the quantity they demand as they switch to buying other luxury cars.

Suggestions for Critical Thinking Exercises CT3.1 Students often have more difficulty with supply as they’re generally on the demand side of most markets. By working together, they will see this and better understand the topic as they talk to each other and describe what they find to be most difficult. CT3.2 It should be a market. Students are likely to have difficulty picking the appropriate theoretical representation of data. Students may also have a problem with this question as they are presented with data and asked what they represent, the type of question they are not used to addressing. CT3.3 The order would be (i) an external (or exogenous) event, (ii) a curve shifting, and (iii) a new equilibrium. Students sometimes have difficulty integrating these separate pieces in the correct order.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 29

SOLUTIONS TO CHAPTER 3 APPENDIX A-1

Quantitative Demand and Supply Analysis Learning Objective: Use quantitative demand and supply analysis.

Review Question 3A.1 The intercept of a demand curve identifies the price at which quantity demanded of the good is zero. This is the price at or above which no one will be willing to purchase the good. The intercept of a supply curve identifies the price at which producers will begin to supply the good. This is the price at or below which no firms will be willing to sell the good.

Problems and Applications 3A.2

a. W = 10; L = 60 b. W = 12; L = 72

3A.3

a. P = 50; Q = 100 b. P = 62.5; Q = 75 c. P = 50; Q = 50

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes SOLUTIONS TO END-OF-CHAPTER EXERCISES Consumer Surplus and Producer Surplus 4.1 Learning Objective: Distinguish between the concepts of consumer surplus and producer surplus.

Review Questions 1.1 Marginal benefit is the additional benefit to a consumer from consuming one more unit of a good or service. The demand curve shows consumers’ willingness to pay for a product. The amount that they are willing to pay for one more unit will equal the extra benefit they will receive from consuming it; therefore, the demand curve equals the marginal benefit curve for consumers. 1.2 Marginal cost is the additional cost to a firm of producing one more unit of a good or service. Supply curves show the willingness of firms to supply a product at different prices. The willingness to supply a product depends on the cost of producing it. The lowest price a firm is willing to accept is the additional cost of making an additional unit of the good; therefore, the supply curve equals the marginal cost curve. 1.3 Consumer surplus is the difference between the highest price a consumer is willing to pay and the price the consumer actually pays. As the equilibrium price falls, consumer surplus grows both because the gap between the willingness to pay and the price grows and because consumers purchase a larger quantity. As the price rises, consumer surplus shrinks. 1.4 Producer surplus is the difference between the lowest price a firm would have been willing to accept and the price it actually receives. As the equilibrium price of the good rises, producer surplus rises. As the price falls, producer surplus falls.

Problems and Applications 1.5 The drought causes the supply curve for wheat in the following graph to shift from S1 to S2. Because the drought will cause the equilibrium price to increase and the equilibrium quantity to decrease, consumer surplus will decrease. Before the decline in supply caused by the drought, consumer surplus was equal to areas A + B + C + D. After the drought, consumer surplus is equal to area A. Price increases, but quantity decreases, so the effect on producer surplus is uncertain. Before the drought, producer surplus was equal to areas E + F + G. After the drought, producer surplus is equal to the areas B + E. If the value of area B is less than the value of area F + G, then producer surplus will be decreased by the drought.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

1.6 The argument is incorrect. The price of the last unit sold equals the willingness of consumers to pay, but on all previous units the willingness of consumers to pay exceeds the equilibrium price, and so there is consumer surplus. 1.7 Consumer surplus equals the total benefit consumers receive from consuming a product minus the price consumers pay for the number of units purchased. Total benefit measures the benefits consumers receive from purchasing the product, without subtracting the amount consumers pay for the product. Consumer surplus would equal total benefit if the price of the product were zero. Producer surplus equals the total revenue firms receive from selling a product minus the cost to firms of producing the amount sold. Total revenue equals the revenue obtained from selling the product, without subtracting the cost to firms of producing the good. The producer surplus would equal total revenue if the marginal cost of production were zero. 1.8 A vertical demand curve implies that there is no limit to the price consumers are willing to pay, resulting in an infinite consumer surplus. In the markets we have studied up to this point, consumer surplus was always finite. 1.9 The producer surplus in this market is a rectangle rather than a triangle (as is typical in most markets). The producer surplus equals P × 15 000, so all of the revenue is producer surplus because the marginal cost of supplying the concert is zero. 1.10 Total consumer surplus for items bought on eBay is likely to be higher than it would have been if the items had been purchased for fixed prices in retail stores. With an online auction, the winning bid is often lower than the price in a retail store—otherwise, the bidder would presumably have bought the good in a retail store rather than on eBay. 1.11 Consumer surplus is the difference between the highest price Melanie was willing to pay and the actual price she paid for the coat. We know that Melanie was willing to pay $79.95, but we don’t know if this was the maximum price she was willing to pay. The value of her consumer surplus is at least $15.99 but could be greater than this amount. 1.12 If Mr. Lindsay knew what the Uber ride would cost and chose to take it anyway, we can only conclude that he valued the ride at more than the $1000+ he paid for it. If he didn’t know that the ride would cost more than $1000—say, if he expected to pay the $125.08 of a regular fare, he very well could have ended up with negative consumer surplus.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

The Efficiency of Competitive Markets 4.2 Learning Objective: Understand the concept of economic efficiency. Review Questions 2.1 Economic surplus is the sum of consumer surplus and producer surplus. Deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium. 2.2 Economic efficiency occurs when the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and where the sum of consumer surplus and producer surplus is maximized. Economists define efficiency this way because it is the best measure we have of the benefit to society from the production of a particular good or service.

Problems and Applications 2.3 You should disagree. A price that is lower than the equilibrium price decreases economic efficiency in the market. Suppliers decrease the quantity supplied, and the marginal benefit exceeds the marginal cost of an additional unit of the good. 2.4 You should disagree. If marginal cost exceeds marginal benefit, reducing output would increase economic surplus. So there must be a deadweight loss when marginal cost exceeds marginal benefit. 2.5 Assuming no illicit market, when the price is P1, instead of P0, consumer surplus changes from an amount equal to the sum of areas A and C to an amount equal to the sum of areas A and B. Producer surplus decreases from the area B + D + E to area E. At competitive equilibrium (P0), there is no deadweight loss. At the price P1, there is a deadweight loss equal to the sum of areas C and D.

2.6 You should disagree. Consumer surplus may increase at the same time producer surplus increases if an economy moves toward greater economic efficiency. The increased consumer surplus may be due to a decrease in deadweight loss. Also, consumer surplus and producer surplus would both increase if there was an increase in demand, ceteris paribus.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

2.7 No. A rightward shift of the supply curve or the demand curve can increase economic surplus even if we started from an efficient point. So, economic surplus will have increased even though economic efficiency is unchanged. 2.8 At Q1, marginal benefit is greater than the marginal cost, so increasing output would increase economic surplus. At Q3, marginal cost is greater than marginal benefit, so reducing output would increase economic surplus. 2.9 You should disagree. The first part of the statement is correct, but second part is incorrect. If marginal cost is greater than marginal benefit, reducing output would increase economic surplus. So, there must be a deadweight loss when marginal cost is greater than marginal benefit. 2.10 In the following graph, at the initial equilibrium price, P1, and quantity, Q1, consumer surplus equals the area ABP1 and producer surplus equals the area P1BD. Economic surplus equals consumer surplus plus producer surplus and is represented by the area ABD. The new hormone-free beef and plant-based burgers increases their cost, so the supply curve shifts from S1 to S2. Consumers’ reaction to the new products causes the demand curve to shift from D1 to D2. At the new equilibrium price, P2, and quantity, Q2, consumer surplus equals the area BCP2 and producer surplus equals the area P2CE. Economic surplus equals the area BCE. As drawn in the graph, the area BCE is larger than the area ABD, so economic surplus has increased. But if we had drawn the supply curve shifting to the left by a larger amount and the demand curve shifting to the right by a smaller amount, then economic surplus would have decreased. Therefore, we can conclude that we can’t determine whether economic surplus will increase or decrease without knowing how much demand and supply actually change.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

Government Intervention in the Market: Price Floors and Price Ceilings 4.3 Learning Objective: Explain the economic effect of government-imposed price floors and price ceilings.

Review Questions 3.1 Some consumers gain from price controls because they can buy the product at a lower price, but other consumers are hurt by price controls because shortages mean they are unable to buy the product. 3.2 Producers tend to favour price floors that are set above the equilibrium price, but only if producer surplus rises—as would be the case when the price rises a lot but the quantity sold doesn’t fall much. Producers don’t like price ceilings that are set below the equilibrium price because the quantity sold and the price received by producers both fall, shrinking producer surplus. 3.3 Economic analysis will show the trade-offs involved from imposing price ceilings and price floors, but it won’t provide a final answer to the appropriateness of the policy because people differ about the goals of such policies. Some people may have the goal of maximizing economic surplus, for example, but others may care mostly about the well-being of certain consumers or producers and be less concerned about the well-being of other consumers or producers. 3.4 An illicit market is one in which buyers and sellers violate government price regulations. An illicit market will arise if there are gains to some buyers and some sellers from violating a price floor or price ceiling.

Problems and Applications 3.5 a. 28 million crates b. A surplus of 6 million crates c. The apple producers will benefit. Their revenue will increase from $8 × 30 000 000 = $240 000 000 to $10 × 28 000 000 = $280 000 000. 3.6

a. PE is the competitive equilibrium price. PF is the price floor. Q1 is the quantity sold in a competitive equilibrium. Q2 is the quantity sold with the price floor.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

b. Economic surplus without a price floor = A + B + C + D + E. Economic surplus with price floor = A + B + D. 3.7 Whether the government should provide dependable income to dairy farmers is a normative judgment. Government officials are likely to use price supports and purchase the surplus of dairy products or provide financial incentives for dairy farmers to restrict supply. Whether government officials should use regulations to try to provide dependable income to every business is another normative judgment. The role of the economist is to indicate the effect of such policies on economic surplus (consumer plus producer surplus). It seems likely, though, that the government’s using price regulations to provide dependable incomes to every business would result in the market system no longer functioning. For a market system to function properly, most prices must be free to adjust to changes in demand and supply. 3.8

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

3.9 a. Price = $20, Quantity = 33 300 b. Price = $30, Quantity = 26 640 c. With no license requirement, consumer surplus = A + B + C, and producer surplus = D + E + F. Consumer surplus = ½(10 × 26 640) + (10 × 26 640) + ½(10 × 6360) = $431 400. Producer surplus = (10 × 26 640) + ½(10 × 6360) + ½(10 × 26 640) = $431 400. d. With the license requirement, consumer surplus = A, producer surplus = B + D + F, and deadweight loss = C + E. The consumer surplus = ½(10 × 26 640) = 133 200. The producer surplus = (10 × 26 640) + (10 × 6640) + ½(10 × 26 640) = $466 000. The deadweight loss = ½(10 × 6640) + ½(10 × 6640) = $66 400. 3.10 a. In the absence of rent control, the equilibrium price is $800 and the equilibrium quantity is 300 000. In this case, every renter who is willing to pay the market price of $800 will find an apartment and every landlord willing to accept the market price of $800 will find a renter. The demand and supply curves are shown in the figure, along with the equilibrium price (PE) and quantity (QE). b. At a price ceiling of $600, the quantity demanded is 350 000 but the quantity supplied is only 250 000, so there is a shortage of 100 000 apartments. c. If all landlords abide by the law, the quantity sold will fall to 250 000. As shown in the figure, consumer surplus with the price ceiling enforced is A + C, producer surplus is E, and deadweight loss is B + D.

d. If landlords supply only 250 000 apartments and ignore the price ceiling, they can charge $1000. $1000 is the highest rent that consumers are willing to pay to rent 250 000 apartments.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

3.11 The first sentence of the student’s argument is correct. The second sentence is incorrect. A price ceiling increases the quantity that consumers demand, but because it also reduces the quantity that sellers supply, it reduces the amount of the product that consumers are actually able to buy. In the graph that follows, without a price ceiling, consumers buy Q1, but with a price ceiling consumers buy only Q2.

3.12 a. The demand for hotel rooms, as shown in the figure below, increases during the Stampede. If prices for rooms are not allowed to rise above P0, which is the equilibrium price during weeks without the Stampede, during Stampede week there will be a shortage of hotel rooms equal to QD minus QS.

b. Out-of-town Stampede goers will have trouble finding a hotel room. They will have to try to secure hotel rooms far in advance, secure hotel rooms in neighbouring communities, or not attend. c. Over time, the supply of hotel rooms will most likely decline. With lower prices of hotel rooms reducing economic profits, some hotels will exit the industry. The exit of hotels makes the shortage of hotel rooms during the Stampede more severe. d. Ski resorts and vacation spots face peak seasons. Laws limiting the prices hotels can charge during peak seasons would decrease the quantity of hotel rooms available and, therefore, the number of tourists visiting these communities and spending money on local businesses. Copyright © 2024 Pearson Canada Inc.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

3.13 Renters who cannot rent apartments in Woburn will look for apartments in Peabody. This will shift the demand curve in Peabody from D1 to D2, which will cause an increase in both equilibrium quantity and price in the market for apartments in Peabody.

3.14 a. Someone currently renting an apartment in Lowell will probably be better off, unless the landlord decides to remove the apartment from the market. b. Someone who will be moving to Lowell next year and who intends to rent an apartment will probably be worse off because of likely difficulty in finding a vacant apartment. c. A landlord who intends to abide by the rent control law will probably be worse off because of being unable to charge the competitive rent for apartments. d. A landlord who intends to ignore the law and illegally charge the highest rent possible for his apartments will probably be better off because he will be able to charge a higher rent than he would have been able to before the rent control law was passed. However, he may end up worse off if he gets caught and the penalty is large. 3.15 a. After the decrease in supply, with no price ceiling, the equilibrium price would be $2.00 and the equilibrium quantity would be 40 million litres. With a price ceiling of $1.50 and no illicit market, the price will be $1.50, the quantity demanded will be 45 million litres, and the quantity supplied will be 30 million litres, resulting in a shortage of 15 million litres.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

b. Consumer surplus = A + B + C, producer surplus = D, and deadweight loss = E + F.

Consumers are willing to pay, at most, $3.00 for the last litre of gasoline suppliers are willing to supply at a price ceiling of $1.50. Consumer surplus = A, producer surplus = B + C + D, and deadweight loss = E + F.

d. Assuming there is no illicit market, some consumers are made better off by the price ceiling as they can purchase gas at a lower price than they otherwise could. However, some consumers will not be able to find gas at a price of $1.50 and will be worse off. Consumer surplus without the price ceiling is A + B + E, but with the price ceiling it would be A + B + C. (C is larger than E. The area of E is ½ × 10 000 000 × $1.00 = $5 000 000, while the area of C is $0.50 × 30 000 000 = $15 000 000.) 3.16 a.

By legalizing the buying and selling of organs, the price would begin to rise, and the quantity supplied would also rise. As a result, the shortage of organs could be eliminated. However, by making the sale of kidneys legal, some members of society who are less educated or less wellinformed might end up selling their kidneys even if it was not in their long-run best interest. There may be other solutions that would avoid the ethical problems of making kidney sales legal. Some economists, including Alvin Roth of Harvard University, have helped set up a kidney exchange that matches compatible kidney donors and recipients. Copyright © 2024 Pearson Canada Inc.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

The Economic Impact of Taxes 4.4 Learning Objective: Analyze the economic impact of taxes. Review Questions 4.1 Tax incidence refers to the actual division of the burden of a tax between buyers and sellers in a market. 4.2 A tax is efficient if it imposes a small excess burden (deadweight loss) relative to the tax revenue it raises. 4.3 The person who officially sends the tax revenue to the government need not be the one who actually bears the burden of the tax. For most taxes, the seller sends the money to the government, but buyers and sellers both pay part of the tax. The share paid by each depends on the slopes of the supply and demand curves and not on who is officially responsible for sending the tax to the government. 4.4 In market equilibrium, the marginal benefit to consumers equals the marginal cost of production of the last unit produced. A tax shifts the supply curve up vertically by the amount of the tax and leads to a lower equilibrium quantity. At this lower quantity, the marginal benefit to consumers exceeds the marginal cost of production of the last unit produced. The deadweight loss is the reduction in units of output where the marginal benefit to consumers exceeds the marginal cost of production.

Problems and Applications 4.5

The deadweight loss is equal to ½ × (10 million − 9 million) × ($5.20 − $4.70) = $500 000. The tax revenue received by the government is equal to ($5.20 − $4.70) × 9 million = $4.5 million.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

4.6 a. The tax is $1.25 per pack. b. Producers receive $3.25 per pack. c. The government receives tax revenues of $1.25 × 18 billion = $22.5 billion a year. 4.7 a. The demand curve for gasoline would not shift down (it would, but you wouldn’t be able to tell). The supply curve wouldn’t change. b. The equilibrium price received by suppliers wouldn’t change. c. The price paid by consumers would be $1.55. 4.8 In most cases it is easier to collect the tax from sellers. There are fewer sellers than buyers, and it is easier to make sure that taxes are paid. 4.9 a. The sum of areas D and G represent the excess burden (deadweight loss) of the tax. b. The revenue collected by the government from the tax equals the amount of the tax (the vertical distance between S1 and S2) times the quantity sold after the tax is imposed (Q2), which equals the sum of areas B, C, E, and F. c. The efficiency of the tax is measured by the excess burden of the tax (the sum of areas D and G) relative to the tax revenue the tax raises (the sum of areas B, C, E, and F). This ratio of the excess burden to the tax revenue would have to be compared to the ratio of the excess burden to the tax revenue for other taxes to determine whether the tax on cannabis is considered efficient. 4.10 This reasoning is incorrect. The demand curve for pizzas slopes downward, and the supply curve slopes upward, just as in other industries. So, as shown in the following figure, the tax will be split between the buyers and sellers. The tax shifts the supply curve up from S1 to S2. The price paid by the buyers increases from PE to PB, while the after-tax price received by the suppliers decreases from PE to PS. PB − $1 = PS.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes

Suggestions for Critical Thinking Exercises CT4.1 Students may not think of efficiency as economists do. They might think of efficiency in terms of low prices for consumers. This question is designed to get them to think about how what they’ve learned compares to their preexisting thinking to make what they’re learned more salient. CT4.2 After the price ceiling is removed, the marginal benefit and marginal cost of apartments should be equal. The student would need to describe this in everyday words instead of just parroting the terms from the text or the class. CT4.3 There would have to be a price floor for there to be a surplus. It might be difficult for students to recognize the correct concept from all of those found in this chapter.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods SOLUTIONS TO END-OF-CHAPTER EXERCISES Externalities and Economic Efficiency 5.1 Learning Objective: Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

Review Questions 1.1 An externality is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Examples of positive externalities include the benefits received by a passerby who enjoys a beautiful garden and the benefits from a postsecondary education that go to one’s children, grandchildren, co-workers, or complete strangers. Examples of negative externalities include the noise from a loud party or from a jetliner and the pollution emitted by a factory. 1.2 The private cost of producing a good will differ from the social cost when there is an externality. For example, the private cost of producing electricity includes the costs of the fuel and of running the power plant, but the social cost also adds the costs of the pollution emitted (a negative externality), which can reduce visibility and cause health problems. The private benefit of consuming a good differs from the social benefit when there is an externality. For example, the private benefit from your postsecondary education includes your enjoyment of the experience and the increase in income you’ll receive as a graduate, but the social benefits add the benefits to third parties (a positive externality), such as your potential co-workers’ improved productivity because you know more or the gains to people who receive more services from the government because you earn more and pay more taxes. 1.3 Market failure is the failure of the market to produce the efficient level of output. Externalities, public goods, and common resources all cause market failure (as does monopoly, which will be covered in a later chapter). 1.4 Economic efficiency occurs when the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and where the sum of consumer surplus and producer surplus is maximized. Externalities generally reduce economic efficiency because buyers and firms ignore the external cost or benefit, which leads firms to either produce more than the efficient quantity of the good if there is an external cost or produce less than the efficient quantity of the good if there is an external benefit. 1.5 Externalities generally arise because of incomplete property rights or from difficulty in enforcing property rights.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Problems and Applications 1.6 Under these circumstances, consumption of Tim Hortons’ coffee causes a small negative externality. These types of externalities also exist on highways, particularly at rush hour, when your decision to drive on the highway causes other motorists to take slightly longer to complete their trips. Governments sometimes deal with traffic externalities by charging higher tolls during peak commuting hours. Governments are unlikely to intervene to relieve congestion in lines at Tim Hortons, because the people being inconvenienced by you are also Tim Hortons’ customers, the firm is in the best position to decide how best to deal with congestion in its stores. 1.7 The neighbour’s barking dog serves as a positive externality when it makes you aware of or prevents a dangerous situation like a thief going into your house. The barking dog serves as a negative externality when it barks at almost anything and disturbs you. 1.8 The smell of decaying fish or other potential food sources attracts bears. Disposing of fish offal near campsites or other places where people gather makes it more likely that bears will end up in contact with humans. The more often bears come in contact with humans, the more likely is an attack. There is a clear negative externality for other campers as your actions increase the likelihood they will be attacked by a bear. The negative externality for the bears is that the more contact bears have with humans, the less able they are to survive in the wild, and bears that have attacked humans are almost always destroyed. 1.9 a. A positive externality arises from getting the flu shot because people in addition to the person getting the shot receive benefits. b. Because a positive externality arises from getting a flu shot, the efficient quantity (QEfficient) and price (PEfficient) are found by locating where the demand curve representing marginal social benefit (D2) and the market supply curve intersect. The gray shaded area represents the deadweight loss.

1.10 The efficient amount of alcohol consumption is Q2, but because the negative externality is ignored, actual consumption is Q1. The deadweight loss is area A.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

1.11 By market failures, JunJie Wu means that an unregulated market will result in more than the economically efficient amount of farmland being developed for other uses, such as shopping malls or residential housing. Inefficient land allocation refers to the conversion of farmland into developed land. Because the market fails to take into account the external cost of lost farmland, an inefficiently large quantity of land (Q1) is developed. The efficient level of land development is Q2, which is determined by the intersection of Demand and S2.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Private Solutions to Externalities: The Coase Theorem 5.2 Learning Objective: Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.

Review Questions 2.1 The economically efficient level of pollution is the quantity at which the marginal cost of eliminating another unit just equals the marginal benefit from eliminating it. The economically efficient quantity of pollution isn’t zero in most cases. Eliminating all pollution would incur costs that are greater than the benefits. 2.2 The Coase theorem argues that if transactions costs are low or zero, private bargaining will result in an efficient solution to the problem of externalities. Parties involved in an externality have an incentive to reach an efficient solution because the benefits from reducing an externality are often greater than the costs. 2.3 Transactions costs are the costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. Private solutions to the problem of externalities are most likely when it is easy to define and enforce property rights and when the costs of making a deal are low.

Problems and Applications 2.4 An increase in pollution could make society better off if the current level of pollution is below the efficient quantity. For example, government restrictions could be so stringent that they require pollution reductions to level A in the figure. The marginal costs of the last unit of pollution reduction exceed the marginal benefit, so society would be better off if pollution reduction was only level B— the efficient quantity.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

2.5 Yes, assuming that the marginal benefit does not drop to zero before all of that type of pollution is eliminated. 2.6 Although there would be health benefits of reducing pollution further, it is not clear that the government should take action to do so. Remember that if the marginal benefit of reducing air pollution is greater than the marginal cost, further reductions will make society better off. But if the marginal cost of reducing air pollution is greater than the marginal benefit, reducing air pollution will actually make society worse off. The government needs to quantify the marginal cost and the marginal benefit of a further reduction in air pollution and take steps to reduce air pollution further only if the marginal benefit exceeds the marginal cost. 2.7 If the group affected by the air pollution offered the steel plant an amount to curtail production that was equal to or greater than the marginal cost of the air pollution, it would be in the interest of the steel plant to internalize the cost of the air pollution. The amount offered to curtail each unit of production would be an opportunity cost (because the steel plant would lose the funds if it did not curtail production) and would become part of the steel plant’s marginal cost of production. The property right to clean air does not need to be assigned to the victims of air pollution to get the steel plant to reduce pollution. As just noted, if the steel plant has the property right, but the victims offer the plant an amount at least equal to the marginal cost of the air pollution, then the plant will internalize the cost of the air pollution. 2.8 It seems likely that private agreements will result in something close to the efficient quantities of apple trees and beehives. We know that private agreements are detailed and enforceable so it is likely that the externalities can be internalized successfully. The transactions costs involved in negotiating the agreements may result in the efficient quantities of apple trees and beehives not being attained exactly. 2.9 The marginal cost of reducing crime would include resources devoted to police, courts, and prisons. The marginal benefit from reducing crime would include the reduction in losses to crime victims, including losses due to personal injury, stolen goods, and anxiety. The marginal benefit from reducing murders and armed robberies is very high, but the marginal benefit from reducing littering is much lower. As with pollution, it would not be economically efficient to reduce the amount of crime to zero. In other words, there is an economically efficient level of crime where the marginal benefit from crime reduction equals the marginal cost. 2.10 The policy is not likely to be economically efficient. Although the benefit to her community from reducing the amount of illegal drug traffic from its (apparently) currently high levels would be substantial, at some point the additional benefit from reducing illegal drug use would likely be less than the additional cost. 2.11 The airline policy does not make it impossible to achieve an economically efficient outcome with respect to reclining seats. The Coase theorem is the argument that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. Before an airline passenger reclines their seat, they may ask for permission from the person seated behind. If the second passenger objects to the first passenger reclining their seat, a compromise could be reached; for example, a partial recline or a complete recline for only part of the flight. Or the second passenger could make a payment to the first passenger in exchange for the first passenger agreeing not to recline their seat.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Government Policies to Deal with Externalities 5.3 Learning Objective: Analyze government policies to achieve economic efficiency in a market with an externality.

Review Questions 3.1 A Pigovian tax or subsidy aims to bring about an efficient level of output in the presence of externalities. The tax is set equal to the marginal external cost, which is the difference between the marginal social cost and the marginal private cost. The subsidy is set equal to the marginal external benefit, which is the difference between the marginal social benefit and the marginal private benefit. 3.2 To internalize an externality means that the producer or consumer that creates the externality bears or receives the cost or benefit of the externality. A tax equal to the cost of a negative externality will cause producers to internalize the negative externality, and a subsidy equal to the benefit of a positive externality will cause consumers to internalize a positive externality. A private solution along the lines of the Coase theorem would also internalize an externality. 3.3 Most economists prefer tradable emissions allowances because they allow pollution to be reduced at the lowest cost. The firm that can reduce pollution cheaply will do so and sell its right to emit pollution to another firm whose costs of reducing pollution are high. The command-and-control approach is generally much costlier, because it often forces firms to adopt expensive methods of pollution control.

Problems and Applications 3.4 Consuming fruits and vegetables has a positive externality to the extent that such consumption decreases medical expenses. Whether the government should subsidize the consumption of fruits and vegetables is complicated in that the people who consume fruits and vegetables may live long and receive more social payments (CPP, OAS, etc.) and may end up costing the health care system even more. 3.5 The production of antibiotics creates a positive externality to the extent that the value of new antibiotics for society exceeds the returns the antibiotics provide to the drug companies. Whether every firm producing a good with a positive externality should receive a subsidy depends partly on how large the positive externality is. The positive externality would need to be larger than the transactions cost or administrative cost of using a subsidy to cause firms to internalize the externality. 3.6 The negative externality causes a deadweight loss of area A where the marginal benefit is less than the marginal social cost of output from QEfficient to QMarket. A Pigovian tax equal to the cost of the negative externality per unit of output would internalize to the firm the cost of the externality. The supply curve would shift from S1 to S2, and output would decrease to QEfficient. A positive externality causes a deadweight loss of area B where the marginal social benefit is greater than the marginal cost of output from QMarket to QEfficient. A Pigovian subsidy equal to the benefit of the positive externality per unit of output would internalize to the consumer the benefit of the externality. The demand curve would shift from D1 to D2, and output would increase to QEfficient.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

3.7 a. The privately optimal level of consumption and production is found by equating demand and supply, 100 – Q = 3Q => 100 = 4Q => Q = 25 b. The socially optimal requires that the private marginal benefit be reduced by the externality. 100 – Q – 10 = 3Q => 90 = 4Q => 22.5 = Q c.

The deadweight loss is 0.5 × 2.5 × 10 = 12.5.

3.8 The negative externality from consuming sugary pop causes a deadweight loss of area A, where the marginal cost exceeds the marginal social benefit for the quantity of pop from QEfficient to QMarket.

a. The government should not prohibit the consumption of sugary pop but should instead implement a way to get pop drinkers to internalize the negative externality. Prohibiting sugary pop would cause the equilibrium quantity to fall to zero, which is not the economically efficient level of output. b. The government could impose a tax on pop. 3.9 “Green” energy firms may provide a positive externality in the form of new technologies or discoveries that allow us to produce energy without damaging the environment. Technology is often seen as a positive externality as knowledge is partially non-excludable and definitely non-rival.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

3.10 a. Annoying people, including babies who cry on buses and planes, cause a negative externality because they impose costs on other people around them. Taxing annoying people, including the parents of the crying children, may discourage people from being annoying (or encourage parents of crying babies to find alternative methods of keeping their children quiet). However, the administrative costs of monitoring crying babies and taxing their parents would be very high. In addition, many people might oppose such a tax because it would represent a government intrusion into what is usually considered a private matter. b. People who plant flowers cause a positive externality because they provide benefits (for instance, higher property values) to other neighbourhood residents. Government subsidies may encourage more people to plant flowers, but again, the administrative costs of identifying beautiful gardens and deciding on the appropriate subsidy would be very large. c. Every negative externality should not be taxed, and every positive externality should not be subsidized. The government should compare the costs of imposing taxes and subsidies to the benefits. So, if the benefits associated with a Pigovian tax outweigh the costs, a Pigovian tax would reduce deadweight loss (and increase efficiency). In the cases discussed in parts (a) and (b) of this problem, administrative costs would likely be too high for taxes or subsidies to be an effective way of dealing with the externalities involved. 3.11 a. To the degree that the use of Uber increases the amount of traffic on the nation’s roads and increases the amounts of congestion and pollution, Uber rides would cause a negative externality. b. If the government determines that automobile traffic from any source results in negative externalities, a tax on the use of vehicles that cause the externalities could be justified. However, what Ronald Coase termed transactions costs associated with the tax could be significant. If, for example, the tax was based on the number of miles each vehicle travelled, a method of measuring distance travelled by each vehicle would have to be developed and implemented. The administrative costs of the tax would be lower from a per-litre tax on the use of gasoline. (The federal and provincial governments already impose gasoline taxes, the revenue from which is used to repair roads and highways.) 3.12 In the following graph of the market for gasoline, the equilibrium price is initially PMarket and the equilibrium quantity is QMarket. An increase in the tax on the sellers of gasoline would shift supply from S1 to S2, resulting in an efficient price of PEfficient and an efficient quantity of QEfficient. In the graph in Step 3 in Solved Problem 5.3, consumers are paying a price P, which corresponds to the price PEfficient in the graph below. So, whether the gasoline tax is imposed on the buyer or the seller, the price consumers pay for gasoline is increased to the efficient level.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

3.13 a. The problem is the externality caused by carbon emissions. If a carbon tax was set equal to the external cost of carbon emissions, private firms would have the freedom and financial incentive to use the least costly means of reducing their carbon emissions. b. The carbon tax would provide incentives for firms to develop or adapt methods of reducing their carbon emissions in order to reduce the amount of tax they need to pay. The tax could be varied over time as the costs and benefits of carbon emissions change. 3.14 a. A carbon tax would establish the external cost of a unit of carbon emission. In this sense, the tax represents the price of a unit of carbon emitted into the environment. b. Producers and consumers would pay higher prices for activities subject to the carbon tax. They would respond to higher prices for these activities as they would respond to an increase in the price of a good or service for any other reason: They will engage in less of the activities and buy more substitutes that have lower relative prices. c. Government-imposed command-and-control policies typically require firms affected by the policies to adopt the same technologies, even though costs of reducing greenhouse gases vary across firms. A carbon tax provides an incentive for the highest-cost producers to reduce their emissions to avoid paying the tax. Although most economists favour taxes and other market-based approaches over command-and-control approaches to reduce emissions of carbon dioxide, many people—including government officials—object to market-based policies giving producers what is disapprovingly called a “license to pollute.” Policymakers may favour a command-and-control approach for another reason: The cost to consumers of reducing emissions is less visible than with a carbon tax. Imposing taxes for any reason is not a popular option for elected officials. 3.15 You should disagree. The burden of the tax would fall more heavily on low-income consumers because their expenditures on energy subject to the tax would represent a greater percentage of their incomes than the percentage of income high-income consumers spend on energy-using products. Economists consider a tax for which people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes a regressive tax.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Four Categories of Goods 5.4

Learning Objective: Explain how goods can be categorized on the basis of whether they are rival or excludable and use graphs to illustrate the efficient quantities of public goods and common resources.

Review Questions 4.1 Rivalry occurs when one person’s consuming a unit of a good means that no one else can consume it. Excludability occurs when anyone who doesn’t pay for a good cannot consume it. Goods that are both rival and excludable are called private goods and comprise most of the goods we consume. Goods that are rival but non-excludable are called common resources, such as fish in the sea. Goods that are both non-rival and non-excludable are called public goods. Goods that are non-rival but excludable are called quasi-public goods. 4.2 A public good is non-rival and non-excludable. Because anyone can get it without paying for it once it has been produced—attempting to “free ride” in this manner—there is often little incentive for firms to supply the good, because they can’t cover their costs if people don’t pay for the good. Free riding will lead to market failure; less than the economically efficient amount of a public good will be produced. 4.3 The tragedy of the commons is the tendency of a common resource to be overused. It can be avoided if there is a way to block overuse. One method is to give someone or some group a property right to the resource, which would give the person or group the incentive to use it efficiently. However, this won’t work well if the person or group cannot easily enforce the property right.

Problems and Applications 4.4 a. The optimal quantity of a public good is the quantity where the public’s marginal benefit from the good—as represented by the demand curve—is equal to the marginal cost of providing the good. To solve the problem, we need to know the demand curve for the city park and the marginal cost to the town of providing acres of park land. To calculate their overall demand, we need to add the dollar amounts that Anjali and Joaquin are willing to pay for each quantity:

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

b. The marginal cost of supplying the second hectare is $13. But the demand curve tells us that the marginal benefit Anjali and Joaquin receive from the second hectare is $21. Because the marginal benefit to society is well above the marginal cost, 2 hectares cannot be the optimal size for the town park. 4.5 The tragedy of the commons arises because all people using the commons neglect the effects their use has on other users. This is similar to each person neglecting to take into account the effects on others— in the form of creating resistant microorganisms that cause hard-to-treat infections—from using antibiotics. 4.6 a. Public b. Private (You’ll be excluded if you don’t use a stamp.) c. Public d. Private 4.7 Buffalo on the Great Plains during the 1800s were a common resource (rival but not excludable) and were overharvested to near extinction. Cattle were privately owned and therefore not overharvested. 4.8 The village elders were trying to prevent the tragedy of the commons. Their solution worked quite well given the small size of the village.

Suggestions for Critical Thinking Exercises CT5.1

Hopefully, students will offer up the idea of addressing externalities with Pigovian taxes. Or, they might use the Coase theorem and the situations in which it applies. In short, this question asks students to pick something they should have learned and to apply it to a general concept.

CT 5.2 It is difficult to grade this question because it asks the student to explain what they truly believe. The answer should be graded on the quality of the argument, not its correctness.

CHAPTER 6 | Elasticity: The Responsiveness of

Demand and Supply

SOLUTIONS TO END-OF-CHAPTER EXERCISES 6.1 The Price Elasticity of Demand and Its Measurement

Learning Objective: Define and calculate the price elasticity of demand.

Review Questions 1.1 Price elasticity of demand = (percentage change in quantity demanded)/(percentage change in price). The price elasticity of demand isn’t measured by the slope of the demand curve because the slope depends on the units of measurement. For example, the slope of the demand curve will change by a factor of 100 if you measure price using cents instead of dollars. Or, consider six-packs of pop versus cans of pop. If the price drops by $1.00 per six-pack and the quantity demanded increases by two sixpacks, that is the same thing as quantity demanded increasing by 12 cans. You could calculate the slope either as −1/2 six-packs or as −1/12 cans. In addition, using percentage changes in the elasticity formula allows for meaningful comparisons of demand responsiveness between very different kinds of goods; for example, breakfast cereal versus health care. 1.2 The price elasticity of demand for Cheerios =

The demand for Cheerios is elastic because the price elasticity of demand is greater than 1 in absolute value. 1.3 In calculating the percentage change in price and quantity, the midpoint formula divides the change in price and the change in quantity by the average of their starting and ending values.

Percentage changes can also be calculated by using the starting value or the ending value without averaging. However, unlike the midpoint formula, these methods give different results depending on whether the starting or ending value is used.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

1.4 A perfectly inelastic demand curve is a vertical line, as shown at the bottom of Table 6.1. Such a good will have no substitutes. A life-saving drug is an example. Therefore, an increase in price from $30 to $40 or a decrease in price from $30 to $20 in the following graph will have no effect on the quantity demanded (Qd) of the good, which remains at 16.

Problems and Applications 1.5 If there is a 13.7 percent decrease in pop consumption in response to a 10 percent increase in price (holding everything else constant), the price elasticity of demand for pop in Chile is:

Because the price elasticity of demand is greater than 1 (in absolute value) the demand for pop is price elastic. 1.6 a. First, note that selling 6.5 times as many Tea Forté samplers means that the quantity demanded increased by 550 percent.

b. Yes. The calculation in part (a) assumes that the demand for tea samplers did not change, so the 550 percent change in the quantity of tea samplers demanded occurred as a result of the 35 percent cut in the price. If consumers’ tastes also changed as a result of the tea samplers being included among Amazon’s Cyber Monday days, then part of the 550 percent change in the quantity demand is the result of a shift of the demand curve for tea samplers and part is due to a movement along the demand curve as a result of the change in price. With this additional information, we know that the price elasticity of demand for tea samplers is smaller in absolute value than −15.7.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

1.7 a. b.

12 000 000 − 8000 000 = −4 000 000 $2.00 − $3.00 12 − 8 = −4 . This value is much smaller than the value in (a). $2.00 − $3.00

c. We can calculate the price elasticity using the midpoint formula as follows: Percentage change in quantity demanded = Percentage change in price =

12 000 000 − 8000 000 ×100 = 40% 10 000 000

$2.00 − $3.00 × 100 = −40% $2.50

So: = Notice that this value is significantly different from the values calculated in (a) and (b). 1.8 For D1: Percentage change in quantity demanded = Percentage change in price = Elasticity = For D2: Percentage change in quantity demanded = Percentage change in price = Elasticity = 1.9 At a higher price of $119, quantity demanded for Amazon Prime services will decrease, so the total revenue (price × quantity sold) will increase by less than $2 billion. Only in the very unlikely case in which the demand for the Amazon Prime services is perfectly inelastic would the business website’s analysis be correct.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

6.2

The Determinants of the Price Elasticity of Demand Learning Objective: List and explain the determinants of the price elasticity of demand.

Review Questions 2.1 The most important determinant of the price elasticity of demand is usually the availability of substitutes for the product. If there are close substitutes, elasticity will be high because people can switch to buying another good as the product’s price rises. Other factors determining the price elasticity of demand for a product include (1) the passage of time, (2) whether the good is a necessity or a luxury, (3) how narrowly the market for the good is defined, and (4) the share of the good in the consumer’s budget. 2.2 The demand for most agricultural goods is inelastic. Food is a necessity, and the demand for necessities tends to be less elastic than the demand for luxuries.

Problems and Applications 2.3 Milk (a), gasoline (c), and prescription medicine (d) are likely to be price inelastic due to the lack of substitutes, but frozen cheese pizza (b) is likely to be price elastic because it is not a necessity and has good substitutes, such as freshly prepared pizza served in restaurants. 2.4 As more competitors enter the coffee house market, consumers have more choices for coffee. As a result, the demand for coffee house services will become more price elastic. If Starbucks raises its price by 1 percent, the company will experience a larger percentage decrease in quantity demanded when it has more competitors than when it had fewer competitors. 2.5 The more narrowly a market is defined, the more elastic demand will be because there are more available substitutes. The price elasticity of Coca-Cola (or any specific brand of pop) will be higher than for pop as a product because there are more substitutes available for a specific product like CocaCola than there are for a product category such as pop.

2.6 a. With to reduce the quantity demanded by 1 percent, the change in price must be:

Solving for the percentage change in price, we get:

So, for the quantity demand to decline by 1 percent, the price must increase by 50 percent. b. We would expect the price elasticity of demand for gasoline to become larger (in absolute value) in the long run. It usually takes some time for consumers to adjust their buying habits as prices change. As time passes, consumers will be better able to find substitutes to driving their own cars, such as riding the bus or subway or carpooling. And some consumers will switch to more Copyright © 2024 Pearson Canada Inc.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply fuel-efficient vehicles, including electric cars, resulting in a larger decrease in the quantity demanded for a given increase in price.

2.7 a. We can’t know with certainty from the information given whether demand for entry into Yellowstone National Park will be elastic or inelastic. We can say, though, that a family that has driven to Yellowstone with the intention of vacationing there is probably not going to be very responsive to changes in the admission price because that price would likely make up only a small fraction of the family’s vacation budget. So, it seems likely that demand for entry from someone driving a car, minivan, or motor home will be inelastic. b. Once again, we can’t answer this question with certainty from the information given. As noted in part (a), someone arriving to Yellowstone National Park for a vacation in a private vehicle is likely to have an inelastic demand for entering the park. Someone who is entering by foot, bike, or on skis likely lives in the area or is staying close to the park. These people may have access to recreational opportunities outside of the park and so may choose not to enter if the price is too high. They are likely to have a more elastic demand for entering the park. People who arrive by motorcycle may be intending to vacation in the park, or they may be from the local area and just planning a short visit. They are likely to have a price elasticity of demand that is between the two other groups. This ordering of the groups from highest price elasticity of demand to lowest corresponds to the ordering of prices the National Park Service charges.

The Relationship between Price Elasticity of Demand and Total Revenue

6.3 Learning Objective: Explain the relationship between the price elasticity of demand and total revenue.

Review Questions 3.1 If demand for orange juice is inelastic, an increase in price will increase revenue because the price will increase proportionally more than the quantity sold will decrease. 3.2 a. The marketing analyst believes that the demand for clothes sold by these stores is price inelastic. b. If the demand for clothes is indeed price inelastic, increasing the prices of the clothes stores sell will result in an increase in the stores’ total revenue. When demand is price inelastic, a given percentage increase in price will result in a smaller percentage decrease in the quantity demanded. As a result, the stores will increase their revenue by selling a smaller quantity at a higher price.

Problems and Applications 3.3 a. If Apple’s total revenue from iPhone sales increased when the quantity decreased, the price of the iPhone must have increased. b. Because revenue increased when price increased, we can conclude that the demand for iPhones is price inelastic. 3.4 a. Because Pampers and Bounty are P&G’s most popular brands, the firm apparently believes that the demand curves for these goods are price inelastic. When a firm raises the prices of goods that have price inelastic demand, the firm’s total revenue increases. b. “Industrywide pricing moves” are price increases or decreases that are made by most firms in an industry at about the same time. In this case, the article is indicating that when P&G raises its Copyright © 2024 Pearson Canada Inc.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

prices, the other firms in the market do as well. Competitors raising their prices will make the demand for Pampers and Bounty less elastic (more inelastic) than if the competitors don’t raise their prices. Because the relative price of Pampers and Bounty compared with competing brands will remain about the same, fewer consumers are likely to switch from Pampers and Bounty to the other brands when P&G raises prices. 3.5 a. We can calculate the price elasticity along D1 between points A and C as follows: Percentage change in quantity demanded = Percentage change in price = So, the price elasticity of demand = Similarly, the price elasticity of demand along D2 between points A and B can be calculated as follows: Percentage change in quantity demanded = Percentage change in price = So, the price elasticity of demand = Because the quantity response is much larger for the same price change, demand curve D1 is much more elastic than D2. b. Along D1, revenue increases from $3 × 200 = $600 to $2.50 × 300 = $750. Revenue rises by $150 as the price is cut because this demand curve is elastic between these prices. Along D2, revenue falls from $600 to $2.50 × 225 = $562.50. Revenue falls by $37.50 as the price is cut because D2 is inelastic between these prices. 3.6 a. The article implies that Chicago previously had not been taxing pop. Therefore, enacting a $0.01per-ounce tax on pop would result in an increase in tax revenues from zero to a positive number regardless of whether the demand for pop is price elastic or price inelastic. But given that policymakers in Chicago were expecting a substantial amount of revenue to be raised from the tax, they most likely believed that the demand for pop was price inelastic. b. Because the tax generated less revenue than anticipated, the demand for pop turned out to be more elastic than policymakers had anticipated. The increase in the price of pop caused by the tax resulted in a larger decrease in quantity demanded than policymakers had expected, causing the tax revenue raised to be less than policymakers had expected. c. The city would have been more successful in discouraging pop consumption with a $0.01-perounce tax on pop if the demand for pop were more price elastic. A $0.01-per-ounce tax on pop would have generated more tax revenue for the city if the demand was more price inelastic because the tax would have discouraged fewer people from purchasing pop. The policymakers’ goals were in conflict because improving public health required having the decline in people buying pop be as large as possible, whereas raising revenue required having the decline in people buying pop be as

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply small as possible. Because policymakers repealed the tax after it failed to raise the expected revenue, it seems likely that the policymakers were more interested in raising revenue than in discouraging the consumption of pop.

3.7 Hulu assumed that the demand for its services was price elastic. Lowering the price of its streaming service was intended to raise its total revenue. Hulu dropped its prices when Netflix raised its because Hulu considers its service to be a substitute for Netflix’s streaming services. 3.8 a. The UPS CEO apparently believed that the demand for UPS’s package delivery service was inelastic. In other words, higher prices would lead to a relatively small decrease in quantity demanded for the company’s service (“large retailers have a way to spread that [price increase] across [larger sales] and nobody knows”), so higher prices would result in greater revenue from the service. The head of the consulting firm, however, assumed that demand for the delivery service was elastic since higher prices would have a much greater effect on quantity demanded (“This [price increase] is devasting to retailers.”). b. Because UPS’s price increases occurred during the COVID-19 pandemic, shoppers were using delivery services much more than they would if they were able to shop in stores without fearing they would contract the COVID-19 virus. This fact likely made the demand for UPS’s delivery service more inelastic than it was prior to the pandemic and will likely be after the pandemic.

Other Demand Elasticities

6.4 Learning Objective: Define and calculate the cross-price elasticity of demand and the income elasticity of demand and explain their determinants.

Review Questions 4.1 Cross-price elasticity of demand equals the percentage change in quantity demanded of one good divided by the percentage change in the price of another good. If the cross-price elasticity is negative, then the goods are complements. If the cross-price elasticity is positive, then the goods are substitutes. 4.2 Income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. If the income elasticity is greater than 0, then the good is normal; if the income elasticity is less than 0, then the good is inferior. Goods with income elasticities between 0 and 1 are often called necessities, and goods with income elasticities greater than 1 are often called luxuries.

Problems and Applications 4.3 a. Lettuce has the higher price elasticity because the percentage change in quantity demanded following a price increase is much larger for lettuce than for bread. b. Positive. As the price of lettuce rises, the quantity demanded of the other green vegetables rises, so they are substitutes. 4.4 a. In Chile, a cross-price elasticity of 0.25 between milk and pop indicates that pop and milk are substitutes because a cross-price elasticity that is positive implies that a higher price of pop will cause an increase in the quantity demanded of milk. A cross-price elasticity between pop and candy equal to 0 indicates that the two goods are unrelated. Changes in the price of pop do not change the

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

quantity demanded of candy. Because pop and candy are often consumed together, it is surprising that the cross-price elasticity of demand between these two goods is 0. b. If the cross-price elasticity of demand between pop and milk is 0.25, then an increase in the price of pop by 10 percent will increase the quantity demanded of milk by 2.5 percent (that is, 10% × 0.25 =2.5%). If the cross-price elasticity of demand between pop and candy is 0, then an increase in the price of pop by 10 percent will result in an increase in the quantity demanded of candy by 0 percent (that is, 10% × 0 = 0%). 4.5 To find the cross-price elasticity, divide the percentage change in the quantity demanded of buns by the percentage change in the price of hot dogs. At the initial price of buns ($1.20), the quantity demanded rises from 10 000 to 12 000, which is the change in quantity demanded that should be used. 12000 − 10000 Percentage change in the quantity demanded = × 100 = 18.2% 11000 Percentage change in the price of hot dogs = So, the cross-price elasticity = Because the cross-price elasticity of demand is negative, we know these two goods are complements. 4.6 Iced coffee and iced tea (a) and steak and chicken (c) are substitutes, so the cross-price elasticities will be positive; french fries and ketchup (b) and iPhones and Apple apps (d) are complements, so the cross-price elasticities will be negative. 4.7 The most likely order is (a) bread, (b) Pepsi, (d) laptop computers, (c) Mercedes-Benz automobiles. A normal good that is considered a necessity (such as food and clothing) has an income elasticity that is positive and less than 1. Normal goods that are considered luxuries (such as laptop computers and Mercedes-Benz automobiles) have income elasticities that are positive and greater than 1. The items are ranked from consumers who are most likely to consider them necessities to consumers who are most likely to consider them luxuries. 4.8 The more narrowly we define a market, the more price elastic demand will be. So, if data for only one brand of beer is used instead of multiple brands, demand for beer will likely be more elastic, which may not be an accurate estimate of the price elasticity for beer as a product. 4.9 During recessions, falling consumer incomes can cause firms selling luxury goods (goods with an income elasticity of demand greater than 1) to see their sales decrease the most. During recessions, falling consumer incomes can cause firms selling inferior goods (goods with an income elasticity of demand less than 0) to see their sales increase the most. Therefore, in a recession Firm C will experience the largest decline in sales of the three firms and Firm A is likely to experience the largest increase in sales.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

Using Elasticity to Analyze the Disappearing Family Farm

6.5 Learning Objective: Use price elasticity and income elasticity to analyze economic issues.

Review Questions 5.1 Increasing productivity in agriculture has brought about lower prices for food products as, over time, increases in supply have dramatically outpaced increases in demand. Because the price elasticity of demand for food is low, lower prices have not caused a large increase in quantity demanded. The increase in incomes over time has not increased the demand for food much because the income elasticity for food is low. Farmers, therefore, need to sell larger and larger quantities of food at lower and lower prices to earn the same revenue. As a result, small farms are no longer as profitable as they once were, and many people have abandoned farming to pursue other occupations.

Problems and Applications 5.2 a. (Percentage change in price) × (price elasticity of demand) = percentage change in quantity demanded: 50% × −0.25 = −12.5%. So, the quantity of cigarettes demanded should decline 12.5 percent from its current level of 360 billion cigarettes per year; 12.5 percent of 360 billion is 45 billion. b. It may be possible that because cigarettes have been around for more than 100 years, while ecigarettes were introduced much more recently (around 2003), more people are familiar with and prefer cigarettes to other ways of consuming tobacco. Also, nicotine from cigarettes is addictive, which often makes it difficult for cigarette smokers to quit smoking even when the price of cigarettes increases substantially. As a result, the demand for conventional cigarettes is price inelastic. The demand for e-cigarettes is more price elastic because they were recently introduced to the market and are less likely to be addictive. If e-cigarettes have more elastic demand, a tax that raises the price of e-cigarettes will result in a larger decrease in the quantity of e-cigarettes demanded compared to the effect of a similar tax on conventional cigarettes. 5.3 a. We can plug into the midpoint formula the values given for the price elasticity, the original price of $3.00, and the new price of $3.70 (= $3.00 + $0.70):

Rearranging and writing out the expression for the percentage change in quantity demanded:

Solving for the new quantity demanded: Q2 = 125.4 billion gallons Because the price elasticity of demand for gasoline is low (−0.55), a 21 percent increase in the price of gasoline leads to only about a 10 percent decline in gasoline consumption per year.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

b. The federal government would collect an amount equal to the tax per gallon multiplied by the number of gallons sold: $1 per gallon × 125.40 billion gallons = $125.4 billion. 5.4 Farm incomes decrease when the total revenue that the farms receive from selling their crops decreases. Increasing farm productivity shifts the supply curve for crops to the right, lowering the equilibrium price. Because the demand for crops is price inelastic, a lower price reduces the revenue that farmers received from selling their crops. 5.5 For the government policy to be effective, the demand for bribes must be elastic. The more elastic the demand curve, the more effective the policy will be. On the following graph, the burden of corruption before the policy is enacted is represented by the area 0Q1AP1. The burden of corruption after the policy is enacted is represented by the area 0Q2BP2. In effect, this problem is applying the result that a price increase will result in an increase in revenue if demand is inelastic but a decrease in revenue if demand is elastic.

5.6 The head of the United Kumquat Growers’ reasoning is correct: Because the demand for kumquats is elastic, a price increase resulting from the implementation of a price floor will decrease the revenue received by kumquat producers. 5.7 Imposing a price ceiling causes the market quantity to decline from Q1 to Q2 and the price to decline from P1 to PC. We measure the loss of efficiency by the deadweight loss. When demand is elastic (D2), the deadweight loss in the figure is A. When demand is inelastic (D1), the deadweight loss is A + B. Therefore, the loss of economic efficiency from a price ceiling is greater when demand is price inelastic.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

The Price Elasticity of Supply and Its Measurement

6.6 Learning Objective: Define price elasticity of supply and explain its determinants and how it is measured.

Review Questions 6.1 The price elasticity of supply = (percentage change in quantity supplied)/(percentage change in price). In this case, the elasticity of supply = 9%/10% = 0.9. The dividing point between elastic and inelastic is 1.0, so the price elasticity of supply for frozen pizzas is inelastic. 6.2 Time is the main determinant of the price elasticity of supply. The longer the time period, the more firms are able to adjust the quantity they supply to a change in price. So, we would expect that as the time period increases, the price elasticity of supply will increase. An exception to this rule is products that require use of a resource that is in fixed supply, such as wine from a particular region in France.

Problems and Applications 6.3 A small decrease in the supply of oil will lead to a large increase in price because the demand for oil is price inelastic. 6.4 a. For a given supply curve for oil, an increase in the demand for oil will result in a smaller equilibrium price change if the demand for oil is highly price elastic than if the demand is highly price inelastic. b. An increase in the supply of oil will result in a smaller decrease in the equilibrium price if the demand curve is more elastic. With a more elastic demand, it requires a smaller decrease in the price to result in consumers purchasing a larger quantity due to the increase in supply.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

6.5 To find the price elasticity of supply, divide the percentage change in quantity supplied by percentage change in price. In panel (a) of Figure 6.6, the percentage change in quantity supplied = $4 − $2 1 400 − 1 200 × 100 = 66.7% . So, the 15.4% , and the percentage change in price = × 100 = $3 1 300 15.4% price elasticity of supply = = 0.23 In panel (b) of Figure 6.6, the percentage change in 66.7% 2 100 − 1 200 quantity supplied = × 100 = 54.5% , and the percentage change in price = 1 650 $2.50 − $2.00 54.5% 22.2% So, the price elasticity of supply = × 100 = = 2.45. $2.25 22.2% 6.6 The following graph assumes that the supply of chocolate is completely inelastic for one year following an increase in demand (from D1 to D2). As a result, the price of chocolate rises from P1 to Pyr1. The supply of chocolate becomes more elastic after four years (Syr1 to Syr4), which results in a lower price (Pyr4) and greater quantity (Qyr4). Therefore, all else equal, the price of chocolate would be greater after one year than after four years.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

6.7 a. The increase in demand for roses on Valentine’s Day causes the price to increase from $1 to $2.

b. Based on this information, we don’t know much about the price elasticity of demand for roses. The demand curve has shifted, so the rise in the quantity of roses demanded is not caused by a change in their price—and we can’t calculate the price elasticity of demand. We have a movement along the supply curve, so we can calculate the price elasticity of supply for roses. The price elasticity of supply = (percentage change in quantity supplied)/(percentage change in price). Using the midpoint formula: Percentage change in the quantity supplied =

30000 − 8000 × 100 = 115.8% 19000

Percentage change in the price = Therefore, the price elasticity of supply = The fact that the elasticity doesn’t have a negative sign is a reminder that with an upward-sloping supply curve, increases in price lead to increases in the quantity supplied, so the price elasticity of supply must be positive. The supply of roses is price elastic given that the value of the elasticity is greater than 1. 6.8 a. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. In this case, the percentage change in quantity supplied is 0, because the quantity supplied by the university is always 15 000 and so does not change in response to a change in price.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

b. As shown in the following graph, when the demand curve for basketball tickets shifts from D1 to D2, the equilibrium price of tickets increases from $15 to $20, but there is no change in the equilibrium quantity.

c. The period of time is one determinant of price elasticity of supply. Over a longer period of time, supply is more price elastic. So, although the supply curve for basketball tickets is perfectly inelastic in the short run, it is possible that over time State University could build a larger basketball arena with more seats to accommodate more fans.

Suggestions for Critical Thinking Exercises CT6.1 The actual values will vary by group, and the portion of students that decides that the results make sense (or don’t make sense) will vary as well. However, sometimes students will blindly calculate values and report them without determining whether they are sensible. CT6.2 Students can only calculate income elasticity from the second table. The first table could not be used to calculate either income or price elasticity because both the price of the good and income vary, and to calculate these elasticities, we need to hold everything else (apart from either price or income) constant. Giving data of varying types can often confound students because they typically expect data of exactly the type they need to answer the questions in class or on exams.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade SOLUTIONS TO END-OF-CHAPTER EXERCISES Canada and the International Economy 7.1 Learning Objective: Discuss the role of international trade in the Canadian economy. Review Questions 1.1 Since the early 1960s, Canada’s exports have generally been larger than imports. The current situation has Canadians importing more than they export. 1.2 Although Canada is a major exporter, Figure 7.2 shows that many other countries export a lot more than Canada. Figure 7.3 shows that countries like Germany, Mexico, and the Netherlands export and import much higher proportions of their GDP than Canada.

Problems and Applications 1.3 Agriculture would see a large decline, as would certain manufacturing industries, such as cars. Many service industries, such as haircutting and medical services, would not be affected much because Canada does not export services of these types. 1.4 Smaller countries generally do not produce as large and as diverse a group of goods and services as larger countries do. Smaller countries are therefore more likely than larger countries to export and import larger fractions of their GDP.

Comparative Advantage in International Trade 7.2 Learning Objective: Understand the difference between absolute and comparative advantage in international trade.

Review Questions 2.1 Absolute advantage is the ability to produce more of a good or service than competitors using the same amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than other producers. A country will often import goods in which it has an absolute advantage. For example, Canada could produce textiles—such as sheets and towels—with fewer resources than China can, but China can produce these goods at a lower opportunity cost than Canada. Importing textile products from China frees up resources Canada can use to produce other goods in which it has a comparative advantage.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

2.2 Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at the lowest opportunity cost. This insight is powerful because it runs counter to most people’s intuition that trade is based on absolute advantage. Applying the economic concept of comparative advantage allows us to analyze which products countries tend to export and which they tend to import. The concept also allows us to see the immense gains—to rich and poor alike—that trading can generate.

Problems and Applications 2.3 The goods that countries import and export change over time because the goods in which they have a comparative advantage change over time. These changes can be caused by technological change as well as changes in the relative abundance of resources. 2.4 The argument does not make sense because Bolivia must have a comparative advantage in producing at least one good. Remember that comparative advantage compares opportunity costs of producing goods between two countries. If Canada has a lower opportunity cost in one good, then it must have a higher opportunity cost in some other good, which would give Bolivia the comparative advantage in producing the other good. 2.5

Greece Italy

Opportunity Costs Olive Oil Pasta 0.5 pasta 2 olive oil 2 pasta 0.5 olive oil

2.6 Based on comparative advantage, some jobs in Canada will be lost to countries that have lower opportunity costs in producing certain goods and services. If T-shirts can be produced at a lower opportunity cost in another country, then it makes economic sense for T-shirts to be produced in that country. Although an individual who loses their job as a result of imports from another country may be justifiably upset and prefer to pay a higher price for a product to keep production at home, consumers in general are better off by purchasing goods from countries that have a comparative advantage, as this will allow resources in Canada to be more efficiently allocated to goods and services in which Canada has a comparative advantage. 2.7 The economic concept the author illustrates is comparative advantage, which is used to demonstrate the gains to individuals and countries from specialization in production. By specializing in the production of goods and services for which an individual or a country has a lower opportunity cost than another individual or country, trade can make both parties better off than if they were selfsufficient. Romans got better pots and better defence by allowing professionals to provide these products because the professionals produced them at lower opportunity costs than the nonprofessional Romans could. 2.8 For Germany to have a comparative advantage in the production of cars and machine tools relative to any other European country it has to have a lower opportunity cost of producing cars and machine tools than the other country. It does not have to produce more cars or machine tools per hour than any of its trading partners. In other words, it can have a comparative advantage in producing cars or machine tools without have an absolute advantage in producing those goods.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

2.9 The opportunity cost for Switzerland to produce one smartphone is 1.25 fitness bracelets (10/8 = 1.25). The opportunity cost for Canada to produce one smartphone is 0.60 fitness bracelet (3/5 = 0.60). Therefore, Canada has a comparative advantage in producing smartphones. The opportunity cost for Switzerland to produce one fitness bracelet is 0.80 smartphone (8/10 = 0.80). The opportunity cost for Canada to produce a fitness bracelet is 1.67 smartphones (5/3 = 1.67). Therefore, Switzerland has a comparative advantage in producing fitness bracelets.

How Countries Gain from International Trade 7.3 Learning Objective: Explain how countries gain from international trade. Review Questions 3.1 Complete specialization would mean producing only one good. It is not typical for a country to completely specialize because not all goods and services are traded internationally. In addition, the production of most goods involves increasing opportunity costs, which means that before complete specialization is reached, a country may have lost its comparative advantage in producing a good. Finally, tastes for products differ across countries, so different countries may have comparative advantages in different varieties of the same good, which leads to intra-industry trade. 3.2 Not everyone gains from international trade. Suppose, based on comparative advantage, it is determined that Japan should only produce cellphones and Canada should only produce tablet computers. The owners of Japanese tablet computer companies, the owners of Canadian cellphone firms, and the people who work for them may be worse off as a result of trade. 3.3 International trade increases a country’s consumption because it allows the country to specialize in the goods and services that it can produce at the lowest opportunity cost and trade for goods and services in the production of which it has a higher opportunity cost than other countries have. As the example in Table 7.3 shows, international trade on the basis of comparative advantage can raise incomes and consumption. 3.4 The main sources of comparative advantage are climate and natural resources, the relative abundance of various types of labour and capital, technology and know-how, and external economies.

Problems and Applications 3.5 Canadians would most likely support tariffs on energy. These industries supply significant exports, but comparatively little is imported. Assuming other countries did not respond to the Canadian tariffs, Canadian producers would suffer (or gain little) from the imposition of a tariff. This might explain why a ban on importing oil from Russia in early 2022 was not given much media coverage. In most years Canada imports little or no Russian oil. Extra credit: There is likely to be different levels of support for energy import tariffs in different parts of the country. Western Canada would benefit (or at least lose nothing) from the tariffs as it produces and exports oil. Ontario, Quebec, and the Maritime provinces would likely object to the tariff as those regions import oil from other countries and would thus end up paying higher prices for oil (and its derivative products) as a result of the tariff.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

3.6 a. A country has an absolute advantage over another country when it can produce more of a good using the same resources. Chile has an absolute advantage in the production of both hats and beer because it can produce more of both goods (8 hats; 6 barrels of beer) than can Argentina (1 hat; 2 barrels of beer) with the same amount of labour input. b. A country has a comparative advantage when it can produce a good at a lower opportunity cost. To produce 8 hats, Chile must give up 6 barrels of beer. Therefore, the opportunity cost to Chile of producing 1 hat is 6/8, or 0.75 barrels of beer. Argentina must give up 2 barrels of beer to produce 1 hat, so its opportunity cost of producing 1 hat is 2 barrels of beer. Chile has a comparative advantage in the production of hats because its opportunity cost is lower. To produce 6 barrels of beer, Chile must give up 8 hats, so its opportunity cost of producing 1 barrel of beer is 8/6, or 1.33 hats. Argentina must give up 1 hat to produce 2 barrels of beer, so its opportunity cost of producing 1 barrel of beer is 0.5 hats. Argentina has a comparative advantage in the production of beer because its opportunity cost is lower. c. As part (b) shows, Chile should specialize in producing hats, and Argentina should specialize in producing beer. By specializing, Chile can produce 8000 hats (1000 labour-hours × 8 hats), and Argentina can produce 2000 barrels of beer (1000 labour hours × 2 barrels of beer). If Chile trades 700 hats to Argentina for 700 barrels of beer, the countries will end up with: Chile Argentina

Hats 7300 700

Beer 700 1300

Both countries are better off than they were before specializing and engaging in trade. 3.7 The commentator is confusing absolute advantage and comparative advantage. Absolute advantage is the ability to produce more of a good or service than competitors when using the same amount of resources. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Every country, no matter how poor, will have a comparative advantage in producing some good. (Often countries are poor because they cannot or will not trade with others.) 3.8 As explained in the text, this statement is correct. Production of most goods and services involves increasing opportunity costs. 3.9 Free trade probably benefits smaller countries more because without trade it would be difficult for producers in these countries to benefit from external economies and economies of scale. Also, larger, more populous countries are likely to have a wider range of both natural resources and people with particular skills, so these countries can gain significantly from internal trade, but this is less likely in smaller countries. 3.10 Trade allows a country to specialize in producing the goods in which it has a comparative advantage. After trading, the country can consume more. In this sense, a country can “produce more with less” and consumers win, thus making both statements correct.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

3.11 Every trade involves costs to someone. Those firms and workers in industries that were previously protected from international competition will likely lose out from a new trade deal. When Canadians begin to buy imports, they reduce their consumption of Canadian-made products. For example, if the TPP reduces protections for Canadian dairy producers, many dairy farms and farm workers will find their businesses and jobs at risk as they will begin to face more competition from lower-cost foreign producers. They may have to find employment in another industry in which Canada is better able to compete internationally.

3.12 Both countries benefited from their bilateral trade. It is not possible to determine which country

benefited more; however, the question assumes that exports benefit a country more than its imports. This assumption is a fallacy. Countries gain when they import goods that are not produced in their own country or can only be produced at a higher cost domestically. The concept of comparative advantage proves that trade between countries is mutually beneficial.

3.13 Although both countries would gain from the trade agreement, not every citizen or company in the United States and Colombia would “win.” Some domestic suppliers and their workers lose if they are driven out of existing markets (and into new markets) by lower-priced imports. 3.14 a. Tanzania produces 8000 bushels of cashew nuts. b. Tanzania will receive 1500 bushels of mangoes in exchange. Because point C (5000 bushels of cashew nuts and 1500 bushels of mangoes) is beyond its production possibilities frontier, Tanzania is better off with trade than without trade. c. With trade, Tanzania is producing on its production possibilities frontier but consuming beyond its production possibilities frontier.

3.15 Ottawa benefits from external economies: reductions in firms’ production costs resulting from an increase in the size of an industry. It would be difficult for technology firms located elsewhere to compete with similar firms located in Ottawa, but a firm could overcome Ottawa’s advantages if it could convince consumers that the quality and variety of the products it offers are worth paying higher prices for. Ottawa’s advantages are likely to persist, and could even grow, over time as more and more technology firms locate there to take advantage of the external economies.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

Government Policies that Restrict International Trade 7.4 Learning Objective: Analyze the economic effects of government policies that restrict international trade.

Review Questions 4.1 A tariff is a tax governments impose on imports. A quota is a numerical limit a government imposes on the quantity of a good that can be imported into the country. Non-tariff barriers include governmental rules—for example, health or safety regulations—that favour domestic firms over foreign firms. 4.2 The winners from tariffs are domestic producers and the government. The losers are domestic consumers and domestic firms that use as an input the product that is protected by the tariff or quota— as, for example, the Canadian pizza industry loses as a result of the Canadian cheese quota. The winners from quotas are domestic producers and whoever holds the import licence. The losers, again, are domestic consumers.

Problems and Applications 4.3 A trade deal with China would most likely benefit Canadians greatly. It would grant Canadian consumers access to more products at lower prices than is currently the case. It would also grant Canadian producers increased opportunities to sell their products in one of the largest markets in the world. More than a billion new consumers to sell products to would create a lot of opportunities for Canadian firms and their workers. Canadian firms would also face additional competition from Chinese firms. It would be very difficult for Canadian workers in some industries to match the low cost of production China’s low wages and less rigorous labour standards allow. Trade agreements typically receive more support from the public when they are between countries with similar levels of development and labour standards. Japan, for example, has wealthier consumers and workers paid in a manner similar to Canadian workers. The legal system in Japan is closer to Canada’s than China’s is. People generally view this as meaning they will be able to compete on a “level playing field”—firms in other countries won’t have an unfair advantage over Canadian firms. 4.4 “Fighting protectionism” refers to governments resisting imposing tariffs, quotas, and non-tariff barriers to protect domestic industries. “Populist policies” refers to policies supported by the average person and designed to promote their rights and beliefs. Adopting populist policies—in this case, the desire to enact protectionist policies to protect domestic industries—is not consistent with the concept of comparative advantage and would result in higher prices, lower consumption, and reduced efficiency, all of which would reduce economic growth and therefore prolong the recession.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

4.5 a.

Before the tariff, the quantity of beef sold by Canadian producers is Q1; after the tariff, the quantity of beef sold by Canadian producers is Q3. Before the tariff, the quantity of beef imported = Q2 – Q1; after the tariff, the quantity of beef imported = Q4 – Q3. c.

The winners from the tariff are domestic producers of beef and the government, which collects the tariff revenue. The losers are domestic consumers of beef.

4.6 Firms in industries that had to compete with Russian exports are most likely to benefit from the sanctions imposed on Russia. For example, banning or restricting the purchase of Russian crude oil caused the price of oil to rise dramatically, benefiting firms in the industry. The same is true of agricultural products and potash. 4.7 The student’s reasoning is flawed. As we saw in the chapter, placing a tariff on imports of a good will raise the price of the good. If foreign competition is entirely eliminated, the prices charged by Canadian producers will rise as much as or more than they will if a tariff is imposed, because eliminating imports will cause the supply curve for the protected good to shift to the left. Also, if the imported goods are a different style or quality than the Canadian goods, then Canadian consumers will have a reduced variety of goods from which to choose.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

4.8 Economists usually measure the standard of living by the goods and services that the typical person in a country is able to purchase. In this case, the Chinese government will have reduced the standard of living of its own people and raised the standard of living of people in Canada. The standard of living in Canada is raised because Canadian consumers are able to purchase Chinese goods at a price below their true cost of production. The standard of living in China is reduced because the government has used some of the country’s resources to cover the cost of goods that are sent to Canada. Subsidizing exports is essentially giving money away to foreign consumers. 4.9 You can refer to Solved Problem 7.1 in the text for guidance in filling out the table. World price of kumquats Canadian price of kumquats Quantity supplied by Canadian firms Quantity demanded Quantity imported Area of consumer surplus Area of domestic producer surplus Area of deadweight loss

Without Quota $0.75 $0.75 4 million 13 million 9 million A+B+C+D+E+F G None

With Quota $0.75 $1.00 6 million 12 million 6 million A+B C+G D+F

4.10 a. “Concentrated opposition” to economic legislation refers to relatively small numbers of individuals who will bear much of the legislation’s costs. “Diffuse support” refers to the relatively large number of individuals that will benefit from the legislation. Because the cost to each individual opponent is greater than the benefit to each individual supporter, legislators typically will choose to oppose such legislation. b. The observation does apply to tariffs (and quotas) although in such cases “concentrated support” for tariffs beats “diffuse opposition.” The benefits of the tariffs are concentrated among the firms and their employees that face less competition from imports, while the costs are spread across many consumers who will pay higher prices for the goods that are subject to the tariffs.

7.5

The Arguments over Trade Policies and Globalization Learning Objective: Evaluate the arguments over trade policies and globalization.

Review Questions 5.1 Globalization is the process of countries becoming more open to foreign trade and investment. Some people oppose globalization because they believe it will make them worse off or will harm other people they care about—especially poor workers in developing countries. Some opponents of globalization believe that it undermines the local cultures in developing countries.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

5.2 Protectionism is the use of trade barriers to shield domestic companies and their workers from foreign competition. The beneficiaries are the protected domestic companies and their workers. The losers are domestic consumers and other domestic producers who cannot buy their inputs as cheaply. The main arguments for protectionism are that it saves jobs and protects high wages, allows “infant industries” a chance to get started and grow, and protects national security. It is important to weigh the benefits of each of these arguments against the costs. 5.3 The collapse of world trade during the Great Depression and the desire to create a stable, prosperous world economy after World War II led to the General Agreement on Tariffs and Trade under which countries agreed to not impose new tariffs or quotas on trade in goods. The WTO eventually replaced the GATT when member countries decided that a new agreement was necessary that would cover trade in services and intellectual property rights as well as trade in goods.

Problems and Applications 5.4 Labour standards refers to the laws and practices governing working conditions and other elements of employment. Labour standards cover everything including how long the working day is, how many hours a week a person can work before they must be paid overtime, safety precautions, and other facets of work. Different countries will have different labour standards based on the relative power of workers and local culture. Canadian laws generally require firms to provide hard hats and other safety equipment. Laws in other countries, particularly developing countries, do not require the same safety equipment that Canadian workers receive. Developing countries resist some labour standards like paid vacation time or sick leave in part because these policies are expensive for employers—essentially these policies mean hiring a worker costs more than it would otherwise. 5.5 You should disagree with the statement because it doesn’t take into account the whole process of international trade. Buying a less expensive good from Brazil leaves a consumer with more money to spend on other domestic goods. In addition, buying a good from Brazil provides Brazilians with the funds to buy goods from Canada. Importing goods does not affect the total number of jobs in Canada. Buying only Canadian-produced products and limiting imports results in higher prices of the Canadian-produced products. This in turn makes these products more expensive for Canadians. When Canada imports products for which it does not have a comparative advantage, it is able to purchase these imports more cheaply, which in turn helps Canadian consumers and may help increase jobs. In the cellphones and televisions example, the Canadian decision to export cellphones and import televisions expanded world production and consumption of these two goods and left employment in Canada unchanged. 5.6 Answers will vary. Globalization, the process of countries becoming more open to foreign trade and investment, enables some foreign firms to better respond to changes in consumer demand for digital photography than Kodak responded. The outcome in Rochester was not “good” for Kodak workers who lost their jobs, but it was beneficial to consumers of digital cameras. The outcome also showed the movement of resources—Kodak’s old buildings—out of an industry that no longer had a comparative advantage and into new industries that do. 5.7 Restrictions on canola imports into China result in higher prices that harm Chinese consumers of canola. Domestic suppliers of canola gain, as do US, Chilean, and South Korean consumers who can consume more canola imported from Canada.

CHAPTER 7 | Comparative Advantage and the Gains from International Trade

Suggestions for Critical Thinking Exercises CT7.1 Students will find this challenging as they are likely just to refer to the tables they’ve seen without understanding the intuition behind comparative advantage. Hopefully, the hint does not provide too much information. CT7.2 Sources include education, experience, and interests. CT7.3 No. The idea behind this question is that students often see ideas in isolation and they have a difficult time seeing which tool is used for a given issue.

CHAPTER 8 | Consumer Choice and Behavioural Economics SOLUTIONS TO END-OF-CHAPTER EXERCISES Utility and Consumer Decision Making

8.1 Learning Objective: Define utility and explain how consumers choose goods and services to maximize their utility.

Review Questions 1.1 Utility is the enjoyment or satisfaction that people receive from consuming goods and services. It is not possible to measure utility or to compare it across people. 1.2 Marginal utility is the extra utility a person receives from consuming one additional unit of a good or service. The law of diminishing marginal utility states that consumers will experience reductions in additional satisfaction as they consume more of a good or service during a given period of time. Marginal utility is more useful than total utility in consumer decision making because consumption decisions are usually made at the margin, involving the decision of whether to consume a little bit more or a little bit less of a product. 1.3 The budget constraint is the limited amount of income available for a consumer to spend on goods and services. The rule of equal marginal utility per dollar spent states that a consumer will make the optimal decision by allocating their budget so that the marginal utility per dollar spent is the same for all goods and services being consumed. 1.4 There is a change in the quantity demanded of the product due to the effect of the change in price on consumer purchasing power (the income effect) and due to the change in price making the good more or less expensive relative to other goods (the substitution effect).

Problems and Applications 1.5 The law of diminishing marginal utility might not hold true in every case and might not hold over certain ranges of consumption. One example would be increasing from less than a full dose of a medicine to a full dose. Also, some people would argue that the marginal utility of potato chips is increasing until a significant quantity has been consumed.

CHAPTER 8 | Consumer Choice and Behavioural Economics

1.6 a.

You should allocate your time so that the last hour devoted to studying each subject results in the same additional number of points. In other words, you should equalize your marginal scores, subject to the constraint that you have only six hours to study. The table above shows that this result occurs when you devote four hours to studying economics and two hours to studying psychology. b. In this case, you need to triple the marginal scores for the psychology exam. Maximum utility now occurs when you spend two hours studying economics and four hours studying psychology. The marginal scores are not exactly equalized, but this is as close as you can get given the budget constraint of six hours.

1.7 Joe will maximize his utility if he spends his $16 so that the marginal utility of Smarties divided by the price of Smarties is equal to the marginal utility of chocolate chip cookies divided by the price of chocolate chip cookies. We can make the analysis easier by constructing a table. Quantity 1 2 3 4 5 6 7 8 9 10

MU 10 8 6 4 2 0 ---------

Smarties MU/P 10 8 6 4 2 0 ---------

Chocolate Chip Cookies MU MU/P 18 9 16 8 14 7 12 6 10 5 8 4 6 3 4 2 2 1 0 0

CHAPTER 8 | Consumer Choice and Behavioural Economics Joe will maximize utility by buying four packs of Smarties and six packs of cookies. At this combination, the marginal utility of each good divided by its price equals 4.

1.8 The substitution effect is likely to be much larger than the income effect. The drop in price of nearly 15 percent is fairly big and will make Fritos relatively cheaper in comparison to other similar snacks, leading to significant substitution of Fritos for these other snacks. The income effect will be tiny because most people don’t spend a large fraction of their incomes on Fritos, so their purchasing power will barely rise. 1.9 If pizza were an inferior good, the income effect would lead you to consume less pizza as its price falls. It is possible that a lower price would lead you to buy less if the income effect were larger than the substitution effect. In reality, though, the income effect is almost always smaller than the substitution effect. 1.10 The last dollar saved should give consumers the same additional utility, in terms of the expected future consumption the saving will make possible, as the last dollar spent on goods and services today. 1.11 Rahim has $55 to spend. To maximize utility, Rahim needs to equalize marginal utility per dollar for both apples and oranges. For apples:

Marginal utility 20 = = 40 per dollar. Price $0.50

For oranges:

Marginal utility 30 = = 40 per dollar. Price $0.75

Rahim is spending $25 on apples (50 apples × $0.50) and $30 on oranges (40 oranges × $0.75), so he is spending a total of $55 on fruit. Therefore, Rahim is maximizing his utility because he has spent his $55 and the marginal utility of each good divided by its price is the same: 40 utils per dollar. 1.12 a. False. The marginal utility of ginger ale is not affected by its price. In response to the decrease in the price of ginger ale, she will buy more ginger ale. The marginal utility she receives from the additional units of ginger ale she consumes will decrease. MU

b. True, at least initially. As the price of ginger ale decreases, the ratio P will increase. But the decrease in the price of ginger ale will cause Maya to consume more ginger ale, driving down the ratio of marginal utility to price. We don’t have enough information to know whether the ratio will eventually return to the value it had before the price of ginger ale decreased. c. True and false. Because of the substitution effect, Maya will buy more ginger ale, but there is not enough information to determine whether ginger ale is a normal good. Ginger ale would be a normal good for Maya if, as her income increased, her consumption of ginger ale increased as well. If her consumption of ginger ale decreased as a result of an increase in income, ginger ale would be an inferior good. d. True. After the price of ginger ale decreases, Maya will buy more ginger ale and less tuna. As she consumes less tuna, its marginal utility will rise. Because the price of tuna is assumed not to change, the marginal utility per dollar Maya receives from tuna will rise.

CHAPTER 8 | Consumer Choice and Behavioural Economics 1.13

8.2

We don’t have enough information to determine whether Afua is maximizing her utility. We know that Afua is maximizing her utility if the marginal utility per dollar spent is the same for each good, and she is spending all of her budget on corn chips and sodas. Because the marginal utility of both goods is 10, she is maximizing her utility only if the price of a bag of corn chips is the same as the price of a bottle of soda, and she is also spending the entire amount of her budget on corn chips and sodas. Because we don’t have any information on the prices of the goods or on her budget, we can’t be sure whether she is maximizing utility.

Where Demand Curves Come From Learning Objective: Use the concept of utility to explain the law of demand.

Review Questions 2.1 When the price of a good falls, a consumer will adjust their purchases because the marginal utility per dollar spent will no longer be the same for all goods. The lower price will lead to a substitution effect and an income effect, both of which will cause the quantity demanded of the good to rise when the good is a normal good. If the good is an inferior good, then the income effect of a price decline will lead the consumer to buy less of the good, but because the substitution effect is usually larger than the income effect, the consumer will also buy more of an inferior good following a price decline. 2.2 The market demand curve is derived from adding horizontally the individual demand curves. So, for each price, the quantities demanded for each buyer are added together to get the total quantity demanded in the market. 2.3 For a demand curve to be upward sloping, the good would have to be an inferior good with an income effect larger than its substitution effect. In this case, a decline in price would lead to the consumer buying less of the good, and an increase in price would lead to the consumer buying more of the good. This is the case of the Giffen good.

Problems and Applications 2.4 If the price of an inferior good falls, the income effect will decrease the quantity demanded while the substitution effect will increase the quantity demanded, so these two effects are working in opposite directions. 2.5 Price $1.75 1.50 1.25 1.00 0.75

Josh 2 4 6 7 9

Quantity Demanded (cones per week) Jon Tim Market Demand 1 0 3 3 2 9 4 3 13 6 4 17 7 5 21

CHAPTER 8 | Consumer Choice and Behavioural Economics

2.6 Yes, there is an income and substitution effect. As your wage rises, the opportunity cost of leisure increases, so you will want to substitute work for leisure. However, the income effect of a higher wage will lead you to “buy” more leisure, because leisure is a normal good. 2.7 a. “Giffen behaviour” means that as the price of the good increases, the quantity demanded of the good will increase as well, leading to an upward-sloping demand curve. b. For a good to be a Giffen good, it must be an inferior good and consumers must spend a large portion of their incomes on it so that the income effect is greater than the substitution effect. The poorest of the poor have very low (if any) income to start with, so for these consumers the income effect might not be greater than the substitution effect. c. Unless the good makes up a large portion of a consumer’s budget, the income effect cannot be greater than the substitution effect. For example, when the price of an inferior good increases, the average consumer in a country will spend only a small fraction of their budget on the good. So, the income effect will be very small relative to the substitution effect and the consumer will buy a smaller quantity of the good following the price increase. 2.8

If the price of a good declines, the consumer has greater purchasing power, so they would want to purchase less of an inferior good. This result does not mean that the demand curves for inferior goods should slope upward because we must also take into account the substitution effect. The substitution effect always results in a lower price leading to an increase in the quantity demanded, and because the substitution effect is almost always greater than the income effect, the demand curve will be downward sloping, even for most inferior goods.

2.9 Neither the statement by Marty nor the statement by Ann is correct. You can explain to Marty that along downward-sloping market demand curves quantity demanded increases as price decreases for two reasons: (a) consumers who are willing to buy a product at a high price are willing to buy more at a lower price because they receive less marginal utility for each additional unit they consume; (b) some consumers who are not willing to buy a product at a high price will begin to buy the product as the price falls. Both groups of consumers make decisions “at the margin”—they compare the additional or marginal utility they will receive from buying one more unit of a product to the additional cost. If the price falls to zero, consumers will buy additional units until the last unit purchased yields zero marginal utility. Remind Marty that at home his parents do not make him pay for an additional slice of pizza (the price to him is zero) and he will eat one more slice if the marginal utility is positive. He will stop eating pizza slices when the marginal utility of the last slice is zero. You can tell Ann that she is confusing demand with supply. She is correct in stating that a producer would not be willing to sell a product at a

CHAPTER 8 | Consumer Choice and Behavioural Economics

zero price, but quantity demanded refers to the amount of a product that a consumer is willing to buy at a certain price, not how much a producer is willing to offer to sell at a certain price. 2.10 No, when the price of pizza falls, the marginal utility per dollar spent on pizza will not always equal the marginal utility per dollar spent for Coke. However, the marginal utilities per dollar spent for the last slice of pizza and the last cup of Coke will eventually become equal (or as close to equal as possible) as the consumption of pizza and Coke changes. As the price of pizza falls, the quantity demanded of pizza will rise due to the income and substitution effects.

8.3

Social Influences on Decision Making Learning Objective: Explain how social influences can affect consumption choices.

Review Questions 3.1 Consumers pay attention to celebrity endorsements because they may think that the celebrity knows more about the right product choice than they do, but mainly because they feel more fashionable and closer to famous people if they use products associated with them. 3.2 Network externalities exist when the usefulness of a product increases with the number of consumers who use it. For example, the more people who use phones or tablet computers, the more useful phones and tablet computers become. Path dependence occurs when high switching costs mean that technology that is available first has advantages over better technologies that were developed later. 3.3 Because consumers apparently value fairness, businesses will sometimes set their prices below the equilibrium level, giving up some profits in the short run to keep their customers happy and increase their profits in the long run.

Problems and Applications 3.4 Network externalities arise when the usefulness of a product increases with the number of consumers who use it. This is very likely for tablet computers, and perhaps for board games (the game is more interesting if all your friends are playing it, too), cellphone operating systems and online games, but not for dog food. 3.5 Many consumers may be influenced to buy a product endorsed by a celebrity even though they may not be consciously aware of it. Some people may associate a product with a particular celebrity but may not believe this association has influenced their decision to purchase the product. 3.6 Coca-Cola and A&W have to pay Christine Sinclair for her endorsement, and these companies would only do so if they believed the benefit received was likely to exceed the cost. The benefit must come in the form of consumers buying more Coca-Cola and A&W products, or being willing to pay more for the same amount of Coke and A&W, or some combination of the two. In other words, the marginal utility from Coke and A&W products must increase, causing the demand for these products to shift to the right. 3.7 The restaurant will want to appear to be acting fairly to local customers in an attempt to get them to return often. Businesses will sometimes set their prices below the equilibrium level, giving up some profits in the short run to keep their customers happy and increase their profits in the long run. However, visitors to Las Vegas generally stay for only a few days at a time, so the restaurant doesn’t lose much repeat business if visitors think that it is behaving unfairly by charging them higher prices. Copyright © 2024 Pearson Canada Inc.

CHAPTER 8 | Consumer Choice and Behavioural Economics

3.8 The theatre may charge the same price for every movie because customers believe that doing so is fair. It may also do this because a sellout creates even more interest in the movie, bringing in more customers later in the week. The people who don’t get in to the latest Star Wars may also decide to stay and watch the other movie, while planning to return to see the Star Wars movie later. 3.9 By not adopting the plug adapters used in other European countries, the Swiss are failing to take advantage of network externalities. As Daniel Hamermesh discovered, universal plug adapters are useless in Switzerland, and the three-prong adapters that must be used in Switzerland are useless in other countries. This fact severely limits the market for, and the usefulness of, the Swiss adapters. 3.10 a. The prices charged by Hamilton’s producers are lower than the prices those who operate the ticket bots sell the tickets for. Because the demand for the play’s tickets has been so great, many theatregoers have been willing to pay high ticket prices rather than wait—possibly for many months—to attend a performance. Therefore, people earn a profit by using bots to buy tickets at their original prices and sell them for higher prices. b. Hamilton’s producers could reduce the waiting list for tickets, and the incentive for those who control the ticket bots to buy tickets, by charging higher ticket prices. Apparently, the producers are reluctant to do this because they fear that theatregoers will see the producers—rather than the ticket bots—as the reason for “unfairly” high prices. If the producers’ reputation is damaged as a result of unfavourable publicity arising from charging high ticket prices, their ability to successfully produce shows in the future may be damaged.

Behavioural Economics: Do People Make Their Choices Rationally?

8.4 Learning Objective: Describe the behavioural economics approach to understanding decision making.

Review Questions 4.1 Being economically rational means taking actions that are appropriate to reach one’s goals, given the available information. 4.2 Behavioural economics studies situations in which people act in ways that appear not to be economically rational. It examines common mistakes that individuals make, including ignoring nonmonetary opportunity costs, failing to ignore sunk costs, and being overly optimistic about their future behaviour. Someone may fail to take into account non-monetary opportunity costs when they purchase a product because it has a mail-in rebate but they do not mail in the rebate. A person has failed to ignore sunk costs when they buy a non-refundable ticket to a baseball game and are later offered a free ticket to a concert (which they would much rather attend) the same night as the baseball game but decide to attend the game. And someone who smokes regularly but expects to be able to give up smoking sometime in the near future is being unrealistic about future behaviour. 4.3 Using heuristics will probably decrease the likelihood that a consumer makes an optimal choice. For example, if a consumer makes a decision based on outdated information (for example, shopping at a store this week because last week this store had the lowest prices), the consumer may not be making an optimal choice.

CHAPTER 8 | Consumer Choice and Behavioural Economics

4.4. Anchoring involves relating the price of a product that is unknown to the price of a product that is known. A firm may use anchoring to take advantage of a consumer’s lack of information by charging a high price for a product to make a discounted sale price appear to be a bargain, even if the product is very rarely offered for sale at the regular price.

Problems and Applications 4.5 The endowment effect describes the tendency of people to be unwilling to sell something they already own for a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it. Your little brother is exhibiting the endowment effect. He is unwilling to sell the Connor McDavid rookie hokey card for $80, even though he would not spend $80 to buy it. 4.6 The endowment effect refers to the tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it. Thaler states that he was not planning to sell the wine, and now that he is being paid for his loss by his insurance company, he will not take this money to replace the stolen bottles of wine. Not being willing to sell the wine he already owned—while at the same time not being willing to repurchase the wine with the insurance payment—is inconsistent behaviour. 4.7 The columnist’s analysis is correct. The opportunity cost of continuing to own the townhouse is the price you could sell the townhouse for. In that sense, by not selling the townhouse, the person is in effect buying it. The price the owner originally paid for the townhouse is a sunk cost and is, therefore, irrelevant to the decision about whether or not to sell it. 4.8 You will want to compare the marginal benefit of spending $4000 to have the car repaired against the benefits you would receive from spending the $4000 in other ways, such as by making a down payment on another car. The price you paid for your car is a sunk cost and is, therefore, irrelevant to the decision of whether you should repair it. 4.9 The statement is probably correct. People often eat food like potato chips in the present because they tell themselves—unrealistically—that they intend to eat better in the future. If they were more realistic about their future actions, they would eat fewer potato chips today and the demand curve would shift to the left. 4.10 By “long-run self,” they mean a person’s long-run objectives, such as succeeding in school or remaining thin. Going to the movies rather than studying and eating doughnuts rather than sticking to a healthy diet are two examples of pursuing immediate gratification. 4.11 They seem to be behaving overly optimistically about their future behaviour. At the time they sign up for the monthly fee, they seem to expect to attend more than seven times per month. 4.12 Because Marvin was unwilling to buy a ticket behind the visitors’ bench for $350, but also unwilling to sell a ticket in the same section for $350, his behaviour is inconsistent. Economists refer to this type of behaviour as the endowment effect: the tendency of people to be unwilling to sell a good they already own even if they are offered a price they would be willing to pay to buy the good if they didn’t already own it. (In this example, the endowment effect is illustrated in a slightly different way because Marvin is unwilling to accept a price for his ticket that is more than the value he placed on it before he bought the ticket.)

CHAPTER 8 | Consumer Choice and Behavioural Economics

4.13 The cost of the ticket is a sunk cost, which Neyer should ignore. Once he’s at the game, it would be rational to weigh the marginal cost of moving into the shade (a slightly worse view) versus the marginal benefit (greater physical comfort). 4.14 The $3000 in recent refinancing fees is a sunk cost and should be ignored. 4.15 From the information given, the only conclusion we can make is that Andrea’s tastes—and, therefore, the utility she receives from meat products and vegetables—have changed. It is likely that her decision was affected by “social influences,” but it is also possible she made her decision to become a vegetarian entirely for her own reasons. 4.16 a. As the text explains, price anchoring describes one way consumers evaluate prices. If they are uncertain whether a price for an item they have not purchased before seems “high” or “low,” they often anchor, or relate, the value of the item to another item with which they are familiar. The known value may, in fact, be irrelevant in accurately assessing the value of the unfamiliar item. b. Placing a $10 000 watch next to a $2000 watch provides an anchor price for consumers who have not previously purchased an expensive watch. A consumer may believe that the $2000 price is a bargain compared to the $10 000 watch. In contrast, if the same $2000 watch was placed next to a $500 watch, the consumer would likely use the lower price as an anchor and consider the $2000 watch to be overpriced. 4.17 The company’s use of anchoring is at work here. When presented with only two choices, consumers went with the lower-priced (online-only) choice. However, when three choices were presented, consumers had another frame of reference (an anchor) that led them to choose the “bargain” price of $125 for print plus online access over the same price of $125 for print only. Consumers seemed to ignore the $56 price for online-only access, which is the choice they had previously preferred.

Suggestions for Critical Thinking Exercises CT8.1 Anchoring explains the location of the expensive jacket. By putting out such an expensive jacket, the store might be trying to anchor customers’ expectations for a rain jacket. The writer of this question actually saw such a jacket on the rack at a local outdoors store. CT8.2 No, you are confusing total with marginal utility. It is likely the case that each additional trip increases utility by a smaller amount than the last trip. Yet, total utility is still increasing. CT8.3 Clearly, the results will vary by student and group. The reports should be evaluated on their thoroughness and completeness.

CHAPTER 9 | Technology, Production, and

Costs

SOLUTIONS TO END-OF-CHAPTER EXERCISES 9.1

Technology: An Economic Definition Learning Objective: Define technology and give examples of technological change.

Review Questions 1.1 Technology is the process a firm uses to turn inputs into outputs of goods and services. Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs. 1.2 Technological change could be negative. Two examples are when a natural disaster damages factories and stores or government restrictions during a pandemic causes them to be operated below capacity, as happened during the COVID-19 pandemic, or when a firm hires less-experienced workers. In both these examples, the firm would produce a lower level of output with the same quantity of inputs.

Problems and Applications 1.3 Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs. The use of iSteer by oil and gas producer EOG is an example of positive technological change because iSteer enables the firm to recover more oil and gas with the same inputs than was possible with previous technology. 1.4 Choices (b), (c), and (d) are examples of positive technological change because they enable a firm to produce more output with the same quantity of inputs. Choice (a) describes a change in production costs that is the result of a change in the price of an input, not a change in technology. Choice (e) is not an example of technological change because the same quantity of inputs is used to produce the same quantity of output. 1.5 a. Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs. If Segment improved employee productivity by moving from text messaging to email communications, that move is an example of a positive technological change. b. An increase in the salaries of software engineers would not be an example of negative technological change. The increase in salaries would not affect Segment’s ability to produce a given amount of output with a given quantity of inputs. 1.6 If the United Airlines app allows flight attendants to access information about customers more efficiently and makes them more productive in helping passengers—perhaps by knowing whether a passenger needs a special diet or help getting on and off the plane—the app results in a positive technological change. But if customers dislike the app enough that they switch to another airline or get into lengthy arguments with flight attendants, the app will turn out to have been a negative technological change.

CHAPTER 9 | Technology, Production, and Costs

9.2

The Short Run and the Long Run in Economics Learning Objective: Distinguish between the economic short run and the economic long run.

Review Questions 2.1 In the short run, at least one of the firm’s inputs is fixed, while in the long run, the firm can vary all of its inputs, adopt new technology, and change the size of its physical plant. The amount of time that it takes a firm to move from the short run to the long run varies from firm to firm. 2.2 Fixed costs are costs that remain constant as output changes. An example of a fixed cost is the lease payment for a factory or retail store. Variable costs are costs that change as output changes. An example of a variable cost is the cost of raw materials such as pizza dough purchased by a pizza restaurant. 2.3 Implicit costs are non-monetary opportunity costs, such as the wages the owner of a firm could have earned if they worked for someone else. Explicit costs involve spending money. 2.4 The production function shows the relationship between the inputs employed by a firm and the maximum output the firm can produce with those inputs. The short-run production function holds constant fixed inputs, such as the number of ovens in Ebba’s pizza restaurant in the example in the chapter.

Problems and Applications 2.5 A fixed cost is a cost that remains constant as output changes. A variable cost is a cost that changes as output changes. The new fees UPS charged because of the surge in online shopping are variable costs for a firm that ships packages because the firm would pay either a $3 or a $4 fee for each package shipped by ground or air, respectively. 2.6 Changing the size of a firm’s physical plant, as with Sears changing the size of its stores, takes place in the economic long run. 2.7 No, we cannot conclude that Apple is making a profit of $609 on each iPhone 11 Pro Max. The article states that each phone has a cost of materials equal to $490. Not included in the cost of materials are other costs Apple incurred, including (1) labour costs, (2) research and development costs, (3) advertising, and (4) a return on the investment Apple’s owners made in the firm. To calculate economic profit, all implicit and explicit costs relating to the production of the iPhone must be subtracted from the total revenue earned from selling the phones. 2.8 a. A firm will have no money coming in if its sales are zero. Therefore, the phrase “the amount of money that will go out even if none at all comes in” describes the firm’s fixed cost because the firm incurs fixed cost even when it is producing and selling a quantity equal to zero. b. Fixed costs can include rent for a store or warehouse, payments for online advertising, or a payment to the city for a permit to operate the business. 2.9 Choices (a), (d), and (e) are fixed costs because they do not change as the quantity of pizzas produced changes. Choices (b) and (c) are variable costs because they increase as the quantity of pizzas produced increases. The time period under consideration is important. In the long run, all of these costs are variable.

CHAPTER 9 | Technology, Production, and Costs

2.10 An airline’s most important fixed costs include the cost of its planes, its repair shops, and its other airport facilities. These costs are fixed because they do not change regardless of the number of passengers who travel on each flight. An airline’s fixed costs will be significantly larger than its variable costs—such as the wages and salaries it pays its employees or the cost of the aviation fuel consumed on each flight. For most firms, including clothing stores and restaurants, their labour costs are their largest cost. An airline’s fixed costs are likely to be a much larger fraction of its total costs than would be true of an Old Navy store or of a Panera Bread restaurant. 2.11

Quantity of Workers 0 1 2 3 4 5

Quantity of Cars per Month 0 20 30 40 50 55

Fixed Cost

Variable Cost

Total Cost

$6000 6000 6000 6000 6000 6000

0 $4 000 8 000 12 000 16 000 20 000

$6 000 10 000 14 000 18 000 22 000 26 000

Average Total Cost — $500 467 450 440 473

2.12 Ebba’s reasoning is faulty. If she could rent out her current building for $4000 per month, then she would incur an opportunity cost of that amount by using the building herself. Therefore, by moving to the suburbs, Ebba’s costs would actually drop by $1000 per month, which is the difference between the implicit rent of $4000 she is paying now, which she forgoes by not renting the building, and the cash rent of $3000 she would pay if she moved. 2.13 The report included DuPont chemical company’s expected earnings as a loss because the return on the investment represents the opportunity cost of the funds the company had invested. In this case, the expected earnings were an implicit cost that DuPont subtracted from revenue when calculating its economic profit or loss.

CHAPTER 9 | Technology, Production, and Costs

9.3

The Marginal Product of Labour and the Average Product of Labour Learning Objective: Explain and illustrate the relationship between the marginal product of labour and the average product of labour.

Review Questions 3.1

Marginal product normally increases at first due to specialization and division of labour, but it eventually decreases because of the law of diminishing returns. The amount of capital per worker declines as more labour is hired to work with a fixed amount of capital. Therefore, the marginal product of labour falls. When the marginal product of labour is greater than the average product of labour, the average product of labour increases. When the marginal product of labour is less than the average product of labour, the average product of labour decreases. The marginal product of labour is equal to the average product of labour when the average product of labour is at its maximum value. 3.2 The law of diminishing returns is the principle that, at some point, adding more of a variable input⸻such as labour⸻to the same amount of a fixed input⸻such as capital⸻will cause the marginal product of the variable input to decline. This principle doesn’t apply in the long run because in the long run none of the inputs is fixed; all inputs can vary.

Problems and Applications 3.3 a. Economists describe this problem as diminishing returns. In this case, the size of the kitchen is fixed (the kitchen is a fixed factor), while the number of cooks is the variable factor. We know that diminishing returns occur in nearly every activity. Therefore, we would expect that as more cooks attempt to prepare food in a kitchen of fixed size, eventually the marginal product of labour for cooks will diminish. Because there is a fixed factor and a variable factor of production, we know that the restaurant owner is describing her short-run production function. b. In the long run, restaurant owners can vary the size or number of kitchens. In the long run, all factors of production are variable. The problem with diminishing returns that the restaurant owner is describing doesn’t exist in the long run. Copyright © 2024 Pearson Canada Inc.

CHAPTER 9 | Technology, Production, and Costs 3.4 Quantity of Workers 0 1 2 3 4 5 6 7

Total Output 0 400 900 1500 1900 2200 2400 2300

Marginal Product of Labour — 400 500 600 400 300 200 –100

3.5

Average Product of Labour — 400 450 500 475 440 400 329

CHAPTER 9 | Technology, Production, and Costs

3.6 The student’s analysis is incorrect. The data in Table 9.3 represent the effects of specialization and division of labour and the law of diminishing returns at Ebba’s pizza restaurant rather than the varying quality of the workers. We assume that the quality of the workers remains the same as Ebba hires more workers. 3.7 Gains from specialization are not limited to the production of physical goods. In retail stores, for example, there is a division of labour among workers who stock shelves, help customers in the aisles, and operate cash registers. 3.8 As long as Sally’s GPA for a semester is below her cumulative GPA, her cumulative GPA will fall. The current semester’s GPA is her marginal GPA, while her cumulative GPA is her average GPA. Even if her marginal GPA goes up, her average GPA will go down if her marginal GPA is below her average GPA at the beginning of the semester. 3.9 a. AP = Q/L = 24/4 = 6 pizzas per worker b. MP = ΔQ/ΔL = (28 − 24)/(5 − 4) = 4/1 = 4 pizzas c. If we add the marginal product of the second worker (6 pizzas) to the number of pizzas produced when 1 worker is hired (5 pizzas), then the total number of pizzas produced when 2 workers are hired is 6 pizzas + 5 pizzas = 11 pizzas. d. The law of diminishing returns sets in when the marginal product of labour first starts to fall. In this case, it sets in with the fourth worker hired, where marginal product falls to five.

9.4

The Relationship between Short-Run Production and Short-Run Cost Learning Objective: Explain and illustrate the relationship between marginal cost and average total cost.

Review Questions 4.1 The average total cost of production is the firm’s total cost divided by the quantity of output a firm produces. The marginal cost of production is the change in a firm’s total cost from producing one more unit of a good or service. 4.2 If the marginal product of labour is rising, it means that each additional worker is contributing more additional output than the previous worker, so the cost for each additional unit produced is less than the cost of the previous unit. Marginal product and marginal cost are mirror images of each other: When marginal product increases, marginal cost falls; when marginal product falls, marginal cost increases. 4.3 When marginal cost is below average total cost, marginal cost pulls average total cost down, so we are on the downward-sloping section of the U-shaped average total cost curve. When output expands enough, marginal cost rises to equal, and then exceed, average total cost. When marginal cost is above average total cost, marginal cost pulls average total cost up, so we are on the upward-sloping section of the U-shaped average total cost curve. Therefore, at the point where marginal cost equals average total cost, the average total cost curve stops sloping downward but hasn’t begun sloping upward. The average total cost curve is at its lowest point when the marginal cost curve equals (or intersects) it.

CHAPTER 9 | Technology, Production, and Costs

Problems and Applications 4.4 You should disagree. The interest you pay on a loan is a fixed cost, so it would have no effect on the marginal cost of producing another barrel of oil. 4.5 Costs incurred from exploring for new oil fields are part of Parsley Energy’s fixed costs because these costs do not change as the quantity of oil the firm produces changes. Parsley Energy’s marginal cost of producing oil is unaffected by changes in its fixed costs. Therefore, if the firm cuts back on oil exploration, its marginal cost of producing oil won’t change. 4.6 Yes. As long as marginal cost is below average total cost, average total cost will be decreasing, even if marginal cost is increasing. 4.7 a. No. In this case, average total cost is also always increasing. We can be sure of this conclusion because in this case the firm has no fixed costs, so there is no (decreasing) average fixed cost component of average total cost. b. Because each unit costs an additional $5 to produce, average total cost will also be $5 for each unit. The average total cost curve and the marginal cost curve will be a straight line parallel to the quantity axis at $5. Note that this result depends on the assumption stated at the beginning of the problem that the firm has no fixed costs. 4.8 a.

Quantity of Workers 0 1 2 3 4 5 6

Quantity of Copies per Day 0 600 1100 1500 1800 2000 2100

Fixed Cost $40 40 40 40 40 40 40

Variable Cost $0 40 80 120 160 200 240

Total Cost $40 80 120 160 200 240 280

Average Total Cost — $0.133 0.109 0.106 0.111 0.120 0.133

Marginal Cost — $0.067 0.080 0.100 0.133 0.200 0.400

b. The average total cost curve is U shaped, which means that it falls initially and then rises. (Note that in this example, we only get the U shape for the average total cost curve if we compute average total cost to three decimal places. At two decimal places, the average total cost of producing 1100, 1500, and 1800 copies is $0.11, so the average total cost curve will have a flat section.) The marginal cost curve, on the other hand, rises continuously rather than being U shaped.

CHAPTER 9 | Technology, Production, and Costs

4.9 Average total cost is total cost divided by total output. In this case, average total cost for 10 000 pizzas is $50 000/10 000 = $5.00. Marginal cost is the change in total cost divided by the change in output. In this case, marginal cost from the additional pizza is $11/1 = $11. As the following graph shows, when average total cost is rising, marginal cost must be above average total cost. Therefore, Ebba is correct to say that her marginal cost must be increasing.

CHAPTER 9 | Technology, Production, and Costs

4.10 Average total cost is total cost divided by total output. In this case, average total cost is $75 002/20 001 = $3.75. Marginal cost is the change in total cost divided by the change in output. In this case, marginal cost is $2/1 = $2. As the following graphs show, when average total cost is greater than marginal cost, marginal cost may be either increasing (as shown in graph (i)) or decreasing (as shown in graph (ii)). Therefore, Ebba is wrong to say that her marginal cost “must” be increasing because it may or may not be increasing. i.

In this case, Ebba’s average total cost is above her marginal cost, and her marginal cost is increasing.

ii. In this case, Ebba’s average total cost is above her marginal cost, and her marginal cost is decreasing.

CHAPTER 9 | Technology, Production, and Costs

4.11 a. ΔVC = wΔL w ∆TC ∆VC w∆L b. = MC = = = , ∆Q ∆Q ∆Q ∆Q ∆L

MC =

w MPL

c. If w = $750 and MPL is 150, then MC = $750/150 = $5. If the wage falls to $600 and MPL is unchanged, then MC = $600/150 = $4. If the wage is $750 and MPL rises to 250, then MC = $750/250 = $3.

9.5

Graphing Cost Curves Learning Objective: Graph average total cost, average variable cost, average fixed cost, and marginal cost.

Review Questions 5.1 The marginal cost curve intersects the average variable cost curve and the average total cost curve at their minimum points. 5.2 The difference between average total cost and average variable cost is average fixed cost. Average fixed cost decreases as output increases, so the difference between average total cost and average variable cost must also continuously decrease. Using symbols: ATC = AVC + AFC, so ATC − AVC = AFC. As AFC continuously decreases, so must ATC − AVC.

CHAPTER 9 | Technology, Production, and Costs

Problems and Applications 5.3 a. Ordinarily, we think of a firm’s labour costs as being a variable cost because labour costs usually increase and decrease with the firm’s production. We assume that if a firm reduces the quantity it produces, it will lay off or fire some of its workers and the cost to the firm of those workers will drop to zero. In this case, though, GM and its union had negotiated an agreement that obligated GM to pay 95 percent of its production workers’ salaries even if the firm lays off these workers. Therefore, 95 percent of GM’s production workers’ salaries were a fixed cost to the firm, with only 5 percent being a variable cost. b. Refer to the following figure. Suppose that GM is initially at point A, producing a quantity Q1 and incurring an average total cost of AC1. When GM reduces production and lays off some of its workers, production drops to Q2. If GM did not have an agreement to pay its workers when they were laid off, GM’s average total cost would drop to AC2. This decline in average total cost is illustrated as a movement from point A to point B along the same average total cost curve, ATC1. But because GM has an agreement with the labour union, GM is obliged to pay 95 percent of the salaries of the workers the firm lays off as a result of decreasing output from Q1 to Q2. These payments to laid-off workers are an additional fixed cost to GM, so the average total cost line shifts up from ATC1 to ATC2. The increase in GM’s average total cost as a result of the agreement with the union is illustrated as a movement from point A to point C as the average total cost curve shifts up from ATC1 to ATC2.

5.4 a. Variable cost = total cost – fixed cost. So, $30 000 − $10 000 = $20 000. b. AVC = VC/Q = $20 000/10 000 = $2 AFC = FC/Q = $10 000/10 000 = $1 c. The gap must get smaller as output rises because ATC = AVC + AFC, and AFC falls as output rises. So, the dollar difference between ATC and AVC is greater when the output of tennis balls is 10 000.

CHAPTER 9 | Technology, Production, and Costs

5.5 a. The “fixed element of mining cost” refers to the fixed costs in mining. Examples of fixed costs in mining include the cost of mining equipment, insurance costs, and the costs of mining permits. b. No. Most average total cost curves are U shaped, similar to the following graph. A reduction in the output raises the firm’s average total cost if the quantities are small and the ATC is downward sloping, which is illustrated in the graph by a decline in output from Q1 to Q2 and a movement from point A to B on the ATC. At larger quantities produced, the ATC will slope upward. A reduction in the output lowers the firm’s average total cost if the ATC is upward sloping, which is illustrated in the following graph by a decline in output from Q3 to Q4 and as a movement from point C to D on the ATC.

5.6 a. The total cost of five scrolls would be equal to the variable costs of 27.83 drachmas × 5 = 139.15 drachmas because there are no fixed costs. The total cost of five codices would be the sum of the variable costs of 20.58 drachmas × 5 = 102.9 drachmas plus the fixed costs of 58 drachmas, or 160.9 drachmas. Given these costs, the publisher should publish the book as a scroll because the total cost is lower when the book is produced in that form. The total cost of 10 scrolls would be equal to the variable costs of 27.83 drachmas × 10 = 278.3 drachmas. The total cost of 10 codices would be the sum of the variable costs of 20.58 drachmas × 10 = 205.8 drachmas plus the fixed costs of 58 drachmas, or 263.8 drachmas. Given these costs, the publisher should publish the book as a codex because the total cost is lower when the book is produced in that form. b. As publishers began to publish more copies of each book, the average cost of a book was lower if the book was published as a codex rather than as a scroll.

CHAPTER 9 | Technology, Production, and Costs 5.7 a.

Quantity of Students Taking the Course 1 000 10 000 20 000

Average Total Cost $220 40 30

Average Variable Cost $20 20 20

Average Fixed Cost $200 20 10

Marginal Cost $20 20 20

b. To offer a massive open online course (MOOC), universities and private companies incur substantial costs to prepare material and design the MOOC so that the material is made available in an accessible and effective way. These are fixed costs. Once the MOOC has been designed and made available, the marginal cost of offering the course to one more student is very low. In the following graph, marginal cost is shown as a low, constant amount of $20 per student. In this case, the shape of the average total cost curve is determined largely by the shape of the average fixed cost curve.

5.8 a. $15 b. Total cost = ATC × Q = $30 × 1000 = $30 000. c. Variable cost = AVC × Q = $20 × 1000 = $20 000. d. Fixed cost = Total cost – Variable cost = $30 000 − $20 000 = $10 000. 5.9 The AFC curve should be downward sloping, not U shaped. Because AFC = FC/Q and because total fixed cost does not change, AFC will always decrease as quantity increases. ATC should be above AVC. Because ATC = AFC + AVC, the ATC curve will always be above both the AFC and AVC curves.

100

CHAPTER 9 | Technology, Production, and Costs

5.10 a. Marginal cost, average variable cost, and average total cost will all increase, but average fixed cost is unaffected. b. Marginal cost, average variable cost, and average total cost will all increase, but average fixed cost is unaffected. c. Average fixed cost and average total cost will decrease, but marginal cost and average variable cost will be unaffected. d. Average fixed cost and average total cost will increase, but marginal cost and average variable cost will be unaffected.

9.6

Costs in the Long Run Learning Objective: Explain how firms use the long-run average cost curve in their planning.

Review Questions 6.1 In the short run, Total cost = Variable cost + Fixed cost. In the long run, however, Total cost = variable cost because there are no fixed costs in the long run. 6.2 Minimum efficient scale is the lowest level of output at which all economies of scale have been exhausted. In other words, minimum efficient scale is where the long-run average cost curve stops sloping downward. In the long run, if Apple’s car business doesn’t reach minimum efficient scale, it will have higher average costs than competitors that do reach minimum efficient scale. In that case, Apple will probably be driven out of the car business. (However, if Apple can differentiate its cars in a way that appeals to consumers, it could sell cars at higher prices and still survive. 6.3 Economies of scale exist when a firm’s long-run average costs fall as the firm increases output. Firms may experience economies of scale because (1) a firm’s technology may allow it to increase production with a smaller proportional increase in at least one input; (2) both workers and managers can become more specialized as output expands; (3) large firms may be able to purchase inputs at lower costs than smaller firms can; and (4) as a firm expands, it may be able to borrow money at a lower interest rate, thereby lowering its costs. 6.4 Diseconomies of scale exist when a firm’s long-run average costs rise as the firm increases output. Diseconomies of scale eventually arise because managing a store or a factory above a certain size becomes more complicated and costly. 6.5 Because short-run average cost includes at least one input that is fixed in quantity, short-run average cost can never be less than long-run average cost (where there are no fixed inputs or fixed costs).

CHAPTER 9 | Technology, Production, and Costs

101

Problems and Applications 6.6 Refer to the following figure. A smaller oil firm produces QSmall firm barrels of oil, which corresponds to point A where ATC1 touches the long-run average cost curve. A large oil firm produces QLarge firm barrels of oil, which corresponds to point B where ATC2 touches the long-run average cost curve. The only way for a smaller oil firm to lower its costs is by expanding or merging with other firms so that it can increase its scale.

6.7 a. In the following graph, SRATC1 represents the short-run average total cost curve for an investment fund that has not reached minimum efficient scale. b. SRATC2 is a short-run average total cost curve for a fund that produces an output (Q1) that achieves minimum efficient scale. c. SRATC3 presents a short-run average total cost curve for a fund that experiences diseconomies of scale. d. Funds that produce within the output range Q1 to Q2 experience constant returns to scale.

102

CHAPTER 9 | Technology, Production, and Costs

6.8 a. Ebba’s average total cost will be lower with a smaller restaurant. b. Ebba’s average total cost will be lower with a larger restaurant. c. Economies of scale often take the form of a larger store or restaurant allowing for lower average cost for a large quantity, but actually higher average total cost for a small quantity. The larger restaurant may use larger ovens, more tables, or other capital that isn’t efficiently used if Jill is only able to sell a smaller quantity of pizzas. 6.9 a. Refer to the following figure. To simplify, we assume that T-Mobile and Sprint were equal in size and were approximately the size of AT&T when they merged. We also assume that AT&T has achieved minimum efficient scale. Because T-Mobile and Sprint were smaller, their long-run average costs were higher than AT&T’s long-run average cost. When T-Mobile and Sprint merged, they became similar in size to AT&T and their long-run average cost decreased to the level of AT&T’s average total cost. This last situation is illustrated in the graph that follows the answer to part b.

CHAPTER 9 | Technology, Production, and Costs

103

b. We can again assume that T-Mobile and Sprint were equal in size and were approximately the size of AT&T when they merged. After their merger, T-Mobile and Sprint claimed that the merged firm as “the leader in 5G.” Assume that this means the merged firm’s infrastructure investment in 5G technology is similar to the amount invested by AT&T and that both firms have reached minimum efficient scale. The following graph depicts this situation:

6.10 Ford would have ended up as the only automobile producer. Other producers would have had higher average costs and, therefore, would not have been able to match Ford’s price cuts without suffering losses that would have eventually driven them out of business. 6.11 a. That the smaller jets are easier to fill with passengers indicates that airlines can sell tickets on these jets at prices low enough that typically all (or nearly all) the tickets for a given flight are sold. Apparently, the airlines need to charge higher prices on flights with larger jets, which makes it harder to sell all the tickets on these flights. The implication is that the average cost of flying a passenger on a smaller jet is lower than the average cost of flying a passenger on a larger jet. b. The answer to part (a) does not mean that there are no economies of scale with respect to jets. It does indicate that because technological change has made it possible for firms manufacturing jets to use carbon fibre parts and more efficient engines, the minimum efficient size of jets is smaller than it had been. In these circumstances, building larger jets may lead to diseconomies of scale. 6.12 Pickens was describing diseconomies of scale. Diminishing returns applies in the short run when at least one of the firm’s inputs is fixed. Diseconomies of scale apply in the long run when a firm can vary all of its inputs, adopt new technology, and vary the size of its facility. Pickens refers to firms that encounter increases in their long-run average total cost as the scale of their operations expand.

104

CHAPTER 9 | Technology, Production, and Costs

Suggestions for Critical Thinking Exercises CT9.1

The answers will depend on the firms that a student selects. Here is an example from an online Wall Street Journal search for “Mesa Airlines,” a regional airline that is publicly traded: Mesa Air Group, Inc. operates as a holding company, which engages in the provision of regional air carrier and passenger transportation services. Its fleet includes American Eagle and United Express flights. The company was founded in 1982 and is headquartered in Phoenix. Employees: 3412 (pilots, maintenance personnel, flight attendants, corporate officers, etc.) Sector: Passenger Airlines Although the exercise doesn’t directly call for it, students can find additional information regarding this firm by doing an online search for “Mesa Airlines.” Because Mesa Airlines is a publicly traded company, its financial statements are available online as well.

CT9.2

The answer is yes. The firm should expand production because marginal revenue exceeds marginal cost. This chapter explains why, in general, business decision makers compare the additional benefit from an action to its additional cost. Business decision makers (sole proprietors, partners, or corporate managers) will often be able to make explicit dollar estimates of the marginal benefit (revenue) and marginal cost, while consumers and other decision makers typically make implicit estimates of these measures. Few students will have had experience with terms such as “marginal revenue,” “marginal benefit,” and “marginal cost” prior to taking their first economics course. However, by this point in the course, greater familiarity with these terms should help students better understand the logic behind comparing MB (or MR) and MC in order to make rational decisions in business and in their personal day-to-day lives. This question helps tie together marginal thinking across the course and gives a preview of profit maximization in the coming chapters. By seeing a topic more than once and by having to think hard about it, in principle a student can learn a concept more deeply (the former is called “spacing” and the latter is “desirable difficulties”).

CT9.3

By hiring local talent and using local suppliers for goods in that industry—such as software in Silicon Valley or financial services on Wall and Bay Streets—firms might lower costs. While the term is not used in this book, this is part of the “economics of agglomeration.”

CT9.4

One clear reason for the expansion in the number of beer brewers is likely due to a change in technology leading to minimum efficient scale occurring at a lower level of output. A second reason is that beer drinkers’ tastes might have changed and they now prefer beer manufactured by smaller, craft brewers.

CHAPTER 9 | Technology, Production, and Costs

105

ONLINE Appendix 9A | Using Isoquants and

Isocost Lines to Understand Production and Cost

Learning Objective: Use isoquants and isocost lines to understand production and cost.

SOLUTIONS TO CHAPTER 9 APPENDIX EXERCISES Review Questions 9A.1 An isoquant is a curve that shows all the combinations of two inputs, such as capital and labour, that will produce the same level of output. The slope of an isoquant is the rate at which a firm can substitute one input for the other while keeping output constant, or the marginal rate of technical substitution (MRTS). 9A.2 The isocost line shows all the combinations of two inputs, such as capital and labour, that have the same total cost. The slope of the isocost line is equal to the ratio of the price of the input on the horizontal axis divided by the price of the input on the vertical axis, multiplied by –1. 9A.3 The firm wants to minimize the cost of producing any level of output, which occurs where the isoquant and isocost lines are tangent or the MRTS equals the ratio of the input prices.

Problems and Applications 9A.4

106

CHAPTER 9 | Technology, Production, and Costs

9A.5 a. If total cost is $2000 and the wage rate and rental price of machines both equal $100, the isocost line’s endpoints are at 20 and 20. Along this isocost curve, the cost-minimizing point for producing 5000 units is point A. b. If the wage rate is one-fourth the rental price of machines, we must be on the isocost line whose endpoints are where capital = 10 and labour = 40, because we can buy four times as much labour with a total cost of $1000. Along this isocost curve, the cost-minimizing point for producing 5000 units is point B. c. In this case, the isocost line’s endpoints are at 40 and 40, so the cost-minimizing point for producing 12 000 units is point C. 9A.6 To minimize costs, Ebba should be at a point where Plugging in the numbers into our equation, we get

MPK 4000 pizzas per dollar and = = 8 pizzas per dollar. r $500 The ratios are not equal, so Ebba isn’t minimizing costs. Ebba produces more pizzas per dollar from the last worker than from the last oven. This result indicates that she has too many ovens and too few workers. If she hired more workers and rented fewer machines, her MPL would fall and her MPK would rise until:

9A.7 At point A, the slope of the isocost = − w/r = −1/2 ovens per worker, while the slope of the isoquant = MRTS = −1 oven per worker (w = wage rate; r is unit capital rate). Because the slope of the isoquant is greater than the slope of the isocost in absolute value, Ebba should employ more workers and fewer ovens (represented by point B) to minimize cost for Q = 20 000 pizzas per week.

CHAPTER 9 | Technology, Production, and Costs

107

9A.8

After the positive technological change, Ebba can produce 20 000 pizzas per week—this is the output produced along the new isoquant—at a cost of less than $20 000 per week. 9A.9 a. Combinations A and B yield the same output because they are on the same isoquant curve. b. The ratio of the wage rate to the rental price of capital will determine which point along this isoquant Ebba chooses. c. The marginal rate of technical substitution is the slope of the isoquant, which is greater (in absolute value) at point A. 11A.10

Ebba Kantzen’s pizza restaurant exhibits economies of scale between 20 000 and 45 000 pizzas per week and diseconomies of scale between 45 000 and 60 000 pizzas per week.

108

CHAPTER 9 | Technology, Production, and Costs

9A.11 The isoquant curve shows that there are many combinations of workers and machines that can pick the same quantity of oranges per day. In the United States, firms select a point like A—using a lot of capital and very little labour—because the isocost curves they face are very steep. In the United States labour has a relatively high price in comparison with capital. In Brazil, firms select a point like B—using lots of labour and very little capital—because the isocost curves they face are very flat; the price of labour is low in comparison with the price of capital.

9A.12 Ebba Kantzen is producing where the MRTS equals the ratio of input prices. Because the ratio of input prices is $600/$2000, the ratio of the marginal product of labour to the marginal product of capital must be the same. So, $600/$2000 = MPL/12 000, or MPL = 3600 pizzas. 9A.13 If Massey and Thaler are correct, the team that has the first pick in the draft should trade it to another team for a lower draft pick. The players chosen with the first few picks of the first round of the draft tend to be paid salaries that are much higher relative to their marginal products than is true for players taken later in the first round. A typical team with a high draft pick would increase its ability to win football games at the constant cost represented by the salary cap if it traded for lower draft picks. The 2011 agreement that limits the salaries that drafted players can receive will mean lower overall salaries, so a team with the first pick should still trade it to another team for a lower pick.

CHAPTER 9 | Technology, Production, and Costs

109

9A.14 a. The new isocost line is shown in the following graph. The line has shifted in to reflect the fact that at the same level of total cost, the firm can now rent a maximum of 40 machines or hire as many as 40 workers. b. The new combination is labelled B on the graph. c. Compared to point A, we can be sure that point B uses fewer workers and fewer machines. After both the wage rate and the rental price of machinery doubled, the isocost line shifted in with new intercepts of 40 machines and 40 workers. Because the original combination of capital and labour that minimized the firm’s cost was 40 machines and 40 workers (point A), the new combination (point B) would have to use fewer workers and fewer machines.

CHAPTER 10 | Firms in Perfectly Competitive

Markets

SOLUTIONS TO END-OF-CHAPTER EXERCISES 10.1

Perfectly Competitive Markets Learning Objective: Explain what a perfectly competitive market is and why a perfect competitor faces a horizontal demand curve.

Review Questions 1.1 Perfectly competitive markets share three characteristics: (1) there are many buyers and sellers, (2) all firms sell identical products, and (3) there are no barriers to firms entering the market. 1.2 A price taker is a buyer or seller who is unable to affect the market price. Firms in perfectly competitive markets are price takers. Because a firm in a perfectly competitive market is very small relative to the market, and because it is selling exactly the same product as every other firm, it can sell as much as it wants to without having to lower its price. If the firm raises its price, the firm will sell nothing. 1.3 The graph should look like Figure 10.2. The following graph on the left below shows the market demand and supply curves for corn. The graph on the right shows the demand for corn produced by Farmer Parker, an individual corn farmer.

CHAPTER 10 | Firms in Perfectly Competitive Markets

111

Problems and Applications 1.4 (a) is perfectly competitive because there are many tomato growers selling the same product; (b) is not perfectly competitive because coffee shops do not sell identical products; (c) is not perfectly competitive because there are only a few automobile sellers, the products being sold are not identical, and there are barriers to new firms entering the market; and (d) is not perfectly competitive primarily because new homes are not identical. 1.5 No. “Fierce competition” does not imply a horizontal demand curve because horizontal demand curves are found only in perfectly competitive markets. Perfectly competitive markets are markets that have (1) many buyers and sellers, (2) the sellers are selling a product or service that is identical, and (3) there are no barriers to firms entering the market. The market for streaming services is not perfectly competitive because the streaming services sold by different firms are not identical. Services offered by Paramount+ are not the same as those offered by Netflix or any other service provider. If Netflix or any of the other firms charges a higher price, that firm will not lose all of its sales. A firm that faces a horizontal demand curve in a perfectly competitive industry would lose all of its sales if it raised prices. 1.6 Not many markets meet the requirements for being perfectly competitive. But a model does not have to be realistic to be useful. The model of perfect competition is important as a benchmark—a market with the maximum possible competition—that economists use to evaluate actual markets that are not perfectly competitive. A further quotation from George Stigler helps us to understand why economists use the model of perfect competition: “If a science is to deal with a large class of phenomena, clearly it cannot work with concepts that are faithfully descriptive of even one phenomenon, for then they will be . . . undescriptive of others.” As we discussed in Chapter 1, Section 1.3, all sciences, including social sciences like economics, rely on abstract models. 1.7 The remark confuses the market demand for wheat with the demand facing one farmer selling wheat. Remember that the units used in drawing the market demand curve are much larger than the units used in drawing the individual farmer’s demand curve. The market demand curve for wheat is downward sloping, while the demand curve for any wheat farmer is a horizontal line. 1.8 The XYZ Company described in the problem is a price taker because it is in a “very competitive industry.” The company should charge the market price.

112

CHAPTER 10 | Firms in Perfectly Competitive Markets

How a Firm Maximizes Profit in a Perfectly Competitive Market 10.2 Learning Objective: Explain how a firm maximizes profit in a perfectly competitive market.

Review Questions 2.1 A firm in a perfectly competitive market is a price taker and can sell as many units as it wants to at the market price P. In other words, the firm faces a horizontal demand curve for its product. By selling an additional unit, the firm receives additional (or marginal) revenue of P. Because each unit is sold at P, the average revenue will also equal P, and we get the result P = MR = AR. 2.2 As long as marginal revenue is greater than marginal cost (MR > MC), a firm should continue to expand production because selling another unit of the product adds more to the firm’s total revenue than to its total cost, thereby increasing the firm’s total profit. When a firm reaches the level of output at which marginal revenue equals marginal cost (MR = MC), it has reached the point where producing that last unit of output will add as much to its total revenue as it does to its total cost, which means that total profit (TR – TC) cannot be increased further and, therefore, must be at a maximum. 2.3 In a perfectly competitive market, marginal revenue = price (MR = P), making these two conditions for the profit-maximizing level of output equivalent.

Problems and Applications 2.4 You should disagree with the student’s argument. A firm maximizes profit by selling where marginal revenue is equal to marginal cost. If a firm stops producing a quantity for which marginal revenue is greater than marginal cost, then it could increase its profit by producing more. Firms do not want to maximize their profit per unit sold; they want to maximize their total profit. 2.5 Revenue is the total dollar amount of a firm’s sales. Firms are interested in what they have left over from their revenues after they have paid all of the costs of producing the goods they sell. Profit is what remains when you subtract total cost from total revenue. That is why firms maximize profit rather than revenue. A revenue-maximizing firm is likely to produce more output than if it were maximizing profit because, for the typical firm, revenue increases beyond the quantity where profit starts to decline. 2.6 Farmer Parker will produce where MR = P = MC, which in this case is 6 bushels. Profit = total revenue − total cost = ($5.50 × 6) − $29.00 = $4.00. 2.7 Assuming a market price of $7 a bushel, Farmer Parker will still produce 7 bushels because marginal revenue is now exactly equal to the marginal cost of $7.00. 2.8 Farmer Parker’s fixed cost is $10. The increase in fixed cost to $20 will not affect marginal cost, so profit is still maximized at 7 bushels of wheat because that is where marginal revenue equals marginal cost. Farmer Parker’s profit, however, would now be $3.50 instead of $13.50 because of the $10 increase in his fixed cost.

CHAPTER 10 | Firms in Perfectly Competitive Markets

113

10.3 Illustrating Profit or Loss on the Cost Curve Graph

Learning Objective: Use graphs to show a firm’s profit or loss.

Review Questions 3.1 The graph should look like the graph in Step 4 of Solved Problem 10.1 (which is reproduced here) showing the situation of a firm in the perfectly competitive market for basketballs.

3.2 The graph should look like the graph in Step 6 of Solved Problem 10.1 (which is reproduced here) showing the situation of a firm in the perfectly competitive market for basketballs.

114

CHAPTER 10 | Firms in Perfectly Competitive Markets

Problems and Applications 3.3 a. To maximize profit, Frances will produce the level of output where marginal revenue is equal to marginal cost. She will charge the market price of $1.80. Her profit-maximizing output is 6 pencils. She should expand output up to the point where MR = MC, but remember that in a competitive market MR = P. The sixth pencil’s marginal cost is $1.60 (see the final column of the following table that lists values for marginal cost at each level of output). This marginal cost is less than the marginal revenue of $1.80 that she receives from selling it. The seventh pencil’s marginal cost is $1.90, which is slightly more than the marginal revenue of $1.80 from selling it. We can conclude that producing the sixth pencil increases Frances’s profit, but producing the seventh pencil would reduce her profit. Frances’s profit = Total revenue – Total cost = (Price × Quantity) – Total cost = ($1.80 × 6) − $6.80 = $4.00.

CHAPTER 10 | Firms in Perfectly Competitive Markets

115

b. Frances will charge $1 and produce 5 pencils. Her loss will be (5 × $1) − $5.20 = $0.20, which is smaller than the loss of $1 (which is equal to her fixed cost) if she shuts down.

If the price of pencils falls to $0.25, Frances should shut down because this price is less than the minimum point on her AVC curve. Her loss will be equal to her fixed cost of $1.

3.4 If the price of basketballs fell to $2.50, Andy would shut down and not produce any basketballs. The price would be less than average variable cost at all output levels, as is shown in the table in Solved Problem 10.1 in the chapter (that table is reproduced below). If Andy shuts down, his loss would equal his fixed cost of $10.00.

0 1 2 3 4 5 6 7 8 9

Output per Day (Q)

Total Cost (TC) $10.00 20.50 24.50 28.00 34.00 43.00 55.50 72.00 93.00 119.00

Fixed Cost (FC) $10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00

Variable Cost (VC) $0.00 10.50 14.50 18.00 24.00 33.00 45.50 62.00 83.00 109.00

Average Total Cost (ATC) — $20.50 12.25 9.33 8.50 8.60 9.25 10.29 11.63 13.22

Average Variable Cost (AVC) — $10.50 7.25 6.00 6.00 6.60 7.58 8.86 10.38 12.11

Marginal Cost (MC) — $10.50 4.00 3.50 6.00 9.00 12.50 16.50 21.00 26.00

3.5 This student’s argument is incorrect. To maximize profit, the firm should produce up to the point where marginal revenue equals marginal cost. By producing only Q1, the firm will miss out on profit to be made on units between Q1 and Q2.

116

CHAPTER 10 | Firms in Perfectly Competitive Markets

3.6 The goal for the Ford Motor Company, and most other firms, is to maximize its profit. Because profit is calculated by taking the difference between total revenue and total cost, a firm can have lower revenue in one quarter than in the previous quarter but still have a larger profit if its costs declined by enough. In this case, because Ford was able to increase its profit by $3.4 billion from the third to the fourth quarter of 2020 despite declining revenue, we know that the firm’s total costs must have decreased. A firm will typically not maximize revenue at the output level that maximizes its profit. If a firm maximized its revenue, it would typically produce a larger quantity than if it maximized its profit. 3.7 In the following graphs, the one on the left represents the wheat market, while the one on the right represents the typical wheat farm. In the graph on the left, the initial market price (P1) and quantity (Q1) are determined by the intersection of the market demand curve (D1) and the market supply curve (S). Because the typical firm is a price taker, it sells quantity q1 where P1 is equal to its marginal cost, MC, shown by point C in the graph on the right. Because it is assumed that the farm is initially suffering a loss, P1 is less than the farm’s average total cost, or ATC; the value of ATC at this quantity is labelled B. The farm’s total loss is equal to its total revenue (P1 × q1) minus its total cost (ATC × q1). The loss is equal to the area ABCP1. The release of the scientific study results in an increase in the market demand for wheat, shown in the graph on the left by a shift from D1 to D2. The increase in demand increases the market price to P2 and the market quantity to Q2. Because the farm is a price taker, its demand curve in the graph on the right shifts up from D1 to D2. The farm can sell all that it wants to at the market price, so its demand curve also represents its marginal revenue (MR) curve. The firm maximizes its profit by increasing its output from q1 to q2. At q2, the farm’s total revenue (equal to area P2Fq20) exceeds its total cost (area EGq20). This short-run economic profit will lead to new farms entering the market, so in the long run all wheat farms will break even.

3.8 a. To maximize profit, Marguerite should produce at the level of output for which MR = MC. Referring to the figure in the book, she should produce 100 caps because this is the quantity where the MC curve intersects the MR curve.

CHAPTER 10 | Firms in Perfectly Competitive Markets

117

b. At 100 caps: TR = $11.00 × 100 = $1100 and TC = $9 × 100 = $900. Marguerite will therefore earn a profit of $1100 − $900 = $200. c.

10.4

If Marguerite decides to shut down, she will incur a loss equal to her total fixed cost. Fixed cost = (ATC – AVC) × Q. So, in this case, fixed cost, or the amount of her loss, is ($9 –$6) × 100 = $300.

Deciding Whether to Produce or to Shut Down in the Short Run Learning Objective: Explain why firms may shut down temporarily.

Review Questions 4.1 In the short run, a firm will shut down if price falls below the minimum point on its average variable cost curve. In the long run, a firm will shut down (and exit the industry) if the price is below the minimum point on its average total cost curve. In the short run, the firm is willing to accept losses because it cannot do anything about its fixed costs—and must pay those costs whether or not it is producing anything. In the long run, however, the firm will close down and exit the industry if it expects continued losses. 4.2 The perfectly competitive firm’s supply curve can be directly derived from its marginal cost curve. The firm will produce where P = MC if price is at or above the shutdown point at the minimum point on the AVC curve. 4.3 The market supply curve is derived by adding up the quantity supplied (using marginal cost curves) by each firm in the market at each price.

Problems and Applications 4.4 Situation 1: Total cost = $5000 + $5000 = $10 000. Average total cost = $10 000/1000 = $10. Therefore, price, marginal revenue, marginal cost, and average total cost will all equal $10, and the firm will produce 1000 units of output and break even. Situation 2: Total cost = $5000 + $6000 = $11 000. By producing an output of 1000, where price equals marginal cost, the firm will earn $10 000, which is less than its total cost of $11 000. Because the firm can cover all of its variable cost and part of its fixed cost, it will produce in the short run although it suffers a $1000 loss. Situation 3: Total cost = $5000 + $11 000 = $16 000. If the firm were to produce 1000 units, the level of output where price equals marginal cost, the revenue of $10 000 it would earn would be less than its variable cost ($11 000). Therefore, the firm will shut down in the short run because its loss of $6000 when producing is greater than its loss of $5000 (its fixed cost) when shut down.

118

CHAPTER 10 | Firms in Perfectly Competitive Markets

4.5 a. Output per Week 0 1 2 3 4 5 6 7 8 9 10

Total Cost $100 150 175 190 210 240 280 330 390 460 540

AFC — $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00

AVC — $50.00 37.50 30.00 27.50 28.00 30.00 32.86 36.25 40.00 44.00

ATC — $150.00 87.50 63.33 52.50 48.00 46.67 47.15 48.75 51.11 54.00

MC — $50.00 25.00 15.00 20.00 30.00 40.00 50.00 60.00 70.00 80.00

b. Alfredo should produce 7 lamps, and he will make a profit = $350 – $330 = $20. c. Price now equals marginal cost at a quantity of 5 lamps. Alfredo’s revenue will be $150 and his total cost will be $240, so he will suffer a loss of $90. This loss is less than his fixed cost of $100, so he should continue to produce in the short run. (We know his fixed cost equals $100 because that is total cost when output equals zero.) Looked at another way, Alfredo should only shut down if the price falls below the minimum point on his AVC curve, which is $27.50. 4.6 a. Output per Week 0 1 2 3 4 5 6 7 8 9 10

Total Cost $100.00 155.70 205.60 253.90 304.80 362.50 431.20 515.10 618.40 745.30 900.00

AFC — $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00

AVC — $55.70 52.80 51.30 51.20 52.50 55.20 59.30 64.80 71.70 80.00

ATC — $155.70 102.80 84.63 76.20 72.50 71.87 73.59 77.30 82.81 90.00

MC — $55.70 49.90 48.30 50.90 57.70 68.70 83.90 103.30 126.90 154.70

b. Using the MR = MC rule, Matt should produce 7 pairs of boots per week at a price of $100 per pair. If he produces 7 pairs of boots, his total revenue will be $700 and his total cost will be $515.10. Therefore, Matt’s profit will be $184.90. c. If price falls to $65, Matt should produce 5 pairs of boots per week. By producing 5 pairs of boots per week and charging a price of $65 per pair, Matt will earn total revenue of $325. Because Matt’s total cost of producing 5 pairs of boots is $362.50, he will incur a loss of $37.50. Because this loss is less than his fixed cost of $100, Matt should continue to produce in the short run.

CHAPTER 10 | Firms in Perfectly Competitive Markets

119

d. By producing 3 pairs of boots per week and charging a price of $50 per pair, Matt will earn total revenue of $150. Because his total cost of producing 3 pairs of boots is $253.90, he will suffer a loss of $103.90. At this point, Matt would minimize his losses by shutting down in the short run because P ($50) is less than AVC ($51.30). In other words, Matt would suffer a loss of $100 by shutting down, as opposed to a loss of $103.90 by producing 3 pairs of boots. 4.7 a. Total cost = A + B + C (see the following graph) b. Total revenue = A + B c. Variable cost = A d. Loss = C The firm will continue to produce in the short run because its revenue is greater than its variable costs.

4.8 If a firm spends more to produce oil than it receives in revenue from selling the oil, that firm is suffering a loss. But a firm should continue to produce in the short run provided that it can cover its variable costs. Whether a firm produces in the short run or shuts down, it must still pay its fixed costs. As long as the loss it incurs by operating is less than its fixed costs, a firm should continue to produce. In the long run, a firm has to at least break even by covering all of its costs. It seems likely that the oil firms referred to in the article were covering their variable costs. That banks were willing to lend these firms money despite their losses indicates that the oil firms (and the banks) expected the firms would eventually be able to at least break even. 4.9 You should continue running the copy store as long as the revenue you earn covers your variable costs. The rent and interest and repayment on the loan are fixed costs that you cannot avoid paying even if you shut down. Therefore, you should ignore those costs in the short run (until the year’s lease expires). 4.10 a. Sunk costs are costs that a firm has already paid and cannot recover. Some of the sunk costs that the oil companies incur are (1) the costs of preparing the land for drilling, (2) the cost of drilling the oil wells, and (3) the costs they incur to get the proper permits and licenses necessary to drill in a particular area. b. With large sunk costs, a firm will continue to operate a well only if the firm’s total revenue from the well is larger than the variable costs of operating the well. As long as revenue exceeds variable cost, the firm is covering the cost of operating the well with some revenue left over to pay at least some of its fixed costs.

120

CHAPTER 10 | Firms in Perfectly Competitive Markets c. No, because in the long run a firm will have to cover all of its costs. There are no sunk costs in the long run. If an oil firm finds that in the long run it can’t break even pumping oil from a well, it will close down the well. A firm that fails in the long run to at least break even on its operations will close down and go out of business.

4.11 a. Disney World would not be profitable unless its revenue exceeded all of its costs, not just its variable costs. We would need to know Disney World’s fixed costs. The company’s total costs equal its variable costs plus its fixed costs. The company would be profitable if its revenue were greater than its variable costs plus its fixed costs. b. If the theme park were to shut down, it would not incur any variable costs. But the theme park would still incur fixed costs. Because the theme park earned enough revenue to more than cover its variable costs, it would be better off—its loss would be smaller—if it were to continue to operate in the short run than if it were to shut down.

10.5

“If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run Learning Objective: Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run.

Review Questions 5.1 When firms in an industry are earning economic profits, new firms will enter the industry. When firms in an industry are suffering economic losses, some of those firms will exit the industry. 5.2 A firm earning zero economic profit will continue to produce, even in the long run, because the firm’s owners are earning as much as they would earn elsewhere. In other words, the owners are covering the opportunity cost of their investment. 5.3 The long-run supply curve in a perfectly competitive market will be a horizontal line if it is a constantcost industry—that is, if the typical firm’s average cost curves are unchanged as the industry expands or contracts. If the firm is in an increasing-cost industry, the long-run supply curve will slope upward. If the firm is in a decreasing-cost industry, the long-run supply curve will slope downward. The following graph, which is similar to Figure 10.10 (b), shows how a perfectly competitive constant cost industry—in this example, the egg industry—adjusts to a permanent decrease in demand.

CHAPTER 10 | Firms in Perfectly Competitive Markets

121

Problems and Applications 5.4 To find this ex-professor’s economic profit, we need to subtract the opportunity cost of her time (the $75 000 salary she had been earning as an economics professor) and the opportunity cost of the funds she is investing in her business ($3000 in interest she had been earning on a bank certificate of deposit) from her accounting profit of $80 000: $80 000 − $75 000 − $3000 = $2000. 5.5 a. The chapter opener states that according to US Department of Agriculture (USDA) data, in early 2021 US farms had more than 82 million cage-free chickens, which was about 26 percent of all egg-laying chickens in the United States. If the market for cage-free chickens was in long-run equilibrium, new farms would not be entering the market to produce cage-free eggs. But the USDA is projecting that by 2026, 64 percent of hens in the United States will be cage free. We can conclude that although the market in 2021 was moving toward long-run equilibrium where cage-free chicken farmers would break even, it was not yet at this point. b. The hope of earning a short-run economic profit should still lead to an increase in the number of farmers who produce cage-free eggs. As a result, the supply of cage-free eggs will continue to increase, and in the long run, the price will fall. 5.6 Because the egg market is perfectly competitive, when the market price falls to $1.75, Sacha must match it or her sales will fall to zero. 5.7 The following two graphs depict the demand curve and the supply curve in the palm oil market (on the left) and the demand curve for a farm producing palm oil tree fruit (on the right). To simplify the graphs, we assumed that the price of palm oil is the same as the price of palm oil tree fruit. An increase in demand shifts the demand curve in the graph on the left from D1 to D2. Because we assume that the markets for palm oil and palm tree fruit are perfectly competitive, the demand curve for the palm tree firm is perfectly elastic—farm owners are price takers. Because the increase in demand causes the equilibrium price of palm oil to double, so does the price of palm tree fruit. The increase in the price of palm oil will increase firms’ profits in the short run, but this will result in an increase in the number of firms producing palm oil in the long run. The increase in the number of firms causes the supply curve in the graph on the left to shift from S1 to S2. Assuming that other things (including the price of resources

122

CHAPTER 10 | Firms in Perfectly Competitive Markets used to produce palm oil) do not change, the price of palm oil decreases from 2P back to P in the long run. The price of palm oil tree fruit also decreases from 2P to P in the graph on the right.

5.8 a. O’Hayer’s decision limits his company, Vital Farms, by reducing the number of chickens he can raise on a given amount of land. Pasture-raised chickens move around more and will therefore eat more chicken feed than those raised in small cages. They are also more likely to be injured or killed by being pecked by other chickens. These factors make it more costly to raise chickens in large outdoor spaces than in cages and limit O’Hayer’s ability to expand his company. b. Vital Farms’ profit depends on the premium consumers are willing to pay for pastured eggs relative to eggs that have been produced in the conventional way and on the number of other farmers producing pastured eggs. Over time, we would expect that competition among farmers will result in the premium consumers pay for pastured eggs declining until it is just enough to cover the additional cost to farmers from producing eggs this way. The result will be that Vital Farms and other farms selling pastured eggs will be just breaking even, which means that they will be earning zero economic profit. 5.9 An increase in the demand for gluten-free spaghetti will lead to an increase in its price in the short run. The higher price will increase the short-run profit from producing this type of spaghetti. But that profit will attract new firms to the industry, shifting the industry supply curve to the right and causing the price of gluten-free spaghetti to return to $3.50 in the long run. The entry of new firms causes the long-run equilibrium quantity to be more than 4 million boxes. Therefore, you should choose (b) as your answer. The answer assumes that gluten-free spaghetti is a constant-cost industry, which seems likely because it does not rely on an input that is available in only a limited quantity. 5.10 In the following graph on the left, the increase in the demand for laptop computers causes the demand curve to shift from D1 to D2, temporarily driving the price up to P3. As the production of laptops increases, more orders are placed for laptop displays. As production of laptop displays increases, their cost and price fall because of economies of scale. As shown in the graph on the right, with increased demand and lower average and marginal costs, the firms that assemble laptops can make economic profits at P3. The result is that new firms enter the industry, the industry supply curve shifts from S1 to S2, driving down the price to P2 and eliminating economic profits. Because the price of laptop computers declines as output increases, the long-run supply curve is downward sloping. This is a decreasing-cost industry.

CHAPTER 10 | Firms in Perfectly Competitive Markets

123

5.11 Professor Dixit is illustrating a fact emphasized in this chapter: In a market system, firms will supply to every consumer willing to pay a price equal to the long-run average cost of production all of a good or service the consumer wishes to purchase. Although the coffee shop doesn’t know when Professor Dixit will arrive (or whether on a particular day he will come at all), the shop expects that at the current equilibrium price, enough buyers will be available to buy the coffee they are selling. Coffee shops are ready and willing to serve coffee to anyone willing to pay the equilibrium price, which is the price that will cover all of their costs—including the opportunity cost of the funds the owners have invested in the firm. 5.12 a. There are 400 000 farms that produce, on average, 350 000 bushels of corn each. Therefore, each farm produced 0.0025% (= (350 000/14 000 000 000) × 100) of the total output of corn. The following graphs assume that the corn market is in long-run equilibrium.

124

CHAPTER 10 | Firms in Perfectly Competitive Markets b. In the following graph on the left, an increase in the corn harvest causes the supply curve for corn to shift to the right from S1 to S2, causing the equilibrium price to decrease from $3.80 to P2 and the equilibrium quantity to increase from 14 billion bushels to 16 billion. In the graph on the right, the representative farmer responds to the decrease in the price by decreasing quantity supplied from 350 000 bushels to q2 bushels. Because the equilibrium price is now below average total cost, ATC, the representative farmer is now suffering a loss.

c. In the following graph on the left, economic losses cause some farmers to exit the corn industry, causing the industry supply curve for corn to shift back to the left from S2 to S1. The equilibrium price returns to $3.80 and the equilibrium quantity decreases back to 14 billion bushels. In the graph on the right, the representative farmer responds to the increase in the price by increasing quantity supplied from q2 bushels to 350 000. Because the equilibrium price is now equal to average total cost, ATC, the representative farmer is breaking even from growing corn.

CHAPTER 10 | Firms in Perfectly Competitive Markets

125

10.6 Perfect Competition and Economic Efficiency

Learning Objective: Explain how perfect competition leads to economic efficiency.

Review Questions 6.1 If consumers want more of a product, the market will supply it. As demand increases, the price of the product increases, and the profits firms earn rise. Higher profits lead existing firms to expand production and new firms to enter the industry. If consumers want less of a product, the market will supply less of it. As demand decreases, the price of the product falls and firms begin to suffer losses. Losses lead existing firms to reduce production and some firms to leave the industry. In this way, consumers are able to dictate to firms the quantities of each good or service the firms produce. 6.2 Allocative efficiency is the state of the economy in which production reflects consumer preferences; specifically, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Productive efficiency is the situation in which a good or service is produced at the lowest possible average cost. Productive efficiency refers to how a good or service is produced, while allocative efficiency refers to producing the goods and services that consumers value most. 6.3 Consumers purchase output up to the point where price equals marginal benefit. Under perfect competition, firms produce up to the point where price equals marginal cost. Perfect competition, therefore, generates an equilibrium output where marginal benefit equals marginal cost, which represents allocative efficiency. In a perfectly competitive industry, free entry and exit ensures that, in the long run, firms are producing where average costs are minimized, thereby ensuring that productive efficiency also is achieved.

Problems and Applications 6.4 The student is correct to note that a firm’s goal is to maximize its profit and not maximize consumer welfare. However, consumers will not purchase past the quantity where marginal benefit equals price. And given that firms produce up to the quantity where price equals marginal cost, we get the efficient outcome the text states. Efficiency is achieved despite consumers and producers acting in their own self-interests. 6.5 a. Because at the profit-maximizing level of output P = ATC, Murat is earning zero economic profit. b. Murat’s firm illustrates both productive and allocative efficiency. Productive efficiency occurs when a firm operates at the lowest possible cost, and Murat’s firm is operating at the lowest point on its ATC curve. Allocative efficiency occurs when a firm operates where MR (or price) is equal to MC, and Murat’s firm is producing at that point. 6.6 In perfectly competitive markets, firms may temporarily earn greater profits from a reduction in costs. However, in the long run, these profits will lead to new firms entering the market. New firms entering the market will shift the supply curve to the right, resulting in lower prices. Lower prices benefit consumers but leave the typical firm just breaking even in the long run. 6.7 A law limiting the price companies can charge for pencils would be inadvisable because, in the long run, competition will force the price of pencils to the economically efficient level. When firms earn a profit, new firms will enter the industry. New firms entering the industry will cause the supply curve to shift to the right, which will lower prices and eliminate economic profits. In the long run, without a law being passed, prices will be equal to the average total cost of production, which means that firms will break even.

126

CHAPTER 10 | Firms in Perfectly Competitive Markets

6.8 a. This is a fair analogy. In the long run, competition among firms in a competitive market forces firms that incur losses to shut down. The firms that survive are those that can produce at minimum longrun average cost while producing goods and services that consumers are willing and able to buy. b. Firms that are best able to respond to changing consumer tastes and are best able to use new technologies to reduce their costs gain from competition, which eliminates rival firms. As a group, consumers win from competition because competition forces firms to produce at the lowest cost those goods and services that match consumer wants. It’s possible that some consumers may lose if they prefer products that most consumers no longer want and that, as a result, firms are no longer able to produce while covering their costs. 6.9 There are more firms competing in the Chinese auto market because the market includes most firms that sell cars in Canada and the United States in addition to local Chinese auto manufacturers. Having more firms competing, however, does not guarantee productive efficiency or allocative efficiency. That the Chinese government must provide support for local Chinese automakers indicates that they are otherwise unable to sell cars at a price that will cover all of their costs. Therefore, these firms are not productively efficient. Government support also prevents the market from achieving allocative efficiency because local manufacturers that receive subsidies may continue to produce cars that are not in line with consumer preferences and therefore the marginal cost to society of these cars may exceed the marginal benefit. 6.10 a. Allocative efficiency is achieved when production of goods and services reflects consumer preferences and the last unit of each good and service produced provides a marginal benefit to consumers equal to the marginal cost of producing it. From Hedrick Smith’s comments about shopping in Moscow in the 1970s, it seems clear that the Soviet Union did not achieve allocative efficiency in the production of textbooks, ballet shoes, or men’s shoes. If the country had achieved allocative efficiency, Smith would have been able to purchase size 8 ballet shoes, sixth-grade textbooks, and a pair of shoes that were the correct size for his feet. b. It is not possible to determine whether the textbooks, ballet shoes, and men’s shoes that were produced during the time Smith lived in the Soviet Union were produced at the lowest possible cost. Therefore, we cannot state whether productive efficiency was achieved in the production of any of these goods.

Suggestions for Critical Thinking Exercises CT10.1 The supply curve is perfectly elastic, while the demand curve can have any type of elasticity. This question asks students to apply elasticity to a new topic and to understand how demand and supply are different in this market in the long run. CT10.2 The ATC and AFC curves for the perfectly competitive firm will shift downward, but the marginal cost curve will be in the same place. Therefore, output stays the same but profits will increase. This question is designed to see if students can understand the different types of costs and how they interact. CT10.3 Barriers to entry deter people from entering a profession such as hair cutting or hair braiding and therefore increase the profits of people who are already in these professions. Barriers to entry are covered in Chapter 12, “Oligopoly,” so this question serves both as an introduction to this topic and allows students to explore the details of perfect competition.

CHAPTER 11 | Monopolistic Competition: The

Competitive Model in a More Realistic Setting

SOLUTIONS TO END-OF-CHAPTER EXERCISES

11.1

Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market Learning Objective: Explain why a monopolistically competitive firm has downwardsloping demand and marginal revenue curves.

Review Questions 1.1 In both perfectly competitive and monopolistically competitive markets, there are many firms and low barriers to entry. However, while products are identical in perfectly competitive markets, products are similar—but not identical—in monopolistically competitive markets. Wheat and many raw materials are sold in perfectly competitive markets. Haircuts and restaurant meals are sold in monopolistically competitive markets. 1.2 A local McDonald’s faces a downward-sloping demand curve for Quarter Pounders because if it increases its price, customers will substitute away from Quarter Pounders and buy something else— such as burgers at Wendy’s or Burger King. If a local McDonald’s raises its prices, it won’t lose all of its customers, however, because it might be located more conveniently than other restaurants for some people or some people might prefer Quarter Pounders to similar products. 1.3 Average revenue is equal to total revenue divided by quantity sold (TR/Q). Because total revenue is price multiplied by quantity (P × Q), dividing by quantity leaves just price. So, average revenue is equal to price (AR = P). Note that price equals average revenue for every firm, not just for monopolistically competitive firms. For any firm that is a price setter, marginal revenue is less than price because when the firm lowers price to sell an additional unit, it must lower the price on all units—not just the last unit.

Problems and Applications 1.4 a. If the wine industry in British Columbia was perfectly competitive there would be many firms, all of which would be small relative to the total market for wine. All firms would sell identical products. The quantity demanded for 50th Parallel would decrease to zero if 50th Parallel tried to raise prices because consumers would switch to buying (identical) wine from other sellers. b. If the wine industry in British Columbia was monopolistically competitive, the quantity demanded of 50th Parallel’s wine would decrease—but not to zero. 50th Parallel can convince some of their customers to buy their wine at the higher price by differentiating their product by, for example, using different varieties of grapes to make their wine and by advertising. The demand curve for their wine is downward sloping but relatively elastic because there are many sellers of a similar product. British Columbia’s wine industry is, in fact, an example of monopolistic competition, not perfect competition.

128

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

1.5 A firm can earn an economic profit either by offering a service, such as selling books, at a lower cost than other firms can or by differentiating its products. CEO James Daunt recognizes that Barnes & Noble cannot sell popular books at a lower cost than can larger firms such as Walmart and Target. And Daunt cannot convince consumers that books written by best-selling authors, such as Stephen King and John Grisham, are any different when purchased from a Barnes & Noble store than when purchased from Walmart or Target. But Barnes & Noble stores can differentiate their book-selling service by offering consumers a different selection of books, including those written by local authors. 1.6 If Sealy’s advertising campaign is successful and consumers start believing that the company’s mattresses maintain support four times better than other brands, the demand curve for its mattresses would become steeper; that is, the demand curve would become less elastic. In other words, Sealy’s customers would become less sensitive to price changes. If Sealy were to increase the price of its mattresses, many of its customers would continue to buy them. 1.7

Snow Skiing Lessons per Day (Q) 0 1 2 3 4 5 6 7 8

Price (P) $80.00 75.00 70.00 65.00 60.00 55.00 50.00 45.00 40.00

Total Revenue (TR = P × Q) $0 75.00 140.00 195.00 240.00 275.00 300.00 315.00 320.00

Average Revenue (AR = TR/Q) — $75.00 70.00 65.00 60.00 55.00 50.00 45.00 40.00

Marginal Revenue (MR = ∆TR/∆Q) — $75.00 65.00 55.00 45.00 35.00 25.00 15.00 5.00

1.8 All wheat farms sell identical goods. But restaurants do not sell identical goods. If a wheat farmer raises their price above the market price, they will lose all of their buyers. A Starbucks coffee house can raise its prices without losing all of its buyers because it is selling products that are not identical to the products sold by other similar coffee houses. 1.9 In a perfectly competitive market, marginal revenue is equal to price, so marginal revenue cannot be negative because price cannot be negative. Because the marginal revenue curve is downward sloping for a monopolistically competitive firm, at a high enough level of output marginal revenue will become negative. However, as we saw in Chapter 10, “Firms in Perfectly Competitive Markets,” firms produce where marginal revenue equals marginal cost. Because marginal cost is never negative, a monopolistically competitive firm would never produce where marginal revenue is negative.

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

129

1.10 The output effect is represented by the dark shaded area in the following graph, which is equal to $4.75 × 1 = $4.75. The price effect is represented below by the lighter shaded area, which is equal to ($5.00 − $4.75) × 10 = $2.50. Therefore, the marginal revenue of the eleventh unit is $4.75 − $2.50 = $2.25.

1.11 a. Sally’s revenue from selling 100 000 tomatoes at $5.00 each is $500 000. Her revenue from selling 200 000 tomatoes at $3.25 each is $650 000. Therefore, her marginal revenue is equal to the change in her revenue divided by the change in her output, or: ($650 000 − $500 000) / (200 000 – 100 000) = ($150 000/100 000) = $1.50. b. The output effect is the change in revenue as a result of Sally lowering the price of tomatoes sold at her vegetable stand from $5.00 to $3.25. This amount is equal to the increase in the quantity of tomatoes sold as a result of lowering price multiplied by the new price: 100 000 × $3.25 = $325 000. The price effect is equal to the revenue lost as a result of lowering the price for the consumers who were willing to buy tomatoes at $5.00: ($5.00 − $3.25) × 100 000, or $1.75 × 100 000 = $175 000. Therefore, Sally’s total revenue increases by ($325 000 − $175 000) or $150 000 as a result of lowering the price of tomatoes to $3.25. As we saw in part (a), her marginal revenue from the price cut is $1.50.

130

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

How a Monopolistically Competitive Firm Maximizes Profit in the Short 11.2 Run

Learning Objective: Explain how a monopolistically competitive firm maximizes profit in the short run.

Review Questions 2.1 Because P > MR for a monopolistically competitive firm, a profit-maximizing monopolistically competitive firm producing where MR = MC will necessarily produce where P > MC. In other words, a monopolistically competitive firm will have produced more than the profit-maximizing level of output if it produces where P = MC. 2.2 If, by grooming another dog, Isabella adds $68.50 to her costs and only $60.00 to her revenues, her profit will fall by $8.50. 2.3 Profit = Revenue – Cost = Quantity × (price – average cost) = 350 × ($3.25 – $3.00) = $87.50.

Problems and Applications 2.4 We need to calculate marginal revenue and marginal cost at the bakery, which we can do by adding three new columns to the table: Marginal Revenue, Total Cost, and Marginal Cost: Ciabatta Bread Sold per Hour (Q) 0 1 2 3 4 5 6 7 8

Price (P) $6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00

Total Revenue (TR) 0 $ 5.50 10.00 13.50 16.00 17.50 18.00 17.50 16.00

Marginal Revenue (MR) — $5.50 4.50 3.50 2.50 1.50 0.50 –0.50 –1.50

Total Cost (TC) $ 3.00 7.00 10.00 12.50 14.50 16.00 17.00 18.50 21.00

Marginal Cost (MC) — $4.00 3.00 2.50 2.00 1.50 1.00 1.50 2.50

a. Maria should sell 5 loaves of ciabatta bread. At this quantity, MC = MR. She should charge a price of $3.50 per loaf of bread. Her profit will equal TR − TC, or $17.50 – $16.00 = $1.50. b. The marginal revenue from selling the profit-maximizing loaf of bread is $1.50, which is the same as the marginal cost of selling this loaf of bread. 2.5 Jerry is correct. We cannot determine the profit-maximizing number of lamps without knowing the revenue that would be earned from selling lamps. Minimizing average costs is not the same as maximizing profit. The profit-maximizing level of output is typically not the same output that would minimize average costs.

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

131

2.6 Assuming that these changes did lower the cost of selling coffee, your graph should look like the following graph. When Starbucks streamlined its operations, its MC and ATC curves shifted down, from MC1 to MC2 and from ATC1 to ATC2, respectively. Lower costs caused Starbucks to reduce the price of cappuccinos from P1 to P2, which increased the quantity of cappuccinos that it sold from Q1 to Q2. Starbucks’s profit before streamlining is represented by the rectangle with a height equal to the difference between the price, P1, and the average total cost, ATC1, and a base equal to the quantity of cups sold, Q1. On the graph, this amount equals P1ACATC1. After the reduction in cost, Starbucks earned a profit equal to the area of rectangle P2BDATC2.

2.7 a. The following graph shows that when the marginal cost (MC) curve and average total cost (ATC) curve shift up, the profit-maximizing price rises from P1 to P2.

132

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting b. Book publishing executive Germano seems to be assuming that demand is perfectly elastic and that the book publishing industry is perfectly competitive, so that by increasing the price of the book, sales would fall to zero. If a publisher does not raise the price of a book following an increase in its production cost, its marginal revenue from the last few copies of the book sold will be less than the marginal cost—so the publisher will earn a smaller profit than it would at a higher price. c. If demand for books is relatively inelastic, a higher price should result in a relatively small decrease in the quantity demanded. Raising a book’s price to cover higher costs will result in a smaller decrease in profit when demand is relatively inelastic than when demand is relatively elastic.

2.8 a. Initial revenue from selling Model Ts = $440 × 500 000 = $220 000 000. Revenue after price cut: $360 × 800 000 = $288 000 000. So, Henry Ford expected total revenue to rise. b. Recall that the midpoint formula uses the average of the initial and final quantity and the initial and final price. The average of the initial and final prices of Model Ts is:

$440 + $360 = $400, 2 and the average of the initial and final quantities is: 500 000 + 800 000 = 650 000. 2 So, the percentage change in the quantity demanded is: 800 000 − 500 000 × 100 = 46.2%, 650 000

and the percentage change in the price is:

Therefore, the price elasticity of demand for Model Ts is:

c. Profit = Revenue – Cost. $60 000 000 = $288 000 000 – (ATC × 800 000); therefore, to earn a profit of $60 000 000, the ATC for making 800 000 cars must be $285. ATC for 500 000 Model Ts: Total Cost = Revenue – Profit = $220 000 000 – $60 000 000 = $160 000 000. Therefore, ATC = $160 000 000/500 000 = $320. So, the ATC of producing 800 000 Model Ts was lower than the ATC of producing 500 000 Model Ts. d. Yes. If the profit is the same and Ford is selling more cars, he must be making a smaller profit per car. We can check this conclusion by calculating the profit per car (price minus ATC): For 500 000 cars, profit per car = $440 – $320 = $120 per car; for 800 000 cars, profit per car = $360 – $285 = $75 per car.

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

133

2.9 a. TR = P × Q. Because the price at the profit-maximizing level of output of 1700 is $3.20, Elijah’s TR = $3.20 × 1700 = $5440. Total cost = ATC × Q, so his total cost = $2.40 × 1700 = $4080. b. Profit = TR – TC, so Elijah’s profit = $5440 − $4080 = $1360

What Happens to Profits in the Long Run?

11.3 Learning Objective: Analyze the situation of a monopolistically competitive firm in the long run.

Review Questions 3.1 New firms entering an industry cause the demand curves for the products of existing firms to shift to the left. Existing firms will sell less at every price, so their profits will decline. 3.2 Economic profit takes into account some non-monetary opportunity costs that accounting profit does not. So, economic profit will typically be smaller than accounting profit. If a firm has zero accounting profit, it will incur an economic loss, while a firm with zero economic profit will earn a positive accounting profit. 3.3 In monopolistic competition, a firm needs to differentiate its products from the products of other firms if it hopes to earn an economic profit. Consumers will buy a product if they believe that it meets a need that is not met by the products of other firms. Firms that fail to continually differentiate their products from the products of competitors will be unable to earn an economic profit in the long run.

Problems and Applications 3.4 Any firm that earns an economic profit will attract competitors as long as there are no significant barriers to entering the firm’s market. Competition from new entrants will lower the price for the product and reduce the firm’s economic profit to zero. A firm can only hope to earn a profit in the long run if it is able to continually find new ways to differentiate its product. 3.5 a. As defined in Chapter 1, Section 1.6, an innovation is the practical application of an invention. For example, in 1936, the Douglas Aircraft company introduced the DC-3 airplane, which took the principles of aviation developed by the Wright Brothers in 1903 and used them in manufacturing a plane capable of making regular intercity passenger flights. b. Innovations dwindle when a firm produces fewer new products or fails to develop lower-cost ways of producing existing products. c. Firm can successfully compete only by introducing new goods and services or better ways of producing existing goods and services. Firms that fail to do either of these things will, at best, find their economic profit competed away and may well be driven out of business by other firms that introduce innovative new goods and services or innovative production methods. 3.6 JAB hopes that few other firms will be selling cold-brewed coffee. As a result, JAB will face limited competition and be able to charge prices that will allow it to earn an economic profit despite the other high costs of making and distributing this type of coffee. JAB is following a strategy of differentiating its product from those offered by competing firms. Ten years from now, we would expect that competing firms will also be offering cold-brewed coffee and that this increased competition will drive down prices, resulting in JAB’s economic profits falling to zero.

134

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

3.7 a. To maximize profit, Angelica should sell sandwiches up to the quantity where MC = MR. She should sell 55 beef brisket sandwiches at a price of $4.50 each. b. Angelica’s loss is equal to the difference between price and average total cost, multiplied by quantity = ($4.50 − $5.50) × 55 = −$55.00. Because the price is greater than her average variable cost, she should continue to produce in the short run even though she is suffering a loss. c. No, because she is suffering a loss. If such losses persist, she should shut down her store and exit the industry. 3.8 The analysis is incorrect. The student has forgotten that economic costs include a normal rate of return on the owners’ investment in the firm. Therefore, firms will not leave the industry when they earn zero economic profit. Also, in the long run, the price will be equal to average total cost—which is the breakeven point—not above average total cost as the student mentioned. 3.9 Your graph should look similar to the following graph. We are assuming that the Best Buy store’s average costs and marginal costs stay the same. When Microsoft’s stores closed, customers needed to purchase Xbox game consoles from a new retailer. Some of these customers will have bought the consoles from this Best Buy store. As a result, the demand curve shifts to the right from D1 to D2. When the demand curve shifts, the marginal revenue curve will also shift from MR1 to MR2. Because Best Buy’s marginal cost and average total cost stay the same, the increase in demand causes the profit-maximizing quantity of Xbox game consoles sold in a Best Buy store to increase from Q1 to Q2, while the price that it charges also increases from P1 to P2. The higher price and quantity raise the profits of a typical Best Buy store from the rectangle P1BDATC1 to P2ACATC2. (Or, if the store had previously been breaking even on its Xbox game console sales, the store will now begin to earn an economic profit from selling them.)

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

135

3.10 The strategies Starbucks, Blue Bottle Coffee, and other coffee houses have used allowed them to earn an economic profit in the short run. But all of these strategies—such as Blue Bottle offering coldbrewed coffee or Starbucks building Reserve Roastery coffee houses—can eventually be copied by competitors. A firm can’t earn an economic profit in the long run using strategies that competitors can easily copy. The firms are aware of this conclusion but hope to earn short-run profits by periodically introducing new products or new ways of selling their existing products. As long as a firm can stay a step ahead of its competitors, it can continue to earn an economic profit, even though those profits would eventually disappear if it were to stop innovating. 3.11 Your graph should look like the following graph. Installing Just Walk Out technology in a convenience store lowers both the fixed cost and the marginal cost of selling a carton of milk. We can show these lower costs by shifting down the marginal cost curve from MC1 to MC2 and the average total cost curve from ATC1 to ATC2. With the lower costs, the store’s profit-maximizing quantity increases from Q1 to Q2 and its profit-maximizing price decreases from P1 to P2. The store’s profit before installing Just Walk Out technology is represented by the rectangle P1ACATC1. This area increases to P2BDATC2 after installing Just Walk Out technology.

136

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

Comparing Monopolistic Competition and Perfect Competition

11.4 Learning Objective: Compare the efficiency of monopolistic competition and perfect competition.

Review Questions 4.1 In the long run, a perfectly competitive firm charges a price equal to marginal cost, and it produces the quantity that minimizes average total cost. A perfectly competitive firm is allocatively efficient and productively efficient. A monopolistically competitive firm charges a price that is above marginal cost (so it is not allocatively efficient), and it produces a quantity that is less than the amount that minimizes average total cost (so it is not productively efficient). Despite these differences, perfectly competitive and monopolistically competitive firms both earn zero economic profits in the long run. 4.2 A monopolistically competitive firm is not productively efficient because it does not produce at minimum average total cost. Excess capacity stems from the fact that when a monopolistically competitive firm produces where MR = MC, it produces a level of output that is below the quantity for which average total cost is minimized. 4.3 A monopolistically competitive firm is not allocatively efficient because it charges a price that is greater than marginal cost. 4.4 Monopolistic competition probably doesn’t cause a significant loss in economic well-being to society. Consumers experience increased economic well-being when they are able to buy products that are more closely suited to their tastes. Monopolistically competitive firms are only successful in differentiating their products when the differentiation improves consumer well-being. Monopolistically competitive firms have higher costs as a result of not being productively efficient and, therefore, charge higher prices. Because consumers buy products offered by monopolistically competitive firms, they reveal that these products increase their well-being—despite having higher prices.

Problems and Applications 4.5 There is no contradiction between producing where price is greater than marginal cost and zero profit. Zero profit occurs when price equals average total cost, which holds in the long run for both perfectly competitive and monopolistically competitive firms. 4.6 a. The graph in the problem shows a monopolistically competitive firm. We know this because the firm faces a downward-sloping demand curve and a downward-sloping marginal revenue curve. A perfectly competitive firm’s demand curve would be horizontal and is the same as its marginal revenue curve. b. The graph in the problem shows a short-run equilibrium because the price is greater than average total cost, so the firm is earning an economic profit. Monopolistically competitive firms earn only an economic profit in the short run. c. If the firm were perfectly competitive, it would produce the quantity where the ATC is at its minimum. On the graph, this quantity is 7.

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

137

4.7 a. By having a different website and packaging for each of its nine restaurants, Green Summit is differentiating its product to better appeal to consumers with different tastes. Although food is prepared in a single kitchen, consumers may believe that the food is “high quality”—in part— because of this differentiation. Green Summit must believe that the differentiation increases its revenue by more than the additional costs it incurs. b. Green Summit’s strategy would not result in greater costs of food preparation because food is cooked in a central location, but the company incurs greater promotion and packaging costs. Therefore, Green Summit’s strategy decreases productive efficiency. However, the company increases allocative efficiency and customer well-being because production of food is more in accordance with consumer preferences. 4.8 a. Profit = TR − TC. Because at the profit-maximizing level of output of 1200, TR = $24 000 and TC = $24 000, the firm is earning zero economic profit. b. Because the firm is not operating at the lowest point on its ATC curve, it is not productively efficient. And because the firm is not producing the level of output where P = MC, it is not allocatively efficient. 4.9 a. Intelligentsia is unlikely to achieve productive efficiency. By offering a large number of coffees, it is likely the firm is producing each of these coffee varieties at a higher cost per unit because the firm is not taking full advantage of economies of scale in production. Economies of scale occur when the cost per unit decreases in the long run as a firm increases the quantity it produces. b. As consumers purchase the new types of coffee Intelligentsia offers, they are benefitting from product differentiation. We can make this inference because in the act of buying these new types of coffee, consumers are revealing that they prefer them to the other coffees that were already available. So, Intelligentsia may be doing a better job of responding to consumers’ preferences than if it produced conventional coffee in a productively efficient way.

How Marketing Differentiates Products

11.5 Learning Objective: Define marketing and explain how firms use it to differentiate their products.

Review Questions 5.1 Marketing consists of all the activities that are necessary for a firm to sell a product to consumers. Marketing is not limited to advertising. For example, product placement and defending a brand name are also forms of marketing. 5.2 Firms are concerned about brand management because maintaining their product’s unique identity and its good reputation help to decrease the likelihood of losing customers to competitors.

138

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

Problems and Applications 5.3 Advertising is a fixed cost, so an increase in spending on advertising shifts the ATC curve upward but does not shift the MC curve. The firm’s profit-maximizing price and quantity are unchanged, but its profit is reduced.

5.4 Looking at what consumers are already buying is a good way to find out what customers want, but it probably isn’t a good way to make an economic profit because other firms already have this information and are selling products to these customers. Entering the market with products exactly like your competitors’ will only work if your firm somehow has lower costs than the other firms. Firms that discover new information about what customers want can temporarily make a profit supplying a new product until new firms enter the market and competition drives the firm’s profit to zero. 5.5 Producing “content” may be cheaper for firms to create because companies do not need to pay for advertising on TV and in print media such as newspapers and magazines. The volume of content of this type a firm can afford is likely to be greater than the volume of traditional advertising. Firms can also reach an audience, particularly younger consumers, who do not watch many conventional TV programs or read print newspapers and magazines. Some firms have encountered problems, though, with this type of content. Because editors or producers aren’t checking the content for accuracy, ageappropriateness, or societal concerns, it’s easier for questionable or inaccurate content to be made public. A number of firms have encountered problems when a tweet, an Instagram post, or a YouTube video offended some viewers or was later revealed to be inaccurate. 5.6 Thermos was originally a brand name for a particular type of vacuum flask, but by the 1960s, other firms had begun selling “thermos” containers. Although the Thermos company sued, a court decision declared that “thermos” had become a generic term that any firm could use, provided the word was spelled with a lowercase “t” to avoid confusion with the Thermos company. Once the courts have declared a company’s brand name generic, there is not much the company can do. Rebranding the product would lose the name recognition the firm had built up over time. Another famous example of a product image mishap is Reebok’s Incubus running shoes for women. Reebok was surprised to learn that in medieval legend an incubus was a male demon who preyed on sleeping women. In response to the negative publicity, Reebok changed the shoe’s name.

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

11.6

139

What Makes a Firm Successful? Learning Objective: Identify the key factors that determine a firm’s success.

Review Questions 6.1 A monopolistically competitive firm’s profitability depends on its ability to differentiate its product (to make it seem more desirable than its competitors’ products) and to produce its product at a lower average total cost than competing firms. 6.2 A monopolistically competitive firm can earn an economic profit only if it always stays one step ahead of its competitors by continually differentiating its product or lowering its costs.

Problems and Applications 6.3 Typically, both luck and managerial skill are involved in a firm’s success. Scott Crane was lucky that when he began expanding Smashburger the recession of 2007–2009 had lowered real estate prices, thereby reducing the cost of buying land to build new outlets. Even in that case, though, Crane had to be alert enough to realize that an opportunity was available. He also had to realize that consumer tastes for casual dining may have changed as a result of the recession. Crane’s emphasis on serving burgers made from fresh meat, rather than frozen meat, was successful in part because of a general change in consumer tastes toward food made from fresh ingredients. Crane benefitted from evolving consumer tastes, but he also needed to be able to recognize that the change in tastes was occurring. We can conclude that Crane’s success with Smashburger was partly due to his skill as a manager and partly due to luck. Determining whether luck or his skill was most important in the firm’s success would be difficult. 6.4 Restaurants face problems earning an economic profit in the long run because barriers to entering the restaurant industry are low. In the case of Ground Round, there was nothing to stop other restaurants from also offering juicy hamburgers and unlimited popcorn. Once other restaurants began doing so, the demand for the food offered by Ground Round declined. We can illustrate this outcome on a graph by shifting the demand curve for the firm’s product to the left until it touches the average total cost curve at the profit maximizing quantity, with the result that Ground Round’s economic profit falls to zero. 6.5 If barriers to entry into a market are low, owners of successful firms will know that economic profits earned in the short run will diminish as new firms enter the market in the long run. Firm owners and managers will need new strategies to earn economic profits in the future. 6.6 In the same industry, a large firm is more likely to reach minimum efficient scale (MES) than a small firm. The large firm would then be able to produce at a lower average cost than the small firm. In this case, to earn an economic profit, the small firm would have to use product differentiation to offer consumers a product they would be willing to pay a higher price for than the price charged by the small firm’s larger rivals. 6.7 The analyst probably meant that “the right idea” is a new good or service that appeals to enough consumers for a firm to earn an economic profit. Successful entrepreneurs often mention that because interest rates and other production costs are relatively low during a recession, such as the recession caused by the COVID-19 pandemic, a recession can be a good time to start a new business. But unless there are barriers to entering the market the new small business is in, the “right idea” will not result in long- run economic profit. As stated in the textbook, “Firms try to continue earning a profit by reducing costs, by improving their products, by providing exceptional customer service, or by convincing consumers that their products are indeed different from what competitors offer.”

140

CHAPTER 11 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

Suggestions for Critical Thinking Exercises CT11.1 a. The cost curves would stay the same, but the demand curve would be downward sloping and the MR curve would separate from the demand curve and would be downward sloping. b. Presumably the firm would have greater short-run profits as it decided to make this move, but it would earn only a normal profit (zero economic profit) in the long run. CT11.2 Answers will vary. While this exercise is open-ended, it connects general ideas from the text to a topic that some students will be interested in. CT11.3 Answers will depend on the sources students find. Some students will likely mention weekend stayovers, seat position (an aisle or middle seat), and how many bags passengers can check without being charged a fee.

CHAPTER 12 | Oligopoly: Firms in Less

Competitive Markets

SOLUTIONS TO END-OF-CHAPTER EXERCISES 12.1

Oligopoly and Barriers to Entry Learning Objective: Show how barriers to entry explain the existence of oligopolies.

Review Questions 1.1 Oligopoly is a market structure in which a small number of interdependent firms compete. Examples of oligopoly industries include cigarettes, beer, aircraft, breakfast cereals, automobiles, music streaming, and pet food. 1.2 Barriers to entry keep new firms from entering an industry, which limits the extent of competition. The most important reason industries such as music streaming are dominated by just a few firms is economies of scale. If the music streaming industry had many firms of similar size, the firms would all have higher costs than the few firms that are in the industry today. 1.3 Government-imposed barriers to entry include patents, occupational licences, barriers to international trade (such as tariffs and quotas), and public franchises. There are two primary reasons governments are willing to erect barriers to entering an industry: (1) These barriers may improve the standard of living in the long run. For example, granting patents encourages pharmaceutical companies and other researchers to develop new products and new technologies. (2) Policymakers may erect barriers to entry to intentionally reduce competition in order to aid certain firms and their employees in exchange for political support.

Problems and Applications 1.4 Economic structure refers to whether there are economies of scale in the industry, whether one or more firms owns a key input or raw material, and whether there are government-imposed barriers to entry or competition. Generally, when there are low barriers to new firms entering an industry, competition is intense, and when there are high barriers to new firms entering an industry, competition is less intense. Most economists agree that economic structure is the main determinant of the intensity of competition in an industry, but other factors, such as the personalities of the managers and members of the boards of directors of different companies, that determine a company’s strategies can also play roles. 1.5 a. Economies of scale exist when a firm’s long-run average costs fall as the firm increases output. b. When a firm attains economies of scale before competing firms in the industry, that firm’s average cost will be lower than its competitors’. A lower average cost means that the firm can sell its products at a lower price than its competitors, thereby attracting some of the other firms’ customers. c. No, because there are no significant economies of scale in the restaurant industry. As an individual restaurant becomes larger, it’s unlikely that its average cost will decline by much. Even if there are some economies of scale, they are likely to be exhausted at a relatively low level of output. As a result, other restaurants will be able to enter the market and compete against you while producing at about the same average cost.

142

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

1.6 a. Barriers to entry refers to anything that hinders new firms from entering an industry in which existing firms earn economic profits. Google, Apple, Facebook, and Amazon have all achieved economies of scale that represent barriers to entry; but unlike traditional manufacturing industries, such as steel and automobiles, that have substantial capital requirements, the economies of scale achieved by these firms are due to technology as well as network externalities—that is, situations in which the usefulness of a product increases with the number of consumers who use it. (Network externalities are described in Chapter 10.) i.

To compete with Google in online advertising, a firm would need to develop a widely used software app that would attract many users, as Google has attracted users to its search engine.

ii. To compete with Apple in smartphones, a firm would need to invest in substantial research and development to offer a product that would have features at least as good as those found on the iPhone. iii. Facebook benefits from large network externalities—people want to be on Facebook because so many other people want to be on Facebook. To compete with Facebook, a firm would have to develop a social media app that was so compelling that people would want to take time away from Facebook to be on it. iv. To compete with Amazon in online retailing, a firm would have to develop a nationwide system of warehouses to make it possible to quickly deliver packages to consumers. b. Rapidly changing technology may create opportunities for new firms to offer goods and services that better serve their customers’ wants. Google, Apple, Facebook, and Amazon have all recognized that they need to develop products and services that embody new technology in order to maintain dominant positions in their respective industries. 1.7 Some entrepreneurs hope to increase profitability by creating “big businesses” that might face less competition and be able to charge consumers high prices. But unless there are significant economies of scale, these entrepreneurs will not be successful. In the following figure, firms producing Q1 have the lowest average costs (AC1). If a firm tries to grow to a larger size in order to produce Q2, its average costs will rise—from AC1 to AC2 in this case. The firm will be unable to compete against smaller firms that have lower costs. An entrepreneur in this industry will be most competitive if it chooses to produce Q1 with a relatively small-scale company.

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

143

1.8 The position of the market demand curve plays a critical role in this market because market demand determines the total number of cars that buyers are willing to buy at various prices. That, in turn, limits the available strategies for the firm, and it limits the extent to which it can take advantage of economies of scale. It may help to think of the market demand curve as a constraint on the firm. a. There would be one or more firms like Little Auto. Because the demand curve slopes downward, we know the firm(s) will achieve the lowest ATC by building assembly lines the size of Little Auto. At output less than 1000 units, the ATC of Big Auto is greater than the ATC of Little Auto. b. A single firm like Big Auto will dominate the market. In this range, the ATC of Big Auto is less than the ATC of Little Auto. c. There will probably be two or more firms like Big Auto, depending on the position of the demand curve (the quantity at which it intersects the horizontal axis). Note that no firm will build an assembly line with a capacity greater than 10 000 autos because the ATC increases for quantities above 10 000. 1.9 As Chandler suggests, there are many firms in these industries because smaller firms can produce at a lower long-run average cost than larger firms. Diseconomies of scale occur when long-run average cost increases as firm size increases, and firms in these industries would experience diseconomies of scale at relatively low levels of output.

12.2

Game Theory and Oligopoly Learning Objective: Use game theory to analyze the strategies of oligopolistic firms.

Review Questions 2.1 a. Game theory is the study of how people make decisions in situations in which attaining their goals depends on their interactions with other people. b. A cooperative equilibrium is one in which players in a game cooperate to increase their mutual payoff. c. A non-cooperative equilibrium is one in which players don’t cooperate but instead pursue their own individual self-interests. d. A dominant strategy is one that is best for a player, no matter what strategies other players choose. e. A Nash equilibrium is a situation in which each player chooses the best strategy for themself, given the strategies the other player or players choose. f. Price leadership is a form of implicit collusion in which one firm in an oligopoly announces price changes and the other firms in the industry match the changes. 2.2 Because there are so few firms in oligopoly markets, each firm must pay attention to the moves (such as pricing and marketing strategies) of the other firms, just as players do in actual games, such as poker or Monopoly. Game theory is the methodology that examines situations in which attaining one’s goals depends on interactions with others, so it is natural to use game theory when studying oligopoly.

144

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

2.3 Explicit collusion involves firms making an agreement to not compete. An example of explicit collusion would be the managers of the only two pizza restaurants in a town agreeing to charge the same price for a medium cheese pizza. A cartel is a group of firms that collude by agreeing to restrict output to increase prices and profits. In implicit collusion, firms do not reach a formal agreement, but they tacitly avoid competing with each other. An example of implicit collusion is a firm advertising it will match a competitor’s lower price. 2.4 A prisoner’s dilemma is a game played only once in which pursuing dominant strategies results in a non-cooperative equilibrium that leaves everyone worse off than they would have been had they achieved the cooperative equilibrium. The outcome of non-cooperative pricing (competition, in other words) will leave firms worse off than if they cooperated and set higher prices. The outcome of a repeated game, however, can be cooperation, especially if there is some enforcement mechanism that punishes a player who doesn’t cooperate.

Problems and Applications 2.5 a.

b. Confessing is a dominant strategy for Bob. c. Confessing is a dominant strategy for Tom. d. They will both confess and each serve 10-year sentences. This outcome is difficult to avoid because both Bob and Tom have a strong incentive to confess, but if they had both refused to confess, each would have served only a 3-year sentence. For many years, organized crime practised a “code of silence” under which any member of the organization knew that if they testified against another member, they were likely to be killed. In game theory terms, the code of silence helped organized crime avoid the prisoner’s dilemma when their members were arrested. 2.6 If just one student had taken the exam, other students would have taken the exam, so this strategy of boycotting the exam would not have worked. In effect, the students were facing a prisoner’s dilemma, so game theory would predict that their strategy of boycotting the exam would not work. But if there is a way to ensure that no one would take the exam, like standing outside the classroom using social pressure to ensure that other students did not go in to take the exam, then this outcome is not unreasonable (as long as the professor honoured the established class grading policy). 2.7 The argument is incorrect. The best strategy for each player is to not cooperate, no matter what the other player does. In a game that is played only once (the assumption in the prisoner’s dilemma game), there is no reason for a player to assume that the other player will cooperate.

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

145

2.8

a. Yes, Coca-Cola should advertise to maximize its profits. If Pepsi advertises and Coca-Cola does not advertise, Coca-Cola will earn a profit of $400 million; however, if Pepsi and Coca-Cola both advertise, Coca-Cola will earn a bigger profit of $500 million. If Pepsi does not advertise, Coca-Cola will earn a bigger profit by advertising ($900 million) than if it does not advertise ($750 million). b. Yes, Pepsi should advertise to maximize its profits. If Coca-Cola advertises and Pepsi does not advertise, Pepsi will earn a profit of $400 million; however, if Coca-Cola and Pepsi both advertise, Pepsi will earn a bigger profit of $500 million. If Coca-Cola does not advertise, Pepsi will earn a bigger profit by advertising ($900 million) than if it does not advertise ($750 million). c. Both firms advertising is a Nash equilibrium. If Coca-Cola advertises, Pepsi is better off by advertising. If Pepsi advertises, Coca-Cola is better off by advertising. 2.9 Game theory can explain why both British and German soldiers during World War I ceased firing on Christmas Eve of 1914. The ceasefire represented a cooperative equilibrium in which troops from both sides benefitted—they were not at risk of being killed by enemy fire—given the strategy chosen by the other side. If it was known to both sides that they would face the same troops the following Christmas Eve, there was a fear among commanding officers that a second “Christmas Truce” might occur. By rotating troops to the front, the officers increased the probability that if one side stopped firing they could not be sure that the other side would do the same, which could lead to a disastrous result. The officers created a “prisoner’s (or soldier’s) dilemma”—a game in which pursuing dominant strategies results in non-cooperation that leaves all worse off: Instead of enjoying a few days of peace, fighting continued throughout the remaining Christmas seasons during World War I. 2.10 Best Buy’s policy is likely to result in higher prices for the products it sells in competition with Amazon and local brick-and-mortar stores. When Best Buy posted its price matching strategy, it discouraged competitors from lowering their prices because Best Buy would match the lower prices. Best Buy attempted to change the payoff matrix so that other firms knew that if they cut prices, Best Buy would automatically match the price cuts. Best Buy’s announcement that it would match price cuts would ensure that other firms knew they would end up in a prisoner’s dilemma, which is a noncooperative equilibrium. 2.11 a. A dominant strategy is a strategy in which a player is better off regardless of which strategy the other player chooses. To analyze Air Canada’s strategy: Suppose Air Canada knew that WestJet was going to charge a high price. In that case, Air Canada could also charge a high price and receive a payoff of $20 000, or it could charge a low price and receive a payoff of $30 000. Clearly, Air Canada would be better off charging a low price if it knew WestJet was going to charge a high price. Now suppose that Air Canada knew that WestJet was going to charge a low price. In that case, Air Canada could charge a high price and receive a payoff of −$10 000, or it could charge a low price and receive a payoff of $0. Clearly, Air Canada would be better off charging a low price

146

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets if it knew WestJet was going to charge a low price. Because Air Canada’s best strategy is to charge a low price regardless of what WestJet does, charging a low price is a dominant strategy for Air Canada. To analyze WestJet’s strategy, first suppose that WestJet knew that Air Canada was going to charge a high price. In that case, WestJet could also charge a high price and receive a payoff of $20 000, or it could choose a low price and receive a payoff of $30 000. WestJet would be better off charging a low price if it knew Air Canada was going to charge a high price. Now suppose WestJet knew that Air Canada was going to charge a low price. In that case, WestJet could charge a high price and receive a payoff of −$10 000, or it could charge a low price and receive a payoff of $0. WestJet would be better off charging a low price if it knew Air Canada was going to charge a low price. Because WestJet’s best strategy is to charge a low price regardless of what Air Canada does, charging a low price is a dominant strategy for WestJet. Each firm has a dominant strategy of charging a low price, so the equilibrium of the game is the outcome in the bottom right quadrant of the payoff matrix that appears in the problem. b. A prisoner’s dilemma exists when there is a possible outcome that makes both players better off, but the players end up with a different outcome. In this game, there is a prisoner’s dilemma because the outcome in the upper left quadrant (both firms charging a high price) results in a higher payoff for both firms. However, this outcome will not occur because each firm has an incentive to change strategies. Air Canada has an incentive to switch from charging a high price to charging a low price to increase its payoff from $20 000 to $30 000. WestJet has the same incentive to charge a low price rather than a high price; the equilibrium is one in which both firms charge a low price and each has a payoff of $0. Charging a low price leads to a worse outcome for both airlines. This game is a prisoner’s dilemma. c. Repeated playing would add the possibility of punishing the other firm for charging a low price and increase the prospects of cooperation—through, for example, advertising a willingness to match a certain fare, which in this case would correspond to the “high” fare, with high prices (and profits) for both firms.

2.12 a. A dominant strategy is a strategy where a player is better off playing regardless of which strategy the other player chooses. To analyze Microsoft’s strategy: Suppose Microsoft knew that Apple was going to charge a high price. In that case, Microsoft could also charge a high price and receive a payoff of $1 billion, or it could choose to charge a low price and receive a payoff of $8 billion. Microsoft would be better off charging a low price if it knew Apple was going to charge a high price. Now suppose that Microsoft knew that Apple was going to charge a low price. In that case, Microsoft could charge a high price and receive a payoff of $10 billion, or it could charge a low price and receive a payoff of $4 billion. Microsoft would be better off charging a high price if it knew Apple was going to charge a low price. Because Microsoft’s best strategy depends on the strategy Apple chooses, Microsoft doesn’t have a dominant strategy. To analyze Apple’s strategy: Suppose Apple knew that Microsoft was going to charge a high price. In that case, Apple could also charge a high price and receive a payoff of $6 billion, or it could charge a low price and also receive a payoff of $6 billion. Apple is indifferent between charging a high price and charging a low price if it knew Microsoft was going to charge a high price. Now suppose Apple knew that Microsoft was going to charge a low price. In that case, Apple could charge a high price and receive a payoff of $2 billion, or it could charge a low price and receive a payoff of $3 billion. Apple is better off charging a low price if it knew Microsoft was going to charge a low price.

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

147

Because Apple is indifferent between strategies if Microsoft charges a high price and better off charging a low price if Microsoft charges a low price, a dominant strategy for Apple is to charge a low price. b. A Nash equilibrium occurs when neither player has an incentive to change strategies given the strategy the other player is using. In this game, Apple always chooses to charge a low price because that is its dominant strategy. If Apple chooses to charge a low price, then Microsoft is better off charging a high price, so the Nash equilibrium for this game is the outcome in the northeast quadrant. Apple has no incentive to change its behaviour given Microsoft is charging a high price. If Apple switched to charging a high price, then its outcome would not improve. Microsoft has no incentive to change its behaviour given that Apple is charging a low price. If Microsoft switched to charging a low price, then its payoff would fall from $10 billion to $4 billion, which makes it worse off. 2.13 No, this decision by one manufacturer of toilet tissue to raise prices and for its three large competitors to match the increase three days later is not evidence of explicit collusion because the four firms may not actually be colluding among themselves to raise their prices. This outcome is more likely to be an example of price leadership, a form of implicit collusion in which one toilet tissue manufacturer announces a price increase and the other firms in the industry match the increase sometime later.

12.3

Sequential Games and Business Strategy Learning Objective: Use sequential games to analyze business strategies.

Review Questions 3.1 In a sequential game one player (or firm) acts first, and then other players respond. 3.2 A decision tree allows players to map out how the other player(s) will respond to their actions, thereby identifying the action that yields the highest payoff.

Problems and Applications 3.3 Your answer does depend on the minimum rate of return owners of fast-food restaurants require on their investment. For example, suppose the minimum required return is 15 percent. Then Burger King will enter whether McDonald’s builds a large store or a small store. Therefore, McDonald’s should build a small store because it will receive a return of 20 percent rather than 16 percent. But suppose the minimum required return is 20 percent. Then Burger King will not enter if McDonald’s builds a large store. McDonald’s should build the large store, in which case it will earn a return of 25 percent. (Note that this answer depends critically on the assumption that McDonald’s moves first. If Burger King’s management is aware of this situation, they may want to try to make a preemptive first move themselves.) 3.4 a. Because the cost of the PlayStation 5 was greater than $499, Sony could not make a profit by selling the product at that price. If the PlayStation 5 sold for more than $499, Sony would have to convince consumers that its console was superior to the Xbox Series X and, therefore, worth paying more than $499 for it. Knowing the cost of the PlayStation 5 was important information for Microsoft.

148

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets b. A game of chicken is a contest between two players where neither one wants to back down or let the other win, even though not backing down can be risky. When Microsoft announced the $499 price of its Xbox Series X, it gambled that Sony would not announce that it would sell its PlayStation 5 at a lower price. By setting the price of the PlayStation 5 at $499, Sony gambled that consumers would consider the PlayStation 5 to be superior to the Xbox Series X.

3.5 In this case, TruImage’s threat that it will reject Dell’s offer of $20 per copy is credible because TruImage is better off rejecting such a low offer. Under this scenario, Dell would be better off offering $30. TruImage will accept this offer. 3.6 a.

The Nash equilibrium for this game is for both countries to produce a low output. The Nash equilibrium exists because Nigeria knows Saudi Arabia has a low output as a dominant strategy. Therefore, Nigeria will never choose a high output, despite the larger payoff for that strategy if Saudi Arabia produces a high output. b. The Nash equilibrium for this game is for both countries to produce a low output.

c. There are no differences in this case between the games illustrated in the answers to part (a) and part (b).

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

149

The Five Competitive Forces Model

12.4 Learning Objective: Use the five competitive forces model to analyze competition in an industry.

Review Questions 4.1 The first of the competitive forces, competition from existing firms, involves differences in the prices of a firm’s product based on the extent of competition in the market for that product. The second of the competitive forces, the threat from potential entrants, may involve a firm pricing its product low (and earning lower profits) as a way to deter entry from additional competition. The third of the competitive forces, competition from substitute goods or services, suggests that the introduction of a new product at a lower price may serve as a good substitute for an existing product, thus reducing demand for the existing product. The fourth of the competitive forces, the bargaining power of buyers, may involve a firm insisting on lower prices because of the large amount it purchases. The fifth of the competitive forces, the bargaining power of a supplier, may involve a limited number of suppliers of a product having a greater ability to charge higher prices for their products. 4.2 The strength of these forces changes over time. For example, a small supplier, with no bargaining power, might grow into a virtual monopolist—as happened to IBM in its dealings with Microsoft.

Problems and Applications 4.3 Motion picture studios, such as Disney and Warner Brothers, produce films that are shown in theatres. When they release films on their own streaming services, studios—the suppliers of films to theatres— limit the bargaining power of theatres. Movie theatres have also suffered from competition from streaming services, which represents competition from a substitute service. Many consumers would rather stay at home than travel to a nearby theatre to watch the same movies. 4.4 Firms in these industries will not earn an economic profit. To earn an economic profit, firms need to offer products or services that competitors have difficulty copying, or they need one of the barriers to entry discussed in this chapter: economies of scale, ownership of a key input, or a governmentimposed barrier, such as a patent. 4.5 Most singers have little or no bargaining power with Apple and other streaming services. Taylor Swift is an exception. Her refusal to make her album available to Apple would have had a significant negative effect on the demand for Apple’s streaming service, given Swift’s popularity and the number of fans who would not use a service that failed to include her songs. 4.6 a.

New technology most likely takes the form of competitive force (3)—competition from substitute goods or services. A firm is always vulnerable to a competitor introducing a new product that fills a consumer need better than the current product does. The new product takes some of the users away from the current product, decreasing its demand.

We cannot conclude that the economy is better off with less technological change. Even though employees and investors lose when a firm fails, for the economy as a whole, in the long run the benefits of having new technologies greatly outweigh the costs associated with the disruption new technologies cause. Once a popular new product is developed, such as a solar-powered car, there are benefits not only to the owners and employees of the new firm but to everyone who uses the new product.

150

CHAPTER 12 | Oligopoly: Firms in Less Competitive Markets

4.7 Competition from Existing Firms: In addition to smaller rivals, Under Armour faces competition from two larger, well-known companies in Adidas and Nike. Both of these firms use celebrity endorsements to establish brand loyalty with their customers. Threat from Potential Entrants: Barriers to entry into the sports apparel market include economies of scale and the cost of establishing brand name recognition (for example, via celebrity endorsements). New entrants to the industry would have to compete with apparel sellers that have become household names. However, in the absence of patent protection, entrants might be able to copy Under Armour’s manufacturing processes and use the same fabrics that it uses. Competition from Substitute Goods or Services: In the near future, the demand for athletic and casual clothing and accessories is expected to increase. This expectation should limit the threat to Under Armour from substitute goods. Bargaining Power of Buyers: Buyers of Under Armour products, including clothing goods stores such as Dick’s Sporting Goods and other national chains, have significant bargaining power because they can substitute other companies’ products for Under Armour’s if Under Armour attempts to raise its prices. Buyers also include retail customers. Because there are many retail buyers and Under Armour has established strong brand recognition, its customers have limited bargaining power. Bargaining Power of Suppliers: The larger and more diverse its base of suppliers, the less bargaining power each supplier has. Under Armour uses many suppliers spread around the world.

Suggestions for Critical Thinking Exercises CT12.1 a. Clearly, the results will vary by the source that each student finds. Examples of oligopolies include cigarettes, beer, aircraft manufacturers, airlines, automobiles, and cellular service. Examples of monopolistic competition include pizza restaurants, movie theatres, supermarkets, and furniture stores. b. Answers will vary by student depending on the industry chosen and the sources used. A student should classify the firms they identify in part (a) as monopolistically competitive if they (1) are in an industry with many sellers and buyers, (2) have a differentiated product, and (3) have few or no barriers to entering the industry. Oligopolies have only a few sellers and have significant barriers to entry. c. Students should be judged on the quality of the answers they provide. CT12.2 The car industry would move from an oligopoly-like structure to one more akin to monopolistic competition. The market structure would unlikely be perfect competition as product differentiation would still exist. CT12.3 Demand has varied more in the examples discussed in Chapters 11 to 14. This exercise encourages students to think about the cost and demand side of firms and the focus of the past few chapters.

CHAPTER 13 | Monopoly and Competition Policy SOLUTIONS TO END-OF-CHAPTER EXERCISES 13.1

Is Any Firm Ever Really a Monopoly? Learning Objective: Define monopoly.

Review Questions 1.1 A monopoly is a firm that is the only seller of a good or service that does not have a close substitute. The firm can’t have a monopoly if a close substitute for its product exists. 1.2 Because consumers in your town could buy hardware on the Internet or by driving to another town that has a hardware store, you would not have a monopoly under the narrow definition of the term. However, because competition from online sellers and stores in other towns may not be sufficient to eliminate your economic profits in the long run, you may have a monopoly in the broader sense of the term.

Problems and Applications 1.3 A monopoly is defined as a firm that is the only seller of a good or service that does not have a close substitute. Ty Cobb considered candlelight a substitute for electric lights, so from his point of view, the local electric company was not a monopoly. 1.4 Your university bookstore should not be considered a monopoly over textbooks. There are many other firms selling copies of textbooks, ranging from off-campus brick-and-mortar stores to amazon.ca or even the publisher’s website. There are also a variety of close substitutes for a hardcopy of your textbook, including e-books. Your university very likely should be considered a monopoly over branded clothing. Your university likely owns a trademark covering its name and logo(s). This would provide a significant barrier to entry for new firms. It would be illegal for a new firm to begin selling clothing with these trademarked images and names. 1.5 Google is concerned with its image, in some people’s eyes, of being a monopolist. If it can broaden the definition of the market in which it operates, Google will appear to be a smaller firm in that market and less likely to be accused of violating competition laws. Because highway billboards are used by companies to advertise their products, these billboards could compete with some of the products promoted on Google’s search engine. But a billboard is not really providing competition to an Internet search engine.

152

CHAPTER 13 | Monopoly and Competition Policy

1.6 The elimination of door-to-door delivery would have likely reduced Canada Post’s monopoly power as it would allow other firms that deliver packages to nearby retail outlets for pickup or couriers that deliver right to your door a greater opportunity to compete with Canada Post. Anything that differentiates a good or service has the potential to increase monopoly power. When those differentiations are eliminated, monopoly power is increased. 1.7 A monopoly is a firm that is the only seller of a good or service that does not have close substitutes. Although HBP is the only seller of Harvard Business School’s case studies, it would have a monopoly in its market only if there were no other firms that sold case studies. In recent years, Harvard Business School’s case studies has had about an 80 percent share of the total market for case studies. Therefore, HBP does not have a monopoly in the narrow sense of being the only seller of case studies. If we apply the narrow definition of monopoly, then the market for case studies is better described as an oligopoly, a market structure in which a small number of interdependent firms compete. Barriers to entry keep firms from entering a market to compete away an economic profit earned by an existing firm. There are no barriers—such as government regulations that would block entry or control over a key resource by HBP—that prohibit entry into the case study market by a new firm. However, given the popularity of HBP’s case studies and given the ability of HBP to still earn a profit selling them after more than 100 years, it is apparently difficult for other firms to compete away HBP’s profit. So, using the broader definition of monopoly, we could say that HBP has a monopoly. Source: Francesca Levy, “Harvard Business School Has the Market Cornered on Case Studies,” Bloomberg Businessweek, April 29, 2015.

13.2

Where Do Monopolies Come From? Learning Objective: Explain the four main reasons monopolies arise.

Review Questions 2.1 The most important ways a firm becomes a monopoly are when (1) government blocks the entry of other firms into the market; (2) the firm has control of a key resource; (3) there are important network externalities in supplying the product; and (4) economies of scale are so large that one firm has a natural monopoly. 2.2 A public franchise is a firm that the government designates as the only legal provider of a good or service. It is doubtful that most public franchises are natural monopolies. If they were, they wouldn’t need the government to restrict their competitors. 2.3 A natural monopoly arises when one firm can supply the entire market at a lower average total cost than can two or more firms. In these cases, the firm doesn’t need a special law or strategy to become a monopoly. The monopoly happens naturally. 2.4 The government grants patents, copyrights, and trademarks because it expects that in the long run society will benefit from them. The profits firms hope to earn from a temporary monopoly will encourage more rapid technological progress and will encourage firms (pharmaceutical companies, for example) to take risks that they otherwise wouldn’t. Competition still exists, but it focuses more on coming up with new products and processes.

CHAPTER 13 | Monopoly and Competition Policy

153

Problems and Applications 2.5 A natural monopoly exists when economies of scale are so large that the minimum efficient scale is not reached before consumers’ willingness to pay (the demand curve) falls below long-run average cost. Thus, the good or service can be provided to the entire market at the lowest production cost by a single firm. Moving gas through an existing pipeline costs very little, making the marginal cost very small. However, obtaining the right of ways and building pipeline can be exceptionally expensive. If the majority of costs in providing a good or service are fixed costs, increasing the number of units provided will tend to reduce the average cost. The more units of output fixed costs can be shared across, the lower the average cost will be. Most natural monopolies have large fixed costs and very small marginal costs. 2.6 Extending the life of patents for pharmaceutical companies would allow them to charge the monopoly price for their drugs for a longer period and earn higher profits. This potential for higher profits would encourage them to develop more new products. Consumers would gain from having a wider range of medicines, but they would lose because the prices of the medicines would stay high longer. 2.7 There are only a limited number of countries in the world, which limits the number of customers in this market. Also, printing currency that is difficult to counterfeit requires specialized printing methods. 2.8 Band names, brand names, and other trademarks serve a different purpose than intellectual property like songs or patents. A trademark tells consumers about the type and quality of a product. When someone buys Nike shoes, they may be choosing based on the reputation of Nike for quality. If just anyone could use the brand name, Nike would be less concerned with the quality of its products as people would be unable to choose based on the reputation of the brand. In short, trademarks generate ongoing benefits for both firms and consumers, but only when they are protected. Things subject to patents or copyright will continue to offer consumers benefits even when anyone can produce them. 2.9 De Beers was concerned that used diamonds would be a close substitute for newly mined diamonds and reduce the company’s market power. De Beers used advertising to convince people not to sell their diamonds. In particular, the advertising slogan “A diamond is forever” was designed to emphasize the sentimental value of diamonds so people and their heirs would not sell the diamonds. Because the advertising campaign was successful, it greatly reduced the number of used diamonds that were available as substitutes for new diamonds. The reduction in the availability of a substitute shifted out the demand curve for new diamonds, increased prices, and increased profits for De Beers. 2.10 We can calculate average total cost at every quantity.

154

CHAPTER 13 | Monopoly and Competition Policy To have a natural monopoly, a firm must be able to produce at a lower average total cost than would two firms in that market. This is not the case here, because the firm’s average total cost begins to increase after it has produced 40 units per day, well before the quantity demanded for the product, which is 90 units per day.

2.11 a. High-technology firms such as Amazon and Google have achieved large market shares without the benefit of barriers to entry that have traditionally resulted in monopolies—namely, government actions (patents, copyrights, trademarks, public franchise), control over a key resource, and economies of scale due to large capital requirements. They are also not the sole providers of a product or service. b. The success of Amazon, Google, and other high-tech firms has been the result of producing new and better goods and services that consumers value. As the market shares of these firms have grown, they have benefited from network externalities: the usefulness and popularity of their products increase with the number of consumers who use them. To a significant degree, network externalities explain why “scale matters” for these firms. 2.12 Legally, if someone else had developed a game similar to Hasbro’s Monopoly game before Charles Darrow, the name Monopoly could not be trademarked. Without the trademark, Hasbro would lose millions of dollars annually as other firms marketed similar games using the same title. Allowing firms to trademark games that already exist would be economically inefficient because trademarks provide an incentive for firms to develop new games (or other products eligible to receive trademarks). 2.13 a. Distribution of electric power occurs through a grid with large fixed costs and low marginal costs. Economies of scale are so large that one firm can supply the entire market at a lower average total cost than two or more firms can. b. There are many power plants that generate electricity from a variety of sources, including nuclear power, wind power, solar power, and by burning coal or natural gas. Minimum efficient scale is less than the total market for electric power; therefore, power generation is provided in a competitive market. 2.14 A natural monopoly occurs when economies of scale are so large that one firm can supply the entire market at a lower average total cost than can two or more firms. Oil refining is not a natural monopoly because in Canada or the United States and other countries, there are multiple firms in the oil refining industry. We can conclude that economies of scale in oil refining are exhausted long before the level of production reaches the quantity demanded in the market. Moreover, if there were substantial scale economies, the government would not need to establish a monopoly; a monopoly would occur naturally.

CHAPTER 13 | Monopoly and Competition Policy

13.3

155

How Does a Monopoly Choose Price and Output? Learning Objective: Explain how a monopoly chooses price and output.

Review Questions 3.1 The monopolist’s demand curve is the market demand curve. The marginal revenue curve is derived from the demand curve. For a linear demand curve, the marginal revenue curve will be below the demand curve (and it is also twice as steep as the demand curve, because in absolute value, the slope of the marginal revenue curve will be twice the slope of the demand curve). 3.2. Assume the graph below represents the market for Shaw Cable’s basic cable package as an example of a monopolist earning a profit.

3.3. A monopolist is a price maker in that it has the ability (by changing the amount it produces) to change the price in the market. However, increasing the price it charges will not always increase a monopolist’s profits. By increasing price, the monopolist reduces the amount it can sell. The monopolist still has to think about how consumers will react. The monopolist still maximizes profit where marginal revenue is equal to marginal cost.

Problems and Applications 3.4 a. Price $20 19 18 17 16 15

Quantity (per week) 15 000 20 000 25 000 30 000 35 000 40 000

Total Revenue $300 000 380 000 450 000 510 000 560 000 600 000

Marginal Revenue --$16 14 12 10 8

Total Cost $330 000 365 000 405 000 450 000 500 000 555 000

Marginal Cost --$ 7 8 9 10 11

156

CHAPTER 13 | Monopoly and Competition Policy b. To maximize profits, Ed should produce where marginal revenue equals marginal cost. So, he should charge $16 per baseball and produce 35 000 baseballs per week. His weekly profits will be $560 000 – $500 000 = $60 000. Note: In the graph, we have rounded the average total cost to $14.28. So, the calculation of total profit would be: ($16.00 − $14.28) × 35 000 = $60 200. It is preferable to direct students to the more accurate value in the table.

c. Because the tax does not affect his marginal revenue or marginal cost, Ed should not change the price he charges or the quantity he produces. His profits will fall by the amount of the tax, from $60 000 to $10 000. d. Because the tax does not affect his marginal revenue or marginal cost, Ed should not change the price he charges or the quantity he produces. His profits will fall by the amount of the tax, from a profit of $10 000 (when the tax is $50 000) to a loss of $10 000 (when the tax is $70 000). If these losses continue, however, Ed will need to exit the market in the long run unless he changes his price and output strategy. 3.5 a. In the short run, Shaw will continue to sell 6 subscriptions at $14 each. Its revenue is $84, but its cost is now $80 + $60, so its loss is $56. If this loss continues, in the long run Shaw will exit the market. b. The new tax increases the marginal cost by $0.50 per subscriber and increases the total cost at each price level by ($0.50 × quantity), as shown in the table: Price

Quantity

$27 26 25 24 23 22

3 4 5 6 7 8

Total Revenue $81 104 125 144 161 176

Marginal Revenue $23 21 19 17 15

Total Cost

Marginal Cost

$57.50 75.00 93.50 113.00 133.50 155.00

$17.50 18.50 19.50 20.50 21.50

Now Shaw will sell 5 subscriptions, since at 5 subscriptions, MR is closest to MC and still greater than MC. Shaw will charge a price of $25 per month and earn profits of $125.00 – $93.50 = $31.50.

CHAPTER 13 | Monopoly and Competition Policy

157

3.6 You are likely to make a loss because demand for slide rules is so low. If a profit was likely in this market, someone would probably have already entered it. The graph below shows the situation you are likely to be in.

3.7 The student’s argument is incorrect. As the graph shows, a reduction in marginal cost will cause a monopolist to reduce their price, produce more, and increase profits.

3.8 Profit maximization is not the same thing as revenue maximization. To maximize revenue, the firm would produce up to the point where marginal revenue is zero. Unless marginal cost is zero, this is a larger quantity than the quantity where marginal revenue equals marginal cost. Maximizing production could mean producing the physical maximum possible. This is likely to be far beyond the profit-maximizing level of output.

158

CHAPTER 13 | Monopoly and Competition Policy

3.9 Here is the definition of the supply curve from Chapter 3: “A curve that shows the relationship between the price of a product and the quantity of the product supplied.” For a firm operating under perfect competition, there is a supply curve because it always equates price to marginal cost. Therefore, there is always just one price for every level of output. Because a monopolist equates marginal revenue to marginal cost, with marginal revenue being less than price, it is possible for there to be different prices for the same level of output. It is also possible to have many different output levels for the same price level. Therefore, a monopolist does not have a supply curve.

Does Monopoly Reduce Economic Efficiency? 13.4 Learning Objective: Use a graph to illustrate how a monopoly affects economic efficiency.

Review Questions 4.1 If a perfectly competitive industry is monopolized, the price will rise and the quantity produced will fall. Consumer surplus will decrease, producer surplus will increase, and there will be a deadweight loss. Figure 13.5 shows this. 4.2 Market power allows a firm to set its price above marginal cost, which creates deadweight loss. Research suggests that in Canada and the United States, total deadweight loss from market power is fairly small, perhaps less than 1 percent of GDP. 4.3 a. The following graph illustrates a monopoly firm that maximizes its profit by charging a price (PM) and selling a quantity (QM) where marginal revenue (MR) equals (MC). Because the profitmaximizing price is greater than the firm’s average total cost (ATC), the monopolist earns a profit, indicated by the grey-shaded area in the graph. If the industry were perfectly competitive, the monopolist’s marginal cost curve would be the industry’s supply curve. In the graph, the equilibrium price would equal PC and the equilibrium quantity would be QC

CHAPTER 13 | Monopoly and Competition Policy

159

b. Society is worse off when a monopolist charges a price that earns monopoly profits rather than a price that is at the competitive level because (1) the monopolist sets a price greater than marginal cost and, therefore, does not achieve allocative efficiency, and (2) the monopolist produces an output for which average total cost is not minimized and, therefore, does not achieve productive efficiency. In contrast, perfectly competitive firms achieve both allocative efficiency and productive efficiency. We can also conclude that a monopoly charges a higher price, and produces a smaller quantity, than would be produced if the industry were perfectly competitive.

Problems and Applications 4.4 The less elastic is the demand curve, the greater market power the firm has, the bigger is the difference between the marginal benefit (which equals the price) and marginal cost of the last unit produced and greater is the deadweight loss due to the monopoly. 4.5 If the monopoly were more efficient, its marginal costs would fall—from MC1 to MC2 in the figure. As the figure shows, if a monopoly has higher costs (MC1) because it does not face competition, then the true deadweight loss is increased. The darker shaded area shows the original deadweight loss as it was in Figure 13.5. The lighter shaded area shows the additional deadweight loss from taking into account x-inefficiency—that is, from the firm not producing more efficiently, at quantity QCX.

4.6 Charging by the litre is more likely to achieve allocative efficiency—as long as the price equals the marginal cost. To charge by the litre, the city has to install a water meter in each firm or home and employ meter readers to gather information on how many litres have been used. Some cities might want to avoid this expense. 4.7 If a market is a monopoly, a negative externality in production will not always lead to production beyond the level of economic efficiency. In the following graph, the competitive output is at Q1, where price, P1, equals marginal private cost, MC1. If this market is a monopoly, the profit-maximizing output is at Q2, where marginal revenue is equal to marginal private cost. With a negative externality in production, the marginal social cost curve is MC2. The point where price, P2, is equal to marginal social cost is Copyright © 2024 Pearson Canada Inc.

160

CHAPTER 13 | Monopoly and Competition Policy economically efficient. In this example, the economically efficient quantity, Q2, is the same as the profitmaximizing quantity. Although the economically efficient quantity and the profit-maximizing quantity are the same on this graph, generally this will not be the case.

4.8 a. Fernando will produce at the level of output at which MR = MC, which is 15 caps. At 15 caps, Fernando would charge a price of $20 per cap. b. Profit is TR – TC. Because TR (= P × Q) is $300 and TC (= ATC × Q) is $240, Fernando would earn a profit of $60. c. Allocative efficiency occurs at the level of output at which MB (or P) = MC. So if Fernando produced at the allocatively efficient level of output, he would produce 20 caps. d. The deadweight loss = ½ ($20 − $10) × (20 − 15) = $25.

Price Discrimination: Charging Different Prices for the Same Product 13.5 Learning Objective: Explain how a firm can increase its profits through price discrimination

Review Questions 5.1 Price discrimination is charging different prices to different customers for the same product when the price differences are not due to differences in cost. A firm can successfully practise price discrimination: (1) if it possesses market power; (2) if some consumers have a greater willingness to pay than others and the firm knows what prices customers are willing to pay; and (3) if the firm can divide up (or segment) the market so that consumers who buy the product at a low price cannot resell it at a high price (in other words, consumers cannot practise arbitrage). 5.2 a. It believes that people travelling as part of a group have greater elasticity of demand, as they are offered a lower price (per person) than individuals. b. From highest to lowest: infants (free), families ($6.25 per person), students ($6.50 per person), adults ($10 per person).

CHAPTER 13 | Monopoly and Competition Policy

161

5.3 Perfect price discrimination, also called first-degree price discrimination, is the practice of a firm charging each consumer a price equal to their willingness to pay. This type of discrimination is not likely to occur in practice because firms cannot know the exact amount most consumers are willing to pay. Perfect price discrimination is economically efficient because output is increased to the point where marginal cost equals marginal benefit. However, all consumer surplus is converted into producer surplus. 5.4 Explanation 4 is correct. As we saw in this chapter, firms can usually increase their profits if they can sell their products for different prices to different buyers. Firms can only use this strategy, though, if they can prevent people buying the product at a low price from reselling it (in other words, consumers cannot practise arbitrage). The person who originally purchased an airline ticket is the only one who can legally use it—a requirement that the airlines strictly enforce—but hamburgers can be resold. If McDonald’s tried to charge a Big Mac lover $20, this person could have someone else buy the hamburger at the original price and resell it to them. 5.5 a. It does appear the street vendors are practising price discrimination because they are charging different prices to different people for the same (or roughly the same) product. The street vendors know that buyers in SoHo have higher incomes and are therefore likely to have more price inelastic demands for trees, so the vendors are charging these buyers a higher price. The street vendors also know that buyers in Harlem have lower incomes and are therefore likely to have more price elastic demands for the Christmas trees, so the vendors are charging these buyers a lower price. Note, though, that we are assuming the vendors do not face a higher cost of selling trees in SoHo in comparison with selling trees in Harlem. b. Yes, this information does affect the answer to part (a) because it indicates that the higher price of Christmas trees in SoHo and the lower price of Christmas trees in Harlem may be due to differences in the costs of selling trees in the two neighbourhoods, rather than to price discrimination. We can’t be sure, though, whether the difference in price is caused entirely by the difference in costs or whether the difference in price is partly due to the difference in cost and partly due to price discrimination. 5.6 a. Yes. Successful price discrimination has three requirements: 1. A firm must possess market power. In the Shanghai market, vendors have market power because they are able to charge consumers prices that are different from sticker prices. In other words, sellers are not price takers. 2. Some consumers must have a greater willingness to pay than other consumers, and the firm must be able to know which consumers have a greater willingness to pay. Sellers in the Shanghai market determine different consumers’ willingness to pay through haggling. 3. The firm must be able to segment the market in order to prevent arbitrage, where those who buy at low prices resell items to other consumers at higher prices. Buyers and sellers bargain for both price and quantity. Shanghai merchants can prevent arbitrage by not selling multiple items at low prices. b. Those consumers with the highest willingness to pay—and those most reluctant to bargain with sellers aggressively—tend to pay the highest prices. Many foreign visitors to markets similar to the Shanghai market where haggling is common are unfamiliar and uncomfortable with this practice. These foreign visitors may prefer to pay high prices to avoid haggling.

162

CHAPTER 13 | Monopoly and Competition Policy

5.7 Selling basic economy tickets is a way for airlines to price discriminate because the airline can charge lower prices to leisure travellers or other passengers who have very elastic demand for airline travel. Business travellers who need more flexibility in scheduling their travel and individuals who want to reserve seats would avoid basic economy tickets and would be charged a higher price for airline travel. The fact that many corporate travel offices block employees from buying these tickets reinforces this conclusion. 5.8 a. Disney must believe that the price elasticity of demand is less during the summer and during the winter holiday season (these are the periods when demand is typically highest) than during other times of the year. They also must believe that people who attend Disney World for longer than a single day have a price elasticity of demand that is the same in the summer as during other times of the year. b. The complexity of ticket options could be considered a form of price discrimination whereby consumers who are unwilling to spend the time required to determine the pricing option that is “best” for them have a more inelastic demand (and are willing to pay higher prices) than those consumers who spend the time needed to determine their best pricing options. This strategy is similar to that used by firms that offer consumers coupons that can be used to receive price discounts. “Coupon clippers” have a more price elastic demand than consumers who choose not to use coupons. 5.9 Firms that produce and sell virtual-reality headsets may be better off charging high prices initially, even though they sell smaller numbers of headsets, in order to take advantage of the demands of early adopters. Early adopters are willing to pay high prices in order to obtain new products. This situation can be described as price discrimination across time, which also explains the demand by some consumers for hardcover editions of new novels because consumers who are willing to wait to buy paperback editions of the same novels pay substantially lower prices. 5.10 Offering different prices to different customers is legally acceptable if the differences in prices reflect differences in costs, and if the price differences do not reduce competition (which can be difficult to prove). A legally unacceptable reason for price differences would be if the price difference did reduce competition. In addition, federal law ordinarily prohibits firms from charging customers different prices on the basis of irrelevant characteristics, such as the customers’ race or gender. Firms can legally charge different prices on the basis of those characteristics in certain cases, as when insurance companies charge young women lower automobile insurance premiums than they charge young men. Whether legal price discrimination is ethically unacceptable is a normative issue. 5.11 a. The graph shows that in Market 1, marginal revenue equals marginal cost at a quantity of 25. Therefore, a price of $7 should be charged to maximize profit. b. The graph shows that in Market 2, marginal revenue equals marginal cost at a quantity of 45. Therefore, a price of $11 should be charged to maximize profit. 5.12 a. Universities can be made better off by attracting more students and charging each student tuition closer to their willingness to pay. Students can be made better off (as a group) as some who were priced out of attending university (and thus received no consumer surplus) will now choose to attend and receive some consumer surplus. Note, however, that students paying the entire increased tuition themselves will be worse off.

CHAPTER 13 | Monopoly and Competition Policy

163

b. These scholarships and bursaries are a form of price discrimination as they charge different groups with different willingness to pay (and different elasticities of demand) different prices for the same good: classes and a degree. The fact that the different prices only come about after scholarships and bursaries are paid to some students by the university (effectively a refund) is not economically important. c. Students and their parents might object to explicitly different levels of tuition based on income (or any other factor). Such explicit price discrimination might lead to either legal challenges or students with higher incomes choosing to attend a different university. 5.13 If prices are largely computer-controlled, we would expect more different ticket prices because computer analysis can analyze sales more completely and adjust prices in response to the analysis more frequently than could the airline pricing executives who were setting prices without the help of software programs. Moreover, with the availability of big data, the computer programs can more accurately estimate consumer demand, which will aid an airline in price discriminating more effectively. 5.14 a. To maximize profit, Fernando should produce where MR = MC. Because MC = $5, we need to find the level of output in which MR = $5. Because MR = the change in TR divided by the change in Q, we can calculate that MR = $5 for the third unit of output. So, Fernando should produce 3 pizzas and charge a price of $15 per pizza. Profit = TR – TC. Because TR for 3 pizzas is $45 and the TC of 3 pizzas is $15, Fernando would earn a profit of $30. b. If Fernando is able to engage in perfect price discrimination, his TR for 3 units would be $15 + $20 + $25 = $60. The marginal revenue of the third unit would be $60 − $45 = $15. c. Profits are maximized where MR = MC. With perfect price discrimination, his marginal revenue is equal to the price of the last unit sold, so MR = MC = $5 at the fifth unit of output, so Fernando should produce 5 pizzas. If 5 pizzas are produced, his total revenue is equal to the highest price he can charge for each unit: $25 + $20 + $15 + $10 + $5 = $75. He is producing the pizzas at a constant cost of $5 per pizza, so his total cost is $5 × 5 = $25. Therefore, his profit would be $75 − $25 = $50. d. In the following graph on the left, the areas of producer surplus, consumer surplus, and deadweight loss are noted. In the graph on the right, in which Fernando practises perfect price discrimination, the consumer surplus and deadweight loss are converted into producer surplus (profit).

164

CHAPTER 13 | Monopoly and Competition Policy

13.6

Government Policy toward Monopoly Learning Objective: Discuss government policies toward monopoly.

Review Questions 6.1 The avowed purpose of antitrust laws is to eliminate collusion and promote competition among firms. The Competition Bureau is the main enforcer (through the court system) of these laws. 6.2 A horizontal merger is between firms in the same industry, while a vertical merger combines firms at different stages in the production of a good. Horizontal mergers are more likely to increase the market power of the newly merged firm because these mergers reduce the number of firms competing in the market for a particular good or service. 6.3 Charging a price equal to marginal cost means that output will equal the level at which marginal cost equals marginal benefit, which is the efficient level of output. However, charging this price would mean that the typical regulated natural monopoly would suffer an economic loss, as this price will be below average cost. If the regulator sets price to equal average cost instead, some efficiency will be lost, but the natural monopoly will stay in business and earn a normal profit.

Problems and Applications 6.4 a. To maximize profits, the monopoly will produce the quantity for which marginal revenue equals marginal cost. So, the monopoly will produce 20 units and charge a price of $30. b. The monopoly’s marginal revenue curve is now a flat line at $18, running from the vertical axis to the demand curve, so the monopoly will produce 33 units and charge a price of $18. The quantity demanded at a price of $18 is 40, but the quantity supplied is only 33, so there will be a shortage of 7 units, and some consumers will not be able to buy the product. 6.5 If the price is set equal to average total cost, the firm will earn a normal profit. If a firm knows that it will always be able to charge a price equal to average total cost, it will have no incentive to reduce average costs since it will not be able to earn more than a normal profit.

CHAPTER 13 | Monopoly and Competition Policy

165

6.6

Before the merger, the price was Pc and the quantity was Qc, so consumer surplus was A + B + C + D + E, and producer surplus was area F + G + H + K + L + M. After the merger, price fell to PMerge and quantity rose to QMerge, so consumer surplus was A + B + C + D + E + F + G + H + I + J and producer surplus became area K + L + M + N + O + P + Q + R. 6.7 a. The Competition Bureau looks closely at cases in which the merged firm will control more than 35 percent of the market. In this case, the merger will create a firm that controls 20 percent of the market and would therefore be unlikely to be opposed by the Competition Bureau. b. Using the same cut-off as before, the Competition Bureau is likely to oppose this merger as it creates a firm that controls 40 percent of the market. 6.8 The Competition Bureau scrutinizes any merger that creates a firm that controls more than 35 percent of the market. By this guideline, the Competition Bureau would be likely to oppose a merger of any of the distributors of Apple, BlackBerry, or Samsung. The Competition Bureau would be unlikely to oppose the merger of any one of the named firms and one of the firms in the “Other” category or a merger between Google and BlackBerry. 6.9 The Competition Bureau’s guideline is to oppose mergers that create firms with more than 35 percent market share. In this case any merger involving Anheuser-Busch InBev or Molson Coors is likely to be opposed. Any merger between Sapporo and one of the other firms is unlikely to be opposed. The number of firms is not an issue in the Competition Bureau’s guidelines.

166

CHAPTER 13 | Monopoly and Competition Policy

6.10 a. If the software codes for iTunes were publicly available, other firms could easily copy any improvement Apple made in the program, and Apple would lose the benefits of the greater sales it expected due to these improvements. In this case, an investment in a better product would not yield a sufficient return. b. The French government wishes to reduce market power in the market and bring about lower prices and less deadweight loss. Doing so, though, might reduce the incentive for firms to undertake the investments necessary for further technological progress in the online distribution of music. 6.11 If the price is set equal to average total cost, the firm will earn a normal return on its investment. If a firm knows that it will always be able to charge a price equal to average total cost, it will have no incentive to reduce average costs because it will not be able to earn more than a normal return. In fact, it might try to inflate its costs in its reports to the regulatory agency. 6.12 a. To maximize profit, the monopoly will produce the quantity where marginal revenue equals marginal cost. So, the monopoly will produce 50 units and charge a price of $10. b. To achieve economic efficiency, the regulatory agency should require the monopoly to charge a price equal to marginal cost, which in this case would be a price of $7. The regulated monopoly will produce 90 units. It will make a profit because price is above average total cost.

Suggestions for Critical Thinking Exercises CT13.1

Monopolists can certainly operate at a loss if their ATC is above the demand curve at the profitmaximizing level of output. Many students believe that monopolists always earn a profit. This question asks students to apply economic analysis to a topic in which many students have an incorrect preconception.

CT13.2

MR = MC. Some students will realize this, but they often do not see common themes across the topics dealing with different market structures.

CT13.3

Perhaps the biggest difference is that with a monopoly there is no entry while with monopolistic competition there is entry and profits are driven to zero in the long run.

CHAPTER 14 | The Markets for Labour and

Other Factors of Production

SOLUTIONS TO END-OF-CHAPTER EXERCISES The Demand for Labour

14.1 Learning Objective: Explain how firms choose the profit-maximizing quantity of labour to employ.

Review Questions 1.1 The demand that firms have for labour is derived from the demand consumers have for the goods and services labour produces. 1.2 The marginal product of labour is the additional output a firm produces as a result of hiring one more worker. The marginal revenue product of labour is the change in the firm’s revenue as a result of hiring one more worker. 1.3 The demand curve for labour is the marginal revenue product of labour curve. The marginal revenue product of labour (MRP) equals the marginal product of labour multiplied by the marginal revenue from selling another unit of output. In the case of a firm that is a perfect competitor in the output market, the MRP equals the marginal product of labour multiplied by the price of the product because price equals marginal revenue. The MRPL, or demand curve for labour, slopes downward because the marginal product of labour decreases due to the law of diminishing returns. 1.4 The most important factors that cause the market demand curve for labour to shift are (1) changes in human capital, (2) changes in technology, (3) changes in the quantity of other inputs, (4) changes in the price of the product, and (5) changes in the number of firms in the market. The first three factors cause changes in the marginal product of labour.

Problems and Applications 1.5 To maximize his profit, Frank equates the wage to the marginal revenue product of the last worker hired, so the marginal revenue product must be $8. Marginal revenue product = marginal product × price. In this case, marginal product = (marginal revenue product)/price = $8/$1.60 = 5 boxes of apples per hour.

168

CHAPTER 14 | The Markets for Labour and Other Factors of Production

1.6 a. Number of Workers L 0 1 2 3 4 5 6

Output of Televisions per Week Q 0 8 15 21 26 30 33

Marginal Product of Labour (television sets per week) MP — 8 7 6 5 4 3

Product Price P $300 300 300 300 300 300 300

Marginal Revenue Product of Labour (dollars per week) MRP = P × MP — $2400 2100 1800 1500 1200 900

Wage (dollars per week) W $1800 1800 1800 1800 1800 1800 1800

Additional Profit from Hiring One More Worker (dollars per week) MRP − W — $600 300 0 −300 −600 −900

Terrell’s Televisions must be a price taker because the product price given in the table is constant and does not depend on the quantity being sold. b.

1.7 a. A decline in the wage rate will cause a movement along the demand curve for labour. b. The marginal revenue product of labour will decline, so the demand curve for labour will shift to the left from D1 to D2.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

169

c. If several firms exit the smartphone market in China, production of smartphones will decrease. As a result, the demand curve for labour will shift to the left from D1 to D2.

d. If this new vocational training increases productivity, the marginal product of labour will increase and the demand curve for labour will shift to the right from D1 to D2.

1.8 A basketball player with a large contract could have a negative value to the team if their marginal revenue product (MRP) or their contribution to the revenue of the team is less than their wage or salary. In this case, Kevin Love added less to his team’s revenue than his salary added to his team’s costs. 1.9 a. The restaurant owner meant that he would have difficulty selling hamburgers at a price of $20. b. The servers’ marginal revenue product (MRP) was less than the wage plus other compensation the city government required the restaurants to pay the servers. As a result, the restaurants were attempting to get customers to do some jobs—such as bussing dirty dishes—that previously had been done by employees.

170

CHAPTER 14 | The Markets for Labour and Other Factors of Production c. The labour regulations are benefiting those restaurant workers who are still able to find jobs (or keep their existing jobs). These workers receive higher wages and more benefits than they would without the regulations. The groups that lose as a result of the labour regulations are (1) the business owners, who are now required to pay their workers more; (2) workers who would otherwise have been hired to bus dirty dishes or perform other tasks that customers are now asked to perform; and (3) customers if restaurants raise their prices following the increase in their labour costs.

14.2

The Supply of Labour Learning Objective: Explain how people choose the quantity of labour to supply.

Review Questions 2.1 The opportunity cost of leisure is the wage that could have been earned by working. The supply curve of labour usually slopes upward because the substitution effect of a wage change is larger than the income effect. The substitution effect of a wage change refers to the fact that as the wage rate increases, the opportunity cost of leisure rises because time away from work becomes relatively more expensive, so people work more. The income effect of a wage change refers to the fact that as the wage rate increases, the individual’s purchasing power rises too, so they will want to buy more normal goods, including leisure. As the wage rate rises, the substitution effect leads individuals to want to work more, and the income effect leads them to want to work less, but the substitution effect is often larger than the income effect, causing the labour supply curve to slope upward. 2.2 The most important factors that cause the market supply curve of labour to shift are (1) changes in population, (2) changing demographics, and (3) changing alternatives to work in general or work within a particular sector of the economy.

Problems and Applications 2.3 We can conclude that Daniel’s income effect (higher wage  higher income  more leisure  less labour) is greater than his substitution effect (higher wage  higher opportunity cost of leisure  lower leisure  more labour). As a result, Daniel works fewer hours as his wage increases. 2.4 Most labour economists assume that many adult men will work the same number of hours despite changes in their current wage rates. If, for example, an adult man worked 40 hours per week, an increase in his wage would result in him working the same 40 hours: the substitution effect of the wage increase (which would lead him to substitute work for leisure and work more hours) is equal to the income effect (which would lead him to work fewer hours). 2.5 Eliminating the income tax on wages increases the opportunity cost of leisure because the after-tax wage (the wage after a worker has paid their taxes) would now be higher than it was. Workers will also earn more income for any given number of hours worked. Whether workers will end up supplying more hours at each wage rate depends on whether the substitution effect of this increase in the aftertax wage is greater than the income effect. If the substitution effect exceeds the income effect, then the workers will supply more hours of work and the labour supply curve will be positively sloped. If the income effect exceeds the substitution effect (and leisure is a normal good), then the workers will supply fewer hours of work and the labour supply curve will be backward-bending. Moreover, if the increase in the after-tax wage attracts more workers to Michigan from other states, the labour supply curve in Michigan will shift to the right.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

171

2.6 a. This change will cause a movement along the labour supply curve. b. The opportunity cost of working in agriculture has increased. So, the supply curve for agricultural labour will shift to the left from S1 to S2.

c. Unlimited immigration will shift the supply curve for agricultural workers to the right from S1 to S2.

172

CHAPTER 14 | The Markets for Labour and Other Factors of Production

14.3

Equilibrium in the Labour Market Learning Objective: Explain how equilibrium wages are determined in labour markets.

Review Questions 3.1 If the labour demand curve shifts to the left while the labour supply curve remains unchanged, the equilibrium wage and the equilibrium quantity of labour employed will both decline.

3.2 If the labour supply curve shifts to the left, the equilibrium wage will rise and the equilibrium quantity of labour employed will fall.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

173

Problems and Applications 3.3 a. If the gap between the wages of workers with university degrees and the wages of workers without university degrees has been increasing, then we know that either (1) the wages of workers with university degrees have been falling more slowly than the wages of workers without university degrees, or (2) the wages of workers with university degrees have been increasing more rapidly than the wages of workers without university degrees. The second possibility is the more likely and is illustrated in the following graph. The demand for the labour of workers with university degrees shifts to the right from Labour demand1 to Labour demand2, while the supply of workers with university degrees shifts to the right from Labour supply1 to Labour supply2. Because we are assuming that the wages of workers with a university degree increased, the demand for labour must have shifted more than the supply of labour, causing the equilibrium wage to increase from W1 to W2, while the equilibrium quantity of labour increases from L1 to L2.

b. The existence of the wage gap provides an incentive for more people to get university degrees. We might expect that over time the resulting increase in the supply of workers with university degrees would reduce the wage gap. 3.4 The columnist is arguing that attending an elite university doesn’t necessarily cause a student to be successful later in life. The student might have possessed the skills and attributes that lead to success in life at the time they enrolled in university. In that case, the student would have succeeded even if they had enrolled in a less selective university. As noted in the Apply the Concept, research by Stacy Dale and the late Alan Krueger of Princeton University found that once they held constant students’ characteristics, the earnings of people who graduate from highly selective universities are no higher 30 years after graduation than are the earnings of people who graduated from less selective universities. Students and their parents may make great efforts to obtain admission to an elite university if they are unaware of research such as that of Dale and Krueger or if they value the prestige

174

CHAPTER 14 | The Markets for Labour and Other Factors of Production of attending an elite university apart from the financial advantage such attendance might give graduates in later life.

3.5 Salaries are not determined by the importance of the work being done. Salaries are determined by the intersection of the demand curve for labour and the supply curve for labour in a specific market. There are many more people with the skills to be a teacher than there are people with the skills to be a film star. In addition, the marginal revenue product of a film star is much greater than the marginal revenue product of a teacher. 3.6 a. Automation refers to using machines to carry out tasks that had previously been performed by human workers. b. While automation has resulted in the elimination of certain jobs, it has also created new jobs as, for instance, in writing software to control a robot that is doing tasks previously performed by an assembly line worker. Moreover, many people who lose their jobs due to automation receive training that allows them to gain the skills needed to succeed in other jobs. 3.7 a. Most of the workers who make shoes, clothing, and automobiles and those who have “offshore” jobs are middle-skill and low-skill workers. Middle-skill workers, including those who make shoes and automobiles, are likely to be affected by the increased use of robots, which would result in a decline in demand for labour and a decrease in wages. The demand for low-skill workers, including those who offer consumers assistance over the phone or online, is not likely to be affected by the use of robots. b. The increased use of robots, increases in manufactured goods imports, and offshoring all affect the Canadian labour market in a similar way. Namely, they result in a decrease in the demand for labour and a decline in the equilibrium wage. Therefore, it is not possible to distinguish these three separate influences. 3.8 a. The average wage of people who work at Creator is likely to be higher than the average wage of people who work at McDonald’s. Most people who work at the typical McDonald’s are unskilled. Therefore, we would expect that their marginal revenue products and their wages would be low. The people listed as working at Creator have skills that would result in their having high marginal revenue products and, therefore, high wages. b. If the owners of Creator expand their firm nationwide, the demand for the skilled workers the firm hires will increase. The increase in demand should raise the wages of these workers, so they will benefit from the firm’s expansion. Low-skilled workers, such as cooks, dishwashers, and cashiers, would experience a decrease in the demand for their labour. This decrease in demand should reduce their wages, so they may lose as a result of Creator’s expansion. These conclusions depend on Creator’s expansion being significant enough to have an effect on the markets for different types of labour. Or, in addition to Creator expanding, other restaurants would have to begin replacing unskilled workers with robots and skilled workers.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

175

Explaining Differences in Wages

14.4 Learning Objective: Use demand and supply analysis to explain how compensating differentials, discrimination, and labour unions cause wages to differ.

Review Questions 4.1 A compensating differential exists when a higher wage compensates workers for unpleasant aspects of a job. An example would be when workers need to be paid an extra $2 an hour to work in a job with a high risk of injury. 4.2 Economic discrimination refers to an employer paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic—such as race or gender. The fact that one group (men, for example) has higher average earnings than another group (women, for example) is not necessarily evidence of economic discrimination. Before concluding that economic discrimination is the reason for the pay gap, we must adjust for differences in the productivity of the two groups. Because it is difficult (especially for someone who doesn’t supervise the workers) to measure productivity precisely, it is hard to determine whether differences in pay are due to differences in productivity or to discrimination. 4.3 By discriminating, employers reduce the supply of workers who apply for jobs with them and increase the supply of workers who apply for jobs at competing firms that do not discriminate. As a result, employers who discriminate have to pay higher wages than do their competitors who do not discriminate. These higher wages are the economic penalty that the market imposes on employers who discriminate. Because employers who do not discriminate have lower costs, they can charge lower prices and, in principle, drive out of business employers who discriminate. The evidence suggests, however, that because of factors such as worker discrimination, customer discrimination, and feedback loops, the higher wages that employers who discriminate must pay are not sufficient to completely eliminate discrimination.

Problems and Applications 4.4 Alex Rodriguez’s marginal revenue product—how much extra revenue he earned for his team—was obviously much higher than the marginal revenue product of this fan’s boss. Rodriguez’s high pay was justified in an economic sense by the willingness of fans to pay more to see a winning Major League Baseball team either in person or on television. 4.5 Even if Nick Saban’s marginal product as a coach—the number of games he is responsible for his team winning—is similar to that of other successful football coaches, you and many football fans could argue that Nick Saban is underpaid because the revenue his Alabama football program generates causes his marginal revenue product to be higher than the marginal revenue products of other coaches. Saban’s marginal revenue product is higher because attendance at University of Alabama football games is higher than for many other schools, television ratings for Alabama games are higher than games involving other schools, and he is responsible for greater alumni donations to his university. In that sense, Saban actually deserves a salary that is higher than the $9.5 million per year he earned in 2021.

176

CHAPTER 14 | The Markets for Labour and Other Factors of Production

4.6 Streaming has increased the revenue music companies can earn from signing popular recording artists. Sales of CDs or individual songs online had been continually declining, causing the revenue music companies earned from selling music to decline. Once Spotify, Apple Music, and other streaming services found they could sell monthly streaming subscriptions, they competed for the rights to stream the most successful performers, raising the amounts the performers received. In effect, streaming had increased the marginal revenue products of popular recording artists. Because less popular acts are unlikely to increase the chances that someone will sign up for a streaming service, the music companies are unwilling to sign these acts. As with other areas of the entertainment industry, technological progress has increased the incomes of the most popular performers while reducing the incomes of the less popular performers. 4.7 There is a great demand, domestic and worldwide, to watch superstar basketball players in person, on television, and streaming on the Internet. This demand results in a correspondingly high marginal revenue product for superstar basketball players. There is no demand to view the works of even the most skilled plumbers and, however skilled a plumber may be, they can fix only a limited number of clogged drains in a day. 4.8 a. Broadcast announcers and radio disc jockeys: The marginal revenue products of announcers and disc jockeys vary by the size of the markets where they are employed and how much experience they have. Announcers and disc jockeys typically begin working in small local markets where they earn relatively modest starting salaries. If they are successful, they may move to larger markets; for example, in cities such as Chicago, Los Angeles, and Philadelphia, where they can earn higher salaries. The most successful announcers and disc jockeys work for employers that have large regional or national audiences. b. Real estate brokers: The incomes earned by real estate brokers are primarily related to the commissions they receive when houses and buildings are bought and sold. Brokers who work hard to facilitate these transactions, especially in areas where real estate values are high, will earn more than other brokers. c. Lawyers: Oher factors being equal, more experienced lawyers will earn higher incomes than lawyers who are less experienced. Those who are partners in law firms will earn more than the firms’ associate lawyers. d. Veterinarians: Veterinarians who are recent graduates of schools of veterinary medicine earn much lower salaries than experienced veterinarians. As is the case with many occupations, salaries in large metropolitan areas are greater than salaries in areas with small populations of people and, therefore, pets. 4.9 a. Sam Goldwyn, who was famous for this and other (often unintentionally funny) sayings, probably meant that the movie star was getting paid more than other actors who could have played the same roles. b. The movie star was worth his high salary if he raised the probability that the movie would be popular with fans and bring in a great deal of revenue. In other words, as long as the movie star’s wage did not exceed his marginal revenue product, Goldwyn’s movie studio increased its profit by employing him.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

177

4.10 Before the passage of workers’ compensation laws, the wages of workers in hazardous industries such as coal and lumber included compensating differentials. After the passage of the laws, these compensating differentials declined because workers now received payments from their employers for injuries suffered while on the job. The decline in the compensating differentials reduced workers’ wages. 4.11 a. By “individual choices,” Katz probably referred to the decision that many women make to leave the labour force for a period when they have a child. As a result, many of these women have less workforce experience, so their lower incomes are the result of lower productivity. b. Because it is sometimes difficult to measure productivity, it is hard to estimate how much of the gap between what men and women earn is due to economic discrimination. 4.12 a. 7000 trash collectors at a wage of $600 per week b. 9000 receptionists at a wage of $400 per week c. The marginal revenue products of the two types of workers may differ. There may also be a compensating differential because the work of trash collectors is dirty and unpleasant. d. 6000 trash collectors and 8000 receptionists 4.13 A government requirement that universities pay economics professors and English professors the same salaries would be a version of comparable worth legislation. Assume, hypothetically, that before the legislation is passed, the equilibrium wage for economics professors is $70 000 per year, and the equilibrium number of economics professors hired is L1. Setting the wage at $60 000, which is below equilibrium, reduces the number of professors who are willing to work in this occupation from L1 to L2 but increases the number of professors colleges demand from L1 to L3. The result is a shortage of economics professors equal to L3 – L2, as shown in the following graph on the left. Without the legislation, the equilibrium wage for English professors is $50 000, and the equilibrium number hired is L1. Setting the wage for English professors at $60 000, which is above equilibrium, increases the number of professors who want to work in this occupation from L1 to L3 but reduces the number of professors colleges demand from L1 to L2. The result is a surplus of English professors equal to L3 – L2, as shown in the graph on the right.

178

CHAPTER 14 | The Markets for Labour and Other Factors of Production

4.14 Employers might believe that applicants with white-sounding names are more productive, so they will be more inclined to interview those applicants. These employers, however, will likely incur an economic penalty. Employers who discriminate, by arbitrarily deciding not to consider some job applicants, will end up paying higher wages than will employers who do not discriminate. Because employers who do not discriminate will experience lower costs, they will be able to charge lower prices for their output and be more profitable than their discriminating competitors. 4.15 Economic discrimination is the practice of paying a person a lower wage or excluding a person from an occupation on the basis of a characteristic—such as race, gender, or even physical appearance— that is irrelevant to productivity on the job. Before concluding below-average-looking men and women earn less than good-looking men and women because of their less appealing physical attributes, we must adjust for differences in the productivity of the two groups. And because of the difficulty involved with measuring productivity precisely, it is hard to determine whether differences in productivity, rather than economic discrimination, explain some of the gap in earnings that Daniel Hamermesh discovered. For example, for a salesperson, being better looking may make it easier to complete sales, and the higher sales will result in employees earning more revenue for the firm. In those cases, we might expect that the market will end up rewarding more attractive workers with higher earnings even if employers are not engaging in discrimination.

Personnel Economics

14.5 Learning Objective: Discuss the role personnel economics can play in helping firms deal with human resources issues.

Review Questions 5.1 Personnel economics is the application of economic analysis to human resources issues, such as compensation packages, promotions, training, and pensions. 5.2 As a firm moves from straight-time pay to commission pay, the productivity of the firm’s employees may increase because (1) the firm would attract and retain the most productive employees, and (2) commission pay provides employees with an incentive to sell more output. Some firms may prefer a salary compensation system when (1) it is difficult to measure worker output, (2) there is concern that workers who would receive commission pay would be less concerned about the quality of the output they produce, or (3) workers fear that their output—and income—will decline for reasons unrelated to their work effort.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

179

Problems and Applications 5.3 a. The compensation scheme at Frito-Lay may benefit delivery drivers because their pay will now be a straight salary and will not exhibit large variations, particularly if the demand for some FritoLay products is seasonal with consumers buying less during certain times of the year. The compensation may also be advantageous to drivers who are on less productive routes. Removing the commissions, however, results in a decrease in incentives for drivers to work harder by delivering more snacks. Workers who received large commissions prior to the compensation change will see a decline in their total earnings, which is why some of them quit. b. By moving away from compensation schemes that are dependent on commissions, Frito-Lay can control costs better, especially if the company thinks that the demand for its snacks and, therefore, its revenues will be increasing. The disadvantage to Frito-Lay is that in removing commissions it is also removing some of the incentive for its drivers to work harder; drivers expect similar pay regardless of whether they just meet their delivery quota or exceed the quota. Another disadvantage is that Frito-Lay may lose some of its better drivers to competing firms that still pay commissions. 5.4 a. A piece-rate system will motivate workers to be more productive because they will earn more income as they produce more output. Salespeople, in particular, will earn more as they sell more. However, manufacturing firms are likely to consider a salary system to be more profitable than a piece-rate system when (1) output is difficult to measure and attribute to individual workers, (2) employers are especially concerned about the quality, rather than the quantity, of output that is produced, and (3) workers are reluctant to have their incomes determined by work effort. In other words, when workers are risk averse. b. Modern manufacturing systems that are designed to produce a variety of products to a demanding quality standard are not well suited to a compensation system that awards workers more income based on the quantity of output produced. When many different products are produced, it is difficult to attribute their production to individual workers, and the quality of output can suffer if workers are more concerned with the quantity of output they produce. For these reasons, firms would likely prefer a salary system of compensation. 5.5 a. Workers paid through piece-rate compensation schemes receive salaries based on their individual effort and ability. This type of compensation benefits both workers who prefer a slower work pace or who have less ability, as well as workers who prefer a faster work pace or who have greater ability. b. Individuals who are on piece-rate schemes are not protected when the company suffers a decline in production (when business conditions are poor) because they will be producing less output and will be paid less. Workers on a salary, however, may receive more stable compensation when the company is experiencing a decline in production. 5.6 Previously, salespeople had an incentive to sell more inexpensive tires that were less profitable for Goodyear than more expensive tires. In addition, because they were compensated on the basis of the quantity of tires sold, they had an incentive to reduce the price to sell more tires, even if doing so reduced Goodyear’s profits.

180

CHAPTER 14 | The Markets for Labour and Other Factors of Production

5.7 Employees who sold the most contact lenses to ophthalmologists and opticians benefited the most from the new compensation plan. It is possible that some sales personnel were worse off as a result of the compensation plan. Those worse off were the sales personnel who were content to earn ceiling commissions under the previous plan and would prefer not to work harder to earn more income under the new plan. These employees are more risk averse than other employees and value leisure time more than the income they could earn by working harder.

The Markets for Capital and Natural Resources

14.6 Learning Objective: Show how equilibrium prices are determined in the markets for capital and natural resources.

Review Questions 6.1 In equilibrium, the price of capital is determined by the intersection of the supply of capital curve and the demand for capital curve. Similarly, the equilibrium price of natural resources is determined by the intersection of the supply of natural resources curve and the demand for natural resources curve. Economic rent is the price paid for a factor of production (for example, land) that is in fixed supply. 6.2 A monopsony is a market with only one buyer of a factor of production. 6.3 The marginal productivity theory of income distribution states that each individual’s income is determined by the marginal productivity of the factors of production (such as labour, capital, and natural resources) that the individual owns.

Problems and Applications 6.4 a.

Number of Machines N 0 1 2 3 4 5 6

Output of Pins (boxes per week) Q 0 12 21 28 34 39 43

Marginal Product of Capital MP — 12 9 7 6 5 4

Product Price (dollars per box) P $100 100 100 100 100 100 100

Total Revenue TR $0 1200 2100 2800 3400 3900 4300

Marginal Revenue Product of Capital MRP = P × MP — $1,200 900 700 600 500 400

Rental Cost per Machine R $550 550 550 550 550 550 550

Additional Profit from Renting One Additional Machine MRP − R — $650 350 150 50 −50 −150

Adam should rent four machines for his pin factory to maximize his profit because at this quantity the additional profit from renting one additional machine is closest to zero without being negative.

CHAPTER 14 | The Markets for Labour and Other Factors of Production

181

b. The demand for capital curve equals the marginal revenue product of capital.

6.5 As the following graph shows, the only way that the prices of natural resources won’t rise is if their supply curve has shifted to the right at least as much as the demand curve has shifted. Paradoxically, even though we continue to consume natural resources, the available supplies of most of them have continued to rise. The supply of natural resources has as much to do with the cost of finding, extracting, and processing the natural resources as with how much of them actually exist. Natural resources are a gift of nature, but it often takes a lot of effort to “unwrap” the gift, and become more innovative and efficient at doing so over time.

182

CHAPTER 14 | The Markets for Labour and Other Factors of Production

6.6 If the supply of land is perfectly inelastic, the whole burden of the tax will fall on the seller. Note that in this case, there is no deadweight loss, so this tax is efficient.

6.7 a. By requiring their employees to sign an agreement barring them from working at the firm’s competitors, WeWork can avoid other firms hiring away some of their workers by offering them higher wages. b. There is no direct benefit to the WeWork employees from signing the agreement, other than it is a condition for employment. WeWork most likely didn’t hire applicants who refused to sign the agreement. 6.8 In the case of a monopsony, imposing a minimum wage removes market power from the single firm and encourages the firm to hire more workers than it would otherwise, assuming that the minimum wage is set at a level that is above the wage that the monopsony firm would otherwise have paid.

Suggestions for Critical Thinking Exercises CT14.1 Demand and supply is the source of the disparity in the pay between US college and professional players in basketball or football. In US college football and basketball, the supply of athletes is much larger because many athletes have the skills to play at that level. By contrast, only a few players have the skills to play professional football and basketball. Moreover, the demand US colleges have for basketball and football players is not as high as the demand professional sports teams have for players because the revenue that schools get from the National Collegiate Athletic Association (NCAA) is much less than what professional teams get from the National Basketball Association (NBA) or the National Football League (NFL). Professional teams receive much more revenue from television contracts than do US colleges. The marginal revenue product of a professional superstar is much higher than is true of a college superstar. CT14.2 Without salary caps, professional sports teams in big cities would likely dominate their sports because the larger populations in those cities would generate more revenue. In turn, this revenue would lead to the teams hiring more and better athletes because their marginal revenue product would be greater in these markets. Those teams could then dominate their sports year after year.

CHAPTER 15 | Public Choice, Taxes, and the

Distribution of Income

SOLUTIONS TO END-OF-CHAPTER EXERCISES Public Choice 15.1 Learning Objective: Describe the public choice model and explain how it is used to analyze government decision making.

Review Questions 1.1 The public choice model applies economic analysis to government decision making. 1.2 The voting paradox is the failure of majority voting to always result in consistent choices. The Arrow impossibility theorem is a mathematical theorem that no system of voting can be devised that will consistently represent the underlying preferences of voters. 1.3 Rent seeking is the attempt by individuals and firms to use government action to make themselves better off at the expense of others. Regulatory capture is one way of accomplishing rent seeking, as it allows firms to influence a regulatory agency to make decisions that are in the best interest of the firms, even if these actions are not in the public interest. 1.4 Market failure is a situation in which the market fails to provide the economically efficient outcome. Government failure is a situation in which government intervention in a market causes an outcome that is not economically efficient. Although government intervention can sometimes increase economic efficiency, in some cases it reduces economic efficiency.

Problems and Applications 1.5 In this case, there is no voting paradox because both David and Katia prefer mass transit as their first choice. This means that, in any two-way vote, David and Katia will vote for mass transit and that will be the outcome, so transitivity holds in this case. 1.6 The median voter theorem states that the outcome of a majority vote is likely to represent the preferences of the voter in the political middle. In selecting a party leader, the only voters the politicians need to be concerned with are the ones in their own party, and therefore, politicians direct their attention to the median voter of this selected group, who is likely to be more right leaning for Conservatives and more left leaning for Liberals. But once politicians have received their party’s nomination, candidates will emphasize policies that are likely to appeal to the median voter in the electorate as a whole. 1.7 You should disagree with this argument because the median voter theorem will hold in both cases. Majority rule will ensure that the politicians will aim for the median voter whether or not preferences among voters are similar to or different from those of the median voter.

184

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

1.8 Although public choice theory applies economic analysis to government decision making, policymakers may act in their own best interests instead of in the interests of society. For example, rent seeking by domestic producers in the cheese industry resulted in quotas being placed on cheese imports. This quota raised profits for domestic producers but at the expense of reduced consumer surplus and reduced economic efficiency. In addition, regulatory agencies that become “captured” by the industries they are supposed to regulate may end up hurting consumers by reducing (instead of increasing) the amount of competition that exists within the industry. 1.9 The typical person is likely to gather more information when buying a new car because they will be significantly and immediately affected by this decision. When voting for a member of the provincial legislative assembly, the person is only one of many voters and their vote is therefore diluted among all other votes and is likely to have very little impact. Because of this, there is little incentive to invest the time and energy to gather information about the candidates. 1.10 a. Government failure means that sometimes government intervention will reduce economic efficiency rather than increase it. Public choice theory suggests that government could fail systemically due to rent seeking, logrolling, and regulatory capture. b. The expression “rent seeking” describes the efforts by individuals and firms to use government action to make themselves better off at the expense of others. Rent seeking may be useful when thinking of policy because, as with the case of the quota Congress placed on sugar imports, rent seeking can result in a policy that benefits a few (Canadian dairy producers) at the expense of others (higher prices to consumers of milk, cheese, and other dairy products and to firms, such as pizza places, that use dairy products like cheese as an input).

The Tax System 15.2 Learning Objective: Understand the tax system in Canada, including the principles that governments use to create tax policy.

Review Questions 2.1 In a progressive tax system, people with lower incomes pay a lower percentage of their income in tax than do people with higher incomes. In a regressive tax system, people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. 2.2 A marginal tax rate is the fraction of each additional dollar that is paid in taxes. An average tax rate is the fraction of all income that is paid in taxes. Because people make their decisions by comparing marginal costs to marginal benefits, the marginal tax rate plays a bigger role than the average tax rate in influencing economic behaviour. For example, when contemplating whether or not to work an extra hour, a person will make the decision based on the after-tax wage earned from working the last hour, which is found by multiplying the marginal tax rate by the wage rate and subtracting the result from the wage rate. 2.3 In deciding which taxes to use, a government will consider (1) the effect of the tax on economic efficiency (whether the tax inflicts a small or large deadweight loss); (2) the ability-to-pay principle (whether people who can afford to pay more do pay more); (3) the horizontal equity principle (whether people in the same economic situation are treated equally); (4) the benefits-received principle (whether people receiving benefits from a government project are the ones paying the taxes and fees to support it); and (5) other social objectives (such as curtailing activities with high external costs). Copyright © 2024 Pearson Canada Inc.

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

185

2.4 Personal income tax is the single largest source of revenue for the federal government, accounting for nearly half of all revenue. The three biggest sources of revenue for provincial governments are personal income tax (22 percent of revenue), taxes on products (22 percent), and transfers from the federal government (19 percent). These values will differ by province, with some provinces receiving the bulk of their revenue from transfers. Local governments have two major sources of revenue: property taxes (37 percent) and transfers from provincial government (35 percent). Again, these values will differ from local government to local government.

Problems and Applications 2.5 One reason is that the total income earned by individuals is much greater than the total profits earned by businesses. Another reason is that taxes on businesses may have a large excess burden. 2.6 A tax is regressive if people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. A tax is progressive if people with lower incomes pay a smaller percentage of their income in tax than do people with higher incomes. Based on the evidence in the question, the cigarette tax is regressive. 2.7 The lottery “tax” is generally considered to be regressive because data show that poorer people spend a greater share of their incomes on lottery tickets than do people with higher incomes. The data we need to determine if the burden of a lottery is progressive or regressive are the different income brackets and the percentage of income people in each income bracket spend on the lottery. 2.8 a. $25 000 Total $3750, all income in the first bracket $25 000*0.15 b. $125 000 Total $24 217.61. $7529. 55 (15%) on income up to $50 197, $10 289.98 (20.5%) on income between $50 197 and $100 392, and $6 398.08 (26%) on income between $100 392 and $155 625. c. $300 000 Total $77 180.54 $7529.55 (15%) on income up to $50 197, $10 289.98 (20.5%) on income between $50 197 and $100 392, $14 360.58 (26%) on income between $100 392 and $155 625, $19164.07 on income between $155 625 and $221 708, and $25 836.36 (33%) on income over $221 708. 2.9 From this data, the tax system has experienced periods of both increasing and decreasing progressivity. This is demonstrated by the increase and decrease of the difference between market income Gini coefficients and the after-tax income Gini coefficients. For example, the tax system became more progressive from 2000 to 2005 but less progressive between 2005 and 2010. 2.10 Eliminating the income tax will increase the after-tax income of everyone, which should lead them to purchase more normal goods. Automobiles are a normal good, so eliminating the income tax should (holding everything else constant) lead to more automobile purchases. However, imposing a consumption tax makes purchasing automobiles and all other consumption items more expensive

186

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income relative to saving. Holding everything else constant, this tends to reduce automobile consumption. So, there are two effects that work in opposite directions. The effect of eliminating the income tax leads to more automobile purchases, while the effect of imposing a consumption tax leads to fewer automobile purchases. It is impossible to tell which of these effects is stronger, so we cannot tell if automobile purchases will increase or decrease.

2.11 a. A market free of externalities and other sources of market failure will result in the economically efficient equilibrium quantity and price where the marginal benefit to consumers equals the marginal cost of production. If a tax is imposed in this market, the supply curve shifts to the left and less than the economically efficient level of output is produced. This inefficiently low level of output results in a loss of economic surplus: a deadweight loss. b. Because, effectively, the tax has increased the cost of providing the good (or reduced the benefit from consuming the good), which means that the market equilibrium price and quantity are no longer the economically efficient price and quantity. 2.12 Food is often exempt from taxation because of the ability-to-pay principle. Poorer households generally spend a large fraction of their incomes on food, which is a necessity. In satisfying these basic needs, they don’t have as great an ability to pay taxes as households with higher incomes. The exemption of services from sales taxes is much harder to understand using the principles of taxation. Taxing services at a lower rate than goods can undermine the goal of achieving economic efficiency. It may be that the exemption of services is an effort to attain other social objectives. It is much easier for tax collectors to monitor the sales of goods, so the exemption may be the result of state legislators believing that a tax on services would be difficult to collect.

Tax Incidence Revisited: The Effect of Price Elasticity

15.3 Learning Objective: Understand the effect of price elasticity on tax incidence. Review Questions 3.1 Tax incidence refers to the actual division of the burden of a tax between buyers and sellers in a market. 3.2 If demand is less elastic than supply, buyers pay the larger share of the tax. If supply is less elastic than demand, sellers pay the larger share of the tax.

Problems and Applications 3.3 The statement means that laws requiring a particular group (for example, sellers) to pay a tax have little bearing on who actually pays the tax. The statement is correct. Even though a law may specify that a seller pays the whole tax, the economic logic explained in Figure 15.4 indicates that most taxes are borne partly by buyers and partly by sellers. After a tax is imposed, the price paid by buyers will generally rise and the price received by sellers after paying the tax will generally fall. The fraction of the tax borne by each group depends on the elasticity of supply relative to the elasticity of demand.

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

187

3.4 Although businesses officially pay federal corporate income taxes, all taxes must ultimately be paid by people. Taxes on businesses are borne partly by the owners of the business (whose investment return falls), partly by the employees of the business (whose wages fall), and partly by the customers of the business (whose prices rise). 3.5 You should disagree with that statement. The more elastic the supply curve, the greater the excess burden of a tax. Figures 1 and 2 that follow show the excess burden of a tax when supply is more elastic (Figure 1) and when supply is less elastic (Figure 2). In each graph, the equilibrium price and quantity before the tax are $10 and 10 units. In each figure, a $2.00 per unit tax will shift the supply curve from S1 to S2. The excess burden in each graph is represented by areas A + B. Using the formula for the area of a triangle, ½ length times height, the value of the area for A + B in Figure 1is [½ × (2 × $1.00) + ½ × (2 × $1.00)] = $2.00. The value of the area for A + B in Figure 2is [½ × (1 × $0.20) + ½ × (1 × $1.80)] = $1.00. The area representing the excess burden is greater in Figure 1, where supply is more elastic, than in Figure 2, where supply is less elastic.

3.6 Because the corporate income tax reduces the returns to firms from investing, firms invest less, which reduces the amount of capital workers have to work with. When workers have less capital to work with, they are less productive. If labour productivity falls, the demand for labour declines. This is shown in the graph that follows by the demand curve for labour shifting to the left from D1 to D2. The equilibrium wage falls, so workers bear part of the burden of the corporate income tax. The deadweight loss is equal to areas A + B in the graph that follows.

188

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

As long as the demand curve shifts to the left, there will be a deadweight loss. How far to the left the demand curve shifts will determine the size of the deadweight loss. Therefore, the size of the deadweight loss will be smaller if the size of the capital stock does not respond much to tax rates or if capital goods do not have a large effect on worker productivity. If either of these things is true, then the demand curve will not shift very far to the left and the deadweight loss will be relatively small. 3.7

a. If the government wants to minimize the excess burden of excise taxes, the taxes should be imposed on goods whose demand is inelastic. In the graph above, the product has an equilibrium price of $5.00 (point A), and a $1.00-per-unit tax is imposed. On the elastic demand curve (D2), the consumer will now pay a price of $5.25 (point C). The excess burden of the tax, which is the deadweight loss, is shown by the area of the triangle made up of w, x, y, and z. On the inelastic demand curve (D1), the consumer will pay a price of $5.80 (point B). The excess burden of the tax in this case is shown by the area of the triangle made up of v, w, and x. The area of the deadweight loss is clearly smaller when demand is inelastic.

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

189

b. If the government is most interested in maximizing the revenue it receives from the tax, the taxes should be imposed on goods whose demand is inelastic. In the graph above, the tax per unit is $1.00. If demand is elastic, the tax revenue received by the government will be equal to the $1.00 tax times the quantity sold, which is 275 (point C), or $275.00. If demand is inelastic, the tax revenue received by the government will be equal to $1.00 × 400 (the quantity at point B), or $400.00. c. If the government wants to discourage the consumption of a product, the tax will have more impact if the demand for the product is elastic. In the graph above, the $1.00 excise tax causes the quantity demanded to fall from 500 to 275 when demand is elastic, but the quantity demanded only falls from 500 to 400 when demand is inelastic. 3.8 a. Although the tax would be levied on credit card lenders, the lenders would raise interest rates on their customers in order to pay for part of the tax. Low-income credit card customers who had fewer other sources of credit would have a more inelastic demand for credit than high-income consumers, who have multiple sources of credit. As a result, an increase in interest rates on credit card balances would have a proportionately greater impact on low-income consumers than on high-income consumers. b. Since Bohannon and Pizzola believe that the proposed tax would have been regressive, they believe that the elasticity of demand for low-income consumers (those who would have been most affected by the tax) was less than the elasticity of supply of credit card lenders. 3.9 The more inelastic demand is relative to supply, the more the burden of a tax is borne by the buyer. Because the beer industry believes the new tax on beer would raise the price of beer by $0.25 per half pint, the beer industry must believe the demand for beer is relatively more price inelastic. The French government must believe the demand for beer is relatively more price elastic. 3.10 a. The price consumers pay will rise more if the demand curve is less elastic, which would be demand curve D2 in this case. In the following figure, the supply curve has shifted upward by $0.10 from S1 to S2. If the demand curve is D1, then the price paid by consumers rises to $4.53. If the demand curve is D2, then the price rises more—to $4.57. b. The revenue received by the government will be greater if the demand curve is D2 because the quantity sold is greater for D2 (Q2) than for D1 (Q1). c. The excess burden will be greater if the demand curve is D1—which is more elastic. With demand curve D1, the excess burden is the area = b + c + d + e. With demand curve D2, the excess burden is the area = a + b + c. The area of d + e is clearly greater than the area of a.

190

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

3.11 a. The vertical distance between the supply curves indicates the amount of the per unit tax, so in this case the tax is $4 per pizza. b. Before the tax, consumers pay $10 per pizza. After the tax, consumers pay $12 per pizza (found by locating where the new supply curve, S2, intersects the demand curve). c. Before the tax, sellers receive $10 per pizza. After the tax, sellers receive $8 per pizza (which is the difference between the $12 price consumers pay after the tax and the $4 tax per pizza the government receives). d. Of the $4-per-pizza tax, consumers pay $2 (the difference between the price consumers pay before the tax and after the tax). Because consumers pay $2 of the $4 tax, producers pay the other $2 of the tax.

Income Distribution and Poverty 15.4 Learning Objective: Discuss the distribution of income in Canada and understand the extent of income mobility.

Review Questions 4.1 In Canada, the top 20 percent of income earners receive 47.3 percent of income, while the bottom 20 percent receive 4.2 percent. Income inequality declined slightly during the 1980s and then rose from the 1990s. 4.2 The low income cut-off is the income level at which a household would have to spend 20 percentage points more of its income on food, clothing, and shelter than the average Canadian household of the same size. The poverty rate is the proportion of the population with incomes below the low income cut-off. In Canada, the poverty rate rose during the early 1990s, peaked in 1996 at 15.2 percent of people, and has been falling since the late 1990s to its current 4.3 percent.

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

191

4.3 A Lorenz curve shows the distribution of income by arraying incomes from the lowest to the highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis. A Gini coefficient is equal to the area between the line of perfect income equality and the Lorenz curve divided by the whole area below the line of perfect equality. A lower Gini coefficient shows a more equal income distribution. If the country had a Gini coefficient of 0.48 in 1960 and 0.44 in 2012, income inequality would have decreased during these years. 4.4 There has been a substantial decline in the global poverty rate in the past 30 years or so. The region of the world that has seen the greatest improvement in the poverty rate is the East Asia and Pacific region, while Sub-Saharan Africa has seen the least improvement.

Problems and Applications 4.5 While policies to redistribute income may be needed in Canada, it doesn’t seem to be true that the more than 10 percent of the population that is currently poor has no hope of ever climbing out of poverty. The chapter cites study findings that of people who were poorest in 1990, 87 percent had moved up the income distribution by 2009. We also saw that intergenerational income mobility was relatively high in Canada. 4.6 a. The distribution of income became less equal in 2016. The Lorenz curve for 2015 is farther away from the diagonal line of equality than is the Lorenz curve for 2015. b. The Gini coefficient = (the area inside the Lorenz curve)/(the area beneath the diagonal line of equality). Thus, for 2015, the Gini coefficient = A/(A + B + C) = 2150/5000 = 0.43. For 2016, the Gini coefficient = (A + B)/(A + B + C) = 2400/5000 = 0.48.

4.7

192

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income The total income of this group is $250 000. Quintile

Share of Income

Lowest 20% (Bhati) Second lowest 20% (Jerome)

12% 16

Cumulative Share of Income 12% 28

Middle 20% (Steve) Second highest 20% (Gore) Highest 20% (Lena)

20 24 28

48 72 100

4.8 Economists like to examine both absolute poverty (measured in dollars or the amount of goods and services that a household can buy in comparison to an objective measure of the amount needed to survive or live at a healthy standard) and relative poverty (measured in comparison to the overall average of a society). The $1.00-per-day standard of living is a useful measure of absolute poverty, because it is very difficult for someone to survive at a healthy standard of living with an income below $1.00 per day (although some people do). If this standard of poverty were used for rich countries, like Canada, virtually no one would be recorded as living in poverty. However, many people in Canada live at a standard that is considered poor by the high standards of the country. To measure this kind of poverty, a higher standard is used, such as the $22 350 per year standard for a family of four with two children. Such families do not live in the absolute poverty of people trying to get by on $1.00 per day, but they are considered relatively impoverished by people in their country. Likewise, the Canadian poverty standard wouldn’t be very useful for people in sub-Saharan Africa. A family of four with two children living on $22 350 per year in a country like Nigeria would be considered very well off by its fellow citizens. 4.9 According to the marginal productivity theory of income distribution, the distribution of income is based mainly on the marginal revenue product of the factors owned by households. Equalizing the distribution of income would require ending the inequality of ownership of resources or ending the inequality of the payments to these resources (by, for example, making wage rates equal). This would require a massive government intervention into the economy, greater even than under the old communist governments of the Soviet Union and China, which never achieved complete income equality. Such a policy would not be very desirable because it would destroy the efficiency of the economy. There would be no incentives to work hard, save, become educated, take entrepreneurial risks, and so forth, if people knew that their income would be the same as everyone else’s whether or not they worked, saved, became educated, or took risks. 4.10 It seems to be impossible to compare the well-being (or utility) of one person to another. Even if we could, it is probable that some people would be able to achieve more well-being than others from a certain level of income. For example, a person in good health would probably have a higher level of well-being than a person in poor health who had the same level of income. 4.11 The low income cut-off is defined as having to spend 20 percentage points more of income on food, shelter, and clothing than an average family of the same size—and it is calculated before taxes and transfers. There are many reasons why consumption and ownership of these goods could rise while poverty rates stay the same. Most importantly, the poverty rate is based on income, and consumption can differ from income, due to transfer payments, for example.

CHAPTER 15 | Public Choice, Taxes, and the Distribution of Income

193

4.12 a. Assortative mating refers to marriage between people with similar levels of education. b. Assortative mating can contribute to inequality when a husband and wife are both well-educated and both earn above-average incomes. c. There is little or nothing government policies can do to reduce income inequality that is due to assortative mating. Assortative mating and its effect on household incomes provides additional evidence of the relationship between education and income. Policymakers may use this evidence to promote programs that are designed to improve access to education for low-income households. 4.13 It is extremely unlikely that the incomes of the poor would rise by $6000. Faced with the higher marginal tax rate, rich households are likely to work less, earn less, and therefore pay less than $6000 each in taxes. Similarly, many poorer households will respond to the transfer by working less, so their pre-transfer labour market earnings will fall below $20 000.

Suggestions for Critical Thinking Exercises CT15.1 No, the theorem still applies as the median voter is roughly in the middle of the charts. CT15.2 Answers will vary. This question comes from research that found that very few students could name more than about two different kinds of taxes. This might not be surprising since students don’t have many reasons to pay attention to many taxes. Therefore, some part of this section is likely to surprise many students. By talking about these surprises, students are more likely to remember and understand this relatively dry topic. CT15.3 Both the video and Section 15.4 of this chapter show a major reduction in worldwide poverty in recent years (and the video goes back to 1800). Surveys have found that very few members of the public are aware that poverty has been falling for years.

Part 2 Solutions Manual For

Macroeconomics Fourth Canadian Edition Glenn Hubbard Anthony Patrick O’Brien Apostolos Serletis Jason Childs

Contents Chapter 1: Economics: Foundations and Models.................................................

Chapter 2: Trade-offs, Comparative Advantage, and the Market System .......

Chapter 3: Where Prices Come From: The Interaction of Supply and Demand

Chapter 4: GDP: Measuring Total Production and Income .................................

Chapter 5: Unemployment and Inflation ...............................................................

Chapter 6: Economic Growth, the Financial System, and Business Cycles .......

Chapter 7: Long-Run Economic Growth: Sources and Policies ..........................

Chapter 8: Aggregate Expenditure and Output in the Short Run ......................

Chapter 9: Aggregate Demand and Aggregate Supply Analysis .....................

Chapter 10: Money, Banks, and the Bank of Canada ......................................... 100 Chapter 11: Monetary Policy .................................................................................. 112 Chapter 12: Fiscal Policy .......................................................................................... 127 Chapter 13: Inflation, Unemployment, and Bank of Canada Policy .................. 137 Chapter 14: Macroeconomics in an Open Economy.......................................... 147

CHAPTER 1 | Economics: Foundations and Models SOLUTIONS TO END-OF-CHAPTER EXERCISES 1.1

Three Key Economic Ideas Learning Objective: Explain these three key economic ideas: People are rational; people respond to incentives; and optimal decisions are made at the margin.

Review Questions 1.1 “People are rational” is the assumption that decision makers explicitly or implicitly weigh the benefits

Problems and Applications 1.3 As noted in the chapter, the economic incentive to banks is clear—it is less costly to put up with bank

robberies than to take these additional security measures. The marginal cost of adding the additional security is greater than the expected marginal benefit.

CHAPTER 1 | Economics: Foundations and Models

1.7 Jill is correct. The difference between the grade before and after watching an extra episode is exactly the same as knowing the change in the grade.

1.8 Your friend is failing to think at the margin. It doesn’t matter how much time your friend has already

2.2 The three economic questions that every society must answer are: (1) What goods and services will

CHAPTER 1 | Economics: Foundations and Models

2.6 a. It is doubtful that centrally planned economies have been less efficient purely by chance. The

b. You might still prefer having a centrally planned economy if you considered it to be more equitable. (Also, you might prefer a centrally planned economy if you were in charge.)

2.7 A complete explanation for the connection between majoring in economics and succeeding in business

1.3

Economic Models Learning Objective: Understand what economic models are and aren’t, and why they are a good idea.

CHAPTER 1 | Economics: Foundations and Models

1.4

Microeconomics and Macroeconomics Learning Objective: Distinguish between microeconomics and macroeconomics.

CHAPTER 1 | Economics: Foundations and Models

SOLUTIONS TO CHAPTER 1 APPENDIX A-1

Using Graphs and Formulas Learning Objective: Review the use of graphs and formulas

Problems and Applications 1A.1 a. The relationship is negative because as price decreases, the quantity of pies purchased increases. b.

The slope = ∆y/∆x = rise/run = −1/1 = –1.

CHAPTER 1 | Economics: Foundations and Models

1A.2

1A.3

We can conclude that sales fell at the highest rate in 2008.

CHAPTER 1 | Economics: Foundations and Models

1A.4

Percentage change in real GDP: [($16 397 billion − $15 982 billion)/$15 982 billion] × 100 = 2.6% The percentage change in real GDP from one year to the next is the economy’s growth rate.

1A.5 a.

The triangle’s area = 0.5 × 60 000 × $0.75 = $22 500.

1A.7

The slope is calculated using the formula: Slope =

Change in value on the vertical axis ∆ y Rise = = . Change in value on the horizontal axis ∆ x Run

At point A: rise = 300 − 175 = 125, run = 7 − 5 = 2. Therefore, the slope = 125/2 = 62.5. At point B: rise = 900 − 700 = 200, run = 14 – 12 = 2. Therefore, the slope = 200/2 = 100.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

1.5 Increasing the number of cells will decrease range, as shown in the figure below. Trade-offs can be between physical goods, such as cotton and soybeans in Problem 1.4, or between less tangible features, such as range or cells, or time to charge battery and cells.

1.6 You would still have an opportunity cost represented by the next best use of your time.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 11 1.7 a.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

Comparative Advantage and Trade 2.2 Learning Objective: Understand comparative advantage and explain how it is the basis for trade.

Production and consumption without trade Production with trade Consumption with trade Gains from trade (increased consumption)

Apples (kilograms) 8 20 10 2

You

Neighbours

Cherries (kilograms)

Apples (kilograms)

Cherries (kilograms)

12 0 10 × 1.25 = 12.5 12.5 − 12 = 0.5

9 0 10

42 60 60 − 12.5 = 47.5

47.5 − 42 = 5.5

2.3

The Market System Learning Objective: Explain the basic idea of how a market system works.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 15

Suggestions for Critical Thinking Exercises CT2.1

CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand SOLUTIONS TO END-OF-CHAPTER EXERCISES 3.1

The Demand Side of the Market Learning Objective: Discuss the variables that influence demand.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 17

b. The coupon results in a cut in the price of Quarter Pounders, so there will be a movement down the demand curve for Quarter Pounders in the following graph.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 19

3.2

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

The Supply Side of the Market Learning Objective: Discuss the variables that influence supply.

Problems and Applications 2.4

a. Change in quantity supplied: A movement up the supply curve. b. Change in supply: The supply curve shifts to the right. c. Change in demand: The demand curve shifts to the left.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 21

3.3

Market Equilibrium: Putting Buyers and Sellers Together Learning Objective: Use a graph to illustrate market equilibrium.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

The Effect of Demand and Supply Shifts on Equilibrium 3.4 Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

4.4

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.8 The demand will be greater if the season is moved, and therefore price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 27

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 29

SOLUTIONS TO CHAPTER 3 APPENDIX A-1

Quantitative Demand and Supply Analysis Learning Objective: Use quantitative demand and supply analysis.

Problems and Applications 3A.2

a. W = 10; L = 60 b. W = 12; L = 72

3A.3

a. P = 50; Q = 100 b. P = 62.5; Q = 75 c. P = 50; Q = 50

CHAPTER 4 | GDP: Measuring Total Production and Income SOLUTIONS TO END-OF-CHAPTER EXERCISES 4.1

Gross Domestic Product Measures Total Production Learning Objective: Explain how total production is measured.

Review Questions 1.1 In microeconomics, we focus on a particular market and can measure production by the quantity of the units produced. In macroeconomics, we look at the production of all goods and services, and measuring production by the quantity of goods and services produced isn’t feasible because it would involve adding together goods and services measured in different units. Therefore, in macroeconomics, economists measure quantity by market value. 1.2 The total of every good and service sold during the year would be larger than GDP, because some of the goods and services sold are intermediate goods and services, and some were produced in a prior year. 1.3 All the money a business receives from the sale of its output is paid out as income to the owners of the factors of production. 1.4 GDP = C + I + G + NX. Consumption (C) is spending by households on goods and services, and investment (I) is spending by firms on new plant, equipment, buildings, and changes in inventories, and by households and firms on new single-family and multi-unit houses. Government purchases (G) are made by the federal, provincial, local, and municipal governments for goods and services, and net exports (NX) equal exports minus imports. Exports are goods and services produced in Canada that are purchased by foreign firms, households, and governments, and imports are goods and services produced in foreign countries, but purchased by Canadian firms, households, and governments. 1.5 A firm’s “value added” refers to the additional market value a firm gives to a product. It is equal to the difference between the price for which the firm sells a good and the price it paid other firms for intermediate goods.

Problems and Applications 1.6 The value of intermediate goods and services, though not counted directly, is included in the value of the final goods and services and therefore is included in GDP. The value of the computer chip is not counted separately but is included in the value of the new PC. 1.7 a. The purchase of flour by a bakery is the purchase of an intermediate good, not a final good, because the flour is included in the bread, or other final goods, the bakery produces. b, c, and d are all purchases of final goods because they are not purchased to become part of other goods or services.

CHAPTER 4 | GDP: Measuring Total Production and Income 31 1.8 a. Consumption b. Not included because the car is not new production. c. Not included because seats are intermediate goods, not final goods. d. Investment 1.9 The value of the house built in 2010 would not be included in the GDP of 2022 because the sale does not represent new production. The value of the services of the real estate agent who helped sell or buy the house in 2022 would be included in the GDP of 2022 because those services were newly provided in 2022. 1.10 Nominal GDP = (100 × $60) + (100 × $2) + (50 × $25) = $7450. Cotton is an intermediate good (in this case, it is used in the production of shirts), so it is not included directly in calculating GDP. 1.11 The statement is incorrect, because it confuses investment in the economic sense of purchases of machinery, factories, and houses with financial investment in stocks and bonds. 1.12 Cutting debt and increasing personal savings requires, for a given amount of income, a decrease in consumer spending. If consumers decided to reduce their spending at the same time, the economy will most likely grow slowly or even shrink in the short run. 1.13 Profits are one part of the income paid to the owners of the factors of production. A business uses the money it receives from the sale of its product to pay wages to labour, interest to capital, rent to natural resources, and profits to the owners of the firm. 1.14 Value added by the artist = ($800 × 10) − $5000 = $8000 – $5000 = $3000 Value added by the local art store = ($1000 × 10) – ($800 × 10) = $10 000 – $8000 = $2000

4.2

Does GDP Measure What We Want It to Measure? Learning Objective: Discuss whether GDP is a good measure of well-being.

Review Questions 2.1 GDP measures the value of final goods and services produced in a country during a given period and the level of income in the country during that same period. Although production of goods and services is not the only factor in determining the quality of life of people in a country, we would normally expect that when a country produces few goods and services, the quality of life in the country will be less than when it produces more goods and services. 2.2 GDP does not include household production and the informal economy. Even if GDP included all production, it would still not be a perfect measure of economic well-being because it does not consider many things that affect well-being. For example, GDP does not include the value of leisure and is not adjusted for the negative effects of pollution or crime and other social problems.

CHAPTER 4 | GDP: Measuring Total Production and Income

Problems and Applications 2.3 a. It is likely to increase measured GDP because work outside the home is measured while work inside the home is not measured. b. This is likely to increase measured GDP if it results in increased government expenditures on law enforcement and increased private expenditures on security. (However, an increase in the crime rate might indicate that the level of production in the informal economy is increasing, which should reduce measured GDP, not increase it.) c. It is likely to reduce measured GDP as more production moves to the informal economy. 2.4 Real GDP per capita is the level of real output or income per person. Real GDP per capita for Canada has risen since 1890. A higher income level today may be due to Canadians working more hours or simply being more productive. The fact that the typical Canadian today works fewer hours while earning a higher income suggests that the economic well-being of the average Canadian has increased more than is indicated by comparing 1890 real GDP per capita with current real GDP per capita. The average person has more leisure time today than in 1890, and the value of this time is not included in GDP. 2.5 Sorted by GNI Country Singapore UAE Norway US Canada Australia South Korea Greece China Iran Venezuela Zimbabwe

Real GNI per Person (2020 PPP) 88 155 67 462 66 494 63 826 48 527 48 085 43 044 30 155 16 057 12 447 7 045 2 666

HDI 0.938 0.89 0.957 0.926 0.929 0.944 0.916 0.888 0.761 0.783 0.711 0.571

CHAPTER 4 | GDP: Measuring Total Production and Income 33 Sorted by HDI Country Norway Australia Singapore Canada US South Korea UAE Greece Iran China Venezuela Zimbabwe

Real GNI per Person (2020 PPP) 66 494 48 085 88 155 48 527 63 826 43 044 67 462 30 155 12 477 16 057 7 045 2 666

HDI 0.957 0.944 0.938 0.929 0.926 0.916 0.89 0.888 0.783 0.761 0.711 0.571

The two rankings parallel each other in the sense that countries with higher real GNI per person tend to be countries with a higher HDI, while countries with lower real GNI per person tend to be those with a lower HDI. However, the orders do not match perfectly. For example, the United Arab Emirates’ real GNI per person was the second highest at $67 462, but the country’s HDI was only seventh out of 12. The possible reasons for the observed differences include differences in factors that affect the HDI but not GNI, such as life expectancy at birth, adult literacy, and school enrolment. 2.6 a. Household consumption would likely change the most. b. Compensation of employees (wages and salaries) and gross mixed income (net mixed income) would likely change the most. c. Government capital consumption and compensation of employees (both wages and salaries and benefits) would likely change the most. 2.7 a. A summary statistic is a single number that characterizes an underlying set of data. GDP is a summary statistic of how well an economy is doing because it measures how much an economy produces during a period of time, which equals a country’s total income. b. GDP provides a summary measure of the performance of an overall economy but not a perfect measure. It excludes production in the informal economy and household production and does not include the value of leisure or adjust for the negative effects of pollution, crime, and other social problems.

CHAPTER 4 | GDP: Measuring Total Production and Income

4.3

Real GDP versus Nominal GDP Learning Objective: Discuss the difference between real GDP and nominal GDP.

Review Questions 3.1 Nominal GDP can change because of either quantity changes or price changes. When there is inflation, nominal GDP overstates the increase in total production. Statistics Canada separates price changes from quantity changes by calculating real GDP. 3.2 The GDP deflator is a measure of the average prices of the final goods and services included in GDP and equals nominal GDP divided by real GDP, multiplied by 100. 3.3 a. Nominal GDP is greater than real GDP. b. Nominal GDP equals real GDP. c. Nominal GDP is less than real GDP.

Problems and Applications 3.4 a. Real GDP, 2018

= (100 × $50) + (100 × $2) + (50 × $30) = $6700

Real GDP, 2019

= (100 × $50) + (120 × $2) + (65 × $30) = $7190

b. Growth rate of real GDP, 2019 $7190 − $6700 × 100 = 7.3% $6700 3.5 a. Disagree. Nominal GDP is less than real GDP if the current price level, which is used in calculating nominal GDP, is less than the base-year price level, which is used in calculating real GDP. A fall in the price level during the year is neither necessary nor sufficient to cause nominal GDP to be less than real GDP. b. Disagree. If prices increase more than the quantity of production decreases, nominal GDP can increase when real GDP declines. c. Agree. If a recession is so severe that both the quantity of production and the price level decline, both real and nominal GDP will decline. d. Disagree. Nominal GDP could decline because either the GDP deflator declined or total production (real GDP) declined. In fact, between 2008 and 2009, nominal and real GDP both declined, while the GDP deflator increased.

CHAPTER 4 | GDP: Measuring Total Production and Income 35 3.6 The only way for nominal GDP to rise while real GDP is constant (or nearly so) is if the value of the GDP deflator is higher. To see this point, look at the formula for the GDP deflator:

= GDP deflator

Nominal GDP × 100. Real GDP

With nominal GDP higher and real GDP the same, the GDP deflator must be higher. A higher GDP deflator means a higher inflation rate. Therefore, the author must be expecting higher oil prices to increase the inflation rate in Canada. 3.7 a. (1)

(2)

(3)

(4)

(5)

GDP Percentage Deflator Real GDP Change Nominal (base year (base year in Real Year = 2016) = 2016) GDP GDP

(6)

(7)

(8)

GDP Deflator Real GDP Percentage (base year (base year Change in = 2018) = 2018) Real GDP

2014 2015 2016

$ 980.00 1020.00 1050.00

90 92 100

$1088.89 1108.70 1050.00

-----1.8% −5.3%

81.8 83.6 90.9

$1198.04 1220.10 1155.12

----1.8% −5.3%

2017

1200.00

105

1142.86

8.8%

95.5

1256.55

8.8%

2018

1400.00

110

1272.73

11.4%

100.0

1400.00

11.4%

The calculations for the annual percentage change in real GDP are not affected by the change in the base year.

A change in the base year used to calculate the GDP deflator would result in the same values for the annual percentage changes in real GDP.

3.8 It is likely that the article is referring to the percentage change in real GDP, which measures the value of output, holding constant the change in the price level. Because changes in nominal GDP measure the change in the value of output in current year prices, it would not be possible to determine how much the euro zone’s economy grew—how much more output of final goods and services were produced and sold, holding prices constant—if the 2 percent change referred to nominal GDP. 3.9 The GDP deflator is calculated as [nominal GDP/real GDP] × 100. The percentage change is calculated as [(value in the second period – value in the first period)/ value in the first period] × 100.

CHAPTER 4 | GDP: Measuring Total Production and Income

2012 2013 2014 2015 2016

Nominal GDP Real GDP GDP Deflator $16 155 $15 355 105.2 16 692 15 612 106.9 17 393 15 982 108.8 18 037 16 397 110.0 18 569 16 662 111.4

Percentage Increase — 1.62% 1.79 1.08 1.31

As shown in the table, 2014 saw the largest percentage increase in the price level.

4.4

Other Measures of Total Production and Total Income Learning Objective: Become familiar with other measures of total production and total income.

Review Questions 4.1 GDP is the market value of all final goods and services produced within Canada. GNI is the market value of all final goods and services produced by residents of Canada, even if the production takes place outside Canada. For Canada, GDP is almost the same as GNI. In many countries, GDP is much larger than GNI. 4.2 National income is the total income received by a country’s residents. National income is equal to GDP minus the value of depreciation, or the consumption of fixed capital. Household income, which is income actually received by households, is national income minus corporations’ retained earnings plus payments received by households from the government in the form of transfer payments or interest on government bonds. Household disposable income, which represents the income available for households to spend, is equal to household income minus personal tax payments, such as the federal personal income tax. 4.3 Gross domestic income is GDP calculated as the sum of income payments to households. Wages, which include all compensation received by employees including fringe benefits, comprise a majority of gross domestic income and are more than three times as large as profits, the second-largest income category.

Problems and Applications 4.4 GNI would be larger than GDP. The country has relatively more of its firms and residents working in other countries. 4.5 With GDP significantly above GNI, the value of income produced within Ireland is significantly above the value of income produced by the residents of Ireland, making the Irish people appear to be richer than they are. 4.6 The federal personal income tax partially accounts for the difference between household income and household disposable income. Therefore, the levels of national income and household income will not change, while the level of household disposable income will decrease.

CHAPTER 4 | GDP: Measuring Total Production and Income 37 4.7 To forecast the level of consumption spending by households, we should focus on the income measure that is most closely related to the households’ ability to spend, which is household disposable income.

Real-Time Data Exercises D4.1

a. In the first quarter of 2021, total personal consumption expenditures were $15 070.1 billion, personal consumption expenditures on durable goods were $1 940.7 billion, personal consumption expenditures on non-durable goods were $3 278.3 billion, and personal consumption expenditures on services were $9 851.2 billion. All figures are expressed as annual rates. b. [($1 940.7 billion + $3 278.3 billion)/$15 070.1 billion] × 100 = 34.6%

D4.2

a. In the first quarter of 2021, gross private domestic investment was $3 920.0 billion, private non-residential fixed investment was $2 960.7 billion, and private residential fixed investment was $1 051.3 billion. All figures are expressed as annual rates. b. $3 920.0 billion − [$2 960.7 billion + $1 051.3 billion] = −$92.0 billion, which equals the change in inventories.

D4.3

a. Real exports of goods and services in 2020 were $2 216.9 billion, and in 2019 they were $2 546.6 billion. Real imports of goods and services in 2020 were $3 142.9 billion and in 2019 they were $3 464.2 billion. b. Net exports in 2020 equaled − $926.0 billion (= $2 216.9 billion − $3 142.9 billion) and in 2019 they equaled − $917.6 billion (= $2 546.6 billion − $3 464.2 billion).

D4.4

a. In the first quarter of 2021, nominal GDP equaled $22 061.5 billion and nominal GNP equaled $22 255.7 billion. Both figures are expressed as annual rates. b. With GNP greater than GDP, foreign production by U.S. firms exceeded U.S. production by foreign firms by $194.2 billion in the first quarter of 2021.

D4.5

a. In the first quarter of 2021, personal income equaled $22 101.6 billion, disposable personal income equaled $22 079.6 billion, and personal consumption expenditures equaled $15 070.1 billion. All figures are expressed as annual rates. b. The difference between personal income and disposable personal income is personal tax payments which in the first quarter of 2021 equaled $22.0 billion (= $22 101.6 billion − $22 079.6 billion).

D4.6

a. Nominal GDP equaled $22 061.5 billion in the first quarter of 2021 and equaled $21 561.1 billion in the first quarter of 2020. Real GDP equaled $19 086.4 billion in the first quarter of 2021 and equaled $19 010.8 billion in the first quarter of 2020. All figures are expressed as annual rates. b. The GDP price deflator in the first quarter of 2021 equaled 115.6 = [($22 061.5 billion/ $19 086.4 billion) × 100], and in the first quarter of 2020 it equaled 113.4 = [($21 561.1 billion/$19 010.8) × 100]. c. The inflation rate from the first quarter of 2020 to the first quarter of 2021 as measured by the GDP price deflator was 1.94 percent [= (115.6 − 113.4)/113.4) × 100].

CHAPTER 4 | GDP: Measuring Total Production and Income d. The nominal and real GDP lines intersect at the base year because the current-year prices used for nominal GDP and the base-year prices used for real GDP are the same when the base year is the current year. The value of the GDP deflator in the year when the nominal and real GDP lines intersect is 100.

D4.7

a. Nominal GDP in the first quarter of 2021 equaled $22 061.5 billion, and in the first quarter of 2020 it equaled $21 561.1 billion. Both figures are expressed as annual rates The GDP Implicit Price Deflator in the first quarter of 2021 equaled 115.588, and in the first quarter of 2020 it equaled 113.415. b. Real GDP in the first quarter of 2021 is approximately $19 086.3 billion [($22 061.5 billion/115.588) × 100], and in the first quarter of 2020 it equaled $19 010.8 billion [($21 561.1 billion/113.415) × 100]. c. The growth rate of the real GDP from the first quarter of 2020 to the first quarter of 2021 was approximately 0.4 percent = [($19 086.3 billion – $19 010.8 billion)/$19 010.8 billion) × 100].

Suggestions for Critical Thinking Exercises CT4.1 Students will likely misunderstand the meaning of the word investment. By thinking more about it and comparing notes with their peers, students will remember this important concept better than they otherwise would. Research in other disciplines has shown that in some instances, simply talking about ideas that conflict with students’ prior knowledge does not lead to much change in students’ views. CT4.2 Answers will vary by student, but by asking students what they expected and what they learned, they should be able to learn the material in a deeper way. CT4.3 The best interpretation is that inflation occurred. Nominal GDP grows, but production is constant; therefore, the GDP deflator increased. This question will encourage students to consider several key points from this chapter.

CHAPTER 5 | Unemployment and Inflation SOLUTIONS TO END-OF-CHAPTER EXERCISES 5.1

Measuring the Unemployment Rate and the Labour Force Participation Rate Learning Objective: Define the unemployment rate and the labour force participation rate, and understand how they are computed.

Review Questions 1.1 The unemployment rate is calculated monthly from data gathered by Statistics Canada in its Labour Force Survey (LFS). The unemployment rate equals the percentage of the labour force that is unemployed: (Unemployed/Labour force) × 100. The three conditions to be counted as unemployed are that the person (1) did not work in the previous week, (2) was available for work, and (3) actively looked for work in the past four weeks. 1.2 The challenge of measuring unemployment is in collecting the data and properly identifying what is happening to people and why. For example, Statistics Canada must determine whether someone actually wants to work or not. The official Statistics Canada measure of the unemployment rate understates the true degree of unemployment to the extent that it does not count discouraged workers as unemployed because they have stopped looking for a job, and it counts involuntary part-time workers as employed even though these workers would prefer to work more hours. The official Statistics Canada measure overstates the true degree of unemployment because (1) some people are not actively looking for work but they claim to do so to remain eligible for government payments to the unemployed and (2) some people have jobs in the informal economy that they do not disclose. 1.3 The labour force participation rate measures the percentage of the working age population that is in the labour force: (Labour force/Working age population) × 100. Since 1970, the labour force participation rate for men has gradually declined, while the rate for women has significantly increased. The overall labour force participation was higher in 2021 than in 1970. In recent years, the decline in the labour force participation rate of prime-age men has been a policy concern. The labour force participation rate for women has declined somewhat since the 2007–2009 recession. Participation of both men and women fell significantly during the COVID-19 pandemic. 1.4 The employment–population ratio measures the percentage of the working-age population that is employed: (Employment/Working-age population) × 100. An unemployed person dropping out of the labour force would decrease the unemployment rate, but it would not change the employment– population ratio. 1.5 The Survey of Household Spending is a sample of about 18 000 households chosen to represent the Canadian population and provides information on household spending habits. The Labour Force Survey is a different survey of households that focuses on labour market activity (employment) of those in the household, not how much and on what they spend.

CHAPTER 5 | Unemployment and Inflation

Problems and Applications 1.6

Working-Age Population (Feb. 2019) Employment Unemployment Unemployment Rate Labour Force Labour Force Participation Rate Employment–Population Ratio

30 575 898 18 662 000 1 212 334 6.1% 19 874 300 65% 61.0%

The number of people unemployed can be found using the definition that the unemployment rate equals the number of unemployed divided by the sum of the number of unemployed and the number of employed. The labour force equals the employed plus the unemployed. The labour force participation rate equals the labour force divided by the working-age population. The employment– population ratio equals the number of employed divided by the working-age population. 1.7 The key is to realize that the labour force is not a fixed number of people. If enough people enter the labour force, with most becoming employed and only some becoming unemployed, then the unemployment rate could decrease while the number of unemployed increases. 1.8 For the unemployment rate to remain unchanged while the number of people employed decreased, the number of people in the labour force must have fallen by even more than the fall in employment. For employment overall to fall while Saskatchewan and Alberta saw increases, other provinces must have seen employment fall. 1.9 For this to occur, more of those remaining in the labour force would have been employed than previously. Those leaving the labour force would have been unemployed. 1.10 a. No, they are not counted as unemployed by Statistics Canada. These people have left the job market and no longer “want” to have a paid job. They have chosen to do other things instead. Therefore, they don’t meet the definition of “unemployed” used by Statistics Canada. b. Yes, new entrants to the labour market are counted as unemployed if they don’t find a job immediately. They meet the definition of unemployment used by Statistics Canada: They are able to work, they want to work, and they have looked for work, but they don’t have a job. 1.11 The unemployment rate can increase while employment increases if the number of discouraged workers and other people not previously counted as unemployed entering the labour force more than offsets the effect of the employment increase. In this case, the number of people counted as unemployed in Georgia was increasing faster than the increase in employment, causing the unemployment rate to increase. 1.12 It’s unlikely that only 3 million jobs were created during this period. What was most likely being referred to was the increase in the total number of jobs compared to March 2020. In order for the total number of jobs to increase by 3 million, many more than 14 million jobs would have to have been created, as some jobs would have been “destroyed” during the same period. If we saw 1 million new jobs created but 1 million jobs destroyed (perhaps because of firms closing), we wouldn’t see any increase in the total number of jobs.

CHAPTER 5 | Unemployment and Inflation 41

5.2

Types of Unemployment Learning Objective: Identify the four types of unemployment.

Review Questions 2.1 The four types of unemployment are frictional unemployment, structural unemployment, cyclical unemployment, and seasonal unemployment. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. Structural unemployment is unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs. Cyclical unemployment is unemployment caused by a business cycle recession. Seasonal unemployment is unemployment caused by changes in economic activity due to changes in the seasons. 2.2 The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is also called the full-employment rate of unemployment. Economists do not define full employment as being an unemployment rate equal to zero because the creating and destroying of jobs that leads to frictional unemployment and the structural changes in the economy from factors such as innovation that lead to structural unemployment are ongoing features of a growing, dynamic economy. No economy attains an unemployment rate of zero, even during wartime.

Problems and Applications 2.3 Decisions are made by comparing the marginal cost and benefit associated with the activities. The decision of applying for graduate school depends on the opportunity cost of attending versus the payoff received from a graduate degree. During a recession, jobs are less plentiful and the chances of getting a high-wage job offer are lower. This means that the opportunity cost of attending graduate school is lower, so new university and college graduates are more likely to attend graduate school instead. Conversely, demand in the job market is higher during an economic expansion, so the opportunity cost of attending graduate school is also higher. 2.4 Disagree. The economy would operate less efficiently if frictional unemployment were eliminated. By devoting time to job search, workers end up with jobs they find satisfying and in which they can be more productive. Government policies to enhance the job search process of matching workers with jobs could make the economy operate more efficiently, but entirely eliminating frictional unemployment would not be efficient. 2.5 For someone frictionally unemployed, the advice would be to keep searching. The person has the required skills, but matching worker skills to job openings takes time. For someone structurally unemployed, the advice would centre on the need to retrain or to find another occupation. For someone cyclically unemployed, the advice would be to realize that the search will take longer because of the recession and to consider temporarily taking a lower-paying job or going back to school until the economy picks up. 2.6 Efficiency wages can increase the productivity of workers as well as workers’ incomes. They can also increase the profitability of firms. The main disadvantage of efficiency wages is they tend to increase unemployment.

CHAPTER 5 | Unemployment and Inflation

2.7 The workers referred to in the article are likely to be structurally unemployed because they lack the skills required for the available jobs or because they have addiction problems or other personal troubles that make it difficult for them to remain employed. 2.8 a. Discouraged workers are people who would like to have a job but have become discouraged about their prospects of finding one and have given up looking for a job as a result. Because these people are not looking for work, they are not included in the official unemployment rate. Increases in the number of discouraged workers is an indication that the economy is not performing well, even if the official unemployment rate is falling. b. Full employment is the level of employment at which we only observe frictional and structural unemployment. Involuntary part-time or discouraged workers may be suffering from either frictional or structural unemployment. Those who are involuntarily working part-time jobs may be between full-time jobs, so they are frictionally unemployed. Discouraged workers may not have the skills employers demand or may be in the wrong location to find a job that uses their skills and are thus structurally unemployed.

5.3

Explaining Unemployment Learning Objective: Explain what factors determine the unemployment rate.

Review Questions 3.1 The payment of employment insurance likely raises the unemployment rate. The employment insurance payments lower the opportunity cost (the income lost by not working) of continuing to search for a job, which leads the unemployed to spend more time searching for a job. The payment of employment insurance lessens the severity of recessions by helping the unemployed maintain their income and spending. 3.2 a. Minimum wage laws likely increase the rate of unemployment if they are set above the marketclearing wage rate. (Author’s note: This is still subject to some debate.) b. Labour unions, by negotiating higher wages for their members, tend to increase the unemployment rate. c. Efficiency wages, like labour unions, tend to increase the unemployment rate. 3.3 A significant reason that the unemployment rate in the United States has been lower than the unemployment rates in Canada and countries in Western Europe is the more generous unemployment compensation payments and social insurance programs in Canada and Western Europe, which lower the opportunity cost of continuing to search for a job.

Problems and Applications 3.4 If Parliament eliminated the employment insurance system, the opportunity cost of job search would increase, decreasing the level of frictional unemployment. There would be conflicting effects on the level of real GDP. Lower frictional unemployment would increase real GDP, but the possibility of less effective matching of worker skills to jobs due to less time for job search would decrease real

CHAPTER 5 | Unemployment and Inflation 43 GDP. Well-being would probably decrease if the employment insurance system were eliminated because unemployed workers would suffer large drops in income. 3.5 Prices were much lower in 1965 than they are today. It is difficult to state whether $0.50 was below the equilibrium wage in 1965 without information about the level of wages in 1965. 3.6 If this analyst is correct, we cannot conclude that Costco is paying efficiency wages and Walmart is not. The higher Costco wages would be due to the higher-skilled workers required to sell Costco’s higher-cost products. 3.7 a. and c. are likely to increase the unemployment rate. Lengthening the time workers are eligible to receive employment insurance lowers the opportunity cost of a job search. An increase in union membership pushes more wages above market wages, thereby increasing unemployment, at least temporarily until these workers can find jobs in the non-union sector of the economy. b. and d. are likely to reduce the unemployment rate. Abolishing the minimum wage lowers the wage from above the market wage for some workers, thereby increasing the number of workers firms will employ. Making information on job openings more available shortens the search involved in frictional unemployment. 3.8 Henry Ford was paying an efficiency wage, which can cut a firm’s cost by increasing the productivity of workers. Paying an efficiency wage results in an increase in the quality of workers willing to work for the firm and a decrease in the turnover of workers. 3.9 By paying an efficiency wage (a wage above the minimum required) Amazon may attract higherquality workers and increase worker productivity. These higher wages will improve Amazon’s profits if the increase in productivity is greater than the increase in wages. Extra credit: By paying higher than required wages, Amazon also can reduce the likelihood of consumer boycotts and regulatory action. By paying a higher wage, Amazon may be protecting the profits it is currently earning.

Measuring Inflation 5.4

Learning Objective: Define price level and inflation rate, and understand how they are computed.

Review Questions 4.1 The GDP deflator is the broadest measure of the price level because it includes the prices of all final goods and services included in GDP. The consumer price index measures the prices of goods and services purchased by consumers. The producer price index measures the prices of goods and services at all stages of the production process. 4.2 The potential biases include the substitution bias, the increase in quality bias, the new product bias, and the outlet bias.

Problems and Applications 4.3 The statement misinterprets the CPI. The inflation rate in 2021 is the percentage change in the CPI since 2020, not since the base year.

CHAPTER 5 | Unemployment and Inflation

4.4 The CPI, at any point in time, uses a fixed market basket, comparing the cost of buying the fixed market basket in the current period to the cost of buying the fixed market basket in the base period. As a fixed market basket, Statistics Canada uses the quantities in the market basket, not the quantities actually purchased in the current period. 4.5 a.

City

Percentage Change in House Price

Halifax

Montreal

18.3%

Toronto

7.4%

Winnipeg

22.5%

Regina

7.6%

Edmonton

6.3%

Vancouver

12.4%

The percentage change is calculated as [(January 2022 index value – January 2021 index value)/January 2021 index value] × 100. Winnipeg saw the largest increase and Edmonton the smallest. b. The home price index measures how much housing prices in the city have changed since the base month. It does not give information on which city had the most expensive homes in January 2021. 4.6 a. During the period from point B to C when the CPI did not change, the country experienced zero inflation. b. During the period from point C to D when the CPI decreased, the country experienced deflation. c. During the period from point A to B when the CPI increased at a decreasing rate, the country experienced a slowdown in inflation (disinflation). d. During the period from point 0 to A when the CPI increased at an increasing rate, the country experienced an increasing inflation rate. 4.7 Until Statistics Canada updates the market basket of goods used to compute the CPI to include the new television models, the introduction of the new models will have no effect on the CPI. Once the new models are included in the CPI market basket, they will most likely contribute to the increase in quality bias that causes changes in the CPI to overstate the true inflation rate. Increases in the prices of these new models partly reflect their improved quality and partly are pure inflation. Statistics Canada attempts to make adjustments so that only the pure inflation part of price increases is included in the CPI, but these adjustments are difficult to make, so the recorded price increases overstate the pure inflation in some products.

CHAPTER 5 | Unemployment and Inflation 45

5.5

Using Price Indexes to Adjust for the Effects of Inflation Learning Objective: Use price indexes to adjust data for the effects of inflation.

Review Questions 5.1 A nominal variable is a variable measured in current dollars, which means that it is measured using the actual prices from that year. A real variable is a variable measured in constant dollars, which means that it is measured using prices from the base year. That is, a real variable is adjusted for the effects of inflation. 5.2 The real wage for a given year between 2004 and 2022 can be calculated by using this formula: Real wage = (Nominal Wage/CPI) × 100. For example, the real wage for 2004 would be calculated as Real wage2004 = (Nominal Wage2004 / CPI2004) × 100. 5.3 As prices of goods and services decrease during a period of deflation, nominal earnings are likely to rise slowly and may even fall. Real earnings will not fall as much as nominal earnings and will rise if the decline in prices is greater than the decline in nominal earnings. Therefore, real average hourly earnings are likely to increase faster than nominal average hourly earnings during a period of deflation.

Problems and Applications 5.4 In the United States, the real minimum wage in 1957 was $3.70 [($1.00/27) × 100], and in 2016 it was $3.02 [($7.25/240) × 100]. In France, the real minimum wage in 1957 was €2.38 [(€0.19/8) × 100], and in 2016 it was €9.21 [(€9.76/106) × 100]. Between 1957 and 2016, there was an 18.4 percent decrease in the real minimum wage in the United States [($3.02 – $3.70)/$3.70] × 100. And there was a 287.7 percent increase in the real minimum wage in France [(€9.21 – €2.38)/€2.38] × 100. It does not matter whether we have information about the base year as long as we have the CPI data. Whatever the base year is, we would get the same percentage increase in prices. The percentage increase in the price level was less in the United States—[(240 – 27)/27 × 100] = 788.9 percent—than in France—[(106 – 8)/8 × 100] = 1225.0 percent. 5.5 Real GDP in 2019 = (Nominal GDP in 2019/CPI in 2019) × 100 = (2311/136) × 100 = $1699 billion. Real GDP in 2020 = (Nominal GDP in 2020/CPI in 2020) × 100 = (2207/137) × 100 = $1611 billion, making the percentage change in real GDP = (1699 - 1611)/1699 × 100% = -5.2%, or a 5.2% decrease in real GDP. 5.6 If three cups of coffee and a doughnut can be purchased in 2022 for $10 and in 2062 for $2000, the CPI would have to be 200 times greater in 2062 than in 2022 because 200 × $10 = $2000. Therefore, the CPI in 2062 would be 240 × 200 = 48 000. 5.7 The real receipts in 2020 dollars for each film are listed in the last column below. The first column shows the rankings of the top 10 films based on their earnings in 2020 dollars. Real receipts in 2020 dollars equal the nominal receipts reported in the third column multiplied by the CPI in 2020 divided by the CPI in the year that the movie was released.

CHAPTER 5 | Unemployment and Inflation

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Film Gone with the Wind Snow White and the Seven Dwarfs Star Wars: A New Hope 101 Dalmatians Jaws ET: The ExtraTerrestrial Titanic Star Wars: The Force Awakens Avatar Avengers: Endgame Star Wars: The Phantom Menace Black Panther Jurassic World The Avengers Avengers: Infinity War Star Wars: The Last Jedi Incredibles 2

Total Box Office Receipts 200 852 579

Year Released 1939

CPI 14

184 925 486

1937

460 998 007

1977

144 880 014 260 758 300

1961 1975

30 54

435 110 554

1982

659 363 944

1997

161

936 662 225

2015

237

760 507 625 858 373 000

2009 2019

215 256

474 544 677

1999

167

700 426 566 652 270 625 623 357 910 678 815 482

2018 2015 2012 2018

251 237 230 251

620 181 382

2017

245

608 581 744

2018

251

Real Receipts (2020 dollars) $3 715 772 712 3 421 121 491 1 957 352 194 1 250 797 454 1 250 674 069 1 161 790 036 1 060 715 910 1 023 609 773 916 146 395 868 432 059 735 970 487 722 750 919 712 818 953 701 955 212 700 451 035 655 620 318 627 978 772

5.8 The economy of Venezuela was suffering from hyperinflation and on the verge of collapse. The hyperinflation would have wiped out the 60 percent increase in the minimum wage, leaving the real minimum wage lower. With the economy near collapse, jobs were hard to find and there was little food available to purchase.

CHAPTER 5 | Unemployment and Inflation 47

Real versus Nominal Interest Rates 5.6 Learning Objective: Distinguish between the nominal interest rate and the real interest rate. Review Questions 6.1 The nominal interest rate is the stated interest rate on a loan, while the real interest rate is the nominal interest rate minus the inflation rate. 6.2 Because the nominal interest rate is the real interest rate plus the inflation rate, an increase in expected inflation raises the nominal interest rate by the increase in the expected rate of inflation, assuming that the real interest rate remains constant. 6.3 It is impossible to know whether a particular nominal interest rate is “high” or “low” without knowing the inflation rate. It is the real interest rate that matters to borrowers and lenders, not the nominal interest rate. A nominal interest rate of 5 percent with an inflation rate of 0 percent has a higher real interest rate than a nominal interest rate of 20 percent with an inflation rate of 19 percent. 6.4 If the economy is experiencing deflation, the nominal interest rate will be lower than the real interest rate. The real interest rate equals the nominal interest rate minus the inflation rate, but with deflation the inflation rate is negative.

Problems and Applications 6.5 The reporter does not understand the definition of deflation. Deflation occurs when the price level declines. Inflation, even if only half the national rate, increases the price level. It is not possible for the CPI to drop below zero. The reporter should have written that the change in the CPI drops below zero when there is deflation. 6.6 The real interest rate on a loan with a nominal interest rate of 20 percent and 19 percent inflation is 1 percent. The real interest rate on a loan with a nominal interest rate of 5 percent and 2 percent inflation is 3 percent. Therefore, you should prefer the loan with the 20 percent nominal rate. 6.7 If the monthly inflation rate is 4 percent, the annual inflation rate is about 60 percent. To see this, notice that at a 4 percent inflation rate, the price level is rising 4 percent per month. If the price level starts at 100, after two months it would have increased to 100 × 1.04 × 1.04 = 108.2; after three months it would have increased to 100 × 1.04 × 1.04 × 1.04 = 112.5; and after twelve months to 100 × (1.04)12 = 160.1, or by 60.1 percent. So, the real interest rate would be 4% − 60% = –56%. 6.8 Real interest rate = Nominal interest rate – Inflation rate. With $1000, you can purchase 500 hamburgers at the beginning of the year. If you lend $1000 for one year at an interest rate of 5 percent, you will receive $1050 at the end of the year. With the higher price of hamburgers, at the end of the year you can buy $1050/$2.08 = 504.8 hamburgers. So, you can purchase [(504.8 − 500)/500] × 100 = 0.96% more hamburgers. Therefore, the real interest rate you receive on the loan is 0.96 percent. Notice that this is very close to the real interest rate on the loan, calculated by subtracting the 4 percent inflation in hamburger prices from the 5 percent nominal interest rate on the loan. 6.9 Lenders would agree to a nominal interest rate of almost 0 percent, because with deflation, the real interest rate would be higher than the nominal interest rate by the rate of deflation.

CHAPTER 5 | Unemployment and Inflation

5.7

Does Inflation Impose Costs on the Economy? Learning Objective: Discuss the problems inflation can cause.

Review Questions 7.1 We know from the circular flow of expenditures and income that when inflation increases the nominal value of expenditures, it must also increase nominal incomes. Consequently, inflation does not reduce the purchasing power of the average consumer. 7.2 Inflation affects the purchasing power of money. People with incomes rising faster than the rate of inflation enjoy an increasing purchasing power, while people with incomes rising more slowly than the rate of inflation are hurt by a decreasing purchasing power. In general, inflation particularly hurts people on fixed incomes, such as retired persons who may be receiving a pension of a fixed number of dollars each year. (As we noted, however, the Canada Pension Plan, Old Age Security, and other social security payments tend to move at the same rate as the CPI, but not always.) 7.3 Unanticipated inflation is the greater problem. Anticipated inflation can be incorporated into nominal interest rates and nominal wage contracts. Unanticipated inflation causes the actual real interest rate and actual real wage rate received to differ from the expected real interest rate and the expected real wage rate. 7.4 Deflation can cause consumers to reduce their current spending in anticipation of future lower prices, and unanticipated deflation increases the burden on borrowers by raising the real interest rate above the expected real interest rate. 7.5 Menu costs are the costs of changing prices. The term comes from the notion that restaurants would have to reprint menus to change (increase) the prices they charged. The internet has likely reduced menu costs for many firms. Online retailers can change the price they charge for each item with a few keystrokes, while previously they would have to pay an employee to replace every price tag on each individual item. 7.6 If inflation turns out to be lower than anticipated, borrowers tend to benefit at the expense of lenders. A higher than expected inflation rate reduces the value of money paid by borrowers to lenders, reducing the real interest rate. So when inflation rises unexpectedly, borrowers pay back less in terms of purchasing power (they give up fewer other purchases) than they were expecting. 7.7 a. Frank is likely to have a higher real income 10 years from now. Real income is income adjusted for inflation. James’s fixed pension income will have been constantly eroded by inflation, while Frank will constantly have to purchase new GICs. The GICs that Frank purchases will be subject to interest rates that change with the rate of inflation. The nominal rate of interest tends to adjust in response to inflation so that the real interest rate is moderately stable. Thus, Frank will be better protected from inflation than will James. b. In this situation James is likely to have a higher income than Frank. Frank’s GICs cannot account for unanticipated inflation, while James’s pension is now adjusted for inflation every year. If inflation is higher than expected in any given year, Frank’s interest payments will be lower in real terms than he was expecting. He will have to wait until his GICs are up for renewal in order to get an interest rate that reflects the higher inflation rate.

CHAPTER 5 | Unemployment and Inflation 49 7.8 If the actual inflation rate is 6 percent rather than 2 percent, Apple will benefit at the expense of those that lent it money (purchased bonds). In this scenario the real interest rate turns out to be zero rather than the expected real interest rate of 4 percent. This means that Apple’s lenders receive no financial benefit from their loan.

Real-Time Data Exercises D5.1

a. The CPI for August 2019 was 256.3 and for August 2018 was 251.9. b. The inflation rate as measured by the CPI from August 2018 to August 2019 equalled [(256.3 – 251.9)/251.9] × 100 = 1.7 percent.

D5.2

a. and b. Data used in the graph in (c) below covers the period from August 2013 to August 2019. c.

Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

d. The inflation rate of 2.95 percent in July 2018 was the highest during these years with the inflation rate of 2.85 percent in June 2018 and 2.74 percent in May 2018 being the second and third highest. D5.3

a. and b. Data used in the graph in (c) below covers the period from July 2009 to August 2019. c.

Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

CHAPTER 5 | Unemployment and Inflation d. The inflation rate as measured by the CPI was more volatile than the inflation rate as measured by the CPI less prices of food and energy. In July 2010 the inflation rate measured by the CPI was 1.34 percent but measured by the CPI less food and energy prices was 0.96 percent. In February 2017, the inflation measured by the CPI was 2.73 percent, but measured by the CPI less food and energy prices it was 2.19 percent. In August 2019, the two inflation rates were 1.76 percent as measured by the CPI and 2.39 percent as measured by the CPI less food and energy prices.

D5.4

a. The CPI for food and beverages in August 2019 was 258.2, and in August 2012 it was 234.1. The CPI for apparel in August 2019 was 125.1, and in August 2012 it was 125.3. The CPI for transportation in August 2019 was 210.3, and in August 2012 it was 217.6. The CPI for medical care in August 2019 was 501.3, and in June 2012 it was 417.6. b. The inflation rate over the entire period from August 2012 to August 2019 for food and beverages was [(258.2 – 234.1)/234.1] × 100 = 10.329 percent; for apparel it was [(125.1 – 126.3)/126.3] × 100 = −10.095 percent; for transportation it was [(210.3 – 217.6)/217.6] × 100 = −3.435 percent; for medical care it was [(501.4 – 417.6)/417.6] × 100 = 20.1 percent. These inflation rates are the percentage changes over the entire five-year period, not annual inflation rates. c. Transportation experienced the lowest inflation rate (−3.35 percent), and medical care experienced the highest inflation rate (20.1 percent).

D5.5

a. In August 2019, the number of unemployed equalled 6044 thousand, the civilian labour force equalled 163 922 thousand, and workers with part-time employment for economic reasons, slack work, or business conditions equalled 2678 thousand. These data are reported monthly and measured in thousands of persons. b. The civilian unemployment rate equalled [(6044 thousand/163 922 thousand) × 100] = 3.7 percent. The civilian unemployment rate including persons who are underemployed equalled [(6044 thousand + 2678 thousand)/163 922 thousand] × 100 = 5.3 percent.

D5.6

a. In August 2019, the number of unemployed men equalled 3233 thousand, the number of unemployed women equalled 2812 thousand, the civilian labour force for men equalled 86 832 thousand, and the civilian labour force for women equalled 77 090 thousand. These data are reported monthly and are measured in thousands of persons. b. The unemployment rate for men equalled [(3233 thousand/86 832 thousand) × 100] = 3.7 percent, and the unemployment rate for women equalled [(2812 thousand/77 090 thousand) × 100] = 3.6 percent.

D5.7

a. In August 2019, the number of unemployed equalled 6044 thousand, civilian employment equalled 157 878 thousand, and those not in the labour force equalled 95 510 thousand. b. The working-age population equals the labour force plus those not in the labour force. In August 2019, the labour force equalled 6044 thousand + 157 878 thousand = 163 922 thousand, and the working-age population equalled 163 922 thousand + 95 510 thousand = 259 432 thousand. The employment–population ratio equals civilian employment divided by the working-age population, which for August 2019 equalled [(163 922 thousand/259 432 thousand) × 100] = 63.18 percent. c. If the economy entered a recession, one would expect the employment–population ratio to decline as fewer people would have jobs.

CHAPTER 5 | Unemployment and Inflation 51 D5.8

a. The civilian unemployment rate equalled 3.6 percent in the second quarter of 2019, and it equalled 4.4 percent in the second quarter of 2017. The natural rate of unemployment equalled 4.381 percent in the second quarter 2019 and 4.611 percent in the second quarter of 2017. Note that the natural rate of unemployment is calculated on a quarterly, not monthly, basis. b. The cyclical unemployment rate equals the unemployment rate minus the natural rate of unemployment. The cyclical unemployment rate equalled (3.6 percent − 4.4 percent) = −0.8 percent in the second quarter of 2019 and equalled (4.4 percent − 4.6 percent) = −0.2 percent in the second quarter of 2017. c. The economy improved over the two-year period, and the unemployment rate in the second quarter of 2019 was further below the natural rate of unemployment than in the second quarter of 2017.

D5.9

a. In August 2019, the number of unemployed equalled 6 044 000, civilian employment equalled 157 878 000, employment level—part-time for economic reasons equalled 4 381 000, and not in the labour force, searched for work and available equalled 1 561 000. b. The official unemployment rate equals the number of unemployed divided by the labour force, which equals the unemployed plus the employed. For August 2019, the official unemployment rate equalled [(6 044 000/(6 044 000 + 157 878 000) × 100] = 3.7 percent. c. This broader measure of the unemployment rate would include as unemployed the three categories of unemployed: unemployed; employed but part-time for economic reasons; and not in the labour force, searched for work and available. In August 2019, this broader measure of the unemployment rate equalled [(6 044 000 + 4 381 000 + 1 561 000)/(6 044 000 + 4 381 000 + 1 561 000 + 157 878 000)] × 100 = [11 986 000/169 864 000] × 100 = 7.1 percent. d. One would expect the gap between the official rate of unemployment and the broader rate of unemployment to widen during recessions and narrow during expansions. One would expect the number of part-time workers for economic reasons and discouraged workers to rise during a recession and fall during an expansion.

D5.10 a. In September 2019, the three-month Treasury bill interest rate equalled 1.89 percent and the University of Michigan inflation expectation equalled 2.70 percent. b. The expected real interest rate equals the nominal interest rate minus the expected inflation rate. In September 2019, the expected real interest rate for the three-month Treasury bill equalled 1.89 percent − 2.70 percent = −0.81 percent. c. If the actual inflation rate is greater than the expected inflation rate, borrowers gain and lenders lose from the actual real interest (nominal interest rate minus the actual inflation rate) being below the expected real interest rate. D5.11 a. In August 2019, the CPI equalled 256.6 and average hourly earnings of private production and non-supervisory employees equalled $23.59, and in August 2019, the CPI equalled 252.1 and average hourly earnings equalled $22.80. b. The average hourly real wage in August 2019 equalled [($23.59/256.6) × 100] = $9.19, and in August 2018 equalled [($22.80/252.1) × 100] = $9.04. With the CPI having a base period of 1982–1984, the real wage is measured in 1982–1984 dollars. c. The percentage change in the average hourly nominal wage equalled [(23.59 – 22.80)/22.80] × 100 = 3.46 percent, and the percentage change in the average hourly real wage equalled [(9.19 – 9.04)/9.04] × 100 = 1.7 percent.

CHAPTER 5 | Unemployment and Inflation d. Given that the average hourly real wage increased 1.7 percent from August 2018 to August 2019, the average worker was better off.

Suggestions for Critical Thinking Exercises CT5.1

The unemployment rate would likely increase as unemployment increased by a large number. If you check the expansions after the recessions of 1991, 2001, and 2007–2009, you’ll see the unemployment rate rising for a time.

CT5.2

A key part in the construction of the CPI is seeing how much a consistent market basket of goods and services costs at different times. The GDP deflator compares real GDP (constructed with constant prices) to nominal GDP to compute the GDP deflator.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles SOLUTIONS TO END-OF-CHAPTER EXERCISES 6.1

Long-Run Economic Growth Learning Objective: Discuss the importance of long-run economic growth.

Review Questions 1.1 Real GDP per capita increased by almost three times. The actual increase in living standards is likely to be larger as this measure does not account for many of today’s goods and services, increases in life expectancy, and the like. 1.2 The rule of 70 is a quick way to calculate the approximate number of years it will take for a quantity such as real GDP per capita to double. Dividing 70 by the growth rate per year yields the approximate number of years to double. If real GDP per capita grows at the rate of 7 percent per year, it will take 10 years (70/7) for real GDP per capita to double. 1.3 The most important factor that explains increases in real GDP per capita in the long run is labour productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. 1.4 Potential real GDP is the level of real GDP attained when all firms are producing at capacity. Historically, potential real GDP has substantially increased over time.

Problems and Applications 1.5 There is no one correct answer to this question, but there are some relevant considerations: An income of $1 000 000 in 1900 represents 23 times more basic purchasing power than $50 000 in 2021, so with that income you could have many more goods and services in 1900 than in 2021. Even though there were no automatic dishwashers, microwaves, or airplanes in 1900, with $1 000 000 you could afford to have servants wash the dishes, cook, do the laundry, and provide other desired personal services. You could travel in private train cars and in luxurious suites on ocean liners. With an income of $1 000 000 in 1900, you could live what in many ways would be a more luxurious life than with an income of $50 000 today. However, you would not have television, personal computers, the Internet, movies, iPads, streaming services, smartphones, or many other goods available today that we often think of as necessities. So, a person living with an income of $50 000 in 2021 might in fact enjoy a higher living standard than a person living with an income of $1 000 000 in 1900. 1.6 A positive relationship between economic prosperity and life expectancy may be due to increased spending on health care in an economy with a higher income level. Therefore, greater economic prosperity would imply a health care sector that is larger relative to the economy. In addition, because the use of the health care system increases with age, as life expectancy increases and the average age of the population increases, we should expect that more people will use the health care system for more years. This should cause the health care sector in Canada to expand relative to the size of the economy. Copyright © 2024 Pearson Canada Inc.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

1.7 Increases in real GDP per capita not only increase the amount of goods and services available to a country’s citizens but also increase life expectancy at birth and allow people to have a higher portion of leisure time over the course of their lives. So, a rising GDP per capita should ordinarily result in a rising quality of life. 1.8 a. Growth rate for 1991 =

8015 − 8034 × 100 = –0.24% 8034

Growth rate for 1992 =

8287 − 8015 × 100 = 3.39% 8015

Growth rate for 1993 =

8523 − 8287 × 100 = 2.85% 8287

Growth rate for 1994 =

8871 − 8523 × 100 = 4.08% 8523

b. Average annual growth =

−0.24% + 3.39% + 2.85% + 4.08% = 2.52% 4

1.9 Using the rule of 70, it will take approximately 38.8 years for real GDP per capita to double if it grows at 1.8 percent a year. If the annual growth rate falls to 1.5 percent, real GDP per capita will take approximately 46.7 (70/1.5) years to double. 1.10 Many developing countries have faced difficulties implementing policies that boost economic growth, such as protecting private property and avoiding political instability and corruption. India faces particular challenges around property rights and corruption. (Thankfully, the political system seems fairly robust.) 1.11 a. The government measure would understate the rate of growth of labour productivity, because the government calculates labour productivity using the official measure of work hours, not the adjusted measure that Smith believes to be more accurate. If Smith is correct, workers are producing the measured level of output in fewer hours than the official work hours used in the calculation in the government statistics. b. Increases in real GDP per capita as calculated by the economists and Statistics Canada would understate increases in well-being. For any given level of output, workers are working fewer hours and consuming more leisure, increasing their well-being beyond that indicated by increases in real GDP per capita alone. 1.12 Real wages increase when workers produce more output per hour. Business firms generally pay workers the marginal revenue product of their labour, which increases as labour productivity increases. Looked at another way, the real wages of workers as a group cannot increase unless the output the workers produce is also increasing.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 55

Saving, Investment, and the Financial System 6.2

Learning Objective: Discuss the role of the financial system in facilitating long-run economic growth.

Review Questions 2.1 The financial system allows businesses to borrow funds to finance purchases of capital equipment, to train workers, and to adopt new technologies. Long-run economic growth depends on increases in the quantity of capital equipment, increases in the amount of human capital, and technological advances. 2.2 The equality between saving and investment follows from national income accounting and the definitions of saving and investment. By rearranging the components of GDP for a closed economy (Y = C + I + G), investment equals income minus consumption minus government purchases. Adding together private saving by households (SPrivate = Y + TR – C – T) and public saving by government (SPublic = T – G – TR) yields total saving, and also equals income minus consumption minus government purchases, or investment. 2.3 Loanable funds are the money that households save and lend to businesses. Businesses demand loanable funds to borrow money to fund new investment projects. Households supply loanable funds to save money and earn interest for future years.

Problems and Applications 2.4 You would have to take the time and expense to gather information on the borrower and their likelihood of repaying. Your funds would not be liquid. If you wanted the money back before the loan was due, the borrower would not have to pay before the due date. If the borrower stopped paying, you might have to go to court to try to get your money back. Lastly, your money would not be spread out across different investments to reduce risk. 2.5 a. Private saving: Sprivate = Y + TR – C – T = $11 trillion + $1 trillion – $8 trillion – $3 trillion = $1 trillion b. Public saving: Spublic = T – G – TR, but G not given. Use I = Sprivate + Spublic; $2 trillion = $1 trillion + Spublic; Spublic = $1 trillion c. Government purchases: Spublic = T – G – TR, or I = Y – C – G G = $1 trillion d. Government budget surplus = T – G – TR = $1 trillion

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

2.6 a. Private saving: Sprivate = Y + TR – C – T, but TR not given. Use I = Sprivate + Spublic I = Y – C – G = $12 trillion – $8 trillion – $2 trillion = $2 trillion. Spublic = −$0.5 trillion, so Sprivate = $2.5 trillion b. Investment spending: I = $2 trillion c. Transfer payments: Spublic = T – G – TR; −$0.5 trillion = $2 trillion − $2 trillion – TR, TR = $0.5 trillion d. Government budget deficit: T – G – TR = –$0.5 trillion 2.7 S and I must drop by $0.5 trillion. I = S = Y – C – G. With no change in Y and C, an increase in G must drop I and S by the same amount. 2.8 a. The shift represents a decrease in the supply of loanable funds. b. The equilibrium quantity of loanable funds decreases. c. The quantity of saving decreases as does the quantity of investment. 2.9 a. Both the equilibrium interest rate and the quantity of loanable funds increase. b. The demand for loanable funds increases. For a given demand for loanable funds, an increase in the interest rate does decrease the quantity of loanable funds demanded, but it also increases the quantity of loanable funds supplied.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 57 2.10 As illustrated in the graph below, an economic expansion will increase the expected profitability of new investment, which will increase the demand for loanable funds. The equilibrium real interest and the quantity of loanable funds will both rise, as will the quantity of saving and investment.

2.11 As illustrated in the graph below, an increase in business taxes will decrease the after-tax rate of return on investment projects, which will decrease the demand for loanable funds. The equilibrium real interest rate and quantity of loanable funds will both decrease, which will decrease the quantity of investment and the economy’s future capital stock.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

2.12 a.

A reduction in deficits shifts the supply of loanable funds to the right. As the supply curve for loanable funds shifts right, the equilibrium real interest rate falls, and the equilibrium quantity of loanable funds rises. Since the equilibrium quantity of loanable funds rises, the equilibrium quantity of saving and investment also rises. b. A decrease in saving by households in anticipation of lower taxes in the near future would partly or fully offset the increase in public saving caused by the reduction in federal budget deficit. If the decrease in private saving matches the increase in public saving, the supply of loanable funds will not shift, and there will be no change in the real interest rate or the equilibrium quantity of loanable funds. 2.13 Households are interested in the return they receive from saving after they have paid their taxes. If the government switched from taxing nominal interest payments to taxing only real interest payments, the tax households would pay would decrease, leaving them a higher after-tax return. This increase in the after-tax return would increase the supply of loanable funds. The supply curve for loanable funds would shift to the right (from S1 to S2 in the graph below) as the after-tax return to saving increases. The equilibrium real interest rate will fall (from i1 to i2), but the quantity of loanable funds would increase (from L1 to L2), as would the quantity of saving and investment. Because investment increases, the capital stock and the quantity of capital per hour worked will grow, and the rate of economic growth should increase.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 59

2.14 Agree. A sound financial system helps to channel saving (the supply of loanable funds) to firms that borrow for capital investment and the adoption of new technologies, both of which are key factors for economic growth. 2.15 a. Graph 4 shows a situation where there would be a small increase in the quantity of loanable funds supplied from an increase in the real interest rate. b. Graph 1 shows a situation where there would be a substantial increase in the quantity of loanable funds demanded following a decrease in the real interest rate. c. Graph 2. The elimination of non-deductible retirement accounts would reduce the after-tax return on saving, which would shift the supply curve for loanable funds to the left. d. Graph 3. A reduction in the tax on corporate profits would increase the after-tax return on investment projects, which would shift the demand curve for loanable funds to the right. 2.16 a. “Index-tracking funds” or “funds” refer to mutual funds, which sell shares to savers and then use the money to buy a portfolio of stocks, bonds, mortgages, and other financial securities. b. The use of artificial intelligence (AI) represents a technological advance and would increase labour productivity in the financial system by allowing financial firms to offer the same number of mutual funds with fewer (human) managers or more mutual funds with the same number of managers. c. By increasing labour productivity and decreasing costs in the financial system, the use of AI would increase the flow of loanable funds, which would increase saving and investment and thereby the rate of long-run economic growth.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

6.3

The Business Cycle Learning Objective: Explain what happens during the business cycle.

Review Questions 3.1 a. Peak b. Trough c. Recession d. Expansion 3.2 During an economic expansion, particularly near the end of the expansion, the inflation rate typically increases. During recessions, the inflation rate typically decreases. The unemployment rate rises during recessions and, after a delay, falls during expansions. The unemployment rate may continue to rise during the early stages of a recovery because employment may grow more slowly than the labor force (from population growth and discouraged workers re-entering the labor force), and because some firms are operating well below capacity, these firms may be slow to hire laid-off workers or may continue to lay off more workers for a period of time.

Problems and Applications 3.3 Ford F-150 trucks (a), refrigerators (c), and Bombardier passenger aircraft (e) are durable goods and would be expected to fluctuate more than real GDP during the business cycle. McDonald’s Big Macs (b) and Huggies diapers (d) are non-durable goods and would be expected to fluctuate less than real GDP. 3.4 As part of the federal government, Statistics Canada could be pulled into politics with the dating of recessions. It could come under pressure to set the start or the end of a recession to help the administration in power. 3.5 When firms expand during a recession, they risk spending too much money too quickly. If it is difficult to predict when a recession will end, firms that expand too quickly will find themselves with increasing debt loads and not enough business to cover their increased expenses. This situation can lead to substantial losses for these businesses. In certain industries, a more cautious approach may be advisable. If a recession has significantly changed consumer spending habits, firms need to be aware of the changes and realize that consumer spending habits from before the recession may not re-emerge after the recession has ended. For example, casual dining restaurants experienced a significant drop in business during the recession of 2007–2009. This particular market may not be quick to rebound once the recession ends, as consumers seem to be taking a much more cautious approach in spending their incomes on items many consider luxuries and instead appear to be more interested in increasing their savings to better insulate themselves from future economic downturns. The recovery from the 2020–2021 COVID-19 recession seems to have taken a different path, likely as the cause was different. In this case, restaurants seemed to boom once the pandemic ended as people who were unable to dine out during lockdowns returned to restaurants.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 61 3.6 You should disagree with this statement. While $1.6 trillion is a lot of money for one person, the GDP in a single year doesn’t tell you about the rate of economic growth. You would need to know the level of GDP in the preceding year to determine the rate of economic growth. 3.7 Samuelson explained that households were willing to assume debt and lenders were willing to make loans during the Great Moderation because they were confident that continued economic growth would allow the loans to be paid off. But consumers were more reluctant to borrow and lenders were more reluctant to make loans after experiencing the effects of the financial crisis: “Consumers are not only . . . paying down debt but also trying to build up savings against possible future setbacks. Businesses are reluctant to invest in major expansions because they’re unsure of future demand.” Greater lending and debt prior to the recession of 2007–2009 increased the number of defaulted loans during the recession, making it worse than it might otherwise have been.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED the first quarter of 2021. D6.1

a. In the first quarter of 2021, nominal GDP equalled $22 061.5 billion, real GDP equalled $19 086.4 billion in chained 2012 dollars, and real potential GDP equalled $19 602.5 billion in chained 2012 dollars. These GDP values are at annual rates. b. The GDP price deflator in the first quarter of 2021 equalled [($21,061.5 billion/$19,086.4 billion) × 100] = 110.35. c. The percentage difference between real GDP and real potential GDP in the first quarter of 2021 equalled [($19,086.4 billion – $19,602.5 billion)/$19,602.5 billion] × 100 = –2.63%. Real GDP in the first quarter of 2021 was 2.63 percent below real potential GDP. d. Real GDP was below real potential GDP in 2011 as the economy continued to recover from a severe recession. Since the trough of the recession in the second quarter of 2009, real GDP has slowly climbed back up to and was above real potential GDP in 2019. However, real GDP fell below potential GPD in 2020 due to the COVID-19 pandemic and remained below potential GDP in the first quarter of 2021.

D6.2

a. Gross private saving equalled $7951.9 billion in the first quarter of 2021 and equalled $4447.7 billion in the first quarter of 2018. Gross government saving equalled − $3654.0 billion in the first quarter of 2021, and it equalled − $537.5 billion in first quarter of 2018. Saving values are at annual rates. b. Total saving equals gross private saving plus gross public saving (gross government saving). Total saving equalled $4297.9 billion (= $7951.9 billion − $3654.0 billion) in the first quarter of 2021 and equalled $3910.2 billion (= $4447.7 billion − $537.5 billion) in the first quarter of 2018. c. The graph below shows the loanable funds market in equilibrium. The supply of loanable funds represents total saving.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

d. The decrease in total saving from the first quarter of 2018 to the first quarter of 2021 shifts the supply curve for loanable funds to the left from S1 to S2, which would decrease the equilibrium quantity of loanable funds and increase the real interest rate. This result assumes that the decrease in total saving was due to factors other than changes in the real interest rate. D6.3

a. Gross government saving equalled −$3654.0 billion in the first quarter of 2021 and equalled −$383.4 billion in the first quarter of 2017. Saving values are annual rates. b. Government saving represents the government budget surplus if positive or budget deficit if negative. c. In both the first quarter of 2021 and the first quarter of 2017, there was a government budget deficit. From the first quarter of 2017 to the first quarter of 2021, government saving decreased, going from −$383.4 billion to −$3654.0 billion.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles 63 d. The decrease in government saving resulting from the larger government budget deficit shifts the supply curve for loanable funds to the left, which raises the equilibrium real interest rate and lowers the equilibrium quantity of loanable funds (and the level of investment).

Suggestions for Critical Thinking Exercises CT6.1

The economy is unlikely to be in a strong expansion and still have unemployment above the natural rate and real GDP less than potential GDP. This question encourages students to bring several related concepts together.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies SOLUTIONS TO END-OF-CHAPTER EXERCISES 7.1

Economic Growth over Time and around the World Learning Objective: Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

Review Questions 1.1

Creative destruction refers to the process of new technologies advancing living standards while destroying many existing firms. Joseph Schumpeter developed the concept of creative destruction. He believed that the key to rising living standards is not small changes to existing products but, rather, new products that meet consumer wants in qualitatively better ways. Many of the new products and new technologies brought about by creative destruction improve worker productivity. The increase in worker productivity ultimately increases the growth rate of the economy in the long run.

1.2

The total percentage increase is the percentage increase in real GDP from 2007 to 2019. It is not an annual growth rate. The average annual growth rate is the growth rate at which the value for real GDP in 2007 would have to grow on average each year to end up with the value for real GDP in 2019.

Problems and Applications 1.3

Shiue and Keller’s finding of the importance of market efficiency in explaining long-run economic growth supports North’s argument that a government can promote economic growth by protecting private property rights, as the British government did beginning with the Glorious Revolution of 1688.

1.4

The annual rate of economic growth is calculated as the percentage change in real GDP from the previous year. For example, the rate of economic growth for Mexico in 2018 equals [(4632 – 4553)/4553] × 100 = 1.74 percent. The average annual growth rate between 2018 and 2020 is calculated as the simple average of the growth rates for each year. Country Mexico France United States

2018 1.74% 1.82% 4.08%

2019 –0.04% 1.48% 5.22%

2020 –8.68% –8.33% –3.50%

Average Annual Growth Rate –2.33% –1.68% 1.93%

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

a. During 2018, the United States experienced the highest economic growth rate of 4.08 percent. b. Between 2018 and 2020, the United States experienced the highest average annual growth rate of 1.93 percent. c. During 2020, Mexico experienced the largest decline in real GDP of –2.33 percent. d. It does not matter that each country’s real GDP is measured in a different currency and uses a different base year. Growth rates are measured as percentage changes, which are not dependent on the specific units (in this case, currencies) or base year used. 1.5

You will have earned more on your Andover Bank CDs due to the compounding in 2023 and 2024 on the extra $30 you earned on the Andover Bank CD in 2022.

Andover Bank Lowell Bank 1.6 Year 2016 2017 2018 2019 2020

Value of CD at End of Year 2022 2023 2024 $1050.00 $1102.50 $1157.63 $1020.00 $1081.20 $1156.88 Real GDP per Capita (2009 prices) $54 861 55 790 57 158 58 113 55 802

Annual Growth Rate — 1.69% 2.45 1.67 –3.98

a. The percentage change in real GDP per capita between 2016 and 2020 was [($55,802 – $54,861)/$54,861] × 100 = 1.72 percent. b. The average annual growth rate in GDP per capita between 2016 and 2020 can be measured as the average of the annual growth rates in the above table, which is 0.46 percent [(1.69% + 2.45% + 1.67% – 3.98%)/4]. 1.7

a. Real GDP per capita most likely did not increase significantly from the near elimination of measles and the large decrease in childhood deaths, but because the health of many people improved, the standard of living did increase significantly. b. For a developing country, the elimination of measles and childhood deaths from diarrhea is more achievable than sustained increases in real GDP per capita. Fewer additional resources and less time are required to achieve the elimination of disease than the additional investment and the institutional changes needed for sustained increases in real GDP per capita.

1.8

Ideas and inventions include vaccines for diphtheria, pertussis, and tetanus (DPT) and recognizing the importance of education. Process technologies include laws and inventory management systems. If inventions “flow like water” while process technologies “flow like bricks,” then lowincome countries will be able to increase their standard of living as measured by better health and more education faster than they will be able to increase real GDP per capita.

7.2

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

What Determines How Fast Economies Grow? Learning Objective: Use the economic growth model to explain why growth rates differ across countries.

Review Questions 2.1

A movement from point A to point B shows the effect on real GDP per hour worked of an increase in capital per hour worked, holding technology constant. A movement from point A to point C shows the effect of an increase in technology, holding the quantity of capital per hour worked constant. 2.2

Diminishing returns to capital imply that, holding technology constant, increases in capital per hour worked result in smaller and smaller increases in real GDP per hour worked. Therefore, sustained increases in real GDP per hour worked require more than continuing increases in capital per hour worked. To maintain high growth rates despite diminishing returns to capital, economies must experience technological change.

2.3

New growth theory is a model of long-run economic growth that emphasizes the effect of economic incentives on technological change, which is determined by the working of the market system. The Solow growth theory does not seek to explain what determines technological change but instead assumes that technological change occurs because of chance scientific discoveries. The new growth theory, besides seeking to explain factors that influence technological change, incorporates knowledge capital. Investments in knowledge capital result in increasing returns, unlike increases in physical capital, which are subject to diminishing returns.

2.4

Firms are likely to underinvest in research and development because competing firms will gain much of the returns from their research and development. To increase the accumulation of knowledge capital, governments can protect intellectual property with patents and copyrights, subsidize research and development, and subsidize education.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Problems and Applications 2.5

Productivity growth increases a nation’s per capita GDP, which is a measure of a nation’s standard of living. China will not be able to increase the standard of living of its citizens as fast as it would if productivity growth had not declined. A growing economy produces both increasing quantities of goods and services and better goods and services. It is only through economic growth that living standards can increase.

2.6

a. An increase in capital per hour worked results in a movement along the per-worker production function. b. and c. Both result in shifts of the per-worker production function because they are likely to lead to technological change by increasing real GDP per hour worked, holding capital per hour worked constant.

2.7

Even though they are not spending their own money, salaried managers in the United States are judged by the profitability of their companies, which often depends on adopting new technologies.

2.8

a. The rapid increases in capital per hour worked in the Soviet Union after 1950 had resulted in rapid increases in real GDP per hour worked. At such rapid rates of growth of real GDP per hour worked, the Soviet economy could eventually become larger than the US economy. b. The Soviet economy ran into diminishing returns to capital and experienced a much slower rate of technological progress than did the US economy.

2.9

a. False, because technology is assumed constant along a given per-worker production function. The movement from point A to point B represents an increase in capital per hour worked. b. False, because the movement from point B to point C represents technological change, which occurs despite the existence of diminishing returns to capital. c. True, because point C represents both a higher level of capital per hour worked and a higher level of technology than point A.

2.10

If the per-worker production function turned upward, with the slope of the curve increasing as capital per hour worked increases, a country could experience increasing rates of economic growth with increases in the quantity of capital per hour worked. Instead of capital per hour worked experiencing diminishing returns, it would experience increasing returns.

2.11

The Soviet Union’s growth strategy of pursuing very high rates of investment ran into the problem of diminishing returns to capital. There was little emphasis on technological change, which meant that the capital stock was increasing much more rapidly than technology. Continuing rapid increases in capital per hour worked led only to diminishing increases in output per hour worked. With these diminishing returns, the growth rate of real GDP per capita in the Soviet Union stagnated.

2.12

a. The success that Greenspan and Wooldridge are referring to is the sustained growth in labour productivity and real GDP per capita over many decades. Creative destruction played a major role in US economic growth because a majority of growth can be attributed to the introduction and the adoption of new technology. Inventions such as the steam engine, electrification, telephones, and airplanes increased both productivity and the standard of living, while investment in universities and research institutions accelerated the rate of technological change that further contributed to more rapid growth rates.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies b. While creative destruction leads to a country’s success, not everyone benefits from it. The introduction of new technologies and new products disrupts existing industries. For example, many people who built horse-drawn wagons and carriages lost their jobs when the automobile became widely available. Today, the introduction of robots and other new technologies has changed the way many products are made. For example, employment in the automobile industry has declined as companies have replaced workers with robots on their assembly lines.

2.13

a. In Romer’s new growth theory, he argues that the accumulation of knowledge capital is a key determinant of economic growth. He notes that the accumulated knowledge, or stock of knowledge, of a country is more important than are the country’s natural resources. Therefore, the more people there are, the more likely it is that additional knowledge will be accumulated, increasing the rate of economic growth. b. The existence of the Portuguese, or of people in general, is more important in Romer’s new growth theory than in Solow’s original growth model. Although economic growth is dependent on technological change in both models, Solow’s model does not explain what causes technological change. The greater knowledge that is accumulated as a result of having more people helps to explain growth in Romer’s model but is not explicitly considered in Solow’s model.

7.3

Economic Growth in Canada Learning Objective: Discuss fluctuations in productivity growth in Canada.

Review Questions 3.1

The growth rate of productivity increased from 1800 through the mid-1970s, slowed for more than 20 years, increased again beginning in the mid-1990s, and then slowed again beginning in 2006. Economists are unsure whether the slowdown in productivity growth during the past 10 years indicates that Canada is heading for a long period of slow economic growth.

3.2

Some economists are optimistic that the increase in productivity that began in the mid-1990s from advances in information and communication technology will continue. These economists believe high rates of growth will come from higher productivity in the information technology (IT) sector itself and in other sectors of the economy as the result of progress that IT advances made possible. Other economists argue that the IT revolution is now having a greater effect on consumer products, such as smartphones and tablets, than on labour productivity. These economists also identify other factors⸻such as an aging population, declining educational achievement, and the consequences of increased regulations and higher taxes⸻that will lead to lower productivity growth rates continuing into the future.

Problems and Applications 3.3

The growth rates would be lower if they were calculated for real GDP per capita instead of per hour worked because the number of hours worked per person in Canada has decreased in the years since 1800. The denominator in the expression for real GDP per capita has increased more than has the denominator in the expression for real GDP per hour worked.

3.4

Productivity growth enables workers to produce more output, which translates to a higher GDP, holding everything else constant. The columnist noted the connection between overall economic output (GDP) and changes in productivity. Specific factors (such as advances in technology) can

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

increase worker productivity and drive economic growth. The second statement is an observation that the columnist does not see any changes coming in the next few years that will push productivity growth higher and therefore increase overall economic growth. So, there is a connection between the two observations. However, it is worth noting that many technological breakthroughs that lead to greater productivity and drive economic growth are difficult to predict. 3.5

Future labour productivity growth rates in Canada will be low if Gordon’s observations are correct. The higher labour productivity growth rates that lasted from 1996 to 2005 were due partly to advances in information and communication technology. To the extent that these advances continue to result more in increased consumer enjoyment than in increased business productivity, labour productivity growth rates will remain relatively low.

3.6

a. There are benefits derived from Internet searches that affect GDP, but those benefits are probably not measured directly. Finding information more quickly and efficiently than was possible prior to the existence of the Internet results in more time and other resources available to produce new final goods and services. In other words, as the opportunity cost of finding information has declined, more resources have become available to produce additional output that is included in GDP. b. There are measurement problems that could explain why productivity growth has declined in recent years, but some economists have pointed out that similar problems resulted in an underestimate of productivity growth in periods when measured productivity growth was higher. Improvements in technology lead to long-run increases in GDP per capita. If these increases occur, the implication will be that the recent decline in productivity was partly the result of measurement problems.

3.7

Secular stagnation is an extended period of slow economic growth. Economists who believe in secular stagnation believe that the demand for loanable funds may be low in the coming years due to (1) slower population growth reducing the demand for housing, (2) high-technology firms needing less capital, and (3) prices for economic capital falling so firms need less money for expenditures. All these factors will shift the demand for loanable funds to the left and result in a lower quantity of loanable funds demanded and a lower equilibrium interest rate. These changes are shown in the following graph.

7.4

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Why Isn’t the Whole World Rich? Learning Objective: Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

Review Questions 4.1

Increases in the quantity of capital per hour worked and the adoption of new technology should occur at a high rate in poor countries because the profitability of using additional capital or better technology is generally greater in a poor country than in a rich country. Some poor countries have been catching up to rich countries, but many have not.

4.2

Foreign direct investment (FDI) occurs when a firm builds or purchases a facility in a foreign country. Foreign portfolio investment occurs when an individual or a firm buys stocks or bonds issued in another country. Foreign direct investment can give low-income countries access to better technologies, as when a Japanese firm builds a clothing factory in Vietnam. Foreign portfolio investment can give a low-income country access to funds that otherwise would not be available, as when investors in the United States buy stock in a firm in Kenya.

4.3

Globalization is the process of countries becoming more open to foreign trade and investment. Globalization can help a developing country break out of a vicious cycle of low saving and investment and low growth by providing access to funds and technology from foreign direct investment and foreign portfolio investment.

Problems and Applications 4.4

The catch-up effect predicts that countries with a lower level of GDP per capita will grow faster than countries with a higher level of GDP per capita. In the table, the data for Botswana, Ireland, and the United States are consistent with the catch-up prediction because Botswana’s GDP per capita in 1960 was the lowest and its growth between 1960 and 2019 was the highest, while Ireland’s GDP per capita and growth rate in 1960 were between that of Botswana and the United States. The data for other countries, however, is not consistent with the catch-up prediction. For example, Uganda and Madagascar should have grown faster than Ireland and the United States, but they grew more slowly.

4.5

a. No, these data do not support the catch-up prediction. The countries with the highest initial levels of real GDP per capita have growth rates of real GDP per capita similar to the countries with average initial levels of real GDP per capita. b. Yes, these data support the catch-up prediction. The countries with the lowest initial levels of real GDP per capita have the highest growth rates of real GDP per capita, and the countries with the highest initial levels of real GDP per capita have the lowest growth rates of real GDP per capita. c. No, these data do not support the catch-up prediction. The countries have roughly the same growth rates of real GDP per capita regardless of their initial levels of real GDP per capita.

4.6

a. The horizontal line in Graph 1 matches the experience of all countries, indicating that most of the world hasn’t been catching up. b. The slight upward-sloping line in Graph 3 matches the experience of Western Europe, Canada, and Japan, indicating that these high-income countries have stopped catching up to the United States.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

c. The downward-sloping line in Graph 2 matches the experience of current high-income countries, indicating that there has been catch-up among high-income countries. 4.7

a. Adopting “thoroughgoing innovation” means the country adopts the latest technology throughout its economy. Getting within “hailing distance of the West” means reaching a standard of living close to that of the countries of Western Europe, the United States, and Canada. b. No. Real GDP per capita in Haiti in 2069 would equal $1245 × (1.065)50 = $29 017, which is below Italy’s real GDP per capita in 2019 of $35 680. Haiti did gain substantial ground but remains behind Italy even after two generations. c. Failure to enforce the rule of law, wars and revolutions, poor systems of public education and health, and low rates of saving and investment can prevent low-income countries from adopting widespread innovation. Even if a low-income country adopts widespread innovation, these same factors can prevent the country from achieving high rates of economic growth.

4.8

a. The article is referring to real GDP, not nominal GDP, because economists, policymakers, and journalists are typically referring to changes in real GDP when they discuss growth. Because changes in nominal GDP are partly the result of changes in the price level, they are not as good an indicator of changes in a country’s production of goods and services as are changes in real GDP. b. More slowly. Real GDP per capita will grow more slowly than the real GDP, as long as a country is experiencing population growth. c. Based on parts (a) and (b) and assuming that the Mexican central bank’s forecast is accurate, Mexican real GDP per capita definitely fell if population grew more rapidly than 1.8 percent in 2019 and definitely rose if population grew more slowly than 0.8 percent. The central bank’s forecast gives a range of possible increases in real GDP, so it isn’t possible to be more specific. In fact, the population of Mexico was forecast to grow about 1 percent during 2019. So, whether real GDP per capita rose or fell depends on where actual growth in real GDP ended up within the forecast range.

4.9

a. Goldman Sachs is an investment banking firm that specializes in raising funds for businesses through stock and bond offerings and also investing money for its clients. Therefore, the analyst knows that government policies that encourage investment, both domestic and foreign, will result in higher economic growth rates. Specifically, foreign direct investment (FDI) is one of the easiest ways for a nation to gain access to technologies that increase productivity and drive economic growth. If Mexico adopted policies that encouraged FDI, it could increase its rate of economic growth. b. Foreign direct investment gives poor nations access to funds and technology that might not otherwise be available. Wealthy nations, such as the United States, already have access to financial capital and technology. However, US investors gain some diversification benefits when US firms engage in FDI in other countries.

4.10

a. Free trade and foreign investment that result from globalization make it possible for poor countries to attract foreign investment and gain access to the best technology. Without the free flow of trade and investment that globalization represents, poor countries would have to rely primarily on their own resources. Supporters of free trade argue that it improves economic efficiency and average incomes. Nevertheless, some countries isolate themselves from the world economy because they believe that globalization (1) destroys domestic industries, (2) is

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies disruptive of domestic culture by replacing native goods with foreign goods, or (3) leads to dominance by foreign firms and governments. b. Someone can argue that globalization can result in unemployment and lower incomes for workers in industries that compete with foreign imports and can lead to greater income inequality. As mentioned in the answer to part (a), critics believe that globalization, by promoting free trade and foreign investment, threatens to destroy the distinctive cultures of developing countries by replacing domestically produced goods with goods imported from foreign markets.

4.11

a. The decline in trade would harm countries that rely heavily on exports. Workers in these nations and industries would lose income from the decline in global trade, and many of these nations lack the social safety nets that exist in Canada. Any labour-intensive industry that exported goods from developing nations to developed nations would feel a significant impact from lower global trade. b. Firms and individuals working in domestic industries that compete with imports will benefit from the reduced competition of declining trade.

4.12

7.5

For the most part, the Roman Empire lacked the secure private property rights required for a market system to work. If modern economic growth had begun 1700 years earlier than it did, the standard of living today would be many times higher than it is.

Growth Policies Learning Objective: Discuss government policies that foster economic growth.

Review Questions 5.1

Governments can aid economic growth through policies that enhance property rights and the rule of law, improve health and education, subsidize research and development, and provide incentives for saving and investment.

5.2

Economic growth is associated with higher living standards, improved health, improved working conditions, and longer life expectancy. However, some critics argue that economic growth has contributed to income inequality, global warming, deforestation, and other environmental problems. Because it is a normative matter, economic analysis cannot settle the question of whether continued economic growth will always improve economic well-being.

Problems and Applications 5.3

a. Restrictions on firing employees make it difficult for a firm to get rid of a worker who it no longer needs or who is no longer productive. This restriction forces the firm to employ the workers that may have low productivity instead of firing them. These workers are likely to be better off if they reenter the job market where they can find a job at which they are more productive. Moreover, restrictions on firing may make firms hire fewer workers if they know that it will be difficult to fire workers who turn out to have low productivity or a poor fit for their jobs. b. Taxing business payrolls is likely to reduce the number of workers hired for two reasons: Hiring workers involves a firm not just paying the workers’ wages and benefits but also paying a tax to the government. A payroll tax also imposes a wedge, or gap, between the amount that a firm

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

pays to hire a worker and the amount that the worker receives. As with any tax, that wedge reduces the equilibrium of the good or service, in this case labour services. Taxing incomes does reduce the return to working (and saving and investing), but the effect on employment is smaller. c. A tax perk is a decrease in a firm’s tax obligation. Firms that receive tax perks are more likely to grow and expand than are firms that don’t receive tax perks because the return on investing in firms receiving tax perks is greater. Levy is assuming that the productivity of small firms is lower than the productivity of large firms, so favouring small firms with tax perks is likely to reduce the growth of the Mexican economy. d. Contract enforcement implies that agreements made by individuals and firms should be binding, and individuals and firms that do not fulfill their end of the bargain will face repercussions. Contract enforcement improves economic growth because the market becomes more efficient as individuals and firms take advantage of gains from trading with other people that they do not know. Without contract enforcement, individuals and firms would be reluctant to enter into an agreement, particularly a long-term agreement, with another individual or firm because they could not rely on the agreement being carried out. 5.4

China’s investment in residential housing will increase economic growth in the short run because construction of the housing employs labour and consumes building materials that may be manufactured in China. However, after the housing is built, it is not used to produce other goods and services (other than providing shelter for its occupants). In contrast, investment in infrastructure, factories, equipment, and research and development does boost productivity in the long term if it is utilized.

5.5

a. The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting property rights and enforcing contracts. b. Without the rule of law, particularly rules that protect property rights, the market cannot operate efficiently. If laws are not well enforced, buyers and sellers are hesitant to participate in market transactions for fear that they may be cheated in the transaction. Owners of firms are less likely to invest in their firms’ growth and expansion if they fear their firms may be confiscated by the government or they are forced to pay bribes to government officials. Firms may also be reluctant to enter into the long-term agreements that are essential to the operation of market economies if they do not have confidence in the agreements being enforceable in court. c. Neither China today nor the Soviet Union during the period before its collapse followed the rule of law. In both cases, the government made arbitrary decisions that affected businesses, and businesses could not expect to necessarily receive impartial justice from the court system. (In fact, the Soviet government allowed few private businesses to operate.) Both China and the Soviet Union achieved high rates of economic growth during the period in which large fractions of their populations moved out of lower-productivity agricultural occupations and into higher-productivity non-agricultural occupations. Both countries also benefited from increasing rapidly what had been very low levels of capital per hour worked. The failure to follow the rule of law and allow for property rights contributed to the eventual stagnation of Soviet economic growth and contributed to the collapse of the government. Whether China can successfully maintain high rates of economic growth without more fully establishing the rule of law remains to be seen.

5.6

a. The passage of an investment tax credit is likely to increase the rate of economic growth in Canada because the credit will give firms incentives to purchase more capital, thereby increasing the capital to labour ratio (K/L). In addition, if some of the new capital embodies

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies new technologies, the tax credit may contribute to shifting the Canadian production function upward. b. Shortening the period of patent protection will decrease the incentive to invest in research and development because the length of time that a firm can have to recoup its investment declines as well. The shorter period of patent protection will therefore decrease the amount of new technology that the country generates and will result in a decline in labour productivity and the rate of economic growth. c. Increasing education funds will result in a more educated workforce. More education increases productivity per worker and will increase economic growth.

5.7

A free press could serve as a watchdog against government violations of property rights and the rule of law. When the government controls the press, it limits the means for citizens of a country to become informed about government misbehavior. Similarly, by publicizing cases of corruption that undermine the rule of law and property rights, the press can help reduce the frequency of its occurrence. Over time, crusading newspapers and news websites can help reduce corruption and improve the rule of law.

5.8

a. Adesina is probably referring to aid in the form of cash transfers from foreign countries. These are funds that are donated by foreign countries that do not need to be repaid. He may also be referring to aid that helps develop infrastructure projects, such as roads, bridges, and dams. b. African countries need investment in new firms and in the expansion of existing firms. Foreign portfolio investment can provide funds that African firms need to expand. Foreign direct investment can provide African countries with access to current technology as foreign firms build new factories and other facilities in African countries. As we’ve seen, economic growth depends on increasing the amount of capital per hour worked and on technological change. Traditional foreign aid programs have not had much success in raising African growth rates, which is why Adesina believes that investment is a better approach.

5.9

a. The tariffs on Chinese goods will result in an increase in the demand for and production of USmade goods because the tariffs will make US-made goods and services relatively cheap in comparison with imported goods and services. Higher production by domestic firms will result in an increase in the growth rate in GDP between 2019 and 2020. This effect will be offset to the extent that foreign retaliation against US exports reduces production by exporters, to the extent that some domestic firms lose sales because US consumers are paying higher prices for imported goods, and to the extent that US firms have to raise their prices to offset the higher costs of imported inputs. b. For reasons discussed in Chapter 9, in the long run, tariffs will make the US economy less efficient. As a result, tariffs will reduce the long-run growth rate of the US economy.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED for the first quarter of 2021. D7.1

a. Output per hour for all persons in the manufacturing sector in the United States was 44.437 in the first quarter of 1987 and 97.53 in the first quarter of 2021. Output per hour for all persons in the non-farm business sector was 58.132 in the first quarter of 1987 and 112.729 in the first quarter of 2021.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

b. Labour productivity in manufacturing increased by 119.48 percent from 1987 to the first quarter of 2021. Labour productivity increased by 93.92 percent in the non-farm business sector from 1987 to the first quarter of 2021. c. If the trend in other advanced countries is similar to that of the United States, labour productivity in these countries will decline in the future as the manufacturing sector shrinks relative to other industry sectors. D7.2

a. Using estimates for 2019, the country with the highest real GDP (purchasing power parity) was China at $22.53 trillion, and the country with the lowest real GDP (purchasing power parity) was Tuvalu at $49 million (Niue, Tokelau, and Saint Helena, Ascension and Tristan da Cunha were excluded because their GDPs were for earlier years). b. Using estimates for 2019, the country with the highest per capita real GDP (purchasing power parity) was Macau with $123 965 (Note: Liechtenstein was higher with $139 100, but the estimate was for 2009), and the countries with the lowest per capita real GDP (purchasing power parity) was Burundi with $752. c. The country with the most equal income distribution was Belarus with a Gini index of 25.2 (the latest value is for 2018), and the country with the least equal income distribution was Brazil with a Gini index of 53.9 (the latest value is for 2018). If you use 2014 estimates, then South Africa has the least income equality with a Gini index of 63.0, and Jersey has a Gini index of 0.3, indicating almost perfect income equality. If income were distributed with perfect equality, the Gini index would equal zero, and if income were distributed with perfect inequality, the Gini index would equal 100. d. Using estimates for 2017, the country with the highest real GDP growth rate was Libya at 64 percent, and the country with the lowest real GDP growth rate was Venezuela at −19.67 percent (2018 estimates). (Note: Syria has a lower real GDP growth rate at 36.5 percent, but the estimate was for 2014.) e. Canada had the 15th highest real GDP (purchasing power parity) among countries, the 34th highest per capita real GDP (purchasing power parity) at $45 900, the 128th least equal income distribution (33.3 for 2017), and the 148th highest real GDP growth rate at 1.66 percent (2019 estimate).

Suggestions for Critical Thinking Exercises CT7.1 Answers may vary. Some answers that students may come up with are cellular phones replacing landline phones, MP3 players replacing cassette and CD players, Google searches replacing dictionaries and library visits, and streaming videos replacing video rental. CT7.2 a. You should disagree. Moldova’s economy today is not heavily industrialized like the economy of the Soviet Union was in the 1980s. Given the low levels of capital in Moldova today, additional investments in more machinery and factories will increase Moldova’s economy’s growth. b. Please refer to the following figure. Point A illustrates Moldova’s position before investments in machinery and factories. With its lower level of capital per worker, Moldova’s investment in capital moves up in the production function to point B, where the country experiences a large increase in the real GDP per hour worked. Point C illustrates the Soviet Union’s position before investments in machinery and factories. With its higher level of capital per worker, the Soviet Union’s investment in capital moves up in the production function to point D, where the country experiences a small increase in the real GDP per hour worked.

CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Source: Central Intelligence Agency, CIA World Factbook, cia.gov.

CT7.3 a. Please refer to the following figure. GDP per capita growth rate, 2020

6.0 YK 3.0 0.0 -3.0 -6.0

NT 0

20,000

40,000 NS PEI NB QB

60,000

1,00,000

NFL SK MB ON AB

-9.0 -12.0

80,000

NWT GDP per capita, 2020 (chained 2012 dollars) Source: Statista.com

b. Yes, the data above exhibit convergence or catch-up in income levels. c. To more accurately test if provinces are catching up, we need to know about the economies of each province and group together those provinces with similar economic profiles. For example, provinces whose economies rely predominantly on agriculture should be grouped separately from provinces that have GDPs that rely mostly on manufacturing.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run SOLUTIONS TO END-OF-CHAPTER EXERCISES 8.1

The Aggregate Expenditure Model Learning Objective: Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

Review Questions 1.1 The key idea of the aggregate expenditure model is that in any particular year, the level of real GDP is determined mainly by the level of aggregate expenditure. 1.2 Inventories are goods that have been produced but not yet sold. Inventories usually rise at the beginning of a recession and usually fall at the beginning of an expansion. 1.3 The aggregate expenditure model seeks to explain the business cycle and by doing so also explains cyclical unemployment. The model does not seek to explain long-run economic growth (the model does not address the factors that cause potential GDP to increase) and inflation (the model assumes the price level is fixed).

Problems and Applications 1.4 a. Consumption b. Government purchases c. Planned investment 1.5 a. Apple’s planned investment equals 100 000 iPhones, which is the expected addition to the inventories in its stores. Apple’s actual investment equals 300 000 iPhones, which equals the sum of planned investment plus the difference between its expected sales of 2.1 million iPhones and its actual sales of 1.9 million iPhones. b. Apple’s planned investment still equals 100 000 iPhones, which is the expected addition to the inventories in its stores. Apple’s actual investment is −100 000 iPhones, which equals the sum of planned investment plus the difference between its expected sales of 2.1 million iPhones and its actual sales of 2.3 million iPhones. 1.6 We can’t tell. We have to know what the planned change in inventories was. 1.7 The article indicates that Japanese firms faced an unplanned increase in inventories. If Japanese firms did not expect the drop in demand and did not sell the amount of a product they were planning to, inventories would increase.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Determining the Level of Aggregate Expenditure in the Economy 8.2

Learning Objective: Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

Review Questions 2.1 In the aggregate expenditure model, real GDP changes only when aggregate expenditure changes, so it is crucial to understand the factors that change each of the four categories of aggregate expenditure. 2.2 An example of consumption spending would be a household buying food; an example of planned investment spending would be a firm buying a computer; an example of government purchases would be the government buying a military airplane; and an example of net exports would be a Canadian automobile purchased by an American minus the value of a Canadian buying a Californian wine. 2.3 The four main determinants of investment spending are expectations of future profitability, the interest rate, business taxes, and cash flow. An increase in the interest rate would decrease investment spending, and a decrease in the interest rate would increase investment spending. 2.4 The three main determinants of net exports are the price level in Canada relative to the price level in other countries, the growth rate of GDP in Canada relative to the growth rate of GDP in other countries, and the exchange rate between the Canadian dollar and other currencies. An increase in the growth rate of GDP in the developing countries, for any given growth rate of GDP in Canada, would increase Canadian net exports.

Problems and Applications 2.5 (a) would cause the demand forecast to rise because it involves an increase in aggregate expenditure, and (b), (c), and (d) would cause the demand forecast to fall because each involves a decline in aggregate expenditure. 2.6 In the graph of the consumption function below, an increase in income increases consumption spending along the consumption function C1 (A to B). The increase in income causes a movement along the consumption function, but an increase in expected future income or household wealth would shift the consumption function upward, from C1 to C2.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

2.7 Consumption will fluctuate less. The five main determinants of consumption spending are current disposable income, household wealth, expected future income, the price level, and the interest rate. The most important determinant is current disposable income. Therefore, as employment insurance benefits reduce fluctuations in income, fluctuations in consumption are also reduced. 2.8 If the Consumer Confidence Index is a strong predictor of household spending, it tells businesses and governments when spending is likely to increase. For business owners, this information will signal when to begin to expand hiring or cut back on workers’ hours before a change in demand for their products actually occurs. In short, it will allow them to get ready. 2.9 Y = C + S + T. With taxes equal to zero, this equation becomes Y = C + S, and this can be used to fill in the Saving column. To fill in the MPC and MPS columns, use the expressions MPC = ΔC / ΔY MPS = ΔS / ΔY. For example, to calculate the value of the MPC in the second row, MPC = ΔC / ΔY = ($875 − $800) / ($1000 − $900) = $75/$100 = 0.75. To calculate the value of the MPS in the second row, MPS = ΔS/ΔY = ($125 − $100)/($1000 − $900) = $25/$100 = 0.25. National Income and Real GDP Consumption (Y) (C) $ 900 $ 800 1000 875 1100 950 1200 1025 1300 1100 2.10

Saving (S) $100 125 150 175 200

Marginal Propensity Marginal Propensity to Consume to Save (MPC) (MPS) — — 0.75 0.25 0.75 0.25 0.75 0.25 0.75 0.25

This question is intended to highlight the importance of regional differences in GDP. Housing is not a geographically traded good; as such, a local builder would be better served by paying attention to local unemployment rates or the growth in incomes in their immediate surroundings.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

2.11

You should disagree. This student is confusing saving and investment. By putting additional funds into a savings account, the student is “saving” money rather than making an investment in the economic sense. Investment in the economic sense is typically done with either borrowed funds or with money that could have been saved (as in a savings account). Economic investment is the purchase of new capital equipment or buying inventory or starting a new business.

2.12

a. Conventional trade statistics treat imported goods as produced entirely within the country of origin. This approach dates to a time when most products were produced entirely within one country. b. With global supply chains being used by large firms, the country of origin often will not produce the product entirely and may produce a relatively small portion of the product, as in the case of the iPhone exported to Canada from China. c. Trade statistics might mislead policymakers (and the public) in terms of the magnitude of a country’s overall trade deficit or trade surplus, and also as to whether a country is running a trade surplus or deficit with another country.

8.3

Graphing Macroeconomic Equilibrium Learning Objective: Use a 45°-line diagram to illustrate macroeconomic equilibrium.

Review Questions 3.1 The 45o line represents all the points that are at equal distances from both axes. In the 45o-degree diagram, the 45o line shows all the points where planned real aggregate expenditure equals real GDP. 3.2

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

3.3 The slope of the aggregate expenditure line is the change in aggregate expenditure for a change in real GDP (ΔAE/ΔReal GDP). The simple aggregate expenditure model assumes that taxes, planned investment spending, government purchases, and net exports are independent of income. So, the slope of the aggregate expenditure line equals the slope of the consumption function, which is the marginal propensity to consume. 3.4 Aggregate expenditure represents the total spending in the economy. Consumption spending is just one component of aggregate expenditure. The other components of aggregate expenditure are planned investment, government purchases, and net exports. 3.5 Firms will decrease production until they sell the unintended inventories.

Problems and Applications 3.6

Planned aggregate expenditure is greater than GDP at point A, equal to GDP at point B, and less than GDP at point C. The unplanned change in inventories is denoted by the vertical distance from the point to the 45o line.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

3.7 Net exports equal the value of exports minus the value of imports. Net exports are graphed as a downward-sloping line because although increases in Canadian real GDP will not directly affect Canadian exports, these increases will cause imports to increase, thereby causing net exports to decline.

3.8 In most of 2007 and 2008, firms expected the economy to grow and so invested in inventories. When the global recession took hold in Canada, firms reduced their costs by reducing their investment in inventories. This explains the negative entries in the table. During 2009, firms reduced their inventory levels by selling what they had already produced. This is an indication that the economy is shrinking rather than growing. Inventory investment returns to positive territory in 2010, but the occasional negative numbers show that the return to economic health has been slow and uneven. 3.9 Calculate the missing values in the last two columns of the table by using two equations: Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government purchases (G) + Net exports (NX) and Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE). Real GDP (Y) $ 900 1000 1100 1200 1300

Planned Government Planned Aggregate Unplanned Consumption Investment Purchases Net Exports Expenditures Change in (C) (I) (G) (NX) (AE) Inventories $ 760 $120 $120 –$40 $ 960 −$60 840 120 120 –40 1040 −40 920 120 120 –40 1120 −20 1000 120 120 –40 1200 0 1080 120 120 –40 1280 20

a. The MPC equals the change in consumption divided by the change in income. In this case, consumption changes by $80 billion for every $100 billion change in income. So, the MPC = $80 / $100 = 0.8. b. Equilibrium real GDP occurs where real GDP equals planned aggregate expenditure. The table above shows that equilibrium real GDP equals $1200 billion.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run 3.10

The argument is incorrect. Aggregate expenditure includes not only consumption but also planned investment, government purchases, and net exports. A decline in GDP can be caused by a decline in any of the four components of aggregate expenditure.

8.4

The Multiplier Effect Learning Objective: Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP.

Review Questions 4.1 The multiplier effect is the process by which a change in autonomous expenditure leads to a change in real GDP. In the graph that follows, the decrease in government purchases causes the line representing planned aggregate expenditure to shift down. Equilibrium real GDP declines by more than the drop in government purchases: Real GDP declines by the drop in government purchases multiplied by the value of the multiplier.

4.2 Multiplier =

1 . 1 − MPC

The multiplier formula ignores the effect that changes in GDP can have on imports, the price level, income taxes, and interest rates. Ignoring these factors causes the multiplier formula to overstate the size of the real-world multiplier. 4.3

The movement from point A to point B shows a change in autonomous expenditure. At each level of income (real GDP), aggregate expenditure has increased. The movement from point B to point C shows a change in induced expenditure. An increase in income (real GDP) has induced (or caused) an increase in aggregate expenditure.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Problems and Applications 4.4 No, because as real GDP increases to $7 trillion, it will induce additional aggregate expenditures. In the simplest case, aggregate expenditure will increase by the marginal propensity to consume multiplied by the increase in real GDP. This effect is the multiplier at work. The increase in investment spending of $1 trillion increases aggregate expenditure to $7 trillion when real GDP is $6 trillion. As real GDP increases, aggregate expenditure will increase further. Real GDP will ultimately increase by the change in investment spending of $1 trillion times the multiplier. 4.5 We can answer this question by adding a column in the table for aggregate expenditure. Real GDP (Y) $800 900 1000 1100 1200

Planned Consumption Investment (C) (I) $730 $100 790 100 850 100 910 100 970 100

Government Aggregate Purchases Net Exports Expenditure (G) (NX) (AE) $100 –$50 $880 100 –50 940 100 –50 1000 100 –50 1060 100 –50 1120

a. Equilibrium real GDP is $1000 billion, because at this level real GDP equals aggregate expenditure. b.

MPC =

$790 − $730 = 0.6 $900 − $800

c. Multiplier =

1 1 = 2.5 . = 1 − 0.6 1 − MPC

So, Change in equilibrium real GDP = Change in autonomous expenditure × 2.5 = $40 billion × 2.5 = $100 billion. The new level of equilibrium real GDP = $1000 billion + $100 billion = $1100 billion. 4.6 The aggregate expenditure line will shift up by the $40 billion increase in planned investment spending. Equilibrium real GDP will increase by $40 billion times the expenditure multiplier. With a marginal propensity to consume of 0.75, the expenditure multiplier equals 4. Equilibrium real GDP increases by $160 billion ($40 billion × 4). 4.7 (a), (b), and (e), would cause the value of the multiplier to be smaller. (c) and (d) would cause the value of the multiplier to be larger. 4.8 Multiplier =

1 =5 1 − 0.8

Change in equilibrium GDP = $75 billion × 5 = $375 billion. 4.9 A larger multiplier would be likely to lead to longer and more severe recessions because it would magnify the effect on the economy of changes in autonomous expenditures.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

4.10 a. $12 trillion b. MPC =

$13.6 − $12 = 0.8 $14 − $12

c. Multiplier =

1 =5 1 − 0.8

4.11 Quebec has a much larger and more diversified economy than Nunavut. Larger and more diversified economies will see less spending on new construction projects go to imports, meaning more new spending at each round of the multiplier process. 4.12 a. The analysts and politicians are referring to the expenditure multiplier, whereby an increase in autonomous expenditure has a multiplied effect on real GDP. Each additional dollar of autonomous expenditure will increase real GDP by more than one dollar. b. The investment spending on plant and equipment by Tesla increases autonomous expenditure, causing an even larger increase through the multiplier effect on real GDP and employment. As Tesla’s suppliers increase their sales to Tesla, they will expand production and employment. Higher incomes earned by newly employed workers will result in increased consumption spending. The increased consumption spending will lead to further increases in production and employment, as the multiplier process continues. c. The real-world multiplier is not simple to calculate. It will be a smaller value than the simple multiplier formula of 1/(1 − MPC), which assumes no change in the price level, interest rates, taxes, or imports. 4.13 Robust business and consumer confidence would increase investment spending and consumption spending, and improving world trade would increase net exports. The increases in these three spending components would increase autonomous expenditure, resulting in an increase in real GDP. In the graph below, the increase in autonomous expenditure shifts the aggregate expenditure line upward from AE0 to AE1, causing equilibrium real GDP to increase from Y0 to Y1.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

4.14

The implied value of the multiplier if $150 billion was spent on infrastructure (= I) is

∆Y $270 billion = = 1.8. ∆I $150 billion The implied value of the multiplier if $180 billion was spent on infrastructure is

∆Y $320 billion = = 1.8. ∆I $180 billion

8.5

The Aggregate Demand Curve Learning Objective: Understand the relationship between the aggregate demand curve and aggregate expenditure.

Review Questions 5.1 Aggregate expenditure is the total amount of spending in the economy, and aggregate demand is the relationship between the price level and the level of planned aggregate expenditure. 5.2 A change in the price level affects (a) consumption by affecting the real value of household wealth, (b) net exports by affecting the domestic price level relative to foreign price levels, and (c) investment spending by affecting the interest rate. 5.3

A change in the price level causes a shift of the aggregate expenditure line but causes a movement along the aggregate demand curve.

Problems and Applications 5.4 An upward-sloping aggregate expenditure line reflects the positive relationship between real GDP and aggregate expenditure, while a downward-sloping aggregate demand curve reflects the inverse relationship between the price level and the level of planned aggregate expenditure. 5.5 You should not agree with the statement that the aggregate demand curve slopes downward because people cannot afford to buy as many goods and services when the price level is higher. A higher overall price level means an equivalent increase in nominal income so that consumers as a group should be able to afford the same number of goods and services as with a lower overall price level. 5.6 If exports become more sensitive to changes in the price level in Canada, then a given change in the price level in Canada will cause a greater change in aggregate expenditure. In this case, the aggregate demand curve becomes less steep.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED the first quarter of 2021.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

D8.1 a. Download data from FRED on real exports from 1990 to the present. b. Real exports of goods and services decreased from $1790.0 billion in the second quarter of 2008 to $1535.3 billion in the first quarter of 2009, for a decline of $254.7 billion. With a multiplier of 2 and holding everything else constant, the decline in exports would have decreased real GDP by $254.7 billion × 2 = $509.4 billion. c. Real exports of goods and services were $2523.97 billion in the second quarter of 2018 and $2554.36 billion in the first quarter of 2019. Between the two quarters, the real exports of goods and services increased by $30.39 billion. If the multiplier is 2, then the increase in the real exports of goods and services by $30.39 billion will increase GDP by $60.78 billion. D8.2 a.

Download data from FRED on annual real consumption expenditures from 2000 to 2018.

b. Download data from FRED on annual real GDP from 2000 to 2018. c. The year with the highest MPC was 2001 with an MPC of 1.66. The year with the lowest value was 2012 with an MPC of 0.46.

Suggestions for Critical Thinking Exercises CT8.1 Answers will vary depending on what the students find confusing. CT8.2 Here, equilibrium is achieved by changes in inventories. In a market, equilibrium is achieved by changes in the price of a product. CT8.3 It would be smaller as an increase in P would reduce the increase in real GDP; see the discussion on the aggregate demand curve at the end of this chapter.

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

SOLUTIONS TO APPENDIX C Review Questions 8A.1 AE = ( C + I + G + NX ) + MPC (Y) The intercept would be ( C + I + G + NX ) and the slope would be equal to the value of the MPC. 8A.2 Y = 150 + 0.75Y + 125 + 125 + 250; Y = 650 + 0.75Y; Y − 0.75Y = 650 Y (1 − 0.75) = 650 Y (0.25) = 650 Y = 650 × 4 = 2600 8A.3 AE = 650 + 0.75Y For GDP of 1600, aggregate expenditure = 1850. The unintended change in inventories = 1600 − 1850 = −250. For GDP of 1200, aggregate expenditure = 1550. The unintended change in inventories = 1200 − 1550 = −350. 8A.4 Equilibrium GDP = Autonomous expenditure × multiplier Equilibrium GDP =

50 +100 +125 − 25 =1250 0.2

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis SOLUTIONS TO END-OF-CHAPTER EXERCISES Aggregate Demand 9.1

Learning Objective: Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve.

Review Questions 1.1 The three reasons the aggregate demand curve slopes downward are the wealth effect, the interest rate effect, and the international trade effect. The wealth effect refers to the effect that a change in the price level has on wealth. For example, an increase in the price level decreases the real value of household wealth, which decreases consumption. The interest rate effect refers to the effect that a change in the price level has on aggregate expenditures. For example, an increase in the price level raises interest rates, which decreases investment spending and consumption spending, particularly on durable goods. The international trade effect refers to the effect that a change in the price level has on spending on exports and imports. For example, an increase in the domestic price level makes Canadian exports more expensive and foreign imports less expensive, which decreases net exports. 1.2 The variables that will cause the aggregate demand curve to shift are interest rates, government purchases, personal income taxes or business taxes, household expectations of future incomes, firms’ expectations of the future profitability of investment spending, the growth rate of domestic GDP relative to the growth rate of foreign GDP, and the exchange rate value of the Canadian dollar. Increases in government purchases, household expectations of future incomes, and firms’ expectations of the future profitability of investment spending will cause the aggregate demand curve to shift to the right. Increases in interest rates, personal income taxes or business taxes, the growth rate of domestic GDP relative to the growth rate of foreign GDP, and the exchange rate value of the Canadian dollar will cause the aggregate demand curve to shift to the left. 1.3 The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. The short-run aggregate supply curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. The long-run aggregate supply curve shows the relationship in the long run between the price level and the quantity of real GDP supplied by firms.

Problems and Applications 1.4 a. An increase in the price level would cause a movement up along the aggregate demand curve. b. Higher provincial income taxes would decrease disposable income, thereby decreasing consumption spending and causing the aggregate demand curve to shift to the left. c. Higher interest rates would decrease investment spending and consumer spending, particularly on durable goods, causing the aggregate demand curve to shift to the left. Copyright © 2024 Pearson Canada Inc.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis d. An increase in government spending would cause the aggregate demand curve to shift to the right. e. Faster income growth in other countries would increase Canada’s exports, causing the aggregate demand curve to shift to the right. f.

A higher exchange rate between the Canadian dollar and foreign currencies would decrease Canada’s net exports, causing the aggregate demand curve to shift to the left.

1.5 Disagree. The increase in aggregate supply with the resulting drop in the price level will not cause a shift in aggregate demand but simply a movement along the aggregate demand curve. 1.6 The relative size of the changes in investment and government spending will determine the impact on the aggregate demand curve. An increase in interest rates can cause investment to fall as firms pass on projects with expected rates of return lower than the opportunity cost of funds, while higher interest rates tend to push up government spending on debt service and can also increase demand for government services 1.7 a. An increase in spending on machinery and equipment will shift the aggregate demand curve to the right. b. Inflation is an increase in the price level. An increase in the price level causes a movement up along the aggregate demand curve. 1.8 (a) Longer skirts and skinnier neckties are both indicators of recession (or at least slowdowns). (b) Instructors will have to be somewhat flexible here. Sample answer: Smartphone sales and contracts. When people are uncertain about the economic future, they are less likely to upgrade their phones. People uncertain about their income are also less likely to take on a long-term phone contract. 1.9 Some sectors of the economy are more dependent on other parts of the world than others. Sectors of the economy that produce goods for export to China are going to be strongly affected by falls in aggregate demand in China (iron ore, oil, etc.). Sectors that produce non-traded goods (barbers, lawyers, etc.) are going to be much less sensitive to changes in the state of the Chinese economy. 1.10 A movement from point A to point B along the aggregate demand curve would be caused by a decrease in the price level. A movement from point A on aggregate demand curve AD1 to point C on aggregate demand curve AD2 would be caused by any of the factors that shift the aggregate demand curve to the right, such as a decrease in interest rates, an increase in government purchases, or a decrease in personal or business taxes.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Aggregate Supply 9.2

Learning Objective: Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve.

Review Questions 2.1 The long-run aggregate supply curve is vertical because in the long run, changes in the price level do not affect the number of workers, the capital stock, or technology, which are the factors that determine potential GDP. 2.2 The variables that will cause the long-run aggregate supply curve to shift are the size of the labour force, the size of the capital stock, and technology. An increase in each variable will increase potential real GDP and cause the long-run aggregate supply curve to shift to the right. 2.3 As the prices of final goods and services rise, the prices of inputs usually rise more slowly. The higher price level increases profits and the willingness of firms to supply more goods and services. A secondary reason the SRAS curve slopes upward is that, as the price level rises, some firms are slow to adjust their prices. A firm that raises its prices slowly when the price level increases may find that its sales increase; therefore, the firm will increase production. 2.4 The variables that will cause the short-run aggregate supply to shift are the size of the labour force, the size of the capital stock, productivity, the expected future price level, workers and firms adjusting to having previously underestimated the price level, and the expected price of an important natural resource. Increases in the labour force, the capital stock, or productivity will cause the short-run aggregate supply curve to shift to the right. Increases in the expected future price level, increases in the price of an important natural resource, and workers and firms adjusting to having previously underestimated the price level will cause the short-run aggregate supply curve to shift to the left.

Problems and Applications 2.5 a. A higher price level would cause a movement up along the long-run aggregate supply curve. b. An increase in the quantity of capital goods would cause the long-run aggregate supply curve to shift to the right. c. Technological change would cause the long-run aggregate supply curve to shift to the right. 2.6 Disagree. The labour force and the capital stock, along with technology, determine potential GDP, but inflation expectations do not. Inflation expectations, however, do affect the short-run aggregate supply of goods and services. 2.7 a. A higher price level would cause a movement up along the short-run aggregate supply curve. b. An increase in what the price level is expected to be in the future would cause the short-run aggregate supply curve to shift to the left. c. An unexpected increase in the price of an important raw material would cause the short-run aggregate supply curve to shift to the left.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis d. An increase in the labour force participation rate would cause the short-run aggregate supply curve to shift to the right.

2.8 Both workers and firms benefit from the ability to plan for the future. Signing long-term contracts increases this ability. 2.9 Menu costs are costs to firms of changing prices. If menu costs were eliminated, the short-run aggregate supply curve would still not be vertical because other factors, such as contracts and the inability of workers and firms to always accurately predict next year’s price level, can still make wages and prices sticky. 2.10 A movement from point A to point B along the short-run aggregate supply curve would be caused by an increase in the price level. A movement from point A on SRAS1 to point C on SRAS2 could be caused by any of the factors that shift the short-run aggregate supply curve to the right, such as an increase in the labour force, the capital stock, or productivity, or a decrease in the expected future price level or the expected price of an important natural resource.

9.3

Macroeconomic Equilibrium in the Long Run and the Short Run Learning Objective: Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

Review Questions 3.1 When the economy is in long-run equilibrium, the short-run aggregate supply curve and the aggregate demand curve intersect at a point on the long-run aggregate supply curve. 3.2 The long-run effects of an increase in aggregate demand differ from the short-run effects because the long-run and the short-run aggregate supply curves differ. With a vertical LRAS, changes in AD affect only the price level, not real GDP. With an upward-sloping SRAS, changes in AD affect both the price level and real GDP. 3.3 The correct answer is (b). The unemployment rate will rise in the short run as real GDP and income decline during the recession. Rising unemployment and lower output will result in lower wages. Eventually the short-run aggregate supply curve will shift to the right, returning GDP to its potential level and unemployment to the natural rate of unemployment but at a lower price level. Even if government policymakers do not respond to a recession, the economy will return to potential GDP in the long run, although the process may take several years.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Problems and Applications 3.4 a.

The large increase in the demand for Canadian exports shifts the aggregate demand curve to the right, moving short-run equilibrium from point A to point B with a higher price level and real GDP. The unemployment rate is lower because real GDP has increased with no change in potential real GDP. Workers and firms will eventually adjust to the price level being higher than they expected. Workers will push for higher wages, causing the short-run aggregate supply curve to shift to the left. In the long run, the economy will be in equilibrium at point C with a higher price level, the same level of real GDP (GDP1), and the same unemployment rate. b.

An unexpected increase in the price of an important raw material causes the short-run aggregate supply curve to shift to the left. Equilibrium moves from point A to point B, with a higher price level and lower real GDP. The unemployment rate has increased with real GDP below potential real GDP. The drop in real GDP and the increase in unemployment lead workers to accept lower wages and firms to accept lower prices. The short-run aggregate supply curve shifts from SRAS2 back to SRAS1, and equilibrium moves from point B back to point A. When the economy has

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis adjusted back to equilibrium at point A, real GDP, the price level, and the unemployment rate are back to their original values.

3.5 Any of the factors that decrease aggregate demand (an increase in interest rates, an increase in personal income taxes or business taxes, an increase in the exchange rate, an increase in the growth rate of domestic GDP relative to the growth rate of foreign GDP, a decrease in government purchases, a decrease in households’ expected future incomes, or a decrease in firms’ expectations of the future profitability of investment spending) would cause a decrease in real GDP. Any of the factors that decrease short-term aggregate supply (an increase in the expected future price level, an increase in the price of an important natural resource, workers and firms adjusting to having previously underestimated the price level, a decrease in the labour force or the capital stock, and a decrease in productivity) would cause a decrease in real GDP. Any of the factors that increase aggregate demand or any of the factors that decrease short-run aggregate supply would cause an increase in the price level—inflation. 3.6 Because of the tight trade relationship between Canada and the United States, growth in the US economy tends to increase demand for Canadian exports, which increases the overall demand for Canadian products. When the US economy grows, the Canadian economy tends to grow too. 3.7 a. Points A and C represent long-run equilibrium points because they are on the LRAS curve where the SRAS curve and the AD curve intersect. b. Point D represents the short-run equilibrium and point C the long-run equilibrium. Workers and firms will eventually adjust to the price level being higher than they expected. Workers will push for higher wages and firms will charge higher prices, causing the short-run aggregate supply curve to shift to the left until it reaches SRAS1, and long-run equilibrium is restored at point C. 3.8 These goods have the potential to be good indicators of the state of the economy because they are common and cheap enough that people purchase them somewhat regularly. These goods often reflect people’s moods at the time the purchase was made. Expect a wide variety of answers for what other goods could play a similar role in forecasting the state of the economy. Smartphone sales, luxury vacations, or take-out coffee sales all have potential. Any good that is widely purchased and is relatively easy to cut back on is a good candidate. 3.9 a. If firms operate beyond their normal capacity, and structural and frictional unemployment drop below their normal levels, then actual real GDP can be above potential GDP. b. The unemployment rate increased from 2000 to 2001 because the increase in actual real GDP was not as large as the increase in potential GDP. c. If the slowdown was caused by a shift in aggregate demand (which, in fact, it was), the inflation rate is likely to have been lower in 2001 than in 2000. If the slowdown was caused by a shift in aggregate supply, the inflation rate was likely to have been higher. 3.10 a. The following graph assumes that the Greek economy was in long-run equilibrium at point A (P1 and real GDP1) prior to the decrease in government spending and net exports in 2016. As a result of the reduction in government spending and net exports, the aggregate demand curve shifts to the left (AD1 to AD2). The price level falls to P2 and real GDP falls to real GDP2 (point B).

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

b. As workers and firms adjust their wages and prices to the decline in aggregate demand, the shortrun aggregate supply curve shifts to the right (SRAS1 to SRAS2). The economy will reach long-run equilibrium at P3 and real GDP1 (point C).

9.4

A Dynamic Aggregate Demand and Aggregate Supply Model Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions.

Review Questions 4.1 In the dynamic model, potential real GDP increases continually, shifting LRAS to the right, aggregate demand shifts to the right during most years, and except during periods when workers and firms expect high rates of inflation or there is a large adverse supply shock, the short-run aggregate supply curve will shift to the right. 4.2 Aggregate demand increasing faster than potential GDP results in inflation. Aggregate demand increasing slower than potential GDP results in the equilibrium level of real GDP being below potential GDP.

Problems and Applications 4.3 To go from potential real GDP in 2022 to potential real GDP in 2023 without inflation, aggregate demand, long-run aggregate supply, and short-run aggregate supply must all increase—or, shift to the right—by the same amount.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

4.4 From the Bank of Canada website: “This can throw the economy in a deflationary spiral, as incomes fall and the real debt burden of borrowers increases. In such a case, ongoing price declines lead to lower production and wages, which further reduce demand by consumers and businesses, leading to still lower prices, and so on.” 97.8 − 95.4 × 100% = 2.5%, which is 95.4 slightly above the Bank of Canada target for inflation. The values of the price level 95.4 in 2000 and 97.8 in 2001 are the values of the CPI relative to 2002, the year in which the CPI is set equal to 100. Values below 100 only indicate that we’re talking about years in which prices were lower than in the base year, which almost always means years before the base year.

4.5 No, the inflation rate between 2001 and 2000 was equal to

4.6 a. Growth rate of potential real GDP =

1.80 − 1.75 2.9%. × 100% = 1.75

b. The unemployment rate will be higher in year 2 than in year 1. In year 1, actual GDP is equal to potential GDP, so cyclical unemployment must be zero, and the only unemployment we will observe is frictional and structural. In year 2, potential GDP is higher than actual GDP, so we will observe cyclical unemployment in addition to frictional and structural unemployment. c. The inflation rate =

127 − 125 × 100% = 1.6%. 125

d. Growth rate of real GDP =

1.77 − 1.75 × 100% = 1.1%. 1.75

4.7 This shows that the economy is in recovery because lowering unemployment and decreasing wages are part of the shift in aggregate supply that returns equilibrium to long-run aggregate supply, removing the recessionary gap.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

4.8 a. An economic bellwether is an indicator of how well the economy is currently doing. b. i.

Tim Hortons isn’t obvious. Students may make an argument for either case. While CN ships necessities as well as luxuries, Tim’s coffee and doughnuts are likely seen as small luxuries. These tend not to be cut back on as quickly as other products. This would suggest that Tim’s is likely to see less fluctuation than CN. Students may also argue that CN ships a lot of raw materials for export, which may not be subject to the same influences as Canadian consumers, making CN’s sales more stable.

ii.

Kent Homes are likely to be subject to greater fluctuations than CN. Again, this is a major consumer purchase and people tend not to buy new homes when they’re concerned about the future.

iii. Novels and romances may in some cases be countercyclical. Like lipstick, purchasing a novel may be a low-cost substitute for other forms of entertainment. When people are feeling poor, they might buy a book ($10 or so) instead of going to the movies ($15+).

Real-Time Data Exercises D9.1

a. The following graph shows the economy at equilibrium at potential GDP in 1960 and in 2019. With real GDP rising from $3 262.0 billion in 1960 to $19 032.7 billion in 2019, the long-run and the short-run aggregate supply curves shifted to the right. With the GDP price deflator (2015 = 100) rising from 15.9 in 1960 to 107.3 in 2019, aggregate demand grew more than long-run aggregate supply.

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis b. Given that real GDP declined from $5687.2 billion in 1973 to $5644.8 billion in 1975 and that the GDP price deflator rose from 24.0 in 1973 to 28.5 in 1975, the short-run aggregate supply curve shifted to the left from 1973 to 1975. For simplicity, the following graph shows for 1975 only the shift to the left of the short-run aggregate supply curve.

D9.2

a. As indicated in the exercise, download monthly data on the personal consumption expenditure price index and calculate the percentage change from the same month in the previous year. Calculate this percentage change over the entire 1982 through 2007 period. b. The average inflation rate from 1982 through 1994 was 3.49 percent and from 1995 through 2007 was 2.03 percent. c. The decline in the inflation rate from 1995 through 2007 compared to 1982 through 1994 is consistent with a continuing positive supply shock after 1994. Positive supply shocks increase aggregate supply, decreasing the inflation rate.

D9.3

a. Data gathered for use in part (b). b. The United Kingdom has had a similar experience to the United States since 2007. The United Kingdom experienced a larger drop in real GDP in late 2008 and early 2009 and has had slower growth in real GDP since 2009. From 2007 to 2011, the United Kingdom experienced higher inflation and lower unemployment than the United States. The data in the following graph show data for the United Kingdom over this period of time.

Source: Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Suggestions for Critical Thinking Exercises CT9.1 There are no common factors for the demand curves and one for the supply curve: productivity (and the expected future price of a good and the price level are clearly analogous). One can conclude from this that much of what was learned in microeconomics does not carry over to macroeconomics. This question targets what seems to be persistent student confusion on the differences between microeconomics and macroeconomics. CT9.2 No. They deal with different sectors of the economy. Students often have difficulty with AD and SRAS; this question helps them explore the factors that shift these curves by comparing them. CT9.3 The economy moved to the upper right as both variables grew.

CHAPTER 10 | Money, Banks, and the Bank of

Canada

SOLUTIONS TO END-OF-CHAPTER EXERCISES 10.1

What Is Money, and Why Do We Need It? Learning Objective: Define money and discuss the four functions of money.

Review Questions 1.1

The problem is called a double coincidence of wants, where each person in a trade must want what the other person has.

1.2

Commodity money, such as gold coins, has value independent of its use as money, while fiat money, typically paper currency, does not have value independent of its use as money.

1.3

The four functions are medium of exchange, unit of account, store of value, and standard of deferred payment. In the long run, something will not serve as money if it does not fulfill all four functions.

1.4

Businesses accept paper currency because they believe paper currency is acceptable to their customers and to other businesses. Paper currency serves as money because people believe that others will accept it from them.

Problems and Applications 1.5

In French Polynesia in the 1880s, the food the French singer received as payment served as a medium of exchange, but the food did not serve well as a store of value, a unit of account, or a standard of deferred payment.

1.6

a. Fiat currency is money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. b. The currency made from the bark of mulberry trees was fiat money because that currency had no other use other than as money, and it required a decree from Kublai Khan’s government in order to achieve acceptance. c. Executing those who did not accept the fiat currency was not necessary. Modern governments get the public to accept their fiat money by requiring that it be accepted in payment of debts and by requiring that cash or cheques denominated in dollars be used in payment of taxes. Governments, however, do have to convince individuals and firms that the fiat money will not lose significant value during the time they hold it. Typically, governments ensure that fiat money does not lose significant value by avoiding issuing too much of it.

CHAPTER 10 | Money, Banks, and the Federal Reserve System 1.7

101

a. Eggs in Venezuela were serving as money in that people were accepting them in exchange for goods and services. Judging eggs by criteria for money set out in the text: 1. Eggs were accepted by most people, though it was out of necessity because people did not want to accept bolivars, the Venezuelan currency. 2. Eggs do not possess standardized quality. Some eggs are larger than others, and eggs that are laid by one breed of chicken may not look and taste the same as those laid by other breeds. 3. Eggs are not durable. Not only can the shells crack easily, but eggs can also lose freshness after a period of time and eventually will spoil and give off a bad odour. 4. Eggs are not valuable relative to their weight. Someone would need a large number of eggs to buy a motorcycle. 5. Eggs are not divisible. You can’t easily split an egg unless you hard boil it and slice it up, which people at the professor’s university weren’t doing. b. Eggs are more durable than some fruits and vegetables. At the correct temperature, eggs can last a few weeks. Eggs, however, require extra care in handling. Aside from breaking easily, they need to be stored in refrigerated trucks in order to extend their shelf life. c. Using eggs was still more efficient than trading directly with other people because trading directly requires a double coincidence of wants. Trades done using eggs as a medium of exchange bypass the need for a double coincidence of wants and allow individuals to complete trades faster and with lower search costs.

1.8

a. A medium of exchange refers to anything that is generally accepted in exchange for goods and services. b. Because many members of the German tribes used Roman coins as they bought and sold goods and services, the coins became the German tribes’ medium of exchange. c. A member of a German tribe was willing to accept the Roman coins as long as they believed that the coins were acceptable to other people in the tribe.

1.9

Legally requiring all firms to accept paper currency in exchange for whatever they are selling would help people who do not use credit cards or debit cards, and it would help people who want to leave little or no record of their purchases. The requirement could hurt issuers of credit cards and debit cards, and it would hurt businesses like Apple that want to prevent customers from buying large numbers of their products to resell on eBay, craigslist, or elsewhere. Some firms—for instance, a car dealership—might also find it awkward to have to accept large amounts of currency in exchange for the goods they are selling. In addition, some firms would worry about robberies if they were known to have large amounts of cash in their stores.

1.10

a. To “ditch cash” means that the business would not accept cash for payment for goods and services. b. Mobile wallet smartphone apps and the development of technology that makes it easy for stores to accept credit card payments on smartphones or tablets make it possible for businesses to ditch cash. c. The pros to a business of ditching cash include faster speed of service and a deterrent to robberies. The cons include losing some customers who strongly prefer using cash.

102

CHAPTER 10 | Money, Banks, and the Federal Reserve System

10.2

How Is Money Measured in Canada Today? Learning Objective: Discuss the definitions of the money supply used in Canada today.

Review Questions 2.1

M1+ includes currency and all chequable deposits at chartered banks, TMLs, and CUCPs. M1++ includes everything that is in M1+, plus all non-chequable deposits at chartered banks, TMLs, and CUCPs.

2.2

Wealth equals the value of assets minus the value of liabilities, or debts; income equals earnings during a period of time, such as a year; and money (using the M1+ definition) equals currency plus chequing account and savings account deposits. The central bank controls the quantity of money. The actions of the central bank have only an indirect effect on income and wealth.

Problems and Applications 2.3

a., b., and c. are all counted in M1+. d. is not counted in M1+ because credit cards are not part of the money supply.

2.4

a. Venmo still performs the function of medium of exchange as long as some sellers are willing to accept it as a payment for goods and services, even if other sellers would not. However, the efficiency of Venmo as a medium of exchange is based on how many sellers use Venmo as a payment for goods and services. b. Venmo is an app that functions as a peer-to-peer payment system. People who want to make payments digitally can transfer funds from their banks or their credit cards into Venmo or a similar payment app. Whether the funds people have in these accounts should be counted in M1 is a complicated question. Funds that are transferred from chequing accounts into Venmo or a similar app reduce M1 by reducing chequing account balances, but because the funds are likely to be quickly spent, they should probably be included in M1. But funds transferred from a credit card to a payment app should probably not be counted for the same reasons that credit cards are not currently counted—the funds are effectively a loan from the credit card company. The Fed currently has no mechanism for measuring funds being held on payment apps or for distinguishing the sources of those funds, which would make including in M1 the balances on payment apps difficult even if the Fed wanted to do so. At this time, the size of the balances on these apps is likely too small to make a significant difference in the size of M1. If the apps grow in popularity, the Fed may have to revisit the issue of whether to include these balances in M1.

2.5

You should disagree. The wealth of Canada consists of the buildings, lands, and other assets owned by the government and by the households and businesses in Canada minus the liabilities of the government and the households and businesses in Canada. The money supply of Canada does not represent the country’s wealth.

2.6

You should disagree. Income is not a way to measure wealth. Wealth equals net worth, or the total value of assets minus the total value of liabilities (or debts). Income, the amount earned over a given period of time, is not a measure of wealth.

CHAPTER 10 | Money, Banks, and the Federal Reserve System

103

2.7

Chequing account deposits and currency are both included in M1+. Therefore, there is no effect on M1+. The $100 was part of M1+ when it was in your chequing account and is still part of M1+ when you hold it as currency.

2.8

Funds in money market mutual funds are included in M2+ but not in M1+. Therefore, this transaction will increase M1+ by $1000. M2+ is not affected because money market mutual funds and funds in chequing accounts are both included in M2+.

2.9

a. The US dollar is formally accepted as a medium of exchange in a number of other countries and territories—including East Timor, Ecuador, El Salvador, and Zimbabwe—and is widely used in the underground economy in other countries. Many economists believe that the majority of US currency is in circulation outside of the United States. b. The Federal Reserve’s measures of the currency component of the money supply (M1 and M2) overstate the amount of currency held domestically.

2.10

a. The reason most people do not use cryptocurrencies to buy goods and services is that their values fluctuate too widely. Currently, most people hold cryptocurrencies such as bitcoin as investments, hoping that their values will increase. b. One advantage of using cryptocurrencies to buy and sell goods and services is that there is no permanent record of the transaction. The lack of a record of the transaction is most useful to people who do not want their transactions monitored by government officials who might limit or tax the transactions. In the United States, if tax rates become sufficiently high or government regulations restrict more currently legal transactions, it’s conceivable that buyers and sellers will be more willing to use cryptocurrencies. If developing countries’ informal economies become significantly larger, it is possible that more people will start using bitcoins rather than government-issued currency to conceal the buying and selling from the government. However, cryptocurrencies are unlikely to be widely used unless their values in terms of governmentissued money become more stable.

2.11

10.3

The monetary value of 1.4 billion pennies is $14 million. If all the pennies were worth $0.05 each, then M1+ would increase by $56 million. Such a change would represent a small fraction in the total value for M1+ and, therefore, would have a negligible effect on the economy.

How Do Banks Create Money? Learning Objective: Explain how banks create money.

Review Questions 3.1 3.2

3.3

The largest asset of a typical bank is loans, and its largest liability is deposits. Assets

Liabilities

Reserves –$100

Deposits –$100

To say that banks “create money” means that banks create chequing account deposits, which are part of M1+, when they make loans from their excess reserves.

104

CHAPTER 10 | Money, Banks, and the Federal Reserve System

3.4

The simple deposit multiplier is 1/rd where rd is the desired reserve ratio (the level of reserves banks want to hold relative to their deposits). The maximum increase in chequing account deposits would be $20 000 × (1/0.20), or $20 000 × 5 = $100 000. The maximum increase is unlikely to occur because some of the chequing account deposits will be converted into currency, and banks are likely to hold some excess reserves rather than use all of their reserves to create new loans, which create new chequing account deposits.

Problems and Applications 3.5

Using your savings to make loans rather than keeping the funds in bank accounts that earn very low rates of interest involves more default risk and less liquidity and requires more information and monitoring. The loans have a higher chance of default and are not liquid because you won’t receive your money back until the loan is paid off. Also, you would want to research the loan recipient; research what the funds will be used for, monitor the loan payments, and take steps—perhaps even going to court—if the borrower misses payments.

3.6

a. Refinancing a loan means that someone is taking out a new loan in order to pay off an old loan. Borrowers usually refinance a loan in order to get a lower interest rate than they were paying on the previous loan. b. Unlike a conventional bank, SoFi does not have customers who make deposits into the bank. The “base of deposits” refers to the customer deposits that banks use to make loans. Lacking deposits, SoFi has to borrow from banks the money that it lends out. c. Conventional banks need to maintain multiple branches in order to attract depositors. SoFi does not have branches like conventional banks do, and therefore SoFi avoids having to pay tellers and incur the other costs of running a conventional bank. Because its costs are lower than the costs of conventional banks, SoFi can pay interest on loans to banks and still make a profit on the loans SoFi makes to recent graduates.

3.7

With a desired reserve ratio of 10 percent, Royal Bank would have to hold $10 000 of reserves against Deja’s $100 000 deposit, leaving Royal Bank with $90 000 of excess reserves. The maximum loan that Royal Bank can make would equal the $90 000 of excess reserves.

3.8

a. Excess reserves = $10 000 – ($70 000 × 0.10) = $3000. b. The maximum amount by which this single bank can expand its loans is the amount of its excess reserves, or $3000. c. The following balance sheet shows the immediate effect of the loan. The entry for loans and the entry for deposits have both increased by $3000. Assets Liabilities Reserves

+$10 000

Deposits

+$2000

Loans

+$69 000

Stockholders’ equity

+$6000

3.9

The larger the fraction of deposits that banks lend out, the larger the money supply. Most of the money supply is created by banks lending out their excess reserves. Funds that banks lend out result in increases in chequing account balances and, therefore, increases in M1+. Funds that the bank keeps as reserves rather than lending out do not increase the money supply.

3.10

You should disagree with the statement because the balance in a chequing account represents something the bank owes to the owner of the account and is a liability for the bank. The car loan represents something that the borrower owes to the bank and is an asset for the bank. Copyright © 2024 Pearson Canada Inc.

CHAPTER 10 | Money, Banks, and the Federal Reserve System 3.11

105

a. T-accounts show only the changes in a balance sheet that result from relevant transactions, with assets listed on the left side and liabilities on the right side. Because the bank now has your $2000 in currency in its vault, its reserves (and, therefore, its assets) have risen by $2000. This transaction also increases your chequing account balance by $2000. Because the bank owes you this money, the bank’s liabilities have also increased by $2000. Bank of Montreal Assets

Liabilities

Reserves + $2000

Deposits + $2000

b. The problem tells you to assume that Bank of Montreal has no excess reserves and that the bank wants to keep 20 percent of the value of its deposits as reserves. So, if the bank’s chequing account deposits go up by $2000, the bank will keep $400 as reserves and will loan out the remaining $1600. The first line of the following T-account shows the transaction from part (a). The second line shows that Bank of Montreal has loaned out $1600 by increasing the chequing account of the borrower by $1600. (Remember, new loans usually take the form of an increase in the borrower’s chequing account balance.) The loan is an asset for Bank of Montreal because it represents a promise by the borrower to make certain payments stated in the loan agreement. Bank of Montreal Assets

Liabilities

Reserves + $2000

Deposits + $2000

Loans

Deposits + $1600

+ $1600

c. The following T-accounts show the effect of the borrower having spent the $1600 they received as a loan from Bank of Montreal. The person who received the $1600 cheque deposits it in their account at CIBC. In the first T-account, once CIBC sends the cheque written by the borrower to Bank of Montreal, Bank of Montreal loses $1600 in reserves (which it transfers to CIBC). Bank of Montreal also deducts the $1600 from the account of the borrower. In the second T-account, CIBC has an increase in deposits of $1600 and an increase in reserves of $1600, which it receives from Bank of Montreal. Bank of Montreal Assets

Liabilities

Reserves +$400

Deposits +$2000

Loans +$1600 CIBC Assets

Liabilities

Loans +$1600

Deposits +$1600

d. The formula for the simple deposit multiplier is: Change in chequing account deposits = (1/rd) × change in bank reserves. Because bank reserves rose by $2000 as a result of your initial deposit and the bank is keeping 20 percent of deposits as reserves (essentially the same result as if there were a desired reserve ratio of 20 percent), the change in chequing account deposits is:

106

CHAPTER 10 | Money, Banks, and the Federal Reserve System $2 000 ×

= $2 000 × 5 = $10 000.

Because chequing account deposits are part of the money supply, it is tempting to say that the money supply has also increased by $10 000. But remember that your $2000 in currency was counted as part of the money supply while you had it, but that currency is not included when it is sitting in a bank vault. Therefore: Change in the money supply = Increase in chequing account deposits – Decline in currency in circulation = $10 000 – $2 000 = $8 000.

10.4

The Bank of Canada Learning Objective: Describe how the Bank of Canada manages the money supply.

Review Questions 4.1 The government established the Bank of Canada to be responsible for monetary policy and a lender of last resort to banks to prevent banking panics. 4.2 The two policy tools are open market buyback operations and lending to banks, with open market buyback operations being the most important. 4.3 When the Bank of Canada buys government securities from the public, the sellers of the securities deposit the funds in their banks, increasing bank reserves. When the Bank of Canada sells government securities to the public, the buyers of the securities pay with cheques, decreasing bank reserves. 4.4 Shadow banking system is a term used when referring to investment banks, money market mutual funds, hedge funds, and other firms engaged in similar activities to these firms. These firms raise funds from individual investors and from other financial firms and lend or invest the funds, either directly or indirectly. In doing so, these firms are carrying out a function that at one time was almost exclusively the domain of commercial banks. The financial firms of the shadow banking system are more vulnerable to runs than commercial banks are because they are more highly leveraged, they do not have deposit insurance, and the government agencies, including OSFI and the Bank of Canada, that regulate the commercial banking system have not regulated these firms as closely.

Problems and Applications 4.5 A government can create money by printing currency, but banks create the majority of the money supply by making loans, which increases chequing account balances. The central bank can increase the number of loans banks make by increasing the banks’ reserves. In this case, the Federal Reserve or the European Central Bank can buy government bonds, which increase the reserves of banks. As bank reserves rise, the banks make more loans, which increase chequing account balances. Because chequing account balances are part of the money supply, the central bank’s actions create money.

CHAPTER 10 | Money, Banks, and the Federal Reserve System 4.6

107

a. Scotiabank Assets Reserves +$10 000 000

Liabilities Bank of Canada Loans +$10 000 000

b. Scotiabank can loan out the entire $10 million. c. If banks are keeping 10 percent of their deposits as reserves, the simple deposit multiplier is (1/0.10) = 10. The money supply can increase by a maximum of (the discount loan × the multiplier) or ($10 million × 10) = $100 million. 4.7

When the Bank of Canada acts as a lender of last resort during a bank panic, it does not “bail out” banks in the way that the US government is said to have “bailed out” private companies during the recession of 2007–2009 and its aftermath. The Bank of Canada does not use taxpayer funds to pay bank debts. Instead, the Bank of Canada offers to lend reserves to banks so that they can meet their depositors’ desires to withdraw funds from their accounts. A bank panic is made possible by the nature of the fractional reserve system. Even banks that are well managed and profitable do not have enough reserves on hand to meet a large volume of deposit withdrawals.

4.8

In the T-account for the Bank of Canada, assets decrease by $25 million in Canada bonds and liabilities decrease by $25 million in bank reserves. In the T-account for the banking system, assets increase by $25 million in Canada bonds and decrease by $25 million in reserves as the Bank of Canada deducts the payment for the Canada bonds from bank reserves. Federal Reserve to Bank of Canada Assets Treasury bill

−$25 million

Liabilities Reserves

−$25 million

Treasury bills to Canada bonds Assets

4.9

Treasury bill

+$25 million

Reserves

−$25 million

Liabilities

Money market mutual funds are not protected by deposit insurance, as commercial banks’ deposits are through the Canada Deposit Insurance Corporation (CDIC). Customers of a bank with CDIC insurance are guaranteed that if the bank fails their individual deposits will be insured for amounts up to $100 000. There would be no need for depositors in such banks to “rush to the exits.”

108

CHAPTER 10 | Money, Banks, and the Federal Reserve System

10.5

The Quantity Theory of Money Learning Objective: Explain the quantity theory of money and use it to explain how high rates of inflation occur.

Review Questions 5.1

The quantity theory of money starts from the quantity equation: M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is the real output. Because velocity is equal to (P × Y)/M, the quantity equation must always hold true. Irving Fisher turned the quantity equation into the quantity theory of money by asserting that velocity was constant. With velocity constant, inflation occurs whenever the growth rate of the money supply is greater than the growth rate of real output.

5.2

The quantity theory of money is better able to explain the inflation rate in the long run because in the short run there can be significant fluctuations in the value of velocity.

5.3

Hyperinflation refers to very high rates of inflation—in excess of 50 percent per month. The rapid growth of the money supply that leads to a hyperinflation typically results from large budget deficits that are financed by money creation—the central bank of the country purchasing government bonds. Governments allow this rapid money creation because the alternative of financing government spending by raising taxes is politically unpopular, and private investors are usually unwilling to buy bonds issued by the governments of low-income countries with large budget deficits.

Problems and Applications 5.4

The inflation rate = Growth rate of the money supply + Growth rate of velocity – Growth rate of real output. So, if velocity is constant, the inflation rate would be 6 percent + 0 percent – 3 percent = 3 percent. If velocity grows at 1 percent, then the inflation rate would be 6 percent + 1 percent – 3 percent = 4 percent.

5.5

The quantity theory of money states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real GDP (Y), or M × V = P × Y. Note that P × Y equals nominal GDP. If velocity does not change, an increase in the money supply must increase nominal GDP. But real GDP may or may not increase. The increase in M × V could lead to an increase in the price level (P) with no change in real GDP.

5.6

a. The quantity equation indicates that the growth rate in a nation’s money supply plus the growth rate of velocity will equal the inflation rate plus the growth rate of real GDP. Because we are given values only for the average annual growth rate of the money supply and for the average inflation rate, we can’t determine whether the values are consistent with the quantity equation. To make this determination, we also need data for the average annual growth rate of velocity and the average annual growth rate of real GDP. Because the quantity equation is an identity, though, the values for the growth rate of velocity and the growth rate of real GDP would be consistent with the quantity equation. b. The quantity theory of money assumes that the growth rate of velocity is constant. In that case, we have:

CHAPTER 10 | Money, Banks, and the Federal Reserve System

109

Inflation rate = Growth rate of the money supply − growth rate of real GDP. Here we have: 1.7 percent = 7.5 percent − growth rate of real GDP, or, Growth rate of real GDP = 7.5 percent − 1.7 percent = 5.8 percent. Although such a high average annual growth rate of real GDP is possible, it has not been experienced in the United States since World War II and is higher than the actual average annual growth rate experienced by the US economy during the years 2011 to 2020. We can conclude that the data given are not consistent over this period of time with the quantity theory of money. 5.7

a. Price deflation occurs when the price level declines from one year to the next. b. Price deflation increases the burden of a debt because it means that the debt must be repaid in money that is increasing in value. If borrowers have to divert more funds to repaying debts, they will have less available to buy goods and services. The resulting decrease in spending can make an economic recession worse. c. Gesell’s proposal would increase the incentive that households and firms have to spend money because, effectively, holdings of currency are being taxed at a rate of 5 percent per year. The result would be an increase in velocity, or the average number of times that a unit of currency is spent. The quantity equation shows us that if velocity (V) increases, for a given level of the money supply (M) and level of real output (Y), the price level (P) must increase. As a consequence, the deflation would end, or at least the size of price decreases (and increases in the real burden of debts) would be reduced.

5.8

a. A country experiences hyperinflation when its central bank increases the country’s money supply much faster than the growth rate of real GDP. b. Yes, because when a country experiences hyperinflation, its money loses much of its value and households and firms become reluctant to accept it in exchange for goods and services. The only alternatives are to use a foreign currency, such as the US dollar, or to engage in barter trades. Both those choices are less efficient than using a stable domestic currency. As a result, economic activity is likely to slow and real GDP will decline.

5.9

Hyperinflation reduced the purchasing power of money. Individuals and firms that borrowed during that period would likely have benefited from the hyperinflation as the same amount of debt would have been worth much less—or nothing at all—in real terms when it was eventually paid back.

Real-Time Data Exercises Note: FRED continues to update data. The solutions below contain the data available on FRED for the first quarter of 2021. D10.1 a. M1 money stock (billion $) M3 money stock (billion $) M1/M3

2020 $1269.8 $2849.2 0.44

2015 $787.4 $1934.4 0.40

2010 $532.1 $1362.2 0.39

110

CHAPTER 10 | Money, Banks, and the Federal Reserve System b. M1 as a proportion of M3 increased over the 10-year period. The exceptionally low interest rates of the recent period probably account for M1 rising as a proportion of M3.

D10.2 a.

b. The scatterplot shows that the money growth rate and the CPI growth rate do not behave as predicted by the quantity equation. This is because the growth rate of GDP and the velocity of money for the UK were not constant during this period. D10.3 For the second quarter of 2019, real gross domestic product equalled $19 021.86 billion in chained 2012 dollars and for the second quarter of 2027 real potential gross domestic product equals $22 014.9 billion in chained 2012 dollars. a. The average annual rate of change for real GDP over this eight-year period, assuming that real GDP equals potential GDP at the end of the eight-year period equals {[($22 104.9 billion/$19 021.86 billion)1/8] – 1} × 100 = 1.84 percent. b. For the annual inflation rate to average 2 percent, the growth rate of M1, if the velocity of money is constant, would have to be 3.84 percent. The equation of exchange indicates that the growth rate of the money supply equals the inflation rate plus the growth rate of real GDP, when velocity is constant: 2 percent + 1.84 percent = 3.84 percent. c. If M1 grows at 3.84 percent and real GDP grows at 1.84 percent, then if actual inflation averages more than 2 percent, the velocity of money will have increased.

Suggestions for Critical Thinking Exercises CT10.1 In general, students seem to count far too much as money and often conflate it with income and wealth. The cognitive scientist Dan Willingham is fond of the phrase “memory is the residue of thought,” and hopefully thinking here will lead to a correct memory on this topic. CT10.2 a. Students’ answers may vary. Some students will say that they use only cash, others may say that they use only credit or debit cards, while some students may use only Wealthsimple Cash or Apple Pay. b. Answers will vary, depending on students’ preferences and on whether stores accept alternative forms of payment. Some students may also state that they prefer paying by using their smartphones with an app like Apple Pay.

CHAPTER 10 | Money, Banks, and the Federal Reserve System

111

c. Answers will vary. d. Again, answers will vary, depending on students’ familiarity with the different alternative payment methods and on their preferences among those methods that they are familiar with. CT10.3 Answers will vary depending on the state of hyperinflation in Venezuela at the time this exercise is assigned. Based on the discussion in this chapter, the Venezuelan government should reduce the rate at which it is printing Venezuelan bolivars. To credibly make such a commitment, the government will likely have to announce a means of eliminating or sharply reducing its government budget deficit so that the government will no longer have to rely on selling bonds to the central bank to pay its bills. Without reducing the rate of growth of the money supply, the government will be unable to end hyperinflation.

CHAPTER 11 | Monetary Policy SOLUTIONS TO END-OF-CHAPTER EXERCISES 11.1

What Is Monetary Policy? Learning Objective: Define monetary policy and describe the Bank of Canada’s monetary policy goals.

Review Questions 1.1 When the government established the Bank of Canada in 1934, the main responsibility of the Bank of Canada was to prevent bank panics by making loans to banks. The government broadened the Bank of Canada’s responsibilities in the aftermath of the Great Depression. 1.2 The Bank of Canada’s four monetary policy goals are price stability, high employment, economic growth, and stability of financial markets and institutions. However, price stability is the Bank’s main policy objective. 1.3 The government can influence the conduct of monetary policy since the objectives of monetary policy in Canada are determined jointly by the Department of Finance and the Bank of Canada. In fact, according to the “joint responsibility system” that dates back to the 1967 revision of the Bank of Canada Act, the Bank of Canada has instrument independence but not goal independence. 1.4 Investment banks can be subject to liquidity problems because they often borrow short term— sometimes as short as overnight—and invest the funds in longer-term investments.

Problems and Applications 1.5

A bank panic occurs when large numbers of depositors simultaneously make withdrawals from many banks. When the Bank of Canada was founded, its primary responsibility was to deal with bank panics by making loans to banks. The failure of a single large bank can lead to a bank panic as depositors (or lenders in the case of shadow banks) become concerned about their deposits (loans). Bank failures disrupt the flow of credit to small and medium-size businesses and to households. Failures of restaurants or clothing stores do not spread to other stores in the way that bank failures spread to other banks (when the government does not provide deposit insurance), and restaurants and clothing stores do not play as important a role in the economy as banks and financial intermediaries do by providing credit to households and firms.

1.6

Many economists consider price stability to be the Bank of Canada’s most important policy goal. As we saw in earlier chapters, the problems that inflation causes the economy include the loss of purchasing power of money, menu costs, an unintended redistribution of income, and the use of scarce resources to avoid losses from inflation.

1.7

Commercial banks are financial institutions that provide commercial services to the public. The Bank of Canada is the central bank, responsible for monetary policy in the country. The Bank of Canada does not provide commercial services.

CHAPTER 11 | Monetary Policy 1.8

113

a. “Stock and bond volatility” means substantial swings in the prices of stocks and bonds. Avoiding volatility in financial asset prices, and promoting stability in financial markets generally, is usually considered to be a policy goal of the central bank. However, avoiding volatility in bond and stock prices is not explicitly a part of the central bank’s dual mandate of high employment and price stability. b. Some economists argue that the central bank should consider key asset prices, such as stock prices, bond prices, and housing prices, in its policy decisions. Rapidly rising stock prices could be a concern for the central bank to the extent that the higher stock prices increase household wealth, spurring consumption spending and, possibly, inflation. A greater concern would be stock prices rising to an unsustainably high level (a bubble), risking a collapse in stock prices that would decrease household wealth, increase uncertainty in the economy, and possibly disrupt the flow of credit. Bond market volatility makes it more difficult for firms to issue bonds to finance new investments. Some firms may wait to issue bonds in order to get a more favourable interest rate. Increased volatility also creates volatility in investors’ holdings of bonds.

The Money Market and the Bank of Canada’s Choice of Monetary Policy 11.2 Targets Learning Objective: Describe the Bank of Canada’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate.

Review Questions 2.1

A monetary policy target is a variable that the Bank of Canada can affect directly and that, in turn, affects variables that are closely related to the Bank’s policy goals, such as low unemployment and low inflation. The Bank uses policy targets because it cannot achieve its policy goals directly but must reach its goals indirectly through its policy targets.

2.2

The demand for money refers to the amount of money, as measured by M1+ or M2+, that households and firms decide to hold at different nominal interest rates. The advantage of holding money (the medium of exchange) is that it can be used to buy goods, services, and financial assets. The disadvantage of holding money is that money earns little or no interest. An increase in the interest rate increases the return that households and firms can earn on Canada bonds or other shortterm interest-bearing financial assets. An increase in the interest rate, therefore, increases the opportunity cost of holding money and decreases the quantity of money demanded.

114

CHAPTER 11 | Monetary Policy

2.3

To lower the equilibrium interest rate, the Bank of Canada would increase the money supply. The following graph shows the money supply curve shifting to the right from MS1 to MS2, which causes the equilibrium interest rate to fall from i1 to i2.

2.4

The overnight interest rate is the interest rate banks charge each other for overnight loans. It is the interest rate that the Bank of Canada targets to conduct monetary policy.

Problems and Applications 2.5

A decrease in the money supply from MS1 to MS2 could be caused by the Bank of Canada selling Canadian government securities, raising the overnight interest rate. An increase in money demand from MD1 to MD2 could be caused by an increase in the price level or an increase in real GDP.

2.6

a. The headline is referring to the overnight interest rate. b. Commercial banks are able to borrow and lend reserves at the overnight funds rate. c. Changes in the overnight interest rate affect other interest rates, including other short-term interest rates, such as the interest rate on Canadian Treasury bills, and long-term interest rates, such as the interest rates on mortgage loans and on corporate bonds.

2.7

The Fed was targeting the federal funds rate. The Fed gave up targeting the money supply because the relationship between M1 and M2 and other key economic variables, such as the inflation rate and the growth of GDP, weakened after 1980.

2.8

a. Scenario 3. Widespread use of mobile wallets shifts the money demand curve to the left because people require less currency and smaller balances in their chequing accounts. b. Scenario 4. The decrease in the desired reserve ratio shifts the money supply curve to the right. c. Scenario 2. The Bank of Canada selling Canada securities shifts the money supply curve to the left because it pulls reserves from the banking system. d. Scenario 1. An increase in real GDP shifts the money demand curve to the right because households and firms require more currency and chequing account deposits to finance their higher level of spending.

CHAPTER 11 | Monetary Policy

11.3

115

Monetary Policy and Economic Activity Learning Objective: Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level.

Review Questions 3.1

An increase in interest rates decreases three of the four components of aggregate demand. Higher interest rates decrease investment spending, including spending on new homes, and consumption spending, particularly spending on durable goods. Net exports also decline as higher interest rates increase the exchange rate between the dollar and foreign currencies. Government purchases are not affected by increases in interest rates.

3.2

If the Bank of Canada believes the economy is headed for a recession, it should conduct expansionary monetary policy, increasing the money supply (or increasing the rate of growth of the money supply) and decreasing interest rates. If the Bank believes that the inflation rate is about to increase, it should conduct contractionary monetary policy, decreasing the money supply (or decreasing the growth of the money supply) and increasing interest rates.

3.3

Quantitative easing refers to the buying of securities (such as 10-year Canada bonds and mortgagebacked securities) with longer maturities than short-term Canada bonds (Treasury bills) that the Bank of Canada usually buys in open market operations. The Bank of Canada cannot reduce the overnight interest rate below zero, so it has used quantitative easing to reduce long-term interest rates. Other central banks are in the same situation of being unable to reduce their short-term interest rate targets below zero, so they have also used quantitative easing to reduce long-term interest rates.

Problems and Applications 3.4

The Bank of Canada typically uses contractionary monetary policy in situations where it believes that real GDP has increased beyond potential GDP, resulting in an increase in the inflation rate. Real GDP cannot remain above potential GDP indefinitely. Rather than wait for the automatic mechanism to return real GDP to the level of potential GDP—which would result in the price level being driven even higher—the Bank of Canada uses contractionary monetary policy by raising its target for the overnight interest rate. By promptly enacting a contractionary policy, the Bank can bring real GDP back to potential GDP more quickly and with a smaller increase in the price level.

3.5

Apparently, banks in Japan were not lending out the new reserves being created by the Bank of Japan’s expansionary monetary policy. For an expansionary monetary policy to be successful, banks have to lend out the reserves created by the central bank. Banks in Japan were either reluctant to make loans to their existing customers—perhaps because they believed that the risk of borrowers defaulting on loans had increased—or the banks were having difficulty finding firms optimistic enough to be willing to borrow to purchase new machinery, equipment, and buildings.

3.6

a. The central bank uses expansionary monetary policy to stimulate consumption and investment. This practice will shift the aggregate demand curve to the right and increase both real output and the price level. An increase in the price level is inflation. b. Since the recession of 2007–2009, the US Fed has been very aggressive is using expansionary monetary policy. During the years following the crisis, the Fed instituted successive rounds of quantitative easing to increase the money supply by trillions of dollars. The Fed had been slowly easing its expansionary policy prior to the pandemic but rapidly responded to the Copyright © 2024 Pearson Canada Inc.

116

CHAPTER 11 | Monetary Policy COVID-19 pandemic by cutting its target for the federal funds rate to near zero in 2020. By early 2021, the US economy appeared to be recovering, but the Fed maintained its expansionary policies. The stock market responded so favourably that many experts forecast a stock market bubble and high inflation. However, the Fed appeared to be more concerned that the economic recovery might derail and push the economy back into recession. The fear of more aggressive strains of Covid-19 emerging appears to have been more important to the Fed’s decisions than were concerns about inflation.

3.7

a. A central bank will typically react to inflation falling and concerns over economic growth by implementing an expansionary monetary policy. The cut in India’s policy rate should result in decreases in other interest rates, which would increase consumption, investment, and net exports, thereby increasing aggregate demand and real GDP, which would amount to “supporting the economy.” b. If inflation rates are slowing, then the central bank has some flexibility to engage in expansionary monetary policy without increasing inflation to levels that might damage the economy. Cutting interest rates when inflation is increasing would continue to push inflation even higher and harm the economy. c. The central bank of India was hoping to see economic growth resulting from increased consumption and investment spending. Lower interest rates encourage both consumers and businesses to borrow and spend, which stimulates the economy by increasing aggregate demand.

3.8

William McChesney Martin meant that if real GDP exceeds potential GDP (“the party is getting going”) and the inflation rate begins to increase, the Fed needs to take steps to restrain aggregate demand (“remove the punchbowl”). He also may have been referring to the need to keep a new higher rate of inflation from being established in the expectations of households, workers, and firms in a way that might make it difficult to reduce.

3.9

a. Rounds of quantitative easing (QE) by the Fed, the European Central Bank (ECB), and other central banks around the world had driven long-term interest rates to very low levels. Eventually, investors bid up the prices of some long-term bonds issued by European governments to such high levels that the yields on the bonds were actually negative—investors would receive less when the bonds matured than they were paying to buy them. In these conditions, the ECB believed that to spur banks to make loans, it needed to make the interest rates on bank reserves negative. b. With interest rates on many corporate bonds and on bank deposits being at very low levels, investors did not believe that the interest rates were sufficiently high to compensate for the default risk on those bonds and deposits. So, investors were willing to receive a negative nominal interest rate on German government bonds because they believed there was no chance that the German government would default on the bonds. c. Negative interest rates in Germany should push depositors to pull most of their money out of banks. Individuals would probably begin using more cash for transactions. d. People can get by without a bank for most transactions, and some demographic groups remain largely unbanked and rely on other mechanisms, such as Venmo or similar smartphone apps, to transfer funds.

3.10

a. The Federal Reserve’s balance sheet is a financial statement that lists all the assets and liabilities of the Fed.

CHAPTER 11 | Monetary Policy

117

b. The Fed increases its balance sheet when it buys financial assets such as Treasury securities or mortgage-backed securities. These purchases increase the reserves banks hold because the funds the Fed uses to pay for the securities are typically deposited in banks. c. By “bank credit,” William Dudley means banks making loans to consumers and businesses. Higher bank reserves mean that banks have funds they can use to make more loans. However, following the financial crisis, government regulators were requiring banks to hold safer assets, like bank reserves, and low interest rates on loans and bonds meant that the opportunity cost to banks of holding more reserves was low. For this reason, most banks increased their bank reserves. If the Fed wants to reduce bank lending, it can simply raise the interest rate it pays on the bank reserves held on deposit at the Fed. Conversely, the Fed can encourage bank lending by lowering or eliminating the interest rate it pays banks on their reserve deposits. 3.11

Forecasting anything as complex as the effects of a new virus or correctly forecasting that a recession will occur are both very difficult. Because COVID-19 was a previously unknown virus, biologists lacked the data necessary to fully understand its effects. As the economy evolves over time, economic institutions may change, which complicates the difficulty of forecasting the likelihood of a recession that results from a shock to aggregate demand or to aggregate supply. For instance, because prior to the 1970s, the Canadian economy had not experienced the effects of a sharp increase in oil prices, few economists predicted the severity of the recession of 1974–1975. Similarly, because the United States had not experienced a significant decline in housing prices since the 1930s and because economists did not fully understand the importance of the growth of the banking system, many economists, including Fed policymakers, were surprised by the severity of the 2007–2009 recession.

3.12

You should disagree because the statement is incorrect. An increase in the money supply does not affect real GDP directly, and certainly not dollar-for-dollar. An increase in the money supply increases real GDP by lowering interest rates, which in turn increases spending. When interest rates are lower, households are more likely to buy new homes and automobiles, and firms are more likely to buy new factories and computers. Lower interest rates also lead to a lower foreign exchange rate for the dollar, which lowers the prices of exports in foreign currencies and raises the prices of imports in dollars, thereby increasing net exports. Because the exact size of these effects is uncertain, the Bank of Canada’s job is much more difficult than the statement suggests.

Monetary Policy in the Dynamic Aggregate Demand and Aggregate 11.4 Supply Model Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy.

Review Questions 4.1

In the basic aggregate demand and aggregate supply model, an expansionary monetary policy is illustrated by the aggregate demand curve shifting to the right, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve still shifts to the right, but by more than it would have in the absence of the expansionary policy. The short-run aggregate supply curve and the long-run aggregate supply curve also shift to the right to illustrate that the economy experiences inflation and long-run growth in potential GDP.

118

CHAPTER 11 | Monetary Policy

4.2

In the basic aggregate demand and aggregate supply model, a contractionary monetary policy is illustrated by the aggregate demand curve shifting to the left, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve shifts to the right, but by less than it would have in the absence of the contractionary policy. The short-run aggregate supply curve and the long-run aggregate supply curve both shift to the right to illustrate that the economy experiences inflation and long-run growth in potential GDP. So, in the basic aggregate demand and aggregate supply model, a contractionary monetary policy will cause a decline in both real GDP and the price level. In the dynamic aggregate demand and aggregate supply model, a contractionary monetary policy will cause real GDP and the price level to increase by less than they would have in the absence of the policy.

Problems and Applications 4.3

You should disagree with this argument. In the basic aggregate demand and aggregate supply model, a contractionary monetary policy causes the price level to fall. In the more accurate dynamic AD-AS model, however, a contractionary monetary policy causes the price level to rise by less than it would have in the absence of the policy. In the dynamic AD-AS model, the short-run aggregate supply curve, the long-run aggregate supply curve, and the aggregate demand curve all typically shift to the right each year. In the dynamic AD-AS model, a contractionary monetary policy causes the aggregate demand curve to shift to the right by less than it would in the absence of policy. As a result, the price level will still increase, but by less than it would have in the absence of the policy.

4.4

a. Without policy action, aggregate demand will shift from AD2024 to AD2025 (without policy). Real GDP increases from $2 trillion to $2.3 trillion, and the price level increases from 124 to 130. b. Because real GDP will be greater than potential GDP in 2025, the Bank of Canada should use a contractionary policy to keep real GDP at its potential level. To implement a contractionary policy, the Bank needs to sell Canada bonds. Selling Canada bonds will decrease reserves in the banking system. Banks will decrease their loans, which will decrease the money supply and increase the interest rate. c. If the Bank of Canada takes no policy action, the price level will increase from 124 in 2024 to 130 in 2025. The rate of inflation would equal [(130 – 124)/124] × 100 = 4.8 percent. If the Bank uses monetary policy to keep real GDP at its full employment level, the price level will increase from 124 in 2024 to 128 in 2025. The rate of inflation would equal [(128 – 124)/124] × 100 = 3.2 percent.

4.5

a. The information in the table tells us that without monetary policy, real GDP will be greater than potential GDP in 2025. The Bank of Canada should use contractionary monetary policy because real GDP is greater than potential GDP. The Bank will increase its target for the overnight interest rate in an attempt to cause real GDP to equal potential GDP. b. i.

If the policy is successful, real GDP in 2025 will decrease from the level given in the table of $2.2 trillion to its potential level of $2.1 trillion.

ii. Monetary policy does not affect potential GDP, so its value will not change. iii. The contractionary monetary policy will shift the AD curve to the left . Therefore, the price level will decrease more than it would have had the Bank of Canada not acted. iv. Because the level of real GDP will be lower, the unemployment rate will be higher than it would have been without policy. c. Equilibrium in 2024 is at point A, with the AD and SRAS curves intersecting along the LRAS2024 curve. Real GDP is at its potential level of $2 trillion, and the price level is 124. Without

CHAPTER 11 | Monetary Policy

119

monetary policy, the AD curve shifts to AD2025 (without policy), and short-run equilibrium occurs at point B. Because potential real GDP has increased from $2 trillion to $2.1 trillion, short-run equilibrium real GDP of $2.2 trillion is above the potential level. The price level has increased from 124 to 130. With policy, the AD curve shifts to the left to AD2025 (with policy), and equilibrium is at point C. At point C, real GDP is equal to its potential level of $2.1 trillion. The equilibrium price level will be at P2025 (with policy), which will be lower than 130. Without policy, the inflation rate in 2025 would have been 4.84 percent [(130 − 124)/124 × 100). With policy, it will be less than 4.84 percent.

4.6

a. By shifting its stance on monetary policy to neutral from accommodative, the Reserve Bank of India (RBI) expected the AD curve in 2017 to shift to AD2017 (RBI), moving equilibrium to point C with real GDP equal to potential.

120

CHAPTER 11 | Monetary Policy b. The private forecasters were more pessimistic about growth, implying that they expected the AD curve to shift only to AD2017(private), leaving short-run equilibrium at point B with real GDP below potential GDP.

A Closer Look at the Bank of Canada’s Setting of Monetary Policy 11.5 Targets Learning Objective: Describe the Bank of Canada’s setting of monetary policy targets.

Review Questions 5.1

With a monetary rule, monetary policy follows a set rule rather than being determined at the discretion of Bank of Canada policymakers. For example, a monetary growth rule is a plan to increase the money supply at a constant rate that does not change in response to economic conditions. Milton Friedman proposed a monetary growth rule where the money supply would grow each year at a rate equal to the long-run growth rate of real GDP. Support for the monetary growth rule has declined because the strong relationship that once existed between changes in the money supply and changes in real GDP and the price level has become much weaker.

5.2

The Bank of Canada can’t hit both targets because it can achieve only combinations of the interest rate and the money supply that represent equilibrium in the money market. Because the Bank does not control money demand, it cannot target both the overnight interest rate and the money supply at the same time.

5.3

The Taylor rule is a rule developed by John Taylor, an economist at Stanford University, which links the central bank’s target for the overnight interest rate to economic variables. The purpose of the Taylor rule is to have a convenient way to determine approximately the target for the overnight interest rate and to use that approximation to help evaluate whether the actual overnight interest rate target set by the Bank of Canada is too high or too low.

Problems and Applications 5.4

Overnight interest target rate = 4% + 2% +

 1 1  $20.2 trillion  $20.0 trillion  (4%  2%) +    100 2 2  $20.0 trillion  

= 4% + 2% +

1 1 (4%  2%) + 1% 2 2

 6%  1%  0.5%  7.5% 5.5

The Taylor Rule can be written as: Federal funds target rate  Current inflation rate  Equilibrium real federal funds rate.  [(1/2) × Inflation gap]  [(1/2) × Output gap]

Overnight funds rate target  1%  2%  [(1/2) × (−1%)]  [(1/2) × 0%]  3%  [−(1/2)%]  [0] 2.5%

CHAPTER 11 | Monetary Policy 5.6

121

a. The central bank is inflation rate targeting if it announces the inflation rate, say 2 percent, that it believes is consistent with its goal of price stability and implements policies that will keep the inflation rate around that target. b. When the central bank announces a target, households and firms need to understand the inflation target so that they will expect the targeted inflation rate will prevail when they make decisions about prices, wages, and interest rates. c. Once a central bank establishes a credible inflation target, it reduces the uncertainty that firms and households would otherwise have about future inflation rates. The result will be that firms and households will be more likely to enter into long-term contracts, thereby reducing uncertainty over future spending. In addition, households and firms will be less likely to experience losses or gains when the actual inflation rate is significantly different from the expected inflation rate. Households and firms generally consider gains resulting from unexpectedly high or low inflation to be unfair.

5.7

a. Recall that the growth rate of nominal GDP is approximately equal to the growth rate of the price level (or the inflation rate) plus the growth rate of real GDP. If the Fed expected 3 percent annual growth in real GDP and wanted an inflation rate of 2 percent, it would set a target of nominal GDP growth of 5 percent per year. If real GDP growth slowed, as during a recession, the Fed would automatically pursue an expansionary monetary policy in an attempt to hit its nominal GDP target. If the inflation rate increased above 2 percent, the Fed would automatically pursue a contractionary policy to keep nominal GDP from rising above its target. b. Because real GDP and the inflation rate declined during the 2007–2009 recession, nominal GDP targeting would have resulted in a more expansionary monetary policy because the Fed would have needed to implement an expansionary policy to increase the growth rate of real GDP and the inflation rate. c. It would be easier to follow a nominal GDP target if a central bank was concerned with both unemployment and inflation than if it were concerned with just inflation because the central bank could conduct an expansionary monetary policy to hit its nominal GDP target even if it had already achieved its inflation target.

5.8

a. Both the headline CPI and the core CPI measure prices paid by consumers, but the headline CPI is broader. b. To set monetary policy, the Bank of Canada wants to use the best measure it can of the underlying inflation rate. For this reason, the Bank uses the core CPI as its preferred measure of inflation.

122

CHAPTER 11 | Monetary Policy

11.6

Central Bank Policies during the 2007–2009 and 2020 Recessions Learning Objective: Describe the policies the central banks used during the 2007–2009 and 2020 recessions.

Review Questions 6.1

A mortgage is a loan a borrower takes out to buy a house. Prior to 1970, mortgages were not considered securities—financial assets that were sold in secondary markets. After 1970, secondary markets in mortgages were created to help the housing market. By the 2000s, investment banks had become significant participants in the secondary market for mortgages. Investment banks began buying mortgages, bundling them together as mortgage-backed securities, and reselling them to investors. Also, by the mid-2000s, lenders had greatly loosened the standards for obtaining a mortgage loan.

6.2

Among the actions the Fed and the US Treasury took were the following: In March 2008:  The Fed announced it would temporarily make discount loans to primary dealers—firms that participate in open market transactions with the Fed.  The Fed announced that it would loan up to $200 billion of US Treasury securities in exchange for mortgage-backed securities to primary dealers.  The Fed and the US Treasury took direct action to keep large financial institutions from bankruptcy by helping JPMorgan Chase acquire the investment bank Bear Stearns. In September 2008:  The US Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were each provided with up to $100 billion in exchange for 80 percent ownership of the firms.  The Fed agreed to provide an $85 billion loan to the American International Group (AIG) insurance company in exchange for an 80 percent ownership stake, effectively giving the federal government control of the company.  The US Treasury announced a plan to provide insurance for deposits in money market mutual funds, similar to the existing insurance on bank deposits.  The Fed announced that it would lend directly to corporations by purchasing three-month commercial paper issued by non-financial corporations. In October 2008:  Congress passed the Troubled Asset Relief Program (TARP), under which the US Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock.

6.3

The Bank of Canada responded to the 2020 recession caused by the COVID-19 pandemic by cutting its target for the overnight interest rate to 25 basis points and by introducing temporary lending facilities that would allow it to lend to businesses that are not commercial banks and so are not typically eligible to borrow from the Bank of Canada. By using these facilities, the Bank of Canada was able to ensure that funds flowed to firms and to provincial and local governments that might otherwise have had difficulty borrowing.

CHAPTER 11 | Monetary Policy

123

Problems and Applications 6.4

a. By the fall of 2007, the housing bubble had collapsed and sales of new homes had declined substantially. Credit availability refers to the ability to get a loan. b. Problems of credit availability affect a homebuilder’s ability to borrow to build and develop real estate properties and affect the ability of households to obtain mortgage loans to purchase new houses.

6.5

a. The establishment of Fannie Mae and Freddie Mac by Congress spurred the development of a secondary market in mortgage-backed securities. The existence of a secondary market, in turn, greatly expanded the sources of funding for mortgages. These developments meant that borrowers have been able to choose from a greater variety of lenders, and small local banks face greater competition. Quoting further from the article by McDonald and Thornton: “For the borrower, robust mortgage trading allows for more intense ‘competition.’ . . . The Internet has provided an outlet to quickly compare mortgage rates.” Small local banks that had little competition for mortgage loans in the 1960s and 1970s now face much greater competition because potential customers can shop for mortgages from their home computers. b. This greater competition has reduced the interest rates borrowers have to pay on mortgages. In addition, the supply of funds available to finance mortgages has also increased as investors purchase mortgage-backed securities. The increased supply of funds has also contributed to lower mortgage interest rates. Source: Daniel J. McDonald and Daniel L. Thornton, “A Primer on the Mortgage Market and Mortgage Finance,” Federal Reserve Bank of St. Louis Review, January/February 2008.

6.6

a. A “subprime mortgage” is a mortgage granted to a borrower with a poor credit history who makes a small down payment or otherwise represents a higher-than-average risk of default. b. A deeper pool of capital refers to greater potential financing for borrowers, which was the result of the increased securitization of the mortgage market after 1970. c. Because of the greater risk of default, a subprime borrower typically would pay a higher interest rate than a borrower with a better credit history. d. A lender would prefer to lend to a borrower with a poor credit history if the lender believed the higher interest rate would more than compensate for the greater risk of default.

6.7

a. The key events that many economists believe led to the financial crisis were the following:     

The increased securitization of mortgage loans The increased availability of mortgage loans to subprime and Alt-A borrowers The investment in mortgage-backed securities by shadow banks Shadow banks financing their investment in long-term mortgage-backed securities with short-term loans The lack of supervision of shadow banks by government regulators

Answers will vary as to whether the events leading to the financial crisis should have been anticipated. In fact, few economists or policymakers did anticipate them. In particular, few economists or policymakers anticipated the dramatic decline in housing prices—by far the largest decline since the 1930s—that led to widespread defaults on mortgage loans. b. “Cheap loans” were encouraged by two government-sponsored enterprises—Fannie Mae and Freddie Mac—that sold bonds to investors and used the funds to buy mortgages from banks in

124

CHAPTER 11 | Monetary Policy

secondary markets. By 2005, lenders were issuing many mortgages to subprime borrowers with flawed credit histories and Alt-A borrowers who were required to make only small down payments and who were not required to document their incomes in order to qualify for mortgage loans. The “American dream” that Fuld refers to is owning a home. 6.8

Case I (20 percent down payment) 0.20 × $150 000 = $30 000 down payment $165 000 – $150 000 = $15 000 profit on sale Your return on investment (ROI) = [$15 000/$30 000] × 100 = 50% Case II (5 percent down payment) 0.05 × $150 000 = $7 500 down payment ROI = [$15 000/$7 500] × 100 = 200%

6.9

a. During typical recessions, the Bank of Canada engages in expansionary monetary policy, cutting its target for the overnight interest rate to encourage consumption and investment. The most common Bank of Canada tool was using open market buyback operations. b. In both recessions, the Bank of Canada rapidly cut its target for the overnight interest rate nearly to zero and directly intervened in financial markets by buying securities, such as corporate bonds, that it typically doesn’t buy in conducting monetary policy. c. The Bank of Canada’s response to the Great Recession was to reduce the overnight interest rate. The Bank of Canada took more actions during the recession caused by the COVID-19 pandemic. The Bank’s response to the recession caused by the pandemic included creating new lending and credit facilities. By using these facilities, the Bank was able to ensure that funds flowed to firms and to provincial and local governments that might otherwise have had difficulty borrowing. The result was that the Canadian financial system largely avoided the credit crunch that had increased the length and severity of the 2007–2009 recession.

CHAPTER 11 | Monetary Policy

125

Real-Time Data Exercises D11.1 a. See the following table:

CPI Inflation CPI-trim Inflation CPI-common Inflation

2020Q3

2021Q3

0.2% 1.7% 1.4%

4.1% 3.2% 1.8%

Inflation Rate Increase (year over year) 3.9% 1.5% 0.4%

b. The inflation rate using the headline CPI was highest at 4.1 percent, and the inflation rate using the CPI-common was the lowest at 1.8 percent. The measures of inflation differ because the price indexes include somewhat different goods and services and are not calculated in the same manner. D11.2 a. In the first quarter of 2012, the output gap was 0.1 percent, or the GDP was slightly above the potential GDP. Because the output gap was positive, we expect that the Bank of Canada increased the overnight interest rate during this period. b. In the third quarter of 2021, the output gap was -2.1 percent, or the GDP was 2.1 percent below the potential GDP. Because the output gap was negative, we expect that the Bank of Canada followed easy monetary policy. D11.3 Other than December 31, 2015, through January 3, 2016—when the effective federal funds rate was below the lower limit—and on September 17, 2019—when the effective federal funds rate was above the upper limit—the Fed has been able to keep the effective federal funds rate within the target range.

126

CHAPTER 11 | Monetary Policy

Suggestions for Critical Thinking Exercises CT11.1 The Bank of Canada is the central bank of Canada and is able to control both the money supply and the level of interest rates. The interest rate the Bank controls is the overnight interest rate, which influences other interest rates in the economy, such as those on car loans and home mortgages. The Bank has influence over these rates, and when they rise or fall, private spending changes and, in turn, employment also changes. So, the Bank of Canada can have a substantial effect on the level of employment in the economy even though it directly hires very few people. CT11.2 a. Answers may vary depending on the bank and the date when the student checks the rates in their financial institution. However, their answers will most likely show that the interest rates for home loans and auto loans are lower than credit card rates and personal loan rates. Home loans and auto rates have lower interest rates because these loans are secured by collateral (for example, the house or car that you plan to buy), while credit card loans and personal loans are not secured by collateral, so they are considered to be more risky. Moreover, the interest rate on loans with a shorter term may be lower than on loans with a longer term (for example, threeyear auto loans in comparison with five-year auto loans), particularly if interest rates are expected to rise in the future. b. The students will observe that interest rates that banks pay when they borrow from each other or from the Bank of Canada are lower than the interest rates that the banks charge consumers who borrow from them. Banks accept more risk when they lend to consumers than when they lend to each other, and banks have higher costs to administer loans to consumers. Banks also need to charge a higher interest rate than the overnight interest rate because banks also need to make a profit from the loans.

CHAPTER 12 | Fiscal Policy SOLUTIONS TO END-OF-CHAPTER EXERCISES 12.1

What Is Fiscal Policy? Learning Objective: Define fiscal policy.

Review Questions 1.1 Fiscal policy is any change in government spending or taxation with the explicit goal of affecting the economy in either the short or the long run. Parliament and provincial legislative assemblies are responsible for fiscal policy. 1.2 Fiscal policy involves changes in government purchases and taxes. Monetary policy involves changes in the money supply and interest rates. Both are intended to achieve macroeconomic policy objectives. 1.3 Federal purchases refer to federal spending where the federal government receives a good, such as a new jet fighter or building, or a service, such as the services of an RCMP officer, in return. Federal expenditures include federal purchases plus interest on the national debt, grants to provincial and local governments, and transfer payments. Federal government expenditure rose as a share of GDP in response to the global recession linked to the global financial crisis that began in 2007.

Problems and Applications 1.4 Fiscal policy refers to changes in government purchases and taxes that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. Because the BC government is paying for cars with low gas mileage, government spending has definitely increased. Whether or not this program is an example of fiscal policy depends on the goals the BC government had in mind when launching the program. If the goals included increasing employment and stimulating economic growth, then this program is an example of fiscal policy. If the goal was to reduce pollution by replacing poor-mileage cars with more fuel-efficient ones, then this is an example of environmental policy and not fiscal policy. In reality, most policies have many objectives. 1.5 This should not be considered a part of fiscal policy. The purchase was made to help provincial governments deal with the expected increase in severe cases of COVID-19, not in pursuit of a macroeconomic objective. 1.6 No, these payments are not made as part of an effort to meet a macroeconomic target. The specific programs the borrowed funds were used for (Canada Emergency Response Benefit, Canada Emergency Wage Subsidy, etc.) may have been fiscal policy, but the interest payments are not.

128

CHAPTER 12 | Fiscal Policy

The Effects of Fiscal Policy on Real GDP and the Price Level 12.2 Learning Objective: Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.

Review Questions 2.1 An expansionary fiscal policy is a decrease in taxes or an increase in government purchases intended to increase aggregate demand. A contractionary fiscal policy is an increase in taxes or a decrease in government purchases intended to decrease aggregate demand. 2.2 If policymakers decide to implement an expansionary fiscal policy, then they should raise government spending or lower taxes. If they decide to implement a contractionary fiscal policy, then they should lower government spending or raise taxes. 2.3

a. The expansionary fiscal policy shifts the aggregate demand curve to the right. Real GDP will increase. b. The increase in real GDP will decrease the unemployment rate. c. The shift of the aggregate demand curve to the right will increase the price level.

Problems and Applications 2.4 You should disagree. A decrease in taxes raises real GDP, and an increase in taxes lowers real GDP. The statements are incorrect because an expansionary fiscal policy involves a decrease instead of an increase in taxes, and a contractionary fiscal policy involves an increase instead of a decrease in taxes. 2.5 i.

Contractionary fiscal policy

ii. Not part of fiscal policy, but part of monetary policy instead iii. Expansionary fiscal policy iv. Expansionary fiscal policy for that province 2.6 The economy begins at the intersection of LRAS, SRAS, and AD1 (point A). The sharp decline in the demand for housing shifts AD to the left, from AD1 to AD2 (point B). Parliament and the prime minister can engage in an expansionary fiscal policy by increasing government spending and/or reducing taxes, to shift AD back to the right, from AD2 back to AD1.

CHAPTER 12 | Fiscal Policy 129

2.7 You should agree. Cutting taxes and increasing government purchases to stimulate a sluggish economy would be more popular than raising taxes and decreasing government purchases to slow down an economy that is growing too fast. 2.8

a. Without the stimulus package, the Japanese government expects short-run equilibrium to be at point A in the following graph, with real GDP below potential GDP.

b. The stimulus package will shift the aggregate demand curve to the right from Aggregate demand(without stimulus) to Aggregate demand(with stimulus), increasing real GDP in the new equilibrium represented by point B in the above graph. 2.9

The purpose of expansionary fiscal policy is to increase aggregate demand either by having the government directly increase its own purchases or by cutting taxes to increase household disposable income and, therefore, consumption spending. Increasing or decreasing government spending or taxes does not have a direct effect on the money supply. So, Parliament and the prime minister can carry out an expansionary fiscal policy without the money supply increasing.

130

CHAPTER 12 | Fiscal Policy

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate 12.3 Supply Model

Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy.

Review Questions 3.1 In the basic aggregate demand and aggregate supply model, an expansionary fiscal policy is illustrated by the aggregate demand curve shifting to the right, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve shifts to the right but by more than it would have in the absence of the expansionary policy. The shortrun aggregate supply curve and the long-run aggregate supply curve also shift to the right because the economy experiences increasing inflation and long-run growth. 3.2 In the basic aggregate demand and aggregate supply model, a contractionary fiscal policy is illustrated by the aggregate demand curve shifting to the left, while neither the short-run aggregate supply curve nor the long-run aggregate supply curve shifts. In the dynamic model, the aggregate demand curve shifts to the right, but by less than it would have in the absence of the contractionary policy. The shortrun aggregate supply curve and the long-run aggregate supply curve both shift to the right because the economy experiences increasing inflation and long-run growth. So, in the basic aggregate demand and aggregate supply model, a contractionary fiscal policy will cause a decline in both real GDP and the price level. In the dynamic aggregate demand and aggregate supply model, a contractionary fiscal policy will cause real GDP and the price level to increase by less than they would have in the absence of the policy.

Problems and Applications 3.3 a. The value of real GDP in year 2 will be $1.51 trillion and the price level will be 110.5. b. The government could conduct expansionary fiscal policy by increasing spending or reducing taxes. c. Without expansionary fiscal policy, the inflation rate between year 1 and year 2 will be 110.5 − 110 × 100% = 0.45% . With the expansionary fiscal policy, the inflation rate will be 110 112 − 110 × 100% = 1.8% . 110 3.4 a. Since real GDP is below potential GDP in 2022, the federal government should use expansionary fiscal policy to keep real GDP at its potential level. Expansionary policy includes increasing government spending and/or decreasing taxes. b. If Parliament is successful in keeping real GDP at its potential level, real GDP will increase, potential GDP will not change, the inflation rate will increase, and the unemployment rate will decrease. c. Without policy, aggregate demand shifts from AD2021 to AD2022 (without policy). Real GDP is $1.50 trillion and the price level is 111.5 (point B). With policy, aggregate demand shifts from AD2021 to AD2015(with policy). Real GDP is $1.54 trillion and the price level will be higher than 111.5. (On the graph, it is shown at 112, represented by point C.)

CHAPTER 12 | Fiscal Policy 131

3.5

The economy does not have to be in a recession during 2022 for deflation to take place. As is shown on the following graph, aggregate demand increases from 2021 to 2022, but the shift to the right in short-run aggregate supply is greater than the shift to the right in aggregate demand, resulting in an increase in real GDP but also a decrease in the price level (point A to point B).

132

CHAPTER 12 | Fiscal Policy

12.4

Government Purchases and Tax Multipliers Learning Objective: Explain how government purchases and tax multipliers work.

Review Questions 4.1 A $1 increase in government purchases initially increases real GDP and national income by $1. The $1 increase in national income increases consumption spending by, say, $0.50. The $0.50 increase in consumption spending increases income, which increases consumption spending again. The process continues as increases in income lead to increases in consumption spending, which lead to increases in income, which lead to increases in consumption spending, and on and on. This process is referred to as the multiplier effect. 4.2 The government purchases multiplier is the ratio of the change in equilibrium real GDP to the change in government purchases. The tax multiplier is the ratio of the change in equilibrium real GDP to the change in taxes. 4.3 At each round of the multiplier process, a higher income tax rate reduces the amount of income after taxes, or disposable income, that households receive. The lower disposable income reduces additional consumption at each round of the multiplier process, decreasing the multiplier effect.

Problems and Applications 4.4 Government construction projects represent an increase in government purchases, which increases aggregate demand, stimulating the economy in the short run. The “ripple effect” means the multiplier effect. 4.5 a. To bring the economy to equilibrium at potential GDP, government purchases need to be increased by ($1.35 − $1.31)/2 = $0.02 trillion. b. To bring the economy to equilibrium at potential GDP, taxes need to be decreased by ($1.35 − $1.31)/1.6 = −$0.025 trillion. c. One example is to increase government purchases by $100 billion and decrease taxes by $125 billion. 4.6 a. MPC = 0.6, which is reasonable, likely even a low estimate for a typical Canadian city. b. MPC = 1, which is unreasonable, as no city completely generates absolutely zero savings. 4.7 Many economists believe that consumers base their spending on their permanent income rather than just on their current income. A consumer’s permanent income reflects their expected future income. By basing spending on permanent income, a consumer can smooth out consumption over a period of years. The longer the time period for which a change in taxes is in effect, the more consumers are likely to accept this change as having a permanent effect on their income and therefore adapt their consumption to reflect the change in taxes. For example, one-time tax rebates, such as the one in 2008, increase consumers’ current income but not their permanent income. Only a permanent decrease in taxes increases consumers’ permanent income. Therefore, a tax rebate is likely to increase consumption spending less than would a permanent tax cut. The tax multiplier effect will therefore be greater after two years than after just one year, when a tax decrease is viewed as being permanent.

CHAPTER 12 | Fiscal Policy 133 4.8 There are a number of different reasons for this. One key reason is that infrastructure projects add to a country’s productive capacity as soon as they’re finished and for years into the future. In this way, governments can not only move the aggregate demand curve but the long-run aggregate supply curve as well. Another important reason why infrastructure projects are a popular option for stimulus packages is that the spending is temporary. Once a new road is built, government spending can return to its pre-stimulus level (or at least close to it). 4.9 You should disagree with the statement. The $30 billion change in government spending or taxation is too large. A decrease in government spending of $30 billion would cause GDP to fall from $1.65 trillion to less than $1.62 trillion. 4.10

Keynes was describing the multiplier effect. By repercussions, he meant the rounds of spending and new production set off by an initial increase in autonomous expenditure. Keynes believed that the government purchases multiplier was about 10. Therefore, even wasteful government spending would result in a substantial increase in the production of goods and services and in employment.

4.11

a. The size of the government purchases multiplier is different from the size of the tax multiplier. So, the size of the multiplier depends on the type of fiscal policy—changes in government purchases or changes in taxes—that is used. b. When real GDP is close to potential GDP, an increase in government purchases or a cut in taxes may have a greater effect on the price level than on real GDP. When real GDP is far away from potential GDP, an increase in government purchases or a cut in taxes may have a greater effect on real GDP than on the price level.

12.5

The Limits of Fiscal Policy as a Stimulus Learning Objective: Discuss the difficulties that can arise in implementing fiscal policy.

Review Questions 5.1 Monetary policy can be changed more quickly than fiscal policy. The Bank of Canada can change monetary policy at any of its meetings, which are scheduled to occur eight times per year—or more frequently, if need be. Fiscal policy has to go through the legislative process of the prime minister, cabinet, and legislature approving a fiscal policy action. Even once approved, it takes time to implement the fiscal policy change. 5.2 Crowding out refers to a decline in private expenditures—consumption, investment, and net exports—as a result of an increase in government purchases. In the short run, an increase in government purchases results in partial crowding out of private expenditures, but in the long run, a permanent increase in government purchases results in the complete crowding out of private expenditures.

Problems and Applications 5.3 Managing the economy and trying to completely offset recessions is virtually impossible. In many cases, the federal government can’t tell the economy is in recession until well after the fact. This makes offsetting each and every reduction in aggregate demand impossible. This is often described as trying to drive down the highway by only looking in the rear view mirror.

134

CHAPTER 12 | Fiscal Policy

5.4 “Heavy public debt” means a large government debt relative to the size of the economy. Heavy public debt might lead to insolvency in that the country’s government might default on the debt. A large and rising debt pushes up the interest rates on the debt, making it more difficult for the government to make the interest payments on the debt. At some point, a country may choose to default on the debt rather than raise taxes or cut government spending sufficiently to substantially reduce the debt. 5.5 An expansionary fiscal policy will, by itself, tend to cause the equilibrium rate of interest to increase. An expansionary monetary policy will cause the equilibrium rate of interest to decrease. An expansionary monetary policy will therefore lessen the effect of crowding out in the short run. 5.6 Ruhm’s findings that average health improves during a recession suggest less need for medical care (and thus medical spending) during a recession. 5.7

a. This outcome will most likely occur if investment spending is crowded out because accumulating more machinery, equipment, and buildings increases economic growth. b. Increased spending on infrastructure such as highways and bridges may aid economic growth, whereas increased spending on national parks is unlikely to do so.

Deficits, Surpluses, and Federal Government Debt

12.6 Learning Objective: Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

Review Questions 6.1 When actual GDP falls below potential GDP, households and firms pay less in taxes to the federal government and the federal government makes more transfer payments to the unemployed. These changes in taxes and transfer payments make the decline in income smaller than it would otherwise be, which results in a smaller decline in consumption spending. With aggregate demand not declining by as much as it otherwise would, the decline in GDP is reduced. When actual GDP increases above potential GDP, households and firms pay more in taxes and the federal government makes fewer transfer payments. These changes reduce the increase in income that would otherwise take place, which results in a smaller decline in consumption spending. With aggregate demand not increasing by as much as it otherwise would, the increase in GDP is reduced. 6.2 The cyclically adjusted budget deficit or surplus measures what the budget deficit or surplus would be if the economy were at potential GDP. A recession would decrease government tax revenues and increase government spending on transfer payments, which would lead to a federal budget deficit. 6.3 Balancing the government’s budget during a recession would require raising taxes or reducing government purchases. These actions would reduce aggregate demand and make the recession worse. 6.4 The federal budget deficit is the annual amount by which federal government expenditures exceed federal tax revenues. To finance the budget deficit, the government must borrow funds by selling bonds. The national debt is the accumulation of past budget deficits minus past budget surpluses and equals the total value of government securities outstanding.

CHAPTER 12 | Fiscal Policy 135

Problems and Applications 6.5 a. Faster. An economy growing faster than expected would result in more tax revenues and less government spending on transfer payments. b. Yes, because it shows that it is difficult to forecast the performance of the economy well enough to accurately forecast the state of the federal budget. 6.6 Requiring that the budget be balanced in each and every year rules out countercyclical fiscal policy. There are times when it may not make sense to pursue a balanced budget at the expense of all other policy objectives. The year 2009 in BC was quite likely one of those times. 6.7 In the long run, large federal deficits and the resulting increase in the federal debt can pose a problem. Crowding out of investment spending may occur if an increasing debt drives up interest rates. Lower investment spending means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. Government debts typically mean higher taxes, lower spending, or higher inflation at some point in the future. As a result, large and sustained government deficits can discourage investment without increasing the interest rate. Provincial governments can “rein in” the provincial budget deficit by decreasing government purchases or increasing taxes. 6.8 A reduction in US government spending would likely cause the US economy to shrink (at least in the short run). This would reduce Americans’ demand for imports, many of which come from Canada. This will reduce demand for Canadian products and could potentially lead to a Canadian recession. 6.9 It doesn’t necessarily tell us anything. Government revenues from income taxes rise when the economy grows, and expenditures shrink when the economy grows. As a result, the increase in surplus could have been due to economic growth alone. 6.10

An excessive budget deficit would be a budget deficit that would be unsustainable in the long run and raise the risk that the government could default on its debt. Judging whether a budget deficit is excessive depends on whether the country is in a recession. If the recession is the primary reason for the budget deficit, then the budget deficit will decline as the economy returns to full employment. Budgetary policies that could be used to reduce a budget deficit are a decrease in government spending and an increase in taxes.

6.11

When a country enters a recession, tax revenues decrease as household incomes and business profits fall. Government payments for unemployment benefits and other transfer programs increase government spending. The typical result is a budget deficit, or an increase in the government’s existing deficit. Governments don’t usually respond to recessions with budget cuts. Increasing taxes and cutting government purchases to cut the budget reduces aggregate demand and makes the recession worse. The Greek budget cuts were part of the bailout deal by the European Union and the International Monetary Fund to aid Greece with its sovereign debt crisis. Otherwise, the Greek government is unlikely to have taken these actions.

6.12

a. “Budget balances” mean the relationship between a government’s expenditures and its tax revenues—in other words, its budget surplus or budget deficit. b. Yes. Budget deficits increase the government debt. Large budget deficits raise the debt-to-GDP ratios when budget deficits increase the government debt at a faster rate than nominal GDP rises.

136

CHAPTER 12 | Fiscal Policy

12.7

The Effects of Fiscal Policy in the Long Run Learning Objective: Discuss the effects of fiscal policy in the long run.

Review Questions 7.1 Supply-side economics refers to fiscal policy actions intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. 7.2 The “tax wedge” is the difference between the pretax and posttax return to an economic activity.

Problems and Applications 7.3 The tax laws are used for many purposes, including encouraging certain activities and discouraging others. This is a main reason for the complexity of the tax laws. 7.4 The increase in marginal tax rates would cause both aggregate demand and long-run aggregate supply to decline relative to what they would have been in the absence of the tax increase. As a result, equilibrium real GDP will be lower relative to what it would have been in the absence of the tax increase and the equilibrium price level will be higher. The effect on real GDP will be larger and the effect on equilibrium price level will be smaller than if the tax increase had affected only aggregate demand, leaving long-run aggregate supply unchanged. 7.5 Brett is arguing that corporate taxes may have significant supply-side effects, but not other forms of taxation. Supply-side effects can have an impact on economic activity only if the economy is supplyconstrained and people are free to increase their supply. In many cases, workers have to work 40 hours a week or less. If there are no opportunities to work more hours, reducing the rate of income tax will have no effect. 7.6 People and businesses in countries like Canada and the United States already have made large investments in setting up the infrastructure to deal with the progressive income tax system and its deductions. Former Soviet Union countries would have to set up that infrastructure from scratch. As a result, opting for a simpler (and thus lower compliance cost) system is more appealing. 7.7

A cut in marginal tax rates increases the incentives to work, save, invest, and start a business. If the cut in marginal tax rates increases economic activity and income enough, total taxes collected can increase even with the lower tax rates. The “behavioural response” refers to the idea that marginal tax rates influence people’s behaviour by changing their incentives to work, save, invest, and start a business.

Suggestions for Critical Thinking Exercises CT12.1 You should ask students to refer again to Chapter 11, Table 11.1, “Expansionary and Contractionary Monetary Policies.” The first two boxes in the table would be replaced with either a change in taxes or a change in federal expenditures, which would then affect aggregate expenditures, specifically consumption and investment for fiscal policy and AE directly for government expenditures. CT12.2 The value of the government purchases multiplier if there were complete crowding out would be zero as, ultimately, an increase in G leads to no change in real GDP.

CHAPTER 13 | Inflation, Unemployment, and

Bank of Canada Policy

SOLUTIONS TO END-OF-CHAPTER EXERCISES The Discovery of the Short-Run Trade-off between Unemployment and 13.1 Inflation Learning Objective: Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

Review Questions 1.1 The Phillips curve is a curve showing the short-run relationship between the unemployment rate and the inflation rate.

1.2 The Bank of Canada would undertake an expansionary monetary policy, which would increase aggregate demand, causing both real GDP and the price level to increase. An increase in real GDP will increase employment, lowering the unemployment rate. 1.3 The Phillips curve had been stable during the 1960s, so it appeared that policymakers could permanently reduce unemployment if they were willing to accept permanently higher inflation. Economists were wrong to think of the Phillips curve as a policy menu because the long-run Phillips curve is a vertical line at the natural rate of unemployment. In other words, the Phillips curve does not represent a policy menu because in the long run there is no trade-off between unemployment and inflation.

138

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

1.4 The late Milton Friedman argued that in the long run the unemployment rate would equal the natural rate of unemployment, which is the unemployment rate that exists when the economy is at potential GDP. Just as the price level does not affect real GDP in the long run because real GDP will be at potential GDP, the inflation rate does not affect the unemployment rate in the long run because the unemployment rate will be at the natural rate of unemployment.

Problems and Applications 1.5 a. A “tight labor market” is a labour market with a very low unemployment rate, usually lower than the natural rate of unemployment. b. With a downward-sloping short-run Phillips curve, a fall in the unemployment rate will increase the inflation rate. If for a given decrease in the unemployment rate, there is a smaller increase in the inflation rate, the short-run Phillips curve must be flatter than if the decrease in the unemployment rate resulted in a larger increase in the inflation rate. c.

If the Phillips curve is steep, a small decrease in the unemployment rate will cause a much larger increase in the inflation rate than would be the case with a flat Phillips curve.

1.6 a. Point E on the Phillips curve graph best represents the same economic situation as point B on the aggregate demand and aggregate supply graph because the smaller increase in aggregate demand results in an inflation rate of 2 percent (= [123.4 – 121.0]/121.0 × 100]), a lower level of real GDP (compared with point C), and a higher level of unemployment. b. Point D on the Phillips curve graph best represents the same economic situation as point C on the aggregate demand and aggregate supply graph because the larger increase in aggregate demand results in an inflation rate of 4 percent (= [125.8 – 121.0]/121.0 × 100]), a higher level of real GDP (compared with point B), and a lower level of unemployment. 1.7 The aggregate demand and aggregate supply model and the Phillips curve provide two different ways of illustrating the same macroeconomic events, but the Phillips curve has an advantage when we want to explicitly analyze changes in the inflation rate and the unemployment rate, which are not directly shown on an aggregate demand and aggregate supply graph. 1.8 In the 1960s, the Phillips curve was widely viewed as a stable relationship representing a menu of policy choices between low inflation and high unemployment and between high inflation and low unemployment. A party that cares primarily about price stability would want low inflation at the cost of high unemployment, and the other party that cares more about keeping unemployment low would be willing to accept higher inflation. Today, the Phillips curve is not viewed as a policy menu, and most economists believe that in the long run there is no trade-off between inflation and unemployment. 1.9 Negotiations between a union such as the CAW and General Motors, or any other company, usually take considerable amounts of time. Annual negotiations would impose a much greater time commitment on both parties than is required for three-year contracts. Multi-year contracts also provide a greater amount of certainty for workers and firms, particularly when inflation rates have been low and stable in the recent past. Some multi-year contracts include a cost-of-living adjustment (COLA) that increases wages by an agreed amount (for example, 2 or 3 percent annually) plus an amount equal to the percentage increase in prices (this is often based on changes in the consumer price index) in the previous year. The COLA helps insulate companies and union members from the effects of unanticipated changes in the rate of inflation.

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

139

1.10 If inflation is higher than households and firms had expected, then real wages will be lower than expected. The lower real wage will cause employment to be higher in the short run than it would be with a higher real wage because firms will increase the quantity of labour that they will demand. In the long run, households and firms will adjust to the higher inflation and employment will return to its full-employment level. 1.11 As discussed in Apply the Concept: Do Workers Understand Inflation?, there is some evidence that the general public does not think that nominal wages keep up with inflation, which means real wages fall. If this conclusion was correct, inflation would be a more important problem than most economists believe it is. 1.12 Inflation is caused by movements in aggregate demand and aggregate supply, not by greed. If greed causes inflation, then fluctuations in the inflation rate would be caused by fluctuations in the extent of greed in the economy. It’s implausible that the extent of greed in the economy fluctuates as much as the inflation rate does.

13.2 The Short-Run and Long-Run Phillips Curves

Learning Objective: Explain the relationship between the short-run and long-run Phillips curves.

Review Questions 2.1 Along the short-run Phillips curve, the expected inflation rate is constant. When the expected inflation rate changes, the short-run Phillips curve shifts. The long-run Phillips curve is a vertical line at the natural rate of unemployment. The short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate. If the expected inflation rate increases from 2 percent to 3 percent, the short-run Phillips curve would shift up so that it intersects the long-run Phillips curve at a 3 percent inflation rate. 2.2 A vertical long-run aggregate supply curve implies that changes in the price level—inflation—do not change potential GDP and the natural rate of unemployment. In order for the long-run Phillips curve to be downward sloping, changes in the price level (inflation) would have to affect the unemployment rate in the long run.

140

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

Problems and Applications 2.3

2.4 A movement from point A to point B would be caused by a decline in aggregate demand—this decline could result from contractionary monetary policy—that decreased the inflation rate and increased the unemployment rate, without changing the expected inflation rate. A movement from point A to point C would be caused by a decrease in the expected inflation rate. 2.5 Because there is no trade-off in the long run between unemployment and inflation, Herbert Stein’s statement is correct. Most economists in 1968 believed that there was a long-run trade-off between unemployment and inflation, so they would not have agreed with Stein’s statement. 2.6 a. Graph 3 matches because a decrease in the proportion of younger and less-skilled workers in the labour force decreases the natural rate of unemployment, shifting the long-run and short-run Phillips curves to the left. b. Graph 4 matches because expansionary monetary policy increases the inflation rate and decreases the unemployment rate. c.

Graph 1 matches because significant new legal barriers to firing workers increases the natural rate of unemployment, shifting the long-run and short-run Phillips curves to the right.

d. Graph 2 matches because a decrease in the expected inflation rate shifts the short-run Phillips curve downward. 2.7 a. When an economy experiences a severe recession, we would expect workers in occupations that require greater skills or training would have less difficulty in finding a job after the recession ends because the greater the skills a worker has, the fewer other workers who are able to compete with the worker for job openings. However, if these skilled occupations have experienced a permanent reduction in the number of workers employed—for instance, if skilled bricklayers were being replaced by bricklaying machines or a declining number of newspapers was reducing the number of journalism jobs available—then workers with these skills will have difficulty being employed unless they acquire new skills or accept employment in an unskilled job. The research by Victor Copyright © 2024 Pearson Canada Inc.

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

141

Ortego-Marti also indicates that if technical workers are unemployed for a significant period during a severe recession, their skills may decline. In that case, the normal advantages that skilled workers have in finding new jobs may shrink or even disappear for workers in these occupations. Additional information on the effect of the recession on different occupations would make it easier to answer the question. b. If jobs in Canada require increasing amounts of skill, unskilled workers may have greater difficulty finding jobs. As a result, the level of structural unemployment may increase, thereby increasing the NAIRU. In these circumstances, the Bank of Canada may achieve its goals. 2.8 a. Flexibility of the labour market refers to the ability of firms to freely hire and fire workers and to set their wages; for workers to easily move among jobs; and for firms to be free to change the requirements of jobs without being hindered by government regulations or union contracts. A country with a more flexible labour market is likely to have a lower natural rate of unemployment and, therefore, a lower NAIRU than would a country with a less flexible labour market. Other factors, including the age structure of the population and the availability of employment insurance and other transfer payments also determine the NAIRU. b. When the unemployment rate drops below the natural rate of unemployment, firms have more difficulty in filling their job openings and are forced to pay a higher wage to attract more workers. The competition among firms to hire the remaining workers in the market will drive the wages up, increasing firms’ costs and causing firms to increase the prices of goods and services at a faster rate.

13.3 Monetary Policy and Expectations of the Inflation Rate

Learning Objective: Discuss how expectations of the inflation rate affect monetary policy.

Review Questions 3.1 Workers, firms, banks, and investors care about real, inflation-adjusted values. The future inflation rate affects real wages, real profits, and real interest rates. During periods of moderate and stable inflation, workers, firms, banks, and investors are most likely to form their expectations adaptively, basing them on the pattern of inflation rates in the recent past. During periods of high and unstable inflation, they are more likely to incorporate all available information, including current central bank policy. 3.2 Rational expectations mean that workers and firms form current expectations using not only information from the past but all available information. In forming expectations of inflation, rational expectations mean that workers and firms don’t use just information on recent inflation rates but also other information, such as knowledge of the central bank’s current monetary policy. 3.3 With rational expectations, workers and firms may correctly anticipate any change in the inflation rate caused by monetary policy. If the actual inflation rate equals the expected inflation rate, then the unemployment rate equals the natural rate of unemployment and the short-run Phillips curve is vertical. If the Phillips curve is vertical in the short run, then expansionary monetary policy cannot reduce the unemployment rate even in the short run.

142

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

Problems and Applications 3.4 Rational expectations are likely to give the more accurate forecasts. When inflation is increasing over time, adaptive expectations that rely on only past information will always result in a forecast of a lower inflation rate than the actual inflation rate will turn out to be. 3.5 a. The economic framework that Lucas’s arguments changed was that workers and firms formed their expectations adaptively, without taking into account the likely effects of monetary policy. Lucas argued that if expansionary monetary policy was anticipated and credible, and if workers and firms had rational expectations, they would adjust their expectations of inflation so that there would be no decrease in unemployment. b. Many economists do not agree with Lucas’s main conclusion that anticipated monetary policy will not affect the unemployment rate because they believe that workers and firms may not have rational expectations, and wages and prices may not be able to adjust rapidly to an unexpected change in inflation. 3.6 This characterization of Lucas’s position is accurate because Lucas argued that people have rational expectations and will make use of all available information about whatever economic variable they are interested in. So, for instance, the Bank of Canada would be unable to permanently expand output and reduce unemployment by keeping the inflation rate higher than workers and firms expect. Workers and firms would incorporate information on Bank of Canada policy into their expectations of future inflation, making ineffective the Bank’s attempt to run an expansionary monetary policy by “tricking” people. 3.7 a. Lucas, Sargent, and Prescott all belong to the new classical macroeconomics school of thought because they share the assumptions that people have rational expectations and that wages and prices adjust rapidly. b. Stabilizing the economy means the Bank of Canada implements policies that result in real GDP being equal to potential GDP, reducing the severity of—or even eliminating—the business cycle. The new classical economists doubt the central bank’s ability to stabilize the economy because they believe that change in “real” factors, such as technology shocks, and not monetary policy, explain movements in real GDP. 3.8 a. The reasoning is that an unanticipated increase in inflation will lower the real wage below its expected level. As a result, firms will hire more workers and increase output. Therefore, an unanticipated increase in inflation will have led to economic growth. b. If the increase in inflation is unanticipated, then the actual real wage will be below its expected level and employment and output are likely to increase. If the increase in inflation was anticipated, then firms and workers would have taken it into account when bargaining over real wages. As a result, the increase in inflation would not result in a decrease in the expected real wage or an increase in employment. Some economists would argue, though, that even an anticipated increase in inflation can cause a decline in the real wage if workers and firms have entered multi-year wage contracts.

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

13.4

143

Bank of Canada Policy from the 1970s to the Present Learning Objective: Use a Phillips curve graph to show how the Bank of Canada can permanently lower the inflation rate.

Review Questions 4.1 The reduction in the inflation rate from above 5 percent in 1979 to 2 percent in 1993 brought about by contractionary monetary policy is known as the “Canadian disinflation.” The disinflation was accompanied by recession, as the unemployment rate increased from about 7.5 percent to 11.4 percent. 4.2 The credibility of policy announcements is important for the effectiveness of monetary policy because a more credible policy allows the Bank of Canada to have a greater effect on the expected inflation rate. In particular, a credible policy of disinflation will cause the short-run Phillips curve to shift down more rapidly than if the policy is less credible, thereby making the increase in the unemployment rate smaller and more short-lived. 4.3 The main reason to keep a country’s central bank independent of the rest of the government is to avoid inflation. Whenever a government is spending more than it is collecting in taxes, it must borrow the difference by selling bonds. The governments of many developing countries have difficulty finding anyone other than their central bank to buy their bonds. The more bonds the central bank buys, the faster the money supply grows, and the higher the inflation rate will be. Another fear is that if the government controls the central bank, it may use that control to further its political interests. It is difficult in any democratic country for a government to be re-elected at a time of high unemployment. If the government controls the central bank, it may be tempted just before an election to increase the money supply and drive down interest rates to increase production and employment, thereby increasing the risk of inflation.

Problems and Applications 4.4 a. A supply chain is a network of firms that are involved in the production and sale of a good or service. b. i. A demand shock that decreases aggregate demand will result in a higher unemployment rate. A supply shock that decreases aggregate supply will also result in a higher unemployment rate. ii. A demand shock that decreases aggregate demand will result in a lower inflation rate. A supply shock that decreases aggregate supply will result in a higher inflation rate. iii. A demand shock that decreases aggregate demand will result in a decline in real GDP (relative to what real GDP would have been in the absence of the shock). A supply shock that decreases aggregate supply will also result in a decline in real GDP (relative to what real GDP would have been in the absence of the shock). c.

You should agree. A negative supply shock forces the Bank of Canada to choose between (1) stimulating aggregate demand to reduce the unemployment rate, but thereby making the inflation rate worse, and (2) decreasing aggregate demand to reduce the inflation rate, but thereby making the unemployment rate worse. With a negative aggregate demand shock, the Bank of Canada can focus on stimulating aggregate demand to restore both the unemployment rate and the inflation rate to their previous levels.

144

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

4.5 Not according to the usual definition of disinflation. There was deflation in 1933 because the price level in 1933 was lower than the price level in 1932. Disinflation refers to a situation in which the inflation rate declines. 4.6 To reduce the inflation rate from 4 percent to 3 percent, the Bank of Canada will have to raise its target for the overnight interest rate. Higher interest rates will reduce aggregate demand, raise unemployment, and cause a movement down the initial short-run Phillips curve, where the expected inflation rate is 3 percent (see arrow 1 on the following graph). As unemployment stays above the full-employment level at U1 and the actual inflation rate is 3 percent, workers and firms will lower their expectations of future inflation, and the short-run Phillips curve will shift to the left (see arrow 2 on the graph). With the new short-run Phillips curve, the unemployment rate will be back at the natural rate of unemployment of 4 percent, and workers and firms will expect the inflation rate to be 3 percent.

4.7 a. Many economists wondered whether the short-run Phillips curve trade-off between unemployment and inflation still holds because the unemployment rate has fallen without resulting in much increase in the inflation rate. b. Some economists note that the short-run Phillips curve trade-off still exists for wage inflation, although not for price inflation, raising the possibility that firms are no longer passing higher wage costs through to higher price increases to the extent that they did in previous decades. Some economists and policymakers argue that there may be more slack in the labour market for a given unemployment rate than was true in earlier years. If this slack in the labour market eventually disappears, the short-run relationship between inflation and unemployment may begin to show a more typical Phillips curve pattern. 4.8 a. The output gap is the percentage difference between real GDP and potential GDP, and it is difficult to estimate potential GDP. b. A preannounced rule, such as the Taylor rule, sets the target for the federal funds rate by a chosen weight between 0 and 1 multiplied by the output gap, such as, 0.5 × output gap. Differences in the estimate of the output gap lead to different targets for the federal funds rate. In conducting Copyright © 2024 Pearson Canada Inc.

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

145

monetary policy, recent Fed chairs have preferred to rely on measures of tightness in labour markets and trends in the underlying rate of inflation rather than on a mechanical rule.

Real-Time Data Exercises Note: FRED and the Bank of Canada continue to update data. The solutions below contain the data available on the first quarter of 2021. D13.1 a. During this period the output gap was negative. b. Although the output gap was negative, it has been decreasing. The expectation is that it will keep on decreasing as the economy recovers from the COVID-19 recession. It is also to be noted that the output gap is the percentage difference between real GDP and potential GDP, and it is difficult to estimate potential GDP. D13.2 See the plot in the following graph of the annual unemployment rate and the annual inflation rate since 1962.

Source: fred.stlouisfed.org a. For the 1966–1969 period, the unemployment rate declined and the inflation rate rose, which implies an upward movement along the short-run Phillips curve. b. For the 1973–1975 period, both the unemployment rate and the inflation rate rose, which implies that the short-run Phillips curve shifted upward. c. For the 1992–1994 period, both the unemployment rate and the inflation rate declined, which implies that the short-run Phillips curve shifted downward. d. For the 2000–2002 period, the unemployment rate rose and the inflation rate declined, which implies a movement down along the short-run Phillips curve.

146

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

D13.3 See the plot in the following graph of consumers’ expectations of the inflation rate and the actual inflation rate as measured by the consumer price index. Consumers did a good job forecasting the inflation rate in the mid-1990s and mid-2000s. Consumers did a poor job forecasting the inflation rate in the late 1970s and early 1980s when the expected inflation rate was lower than the actual inflation rate and between 2009 and 2020 when the expected inflation rate was typically higher than the actual inflation rate. Consumer expectations of the inflation rate tend to be less volatile than the actual inflation rate.

Source: fred.stlouisfed.org

Suggestions for Critical Thinking Exercises CT13.1 Answers may vary, but many students will cite unemployment and inflation rate data for OECD countries from the FRED website. Countries like the United States, Germany, and Japan have low inflation rates and unemployment rates that are between 3 percent and 6 percent. Other countries, like France and Italy, have low inflation rates but unemployment rates close to 10 percent. For these countries, students may suggest that their central banks conduct expansionary monetary policy to lower their unemployment rates. (In the case of France and Italy, their governments would have to convince the European Central Bank to follow such policies because countries that use the euro cannot conduct independent monetary policies.) CT13.2 a. Every five years, the Bank of Canada and the government of Canada review the country’s monetary policy framework. In December 2021, the Bank and the government agreed to continue the flexible inflation-targeting framework. They agreed that the Bank of Canada would target the inflation rate (based on headline CPI) between 1 percent and 3 percent for another five years, until December 2026. b. In general, economists and policymakers have supported the agreement, because the flexible inflation-targeting framework is well understood by the public and delivered low and stable inflation rates for over 30 years, allowing Canadians to better plan for their future. c. There was not really opposition to the agreement, but recommendations for alternative monetary policy frameworks could include, for example, average inflation targeting or nominal GDP growth targeting.

CHAPTER 14 | Macroeconomics in an Open

Economy

SOLUTIONS TO END-OF-CHAPTER EXERCISES 14.1 The Balance of Payments: Linking Canada to the International Economy Learning Objective: Explain how the balance of payments is calculated.

Review Questions 1.1

Leaving aside the statistical discrepancy and the capital account, both of which are small for Canada, the current account plus the financial account equals the balance of payments, which always equals zero.

1.2

The current account balance includes net exports plus net income on investments and net transfers.

1.3

a. The current account records (1) the value of a country’s net exports (exports of goods and services minus imports of goods and services); (2) net income on investments (income received on foreign investments minus income payments on investments); and (3) net transfers. b. The following answers explain why in each case a country is likely to have a deficit in its current account. Note that because net exports are part of a country’s current account, anything that causes net exports to become negative makes it more likely, holding other factors constant, that the country will have a deficit in its current account. i.

A higher price level would make a country’s exports more expensive and its imports less expensive.

ii. Higher interest rates would increase a country’s exchange rate, which would make the prices of its exports higher in foreign currencies and the prices of its imports lower in domestic currency. iii. Lower import barriers would encourage firms and households in the country to increase their imports. iv. More attractive investment opportunities would increase foreign demand for the country’s currency, thereby increasing the country’s exchange rate. A higher exchange rate will decrease net exports.

Problems and Applications 1.4

With a current account deficit of €44.3 billion in 2020, France would have experienced a net capital inflow because having a current account deficit means that France must have run a financial account surplus. A country running a financial account surplus experiences a net capital inflow.

148

CHAPTER 14 | Macroeconomics in an Open Economy

1.5

The best way to answer this question is by placing the values given into a table in a format similar to that of Table 14.1: Current Account Exports of goods Imports of goods Balance of trade Exports of services Imports of services Balance of services Income received on investments Income payments on investments Net income on investments Net transfers Balance on current account Financial Account Increase in foreign holdings of assets in the United States Increase in US holdings of assets in foreign countries Balance on financial account Balance on Capital Account

$856 −1108 325 –256 392 –315

–252 69 77 –60 –166

1181 –1040

Statistical discrepancy Balance of payments

141 0 25 0

1.6

The reason Germany’s current account surplus was larger than its trade surplus is that the sum of the other components in the current account, other than trade, was positive. These components are the balance of services, net investment income, and net transfers. A trade surplus of €193 billion and a current account surplus of €233 billion implies that the sum of the balance of services, net investment income, and net transfers was a surplus of €40 billion. Leaving aside the balance on the capital account and the statistical discrepancy, a current account surplus of €233 billion would mean a financial account deficit of €233 billion.

1.7

a. By “foreign-trade gap” the article meant the trade balance. In this case, a widening of the trade gap meant that US imports of goods had increased relative to US exports of goods. b. The United States usually sells more services to other nations than it buys from them, and so the United States runs a positive balance on services This positive balance on services helps offset the usual negative balance on trade in goods, so a smaller positive balance on services would not offset as much of the negative balance on goods and, therefore, widen the overall US foreign trade gap.

1.8

When a country runs a current account surplus, it must also run a financial account deficit. When a country runs a financial account deficit, capital inflows—foreign direct investment and foreign portfolio investment—are less than capital outflows. These countries use often use some of their current account surplus to buy foreign government bonds. So, the article is correct in making these two statements.

1.9

Disagree. The observation confuses the capital account with the financial account. With a current account deficit, the United States must have a financial account surplus.

CHAPTER 14 | Macroeconomics in an Open Economy 1.10

14.2

149

When the country experiences current account deficits, it is also experiencing financial account surpluses. A financial account surplus represents a net capital inflow—the country is selling more physical assets (direct foreign investment) and financial assets (foreign portfolio investment) than it is buying from other countries. To the extent that the capital inflow takes the form of foreign portfolio investment, the article is correct that foreign investors “can end up owning a big share of assets.”

The Foreign Exchange Market and Exchange Rates Learning Objective: Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports.

Review Questions 2.1

The reciprocal: $1/¥115, or $0.0087 = ¥1. If the exchange rate changes from €0.85 = $1 to €0.90 = $1, then the quantity of euros required to buy a dollar has increased and the euro has depreciated against the dollar.

2.2

The three main sets of factors are (1) changes in the demand for US-produced goods and services and changes in the demand for foreign-produced goods and services; (2) changes in the desire to invest in the United States and changes in the desire to invest in foreign countries; and (3) changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

2.3

The theory of purchasing power parity holds that in the long run, exchange rates move to equalize the purchasing power of different currencies. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates in the long run: (1) not all products are traded internationally; (2) products and consumer preferences are different across countries; and (3) countries impose barriers to trade.

Problems and Applications 2.4

1.9558 marks = 1 euro and 2.0938 marks = 1 dollar. First, convert the euro and the dollar exchange rates in terms of 1 German mark: (1/1.9558) euros = 1 mark, or 0.5113 euros = 1 mark, and (1/2.0938) dollars = 1 mark, or 0.4776 dollars = 1 mark. So, 0.5113 euros = 0.4776 dollars, or 1.07 euros = $1. Similar results would follow if we use one of the other currencies, for example French francs. Put both the euro and the dollar in terms of 1 French franc: 6.5596 French francs = 1 euro, or 0.1524 euros = 1 French franc, and 7.0223 French francs = 1 dollar, or 0.1424 dollars = 1 French franc. So, 0.1524 euros = 0.1424 dollars, or 1.07 euros = $1.

150

CHAPTER 14 | Macroeconomics in an Open Economy

2.5

a. The Canadian dollar appreciated against the yen because now it takes more yen to purchase a Canadian dollar. b. Events (ii) and (iii) could have caused the shift in demand shown in the graph: (i) would cause the demand curve for Canadian dollars to shift to the left, as foreign investors decrease their demand for Canadian financial assets; (ii) would cause the demand curve for Canadian dollars to shift to the right as Japanese consumers increase their demand for Canadian exports; and (iii) would also cause the demand curve for Canadian dollars to shift to the right as investors anticipate a future increase in the value of the Canadian dollar.

2.6

a. “Additional monetary stimulus” means that the European Central Bank will conduct an expansionary monetary policy to lower interest rates to increase aggregate demand and real GDP. An expansionary monetary policy will lower interest rates, making financial assets priced in euros less desirable than financial assets priced in US dollars. As a result, the demand for the euro will decrease, causing it to depreciate against the US dollar.

CHAPTER 14 | Macroeconomics in an Open Economy

151

b. In the following graph, because Draghi’s remarks caused investors to expect that they will receive lower interest rates in the future on financial assets priced in euros, the demand for euros shifts to the left from D1 to D2. The result is a lower equilibrium exchange rate between the euro and the US dollar. The graph shows the exchange rate falling from $1.20 per euro to $1.15 per euro.

2.7

a. A “weak dollar” means that the US dollar will not buy as many units of foreign currency given the current exchange rate. b. Investors constantly look for investments that pay higher returns for a given level of risk. If investors decide to invest abroad, they will sell dollars to buy other currencies needed to invest in foreign assets. An increase in the supply of US dollars lowers the price of the dollar in other currencies or weakens the dollar.

2.8

a. The exchange rate between the yen and the pound is (¥115/$1) × ($1/£0.75) = ¥153.33/£1. b. The new exchange rate between the yen and the pound is (¥120/$1) × ($1/£0.70) = ¥171.43/£1. The Canadian dollar appreciated against the Japanese yen because it now takes more yen to buy a dollar. The Canadian dollar depreciated against the British pound because it now takes fewer pounds to buy a dollar. The yen depreciated against the pound because it now takes more yen to buy a pound.

2.9

a. A strong euro means the euro will exchange for more dollars or other currencies. b. When the euro is strong, European exporters of goods and services to other countries are harmed because their exports have higher prices in foreign currencies. Higher prices will reduce foreign consumers’ demand for these products. In addition, the profits European firms earn on these products will be exchanged for fewer euros when the firms transfer the profits back to Europe.

2.10

When the Reserve Bank of Australia cut interest rates, the return on investing in Australian dollar– denominated assets, such as bonds issued by the Australian government, decreases. As a result, the demand for the Australian dollar decreases, which causes the Australian dollar to depreciate versus the US dollar.

152

CHAPTER 14 | Macroeconomics in an Open Economy

2.11

a. Amazon is exposed to foreign exchange risk primarily because of its many operations in foreign markets. The dollar value of the profits earned in foreign currencies varies with changes in the exchange rate between the foreign currencies and the US dollar. b. Amazon’s profit would be affected to the extent that households and firms in other countries buy its products. For example, if the dollar appreciates, buyers in other countries would pay higher prices for Amazon’s products. An appreciating dollar would also make imports into the United States cheaper, which could decrease Amazon’s sales in the United States. Finally, because some of the goods that Amazon sells on its US website are imported from other countries, an appreciation or depreciation of the dollar will still expose Amazon to exchange rate risk.

2.12

a. The phrase “75 or 80 cent Canadian dollar” refers to the exchange rate between the US dollar and the Canadian dollar: 1 Canadian dollar exchanges for $0.75 to $0.80 in US dollars. b. An NHL team that is based in Canada receives most of its revenue in Canadian dollars from sales of tickets to its games and in payment from Canadian television and streaming services. c. An NHL team that operates in Canada would be better off if the Canadian dollar appreciates against the US dollar. With an appreciation against the US dollar, the NHL team’s costs that are denominated in US dollars, such as the salaries of its players, can be paid for by the expenditure of fewer Canadian dollars.

2.13

By this standard, the US dollar is overvalued against the Mexican peso, Japanese yen, British pound, Indonesian rupiah, Canadian dollar, and Chinese yuan because the implied exchange rate indicates that it should take fewer units of these currencies to purchase a US dollar than is indicated by the actual exchange rate. The US dollar is undervalued against the Swiss franc because the implied exchange rate indicates that it should take more units of this currency to purchase a US dollar than is indicated by the actual exchange rate.

2.14

To calculate the purchasing power exchange rate, divide the foreign currency price of a Big Mac by the US price ($5.66). Country Chile Israel Russia New Zealand

Big Mac Price 2940 pesos 17 shekels 135 rubles 6.8 NZ dollars

Implied Exchange Rate 519.43 3.00 23.85 1.20

Actual Exchange Rate 719.43 pesos per dollar 3.18 shekels per dollar 74.63 rubles per dollar 1.40 NZ dollars per US dollar

The US dollar is overvalued if the actual exchange rate is greater than the implied exchange rate and undervalued if the actual exchange rate is less than the implied exchange rate. In this case, the US dollar is overvalued against the Chilean peso, the Israeli shekel, the Russian ruble, and the New Zealand dollar. Overvaluation of the US dollar would lead us to predict that the value of the dollar will fall in the future relative to the value of all four currencies. The implied exchange rate between the Russian ruble and the New Zealand dollar is 135 rubles/6.8 NZ dollars, or 19.85 rubles per New Zealand dollar. The actual exchange rate between the two currencies is 53.31 rubles per NZ dollar (74.63/1.40 = 53.31). Therefore, in terms of Big Mac purchasing power parity, the New Zealand dollar is overvalued.

CHAPTER 14 | Macroeconomics in an Open Economy

153

2.15

If Australia’s inflation rate is higher than New Zealand’s inflation rate, then the Australian dollar will depreciate relative to the New Zealand dollar.

2.16

These data are consistent with the theory of purchasing power parity, but the data also show that the theory does not offer a full explanation of movements in exchange rates. The theory of purchasing power parity argues that in the long run, the most important determinant of exchange rates between two currencies is the relative price levels in the two countries. With the Mexican consumer price index increasing by 98 percent and the US consumer price index increasing by 35 percent, purchasing power parity predicts that the exchange rate value of the dollar should rise approximately 63 percent against the peso. The dollar actually rose 67 percent against the peso, so purchasing power parity offers a good explanation of the rise of the dollar against the peso.

14.3 Exchange Rate Systems

Learning Objective: Discuss the three key features of the current exchange rate system.

Review Questions 3.1

An exchange rate system is an arrangement among countries about how exchange rates should be determined. The current exchange rate system is a managed float exchange rate system under which the value of most currencies—including the US dollar—is determined by demand and supply, with occasional government intervention.

3.2

Countries such as France, Germany, Spain, and Italy decided to adopt a common currency in order to increase trade with other countries using the same currency. A common currency makes it easier for consumers and firms to buy and sell across borders and, therefore, should reduce production and transactions costs and increase competition.

3.3

One currency is pegged against another currency when a country decides to keep the exchange rate between its currency and another currency fixed. Countries peg their currencies for the following reasons: (1) to make planning easier for firms with extensive trade with another country; (2) to aid firms that have borrowed foreign investment funds denominated in other currencies; and (3) to reduce inflation. Countries that peg can find that their currencies become either overvalued or undervalued relative to the equilibrium exchange rate. A pegged currency that is overvalued can lead to capital flight and a destabilizing speculative attack.

Problems and Applications 3.4

a. To alleviate recession in Germany, interest rates should be lowered. b. To curb inflation in Ireland, interest rates should be raised. c. Because they use the same currency, Germany and Ireland cannot have different monetary policies, which means they cannot have different interest rate policies.

3.5

Between March 2020 and November 2021, the euro depreciated against the Canadian dollar. This depreciation was bad news for Canadian firms exporting goods and services to Europe as the euro prices of Canadian goods and services increased. The euro’s depreciation was also bad news for European consumers buying goods and services imported from Canada as the euro prices of those imports increased.

154

CHAPTER 14 | Macroeconomics in an Open Economy

3.6

a. South Korea would not want its currency to appreciate too much relative to the Chinese yuan because it would worsen their trade balance with China. If the won appreciated against the yuan, Korean exporters to China would be hurt because their products would have a higher price in yuan. As a result, businesses and firms in China would be likely to buy fewer Korean imports. b. If the won appreciated against the yuan, the Korean central bank would want to sell won in exchange for yuan. Doing so would increase the supply of won, lowering the exchange rate between the won and the yuan.

3.7

a. There is a shortage of baht in exchange for Canadian dollars because at the pegged exchange rate the quantity of baht demanded is greater than the quantity of baht supplied. b. To maintain the pegged exchange rate, the Thai central bank will have to sell baht in exchange for Canadian dollars. The Thai central bank will have to sell 50 (= 120 – 70) million baht per day.

3.8

Argentina’s peg collapsed when it stopped fixing the value of the peso against the US dollar, and the value of the peso declined dramatically. Argentine firms that borrowed dollars had to make interest payments in dollars, but their revenues were in Argentine pesos. After the end of the peg, the firms needed to spend more pesos in order to buy the dollars they needed to make their interest payments.

3.9

The following graph assumes that the Chinese central bank pegs the exchange rate for the yuan below the market equilibrium exchange rate. As a result, the yuan is undervalued. Compared to the equilibrium exchange rate, an undervalued yuan will increase exports and decrease imports. As shown in this graph, the Chinese central bank would have to supply Y2 – Y1 yuan each trading period to maintain the exchange rate peg.

3.10

It would be good news for US-based firms such as Apple and Yum Brands if the yuan increases in value relative to the US dollar. These firms earn significant sales revenue in China. The firms will earn more dollars when they convert an appreciated yuan into US dollars.

CHAPTER 14 | Macroeconomics in an Open Economy

155

14.4 The International Sector and National Saving and Investment Learning Objective: Define and apply the saving and investment equation.

Review Questions 4.1

Net exports equal net foreign investment, assuming that net exports are roughly equal to the current account balance. When a country’s net exports are negative, households, firms, and the government must have sold assets and borrowed (negative foreign investment) from foreign households, firms, and governments to pay for the excess of imports over exports. When a country’s net exports are positive, households and firms must have bought foreign assets and lent (positive foreign investment) to foreign households, firms, and governments.

4.2

National saving = Domestic investment + Net foreign investment, or S = I + NFI. If national saving declines, the sum of domestic investment and net foreign investment will decline.

4.3

Because S = I + NFI, if S > I, then net foreign investment must be positive.

Problems and Applications 4.4

Recall that National saving = Domestic investment + Net foreign investment, or S = I + NFI. Because NFI = Net Exports, then S = I + NX. If we assume that the current account is roughly equal to net exports, we arrive at the equation S = I + CA or CA = S − I. Based on this equation, a country that saves more than it invests domestically will have a current account surplus, while a country that invests domestically more than it saves will have a current account deficit.

4.5

a. “Excess saving” means that national saving exceeds domestic investment, or S > I. b. Recall that National saving = Domestic investment + Net foreign investment, or S = I + NFI. Because NFI = Net Exports, then S = I + NX. If the current account is roughly equal to net exports, we arrive at the equation S = I + CA or CA = S − I. Based on this equation, a country with “excess saving” (that is S > I) will have a current account surplus, while a country that invests more than it saves will have a current account deficit.

4.6

We know that S = I + NFI, or S − I = NFI. So, for Germany: 27.2 percent − 21.5 percent = 5.7 percent. Therefore, German net foreign investment in 2020 was 5.7 percent of GDP.

4.7

You should disagree. The statement is incorrect because national saving as a percentage of GDP is not equal to domestic investment as a percentage of GDP due to the presence of net foreign investment. So, it could be the case that in 2020 the United States had larger net foreign investment than did the United Kingdom. If that was true, then domestic investment in the United States might have been smaller than domestic investment in the United Kingdom, even though national saving was larger in the United States.

4.8

156

CHAPTER 14 | Macroeconomics in an Open Economy National saving now becomes:

Substituting the expression for Y into the above equation, we have:

14.5

The Effect of a Government Budget Deficit on Investment Learning Objective: Explain the effect of a government budget deficit on investment in an open economy.

Review Questions 5.1

National saving increases when the government runs a budget surplus unless private saving decreases by the amount of the budget surplus, which is unlikely. The twin deficits idea is that a government budget deficit will lead to a current account deficit. The twin deficits did not hold in Canada in the years before the COVID-19 recession, when government budget deficits fell and eventually became budget surpluses, while the current account deficit remained stable.

5.2

The exchange rate of the dollar for other currencies was high, which increased the foreign currency price of Canadian exports. As a result, Canadian exports declined.

Problems and Applications 5.3

a. Net foreign investment in Korea = national saving – domestic investment = 34.8 percent of GDP – 30.0 per cent of GDP = 4.8 percent of GDP. b. No, there is not enough information to make this conclusion. National saving, which was 34.8 percent of GDP, equals private saving plus public saving. To determine if the government was in a surplus or a deficit, we would need information on private saving.

5.4

High interest rates raise the foreign exchange value of a country’s currency, decreasing net exports and increasing current account deficits.

5.5

The United States is sometimes called the “world’s largest debtor” nation because, since the 1980s, the large net capital flows into the United States resulting from the large US current account deficits have resulted in foreign investors owning, as of the end of 2020, over $14 trillion more of US assets—such as stocks, bonds, and factories—than US investors own of foreign assets.

5.6

The willingness of foreign investors and companies to purchase financial and physical assets in the Canada leads to a Canadian financial account surplus. If Canada runs a financial account surplus, it must run a current account deficit.

5.7

a. In this context (stating that the financial account surplus “goes to finance an investment shortfall in the United States, especially government borrowing”), the editorial means a shortfall in US financial investment—that is, a shortfall in national saving, which is caused by government saving being negative as a result of a federal budget deficit. b. The editorial means that the financial capital from foreign investments could be used to finance US private investment instead of being used to finance the federal budget deficit. c. Possibly. The federal budget deficit could raise interest rates, which increases the foreign exchange value of the dollar, decreasing net exports and increasing the current account deficit. This is the Copyright © 2024 Pearson Canada Inc.

CHAPTER 14 | Macroeconomics in an Open Economy

157

twin deficits idea. Leaving aside the statistical discrepancy and the capital account, the current account plus the financial account equals zero, so an increase in the current account deficit increases the financial account surplus. From the perspective of the financial account, the higher US interest rates resulting from the federal budget deficit attract foreign investment into the United States, which increases the financial account surplus. 5.8

14.6

Every country poses a unique set of risks. Factors to consider include (1) foreign exchange rates and historic volatility of those exchange rates; (2) trade barriers; (3) political risks; (4) shipping costs or proximity to the customer base; (5) labour issues; and (6) environmental concerns.

Monetary Policy and Fiscal Policy in an Open Economy Learning Objective: Compare the effectiveness of monetary policy and fiscal policy in an open economy and in a closed economy.

Review Questions 6.1

A policy channel is a way in which monetary or fiscal policy affects the domestic economy. In an open economy, monetary or fiscal policy affects domestic spending and also the exchange rate and, therefore, net exports.

6.2

In an open economy, changes in interest rates that result from monetary policy will not only affect investment spending and consumer spending on durable goods but also net exports through changes in the exchange rate. For instance, lower interest rates from expansionary monetary policy will increase investment spending and consumer spending on durables and will decrease the exchange rate, which increases net exports.

6.3

Fiscal policy has a smaller effect in an open economy than in a closed economy because of a larger crowding out effect. In an open economy, through its effect on interest rates, fiscal policy affects the exchange rate and net exports. For example, higher interest rates as a result of an expansionary fiscal policy lead to an increase in the exchange rate and a decrease in net exports, thereby offsetting some of the effect of the expansionary fiscal policy.

Problems and Applications 6.4

An open economy is an economy that has interactions in trade and finance with other countries. Fiscal policy in Switzerland is likely to be less effective than it would be in a less open economy. The crowding out effect of an expansionary fiscal policy is typically higher in a more open economy where net exports represent a larger percentage of GDP.

6.5

a. For a closed economy, higher interest rates reduce domestic investment spending and purchases of consumer durables in the short run, which would cause real GDP to decline. b. For an open economy, higher interest rates reduce domestic investment spending and purchases of consumer durables, as they do in a closed economy. However, in an open economy, higher interest rates also raise the exchange rate between the dollar and foreign currencies. As a result, net exports will decrease; therefore, the decline in real GDP as a result of this contractionary monetary policy is larger in an open economy than in a closed economy. c. If the interest rates of the trading partners of Canada also rise, then the effect of the Bank of Canada’s policy on the foreign exchange rate will be reduced, and the effects of policy on real GDP will be closer to those of a closed economy.

158

CHAPTER 14 | Macroeconomics in an Open Economy

6.6

As the Canadian economy has become more open, monetary policy has become more effective and fiscal policy has become less effective.

6.7

In a closed economy, an expansionary fiscal policy directly increases aggregate demand, leading to increases in real GDP and the price level. An expansionary fiscal policy also results in crowding out as higher interest rates reduce domestic investment and purchases of consumer durables. In an open economy, an expansionary fiscal policy also directly results in an increase in aggregate demand and, therefore, increases in real GDP and the price level. However, in addition to lower domestic investment, higher interest rates in an open economy also lead to an increase in the country’s exchange rate with foreign currencies, which decreases net exports. The crowding out effect in an open economy is, therefore, larger than in a closed economy.

Real-Time Data Exercises Note: FRED and the Bank of Canada continue to update data. The solutions below contain the data available on the first quarter of 2021. D14.1 a. The value of the euro decreased from 1.5586 Canadian dollars per euro in December 2020 to 1.4462 Canadian dollars per euro in December 2021. The euro depreciated by 7.2116 percent against the Canadian dollar. b. The Canadian dollar appreciated in value against the euro because it took less dollars to purchase the same number of euros in December 2021 than it did in December 2020. D14.2 See the following graphs of the US dollar–euro exchange rate, the yen–US dollar exchange rate, and the Canadian dollar–US dollar exchange rate. Note that the US dollar–euro exchange rate has been converted to euros per dollar. The yen–US dollar exchange rate is yen per US dollar, and the Canadian dollar–US dollar exchange rate is Canadian dollars per US dollar.

CHAPTER 14 | Macroeconomics in an Open Economy

159

a. The euro reached its highest value in July 2008 at 1.58 US dollars per euro (or 0.63 euros per dollar). b. During the financial crisis of 2007–2009, by and large, the yen appreciated against the dollar as the exchange rate was above 110 yen per dollar at the beginning of the financial crisis and was about 96 yen per dollar at the end of the crisis. The yen did, however, depreciate against the dollar during the worst of the crisis in the fall of 2008. c. From January 2001 to May 2021, the dollar depreciated the most against the euro. The dollar went from 1.08 euros per US dollar in January 2001 to 0.82 euros per US dollar in May 2021, for a depreciation of 24 percent. Note that these exchange rates are expressed as euros per US dollar.

160

CHAPTER 14 | Macroeconomics in an Open Economy

Suggestions for Critical Thinking Exercises CT14.1 You would hope that between now and the time you convert your Canadian dollars into euros that the dollar appreciates so that you will have more for living expenses. If you have any euros left over after the semester, you would hope that the euro appreciated so you would be able to convert them into more dollars on your return to Canada. CT14.2 a. If you invest in Canada, you will have $100 000 × 1.05 = $105 000. If you invest in Japan, your $100 000 will be worth ¥120/$ × $100 000 = ¥12 000 000. After one year, your Japanese bond is worth ¥12 000 000 × 1.03 = ¥ 12 360 000. Converting it back to Canadian dollars will yield ¥12 360 000 × $1/¥120 = $ 103 000. b. If the exchange rate is expected to change to $1 = ¥110, your investment in Japan will now be worth ¥12 360 000 × $1/¥110 = $ 126 300. Because your return on your investment in Canada bonds will still be $105 000, it would be more profitable to invest in Japanese bonds. c. No. Investments are not based solely on interest rates but are also based on the expected appreciation or expected depreciation of the home or foreign currency. The example in this problem shows that investing in a country with a lower interest rate on government bonds is still more profitable than investing at home if the home currency is expected to depreciate by more than the interest rate difference between the bonds of the two countries.

Appendix Solutions | The Gold Standard and the Bretton Woods System Review Questions 14A.1 Under the gold standard, the exchange rate between two currencies was determined by the quantity of gold in each currency. The gold standard collapsed during the Great Depression because central banks wanted to fight the Depression with expansionary monetary policy, but under the gold standard central banks had only limited control of their countries’ money supplies. 14A.2 Under the Bretton Woods System of fixed exchange rates, the United States pledged to buy or sell gold at a fixed price of $35 per ounce, and the central banks of the member countries pledged to buy and sell their currencies at a fixed rate against the dollar. If a shortage or surplus of a country’s currency occurred at the fixed exchange rate (also known as the par exchange rate), the central bank of the member country would buy or sell dollars with their currency to maintain the fixed exchange rate. 14A.3 A devaluation is a reduction in a fixed exchange rate. A revaluation is an increase in a fixed exchange rate. 14A.4 Capital controls are limits on the flow of foreign exchange and financial investment across countries. 14A.5 The International Monetary Fund provided loans to central banks that were short of dollar reserves, oversaw the operation of the Bretton Woods system, and approved adjustments to fixed exchange rates.

CHAPTER 14 | Macroeconomics in an Open Economy

161

14A.6 Destabilizing speculation refers to actions by investors that make it more difficult to maintain a fixed exchange rate. Destabilizing speculation in 1971 involving the German mark led to the collapse of the Bretton Woods system. Investors became convinced in early 1971 that Germany would have to allow a revaluation of the mark against the dollar. Investors increased their demand for marks, which increased the shortage of marks. The West German government finally opted out of the fixed exchange-rate system and allowed the mark to float against the dollar.

Problems and Applications 14A.7 With the $4 = £1 exchange rate, you would buy gold in London for £1 per ounce and sell the gold in the New York for $5. You could then exchange $4 for £1 and have a $1 profit per ounce of gold. You could make an unlimited profit by buying gold in London and shipping it to New York. With the $6 = £1 exchange rate, you would buy gold in the United States for $5 per ounce and sell the gold in London for £1. You could then exchange £1 for $6 and have a $1 profit per ounce of gold. You could make an unlimited profit by buying gold in New York and shipping it to London. 14A.8 A discovery of new gold deposits would cause the money supply to increase. Unless the increase in the money supply was matched by an increase in output, the new gold discovery would lead to inflation, which would not be a desirable result. 14A.9 Countries on the gold standard during the Great Depression of the 1930s could not pursue monetary policies that were expansionary enough to counteract the severity of the downturn. 14A.10 Both the gold standard and the euro are fixed exchange rate systems. Under fixed exchange rate systems, countries are not free to pursue independent monetary policies and to allow their currencies to depreciate to stimulate their economies during economic downturns. 14A.11 The author was incorrect about what the United States abandoned in the 1970s. It was the Bretton Woods fixed exchange rate system that the United States abandoned rather than the gold standard, which the United States abandoned in 1933. Two problems led to the collapse of the Bretton Woods system. First, the total number of dollars held by foreign central banks had become much larger than the gold reserves of the United States. The basis of the Bretton Woods system was a credible promise by the United States to redeem dollars for gold if called on to do so by foreign central banks. Second, some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies, which would have raised the foreign currency prices of their countries’ exports. 14A.12 a. The gold standard did not allow countries to stimulate their economies by pursuing expansionary monetary policies that would have allowed for lower interest rates and the depreciation of their exchange rates. b. Fixed exchange rates can provide important advantages to businesses involved in international trade. When the exchange rate is fixed, business planning becomes much easier. For instance, businesses that export products abroad do not need to be concerned about an appreciation of their country’s currency raising the prices of their products abroad. 14A.13 a. By using the phrase “zealous money printing,” the writer of this column means that the Federal Reserve increased the money supply more at a rate that exceeded the rate of increase in US real GDP in the 1960s. Inflation results when a country’s money supply increases more rapidly than its rate of output.

162

CHAPTER 14 | Macroeconomics in an Open Economy b. With the United States pursuing zealous money printing, the theory of purchasing power parity implies that the underlying equilibrium exchange rates would get out of alignment if the other countries did not follow suit with similar inflationary monetary policies. Not wanting to incur higher inflation, some of the other countries, particularly West Germany, were reluctant to follow suit. Pressure mounted for a revaluation of their currencies at a higher exchange rate. Not wanting an increase in the foreign currency prices of their exports, countries resisted revaluation. c. Domestically, under the Bretton Woods system, the dollar was already fiat money because US residents could not redeem paper dollars for gold. Internationally, though, under the Bretton Woods system, foreign central banks could redeem dollars for gold. With the collapse of the Bretton Woods system, there was no longer any link between dollars and gold, either domestically or internationally. So, the dollar (and the other currencies involved in the Bretton Woods system) became complete fiat money.

14A.14 The Bretton Woods system broke down because countries were not able to maintain exchange rates that were either above or below equilibrium exchange rates; fixed exchange rates are difficult to maintain in the long run. By pegging their currencies to the dollar, East Asian countries were following a fixed exchange rate policy. 14A.15 For a country to leave its currency to the “whims of the markets” means that the currency floats with the exchange rate determined by demand and supply. A floating exchange rate makes doing business across countries more difficult, and large fluctuations in the exchange rate significantly affect the prices of a country’s exports and imports. Most European Union member countries eventually replaced their floating exchange rates by adopting the euro, a single currency. The adoption of the euro is equivalent to adopting a fixed exchange rate system within the euro zone.

Real-Time Data Exercises

Note: FRED continues to update data. The solutions below contain the data available on FRED for the first quarter of 2021. D14A. 1 a. Until mid-1971, the United States fixed the price of gold at $35 ounce, so it did not fluctuate much until the United States abandoned that policy. To keep the price of gold at $35, the US government bought and sold gold. b. It would be difficult to return to the gold standard since fixing the dollar price of gold would require constant market intervention to maintain the price. Notice how volatile gold prices are over that period of time. The same would be true for any other currency. In October 2021, the price of gold was about $1800 per ounce.