SOLUTIONS MANUAL for Foundations of MicroEconomics, 9e (Global Edition) By Robin Bade, Michael Parki by StudyGuide

SOLUTIONS MANUAL for Foundations of MicroEconomics, 9e (Global Edition) By Robin Bade, Michael Parkin

Getting Started

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

n Problems and Applications 1.

Provide three examples of scarcity that illustrate why even the 1,826 billionaires in the form world face scarcity. The 1,826 billionaires might want to be able to eat unlimited meals without gaining weight; live to be at least 140 years old and enjoy perfect health everyday; be able to wake up in San Francisco and go to sleep in Paris after spending no more than 3 hours on a plane. None of these wants can be fulfilled given the present state of technology and resources available.

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

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

•

Globalization has reduced African poverty. This entry is a macroeconomic topic because globalization is the result of choices made by billions of people rather than an individual or business. The government must cut its budget deficit. This entry is a macroeconomic topic because neither an individual nor a business makes decision to cut expenditures.

•

Apple sells 20 million iPhone 6 smartphones a month. This entry is a microeconomic topic because individuals and Apple make decision whether to buy or sell iPhones.

Part 1 . INTRODUCTION

Use the following information to work Problems 3 to 6. Jurassic World had world-wide box office receipts of $1.66 billion. The movie’s production budget was $150 million with additional marketing costs. A successful movie brings pleasure to millions, creates work for thousands, and makes a few people rich. 3. What contribution does a movie like Jurassic World make to coping with scarcity? When you buy a movie ticket, are you buying a good or a service? Scarcity still exists but the amount of entertainment available in the economy increases. Buying a ticket to watch a movie is buying a service. 4.

Who decides whether a movie is going to be a blockbuster? How do you think the creation of a blockbuster movie influences what, how, and for whom goods and services are produced? The audience decides whether a movie will be a blockbuster because the audience decides whether to attend the movie. The “what” question is affected in three ways: First, one good or service that is produced is the blockbuster movie. Second, the people whose incomes are higher as a result of the blockbuster then buy an assortment of goods and services and so this assortment of goods and services is produced. Finally, the “what” question is influenced if the movie leads to spinoff goods (such as toys) or creates a series of sequels or similar films. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who receive the profits of a blockbuster movie have higher incomes and so more goods and services are produced for them.

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

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

Chapter 1 . Getting Started

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

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

Dina, Mina, and Tina are deciding on the Birthday Party of their close friend Gina. Dina hates balloons, is happy to get birthday cupcakes, but prefers a big birthday cake. Mina prefers birthday cupcakes, has no problem with a big birthday cake, she also likes to have balloons filling the place. Cupcakes destroy the mood of Tina, she prefers to surprise Gina with balloons, but she's equally satisfied to buy a big birthday cake instead. They decide to buy a big birthday cake. Is this decision rational? What is the opportunity cost of the cake for each of them? What is the benefit that each gets? Their decision was rational because all of them considered the costs and benefits of getting the cake and none of them were opposed to it. Dina was opposed to balloons, Mina was opposed to nothing, and Tina didn't want cupcakes. The opportunity cost of the cake for both Dina and Mina is buying cupcakes; for Tina, it is getting balloons. The benefit each gets is the happiness in celebrating Gina's birthday, the satisfaction from sharing the cake, and the strengthening of their friendship.

Label each of the entries in List 2 as a positive or a normative statement.  Fixed-income receivers get hurt by inflation. Fixed-income receivers get hurt by inflation. Positive. 

World population is growing continuously. World population is growing continuously. Positive.

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Way too many companies are outsourcing production to China. Way too many companies are outsourcing production to China. Normative.

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If tax on cigarettes is increased, smoking decreases. If the tax on cigarettes is increased, smoking decreases. Positive.

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Part 1 . INTRODUCTION

Protecting the environment should be the number one concern of world leaders. Normative. Use the following information to work Problems 10 to 12. Italy is giving away over 100 castles for free – there’s only one catch Under a new scheme backed by the Ministry of Tourism, Italy is giving away castles, monasteries, and farmhouses for free to investors for 9 years, with the option to extend for an additional 9 years. The catch is that investors should transform these sites into tourist attractions. Source: CNBC, May 18, 2017 10. With Italy giving away castles for free, explain what is free and what is scarce. As numerous potential investors start applying and submitting proposals of their plans, the offered sites are scarce. The demand for them would be higher than their actual number: 103 sites. Even though the word "free" is used, the project is not free because investors will have to put in resources and time to accomplish the objective of transforming these sites and bringing in tourists. 11. What’s the Italian government’s incentive to give away these buildings for free? Was this decision made in self-interest or in the social interest? Explain. The goal of the government was to breathe new life into these lifeless, offthe-tourist-map places. The government's self-interest reverts to the social interest of the country as a whole in driving in tourists and causing economic activity in dormant parts of the country. 12. How do the potential investors benefit from this scheme? Potential investors benefit from profits or at least a portion of profits because they will have the rights to the property for 9 years, which can be extended to 18. Even without the extension, it would be a huge entrepreneurial leap in their record if their project is successful. 13. Read Eye on the Benefit and Cost of School on p. XX. When deciding about the offered scholarship, if Clayton Kershaw was guaranteed that he’d be made coach of the Dodgers once he graduates, a position that would earn him $60 million a year, would he have accepted the scholarship or would he have immediately signed with the Dodgers? Given this new information, the right decision would be to accept the scholarship. With this new offer, the benefit of pursuing his education became bigger than the benefit of immediately signing with the Dodgers. If he signs with the Dodgers, the opportunity cost would be huge, but he would be giving up a much higher salary in the future, plus the education he would earn.

Chapter 1 . Getting Started

 Additional Problems and Applications 1.

Read Eye on the Benefit and Cost of School on p. 12 and explain which of the following items are components of the opportunity cost of being a full-time college student who lives at home. The things that the student would have bought with  A higher income The items the student would have purchased with the higher income he or she would have earned if he or she was not a full-time student are an opportunity cost of being a full-time student. 

Expenditure on tuition The cost of tuition is part of the opportunity cost of being a full-time student because this expense is paid only because the person is a student.

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



The income a student will earn after graduating The income earned after graduation is not an opportunity cost of being a student. Think about the following news items and label each as involving a what, how, or for whom question: Today, most stores use computers to keep their inventory records, whereas 20 years ago most stores used paper records. Stores using computers for inventory records today versus paper 20 years ago answers the how question.

 



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

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An increase in the gas tax pays for low-cost public transit. Building a low-cost public transit system answers a what question. Because not everyone will use the public transportation equally nor will everyone pay the same amount of taxes, there also is a for whom aspect of the headline.

The headlines in List 1 are from an imaginary newspaper. Classify each headline as a signal that the news article is about a microeconomic topic or a macroeconomic topic. Explain your answers. © 2023 Pearson Education, Ltd.

Part 1 . INTRODUCTION

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XYZ Bank on Brink of Bankruptcy XYZ Bank on Brink of Bankruptcy; this entry is a microeconomic topic because it concerns the financial situation of a specific company, Bank XYZ.



Brain Drain hits Firefly Island Brain Drain hits Firefly Island; this entry is a macroeconomic topic because it deals with brain drain, a situation when the well-educated leave the country for better job opportunities abroad, a concern for the whole economy.

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Good Crop, Wheat Price Falls Good Crop, Wheat Price Falls; this entry is a microeconomic topic because it is about the price of one good in particular, wheat, not the overall price level in the economy.

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Inflation Scare Again? Inflation Scare Again?; this entry is a macroeconomic topic because inflation affects the whole economy, it ims an increase in the level of prices in general.

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

The following list gives examples of incentives that government policies use to influence behavior: (a) speed humps; (b) school immunization programs; (c) increased taxes on cigarettes; (d) rebates for installing energy efficient windows. Complete the table by classifying each item in the list as a "carrot" incentive or a "stick" incentive, and as a "monetary" incentive or "non-monetary" incentive.

Chapter 1 . Getting Started

(a)

Speed humps are non-monetary sticks because they represent an incentive to discourage motorists from speeding, yet they do not involve monetary payments.

(b)

School immunization programs are examples of non-monetary carrots given that the incentive is a benefit to students and does not involve the payment of money.

(c)

Increased taxes on cigarettes is an example of a monetary stick incentive because it discourages the consumption of cigarettes involving an out-of-pocket payment per unit purchased.

(d)

Rebates for installing energy-efficient windows involves making monetary payments to people who install energy-efficient windows in order to encourage such an action; therefore, it is a monetary carrot incentive.

Think about each of the items in List 2 and explain how they affect incentives and might change the choices people make.  Terrorists announce that the next attacks will hit the subway metro system in Europe. Such news will affect European countries. Residents’ incentives to take the subway will decrease: some will turn to other types of public transportation, many will start using their cars to go to work, and some others might decide to move out of the major cities. It would also increase government incentives to increase security measures.  A rare disease kills huge numbers of cows which leads to the price of milk skyrocketing. The rise in the price of milk affects consumers’ incentives to buy milk and dairy products in general. Restaurants will be affected as well, as the dairy-based ingredients of their dishes now cost more, so it would be an incentive for them to produce less. Consumers and restaurants will start substituting plant-based milks and vegan recipes for milk and regular dairy products.  The price of DSLR cameras plummets to the €100 range. The fall in the price of DSLR cameras increases consumers’ incentives to buy cameras and decreases producers’ incentives to produce cameras. More consumers will buy new DSLR cameras, but producers will focus on the production of more professional cameras instead.  Studies find that lack of physical activity increases the risk of cancer. Such findings will increase people’s incentives to join gyms and others to purchase exercise and fitness equipment to exercise at home. This increased demand on gym memberships and sport equipment will lead to higher prices, which in turn will increase the incentives of suppliers of such services and products to offer more.

Part 1 . INTRODUCTION

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

The following headlines are examples of economics being used as a tool to make a decision. 1. More people choose home ownership over renting 2. Laws tightened to limit urban sprawl as housing market keeps booming. 3. Lower taxes for seniors encourages later retirement Which statements are examples of a tool used by a person, a business, and a government? • Statement #1 is an example of people using economics as a tool to make a home ownership versus renting decision. • Statement #2 is an example of a government using economics as a tool to make a decision as only governments, not individuals or businesses, can change laws. • Statement #3 is an example of a government using economics as a tool to make a decision. This headline pinpoints the government changing taxation policy in order to encourage seniors to retire later.

Use the following news clip to work Problems 9 to 12. To vaccinate or not debate: Italy is succumbing to eradicable diseases The vaccination debate is taking a toll on Italy after a recent outbreak of measles in March 2017. Vaccination is on the decrease in Italy after links were made to autism in a study. Opponents to vaccination do not trust the government and the pharmaceutical industry, whereas proponents are afraid of dire health consequences if opting out of vaccination becomes a legal option. Source: Financial Times, April 19, 2017 8. What are the benefits of making vaccination compulsory for all? Who benefits: citizens, the government, or pharmaceutical companies? If vaccination is compulsory, citizens benefit in terms of health and avoiding illnesses that might be deadly, the government benefits from the decrease in the cost of caring for the ill children, and pharmaceutical © 2023 Pearson Education, Ltd.

Chapter 1 . Getting Started

companies benefit from the profit they would make selling vaccines. 9. What are the costs of opting not to vaccinate children? Who bears these costs: citizens or the government, or both the citizens and the government? The cost of not vaccinating is the risk of having long-eradicated illnesses return. Both parents and the government share those costs because parents will have to deal with sick children, parents of vaccinated kids will deal with infectious diseases, and the government will have to care about the healthcare costs of the illnesses returning. 10. Explain why someone would oppose vaccination when its benefits outweighs its costs? For people opposing vaccination, governments and pharmaceuticals are in favor of vaccination because they are following their own selfinterest—making profits. Even after the discrediting of the study linking autism to vaccination, they still hold on to this study, not realizing that the social benefits of vaccination far outweigh its costs. Conspiracy theories might be proven correct one day, but this particular theory linking autism to vaccination has still not been proved. 11. Does vaccination have an opportunity cost? Explain from the point of view of opponents and proponents of vaccination. For opponents of vaccination, the opportunity cost of vaccination is giving up a healthy child to the risk of autism. For proponents of vaccination, the opportunity cost of vaccination is the financial cost of the vaccination itself and maybe a couple of sick days when the effect of the vaccine starts to show itself.

Part 1 . INTRODUCTION

 Multiple Choice Quiz 1.

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

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

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

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

Chapter 1 . Getting Started

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

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

The scientific method uses models to . A. clarify normative disagreements B. avoid the need to study real questions C. replicate all the features of the real world D. focus on those features of reality assumed relevant for understanding a cause and effect relationship Answer: D Answer D uses the definition of an economic model from Checkpoint 1.3. 8.

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

1 1

Chapter

Appendix: Making and Using Graphs

ANSWERS TO APPENDIX CHECKPOINT

 Problems and Applications 1.

Draw a scatter diagram to show the relationship between quantities sold of compact discs and singles downloads. Describe the relationship.

The relationship between the quantities of compact discs sold and singles downloaded is negative, except between the years 2012 and 2014, where it becomes positive. It shows that as the years progress, consumers decreased purchases of compact disks and downloaded more singles instead, except from 2012 to 2014, where sales and downloads both decreased.

Part 1 . INTRODUCTION

Draw a time-series graph of the quantity of singles downloads. Say in which year or years the quantity of singles downloaded (a) was highest, (b) was lowest, (c) increased the most, and (d) increased the least. If the data show a trend, describe it. Highest Singles Downloads: 2012 Lowest Singles Downloads: 2004 Increased the most: The increase from year 2004 to 2006 was 447 single downloads, and from year 2006 to 2008 also 447 downloads. These were the highest increases in downloads. Increased the least: From 2008 to 2010, the increase was the lowest— 129 downloads.

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

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

Appendix 1 . Making and Using Graphs

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

Balloon rides (number per day) 50F

70F

90F

32 27 18 10

50 40 32 27

40 32 27 18

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

Part 1 . INTRODUCTION

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

2007

500

2009

297

2011

241

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

2013

174

2015

117

2017

125

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Appendix 1 . Making and Using Graphs

Draw a time-series graph of the quantity of music videos sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) decreased the most, and (d) decreased the least. If the data show a trend, describe it. Figure A1.6 illustrates the time series of music videos sold using the data from the spreadsheet. a. b. c.

The quantity sold was the highest in 2007. The quantity sold was the lowest in 2017. The quantity sold decreased the most between 2007 and 2009, when it decreased by 16 million. d. The quantity sold decreased the least between 2013 and 2015, when it decreased by 1 million. There is a downward trend in the quantity of music videos sold. Use the following data on the relationship between two variables x and y to work Problems 3 and 4. x

5 16

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

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

Part 1 . INTRODUCTION

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

Hot chocolate (cups per week) 50F

70F

90F

40 30 20 10

30 20 10 0

20 10 0 0

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

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

 Problems and Applications

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

Chapter

Part 1 . INTRODUCTION

Which factor of production earns the highest percentage of total U.S. income? Define that factor of production. What is the income earned by this factor of production called? Labor earns by far the largest percentage of total U.S. income, 68 percent of total income in 2017. Labor consists of the work time and the work effort that people devote to producing goods and services. The income earned by labor is a wage.

5. Lebanon has been suffering from brain drain, which is the emigration of its highly-educated labor force, for a long period of time due to lack of job opportunities and political insecurity. Which factor of production is decreasing in this country? Brain drain is when highly educated and trained people leave their country for a better life or better job opportunities abroad. Therefore, Lebanon is losing its human capital. 6.

Define the factor of production called capital. Give three examples of capital, different from those in the chapter. Distinguish between the factor of production capital and financial capital. Capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that businesses now use to produce goods and services. Capital includes railroad engines and cars, servers, and ATMs. The factor of production “capital” is the actual good itself; “financial capital,” such as stocks and bonds, are the funds that provide businesses with their financial resources which can be used to acquire capital goods. 7. The Australian government supports its small businesses and startups to a great extent. They provide numerous grants ranging from the Entrepreneurs' Programme and the R&D tax Incentive to the Export Market Development Grant scheme. Source: smartcompany.com.au, October Explain how you would expect these grants and incentives to influence what, how, and for whom goods and services are produced in Australia. The what question would depend on the nature of work of these small businesses and startups; by being able to increase their investments, more of their products and services will be produced. By receiving grants and incentives, small businesses and startups can enhance their production processes and technology used, which answers the how question. Entrepreneurs and owners of the small businesses would have more profits as a result of this government support, so they would be able to buy more of the goods and services produced—this would answer the whom question.

Chapter 2 . The U.S. and Global Economies

In the circular flow model, explain the real and/or money flow in which each item in List 1 belongs. Illustrate your answers on a circular flow diagram.  The government pays unemployment benefits to the unemployed. This payment is a type of transfer, which is a money payment from the government to households. It flows from the government to households.  A firm pays its business taxes. The firm’s business tax payments fall under the category of money flow from firms to the government.  Your friend buys a T-shirt from the mall. In Figure 2.1, your friend’s expenditure is a money flow represented by the black arrow from households to firms through the goods market. The T-shirt is a flow from firms through the goods market to households, represented by the grey arrow.  The government in the Netherlands decides to build another animal bridge for wildlife crossing. The building of the animal bridge by the government represents a flow from construction firms through the goods market to the government. The payment made by the government for the construction of the bridge is represented by the black arrow going from the government to firms through the goods market.  You take a summer job at your local library. The student working at Kinko is a factor of production, so the flow is a flow of the services of the factor of production from households to the factor markets, labeled as c in the figure. Why you can get a free college education in Germany but not in CaliforniaEven American students can get a free college degree in Germany, where

Part 1 . INTRODUCTION

high taxes pay for colleges. Despite college being free, fewer students in Germany earn college degrees than in the United States and more enter vocational apprenticeships. Source: Los Angeles Times, October 29, 2015 If California adopted the German model of higher education, how would that change for whom goods and services are produced? The students in California who otherwise would not have gone to college but who take advantage of the “free” college education will have higher incomes than otherwise. Consequently, more goods and services will be produced for them. The taxpayers who must pay the taxes necessary to fund these college educations will have less income to spend on goods and services, so fewer goods and services will be produced for them. 10. Read Eye on the Dreamliner on p. 43 and then answer the following questions:  How many firms are involved in the production of the Dreamliner and how many are identified in the figure on p. 43? Over 400 firms are involved in the production of the Dreamliner. Only 15 of them are identified in the figure.  Is the Dreamliner a capital good or a consumption good? Explain why? The Dreamliner is a capital good because it will be used to produce services (airline travel) throughout many future years.  State the factors of production that make the Dreamliner and provide an example of each. All the factors of production—land, labor, capital, and entrepreneurship—are used to make the Dreamliner. The copper used for wiring is an example of the land used; the engineer who helped design the landing gear is an example of labor; the huge cranes that lift the various pieces of the Dreamliner to assemble them is an example of capital; and the creative and imaginative input of Boeing’s top managers who organize the resources used to produce the Dreamliner exemplify entrepreneurship.  Explain how the production of the Dreamliner influences what, how, and for whom, goods and services are produced. Dreamliner influences “what” goods and services are produced by creating a demand for components manufactured around the world. It influences “how: goods are produced because Boeing and the other 400 firms all determine the best way to produce each particular part of the Dreamliner. It influences “for whom” because factors of production employed to make the Dreamliner receive income from this

Chapter 2 . The U.S. and Global Economies

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production, thereby increasing the quantity of goods and services they can purchase. Use a graph to show where in the circular flow model of the global economy the flows of the components listed on p. 43 appear and where the sales of Dreamliners appear. Except for the components built in the United States, spending on the other components appear in the flow of expenditure on U.S. imports. Sales of Dreamliners appear in the flow of expenditure on U.S. exports.

Part 1 . INTRODUCTION

 Additional Problems and Applications 1.

Read Eye on the Dreamliner on p. 43 and then answer the following questions:  Why doesn’t Boeing manufacture all the components of the Dreamliner at its own factory in the United States? Boeing wants to manufacture the Dreamliner at the lowest possible cost. It would be more expensive for Boeing to manufacture Dreamliners at its own factory in the United States because Boeing does not have the expertise possessed by its subcontractors and because the wages Boeing pays U.S. workers exceed the wages its subcontractors pays their workers.  Describe some of the changes in what, how, and for whom, that would occur if Boeing manufactured all the components of the Dreamliner at its own factories in the United States. If Boeing manufactured all the components of the Dreamliner at its own factories in the United States, more components would be produced in the United States and more capital would have been used in their production. U.S. workers and investors would have received higher incomes but the Dreamliner would cost more to produce so Boeing would have earned a lower profit.  State some of the tradeoffs that Boeing faces in making the Dreamliner. Boeing faced a huge number of tradeoffs. For example, when designing the plane, Boeing’s engineers had to make decisions about fuel economy and passenger load. Increasing the passenger load decreased fuel economy, so the engineers traded passenger load for fuel economy. Another example revolves around the construction of the Dreamliner. Boeing could have constructed the plane using just a few companies but instead it used over 400. Boeing was trading off the simplicity of dealing with just a handful of companies for the increased specialization by dealing with many specialized companies.  Why might Boeing’s decisions in making the Dreamliner be in the social interest? Building the Dreamliner itself advances the social interest because it increases the quantity of comfortable, rapid transportation. The amount of high-quality transportation available in the economy increases, which benefits society. The decisions in making the Dreamliner advance the social interest because they were designed to make the Dreamliner at low cost and thereby avoid wasting resources.

Chapter 2 . The U.S. and Global Economies

The global economy has seen a fall in the number of landlines and rapid growth in the number of smartphones. In the United States, 51 percent of households have no landline and 95 percent have a smartphone. In Africa, 70 percent have a smartphone. Describe the changes in what, how, and for whom telecommunication services are produced in the global economy. What: As the number of cell phone users increases, the global economy has been producing more cell phone telecommunication services. More cell phones are produced, fewer land phones are produced, and presumably more cell phone frequencies are used. How: More telecommunication services are being produced using cell phones rather than fixed-line phones. For whom: While the amount of telecommunication services has been rising throughout the world, it has been increasing most rapidly in Africa. So more telecommunication services are being produced for residents of Africa as well as for residents in the rest of the world.

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

Part 1 . INTRODUCTION

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

China’s race to the top in income inequality China has lifted millions out of poverty, but inequality has also increased. In 2017, 8 million students graduated from Chinese universities, 10 times more than two decades ago and double the number at U.S. universities. But the gap in graduation rates between rural to urban areas and richer and poorer people widened. Source: Bloomberg, September 23, 2018 Explain how the distribution of personal income in China can be getting more unequal even though the poorest are getting richer. The distribution of income in China can be getting more unequal even when the poorest are getting richer if the richest are getting richer even faster. If the rich are getting richer faster, the fraction of the nation’s total income received by the poorest 20 percent falls, which makes the personal distribution of income more unequal.

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

Chapter 2 . The U.S. and Global Economies

On a graph of the circular flow model, indicate in which real or money flow each entry in List 2 belongs. Explain how you would expect these grants and incentives to influence what, how, and for whom goods and services are produced in Australia.  General Motors pays its workers’ wages. General Motors wage payment is a money flow that is a payment for use of the services of a factor of production. It flows out of the factor market to households (it flowed into the factor market from General Motors, a firm). In Figure 2.3, the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors. The flow of wage payments to households is labeled a in the figure in Figure 2.3.

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IBM pays a dividend to its stockholders. IBM’s dividend payment is a money flow that is a payment for use of the services of a factor of production. It flows out of the factor market to households (it flowed into the factor market from IBM, a firm). The flow to households is labeled b in the figure. You buy your groceries. Your purchase of groceries represents a money flow from households to the goods market, labeled c in the figure. Chrysler buys robots. The robots are factors of production, so the flow is the services from these factors of production from the factor markets to firms, labeled d in the figure. Southwest rents some aircraft. The aircraft are factors of production, so the flow is the services from these factors of production from the factor markets to firms, labeled e in the figure. Nike pays Roger Federer for promoting its sports shoes. Roger Federer is a factor of production, so the flow is a money flow from the factor markets to households in exchange for Mr. Federer’s services of promoting the sports shoes. The flow is labeled f in the figure.

Part 1 . INTRODUCTION

10. Led by China, a new billionaire is created in Asia every other day Billionaire wealth in Asia increased 17 percent to $6 trillion in 2016. Led by China, the number of the region’s billionaires surpassed the United States for the first time. Source: The Straits Times, October 26, 2017 How is the personal distribution of income in Asia changing? If the number of billionaires is growing more rapidly than the number of other income groups, it will be the case that the personal distribution of income in Asia is becoming less equally distributed.

Chapter 2 . The U.S. and Global Economies

 Multiple Choice Quiz 1.

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

Which of the following statements about U.S. production is correct? A. Construction accounts for a larger percentage of total production than does manufacturing. B. Real estate services account for 14.5 percent of the value of total production, larger than any other item of services or goods. C. Consumption goods and services represent 78.5 percent of U.S. production by value and that percentage doesn’t fluctuate much. D. The manufacture of goods represents more than 50 percent of total production. Answer: C Answer C is correct as the data on page 34 show.

Which of the following is a factor of production? A. Stocks and bonds bought by a Japanese citizen. B. A bank loan given to the owner of the small shop in your street. C. Coal extracted from mines in China. D. Amount of money deposited in a savings account by a British citizen. Answer: C Answer C is correct. Stocks, bank loans, and savings accounts are not factors of productions. However, coal is a natural resource that is used in production, so option C is the correct answer.

What is human capital? A. A fruit picker B. Unskilled labor C. Your professor’s knowledge of the economy D. An auto assembly line robot Answer: C Answer C uses the definition of human capital on page 37.

Part 1 . INTRODUCTION

Which of the following statements is correct? A. Labor earns wages and entrepreneurship earns bonuses. B. Land earns interest and capital earns rent. C. Entrepreneurship earns interest and capital earns profit. D. Capital earns interest and labor earns wages. Answer: D Page 39 shows that answer D is correct.

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

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

The Economic Problem

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

Problems and Applications Use the following information to work Problems 1 to 4. The World Bank is backing the modernization of brick kilns towards more efficient and cleaner ones in Bangladesh. Traditional kilns, operated seasonally, produced an estimated 10 million tons of CO2 and other pollutants killing the environment and causing health problems to workers and citizens. Thanks to the World Bank backed technology, Hybrid Hoffman Kiln, new kilns produced 15 million bricks per year instead of 4 million produced by traditional kilns but they cost 15 times more. CO2 emissions are decreased by 75,000 tons per year, and full-time, less hard work is provided for laborers as mechanization increased. The challenge is mainly the cost: $3 billion are needed to construct enough new kilns to replace all traditional ones in terms of output. However, Bangladesh will be able to sell the certified carbon credits (CERs) resulting from reduced CO2 emissions to the World Bank; so far credits for 67,000 tons of CO2 were issued. Source: worldbank.org, July 20, 2016 1.

Would Hybrid Hoffman Kilns achieve production efficiency? As the news clip states that the modern brick kilns are more productive, we can safely assume that higher efficiency can be achieved. Use a PPF showing the tradeoff between producing bricks and clean air. Production efficiency requires producing on the PPF, so gaining more clean air results in reducing the number of bricks produced. The PPF using traditional kilns resulted in a given curve and the new technology of HHK kilns resulted in a rightward shift of the PPF; hence, productive efficiency has increased.

Is the price of the 67,000 CERs that Bangladesh received from the World Bank part of the opportunity cost of the HHK project kilns? The price of the 67,000 CERs received by Bangladesh for reducing CO2 emissions is part of the opportunity cost of not introducing the new technology to the kiln industry. If Bangladesh doesn’t adopt the new HHK technology, it would lose the © 2023 Pearson Education, Ltd.

opportunity to reduce CO2 emissions and decrease the value of the CERs it could sell to the World Bank. 3.

As per the news clip, new kilns cost 15 times more than traditional kilns. Explain if this cost is part of the opportunity cost of not implementing the modernization. If not, what is the corresponding opportunity cost? If Bangladesh does not implement the modernization, it wouldn’t incur the cost of the new kilns, which is 15 times the cost of the traditional ones. So, this cost is not the opportunity cost of not modernizing the kilns. The opportunity cost of not implementing the modernization includes losing the opportunity to decrease CO2 emission and benefitting from the value of the 67,000 CERs plus the value of the extra output that would be lost (in the case of those kilns already replaced, the value lost would be the value of 15 – 4 = 11 million bricks per year) and the sacrifice of the easier life and better work conditions provided for those working in the new kilns. Use the following information to work Problems 4 to 6.Is a cure for Aids within reach? More than 50 years after one of the most devastating viruses to affect man- kind, HIV remains a stubborn adversary. Treatment has improved dramatically over the past 20 years and now, a cure could be in sight. Source: The Guardian, November 30, 2018

Is the $3 billion cost part of the opportunity cost of implementing the HHK project? The $3 billion is part of the opportunity cost of implementing the kiln-modernization project because it is the actual cost of the process of changing the technology used and constructing new kilns.

How does the opportunity cost of treating HIV/AIDS changes as the number of casestreated increases with no change in technology? With no change in technology, moving along a PPF as the number of cases treated rises the opportunity cost of treating a case increases.

How has the opportunity cost of treating HIV/AIDS changed as the technology for treating it has advanced? With advances in technology in HIV/AIDS treatments, along the New PPF resources are more productive and fewer other goods and services must be given up to increase production of HIV/AIDS treatments. So the opportunity cost of producing HIV/AIDS treatments decreases. 7.

Explain how the following events influence U.S. production possibilities:  Some retail workers are re-employed building dams and wind farms. When these former retail workers are re-employed at their new occupations, more dams and wind farms are produced and fewer retail services are produced. The opportunity cost of the increased numbers © 2023 Pearson Education, Ltd.

of dams and wind farms is the forgone production of retail services. There is a movement along the PPF.  More people take early retirement. As more people retire, the quantity of labor available in the economy shrinks. As a result, the nation’s PPF shifts inward.  Drought devastates California’s economy. The nation’s PPF shifts inward as a result of the drought. The drought decreases the amount of productive land, thereby decreasing production of agricultural products and shifting the PPF inward Use the following information to work Problems 8 and 9. Figure 3.3 (on the next page) shows Tom’s production possibilities and Figure 3.4 (on the next page) shows Abby’s production possibilities. Tom uses all hisresources and produces 2 rackets and 20 balls an hour. Abby uses all her resources and produces 2 rackets and 40 balls an hour. 8.

What is Tom’s opportunity cost of producing a racket? What is Abby’s opportunity cost of a racket? Who has a comparative advantage in producing rackets? Who has a comparative advantage in producing balls? If Tom increases his production by 1 racket, he forgoes 10 balls. So his opportunity cost of 1 racket is 10 balls  1 racket, or 10 balls per racket.

If Abby increases her production by 1 racket, she forgoes 20 balls. So her opportunity cost of 1 racket is 20 balls  1 racket, or 20 balls per racket. Tom has the comparative advantage in producing rackets. Tom’s opportunity cost of a racket is 10 balls per racket and Abby’s opportunity cost of a racket is 20 balls per racket. Abby has © 2023 Pearson Education, Ltd.

the comparative advantage in producing balls. Tom’s opportunity cost of a ball is 0.10 rackets per ball and Abby’s opportunity cost of a ball is 0.05 rackets per ball. Use the following information to work Problems 9 to 11. Cheap broadband’s a winner Inexpensive broadband access has created a new generation of television producers and the Internet is their native medium. Source: The New York Times, December 2, 2007 9. How has inexpensive broadband changed the production possibilities of video entertainment and other goods and services? Inexpensive broadband means that the production of video entertainment increases when all available resources are used for this purpose. It does not change the production of other goods and services when all available resources are used for that purpose. 10. Sketch a PPF curve with video entertainment on the xaxis and other goods and services before broadband on the y-axis. As illustrated in Figure 3.5 by the production possibilities frontier labeled “Initial PPF,” the PPF has video entertainment on one axis and other goods and services on the other. The PPF is bowed outward as a conventional PPF. 11. Explain how the arrival of inexpensive broadband has changed the PPF. The arrival of inexpensive broadband shifts the PPF outward as shown by the change from the initial PPF to the new PPF in Figure 3.5. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

 Additional Problems and Applications Use the following information to work Problems 1 to 4. Representatives Waxman of California and Markey of Massachusetts proposed a law to limit greenhouse gas emissions from electricity generation and require electricity producers to generate a minimum percentage of power using renewable fuels, with some emission rights to be auctioned. The Congressional Budget Office estimated that the government would receive $846 billion from auctions and would spend $821 billion on incentive programs and compensation for higher energy prices. Electricity producers would spend $208 million a year to comply with the new rules. (Think of these dollar amounts as dollars’ worth of other goods and services.) 1.

Would the Waxman-Markey law achieve production efficiency? Production efficiency requires producing on the PPF. Use a PPF showing the tradeoff between electricity and clean air. Production efficiency requires producing on the PPF so that gaining more clean air means giving up some electricity. Before the new law, production might have been on the PPF if the producers had used the most efficient technologies and taken account of the pollution they created. After the law is in place, production might be inside the PPF if the law requires more production of energy from renewable sources than is production efficient.

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

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

Is the $208 million that electricity producers will spend to comply with the new rules part of the opportunity cost of producing electricity? The electricity producers will spend $208 million on other goods and services to comply with the law. These goods and services had other alternative uses that are now foregone, so this expenditure is part of the opportunity cost of producing electricity.

The people of Foodland have 40 hours of labor a day to bake pizza and bread. The table shows the maximum quantity of either pizza or bread that Foodland can bake with different quantities of labor. Can Foodland produce 30 pizzas and 30 loaves of bread a day? If it can, is this

Labor

Pizzas

0 10 20 30 40

0 30 50 60 65

Bread (loaves) or or or or or

0 10 20 30 40

output efficient, do the people of Foodland face a tradeoff, and what isthe opportunity cost of producing an additional pizza? Producing 30 pizzas and 30 loaves of bread is attainable and efficient. There is a tradeoff because the nation is operating on its production possibilities frontier. As a result, if the production of pizza increases, less bread can be produced and if the production of bread increases, less pizza can be produced. For the nation to produce 20 more pizzas requires 10 more hours of labor devoted to making pizza, which means 10 fewer hours devoted to making bread. Foodland gives up 10 loaves of bread. The opportunity cost of another pizza equals the loaves of bread forgone, 10 loaves, divided by the pizzas obtained, 20 pizzas, or 10 loaves of bread  20 pizzas, or 1/2 of a loaf of bread per pizza. Chicken Use the table, which shows a farm’s production Soybean (pounds possibilities, to work Problems 6 and 7. (bushels per year) per year) 6. If the farm uses its resources efficiently, what is the opportunity cost of an increase in chicken production from 300 pounds to 500 pounds a year? Explain your answer.

500 400 200 0

and and and and

If the farm expands chicken production from 300 pounds to 500 pounds, soybean production decreases from 400 to 200 bushels. The opportunity cost of the additional 200 pounds of chicken is 200 bushels of soybean, or 1 bushel of soybeans per pound of chicken. 7.

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

In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. Who has a comparative advantage in producing caps? If Sue and Tessa specialize and trade, who will gain? Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of pro© 2023 Pearson Education, Ltd.

0 300 500 550

ducing one cap is (4 jackets) ÷ (40 caps) or 0.1 jackets per cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets) ÷ (80 caps) or 0.05 jackets per cap. Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps. If Tessa specializes in caps and Sue specializes in jackets, both Sue and Tessa gain from trade. For instance, suppose they settle upon a price of 1 jacket for 15 caps. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket) ÷ (15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa alsogains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap. Use the following opinion to work Problems 9 to 11.Free Internet? Everyone should have free Internet access to education, news, jobs, and more. 9.

Explain how Internet access has changed the production possibilities and the opportunity cost of producing education and news. Internet access is a technological advance that has increased the production possibilities of all goods and services. The opportunity cost of producing more education and news is the quantity of other goods and services that must be given up to get an additional unit of education and news. If Internet access expands the production possibilities of education and news by more than it expands the production possibilities of goods and services, fewer other goods and services must be given up to produce an additional unit of education and news. The opportunity cost of producing more education and news decreases.

10. Sketch a PPF with education and news on the x-axis and other goods and services on the yaxis before and after the Internet. The PPFs in Figure 3.5 have the conventional outward bowed shape. The figure shows that the introduction of the Internet shifted the production possibilities frontier outward from the PPF labeled “Initial PPF,” to the PPF labelled “New PPF.” The illustrated PPF assumes that effect on education and news is larger than the effect on other goods and services.

11. Explain why it is not possible for everyone to have free Internet access to education, news, jobs, and more. Providing Internet access is not free because it takes resources. But the opportunity cost of Internet service increases as more people gain access, so the opportunity cost of giving everyone “free” access to the Internet would be extremely high, probably much higher than society is willing to pay.

 Multiple Choice Quiz 1.

The table shows the production possibilFish ities of an island community. Choose the Possibility (pounds) best statement. A 0 B 1 A. This community has enough reC 2 sources to produce 2 pounds of fish D 3 and 36 pounds of berries. E 4 B. This community cannot produce 2 F 5 pounds of fish and 36 pounds of berries because this combination is inefficient.

Berries (pounds) and and and and and and

C. This community will waste resources if it produces 2 pounds of fish and 22 pounds of berries. D. This community can produce 2 pounds of fish and 30 pounds of berries but this combination is inefficient. Answer: C The economy is wasting resources because if it produces 2 pounds of fish, it can also produce 30 pounds of berries (which is more than the 22 pounds it is producing), and if it produces 22 pounds of berries, it can also produce 3 pounds of fish (which is more than the 2 pounds it is producing). 2.

The table above shows the production possibilities of an island community. Choose the best statement. A. Suppose that this community produces 3 pounds of fish and 20 pounds of berries. If it decides to gather more berries, it faces atradeoff. B. When this community produces 4 pounds of fish and 12 pounds of berries it faces a tradeoff, but it is inefficient. C. Suppose that this community produces 5 pounds of fish and 0 pounds of berries. If it decides to gather some berries, it will get afree lunch. D. If this community produces 3 pounds of fish and 22 pounds of berries, production is efficient but to produce more fish it faces a tradeoff. Answer: D Production of 3 pounds of fish and 22 pounds of berries is on the PPF and therefore efficient. To produce more fish, the community moves along its PPF, increasing production offish and decreasing production of berries. The communityfaces a tradeoff. .

40 36 30 22 12 0

The table above shows the production possibilities of an island community. This community’s opportunity cost of producing 1 pound of fish .

A. is the increase in the quantity of berries gathered as the quantity of fish increases by 1 pound B. increases as the quantity of berries gathered increases C. is 10 pounds of berries if the quantity of fish increases from 2 to 3 pounds D. increases as the quantity of fish caught increases Answer: D Page 70 discusses why opportunity increases as production of the good increases. 4.

The table above shows the production possibilities of an island community. Choose the best statement. A. When a drought hits the island, its PPF shifts outward. B. When the islanders discover a better way of catching fish, the island’s PPF shifts outward. C. When islanders reduce the time they spend gathering berries, the PPF shifts inward.

D. If the islanders decide to spend more time gathering berries but continue to spend the same amount of time fishing, they face a tradeoff. Answer: B Page 72 shows that technological progress, such as exemplified in answer B, shifts the PPF outward. 5.

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

Chapter

Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Each of the following four events occurs (one at a time) in the market for air travel. Explain how each of the following events changes the demand for or supply of air travel.  Airfares rise, while train fares don't change. A change in the price of airfares does not change either the demand for or the supply of air travel. (It changes the quantity demanded and the quantity supplied of air travel.)  The price of jet fuel falls The fall in the price of jet fuel increases the supply of air travel because it decreases the cost of producing air travel.  Airlines reduce the number of flights each day The reduction in the number of flights is a decrease in the supply of air travel.  People expect airfares to increase next summer The current demand for air travel increases when people expect airfares to increase next summer because people prefer to fly now, when airfares are relatively cheaper, rather than next summer when it might get more expensive.  A severe winter in New York induces more people to vacation in Florida. More people vacationing in Florida means that there is an increase in the demand for air travel.  With no snow in the Rockies, fewer people travel to the ski slopes. The lack of snow in the Rockies leads to a decrease in the demand for air travel.  The price of train travel rises. Train travel is a substitute for air travel. So, a rise in the price of train travel increases the demand for air travel as consumers would prefer to travel by air instead. © 2023 Pearson Education, Ltd.

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

[Use the laws of demand and supply to explain whether the statements in Problems 2 and 3 are true or false. In your explanation, distinguish between a change in demand and a change in the quantity demanded and between a change in supply and a change in the quantity supplied.] 2.

In 2016, a wheat fungal outbreak that started in Sicily spread widely and destroyed a large portion of Europe’s wheat crop. The fungal outbreak increased the price of wheat and pasta. The statement is true. The smaller supply of wheat in Sicily resulted in a leftward shift of the supply curve of wheat. The equilibrium price of wheat increased and the equilibrium quantity decreased. The quantity of wheat demanded decreased and there was a movement up along the demand curve. Wheat is a resource used in the production of pasta. When the price of wheat increases, it costs more to produce pasta and the supply of pasta falls. The quantity of pasta demanded decreases and there is a movement up along the demand curve. The equilibrium price of pasta increases and the equilibrium quantity decreases. If the price of coffee falls, the quantity of tea consumed will decrease and the price of tea will rise. The statement is false. Coffee and tea are substitutes for consumers. When the price of coffee falls, people substitute coffee for tea. The demand for tea decreases and the demand curve shifts leftward. The equilibrium quantity of tea decreases but the equilibrium price of tea falls. There is a change in the quantity of tea supplied and a movement down along the supply curve. The table shows the demand and supply schedules for magazines. What is the market equilibrium? If the price of a magazine is $ 3.50, what is the situation in the market? How is market equilibrium restored? If a rise in the price of a newspaper increases the quantity of magazines demanded by 11 a week at each price, how does the market adjust to its new equilibrium?

equals the quantity supplied. If the price is $3.50 per magazine, the quantity demanded is 155 magazines and the quantity supplied is 144 magazines. There is a shortage of 11 magazines a day and the price rises. As the price rises, the quantity demanded decreases, the quantity supplied increases, and the shortage decreases. The price rises until the shortage disappears. This table shows the new demand schedule after the rise in the price of a newspaper has increased the quantity demanded by 11 magazines at each price. At the original equilibrium price of $4.00 per magazine, there is a shortage and the price rises. As the price rises, the quantity demanded decreases, the quantity supplied increases, and the shortage decreases. The price rises until the shortage disappears. The price rises to $4.50 a magazine and the quantity increases to 156 magazines.

“As more people buy bicycles, the demand for bicycle helmets will increase and the price of a bicycle helmet will rise. The rise in the price of a bicycle helmet will increase the supply of bicycle helmets.” Is this statement true? Explain. The first statement is correct. As more people buy bicycles, the demand for bicycle helmets will increase as the two goods are complements. The price of bicycle helmets will increase. The second statement is false. The demand for bicycle helmets increases and the demand curve shifts rightward. There is a movement along the supply curve and an increase in the quantity of bicycle helmets supplied but no change in supply.

OPEC and allies agree to cut oil production With oil prices stuck at a low of $60-a-barrel, major oil producers agree to cut crude production. Source: CNBC, December 7, 2018 Explain and illustrate on a graph of the oil market the effect of this decision on the market equilibrium. The market initially is in equilibrium in Figure 4.1 with demand curve D and supply curve S0. The initial equilibrium price is $60 per barrel ofoil and the initial equilibrium quantity is 100 million barrels per day. When OPEC agreed to decrease the supply, the supply curve shiftsleftward, as illustrated in Figure 4.1 by the shift © 2023 Pearson Education, Ltd.

from S0 to S1. In the figure the price of a barrel of oil rises from $60 per barrel to $63 per barrel and the quantity decreases by 1.2 million barrels, from 100 million barrels per day to 98.8 million barrels per day. Use the following information to work Problems 7 and 8. Monsoon’s delay has Indian farmers on edge The one-week delay of monsoon rains is threatening India’s sugarcane, rice, and corn crops. Source: Bloomberg, June 1, 2016 7. Explain how lack of rainfall will change the prices of sugar cane, rice, and corn. The delay in the monsoon rains will damage sugar cane, rice, and corn crops, so the supply of these crops will be lower than usual, which will result in higher prices. 8. Use graphs to show how supply and demand will change in the markets for sugar cane, rice, and corn. In each market, supply decreases so the supply curve shifts leftward. The equilibrium price rises, which decreases the quantity demanded shown by a movement along the same demand curve. The equilibrium quantity decreases.

Read Eye on the Price of Avocados on p. 105 and explain how we know that the price increased during August 2018 because the supply of avocados decreased and not because the demand for avocados increased. When the supply decreases, the price rises and the quantity decreases and when the demand increases the price also rises but the quantity increases. The table shows that when the equilibrium price of an avocado rose during August, the equilibrium quantity decreased, so the price rise had to be the result of a decrease in supply rather than an increase in demand.

 Additional Problems and Applications 1.

Read Eye on the Price of Avocados on p. 105. Why can we be confident that the market for avocados is competitive and that a decrease in supply rather than the greed of avocado growers is the reason for the August 2018 rise in price? There are thousands of avocado growers and buyers, so the market for avocados is competitive—no one buyer or seller can influence the price. Greedy growers cannot successfully raise the price above its equilibrium. If greedy growers raised their price, there would be movements up along the demand curve, reducing the quantity demanded, and up along the supply curve, increasing the quantity supplied. The result would be a surplus of avocados, which would force the price to fall back to its equilibrium. What is the effect on the equilibrium price and equilibrium quantity of orange juice if the price of apple juice decreases and the wage rate paid to orange grove workers increases? Apple juice and orange juice are substitutes for consumers, so the fall in the price of apple juice decreases the demand for orange juice. The demand curve for orange juice shifts leftward. The increase in the wage rate paid to orange grove workers raises the cost of producing oranges and thereby boosts the cost of producing orange juice. The supply of orange juice decreases and the supply curve of orange juice shifts leftward. The net effect of these events decreases the equilibrium quantity but has an undetermined effect on equilibrium price. If supply decreases by more than the demand decreases, the equilibrium price rises. If demand decreases more than the supply decreases, the equilibrium price falls. And if they decrease by the same amount, the equilibrium price does not change. What is the effect on the equilibrium in the orange juice market if orange juice becomes more popular and a cheaper robot is used to pick oranges? Because orange juice becomes more popular, demand increases and the demand curve for orange juice shifts rightward. The cheaper picking robot lowers the production costs of orange juice, so the supply of orange juice increases and the supply curve of orange juice shifts rightward. The equilibrium quantity increases. But the effect on the equilibrium price is ambiguous. If the increase in supply is greater than the increase in demand, the equilibrium price falls. If the increase in demand is greater than the increase in supply, the equilibrium price rises. And if the increase is the same size, then the equilibrium price does not change. 45 days of no rain in Lebanon Lebanon may face a water crisis with less than 15 percent the average rate of rainfall and an increase in the cost of well water. Source: English.al-akhbar.com, January 22, 2014 Explain how an expected water crisis will affect today’s price of well water. © 2023 Pearson Education, Ltd.

The lack of rainfall will cause an increase in the demand for well water as the surface water may not be suitable for consumption. The higher expected demand for well water (causing a rightward shift of the demand curve for well water) will induce suppliers to increase the price of the product and decrease the current supply (causing the supply curve to shift leftward). Due to the simultaneous increase in demand and decrease in supply, the equilibrium price of well water will increase. The effect on the equilibrium quantity is ambiguous depending on whether the shift in demand dominates, the shift in supply dominates, or they offset each other. The table shows the demand Price Quantity Quantity (dollars demanded Supplied and supplyschedules for boxes of per box) (Boxes per week) chocolates in an average week. 13.00 1,600 1,200 Use this information to work 14.00 1,500 1,300 Problems 5 and 6. 15.00 1,400 1,400 16.00 1,300 1,500 If the price of chocolates is $17.00 a 17.00 1,200 1,600 box, describe the situation in the 18.00 1,100 1,700 market. Explain how market equilibrium is restored. At the price of $15.00 a box, the quantity supplied equals the quantity demanded. At a price of $17.00 a box, the quantity demanded is 1,200 boxes and the quantity supplied is 1,600 boxes. There is a surplus of 400 boxes a week and the price falls. As the price falls, the quantity demanded increases, the quantity supplied decreases, and the surplus decreases. The price falls until the surplus disappears. The market equilibrium occurs at a price of $15.00 a box and 1,400 boxes a week so the price falls to $15.00 a box. During Valentine’s week, more people buy chocolates and chocolatiers offer their chocolates in special red boxes, which cost more to produce than the everyday box. Set out the three-step process of analysis and show on a graph the adjustment process to the new equilibrium. De- scribe the changes in the equilibrium price and the equilibrium quantity. Starting with the demand side, Valentine’s week increases people’s preferences for boxes of chocolate so the demand for boxes of chocolate increases. The demand curve for chocolates shifts rightward, from D0 to © 2023 Pearson Education, Ltd.

D1 in Figure 4.4 (on the next page). Moving to the supply side, the fancy red box raises the cost of producing boxes of chocolate, which decreases the supply. The rise in the cost of producing boxes of chocolates shifts the supply curve leftward, from S0 to S1 in Figure 4.4. After these changes, at the initial price of a box of chocolate, $15.00, in Figure 4.4 there is a shortage of 600 boxes of chocolate per week. The shortage forces the price higher, so the equilibrium price of a box of chocolate rises, to $18.00 in the figure. The problem points out that people buy more boxes of chocolate during Valentine’s week. This result means that the change in demand exceeds the change in the supply, that is, the magnitude of the increase in demand exceeds that of the decrease in supply. Figure 4.4 illustrates this situation and in the figure the equilibrium quantity increases from 1,400 boxes per week to 1,500 boxes per week. 7.

After a severe bout of foreclosures and defaults on home loans, banks made it harder for people to borrow. How does this change influence the demand for new homes, the supply of new homes, and the price of a new home? Illustrate your answer with a graphical analysis. The demand for homes decreases, the supply of new homes does not change, and the price of new homes falls. Figure 4.5 shows the effect of making home loans more difficult to obtain. Before the change in difficulty, the demand curve is D0. In the figure the price of a new home is $350,000. After the increase in difficulty, the demand decreases and the demand curve shifts leftward, in the figure from D0 to D1. The supply curve does not shift. The price of a new home falls, in the figure from $350,000 to $275,000. Chicken prices rise over ban on cattle sale Following the ban on the sale of cattle for slaughter in India, the price of chicken in the country are projected to go up by 25-30 percent due to the likelihood of an increase in the chicken consumption by 35-40 percent. The global price of beef also increased amid fears of supply shortages. Source: Business Standard, June 5, 2017 Based on the news clips, explain (a) how the law of demand works in the global market for beef and why the price of beef is rising, and (b) how the Indian markets for beef and chicken would influence each other. Draw a graph to illustrate your explanation. © 2023 Pearson Education, Ltd.

(a) The law of demand states that when all other things remain the same, as the price of beef rises, people will buy less beef, indicating a decrease in the quantity demanded for beef. The news clip states that as a result of the decrease in India's beef exports, the global supply of the good decreases. The supply curve shifts leftward and the equilibrium price of beef rises. This causes a movement along the demand curve. (b) Chicken and beef are substitute goods as they are alternative sources of protein, so their markets will influence each other. Consider the market for chicken—the ban on beef increases the demand for chicken as people substitute beef with chicken, so the demand curve for chicken shifts rightward (shown in the figure that follows). The news clip also mentions an increase in consumer income, which contributes to the demand for chicken shifting rightwards as well. At the same time, the ban on beef encourages chicken producers to increase their supply. The supply curve of chicken shifts rightward. Due to the change in demand currently being greater than the change in supply (18% > 12%), both the equilibrium price and the equilibrium quantity of chicken will increase. This explains the current rise in the price of chicken in India. Note that the equilibrium quantity will still increase while prices might fall if, in the future, the change in supply dominates, or remains the same if the changes in demand and supply offset each other. 9. “As more people buy computers, the demand for Internet services increase and the price of Internet services decrease, which decrease the supply of internet services.” Is this statement true or false? The assertion that the demand for Internet services increase as more people buy computers is true. However, the claim that the increase in demand reduces the price of Internet services is false; the increase in demand raises the price of Internet services. The second statement is false. Regardless of whether the price of Internet services rises or falls, the supply of Internet services does not change. Instead, the change in price changes the quantity of Internet services supplied. 10. Record number waiting to upgrade cell phones Faced with a $1,000 price tag for an old-tech phone, consumers may be waiting for the new 5G technology coming before buying a replacement phone. Source: Bloomberg, April 24, 2019

Explain how the expected arrival in 2020 of a new technology cellphone service might influence the equilibrium price and quantity of cell phonesin 2019 and 2020. Source: The Wall Street Journal, September 8, 2015 In 2019, the expected arrival of new technology cell-phone service might lead consumers to decrease their demand for phones in order to wait for new phones that they are certain can use the new technology. The decrease in the demand shifts the demand curve leftward, so the equilibrium price of a cell phone falls and the equilibrium quantity decreases. In 2020, new 5G compatible cell phones become available. For a given supply, if the demand for cell phones increases, the equilibrium price of a cell phone rises and the equilibrium quantity of cell phones increases.

 Multiple Choice Quiz 1.

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

In the market for jeans, which of the following events increases the demand for a pair of jeans? A. The wage rate paid to garment workers rises. B. The price of a denim skirt (a substitute for jeans) rises. C. The price of denim cloth falls. D. New technology reduces the time it takes to make a pair of jeans. Answer: B The other factors listed change the supply; only answer B increases the demand. 3.

Other things remaining the same, a fall in the price of peanuts will . A. increase the supply of peanuts B. decrease the supply of peanut butter C. decrease the quantity supplied of peanuts D. decrease the supply of peanuts Answer: C A fall in the price of the good creates a movement along the supply curve and decreases the quantity supplied. 4.

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

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

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

Many Lebanese are now using quinoa instead of the traditional bourghul in their staple foods, like tabbouleh. Other things remaining the same, in the market for bourghul, __________ and in the market for quinoa, __________. A. demand decreases and the price falls; demand increases and the price rises B. demand decreases and the price rises; supply increases and the price falls C. both demand and supply decrease and the price might rise, fall, or not change; demand increases and the price rises D. demand decreases, supply increases, and the price falls; supply increases and the price falls

Answer: A

Chapter

Elasticities of Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

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

If the price of a wool sweater did not change, calculate the cross elasticity of demand for wool sweaters with respect to the price of home heating oil. Are home heating oil and wool sweaters substitutes or complements? Why? The cross elasticity of demand for wool sweaters with respect to home heating oil is:

 Percentage change in quantity of sweaters demanded  10 percent   = 20 percent = 0.55 Percentage change in price of heating oil   Home heating oil and sweaters are substitutes because as the price of home heating oil rises, you can stay warm by using less home heating oil and putting on a sweater. The cross elasticity of demand for a substitute is positive.

The figure shows the demand for movie tickets. Is the demand for movie tickets elastic or inelastic over the price range $7 to $9 a ticket? If the price falls from $9 to $7 a ticket, explain how the total revenue from the sale of movie tickets will change. Calculate the price elasticity of demand for movie tickets when the price is $8 a ticket. The percentage change in the quantity of movie tickets demanded equals

 300 tickets - 100 tickets   (100 tickets + 300 tickets) ÷ 2  × 100, or 100   percent. The percentage change in the price of a movie ticket equals

 $9 a ticket - $7 a ticket   ($9 a ticket + $7 a ticket) ÷ 2)  × 100, or 25 per   percent. So the demand for movie tickets is elastic because the percentage change in the quantity demanded is larger than the percentage change in price. Because the demand is elastic, the fall in the price of a movie ticket increases the total revenue from the sale of movie tickets. When the price 300 tickets, which is $2,100. So the total revenue increases by $1,200. The price elasticity of demand for movie tickets is the percentage change in the quantity of movie tickets demanded divided by the percentage change in the price of a movie ticket. The percentage change in the quantity of movie

tickets demanded equals

 300 tickets - 100 tickets   (100 tickets + 300 tickets) ÷ 2  × 100,  

which is 100 percent. The percentage change in the price of a movie ticket



  × 100, which is 25 percent. So the  ($9 a ticket + $7 a ticket) ÷ 2) 

equals 

$9 a ticket - $7 a ticket

price elasticity of demand for movie tickets at the price of $8 is 100 percent ÷ 25 percent, or 4.00. The price elasticity of demand for Una's popcorn is 0.6. Una wants to increase her total revenue. Would you recommend that Una raise or lower her price of popcorn? Explain your answer. As the price elasticity of demand for popcorn is 0.6, Una should raise the price of popcorn to raise her total revenue. As demand is inelastic, an increase in the price of popcorn will bring about a lower percentage decrease in the quantity demanded, thus the net effect on total revenue will be an increase. © 2023 Pearson Education, Ltd.

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

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

A survey found that when incomes increased by 10 percent, the following changes in the quantities demanded occurred: spring water up by 5 percent; sports drinks down by 2 percent; cruises up by 15 percent. For which good is demand income elastic? For which good is income inelastic? Which goods are normal goods? Because the percentage change in the quantity of cruises demanded increased by more than the percentage change in income, the demand for cruises is income elastic. Because the percentage change in the quantity of spring water demanded increased by less than the percentage change in income, the demand for spring water is income inelastic. The demand for cruises increases with income, so cruises are a normal good. The demand for spring water increases with income, so it is a normal good. The demand for sports drinks decreases with income, so it is an inferior good. Use the following information to work Problems 8 and 9. Record U.S. corn crop, up 24%, is forecast The USDA reported that world corn production will be 9.9 percent greater than last year’s, while U.S. corn production will be 24 percent larger. The price of corn is expected to be 46 percent higher than last year’s price. Source: Bloomberg News, August 11, 2007

Tomato prices rocket 37pc as bad weather hits growing regions Tomato wholesale prices rocketed to a level that is 36 percent higher than what it was the same time last year due to bad weather in key European tomato-growing regions. Source: telegraph.co.uk The price of tomato per ton has increased from ￡1,052 in 2011 to ￡1,226 in 2015 and the quantity supplied decreased from 498.6 thousand tons in 2011 to 495.2 thousand tons in 2015. Calculate the U.K.-price elasticity of supply of tomato: Is its supply elastic? [Source: Horticulture statistics 2015 https://www.gov.uk/government/statistics/horticulture-statistics-2015] The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The change in the U.K. quantity supplied is 0.7 percent and the change in the price is 15.3 percent. So, for the United Kingdom, the price elasticity of supply equals 0.7 percent  15.3 percent, which is 0.05. The U.K. supply of tomato is not elastic; it is inelastic.

Read Eye on Elasticity at the Coffee Shop on p. 125 and then explain why the demand for latte is inelastic while the demand for a Starbucks latte is elastic. Which demand is likely to be more inelastic: the demand for latte or the demand for coffee? The demand for latte is inelastic because there are not many substitutes for a latte. Most of the substitutes, such as tea or water, are poor substitutes, which also makes the demand for latte inelastic. The demand for Starbucks latte, however, is elastic because there are good substitutes for Starbucks latte. As the Eye on Elasticity at the Coffee Shop explained, a Dunkin’ latte is a substitute. So, too, are lattes from independent coffee shops. With more good substitutes, the demand for Starbucks latte is elastic. The demand for a latte is probably more elastic than the demand for coffee because a latte is a more narrowly defined good than coffee, which is a more broadly defined good. Anything that substitutes for coffee also substitutes for a latte and all other coffee-based drinks are also substitutes for a latte. Because a latte has more substitutes than does coffee, its demand is more elastic than the demand for coffee.

 Additional Problems and Applications Use the following information to work Problems 1 and 2. Why has there been tepid response to higher gasoline prices? Most studies report that when U.S. gas prices rise by 10 percent, the quantity purchased falls by 1 to 2 percent. In September 2005, the retail gasoline price was $2.90 a gallon, about $1.00 higher than in September 2004, but purchases of gasoline fell by only 3.5 percent. Source: The New York Times, October 13, 2005 1. Calculate the price elasticity of demand for gasoline implied by what most studies have found. The price elasticity of demand equals the percentage change in the quantity demanded, 1 or 2 percent, divided by the percentage change in price, 10 percent. Doing the division shows that most studies have found that the price elasticity of demand equals 0.1 or 0.2. 2. Compare the elasticity implied by the data for the period from September 2004 to September 2005 with that implied by most studies. What might explain the difference? From September 2004 to September 2005, the price of gasoline increased by 41.67 percent (The percentage change equals ($2.90  $1.90)  $2.40, where $2.40 is the average of the September 2004 and September 2005 price). The quantity demanded decreased by 3.5 percent, so the price elasticity of demand over this year was 3.5 percent  41.67 percent, which is 0.08. The price elasticity of demand of demand for gasoline calculated over this year is slightly lower than the conventional range. The price elasticity of demand over the year is probably lower than normal because other factors that affected the demand for gasoline also changed. In particular, income increased. Gasoline is a normal good, which means that the increase in income increases the demand for gasoline and thereby increases the equilibrium quantity of gasoline. So, the 3.5 percent change in the quantity reported in the news clip was composed of two parts—the decrease in the quantity demanded moving along the demand curve resulting from the higher price, and the (offsetting) increase in the quantity resulting from higher income. The elasticity of demand should use only the decrease in the quantity demanded resulting from the price rise. As the decrease in the quantity demanded from a higher price is offset by the increase from higher income, the reported 3.5 percent change in quantity is less than what would be the change resulting from only a higher price, so the computed elasticity of demand is smaller than the conventional range. 3. Because of heavy rainfall in India, there will be a yield loss for new potatoes. The price of potato are getting up to twice as much per kilogram, affecting buyers who are buying potato at 25 per kilogram now © 2023 Pearson Education, Ltd.

from 8 per kilogram a week ago. Grower sold fewer potatoes, but their total revenue was unchanged. By what percentage did the quantity demanded of potatoes change? Is the demand for potatoes elastic, unit elastic, or inelastic? As the total revenue did not change, the percentage change in the demand for potatoes equals the percentage increase in price. Using the mid-point method, the percentage increase in the price equals (8  16.5) = 48.49 percent. So the quantity of potatoes demanded decreased by 48.49 percent. The demand for potatoes is neither elastic nor inelastic; it is unit elastic because the percentage increase in the price equals the percentage decrease in the quantity of potatoes demanded. 4.

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

Drought cuts the quantity of wheat grown by 2 percent. If the price elasticity of demand for wheat is 0.5 by how much will the price of wheat rise? If pasta makers estimate that this change in the price of wheat will increase the price of pasta by 5 percent, and decrease the quantity demanded of pasta by 2 percent, what is the pasta makers' estimate of the price elasticity of demand for pasta? If pasta sauce makers estimate that, with the change in the price of pasta that the quantity of pasta sauce demanded will decrease by 7 percent, what is the pasta sauce makers' estimate of the cross elasticity of demand for pasta sauce with respect to the price of pasta? Rearranging the price elasticity of demand formula shows that the percentage change in the price of wheat equals the percentage change in the quantity demanded divided by the price elasticity of demand. The percentage change in the price of wheat is (2 percent) ÷ (0.5), or 4 percent. The estimated price elasticity of demand for pasta is equal to the percentage change in the quantity demanded of pasta divided by the estimated change in the price of pasta. Therefore, the estimated price elasticity of demand for pasta is (2 percent) ÷ (5 percent), which is 0.4. The estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is equal to the percentage change in the quantity © 2023 Pearson Education, Ltd.

demanded of pasta sauce divided by the estimated change in the price of pasta. So, the estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is −(7 percent) ÷ (5 percent), which is −1.4. 6.

“In a market in which demand is price inelastic, producers can gouge consumers and the government must set high standards of conduct for producers to ensure that consumers get a fair deal.” Do you agree or disagree with each part of this statement? Explain how you might go about testing the positive part.

Most of this statement is normative in nature. The terms “gouge,” “high standards of conduct,” and “fair deal” are all normative. To the extent that the statement can be interpreted as a positive statement, the first part might mean “in a market in which demand is price inelastic, producers can set a higher price than otherwise.” If this is the meaning of the first part, then it is testable by determining the extent to which the price elasticity of demand affects the equilibrium price in markets. Use the following information to work Problems 7 and 8. Price rise in seafood ahead of Chinese New Year in Singapore Prices of seafood increased by 50 percent before the Chinese New Year, which fell on January 28 in 2017. The wholesale price of seafood increased from 3,557 tons in December 2016 to 4,249 tons in January 2017. Source: straitstimes.com, January 6, 2017 Use the following information to work Problems 7 and 8. Price rise in seafood ahead of Chinese New Year in Singapore Prices of seafood increased by 50 percent before the Chinese New Year, which fell on January 28 in 2017. The wholesale price of seafood increased from 3,557 tons in December 2016 to 4,249 tons in January 2017. Source: straitstimes.com, January 6, 2017 7. Does the information about the market for seafood enable us to estimate an elasticity, and if so, which one: the price elasticity of demand, the price elasticity of supply, and income elasticity, or a cross elasticity? Explain your answer. The information about the market for seafood enables us to estimate the price elasticity of demand. According to the information, we can calculate the percentage change in quantity demanded and percentage change in price. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. 8. What is the magnitude of the elasticity that you can estimate using the information provided? Explain your answer. According to the information, the percentage change in quantity demanded is 17.7 percent and the percentage change in price is 50 percent. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. Therefore, the price elasticity of demand is equal to 17.7 percent  50 percent, which is 0.35. © 2023 Pearson Education, Ltd.

 Multiple Choice Quiz 1.

Suppose when the price of one pack of Nestlé cappuccino powder rises from €5.5 to €8.5, the quantity of one pack bought decreases by 10 percent. The price elasticity of demand for cappuccino powder is _ . A. 2.5 B. 5 C. 0.4 D. 0.55 Answer: A 2.

In Hong Kong, the price elasticity of demand for MTR (Mass Transit Railway) rides is 0.4. When the price of a MTR ticket rises by 2 percent, ____., . A. the demand for MTR rides decreases by 5 percent B. the quantity of MTR rides demanded decreases by 0.8 percent C. the demand for bus rides increases by 5 percent D. the quantity of bus rides demanded increases by 0.8 percent Answer: B. The quantity of bus rides demanded decreases by (0.4) × (2 percent), which is 0.8 percent.

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

If the price of a good falls and expenditure on the good rises, the demand for the good is . A. elastic B. perfectly elastic C. inelastic D. unit elastic Answer: A The total revenue test on page 125 shows that demand iselastic.

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

Efficiency and Fairness of Markets ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications

In Taiwan, no reservations are accepted for Shilin Official Residence; at National Palace Museum, reservations are accepted; at Kenting National Park, reservations are essential. Use this information to answer Problems 1 to 3. 1. Describe the similarities and differences in allocating resources in these three tourist attractions. All three sites use a first-come, first-serve system. The difference lies in how they use the system. Shilin Official Residence uses this system directly. National Palace Museum uses a first-come, first-serve system because the first person to call to make a reservation at a particular time is allocated a ticket at that time. Kenting National Park uses a combination of the immediate first-come, first-serve system and the reservation based first-come, first-serve system. 2.

Why do you think attractions have similarities and differences in allocating resources? The first-come first-serve systemworks best when a scarce resource can serve just one user at a time in a sequence. By serving the customers who arrive first, there will be fewer people waiting in line for the attractions to be free. The difference in the speed with which tickets turn over at the different attractions and the difference in customers’ values of time are the main reasons why each attraction has different reservation policies. Kenting National Park has a low turnover rate, as each visitor needs to spend at least one day to go around the park, and its customers have a high value of time. Also considering the protection of the environment, the number of visitors needs to be kept in check. If Kenting National Park refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere, resulting in Kenting National Park’s profits being lower. At Shilin Official Residence, the turnover rate is high — visitors only need to spend around one hour there. Allowing reservations would be costly for Shilin Official Residence © 2023 Pearson Education, Ltd.

Chapter

Chapter 6 . Efficiency and Fairness of Markets

and would spare its customers only a slight wait at most, so allowing reservations would decrease its profits. At National Palace Museum, the turnover rate is between Shilin Official Residence and Kenting National Park, so it uses a combination of online reservations on a first-come, first served basis and an in-person first-come, first-serve basis. 3.

Under what conditions would the ticket fare be an example of the market price method of allocation resources and why don’t all attractions use the market price to allocate their resources? If the ticket fare is the equilibrium price at which the quantity demanded equals the quantity supplied, it would be an example of the market price method. The price would fluctuate from time to time depending on the number of customers, leading to high uncertainty about the price faced by customers and lowering of demand for tickets to the sites. The decreased demand would lower the attraction’s profit.

The table shows the demand and supply schedules for sandwiches. Use the table to work Problems 4 to 7. 4. Calculate the equilibrium price of a sandwich, the consumer surplus, and the producer surplus. What is the efficient quantity of sandwiches? The equilibrium quantity is 200 sandwiches and the equilibrium price is $4 a sandwich. Figure 6.1 can be used to calculate the consumer surplus. The consumer surplus equals the area of the light gray triangle above the price and below the demand curve. The area of the triangle is 1/2 × base × height, so the consumer surplus is 1/2 × (200 sandwiches) × ($4 a sandwich), which is $400. Figure 6.1 also can be used to calculate the producer surplus. The producer surplus equals the area of the dark gray triangle below the price and above the supply curve. This area is 1/2 × (200 sandwiches) × ($4 a sandwich), which is $400. The efficient quantity is 200 sandwiches. 5.

Price (dollars per sandwich) 0 1 2 3 4 5 6 7 8

If the quantity demanded decreases by 100 sandwiches an hour at each price,

Quantity Quantity demanded supplied (sandwiches per week) 400 0 350 50 300 100 250 150 200 200 150 250 100 300 50 350 0 400

Part 2 . A CLOSER LOOK AT MARKETS

what is the equilibrium price and what is the change in total surplus? If the quantity demanded of sandwiches decreases by 100 per hour at each price, the new equilibrium price of a sandwich is $3 and the new equilibrium quantity is 150. This consumer surplus equals the area of the triangle above the price and below the demand curve and so is equal to 1/2 × (150 sandwiches) × ($3 a sandwich), which is $225. The producer surplus equals the area of the triangle below the price and above the supply curve and so is equal to is 1/2 × (150 sandwiches) × ($3 a sandwich), which is $225. The total surplus equals the sum of the consumer surplus plus producer surplus. Before the change the total surplus is $400 + $400 = $800 and after the change the total surplus is $225 + $225 = $450, for a change of −$350. 6.

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

If Sandwiches To Go, Inc., buys all the sandwich producers and cuts production to 100 sandwiches an hour, what is the deadweight loss that is created? If Sandwiches To Go, Inc. rations sandwiches to two per person, by what view of fairness would the allocation be unfair? If only 100 sandwiches are produced, the deadweight loss equals the area of the darkened triangle in Figure 6.2. This area is 1/2 × (100 sandwiches) × ($4 a sandwich), which is $200. Rationing sandwiches might be fair based on the “fair results” principle because everyone has an equal number of sandwiches. However, because Sandwiches To Go, Inc. is restricting the number of sandwiches it produces, some customers might go without. If the “fair results” view incorporates these consumers into the picture, then the rationing is unfair because not every consumer has a sandwich. The “fair rules” approach is likely to consider the rationing fair, because all exchanges are voluntary. But, it is worth noting © 2023 Pearson Education, Ltd.

Chapter 6 . Efficiency and Fairness of Markets

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

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

Part 2 . A CLOSER LOOK AT MARKETS

10. Resellers are trying to turn a profit on Nipsey Hussle memorial tickets Free memorial tickets, given to fans, were scooped up and within minutes, some appeared on secondary site for more than $400. Source: Billboard Magazines, April 10, 2019 Was the allocation of tickets efficient and fair? Is the secondary site selling tickets for more than $400 an example of the market price method of allocating scarce resources? Is the market for these tickets efficient? Is it fair? The initial allocation was by “first-come, first-served.” This allocation was not efficient because fans who most valued the tickets almost surely were not the people who were first in line and who got the tickets. It was fair using the fair rules approach because everyone had the chance of being first. It was unfair using the fair results approach because it is unlikely that only poorer people received the tickets. The secondary site selling the tickets is an example of the market price allocating resources. If the price is set at its equilibrium, the market for these tickets will be efficient because people who most highly value the tickets will buy them while people who less highly value the tickets will sell them. In particular, fans who value the tickets at or above the market price will buy tickets while fans who value the tickets below the market price will sell them. The market is fair using the fair rules approach because everyone has the chance of buying the tickets. It is unfair using the fair results approach because poorer fans will not be able to afford to buy the tickets. 11. Online sellers guide to eBay spring update On eBay, the bidder who places the highest bid wins the auction and pays what the second highest bidder offered. Each spring, eBay updates its rules and fees and in spring 2019 it announced higher fees to start later in the year. Source: EcommerceBytes, May 19, 2019 What method is used to allocate goods on eBay? How does an eBay auction influence consumer surplus on the good traded? How does eBay’s fee for service influence consumer surplus? eBay is using market price to allocate the goods. The market price is the price established in the auction. If someone is willing and able to pay that price, the person will get the item. For the vast majority of auctions the winning bidder will enjoy a consumer surplus so eBay increases consumer surplus. For instance, if there are bidders on a unique item, the winning bidder—who sets the price for the good—will pay a price that is equal to the value of the item to the bidder with the second-highest valuation plus the minimum bid increment. The

Chapter 6 . Efficiency and Fairness of Markets

winning bidder has some consumer surplus as long as his or her value of the good exceeds the price that must be paid, which will almost always be the case. Indeed, a person chooses to buy on eBay rather than elsewhere if the person believes that his or her consumer surplus is largest by purchasing on eBay. eBay’s fee for service is a cost of using the eBay marketplace. If eBay raises its fees, the cost of using eBay increases, which decreases the supply of items offered on eBay. The decrease in supply raises the equilibrium price and decreases the equilibrium quantity of products sold on eBay, thereby reducing the amount of consumer surplus. 12. Read Eye on Ticket Scalping on p. 162 and explain why the allocation of tickets is inefficient if the re-selling of tickets is made illegal. After the tickets are sold in the primary market, there may be new demanders who are willing to pay a higher price for the tickets. These consumers are willing to pay the higher price scalpers are charging, which means that their marginal benefit of the tickets equals or exceeds the price in the secondary market. Additionally, this price exceeds the scalpers’ marginal cost, which is why they are selling the tickets. Consequently, the marginal benefit from selling these tickets exceeds their marginal cost. Making resale of the tickets illegal would prevent these sales. Forbidding the resales creates a deadweight loss because in the secondary market the marginal benefit of the tickets exceeds their marginal cost, which means that preventing the sales is inefficient.

Part 2 . A CLOSER LOOK AT MARKETS

 Additional Problems and Applications 1.

Tickets dominated by touts in the UK As long as there have been ticketed events, there have been people hoovering up hundreds of tickets at a time and reselling them via websites such as Get Me In and Viagogo. For instance, a ticket for Adele’s concert at the O2 Arena in London was listed on Get Me In for £24,840, which is 290 times the face value. Source: theguardian.com, May 15, 2016 Is a £24,840 ticket price similar to “price gouging”? If yes, why? Is the high price an example of the market price method of allocating scarce resources? Is the market for tickets efficient? Is it fair? The tickets price was boosted much higher than normal, which is gouging. If £24,840 is the equilibrium price at which the quantity demanded of tickets equaled the quantity supplied, then the £24,840 fare is an example of resources being allocated by the market price. The market for tickets is not efficient as tickets are dominated by touts. Under the “fair rules” approach, the different prices are fair because transactions are voluntary. By the “fair results” approach, it is not fair as poor people will not be able to buy the expensive tickets.

Chapter 6 . Efficiency and Fairness of Markets

The table shows the demand schedule for Price (dollars per personal trainer services and the supply hour) schedule of personal trainer services. Use 0 the table to work Problems 2 and 3. 20 2. How many personal trainer hours are 40 bought, the value of an hour, and the 60 total surplus from the hours bought? 80 100 The equilibrium quantity of personal training hours is 40 per day. The value of the 40th hour is $60. The total surplus is equal to the sum of the consumer surplus plus the producer surplus. Figure 6.3 helps in calculating the consumer surplus and producer surplus. The consumer surplus is equal to the area of the dark grey triangle. The consumer surplus equals 1/2  40 hours  $40 per hour), or $800. The producer surplus is equal to the lighter grey area which is also $400 so total surplus is $800 + $800 = $1,600.

Quantity Quantity demanded supplied (hours per day) 100 0 80 0 60 20 40 40 20 60 0 80

If all personal trainers agree to charge $80 an hour, how do consumer surplus and producer surplus change? What is the deadweight loss created? If the price is $80 a haircut, the quantity of hours is 20. The consumer surplus in Figure 6.4 is the dark triangle and is $200, so the consumer surplus has decreased by $600. The producer surplus in Figure 6.4 is the light grey area and is $1,000, so the producer surplus has increased by $200. The deadweight loss is $400. Note that the deadweight loss is equal to the gain in producer surplus minus the loss in consumer surplus.

Part 2 . A CLOSER LOOK AT MARKETS

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

If farmers were charged the same price as city residents pay, how would the price of agricultural produce, the quantity of produce grown, consumer surplus, and producer surplus change? If farmers are charged the same price for water as city residents, farmers’ costs increase. The increase in costs decreases the supply of agricultural products, so the price of agricultural produce rises and the quantity decreases. Consumer surplus decreases and producer surplus also decreases.

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

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

Chapter 6 . Efficiency and Fairness of Markets

What method is used to allocate flowers at the Bloemenveiling? The auction uses the market price (as established by the auction) to allocate the flowers.

How does a Dutch flower auction influence consumer surplus and producer surplus? Are the flower auctions at the Bloemenveiling efficient? A Dutch auction means there is little or no consumer surplus. If the buyers bid the moment the price reaches their value for the flower, then the successful buyers have no consumer surplus. The producers, however, likely have substantial producer surplus. As long as the price exceeds the marginal cost of producing the flowers, the producers have some producer surplus.

The flower auctions are efficient because there are no obstacles (taxes, subsidies, monopoly, and so on) that prevent the market price from reaching allocative efficiency. The buyers pay a price equal to their marginal benefit and the sellers receive a price equal to their marginal cost. Forest industry in Canada Forests are a major source of wealth for Canadians and Canada has the world’s largest forest product trade balance. Though merely 6% of Canada’s forests are privately owned (94% are publicly owned), they contribute considerably to the country’s wood products sector. 10% of the timber harvested in Canada comes from private lands. Source: nrcan.gc.ca, February 14, 2017 Is the Canada timber industry efficient and do forest-land owners operate in the social interest or self-interest? Since private lands have great contribution to Canadian timber industry, would it be efficient to transfer more publicly owned land to privately owned land? The Canada timber industry is efficient. About 94% of Canada’s forests are publicly owned, which ensures strong oversight of forest management activities. For the 6% of Canada’s forests that are privately owned, private owners face strong incentives compared with public owners. Operating in their self-interest, private owners tend to limit the amount of the harvest to ensure that there will be enough timber for the future profit. With government ownership, however, the same incentive does not exist because the government is not trying to ensure its profitability in the future. Logging companies were probably able to convince government officials to allow more than the efficient amount of logging, so the forests were likely over-logged when the government owned them. With the limitation on the extent of logging, private land owners have operated in their self-interest as well as the social interest. It would be more efficient with more privately owned land because private owners have an incentive to make the highest profit as well as preserve specific forests.

Part 2 . A CLOSER LOOK AT MARKETS

 Multiple Choice Quiz 1. The method of allocation that most stores use during Chinese Spring Festival sales is ________. A. A combination of market price and first come, first served B. A combination of market price and lottery C. First come, first served D. A combination of contest and command Answer: A 2.

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

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

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

Chapter 6 . Efficiency and Fairness of Markets

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

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

The allocation of resources is fair . A. in the fair-rules view if everyone has equal opportunity B. in the fair-results view if most resources are distributed to the poorest people C. in the fair-rules view if owners of the resources are protected by property rights and all transfers of resources are voluntary D. in the fair-results view if resources are transferred voluntarily so that everyone has the same quantity Answer: C Page 163 discusses the rules view of fairness.

Government Actions in Markets

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications The table shows the demand and supply Rent Quantity Quantity schedules for on-campus housing. Use the (dollars per demanded supplied table to work Problems 1 to 3. month) (rooms) 500 2,500 2,000 1. If the college puts a rent ceiling on 550 2,250 2,000 rooms of $650 a month, what is the rent, 600 2,000 2,000 how many rooms are rented, and is the on650 1,750 2,000 campus housing market efficient? 700 1,500 2,000 The equilibrium rent is $600 a month 750 1,250 2,000 and the equilibrium quantity of rooms is 2,000 rooms. The rent ceiling of $650 a month is above the equilibrium rent and does not change the market equilibrium. The rent remains the equilibrium rent of $600 a month, the quantity of rooms rented remains 2,000 rooms, and the market remains efficient. 2.

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

Suppose that with a strictly enforced rent ceiling on rooms of $550 a month, a black market develops. How high could the black market rent be and would the on-campus housing market be fair? Explain your answer. The black market rent could be as high as $600 a month, which is the maximum rent someone is willing to pay for the 2,000th room. If a black market develops, using the “fair results” approach, the market is not fair be-

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

cause the poorest students cannot afford the higher black market rent. Using the “fair rules” approach, the market is not fair because the rent ceiling blocks some voluntary exchanges unless the buyers and sellers are willing to participate in the black market. Use the table, which shows the demand and Wage rate Quantity Quantity supply schedules for student workers at on(dollars per demanded supplied hour) (student workers) campus venues, to work Problems 4 to 6. 4. If the college introduces a minimum 10.00 600 300 10.50 500 350 wage of $10.50 an hour, how many stu11.00 400 400 dents are employed at on-campus ven11.50 300 450 ues and how many are unemployed? 12.00 200 500 The equilibrium wage rate is $11.00 an 12.50 100 550 hour and 400 workers are employed. If the minimum wage is set at $10.50 an hour, the minimum wage is below the equilibrium wage rate, so the minimum wage does not affect the market equilibrium. The wage rate remains $11.00 an hour, 400 student workers are employed, and no student workers are unemployed. 5.

If the college introduces a strictly enforced minimum wage of $11.50 an hour, how many students are employed, how many are unemployed, and what is the lowest wage at which some students would be willing to work? If the minimum wage is set at $11.50 an hour, the minimum wage is above the equilibrium wage rate, so the minimum wage has an impact. The wage rate is $11.50 an hour and 300 student workers are employed. At $11.50 an hour, the quantity of labor supplied is 450 student workers, the quantity demanded is 300 student workers, so 150 student workers are unemployed. Some workers are willing to work for $10.00 an hour.

If the college introduces a strictly enforced minimum wage of $11.50 an hour, who gains and who loses from the minimum wage, and is the campus labor market efficient or fair? The workers who retain their jobs and are paid the higher wage rate gain from the minimum wage. The employer, the workers who lose their jobs, and workers who must undertake extensive search for a job lose from the minimum wage. The minimum wage of $11.50 an hour is not efficient. There is a surplus of workers and the marginal benefit to firms exceeds the marginal cost to workers. A deadweight loss is created. The minimum wage is unfair under the “fair results” approach because some student workers lose their jobs. The minimum wage is unfair under the “fair rules” approach because it blocks voluntary exchange.

Chapter 7 . Government Actions in Markets

Use the table, which shows the demand and Price supply schedules for mushrooms, to work (dollars per pound) Problems 7 and 8. 1.00 7. Suppose that the government 2.00 introduces a production quota for 3.00 mushrooms and sets it at 3,000 pounds 4.00 per week. What is the market price of 5.00 mushrooms? Calculate the producer 6.00 surplus and the deadweight loss created. The equilibrium price is $4.00 a pound and the equilibrium quantity is 3,000 pounds a week. With a production quota of 3,000 pounds per week, because the quota equals the equilibrium quantity, the price does not change—it remains $4.00 per pound. Consequently there is no deadweight loss. Figure 7.1 can be used to calculate the producer surplus. The producer surplus is equal to the area of the grey triangle in the figure. The area of a triangle is equal to 1/2  base  height, so the producer surplus is 1/2  (3,000 pounds)  ($3 a pound), which is $4,500. 8.

Suppose that the government introduces a production quota for mushrooms and sets it at 2,000 pounds a week. What is the market price of mushrooms? Calculate the producer surplus and the deadweight loss. Who gains and who loses? If the government introduces a production quota of 2,000 pounds, Figure 7.2 shows that the market price is $6.00 per pound. The producer surplus is equal to the light grey area in the figure and the deadweight loss is equal to dark grey triangle. The producer surplus is $8,000 and the deadweight loss is $1,500. Producers gain—their producer surplus increases by $3,500. Consumers lose because their consumer surplus decreases.

Quantity Quantity demanded supplied (pounds per week) 4,500 0 4,000 1,000 3,500 2,000 3,000 3,000 2,500 4,000 2,000 5,000

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

Use the following information to work Problems 9 and 10. Coal shortage at China plants The government of China has set price controls on coal and gasoline in an attempt to shield poor urban families and farmers from rising world energy prices. Chinese power plants have run short of coal, sales of luxury, gasguzzling cars have increased, and gasoline consumption has risen. Oil refiners are incurring losses and plan to cut production. Source: CNN, May 20, 2008 9. Are China’s price controls price floors or price ceilings? Draw a graph to illustrate the shortages of coal and gasoline created by the price controls. China’s price controls are price ceilings. In the face of increased demand, China’s price controls have kept the price from rising to its equilibrium. As a result, the quantity demanded exceeds the quantity supplied and shortages have resulted. Figure 7.2 illustrates the situation in the market for coal; the figures for gasoline are similar. In Figure 7.2, at the controlled price of $550 per ton, the quantity of coal demanded is 100 million tons per week. As the quantity of coal supplied is 97.5 million tons per week, there is a shortage of 2.5 million tons per week. .

Chapter 7 . Government Actions in Markets

10. Explain how China’s price controls have changed consumer surplus, producer surplus, total surplus, and the deadweight loss in the markets for coal and gasoline. Draw a graph to illustrate your answer. China’s price controls aim to keep the price from rising to the equilibrium level, so they are examples of a price ceiling. A price ceiling decreases the quantity available to the quantity supplied at the price ceiling. In Figure 7.2, the quantity with the price control is 97.5 million tons of coal per week. The price ceiling also increases the willingness to pay for the quantity available (to $675 per ton in Figure 7.2) and creates an incentive to incur search costs and trade illegally in a black market. As the price and quantity decrease, the producer surplus decreases. As the quantity decreases and search costs are incurred, the consumer surplus decreases. Therefore, as the quantity decreases and the marginal benefit exceeds the marginal cost, a deadweight loss arises. Figure 7.3 shows the changes in consumer surplus, producer surplus, and deadweight loss. With no price ceiling the consumer surplus is equal to area A + area B + area C. With the price ceiling, the consumer surplus is equal to area A. Search costs are area B + area E. The producer surplus without the price ceiling is equal to area E + area F + area G. With the price ceiling, the producer surplus is equal to area G. Without the price ceiling, there is no deadweight loss. With the price ceiling there is a deadweight loss equal to area C + area F and area B + area E are resources lost to search activity 11. Read Eye on Price Regulation on p. 183 and explain why a mismatch between intention and outcome is inevitable if a price regulation seeks to block the laws of supply and demand. Price regulations have as their purpose the goal of changing the market outcome. For example, minimum wage laws raise the wage rate paid lowerskilled workers and rent controls lower the rent paid for apartments. In both instances, the law is designed to change the equilibrium price (the wage for the minimum wage and the rent for rent controls) determined by supply and demand. Because the equilibrium price is the only price at which there is neither a shortage nor a surplus, a law that changes the price automatically creates either a shortage or a surplus. In the Eye on Price Regulation, the cap on executive pay would create a shortage of executives. © 2023 Pearson Education, Ltd.

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

 Additional Problems and Applications 1.

Read Eye on Price Regulation on p. 183. Suppose that Congress caps executive pay at a level below the equilibrium. a. Explain how the quantity of executives demanded, the quantity supplied, and executive pay will change. Why is the outcome inefficient? Because the price cap is below the equilibrium salary, the executive pay falls. The quantity of executives demanded increases and the quantity of executives supplied decreases. There is a shortage of executives. The outcome is inefficient because the marginal benefit exceeds the marginal cost. b. Draw a graph of the market for corporate executives. On your graph, show the market equilibrium, the pay cap, the quantity of executives supplied and the quantity demanded at the pay cap, and the deadweight loss created. Also show the highest pay that an executive might be offered in a black market. Figure 7.5 shows the market for executives. In the absence of a price cap, the equilibrium salary is $600,000 a year and the equilibrium quantity of executives is 60,000. With a price cap (which is the same as a price ceiling) of $550,000, the salary falls to $550,000 per year. At this salary, the quantity of executives demanded increases to 65,000 per year and the quantity supplied decreases to 50,000 per year. There is a shortage of 15,000 executives. The price ceiling is inefficient. The deadweight loss is the darkened triangle. If a black market develops, the figure shows that firms are willing to pay $700,000 per year to hire an executive, so executives who participate in the black market can be paid as much $700,000 per year. Use the following information to work Problems 2 to 4. Concerned about the political fallout from rising gas prices, suppose that the U.S. government imposes a price ceiling of $3.00 a gallon on gasoline. 2. Explain how the market for gasoline would react to this price ceiling if the oil-producing nations increased production and drove the equilibrium price of gasoline to $2.50 a gallon. Would the U.S. gasoline market be efficient? If the equilibrium price of gasoline is $2.50 a gallon, then a price ceiling of $3.00 a gallon has no effect on the market because it does not change the equilibrium price. The market is efficient because at the equilibrium the marginal benefit equals the marginal cost.

Chapter 7 . Government Actions in Markets

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

Under what conditions would the price ceiling create lines at the pumps? The price ceiling creates lines if the equilibrium price of gasoline exceeds the price ceiling.

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

Use the following information to work Problems 6 and 7. Japan raises minimum wage by 3 percent Japan will raise minimum wage by 3 percent to boost domestic demand and add fairness to its economy. A 3 percent increase will be equal to ¥24 as the national average of Japan’s minimum wage was ¥780 per hour the previous fiscal year. Source: Reuters, July 27, 2016 6. On a graph, show the effect of the 3 percent increase on employment of workers in Japan. Figure 7.5 shows the market for workers. In the figure, the

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

equilibrium wage rate is assumed to be ¥790 a week. Before the ¥24 hike in the minimum wage, the previous minimum wage was ¥780. This minimum wage is below the equilibrium wage rate of ¥790, so before the hike in the minimum wage, the wage rate was ¥790 and employment was 2.9 million workers. After the boost in the minimum wage, the new minimum wage exceeds the equilibrium wage rate. Consequently, the wage rate equals ¥804. Employment decreases to 2.8 million workers, the quantity demanded at the minimum wage of ¥804. 7.

Explain the effects of the higher minimum wage on the workers’ surplus and the firms’ surplus. Will the 3 percent increase in wage bring fairness, dignity, and respect The minimum wage decreases both the firms’ and the workers’ surpluses. Figure 7.5 shows the surpluses after the minimum wage is imposed. The white rectangle between the surpluses reflects resources lost because of workers searching for jobs. The labor market has become less efficient because the marginal benefit from employing another worker exceeds the marginal cost of employing the worker. There is a deadweight loss created, as illustrated in the Figure.

Chapter 7 . Government Actions in Markets

Use the following information to work Problems 8 and 9. Crop prices erode farm subsidy program High corn and soybean prices mean farmers are making the most money in their lives. At the same time, grain prices are far too high to trigger payouts under the U.S. primary farm-subsidy program’s “price support” formula. The market has done what Congress couldn’t do and that is “slash farm subsidies.” Source: The Wall Street Journal, July 25, 2011 8. Draw a graph to illustrate the soybean market when the soybean price was low. Show the quantity of soybeans produced, the subsidy farmers received, and the deadweight loss created. Figure 7.6 illustrates the market for soybeans. In the absence of the price support, the equilibrium price is $12.00 per bushel and 2.9 billion bushels are produced. With a price support of $12.50 per bushel, 3.1 bushels are produced. The subsidy the farmers received is illustrated in the figure as the light grey rectangle (some of which lies behind the deadweight loss triangle). The deadweight loss is the dark grey triangle in the figure. 9.

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

 Multiple Choice Quiz 1.

A rent ceiling creates a of housing if it the equilibrium rent. A. surplus; is less than B. shortage; is less than C. surplus; exceeds D. shortage; exceeds Answer: B Figure 7.2 in the text shows that answer B is correct.

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

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

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

Chapter 7 . Government Actions in Markets

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

A minimum wage is . A. efficient if the wage paid rises and more people look for jobs B. inefficient if workers’ surplus decreases and firms’ surplus increases C. inefficient if job search increases and total surplus decreases D. efficient if workers’ surplus increases and firms’ surplus decreases Answer: C The minimum wage decreases total surplus and hence creates inefficiency.

A production quota set below the market equilibrium quantity . A. increases the price, increases producer surplus, and is inefficient B. creates a shortage and increases farmers’ total revenue but is unfair C. is inefficient because farmers’ marginal cost exceeds consumers’ marginal benefit D. is efficient because farmers’ surplus increases Answer: A Production quotas set below the equilibrium quantity force the market price and quantity to change, raising the price and increasing the producer surplus. 8.

An effective production quota for peanuts with no imports of peanuts will . A. lower the peanut growers’ costs, raise the market price of peanuts, and decrease consumer surplus B. raise the price of peanuts, which will decrease the demand for peanuts C. make the peanut market more efficient if the demand for peanuts is inelastic D. decrease the quantity of peanuts produced, decrease the quantity consumed, and increase the total surplus from peanuts Answer: A Figure 7.9(b) in the text illustrates all three of the results.

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Chapter

Taxes

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

Concerned about the political fallout from rising gas prices, the government cuts the tax on gasoline. Use this information to work Problems 3 and 4. 3. Explain the effect of this tax cut on the price of gasoline and the quantity bought if, at the same time, the oil producing nations increase production. The tax cut increases the supply of gasoline. If the oil-producing nations increased their production, the supply of gasoline increases for this rea-

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

son, also. As a result, the equilibrium price of gasoline falls and the equilibrium quantity increases. 4.

Explain the effect of this tax cut on the price of gasoline and the quantity bought if, at the same time, a global shortage of oil sends the price up. The tax cut increases the supply of gasoline. The global shortage of gasoline decreases the supply of gasoline. If the effect of the global shortage exceeds the effect of the tax cut, the price of gasoline rises and the quantity decreases; if the effect of the tax cut is larger, then the equilibrium price of gasoline falls and the equilibrium quantity increases.

The table illustrates the market for Internet service. Use the information in the table and a demand-supply graph to work Problems 5

Price (dollars per month)

and 6. 5. What is the market price of Internet service? If the government taxes Internet service $15 a month, what price would the buyer of Internet service pay? What price would the seller of Internet service receive? As Figure 8.1 shows, the market price of an Internet service is $20 a month because that is the price at which the quantity demanded equals the quantity supplied. If the government imposes a tax of $15 a month on Internet services, Figure 8.1 shows that the buyer pays $30 a month for Internet services. If the government imposes a tax of $15 a month on Internet services, the seller receives $15 a month for Internet services. 6.

0 10 20 30 40 50 60

Quantity Quantity demanded supplied (units per week)

30 25 20 15 10 5 0

If the government taxes Internet service $15 a month, does the buyer or the seller pay more of the tax? What is the tax revenue? What is the excess burden of the tax? Is the tax proportional, progressive, or regressive? The buyers pay more of the tax because the price the sellers receive falls by only $5 while the price the buyers pay rises by $10. With the tax, the quantity of Internet services is 15 units per month. The government collects a tax of $15 a month on each unit, so the government collects $15 a unit  15 units, which is $225 a month. The excess burden is equal to the area of the deadweight loss triangle, the grey triangle illustrated in Figure 8.1. The area of the triangle equals 1/2  base  height. The deadweight loss trian-

0 10 20 30 40 50 60

Chapter 8 . Taxes

gle has a base of 5 units a month, the difference between the initial equilibrium quantity and the quantity after the tax is imposed. The triangle’s height is equal to the tax, $15 a month. The excess burden equals 1/2  5 units  $15 a unit, which is $37.50 a month. The tax is regressive; the average tax rates decreases as income increases. Figure 8.2 illustrates the labor market in a country that does not tax labor income. Suppose that the government introduces a Social Security tax on workers of $2 per hour. Use this information to work Problems 7 and 8. 7. How many workers are employed? What is the wage rate paid by employers and what is the workers’ after-tax wage rate? How many workers are no longer employed? Before the tax, 900 workers are employed and the wage rate is $10.00 an hour. With a social security tax of $2.00 an hour, 800 workers are employed, employers pay a wage rate of $11.00 an hour, workers receive $9.00 an hour, 100 workers are no longer employed, and the government tax revenue is $1,600 per hour of work. 8.

If the government splits the Social Security tax equally between workers and employers, how many workers are employed? What is the wage rate paid by employers and what is the workers’ after-tax wage rate? If the government splits the tax equally, 800 workers are employed, employers pay a wage rate of $10.00 an hour (plus $1.00 in tax to the government), workers receive $9.00 an hour, 100 workers are no longer employed, and the government tax revenues is $1,600 per hour of work. This situation is identical with that in Problem 7. The incidence of the tax is independent of upon whom the law imposes the tax.

Statewide soda tax gaining momentum in Calif. Legislature Fueled by a recent survey showing growing public support, a penny-per ounce tax on sugary drinks appears to be gaining traction in the California Legislature. Source: www.californiahealthline.org, May 6, 2013 Sugary drinks cost California $41 billion a year in medical expenses. On the basis of what principle would this tax be fair? This tax is fair under the benefits principle if soda does indeed, lead to obesity

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

and if the funds raised are used to help pay for the medical expenses of the obese. The tax is fair under the ability-to-pay principle if soda drinkers have higher incomes than non-soda drinkers. 10. Read Eye on Congress on p. 205 and then explain how Congress can decide who pays the taxes, regardless of the elasticities of supply and demand. In your explanation, distinguish between taxes that do and taxes that do not impact the margin on which a decision is made. Congress can decide who pays the taxes if the tax does not depend on the number of hours worked. For example, a tax of $1,000 per worker does not depend on the hours worked and so does not affect the wage workers receive for another hour of work. Workers use the wage for another hour of work as the marginal wage when making their labor supply decisions. Because the marginal wage does not change, workers’ supply of labor does not change and consequently neither does the equilibrium quantity of employment or the wage rate paid workers. With no change in the wage rate, workers pay the full amount of the tax. If, however, the tax is 10 percent of income, then the tax decreases the wage workers receive for another hour of labor. Because the marginal wage changes, so too will workers’ supply of labor, which thereby changes the equilibrium quantity of employment and wage rate. In this case, the division of the tax depends on the elasticities of labor demand and labor supply.

Chapter 8 . Taxes

 Additional Problems and Applications Use the following information to work Problems 1 to 3. According to the WHO ranking, Bosnia and Herzegovina have the highest tax on cigarettes, with 86 percent of the total price of cigarettes made up of tax in 2014. The price of an average pack of cigarettes in Sarajevo, the capital of Bosnia and Herzegovina, is 5.04 KM (Bosnian Convertible Marka) and the taxes are 4.33 KM a pack. The average income of smokers is less than that of non-smokers. 1. Draw a graph to show the effects of the 4.33 KM tax on the buyer’s price, the seller’s price, the quantity of cigarettes bought, and the tax revenue. Does the buyer or seller pay more of the tax? Why? Figure 1 shows the cigarette market. As the figure shows, the price paid by the buyers rises (from 0.71 KM to 5.04 KM per pack) and the price received by the sellers falls (from $5.50 to $4.50 per pack). The quantity of cigarettes bought decreases. The tax revenue is the tax multiplied by the number of packs sold and is the area ebdg in the figure. The demand for cigarettes is more inelastic than the supply, so the buyers pay more of the tax. PRICE (KM PER PACK)

figure 1 8 7

6 5

e b

4 3 2 1

-1

Supply+tax

supply

-2 demand

QUALITY(MILLION PACKS PER MONTH)

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

The consumer surplus shrinks from area acf to area abe and the producer surplus shrinks from area fch to area gdh. The excess burden, or deadweight loss, is equal to the dark grey triangle in the figure. 3.

Is this tax on cigarettes a progressive, regressive, or proportional tax? The tax is regressive. Richer people spend less average income on cigarettes than poorer people since richer people have higher incomes.

The supply of luxury boats is perfectly elastic, the demand for luxury boats is unit elastic, and with no tax on luxury boats, the price is $4 million and 390 luxury boats a week are bought. Now luxury boats are taxed at 20 percent. What price do the buyers pay? How is the tax split between buyers and sellers? What is the government’s tax revenue? On a graph, show the excess burden of this tax. Is this tax efficient? As the supply is perfectly elastic, the buyers pay all the tax: the price rises by the full amount of the tax and buyers pay $4.8 million per boat. As the supply is perfectly elastic, the buyers pay all the tax and the sellers pay none of the tax. Demand is unit elastic, which means as the price rises the total revenue (total expenditure) remains constant at 390 boats x 4 million per boat = $1,560 million. The price rises by 20 percent to $4.8 million because supply is perfectly elastic. So $1,560 million / $4.8 million = 325 boats are produced. The tax decreases the number of boats by 65 per year. Consequently, tax revenue = 325 boats x $800,000 per boat = $260 million. The shaded area in Figure 8.4 is the excess burden of the tax. The tax is not efficient because the marginal benefit exceeds the marginal cost, and a deadweight loss is created.

Chapter 8 . Taxes

Figure 8.5 illustrates the market for chocolate bars. If a new tax of $1.50 a chocolate bar is imposed, what is the change in the quantity of chocolate bars bought, who pays most of the tax, and what is the deadweight loss? The initial price of a chocolate bar is $3.00 per bar and the initial quantity of chocolate bars is 6 million bars per year. Figure 8.6 (on the next page) shows the situation after the tax is imposed. As Figure 8.6 shows, the tax shifts the supply curve upward by $1.50 to the S + tax curve. Once the tax is imposed, including the tax consumers pay $4.00 a bar. Manufacturers must send $1.50 to the government as the tax, so after the tax is imposed, the suppliers receive $2.50. The equilibrium quantity of chocolate bars is 4 million bars per year. The quantity of chocolate bars decreases by 2 million bars per year. The amount that the consumer pays rises by $1.00 and the amount that the supplier receives falls by $0.50. Hence the consumers pay most of the tax. The deadweight loss is shown in Figure 8.6 as the area of the grey triangle. The area of a triangle is 1/2 × base × height. Hence the deadweight loss is equal to 1/2 × 2 million bars × $1.50 per bar, which is $1.5 million.

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

In an hour, a baker earns $10, a gas pump attendant earns $6, and a copy shop worker earns $7. Suppose that the government introduces an income tax of $1 an hour. Calculate the marginal tax rates for bakers, gas pump attendants, and copy shop workers. Is this tax progressive or regressive? The marginal tax rate is the percentage of an additional dollar of income that is paid in tax. For bakers the marginal tax rate is ($1 tax an hour)  ($10 an hour), which equals 10 percent. For gas pump attendants, the marginal tax rate is ($1 tax an hour)  ($6 an hour), which equals 16.7 percent. For copy shop workers, the marginal tax rate is ($1 tax an hour)  ($7 an hour), which is 14.3 percent. The tax is regressive because the average tax rate falls as income increases.

Nelson earns $40,000 and pays $4,000 in tax, while Suzy earns $50,000 and pays $10,000 in tax. If Nelson’s income increases by $100, his tax increases by $39, but if Suzy’s income increases by $100, her tax increases by $51. Calculate the average tax rate and marginal tax rate that Nelson pays and that Suzy pays. Is this income tax fair? Explain. Nelson’s average tax rate equals $4,000 ÷ $40,000, which is 10 percent. Nelson’s marginal tax rate equals $39 ÷ $100, which is 39 percent. Suzy’s average tax rate equals $10,000 ÷ $50,000, which is 20 percent. Suzy’s marginal tax rate equals $51 ÷ $100, which is 51 percent. The income tax is progressive because the average tax rate increases as income increases. As the income tax is progressive such that richer people pay a larger share of their income as taxes compared to poorer people, using a “fair results” approach the income tax is fair. The ability-to-pay principle would also classify the tax as fair. The benefits principle would conclude that the tax was fair if the rich receive a disproportionately large share of the benefit from law and order.

Chapter 8 . Taxes

study of the Bush tax cuts of 2001 noted that the top 1 percent of income earners reaped the biggest benefits. What assumptions about the elasticities of demand and supply for high-wage labor and capital might be consistent with this assessment? What other facts about demand and supply and market outcomes would you need to know to verify this claim? The question of who benefits from a tax cut is the same question as who pays a tax when it is levied. In order to determine who pays a tax, the elasticities of demand and supply must be known. For an income tax, the more inelastic the supply of labor and the more elastic the demand for labor, the greater the fraction of the income tax paid by the worker or, conversely, the greater the benefit received by the worker from a tax cut. Similarly, the more inelastic the supply of capital and the more elastic the demand for capital, the greater the fraction of the income tax paid by the supplier of capital, that is, a saver or, conversely, the greater the benefit received by the saver from a tax cut. So the assertion that the richest 1 percent of Americans will receive the biggest benefits of the tax cuts enacted in 2001 assumes that the supply of labor is very inelastic and the demand for labor is very elastic. It also assumes that the supply of capital is very inelastic and the demand for capital is very elastic. Use the following news clip to work Problems 9 and 10. Britain has one of lowest petrol prices in Europe before tax According to official figures, without the tax British drivers would have the cheapest petrol in Western Europe. However, the prices are among the highest with 70 percent of the price of a liter of fuel constituting tax. Source: Mail Online India, March 8, 2015 9. Would a tax per mile driven be more efficient or less efficient than a tax per gallon of gasoline? Which tax would be more regressive? Explain your answers. A tax per gallon of gasoline would be more efficient. The reason is that a tax per mile driven is borne equally per mile of road use by all road users, while a tax per gallon of gasoline makes the price per mile lower for users of small economy vehicles and higher for users of large heavy vehicles. Efficiency requires the marginal social benefit to equal the marginal social cost. The price of road use inclusive of the tax is a measure of the marginal social benefit and if larger and heavier vehicles impose a larger marginal social cost of road use, then a tax per gallon of gasoline is more efficient 10. Would a tax per mile driven be fairer than a tax per gallon of gasoline? Explain your answer. Neither tax is definitely fairer. The benefits principle requires that vehicles that cause greater wear and tear on highways and bridges pay a higher tax. If, as seems likely, larger and heavier vehicles cause greater wear and tear and also use more gasoline per mile, then a tax per gallon © 2023 Pearson Education, Ltd.

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

of gasoline is the fairer tax on the benefits principle. On the ability-to-pay principle, however, vertical equity requires that taxpayers with a greater ability to pay bear a larger share of the taxes. If higher income people drive vehicles that use more gasoline per mile driven, a tax per gallon of gasoline achieves greater vertical equity and is the less regressive tax. However, if low-income people drive older, less fuel-efficient vehicles, a tax per mile driven achieves greater vertical equity and is the less regressive tax.

Chapter 8 . Taxes

 Multiple Choice Quiz 1.

If a tax of $1 a can is imposed on the buyers of sugary drinks, the demand for sugary drinks and the price that buyers pay . A. doesn’t change; doesn’t change B. doesn’t change; rises by $1 a can C. decreases; rises by more than $1 a can D. decreases; rises by less than $1 a can Answer: D Figure 8.1(a) illustrates this result. 2.

A tax on sugar will be paid by only . A. buyers if the supply of sugar is perfectly elastic B. sellers if the demand for sugar is perfectly inelastic C. buyers if the demand for sugar is perfectly elastic D. sellers if the supply of sugar is perfectly elastic Answer: A If the supply is perfectly elastic, demanders pay all of the tax and suppliers pay none of the tax.

If the government imposes a new tax on plastic bags, . A. total surplus from bags shrinks by more than the amount of tax collected B. total surplus from bags shrinks by the amount of the tax revenue collected C. a deadweight loss arises equal to the amount of tax revenue collected D. the market for plastic bags remains efficient if the tax is fair Answer: A The deadweight loss is the excess burden—the burden over and above the tax collected—from a tax. 4.

The demand for labor is more elastic than the supply of labor. An income tax the wage rate paid by employers and . A. lowers; workers pay all the tax B. raises; workers pay most of the tax C. does not change; employers pay all the tax D. raises; employers pay most of the tax Answer: B When the supply is more inelastic than the demand, suppliers pay more of the tax.

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

The supply of low-skilled workers in China is perfectly elastic. In 2011, when China cut the tax on these workers’ incomes from 5 percent to zero, . A. employers cut the wage rate but hired the same number of workers B. employers cut the wage rate and hired more workers C. employers didn’t change the wage rate but hired more workers D. employers didn’t change the wage rate and hired the same number of workers Answer: B Figure 8.4(b) on page 198 illustrates the result of imposing a tax when the supply is perfectly elastic. The effect of removing the tax is the opposite of the impacts illustrated in the figure. 6.

The supply of land is perfectly inelastic so a tax on land rent is A. efficient and the landowner pays all of the tax B. inefficient because the renter pays all of the tax C. inefficient if the tax is too high D. efficient and the renter pays all of the tax Answer: A Figure 8.7 on illustrates this result.

The demand for labor is more elastic than the supply of labor. A Social Security tax imposed equally on workers and employers . A. raises the wage rate by more than the Social Security tax B. decreases employment and workers pay most of the tax C. increases the wage rate paid by employers by the amount of the tax D. is fair because workers and employers pay the same amount of tax Answer: B Figure 8.8 on illustrates this result. 8.

The principle of fairness is the proposition that . A. benefit; people should pay taxes equal to the benefits they receive from the public goods bought with the tax revenue B. benefit; people should receive benefits equal to their ability to pay C. ability-to-pay; people should pay taxes equal to the benefits they receive D. ability-to-pay; people should receive benefits equal to their ability to pay Answer: A The definition of the benefits principle on page 208 shows that answer A is correct.

Global Markets in Action ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use Figures 9.1 and 9.2 to work Problems 1 to 4. Figure 9.1 and Figure 9.2 show the markets for shoes if there is no trade between the United States and Brazil.

Which country has a comparative advantage in producing shoes? With international trade, explain which country would export shoes and how the price of shoes in the importing country and the quantity produced by the importing country would change. Explain which country gains from this trade. Brazil has the comparative advantage in producing shoes because, with no international trade, the price in Brazil is less than the price in the Unit© 2023 Pearson Education, Ltd.

Chapter

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

The world price of a pair of shoes is $20. Explain how consumer surplus and producer surplus in the United States changes as a result of international trade. On the graph, show the change in U.S. consumer surplus (label it A) and the change in U.S. producer surplus (label it B). The consumer surplus of U.S. consumers increases because the price U.S. consumers pay for a pair of shoes falls. As a result of the fall in price, U.S. consumers increase the number of shoes they buy. Consumer surplus increases because the price falls and because the quantity of shoes purchased increases. The producer surplus of U.S. producers decreases because of the fall in the price of a pair of shoes. As a result of the fall in price, U.S. producers decrease the quantity of shoes they produce. Producer surplus decreases both because the price falls and because the quantity of shoes produced decreases. Figure 9.3 shows the change in consumer surplus and the change in producer surplus. The increase in consumer surplus equals the area A + B (the part of the light colored gain that lies beneath area B is not visible). The loss of producer surplus equals the dark gray area B.

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

Chapter 9 . Global Markets in Action

rises and because the quantity of shoes produced increases. Figure 9.4 shows the change in consumer surplus and the change in producer surplus. The decrease in consumer surplus equals the dark gray area C. The increase in producer surplus equals the area C + D (the part of the light colored gain that lies beneath area C is not visible). 4.

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

Use the following information to work Problems 5 to 7. 5. The supply of roses in the United States is made up of U.S. grown roses and imported roses. Draw a graph to illustrate the U.S. rose market with free international trade. On your graph, mark the price of roses and the quantities of roses bought, produced, and imported into the United States. Figure 9.5 shows a graph of the rose market. In the figure, the world price of roses is $10 per dozen and this is the price in the United States. In the United States, the demand curve shows that 400,000 dozen roses are purchased and sold per month. The supply curve shows that 100,000 dozen roses per month are produced in the United States. The difference, or 300,000 dozen roses per month, is imported into the United States. 6.

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

$10 per dozen tariff on rises, Figure 9.6 shows the consequences. The $10 per dozen tariff equals the length of the two-headed gray arrow. The price in the United States rises to $20 per dozen. The number of roses purchased in the United States decreases to 300,000 per month and the number of roses produced in the United States increases to 200,000 per month. The quantity of roses imported falls to 100,000 per month. The government’s tariff revenue is equal to the area of dark rectangle, $10 per dozen multiplied by 100,000 dozen imported, or $1,000,000 per month. The increase in producer surplus from the tariff equals the area of the medium grey trapezoid.

Suppose that the U.S. government puts an import quota on roses. Show on your graph the consumer surplus that is redistributed to producers and importers and also the deadweight loss created by the import quota. In Figure 9.7, the import quota is equal to the length of the light grey arrow, 100,000 dozen roses per month. With the import quota in place, the supply curve becomes S1 so that the equilibrium price in the United States is $20 per dozen and equilibrium quantity becomes 300,000 dozen. The consumer surplus is redistributed to producers (the area of the light grey trapezoid) and to importers (the area of the light grey rectangle). The deadweight loss is equal to the area of the two dark grey triangles.

Use the following information to work Problems 8 to 10. EU ramps up anti-dumping duties on Chinese steel Aimed at protecting local industry against unfair trading, the European

Chapter 9 . Global Markets in Action

Union introduced levies increasing from provisional tariffs of 13.2 percent to 22.6 percent. Source: The Wall Street Journal, April 6, 2017 8. Explain who in the European Union countries gains and who loses from restrictions on steel imports. How do you expect the prices of automobiles and office towers to be affected? The European Union’s (EU) producers of steel will gain. The EU member countries will also gain as they will receive additional tariff revenue. Consumers of steel in the EU will lose. The higher price of steel will increase the costs of automobiles and office towers. The supply of automobiles and office towers will decrease, so their price will increase. 9.

What is dumping? Who in the European Union countries loses from foreign firm’s dumping of steel? Dumping occurs when a foreign firm sells its exports at a lower price than the cost of production. The European Union’s (EU) producers of steel lose from China’s dumping of steel.

10. Explain what an antidumping tariff is. What argument might the EU use to raise the tariff on steel imports? Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. The European Union (EU) might have argued that Chinese exporters of steel were charging a price of (approximately) one half the cost of production. In this case, a tariff of 99.65% (approximately) will double the EU price of the imported steel, thereby raising the price to the (alleged) cost of production.

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11. Read Eye on Globalization on p. 223 and draw two graphs to show how U.S. consumers gain from iPads manufactured in China and why Chinese workers also gain. Figure 9.8 shows the market for iPads in the United States. As the figure illustrates, U.S. consumers gain because they pay a lower price and consequently buy more iPads. In the figure the price falls from $300 per iPad with no trade to $200 per iPad with trade. The lower price means that consumers increase the quantity of iPads they buy, in the figure from 75 million iPads per year to 100 million per year. Figure 9.9 (on the next page) shows that Chinese workers also gain. As the figure illustrates, Chinese workers gain because more iPads will be produced in China. Consequently more workers are employed and potentially their wage rate also rises. In the figure the price rises from $100 per iPad with no trade to $200 per iPad with trade. The quantity of iPads produced in China increases from 75 million with no trade to 100 million with trade.

Chapter 9 . Global Markets in Action

 Additional Problems and Applications Read Eye on Globalization on p. 223 and use the following information to work Problems 1 and 2. The future of U.S.–India relations When she was Secretary of States, Hillary Clinton gave a major speech covering all the issues in U.S.–India relations. On economic and trade relations she noted that India maintains significant barriers to U.S. trade. The United States also maintains barriers against Indian imports such as textiles. Mrs. Clinton, President Obama, and Anand Sharma, the Indian Minister of Commerce and Industry, say they want to dismantle these trade barriers. Source: www.state.gov 1. Explain who in the United States would gain and who might lose from dismantling trade barriers between the United States and India. Winners from increased trade are U.S. producers and Indian consumers from U.S. exports and U.S. consumers and Indian producers from Indian exports. Losers from increased trade are U.S. consumers and Indian producers from U.S. exports and U.S. producers and Indian consumers from Indian exports 2.

Draw a graph of the U.S. market for textiles and show how removing a tariff would change producer surplus, consumer surplus, and the deadweight loss from the tariff. Figure 9.10 shows the market for textiles. With the tariff the price of a unit of clothing in the United States is $20 while the world price is $10. When the tariff is removed, producers’ lose producer surplus equal to area A. This area is converted into consumer surplus. The deadweight loss with the tariff is equal to the sum of areas B. When the tariff is removed, the deadweight loss disappears—it becomes part of the consumer surplus. When the tariff is removed, consumer surplus increases by an amount equal to the sum of area A (which had been producer surplus with the tariff) plus both areas B (which had been the deadweight loss with the tariff) and area C (which was the amount of the tariff revenue).

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The United States exports wheat. Draw a graph to illustrate the U.S. wheat market if there is free international trade in wheat. On your graph, mark the price of wheat and the quantities bought, produced, and exported by the United States. Figure 9.11 illustrates the situation. In the figure, without international trade, the price of a bushel of wheat in the United States is $2 per bushel and 20 billion bushels are grown and consumed. With international trade the price of a bushel of wheat in the United States rises to $6 per bushel. At this higher price, 10 billion bushels are consumed and 40 billion are produced. The difference between the quantity produced and the quantity consumed, which is 30 billion bushels, is exported by the United States.

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

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

Chapter 9 . Global Markets in Action

fee it consumes than would otherwise be the case. For imports, consumers gain increased consumer surplus while producers lose producer surplus. But the increase in consumer surplus is larger than the loss in producer surplus. Economists measure the net gain from international trade as the increase in the total surplus. 6.

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

Use Figure 9.12 and the following information to work Problems 7 to 9. Figure 9.12 shows the car market in Mexico when Mexico places no restriction on the quantity of cars imported. The world price of a car is $10,000. 7. If the government of Mexico introduces a $2,000 tariff on car imports, what will be the price of a car in Mexico, the quantity of cars produced in Mexico, the quantity imported into Mexico, and the government’s tariff revenue? If the Mexican government imposes a $2,000 per car tariff on cars imported into Mexico, the price of a car in Mexico rises from $10,000 to $12,000. At this price, 10 million cars per year will be purchased in Mexico and 6 million cars per year will be produced in Mexico. The difference, 4 million cars per year, will be imported. The Mexican government’s tariff revenue is $2,000 per car multiplied by 4 million cars imported, which is $8 billion per year. 8.

If the government of Mexico introduces an import quota of 4 million cars

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a year, what will be the price of a car in Mexico, the quantity of cars produced in Mexico, and the quantity imported? If the Mexican government imposes an import quota of 4 million cars a year, the price of a car in Mexico will rise from $10,000 to $12,000. At this new, higher price, the quantity of cars demanded in Mexico is 10 million; the quantity of cars produced in Mexico is 6 million. The difference between Mexican consumption and Mexican production, 4 million, is equal to the amount of the import quota and so is imported from abroad. 9.

What argument might be used to encourage the government of Mexico to introduce a $2,000 tariff on car imports from the United States? Who will gain and who will lose as a result of Mexico’s tariff? The tariff might be imposed because the government gains revenue from the tariffs it imposes. It might also be imposed because of rent seeking, in particular, auto producers who profit from the tariff might lobby intensively to impose the tariff. They likely will suggest that the Mexican auto industry is new (an infant) and therefore needs protection until it matures and can compete with the rest of the world. They might also argue that a tariff will save (actually, gain) jobs in Mexico because of the expansion of Mexican auto production. Mexican auto producers and the Mexican government gain from the tariff. The auto producers have more producer surplus and the Mexican government gains tariff revenue. Mexican consumers lose from the tariff. The consumers have less consumer surplus with the tariff.

Chapter 9 . Global Markets in Action

 Multiple Choice Quiz 1.

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

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

With free trade between the United Kingdom and Germany, the United Kingdom exports crude petroleum and Germany exports cars. U.K. consumers. . A. of crude petroleum gain and German consumers of cars lose B. of both crude petroleum and cars gain more than either producer C. of cars gain more than U.K. producers of cars lose D. crude petroleum gain more than U.K. producers of crude petroleum lose Answer: C

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With free trade between China and the United States, the winners are and the losers are . A. U.S. consumers of U.S. imports; U.S. producers of the U.S. import good B. China’s consumers of China’s imports; China’s producers of its export good C. U.S. producers of the U.S. export good; U.S. consumers of U.S. imports D. China’s consumers of China’s export good; China’s producers of its imported good Answer: A Figure 9.3 shows that the U.S. price of the imported good falls, so that U.S. consumers win and U.S. producers lose. 5.

The Canada tariff on cars _____ the Canada price of cars, ____ Canada production of cars and _____ the Canada gains from trade. A. raises; increases; increases B. doesn’t change; increases; increases C. doesn’t change; doesn’t change; decreases D. raises; increases; decreases Answer: D 6.

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

The people who support restricted international trade say that . A. protection saves jobs in every economy. B. domestic firms won’t be able to compete with low-wage foreign labor if trade is free C. outsourcing sends job abroad, which brings diversification and makes our economy more stable D. protection is needed to enable domestic firms to produce the things at which they have a comparative advantage. Answer: B

Chapter

Externalities ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Quantity Price The first table shows the demand schedule for electricity (cents per demanded from a coal-burning utility. The second table shows the utilikilowatt) (kilowatts per day) ty’s cost of producing electricity and the external cost of the 4 500 pollution created. Use this information to work Problems 1 8 400 to 3. 12 300 16 200 1. With no pollution control, calculate the quantity of elec20 100 tricity produced, the price of electricity, and the margin24 0 al external cost of the pollution generated. With no pollution control, the quantity of elecQuantity Marginal Marginal tricity produced is the amount at which the (kilowatts cost external cost per day) quantity demanded equals the quantity sup(cents per kilowatt) plied as determined by the marginal private cost 0 0 0 100 2 2 of producing electricity. In this case, the quanti200 4 4 ty is 400 kilowatts per day and the price is 8¢ per 300 6 6 kilowatt. At this quantity, the marginal external 400 8 8 cost is (also) 8¢ per kilowatt. 500 10 10 2. With no pollution control, calculate the quantity of electricity produced, the marginal social cost of the electricity generated, and the deadweight loss. With no pollution control, the quantity of electricity produced is the amount at which the quantity demanded equals the quantity supplied as determined by the marginal private cost of producing electricity. In this case, the quantity is 400 kilowatts per day. At this quantity the marginal external cost is (also) 8¢ per kilowatt so the marginal social cost is 16¢ per kilowatt. The deadweight loss equal to the area of the triangle whose height is the marginal external cost at the equilibrium quantity and whose base is the difference between the efficient quantity and the privatemarket equilibrium quantity. The efficient quantity is 300 kilowatts and at

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

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

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

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

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

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

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

With no public college and no government involvement, 1 million students enroll in college and the tuition is $5,000 a year. The efficient number of students is 2 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The deadweight loss is the grey area in Figure 10.1 and equals the area of a triangle with a height equal to the marginal external benefit at the unregulated equilibrium and a length equal to the difference between the efficient quantity and the equilibrium quantity. In this case the deadweight loss equals ½ × $2,000 per student × 1 million students, which is $1 billion. 7.

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This figure illustrates the market for college education. With no public college and no government involvement, 2 million students enroll in college and the tuition is $3,000 a year. The efficient number of students is 6 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The required subsidy is $2,000 a student, which leads to 6 million students enrolling. The cost to the taxpayers is $2,000 per student × 6 million students, which is $12 billion. 8.

The marginal cost of educating a college student is $3,000 a year. The table shows the marginal benefit schedule of a college education. The marginal external benefit of a college education is a constant $1,000 per student per year. There are no public colleges. If the government offers vouchers to students, what is the value of the voucher that will encourage the efficient number of students to enroll? This figure illustrates the market for college education. MSB’ is the valid curve, not MSB. With no public college and no government involvement, 2 million students enroll in college and the tuition is $3,000 a year. The efficient number of students is 3 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. If the government offers a $1,000 voucher, which is equal to the marginal external benefit, the efficient number of students, 3 million, will enroll

Chapter 10 . Externalities

China’s smoggy air Chinese Premier Li Kequang has promised to increase the use of renewable energy sources in a stepped up effort to reduce emissions, which cause severe smog and health problems. Source: CBC News World, March 5, 2017 What is the externality described in the news clip? How could a high pollution tax on power generators reduce the emission of pollutants? If a high pollution tax cut emissions, would China's air quality and power generation be more efficient? Explain your answers. The emission of pollutants by power generators makes the marginal social cost of power higher than the marginal private cost, so it creates a negative production externality. There is an overproduction by the power generators. With the imposition of a pollution tax, the cost of burning dirty fuels increases, thereby raising the marginal private cost. With a high enough tax, output decreases to the efficient output level and the level of air pollution falls.

10. Read Eye on Climate Change on p. 258-259 and then describe the government actions that could decrease carbon emissions. Explain why the government is not using them more aggressively. Governments could decrease carbon emissions by imposing carbon taxes, using a cap-and-trade policy, or by subsidizing green alternatives. A carbon tax increases the cost of carbon emitting activities, and decreases the amount of these activities. A cap-and-trade policy decreases carbon emissions because it sets a limit on the quantity of greenhouse gases that can be emitted. Governments have not moved aggressively to impose these policies. First, developing nations want to use low-cost energy, such as coal, to grow their economies. Second, it is hard to get agreement on the policies. Third, the costs of limiting the emissions are incurred now but the benefits, if any, would come sometime in the future. And, fourth, technology is lowering the cost of cleaner energy so there is the temptation to rely on further technological advances.

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 Additional Problems and Applications 1.

Read Eye on Climate Change on pp. 258–259 and then use the information to work this problem. The price of gasoline in Europe is about three times that in the United States, mainly because the European gas tax is higher than the U.S. gas tax. How would an increase in the gas tax in the United States to the European level change carbon emissions? Would this tax increase bring greater efficiency or would it increase deadweight loss? Burning gasoline while driving creates carbon emissions. The increase in the gas tax increases the cost of driving, which leads to less driving. Consequently raising the gasoline tax leads to less carbon emissions. The case for raising the gasoline tax asserts that the carbon emissions from driving contribute to global warming. These emissions are an external cost, so the marginal social cost of the carbon emissions from driving exceeds the marginal social benefit. The efficient amount of driving automobiles is the amount such that the marginal (social) benefit equals the marginal social cost. Increasing the tax makes the marginal private cost closer to (or, in an ideal world, equal to) the marginal social cost and decreases (potentially eliminates) the deadweight loss.

A warming Arctic could cost the world $70 trillion A study warns that the Arctic is warming at an accelerating pace that will cost nearly $70 trillion. But keeping the temperature rise to 1.5 Celsius lowers the cost to $25 trillion. Source: National Geographic, April 23, 2019 What is the externality described in the news clip? Why are property rights in the Arctic not a solution to this externality? What solution might be effective? The externality described in the news clip is the harm created by a warmer Arctic. According to the Coase theorem if property rights exist and the costs of enforcing them are low, then the market outcome is efficient. Because the externality is the result of billions actions taken elsewhere in the world, the transactions costs of confronting each emitter with its marginal cost is too high, so the Coase theorem does not apply. Taxes imposed worldwide on the products leading to the warmer Artic or a worldwide cap-and-trade policy imposed on the emissions that warm the Artic leading may be effective solutions.

Use the following information to work Problems 3 and 4. Whole foods to become first national supermarket to ban plastic straws Whole Foods is set to completely ban plastic straws and will introduce paper straws across all its stores in the U.S., Canada and the U.K. by July 2019. Source: Newsweek, May 23, 2019 3. Explain how Whole Foods’ decision will change the deadweight loss cre-

Chapter 10 . Externalities

ated by plastic straws. Figure 10.2 illustrates a city-wide market for plastic straws. Prior to Whole Food’s decision, the unregulated market equilibrium quantity of plastic straws is 300,000 per week. Because use of plastic straws creates pollution, the equilibrium quantity exceeds the efficient quantity, which in the figure is 200,000 per week. A deadweight loss, equal to the area of the grey triangle in the figure, results. Whole Food’s decision decreases the demand for straws and shifts the demand curve leftward. If the demand decreases to DWH, the deadweight loss is eliminated because the equilibrium quantity of plastic straws changes to 200,000 per week, the efficient quantity. If, however, the demand decreases less than what is illustrated, the deadweight loss decreases but is not eliminated, while if the demand decreases more than what is illustrated, a deadweight loss from underproduction is created. 4. Explain why Whole Foods’ decision might create an inefficiency. As Figure 10.2 illustrates, Whole Food’s decision decreases the quantity of plastic straws. If the quantity decreases by enough so that the MSC of plastic straws is less than the MC of its substitute, paper straws, then the market quantity of plastic straws is less than the efficient quantity. Marginal Use the following information to work Problems 5 to 7. Students private benefit The marginal cost of educating a college student online (millions (dollars per is $3,000 a year. The table shows the marginal private per year) student per year) benefit schedule from a college education. The marginal 1 6,000 external benefit is 50 percent of the marginal private 2 5,000 benefit. 3 4,000 4 3,000 5. With no government action in online college educa5 2,000 tion, how many students enroll and what is the tui6 1,000 tion? Calculate the deadweight loss created. With no government involvement, 4 million students enroll in college and the tuition is $3,000 a year. The efficient number of students is 5 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The deadweight loss equals the area of a triangle with a height equal to the marginal external benefit at the unregulated equilibrium and a length equal to the difference between the efficient quantity and the equilibrium quantity. In this case the deadweight loss equals ½  $1,500 per student  1 million students, which is $750 million.

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

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

Oregon legislative committee passes cap-and-trade bill Lawmakers are moving Oregon a step closer to adopting what would be the nation’s second economywide carbon pricing scheme, after California. Source: Portland Business Journal, May 17, 2019 Explain the conditions under which Oregon’s carbon pricing scheme would reduce the amount of carbon emissions to the efficient quantity. Use a graph of the Oregon market for energy to illustrate your explanation. On your graph, show the effects of setting the price of carbon too low and too high. A cap-and-trade system can reduce the amount of carbon emissions to the efficient quantity if (1) the government can correctly determine the efficient quantity, and (2) then issues the correct of number of emission permits to reach the efficient quantity, in which case the price of a permit equals the marginal external cost. Figure 10.3 illustrates the situation in the Oregon market for electricity. In the absence of any government action, the quantity of electricity, 400 megawatts per week, is determined by supply curve (S = MC) and demand curve (D = MB). The efficient quantity, 200 megawatts, is determined by the marginal social cost curve (MSC) and the marginal benefit curve (D = MB). To achieve the efficient quantity, permits must be issued so that the price of a permit must be 15¢, the difference between the marginal social cost of 20¢ at the efficient quantity and the private cost marginal cost, 5¢ at the efficient quantity. If the government issues too many permits, the price of a permit will be too low, say 7.5¢. In this case, the supply curve after taking account of the

Chapter 10 . Externalities

cost of the permits is SLOW so that at each quantity, SLOW lies above the supply curve by 7.5¢. Consequently, the equilibrium quantity of electricity is 300 megawatts, which exceeds the efficient quantity. If the government issues too few permits, the price of a permit will be too high, say at 22.5¢. In this case, the supply curve after taking account of the cost of the permits is SHIGH so that at each quantity SHIGH lies above the supply curve by 22.5¢. Consequently, the equilibrium quantity of electricity is 100 megawatts, which is less than the efficient quantity. 9.

Italy adopts new law to cut down food waste As food waste costs Italy's businesses and households more than €12 billion per year, which could amount to more than 1 percent of GDP, the government passed into law new measures to try to reduce the amount of food wasted each year and seek to make donating food easies. Source: Washington Post, May 1, 2019 Illustrate the pros and cons for the Italian government’s new food waste tax by drawing a graph of the market for Italy’s restaurant. Figure 1 shows the market for Figure 1 restaurant foods. At the market demand and supply equilibrium, Price (dollars per dish) Italians demand more food than MSC they can consume, thus there is food waste. When food is wasted MPC in restaurants, an external cost is created to dispose of them, so the marginal social cost for Food waste tax restaurant food is higher than the marginal private cost. A food waste tax is needed to shift the marginal private cost curve D upward and make it equal to MSC, lowering the equilibrium quantity and reaching the Quantity (dishes sold per day) socially efficient quantity. The market for restaurants in Italy The argument in favor of the food waste tax (pros) is that the tax eliminates the deadweight loss from the negative externalities caused by restaurant foods waste. The argument against the tax (cons) is that it raises the price of restaurant food, exerting a higher burden on customers. Also, the food waste tax is confined to restaurants only.

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 Multiple Choice Quiz 1.

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

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

An unregulated paint factory that pollutes a river results in and . A. overproduction; a price that exceeds the marginal benefit of the good B. underproduction; a price that equals the marginal benefit of the good C. the efficient quantity produced; a marginal benefit equal to the marginal social cost D. an inefficient quantity produced; a marginal benefit below the marginal social cost Answer: D Figure 10.2 shows that answer D is correct.

Chapter 10 . Externalities

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

A good or service with a positive externality is one which . A. everyone wants to have access to B. is produced in the social interest C. the marginal social benefit exceeds the marginal private benefit D. the marginal external benefit exceeds the marginal private benefit Answer: C The definition of marginal social benefit on page 261 shows that answer C is correct.

Because education generates a positive externality, . A. everyone who wants a college education should get one B. graduates’ marginal benefit exceeds the society’s value of the education C. the quantity of education undertaken will achieve the social interest if it is free D. subsidies to colleges or vouchers to students are means of achieving the efficient number of graduates Answer: D Figures 10.8 and 10.9 show how subsidies and vouchers increase the number of students to be equal to the efficient number.

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 Problems and Applications Use the following list of items to work Problems 1 and 2.  New Year’s Eve celebrations in Times Square, New York  A city’s sewer system  New York subway system  A skateboard  Cable TV  Niagara Falls 1. Classify each of the items in the list as a private good, a public good, a common resource, or a club good. Explain each classification.  New Year’s Eve celebrations in Times Square, New York New Year’s Eve celebrations in Times Square are a public good because they are nonexcludable and, as long as Times Square is not too crowded, nonrival.  A city’s sewer system A sewer system is a club good because it is nonrival and is excludable.  New York subway system The New York subway system as a private good. It is excludable because you have to buy a ticket and it is rival because when you get a seat or a spot to stand no one else can occupy the same space.  A skateboard A skateboard is a private good.  Cable TV Cable TV is a club good because it is nonrival and excludable.  Niagara Falls Niagara Falls is a common resource. It is nonexcludable because neither the United States nor Canada charge admission and it is rival be. .

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cause it is generally very crowded. For each public good in the list, is there a free-rider problem? If not, how is the free-rider problem avoided?  New Year’s Eve celebrations in Times Square, New York There is a free-rider problem because New York City does not put up gates and charge an entrance fee to enter Times Square.  A city’s sewer system There is no free-rider problem because if you do not pay your bill, you are excluded by not receiving the service.  New York subway system The subway system is not a public good, so there is no free-rider problem, because a rider must pay to ride the subway.  A skateboard A skateboard has no free rider problem because it is a private good, so it is necessary to first purchase the skateboard to use it.  Cable TV There is no free-rider problem because if you do not pay your bill, you are excluded by not receiving the service.  Niagara Falls Niagara Falls has a free rider problem because it is generally very crowded. 3. The table sets out total benefit of a public good for Wendy, Sara, and Tom, who are only people in the society. If the government provides 3 units of the public good, what is the marginal social benefit? 2.

The marginal social benefit equals the sum of the marginal benefits of each person at the specified quantity. For each person, the marginal benefit is the change in the total benefit. For 2 to 3 units, Wendy’s marginal benefit is 20, while from 3 to 4 units her marginal benefit is (also) 20. So, Wendy’s marginal benefit at 3 units is 20. For 2 to 3 units, Sara’s marginal benefit is 5, while from 3 to 4 units her marginal benefit is (also) 5. So, Sara’s marginal benefit at 3 units is 5. For 2 to 3 units, Tom’s marginal benefit is 10, while from 3 to 4 units his marginal benefit is 5. So, Tom’s marginal benefit at 3 units is 7.5. The marginal social benefit at 3 units equals the sum to Wendy’s marginal benefit plus Sara’s marginal benefit plus Tom’s marginal benefit, which is 20 + 5 + 7.5 = 32.5

Chapter 11 . Public Goods and Common Resources

Use the figure to work Problems 4 and 5. It shows the marginal social benefit and marginal social cost of a waste disposal system in a city of 1 million people. 4. What is the efficient capacity of the system and how much would each person have to pay in taxes if the city installed the efficient capacity? The efficient capacity is 2.5 million gallons a day. If the city installs the system, the total cost (which is the area under the MC curve— see Figure 6.7 on page 152) is 1/2  2.5 million gallons  $50 per gallon, which is $62.5 million. There are 1 million residents, so everyone pays $62.50. 5.

If voters are well informed about the costs and benefits of the waste disposal system, what capacity will voters choose? If voters are rationally ignorant, will bureaucrats install the efficient capacity? Explain your answer. If voters are well-informed, a system with a capacity of 2.5 million gallons will be installed. If voters are rationally ignorant, bureaucrats will install a system with a capacity of greater than 2.5 million gallons to maximize their budgets.

Use the figure which shows the market for North Atlantic tuna, to work Problems 6 to 8. 6. a. What is the quantity of tuna that fishers catch and the price of tuna? Is there overfishing? Explain why or why not. In an unregulated market, the price and quantity are determined by the marginal cost and marginal social benefit. So the price is $100 per ton and the quantity is 80 tons per month. There is overfishing because the efficient quantity of tuna, determined by the quantity at which the marginal social cost equals the marginal social benefit, is 40 tons per month. b. If the stock of tuna is used efficiently, what would be the price of fish? If the stock is used efficiently, the price is $150 per ton.

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7. a. With a quota of 40 tons a month for the tuna fishing industry, what is the equilibrium price of tuna and the quantity of tuna that fishers catch? With a quota of 40 tons a month, the price of tuna is $150 per ton and the quantity is 40 tons a month. b. Is the equilibrium an overfishing equilibrium? This equilibrium is not an overfishing equilibrium because the quantity equals the efficient quantity. 8.

If the government issues ITQs to individual fishers that limit the total catch to the efficient quantity, what is the market price of an ITQ? The market price of an ITQ is equal to the difference between the price (MSB) of a ton of tuna and the marginal (private) cost of a ton of tuna, so the market price is $100.

9. Lawmakers set to allow speedier Arctic drilling The U.S. government will allow Arctic drilling that would speed the development of oil and gas reserves off the Alaskan coast. Environmentalists say that the area should not be drilled because there is wildlife in the area. Source: CNNMoney, June 21, 2011 Are the oil and gas reserves public goods, private goods, or common resources? When an oil company receives a permit to develop a particular oil reserve, is that oil reserve a public good or a private good? Will the oil company produce an inefficient quantity or the efficient quantity? Explain If the government has sold the property rights to the reserves to oil companies, so that each particular oil or gas deposit is owned by one company, then the reserves are a private good. In this case, the oil company will produce the efficient quantity. If the property rights overlap (so that more than one oil company has rights to a particular oil or gas deposit), then the reserves are a common resource. In this case, without any other agreement, the oil companies will overproduce and the tragedy of the commons will occur. 10. Read Eye on the U.S. Infrastructure on p. 318 and then explain why the United States should spend more on transportation infrastructure? Why haven’t U.S. officials found an outcome? Figure 2 on p. 318 illustrates the deadweight loss in the provision of infrastructure. Here, the marginal social benefit exceeds the marginal social cost at this point (4, 2.5); therefore, the United States should spend more on repairing infrastructures such as roads. However, in terms of a policy, people see the increase in the gasoline tax and the infrastructure repairs as separate events, and are unwilling to accept the higher tax rate. As a higher gasoline tax can also cause deadweight loss on the gasoline market, U.S. officials will find it difficult to raise the gasoline tax in order to increase the expenditure on infrastructure repairs © 2023 Pearson Education, Ltd.

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 Additional Problems and Applications Read Eye on the U.S. Infrastructure on p. 282 and then work the problem: a. What type of good is a highway bridge? A bridge is a public good because it is nonrival and nonexcludable. b. Why might a bridge be provided by government rather than privately? The government might provide a bridge because if it was privately provided, the owner would be unable to overcome the free-rider prober. If that was the case, then the private market would not provide the bridge. c. Why might it be efficient to charge drivers every time they use a bridge? By charging a price, only the drivers whose marginal benefit of using the bridge equals or exceeds the toll will use the bridge. By reducing the number of vehicles, the number using the bridge is closer to the efficient quantity. d. What information would be needed to determine the efficient number of bridges to repair each year? Information about the marginal social benefit and the marginal social cost of repairing bridges would be ideal. Absent direct information about marginal social benefit, information about population density or use of the bridge, which are related to the bridge’s marginal social benefit, would be important. Use the table, which provides data about a dandelion Quantity Marginal Marginal control program, to work Problems 2 and 3. (square miles social social sprayed per cost benefit 2. What quantity of spraying would a private control day) (dollars per day) program provide? What is the efficient quantity of 0.5 0 600 spraying? 1.0 100 500 Dandelion spraying is a public good. A private con1.5 200 400 trol program, beset by free riders, would provide 2.0 300 300 no spraying. The efficient quantity of spraying is 2.5 400 200 3.0 500 100 the quantity that sets the marginal social cost equal to the marginal social benefit, or 2.0 square miles sprayed per day. 3. Two political parties, the Conservers and the Eradicators, fight an election in which the only issue is the quantity of spraying to undertake. The Conservers want no spraying and the Eradicators want to spray 2.5 square miles a day. The voters are well-informed about the benefits and costs of the program. What is the outcome of the election? If voters are well informed, then the Eradicators would win the election. Both parties are proposing an inefficient quantity of spraying; the Conservers propose too little and the Eradicators propose too much. But the

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deadweight loss from the Eradicators’ proposal is less than the deadweight loss from the Conservers’ proposal. 4.

If hikers and others were required to pay a fee to use the Appalachian Trail, would the use of this common resource be more efficient? Would it be even more efficient if the most popular spots such as Annapolis Rock had more highly priced access? Why do you think we don’t see more market solutions to the tragedy of the commons? The Appalachian Trail, or AT, is a common resource because it is nonexcludable and rival. As those who have hiked the AT know, this resource is over utilized; the natural beauty is adversely affected by the number of hikers. If there was a fee to hike the trail, its use would be more efficient. It would be even more efficient if the fee to use the trail was higher in more popular areas, such as Annapolis Rock, because these areas are even more over-utilized than the less popular areas. However, probably fees are not imposed because politicians resist imposing fees that their constituents must pay on goods and services that had previously been “free.” Use the following information to answer Problems 5 to 7. A natural spring runs under land owned by ten Quantity of Marginal Marginal people. Each person has the right to sink a well water external social and can take water from the spring at a constant (gallons cost benefit per day) marginal cost of $5 a gallon. The table sets out the (dollars per gallon) marginal external cost of water and its marginal 10 1 10 20 2 9 social benefit. 30 3 8 5. Draw a graph to illustrate the market equilib40 4 7 rium. On your graph, show the efficient quan50 5 6 tity of water taken. 60 6 5 The natural spring is a common resource. The 70 7 4 market equilibrium is where the marginal cost equals the marginal social benefit, which is 60 gallons per day. The marginal social cost equals the marginal cost of $5 per gallon plus the marginal external cost. With this calculation, Figure 11.3 shows that the efficient quantity is 30 gallons per day. 6. If the government sets a production quota on the total amount of water such that the spring is used efficiently, what would that quota be? The production quota would be set at 30 gallons per day. 7. If the government issues ITQs to land owners that limit the total amount of water taken to the

Chapter 11 . Public Goods and Common Resources

efficient quantity, what is the market price of an ITQ? The market price of an ITQ equals the MSB (price) of water at the efficient quantity, $8 per gallon, minus the marginal cost of producing water, $5 per gallon, or $3. 8.

What is in the Paris climate agreement? Nearly 200 countries were in consensus on the need to cut greenhouse gas emissions by switching to renewable energy. According to the Paris climate deal, each country's contribution to cutting emissions will be reviewed every five years. One goal is to try to limit global temperatures to 1.5°C. Source: BBC News, May 31, 2017 Is clean air a public good, a private good, or a common resource? What are the goals of the Paris Agreement? How might they be achieved? While there may be exceptions, clean air is a common resource. The Paris Agreement acts like a contract. Its goals include limiting greenhouse gas emissions by each country and reducing the effect of the tragedy of the commons on global temperature by achieving a universal limitation. These goals may be achieved by adhering to the terms of the Agreement, and by increasing the response from other countries.

Malaysian parliament passes Tourism Tax Bill in record session In April, 2017, the parliament of Malaysia passed a Tourism Tax Bill. The Act stipulates that operators of accommodation premises, used for commercial purposes, must collect tourism tax from every tourist using its facilities. The government believes that this will ensure a more competitive tourism industry. Source: channelnewsasia.com, April 6, 2017 Explain how the tourism tax issued influences the efficient use of tourism resources. Illustrate your answer with a graph of the Malaysia tourism market. Originally, the tourism resources in Malaysia was free to all visitors, so it was nonexcludable yet rival. It was like a common resource. As the marginal private cost for tourists was lower than the marginal social cost, there was overuse of the resource. With the tourism tax, marginal private costs will rise, and the use of resources will fall to the efficient level. Therefore, efficiency will increase. The following graph illustrates this movement.

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Price

MSC

P’ P

MSB Quantity

Q’ Q Tourism Market in Malaysia

Chapter 11 . Public Goods and Common Resources

 Multiple Choice Quiz 1.

A good is if it is possible to prevent someone from enjoying its benefits and such a good might be a good. A. rival; private B. excludable; public C. excludable; private D. nonexcludable; common resource Answer: C A good is defined as excludable is it is possible to prevent someone from enjoying its benefits. Private goods are defined to be excludable (and rival). 2.

A free-rider problem arises if a good is . A. nonrival and nonexcludable B. nonrival and excludable C. rival and nonexcludable D. rival and excludable Answer: A The free-rider problem exists for public goods, which are nonrival and nonexcludable.

The marginal social benefit of a public good is . A. the quantity demanded by all the people at a given price B. the amount that all the people are willing to pay for a given quantity C. the amount that all the people are willing to pay at a given quantity for one more unit D. the quantity demanded by all the people at a given marginal social cost Answer: C The marginal social benefit of a public good is the maximum each person is willing to pay for another unit of the good summed over all the people.

The efficient quantity of a public good is most likely to be delivered by . A. an election contest between two parties that want different quantities B. highly trained bureaucrats C. efficient private companies D. an individual transferable quota Answer: A If voters are fully informed about the costs and benefits, the winner of the election will be the party that proposes the efficient quantity.

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A renewable common resource is used sustainably if . A. private benefits and public benefits are equal B. private benefits equal private costs C. the rate of renewal of the resource equals its rate of use D. the rate of use of the resource equals the social benefit of its use Answer: C If the rate of renewal equals the rate of use, the stock of the resource does not change.

Overfishing occurs if, at the quantity caught, . A. marginal social cost equals marginal private cost plus marginal external cost B. marginal social benefit equals the fishers’ marginal private cost C. marginal social benefit equals marginal social cost D. marginal social benefit equals marginal private cost plus marginal external cost Answer: B The fisher’s marginal cost is less than the marginal social cost, so overfishing occurs.

All the following can achieve an efficient use of a common resource except . A. a production quota equal to the marginal external cost B. individual transferable quotas that total the efficient quantity C. assigning property rights to convert the common resource to private use D. individual transferable quotas that trade at marginal external cost Answer: A The production quota must be set to equal the efficient quantity not the marginal external cost.

When ITQs are assigned, the market price of an ITQ equals the . A. marginal benefit consumers receive from the fish caught B. marginal private cost of fishing C. marginal external cost of fishing D. marginal social cost of fishing Answer: C As Figure 11.10 shows, because the price of an ITQ equals the marginal external cost, once the government introduces ITQs, the market equilibrium is the same as the efficient quantity.

Markets with Private Information ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Judy knows that her car is a lemon and offers it for sale. If the used-car market is working efficiently, will buyers know whether her car is a lemon? Why or why not? If the used car market is working efficiently, then buyers will know that her car is a lemon. Knowing the car is a lemon, the price is lower than the price of a good car and Judy offers no warranty. If buyers did not know that her car was a lemon, then a buyer might mistakenly take it for a good car, which would lead the buyer to pay more than the car’s marginal benefit.

Some car dealers offer used cars for sale with warranties and some offer them without warranties. Describe the equilibrium in the market for used cars. Is the market efficient? The cars with warranties—the good cars—sell for a higher price than the cars without warranties—the lemons. The used car market is efficient.

G.M. recalls 6,800 pickups for inaccurate shift-lever reading General Motors is recalling 6,800 pickups from the 2011 model year because a defective clip could allow the automatic transmission’s selector to appear to be in Park when it was not. A worker at the assembly plant discovered the problem. Source: The New York Times, July 1, 2011 Did G.M. sell 6,800 lemons to people who bought the pickups? If G.M. did, what was the private information that it had that buyers did not know? If G.M. didn’t, explain why not. G.M. sold defective cars. G.M. did not have private information about the quality of the car because the defect was unknown to G.M. until discovered by a worker. As G.M. did not know it was selling defective cars, they are not defined as lemons.

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Use the following information to work Problems 4 and 5. Mary is an 18-year-old student, who recently bought a used car. Mary is looking to buy car insurance. Insurance companies compete for her business. 4. Is there a moral hazard problem in a transaction between Mary and an insurance company? Explain why or why not. There is a moral hazard problem. Once Mary has purchased insurance, she might change her behavior by driving less carefully than before. 5.

Is there an adverse selection problem in a transaction between Mary and an insurance company? Explain why or why not. There is an adverse selection problem. Mary has private information about how safe or how risky a driver she is. The insurance company will attempt screen Mary to determine her riskiness. In part, the company gets around the adverse selection problem by charging higher premiums to younger, and hence generally riskier, drivers.

If you have private information that you are a more aggressive driver than your driving record indicates, would you buy collision insurance? If the insurance company offers you a large deductible or a no-claim bonus are you likely to take the offer? Why or why not? You are definitely going to be interested in buying collision insurance. But you would not be interested in buying a policy with a large deductible or a no-claim bonus policy. You realize that you are more likely to have an accident than the insurance company realizes. If you have a large deductible, you realize the probability is high that you will have to pay this deductible. Similarly you also realize that the probability is low that you will collect the no-claim bonus.

Use the following information to work Problems 7 to 9. President Obama campaigned on a health-care reform plan that did not include mandatory health insurance. Hillary Clinton wanted mandatory health insurance with no opting out. In 2009, the President said he would support making health insurance mandatory with the cost covered by employers, but those who could not afford to pay and small businesses would be exempt. 7. If health insurance is optional, would healthy people be more likely or less likely to buy insurance? Healthy people are less likely to buy optional health insurance. 8.

What obstacles to efficiency does optional health insurance create? Optional health insurance leads to a severe adverse selection problem. The price of insurance would be high because only those people who believe they are likely to need the insurance will buy it. Additionally, there will still be some people who do not buy insurance yet, through bad luck,wind up being uninsured when they need it.

Chapter 12 . Markets with Private Information

U.S. healthcare per person costs twice that of other rich countries. Does the United States overprovide? Do other countries underprovide? What economic concepts do you need to answer? What data might be relevant? The United States might overprovide health care to those who wealthy and have health insurance while simultaneously underproviding health care to those who are not wealthy and do not have health insurance. Based on the observation that citizens of other countries travel to the United States for health care, other countries might be underproviding health care.

10. If U.S. healthcare were delivered like basic education is, how would the healthcare system compare to that in Canada? Would it be efficient? In the United States, most students’ basic education, K through 12, is provided by publically run, publically financed schools. Teachers in most elementary, middle, and high schools are employed by the government and the government is in charge of how these schools operate. They are funded by taxes. There are some exceptions: private schools, charter schools, church-run schools, and homeschooling. The U.S. health care system currently is similar insofar as it is a mixture of public (government) and private hospitals, programs, and insurance. However, aside from insurance, in which Medicare and Medicaid cover a very sizeable fraction of citizens, most hospitals, doctors’ practices, and other programs are privately run. Currently in the United States the majority of health care is provided by the private sector. If basic health care and health insurance were delivered the same way basic education is delivered, the situation would change with the government sector increasing its size and the private sector drastically shrinking. Most doctors would be employed by the government and most hospitals would be run by the government. Taxes would be used to (help) fund these operations. The system just described is closer to the Canadian system than the current situation in the United States but with one key difference: In Canada all heath care is provided by the government with no private provision at all. (Of course, some Canadians cross the border into the United States in order to acquire privately purchased health care.) 11. Read Eye on the Market for Used Cars on p.336 and then explain what two methods help the used-car market in the United States. Analyze how they solve the lemon problem. Does the government play any role in this market? The answer is dealers’ warranties (signaling), and third-party inspection services. By offering warranties, dealers signal their customers that their cars are not lemons, solving the asymmetric information problem. In addition, thirdparty inspectors can use their reputation to guarantee the quality of a car for buyers. The government plays a role in the market by ensuring that warranties are effective, and protecting customers by “lemon laws”, if customers buy lemons unexpectedly.

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 Additional Problems and Applications 1.

There is a lemons problem in the used-car market and insurance market. How does each market solve this problem? What is the difference between the two lemons problems? The used-car market avoids lemons by signaling. Sellers offer warranties to buyers to ensure the quality of the cars. The insurance market solves this problem by screening, by offering deductibles to low-risk buyers. The difference is that in the used-car market, sellers hold the private information about their cars, while in the insurance market the buyers hold the private information about their health conditions.

Zaneb is a high-school teacher and is well known in her community for her honesty, integrity, and sense of social responsibility. She is shopping for a used car. She plans to borrow the money to pay for it from her local bank and she plans to buy auto insurance from her local insurance company. What asymmetric information problems is Zaneb likely to encounter and what arrangements are likely to help cope with those problems? Explain your answers. Zenab is well known for her honesty and integrity, so she creates no moral hazard or adverse selection problems for the car dealer or for the bank. However the car dealer creates an adverse selection problem for Zenab because the car might be a lemon. The bank does not create either a moral hazard or adverse selection problem for Zenab. Warranties are designed to help cope with the moral hazard and adverse selection problems with cars.

Suppose that there are two national football leagues: The Time League and The Bonus for Win League. The players have private information about their effort. In The Time League, players receive a fixed wage based on the time they spend practicing and playing matches. In The Bonus for Win League, the players are paid one wage for a loss, a higher wage for a tie, and the highest wage of all for a win. Describe the moral hazard and adverse selection problems in these two leagues. Which league best addresses these problems? In the Time League, there is the moral hazard that the players have no incentive to play hard or to win the game. In this league the games are likely to be dull, drawn out, low quality affairs with players not playing particularly hard. In the Bonus for Win League the players have an incentive to play hard in order to win so the moral hazard problem is mitigated.

Chapter 12 . Markets with Private Information

The Time League faces the adverse selection problem that lazy players will want to play for it. The Bonus for Win league best addresses the moral hazard and adverse selection problems. 4.

Oilers, Jets top NHLers’ no-trade lists ESPN asked 10 player agents to name their top three most frequent no trade teams. The top three, in order, were the Edmonton Oilers, the Winnipeg Jets, and the New York Islanders. Source: Sportsnet, March 25, 2016 Provide an example of private information that a hockey player who wants a no-trade clause possesses. Does a hockey player with a long-term contract that includes a no-trade clause present a moral hazard to his team? Does a hockey player with a long-term contract that includes a no trade clause present adverse selection problems to his team? Players can have significant private information. For instance, a player could know that he was injured or that he had not healed as well as possible from an injury. A player with a long-term contract with a no-trade clause presents a moral hazard problem. The player can claim to be more badly injured than is truly the case to avoid playing some games. The player can make this claim knowing that even if he often does so, his team cannot trade him and must continue to pay his salary for the length of his contract.

If there are two types of contracts—long-term contracts with the no-trade clause and contracts without it—then there is a potential adverse selection problem. Players who know they are more inclined to want to skip a game or two will be eager to sign a long-term, no-trade contract because this contract lessens their cost of feigning injury to take leisure. What are the key economic problems in providing an efficient quantity and distribution of health-care insurance and service? Explain how the U.S. health-care system addresses these problems. The key economic problems in providing an efficient quantity and distribution of healthcare insurance and service are asymmetric information, underestimation of benefit and future needs, and inequality in the ability to pay. Adverse selection is a major issue in the health care market. People who know they are more likely to use health insurance are more likely to be in the market to buy it. Moral hazard also is an issue in the health care market. Both patients and providers face moral hazard. Once insured, patients have a smaller incentive to adopt a healthy life style. Providers have the incentive to over-treat patients in order to avoid claims that they missed an important health issue.

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These asymmetric information problems can be tackled by offering some health insurance policies with high deductibles and low premiums and others with low deductibles and high premiums. Healthy people will buy the first policy and less healthy people the second. These deductibles and premiums move the market toward a separating equilibrium. Underestimation of the benefit of healthcare and of the future needs also lead to the market failure in the healthcare market. People, especially the healthy and young underestimate the health risks they face in the present time and over their lifetimes. Consequently they undervalue insurance policies that can help them pay for healthcare. Finally, there is inequality in people’s ability to pay for health insurance. Because most people want to live in a society that offers healthcare for even those unable to pay for it, there is an additional social benefit from providing healthcare to those otherwise unable to pay. The Obama Affordable Care Act addresses these issues. First, it requires that everyone buy health insurance, thereby overcoming the adverse selection problem that very healthy people will not buy health insurance and the undervaluation of health insurance. Second it also creates government subsidies for those unable to pay for the insurance. 6.

Switzerland has its own kind of Obamacare — and loves it Switzerland’s healthcare model successfully delivers universal coverage through mandatory private insurance, something that Obamacare has long been trying to achieve. The Swiss government takes serious control over prices and quality in healthcare and it costs nearly $5,350 per resident. Source: TIME, August 16, 2012 What are the economic problems in the healthcare market? Compare the U.S. and Swiss healthcare systems. How does each system solve its economic problems? The economic problems in the healthcare market are adverse selection and moral hazard problems. People with potential health problems are more likely to buy healthcare insurances, and both patients and insurers face certain moral hazards. Once insured, the patients have a smaller incentive to adopt a healthy life style. The doctors who provide healthcare services have the incentive to over-treat patients to avoid claims that they missed an important health issue. Both healthcare systems solve the adverse selection problem by restricting every citizen to choose a single private healthcare insurance policy; however, the U.S. system fails to solve the moral hazard problem, and the cost of healthcare in America has increased. The Swiss system alleviates the moral hazard problem by universal coverage where the government controls the cost of the healthcare services provided © 2023 Pearson Education, Ltd.

Chapter 12 . Markets with Private Information

What are the problems that Medicare and Medicaid address and what problems do they cause? Medicare helps pay the health costs for people over 65 and for some longterm disabled patients. Medicaid pays for health care costs of those living in poverty. A major problem with these programs is their cost. The cost is driven by patient demand with small regard for the costs because the patients pay either a little or none of the costs. Consequently these programs may overprovide healthcare services and lead to the problem of increasing healthcare costs.

What is the cost of health care in the United States compared to that in Canada and major European countries? Do health outcomes correlate with health-care costs? Can you think of explanations for the facts you’ve just provided? The costs of health care in the United States exceed—by far—the costs in Canada and in other major European countries. For wealthy individuals, health care in the United States is perhaps the best in the world. However, the efficiency of delivering health care services in the United States lags behind that in these other nations. In part, this difference reflects the relatively inefficient system in the United States. However, it also indicates that citizens of other nations can travel to the United States, partake of the advanced health care available in the United States, and thereby make the health care system in their nation appear more efficient.

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What is Laurence Kotlikoff’s proposal for fixing health care in the United States? Draw a graph to illustrate how his proposal would work and show whether it could be efficient. Mr. Kotlikoff proposes issuing health care vouchers. Everyone would get a voucher and those with higher expected medical expenditures would receive larger vouchers. Consumers, who know best the quality of care they receive, would have the incentive to go to highquality, low-cost providers. Additionally, consumers who bear the costs above the voucher amount, also would have the incentive to avoid over-treatment. Figure 12.1 illustrates the outcome with vouchers. Prior to the issuance of vouchers, the demand curve is D0, which reflects the point that not everyone has insurance, which reduces the demand, and the supply curve is S0, which reflects the point that suppliers have little incentive to cut costs. The initial equilibrium has a health-care price of $400 and 30 million units of health care. With vouchers, more people can afford health case, so the demand increases and the demand curve shifts rightward to D1. Vouchers give patients the incentive to monitor health care providers, so the costs decrease. The supply increases and the supply curve shifts rightward to S1. At the new equilibrium, in the figure the price of health care remains constant and the quantity of health care increases to 60 million units. In general, the quantity increases but the effect on the price is ambiguous.

Chapter 12 . Markets with Private Information

 Multiple Choice Quiz 1.

A market with asymmetric information is one in which . A. sellers offer a product for sale at a low price and buyers are pleased to get a bargain B. sellers know how reliable the product is and they share that information with buyers C. only the buyers or the sellers have information about the quality of the product D. buyers are willing to pay less for the product than the seller is offering it for sale Answer: C Asymmetric information means that one side of the market— buyers or sellers—possesses relevant information that the other side does not.

The lemons problem arises in markets in which . A. sellers are better informed than buyers about which products are reliable B. buyers are better informed than sellers about which products are reliable C. there is a shortage of lemons D. buyers have private information Answer: A The lemons problem is essentially that buyers are unable to determine a good product from a bad one. 3.

In the market for used cars with no warranties, lemons are bought and the equilibrium is a equilibrium. A. too few; separating B. too many; separating C. only; pooling D. no; pooling Answer: C With no warranties, only lemons are offered for sale. 4.

In a used-car market in which dealers offer cars with warranties, . A. there is private information B. a separating equilibrium does not occur C. a lemon problem does not arise D. the market is inefficient Answer: C The lemon problem does not arise because good cars are those with warranties and lemons are those with no warranties.

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Moral hazard arises in the insurance market because . A. buyers of insurance have private information that they can use B. insurance companies can offer a range of premiums to buyers C. buyers can opt to take a deductible or a no-claim bonus D. insurance companies can match premiums to customer risk Answer: A Buyers use their private information to impose additional costs on the insurance companies.

The private market delivers too little health care because . A. insurance companies cannot avoid the problems of moral hazard and adverse selection B. too many young healthy people buy insurance C. insurance companies cannot monitor health-care providers D. pre-existing health conditions are too costly to insure Answer: D Because buyers cannot purchase health insurance to help cover pre-existing health conditions, too little health care is delivered for them. 7.

In a situation with asymmetric information, the person _____ the private information has the incentive of conducting moral hazard, and ____ the effect of adverse selection. A. with, face B. with, doesn’t face C. without, face D. without, doesn’t face

Answer: B

The party that holds private information and is insured has an incentive to expose themselves to risks, as only they know how they behave while the insurer will bear the cost. This is how moral hazards occur. The adverse selection is conducted by people who make decisions with more information

Consumer Choice and Demand ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Sarah has $12 a week to spend on coffee and soda. The price of a cup of coffee is $2 and the price of a can of soda is $1. Draw Sarah's budget line and label it (plot the quantity of soda on the x-axis). Can Sarah afford to buy 6 cans of soda and 2 cups of coffee? Can Sarah afford to buy 8 cans of soda and 3 cups of coffee? What is the relative price of a cup of coffee The figure illustrates Amy’s budget line. Sarah can afford to buy 6 cans of soda and 2 cups of coffee. Sarah cannot afford to buy 8 cups of coffee and 3 cans of soda. The relative price of a cup of coffee is the number of cans of soda that Sarah must forgo to get 1 cup of coffee. The relative price of a cup of coffee equals the price of a cup of coffee divided by the price of a can of soda, which is $2 a cup of coffee ÷ $1 per can of soda = 2 cans of soda per cup of coffee.

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Roger has $12 a week to spend on coffee and soda. The price of a cup of coffee is $2 and the price of a can of soda is $1. Suppose that the price of soda remains at $1 a can but the price of coffee rises to $3 a cup. Draw Roger’s new budget line after the price rise. If Roger buys 6 cans of soda, what is the maximum number of cups of coffee he can buy after the price of a cup of coffee rises to $3? What is the relative price of a cup of coffee? Has the relative price of a can of soda changed? The figure plots Roger’s old budget line, which illustrates his old consumption possibilities, and his new budget line, which illustrates his new consumption possibilities . If Roger buys 6 cans of soda, he can buy 2 cups of coffee. The relative price of a cup of coffee is the number of cans of soda that Roger must forgo to get 1 cup of coffee. The relative price of a cup of coffee equals the price of a cup of coffee divided by the price of a can of soda, which is $3 a cup of coffee ÷ $1 a can of soda = 3 cans of soda per cup of coffee. The relative price of soda is the inverse of the relative price of coffee, so it decreases from 1/2 cup of coffee per can of soda to 1/3 cup of coffee per can of soda.

Use the table, which shows Ben’s utility, to work Problems 3 and 4. 3. Calculate the values of A, B, C, and D in the table. Does the principle of diminishing marginal utility apply to Ben’s consumption of orange juice? Why or why not? A is equal to 12; B is equal to 3; C

Orange juice (cartons per day) 0

Total utility

Would Ben ever want to buy more than one carton of orange juice a day or no orange juice? Explain your answer. The number of cartons of orange juice Ben buys depends on his budget, the price of orange juice, the prices of the other goods and services Ben buys, and Ben’s marginal utility from these other goods and services. Ben will buy the quantity of orange juice that sets the marginal utility per dol lar from orange juice equal to the marginal utility per dollar from the oth er goods and services. So Ben buys the quantity of orange juice such that © 2023 Pearson Education, Ltd.

7 5

is equal to 17; and D is equal to 1. The principle of diminishing mar4 C ginal utility applies to Ben’s con5 18 sumption of orange juice because as the quantity of orange juice Ben consumes increases, his marginal utility from orange juice diminishes. 4.

Margina lutility

B 2 D

Chapter 13 . Consumer Choice and Demand

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the marginal utility per dollar from the last carton of orange juice equals the marginal utility per dollar from the other goods and services Ben buys. Ben would buy no orange juice if the marginal utility per dollar from the first carton of orange juice is less than the marginal utility per dollar from the other goods and services Ben buys. 5.

Every day, Josie buys 2 cups of coffee and 1 sandwich for lunch. The price of coffee is $2 a cup and the price of a sandwich is $5. Josie’s choice of lunch maximizes her total utility, and she spends only $9 on lunch. Compare Josie’s marginal utility from coffee with her marginal utility from the sandwich. Because the price of a sandwich is 2 1/2 times greater than the price of a coffee and Josie is maximizing her utility, the marginal utility from the last sandwich must be 2 1/2 times greater than the marginal utility from the last coffee. When the marginal utility of the sandwich is 2 1/2 times larger than the marginal utility of the coffee, Josie is equating the marginal utility per dollar from coffee and sandwiches.

Susie spends $28 a week on sundaes and magazines. The price of a sundae is $4 and the price of a magazine is $4. The table shows Susie’s marginal utility from sundaes and magazines. How many sundaes does she buy? If the price of a sundae doubles to $8 and other things remain the same, how many sundaes will she buy?

Sundaes Quantity Margina per week lutility 1 60 2 56 3 50 4 42 5 32 6 20

Magazines Quantity Margina per week lutility 1 40 2 32 3 28 4 25 5 23 6 22

What are two points on her demand curve for sundaes? When the price of a sundae is $4, Susie buys 5 sundaes. (She also buys 2 magazines, so she allocates her entire budget. Her marginal utility per dollar from sundaes equals her marginal utility per dollar from maga zines, 8 units per dollar.) If the price of a sundae rises to $8, Susie will buy 2 sundaes. (She also will buy 3 magazines, so she allocates her entire budget. Her marginal utility per dollar from sundaes equals her marginal utility per dollar from magazines, 7 units per dollar.) Two points on her demand curve for sundaes are a price of $4, a quantity demanded of 5 sundaes and a price of $8, a quantity demanded of 2 sundaes. 7.

When Erin has $25 to spend, she sees 2 movies at $10 a movie ticket and buys 1 six-pack of soda. Calculate the price of soda. If her budget for soda and movies increases to $50, what is the change in the relative price of a movie ticket? How does her marginal utility per dollar from movies change? From her budget of $25, Erin is spending $20 (2 movies at $10 each) on movies. That leaves her with $5 to spend on soda. Because she buys 1 six-

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pack of soda, the six-pack must have a price of $5 per six-pack. The relative price of a movie ticket is the number of sodas that Erin must forgo to buy 1 movie ticket. The relative price of a movie ticket equals the price of a movie ticket divided by the price of a soda. The change in budget does not change the relative price of a movie. If the increase in her budget leads Erin to buy more movies, the marginal utility from a movie falls. With the fall in marginal utility from movies, the marginal utility per dollar from movies decreases. 8.

HTC virtual reality unit Vive will not match Oculus price cut-statement Facebook Inc.'s Oculus virtual reality platform announced a price cut earlier this month at the same time as its competitor HTC Corp's virtual reality unit Vive said that it would not cut the price of its system. Source: CHANNEL NEWSASIA, March 2, 2017 Explain how the budget line for a retailer of both Oculus and Vive will shift after the announcement in the news clip. How does the marginal utility and quantity of Oculus change?

Q (Vive)

B (before) 0

B (after) Q (Oculus)

As shown in the graph, the budget line will shift outward because the retailer can now buy more Oculus with the same budget and price of Vive. Due to the fall in the price of Oculus, the marginal utility per dollar for Oculus is higher than before. To make the marginal utility per dollar for Oculus equal to that for Vive and maximize the retailer’s total utility, they will stock more units of Oculus to lower the marginal utility for Oculus . Gas prices send surge of travelers to mass transit As the gas price hit $4 a gallon, commuters in New York and Boston switched from cars to public transit, with ridership rising 5 percent. Source: The New York Times, May 10, 2008 Explain the effect of a rise in the price of gasoline on a commuter’s budg et line and the quantities of gasoline and public transit services purchased. The rise in price of gasoline rotated consumers’ budget lines inward so © 2023 Pearson Education, Ltd.

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Chapter 13 . Consumer Choice and Demand

that the maximum quantity of gasoline they could purchase decreased. The marginal utility per gallon of gasoline fell, so to maximize their utility consumers decreased the quantity of gasoline purchased. The quantity of public transit purchased increased. 9.

From Jackie Kennedy to Michelle Obama: 16 Stunning Inaugural Gowns In U.S. history, the beautiful dresses worn by first ladies in inaugural balls have always been eye-catching. It’s the first formal chance to imply to the Americans the value and spirit of the new administers and the time they are in. But they usually cost a treasure. For example, it was estimated that first lady Michelle Obama’s dress for the Inaugural Ball by Jason Wu costs an estimated $5,000. Source: TIME, January 18, 2017 Why are some designer gowns more expensive than everyday wear, even though they are not as practical as the latter? Though they are both clothes that have to be worn, designer gowns have many differences with the daily clothes. Total utility affects the relative value, while marginal utility affects relative price, but the total utility of daily clothes is higher than that of designer gowns because they are more practical. However, as we already have many clothes for everyday wear, the marginal utility of having one more unit of dailywear is low. Also, designer gowns show one’s status, give one confidence and are delicately designed. These add on to its marginal utility. To make the marginal utility per dollar of the two equal, the prices of designer gowns are much higher than those of everyday wear .

10. Read Eye On Song Downloads on pp. 336-337, then draw a student’s budget lines for songs versus other goods and services in 2001, 2012, and 2018. Explain the changes in the budget line. Figure 13.3 shows the budget lines in 2001, 2012, and 2018 for songs versus other goods and services. The maximum number of other goods and services the consumer can purchase is assumed equal to 600 per week (the y- axis intercept). The price of a song fell from $5.00 in 2001 to $1.20 in 2012. This fall increased © 2023 Pearson Education, Ltd.

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the maximum number of single songs a consumer could buy and rotated the budget outward as illustrated. The relative price of a single song fell, as illustrated by the decrease in the slope of the budget line. In 2018, the advent of streaming services means that once a consumer buys the steaming subscription, the price of an additional song is zero. So, the budget line is a point at 600 other goods and services and 0 songs for a consumer who does not buy a streaming service. For any other quantity of songs, the budget lineis a horizontal line at 600 goods and services (the y-intercept for the budget lines in 2001 and 2012) minus the number of other goods and services foregone by the price of the streaming subscription.

Chapter 13 . Consumer Choice and Demand

 Additional Problems and Applications 1.

Read Eye on Song Downloads and Streaming on pp. 336–337. In 2018, Americans downloaded 400 million singles at $1.20 each and 50 million albums at $10 each. They also bought 52 million albums on CDs at $13 each and 50 million streaming subscriptions at $94 each. What does marginal utility theory tell you about the marginal utility of a single, an album download, an album on a CD, a streaming subscription, and a song streamed? Marginal utility theory concludes that the ratio of the marginal utility to price for all goods is the same in the consumer equilibrium. In the context of music, marginal utility theory says that MUsingle÷ Psingle = MUalbum÷ Palbum

÷ PCD = MUstream sub ÷ Pstream sub. Rearranging the first equality shows that MUalbum ÷ MUsingle = Palbum ÷ Psingle When the price of an album = MUCD

download is $10 and the price of a singles download is $1.20, then the price ratio is $10 ÷ $1.20, which is 8.3. So the ratio of the marginal utility from an album download to a singles download is 8.3. The price ratio of a CD to a singles download is $13 ÷ $1.20 = 10.8, so the ratio of the marginal utility from a CD to a singles download is 10.8. And, the price ratio of a streaming subscription to a singles download is $94 ÷ $1.20 = 78.3, so the ratio of the marginal utility from a streaming subscription to a singles download is 78.3. Once a consumer buys a streaming subscription the price of an additional song is zero. In this case, the consumer will listen to songs until the mar ginal utility from an additional song is zero. 2.

Tim buys 2 smoothies and 6 album downloads a week when he has $76 to spend, the price of an album download is $12, and the price of a smoothie is $2. What is the relative price of an album download? If the price of an album download falls to $6, how do Tim's consumption possibilities change? Explain. The relative price of an album download is the number of smoothies that Tim must forgo to buy 1 album download. The relative price of an album download equals the price of an album download divided by the price of a smoothie, which is $12 a download ÷ $2 a smoothie = 6 smoothies per album download. Tim’s consumption possibilities expand because his budget line rotates outward.

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Jim spends all his income on apartment rent, food, clothing, and vaca tions. He gets a pay raise from $3,000 a month to $4,000 a month. At the same time, airfares and other vacation-related expenses increase by 50 percent. How has Jim’s budget in terms of airfares and other vacationrelated expenses changed? Is Jim better off or worse off in his new situation? Jim’s budget in terms of airfares and vacation-related expenses is lower than before. His income increased by 33 percent but the airfares and vaca tion-related expenses rose by 50 percent. Depending on his preferences, Jim might be better off, but we cannot say for sure. For instance, if prior to the changes Jim spent, say, $1 on vacation travel and the rest of his in come on the other goods, almost certainly Jim is better off. But, if prior to the changes Jim spent $2,999 on vacation travel and the rest of his income on the other goods, than almost surely Jim is worse off.

Use the table, which shows Martha’s total utility from burgers and pasta, to work Problems 4 to 6. 4.

When Martha buys 3 burgers and 2 dishes of pasta a week, what is her total utility and her marginal utility from the third burger? If the price of a burger is $4, what is her marginal utility per dollar from burgers?

Burgers Quantity Total per week utility 0 0 1 10 2 18 3 25 4 31 5 36 6 40

Pasta Dishes Total per week utility 0 0 1 20 2 36 3 48 4 56 5 60 6 62

The total utility from consuming 3 burgers and 2 dishes of pasta is 61 units. The marginal utility from the third burger is 7 units. The marginal utility per dollar from the third burger is (7 $4), which is 1 3/4 units per dollar. 5.

When the price of a burger is $4, the price of pasta is $8 a dish, and Martha has $24 a week to spend, she buys 2 burgers and 2 dishes of pasta. Does she maximize her total utility? Explain your answer. Martha is maximizing her utility because she is allocating her entire budget and the marginal utility per dollar from burgers (2 units per dol lar) equals the marginal utility per dollar from pasta (2 units per dollar).

When the price of a burger is $4, Martha has $24 to spend, and the price of pasta falls from $8 to $4 a dish, how many burgers and dishes of pasta does Martha buy? What are two points on Martha’s demand curve for pasta? If the price of a dish of pasta falls to $4, Martha buys 2 burgers and 4 dishes of pasta. This combination maximizes Martha’s utility because it allocates her entire income and equates her marginal utility per dollar from both goods. When the price of a dish of pasta is $8 (and the price of a burger is $4), Martha buys 2 dishes of pasta. So, one point on Martha’s demand curve for pasta is a price of $8 for a dish of pasta and a quantity

Chapter 13 . Consumer Choice and Demand

of 2 dishes. When the price of a dish of pasta is $4 (and the price of a burger is $4), Martha buys 4 dishes of pasta. So, another point on her demand curve is a price of $4 for a dish of pasta and a quantity of 4 dishes. Use the following information to work Problems 7 and 8. The table shows the marginal utility Quantity that Ali gets from smoothies and movies. Ali has $30 a week to spend. The price of a movie ticket is $6, and the price of a smoothie is $3. 7.

(per day) 1 2 3 4 5 6

Marginal utility from smoothies 7 6 5 4 3 2

If Ali buys 4 smoothies a week and sees 3 movies, does he spend all $30? What is his utility from smoothies and his utility from movies? Does he maximize his utility? If not, which good must he buy more of? If Ali buys 4 smoothies and sees 3 movies, he spends $12 on smoothies and $18 on movies, so Ali spends all of his income. Ali’s marginal utility from smoothies is 4 and his marginal utility from movies is 18. Ali is not maximizing his utility. His marginal utility per dollar from movies is 3 units per dollar and his marginal utility per dollar from smoothies is 1.33. To maximize his utility, Ali should see more movies.

When Ali allocates his budget so as to maximize his utility, what does he buy and what is the marginal utility per dollar? Ali buys 4 movies and 2 smoothies. His marginal utility per dollar from both movies and smoothies is 2 units per dollar.

movies 30 24 18 12 6 0

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Use the following information to work Problems 9 and 10. Goodnight Warsaw Apartments Offering Sophisticated Quality and Comfort s Goodnight Warsaw is an apartment managing company in the Polish capital, it rents out its apartments to customers and charge according to periods of stay. Competition is fierce in this field, and its prices go down to lower than hotels . Source: The European Times, March 22, 2019 9.

What is the marginal benefit and marginal utility for visitors of Goodnight Warsaw? Is there any relationship between them ? The marginal benefit is the customers’ benefit (the maximum price) from staying for an additional night when total utility is maximized, and marginal utility is the additional utility from an additional night of stay. So, we see that marginal benefit is equal to the marginal utility given the condition that total utility is maximized. It can be seen from the demand curve

10. Compare the marginal utility of Goodnight Warsaw apartments to other hotels. What is the change in Goodnight Warsaw’s marginal utility? What is the change in its relative value? The lower rental price of Goodnight Warsaw apartments reflects that more people choose these apartments compared to hotels, so the marginal utility of renting a Goodnight Warsaw apartment is lower than hotels. The relative value is determined by the total value customers get, since Goodnight Warsaw has a higher demand curve than hotels, so its consumer surplus is bigger—therefore, the relative value of a Goodnight Warsaw apartment is higher.

Chapter 13 . Consumer Choice and Demand

 Multiple Choice Quiz 1.

A consumer’s consumption possibilities depend on all of the following items except . A. the prices of the goods that the consumer wants to buy B. the consumer’s budget C. the quantities of the goods that the consumer can afford

D. the consumer’s preferences Answer: D The consumer’s preferences are captured in his or her utility function but they do not affect the consumption possibilities. 2.

Jane’s budget line

A. shifts outward with no change in its slope if her budget increases and prices don’t change B. rotates inward if the prices of both goods double and her budget doesn’t change C. shifts inward with no change in its slope if the price of one good rises and her budget doesn’t change D. rotates outward if her budget increases and prices don’t change Answer: A

Total utility sumed.

If the budget changes, the budget line shifts and its slope does not change. and marginal utility

as more of a good is con-

A. increases; increases B. diminishes; diminishes C. increases; diminishes D. diminishes; increases Answer: C Table 13.1 on page 329 demonstrates that answer C is correct. 4.

Tom will maximize his total utility if he buys the quantities of pasta and milk at which . A. the marginal utility from pasta equals the marginal utility from milk B. he spends all of his budget and marginal utility from each good is equal C. the marginal utility from the more expensive good is less than the marginal utility from the cheaper good D. he spends all his budget and the marginal utility per dollar for pasta and milk are equal

Answer: D

The “Utility-maximizing Rule” on page 330 means that answer D is correct.

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Sara buys bread and bananas and is maximizing her total utility. If the price of bananas rises, Sara will maximize her total utility by . A. increasing her budget so that she can buy the same quantities B. buying more bananas and less bread C. buying fewer bananas and possibly more bread D. buying less bread and possibly more bananas

Answer: C

With the rise in the price of bananas, the marginal utility per dollar on bananas is less than that of bread, so Sara will in crease her total utility if she buys fewer bananas.

When Joe’s budget increases, he will spend the increase in his budget on . A. normal goods B. inferior goods

C. more of all the goods he usually buys D. essential goods Answer: A A normal good is defined as one for which the demand increases when income increases. 7.

The paradox of value arises when people

A. prefer to buy cheap goods rather than expensive goods B. spend more on expensive useless goods than on cheap useful goods C. buy so much of a useful good that its price falls D. get the same marginal utility per dollar from cheap useful goods and useless expensive goods Answer: D

Because consumers buy a lot of the “useful” good, its marginal utility is low but its total utility will be large.

Chapter

Production and Cost ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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After the second worker is hired, marginal returns decrease.

Labor 0

Total product 0

Average product xx

Marginal product 20 24 16 12

Chapter 14 . Production and Cost

Use the following information to work Problems 3 to 6. Table 1 Nikon to cut 1,000 jobs in Japan Nikon plans to eliminate about 400 jobs from its 1000 jobs in Japan, shifting its resources from producing cameras to medical-devices. In 2015, Nikon’s camera business fell 30 percent in three years to ¥520.4 billion ($4.7 billion). Source: Nikkei Asian Review, November 8, 2016

Labor (workers)

Total Product (cameras produced per month)

1,000

6,750

800

6,500

600

6,000

400

3,500

200

2,000

Table 2 shows Nikon’s expected production and costs.

Labor

1,000 800 600 400 200

6,750 6,500 6,000 3,500 2,000

TVC

ATC

2,200,000

Nikon is paying $600/month to each worker employed, and the materials and other efforts of producing one camera costs $200. Complete the total variable costs and total costs in Table 2. The total variable costs of Nikon’s camera production include the wages and the costs of the materials and other efforts of producing cameras. The total fixed costs can be computed by deducting the first total variable cost from $1,500,000. The total costs equal TVC plus TFC. Labor

TVC

1000

6,750

1,950,000

2,200,000

800

6,500

1,780,000

2,030,000

600

6,000

1,560,000

1,810,000

400

3,500

940,000

1,190,000

200

2,000

520,000

770,000

Determine the marginal cost in Table 2. How is Nikon’s camera line’s marginal cost changing? Was Nikon facing increasing, constant, or diminishing marginal returns before the layoffs? Marginal cost can be computed by formula

change in the total cost change in the quantity produced

. Labor

ATC

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Nikon originally was facing diminishing marginal returns. Labor 1000 800 600 400 . 200 5.

TP 6,750 6,500 6,000 3,500 2,000

Compute Nikon’s short-run average total costs. Nikon’s average total cost equals its total costs divided by its total product. As shown in the table, Nikon’s average total costs is lowest at labor level 600, so it is the most efficient.

MC 680 440 248 280 Labor

ATC

1000 800 600 400 200

6,750 6,500 6,000 3,500 2,000

325.93 312.31 301.67 340.00 385.00

Construct the average total cost, average variable cost, and marginal cost schedules to illustrate the change. In Problem 5, we find that after this layoff, Nikon’s average total cost falls, so the original production level of Nikon’s camera is beyond the efficient output, and production moves leftward. Average and marginal costs

MC ATC AVC

AFC Efficient output

output

Chapter 14 . Production and Cost

The table shows the costs incurred at Pete’s peanut farm. Complete the table. L 0

TP 0

TVC 0

TC 100

AFC

AVC

ATC

105

140

L 0

TP 0

TVC 0

TC 100

AFC xx

AVC xx

ATC xx

135

10.00

3.50

13.50

170

4.17

2.91

7.08

105

205

2.63

2.76

5.39

140

240

2.27

3.18

5.45

13.50 2.50 2.50 5.83

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

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8. Blue Riband biscuit production to be moved to Poland Nestlé is planning to cut 300 jobs in York and Newcastle and move the production of the Blue Riband chocolate biscuit to a factory in Poland. This decision is to simplify production and operate more efficiently Source: BBC, April 25, 2017 Thinking of Nestlé’s factory as a unit of capital, explain why Nestlé is reloc ating its factories and reducing the number of workers. Does the news clip illustrate whether Nestlé’s decisio n will improve its efficiency? Relocating the production of Blue Riband Biscui ts is a long-run decision, leading to a smaller-siz ed workforce in the plants located in York and Newcastle. The decision to cut its workforce is a short-run decision, decreasing the short-run pro duction level. There is a leftward movement of Nestlé’s ATC along the short- and long-run AT C curve. If Nestlé wants to be efficient and take advantage of the economies of scale, it should k eep its ATCs at a minimum. The news clip alone does not confirm whether Nestlé’s decision is co rrect; more information is required. 9. Read Eye On Retailers’ Costs on p. 371 and draw a graph to show how the retailers’ cost curves would change if they introduced cost-saving self- checkouts. The substitution of capital—self-serve checkouts—for labor—clerks—increases 7- 11’s and Wal-Mart’s average total costs at low levels of output. The substitution, however, decreases these costs at higher levels of output. These changes are illustrated in Fig- ure 14.1. The initial average total cost curves for 7-11 and Wal-Mart are in grey; the curves after the substitution has been made are in black.

Chapter 14 . Production and Cost

 Additional Problems and Applications 1.

If the ATC curves of a Wal–Mart store and a 7–Eleven store are like those in Eye on Retailers’ Costs on p. 369, and if each type of store operates at its minimum ATC, which store has the lower total cost? How can you be sure? Which has the lower marginal cost? How can you be sure? Sketch each firm’s marginal cost curve. The total cost equals ATC × q. For Wal-Mart the total cost equals $1.00 × 30,000 = $30,000 and for 7-11 the total cost equals $2.00 × 5,000 = $10,000. The MC equals the ATC at the minimum ATC. Because each store is operating at its minimum ATC, Wal-Mart’s MC is $1.00 per customer and 7-11’s MC is $2.00 per customer. Figure 14.2 shows the marginal cost curves. Sonya used to earn $25,000 a year selling real estate, but she now sells greeting cards. The return to entrepreneurship in the greeting cards industry is $14,000 a year. Over the year, Sonya bought $10,000 worth of cards from manufacturers and sold them for $58,000. Sonya rents a shop for $5,000 a year and spends $1,000 on utilities and office expenses. Sonya owns a cash register, which she bought for $2,000 with funds from her savings account. Her bank pays 3 percent a year on savings accounts. At the end of the year, Sonya was offered $1,600 for her cash register. Calculate Sonya’s explicit costs, implicit costs, and economic profit. Sonya’s explicit costs are $10,000 for cards, $5,000 for rent, and $1,000 for utilities. So Sonya’s explicit costs are $16,000. Sonya’s implicit costs are $25,000 in forgone income as a real estate agent, $14,000 normal profit, $60 in forgone interest, and $400 in economic depreciation on the cash register, for a total of $39,460. Sonya’s economic profit equals her total revenue, $58,000, minus her total opportunity costs or $55,460, which is the sum of her explicit and implicit costs. Sonya’s economic profit is $58,000  $55,460, which equals $2,540.

Use the following information to work Problems 3 to 5. Andy owns a small Peruvian coffee bean farm. Andy pays $300 a month as rent and spends $300 to buy equipment. He pays each worker $100 per month. Suppose labor is the only variable cost

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Table 1 shows the total product given the labor input. Calculate the marginal product and average product for Andy? The given table shows the marginal product and average product per month for Andy

Labor

1 2 3 4 5 6

1 2 6 10 12 13

Marginal product/ton 0 1 4 4 2 1

Andy’s coffee farm Labor 1 2 3 4 5 6

TP 1 2 6 10 12 13

Average product/ton 1 1 2 2.5 2.4 2.17

Calculate the average variable cost and average total cost of Andy’s farm. The AVC is equal to the total variable cost (number of workers hired times wage per person) divided by the total number of tons of coffee produced. The ATC is equal to the total variable cost plus the total fixed cost (the farm rent is $300 and equipment costs $300) divided by the total number of tons of coffee produced.

Labor 1 2 3 4 5 6

TP 1 2 6 10 12 13

AVC 100 100 50 40 41.7 46.2

ATC 700 400 150 100 91.7 92.3

At what output is Andy’s average total cost at a minimum? Andy’s average total cost is at a minimum at $91.7 when 12 tons of coffee beans are produced 6. The table shows some of the costs incurred at a Tea Curing Shed. Calculate the values of A, B, C, D, and E. Show your work. Costs incurred at a Tea Curing Shed TC/$ AFC/$ AVC/$ 500 C 20

Labor 1

TP/$ 10

TVC/$ 200

ATC/$ D

400

900

800

1100

8.6

22.9

31.4

MC/$ E

5 40 1000 1300 7.5 25 32.5 A=$600, because for tea curing, labor is the only factor needed to produce, and it is the only factor which incurs variable costs. TVC is equal to wages multiplied by © 2023 Pearson Education, Ltd.

20 40 40

Chapter 14 . Production and Cost

the number of workers, and wages are $200 from the table. B=$700, because TC=TVC+TFC, while from the first line TFC=$500-$200=$300. C=$30, because AFC=TFC/TP, while TFC is $300. D=$40, because ATC=TC/TP. E=$20, because MC= 7.

∆TC ∆TP

$400−$200 20−10

= $20.

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

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 Multiple Choice Quiz 1.

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

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

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

Average variable cost is at a minimum when . A. marginal cost equals average variable cost B. average total cost is at a minimum C. marginal cost exceeds average fixed cost D. average total cost exceeds average variable cost Answer: A Figure 14.6 in the textbook shows that A is the correct answer.

Chapter 14 . Production and Cost

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

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

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

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

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Perfect Competition ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Consider the markets for pickles, baseball caps with logos, real estate, toothpaste, and gym memberships in a town with one gym. In what type of market is each good or service sold? Explain your answers. Pickles Pickles are sold in a perfectly competitive market because there are many producers, an identical product, and no barriers to entry or exit. Baseball caps with logos The baseball caps with logos market is monopolistically competitive. There are many firms, no barriers to entry, and each firm produces similar caps, but with different logos. Real Estate The real estate market is possibly an oligopoly as there are a few firms in this market. Toothpaste The toothpaste market is monopolistically competitive with a large number of similar but not identical brands. Gym membership in a town with one gym The membership is provided by a monopoly because there is only one firm in the market.

Explain why in a perfectly competitive market, the firm is a price taker. Why can’t the firm choose the price at which it sells its good? The firm cannot choose its price because it produces only a sma ll portion of the entire market output and its good has perfect substitutes. If the firm increases its production, it has no impact on the market price. If the firm raises the price of its good above the market price, no one buys from it, switching instead to cheaper, perfect substitutes. And, if the firm lowers its price below the market price, the firm does not maximize its profit because it does not pick up any sales beyond what it could have gained

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even if it did not lower its price. The firm’s horizontal demand curve shows it can sell as much output as it wants at the market price. 3.

Table 1 shows the demand schedule for Lila's Nails. Calculate Lila’s marginal revenue for each quantity demanded. Compare Lila’s marginal revenue and price. In what type of market does Lila’s Nails operate? Lila's marginal revenue equals the price, $20 a batch, because price is constant. Lila's Nails operates in a perfectly competitive market because Lila can sell all the boxes that she produces at a price of $20 a batch.

The market for cookies is perfectly competitive. The table to the right shows some cost data for Lin’s Fortune Cookies. Use this information to work Problems 4 to 7. (Hint: Make a sketch of Lin’s short-run cost curves.) 4.

At a market price of $50 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run?

Price Quantity (dollars per demanded batch) (batches per day) 30 30 30 30 30 30 30

0 1 2 3 4 5 6

Quantity (batches per day)

AFC

AVC ATC (dollars per batch)

84.0

51.00

135

42.0

44.00

28.0

39.00

21.0

36.00

16.8

35.20

For reference, Lin’s cost curves are 6 14.0 36.00 50 in Figure 15.2 (on the next page). 7 12.0 39.00 51 Lin produces the quantity at which marginal revenue equals marginal 8 10.5 44.50 55 cost. The marginal revenue is $50.00 a batch of cookies. So Lin produces 6.0 batches a day. Lin’s firm makes zero economic profit. 5.

At a market price of $35.20 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run? Lin produces the quantity at which marginal revenue equals marginal cost. The marginal revenue is $35.20 a batch of cookies. So Lin produces 5 or 0 batches a day. Lin’s average total cost is $52, so Lin incurs an economic loss of $16.80 per batch of cookies, which means she incurs a tota l economic loss of $84.00.

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Chapter 15 . Perfect Competition

Create Lin’s short-run supply schedule and make a graph of Lin’s shortrun supply curve. Explain why only part of Lin’s short-run supply curve is the same as its marginal cost curve. At a price of $35.20 a batch of cookies, Lin’s produces 5.0 batches; at a price of $40 a batch of cookies, Lin’s produces 5.5 batches; at a price of $57 a batch of cookies, Lin’s produces 6.5 batches; and, at a price of $83 a batch, Lin’s produces 7.5 batches. At any price less than $35.20 a batch, Lin’s produces no cookies because her minimum average variable cost is $35.20. Figure 15.1 shows Lin’s supply curve. Lin’s supply curve is the part of the marginal cost curve that is above minimum average variable cost. At prices below minimum average variable cost, Lin’s produces no cookies. For prices less than minimum average variable cost, $35.20 a batch, Lin’s incurs a smaller economic loss by shutting down and producing nothing than by remaining open. So, at these low prices, the firm’s supply curve runs along the vertical axis and the firm produces zero cookies.

At a market price of $83 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run? Do firms enter or exit the market and what is Lin’s economic profit in the long run? Lin produces the quantity at which marginal revenue equals marginal cost. The mar ginal revenue is $83 a batch of cookies. As Figure 15.2 shows, at this price Lin produces 7.5 batches a day. Lin makes an economic profit of $225. Firms enter the market. In the long run, Lin’s makes zero economic profit.

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Use the following information to work Problems 8 to 10. Quebec losing hold over maple syrup industry to U.S. competition The Federation of Quebec Maple Syrup Producers tries to limit production and stockpiles a “strategic reserve” to keep the price of syrup high. But Quebec producers are feeling increased competition from Vermont, New York, and Maine, where market share has increased and is expected to increase further in 2017 and 2018. 8.

Source: The Globe and Mail, April 6, 2015 Do you think global beverage market is a competitive market or oligopoly market? Explain. What do you think is the reason for Coca Cola to take such a big share in this market? The global beverage market is not much differentiated as the cost faced by different producers and the benefit of different brands to consumers are not very different, so for most people, the global beverage market can be seen as perfectly competitive. Though Coca Cola and Dr. Pepper Snapple Group are holding widely different market shares, that is only on the level of the scale of production. The reason for Coca Cola for taking such a big share of the market is that, given a fixed price in the market, a larger share means that Coca Cola can make higher profits, and it also obtains the power of changing the price by a small amount in the beverage market Suppose the price for a bottle of Cola is $1, and the global beverage market is perfectly competitive, please compute the total revenue Coco Cola earns in year 2018. In 2018, the global beverage market will grow into 21 billion × (1 × 6%) = 22.26 billion bottles per year. The beverage market sales Coco Cola faces will be 22.26 billion × 50% = 11.13 billion bottles per year. So, the total revenue of Coco Cola in 2018 will be 11.13 × 10 8 × $1 = $11.13 ×10 8.

10. With the help of a graph, explain the changing situation PepsiCo faces after the expansion of Coco Cola’s still beverages and waters. How is the rest of the market affected? When Coco Cola expands its market, the supply for beverages rises, and the supply curve shifts to the right, leading to a lower price for beverages and a higher quantity sold in total. For PepsiCo, the price it faces is the marginal revenue it receives, so the marginal revenue curve for PepsiCo shifts downwards, leading to a lower profit and fewer sales. See the graphs. Notice that the second graph is not perfectly competitive.

Chapter 15 . Perfect Competition

Price (dollars per bottle)

ATC P P’

Bottle s pe r ye ar

Beverage market PepsiCo faces Price (dollars per bottle)

S’

Bottle s pe r ye ar

Global beverage market 11. Read Eye on Record Stores on p. 432 and reflect on the following questions: in the former chapter, we learned that the rise of music streaming services greatly changed the landscape of music industry. Please compare the influences of internet retailing of recorded music and the music-streaming services, and analyze why lower cost products can squeeze out higher cost products? The online retailing of recorded music is the first stage of change in the sales of music. It cut the cost of physical stores and management fees, and therefore has a lower ATC and makes profits given the market price. The positive economic profit makes it able to lower the price and then expel its competitors. Music-streaming services is the second stage of change in the sales of music. It cut the cost of producing CDs and logistics, and the AVC of each piece of music is pretty low, so companies make profits through subscription fees. Lower prices and a greater variety of products expelled © 2023 Pearson Education, Ltd.

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physical CD sellers. Lower-cost products have a lower ATC, thus making positive economic profits in the short -run given a fixed market price. Higher-cost producers are price takers. New firms will enter the lower cost production system, driving down the price—when the price is below the higher-cost producers’ ATC, they will choose to exit the market .

Chapter 15 . Perfect Competition

 Additional Problems and Applications 1.

In the long run, each firm in the competitive online music record market is making zero economic profit, then why do they still stay in the market instead of exiting or moving to another industry? Is marginal revenue always equal to price in all markets. That happens because even though firms in a perfectly competitive market are making zero economic profit, they are still making a positive accounting profit. A firm making a positive accounting profit doesn’t necessarily have to stay in the industry, but because the return to entrepreneurship = normal profit + economic profit (and it is equal to normal profit in this case) the firm does not earn more by shifting to another industry. Marginal revenue is only equal to price in a perfectly competitive market. However, in a monopoly market, if production rises, the price of all products falls, so marginal revenue = price of the marginal product – loss in revenue of previous goods.

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

In what type of market is each of the following goods and services sold? Explain your answers. 

Breakfast cereals The breakfast cereal market is an oligopoly because it is dominated by 4 large firms: Kellogg’s, General Mills, The Quaker Oats Company, and Post Cereals.



Smartphones The smartphone market is monopolistically competitive. There are many firms (LF, Apple, Nokia, Motorola, Panasonic, Sony Ericsson, Sanyo, and others) each making a differentiated smartphone. There are no barriers to entry into the market.



The only restaurant in a small town The only restaurant in a small town is a monopoly because it is the only firm in the market.



Oranges Oranges are a perfectly competitive market. There are many orange growers, with no barriers to entry into the market, and each orange grower produces an identical product—oranges.

 4.

Air travel in a town serviced by one airline The company is a monopoly because it is the only firm in the market.

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Why doesn’t Joe’s Diner close—temporarily shut down—at lunchtime? Joe’s Diner doesn’t shut down because the price of a meal is greater than average variable cost. By staying open, even though Joe does not have many customers, he can pay all of the variable costs of remaining open and some of his fixed cost. Use the following information to work Problems 5 to 7. Figure 15.5 shows the short-run cost curves of a toy producer. The market has 1,000 identical pro ducers and the table shows the market demand schedule for toys. 5.

At a market price of $21 a toy, what quantity does the firm produce in the short run and does the firm make a positive economic profit, a zero economic profit, or an economic loss? At a market price of $21 the firm will produce 2,000 toys per week because this is the quantity of toys for which the marginal revenue, $21, equals the marginal cost. At this price the firm makes a positive economic profit because the price exceeds the average total cost.

At a market price of $12 a toy, how many toys does the firm produce and what is its economic profit in the short run? How will the number of firms in the market change in the long run?

Quantity Price demanded (dollars per (thousands of toy) toys per week) 24 1,000 21 1,500 18 2,000 15 2,500 12 3,000

At a market price of $12 the firm will produce either 1,000 toys or 0 toys per week because this price equals the firm’s shutdown point, the minimum of its average variable cost. At this price the firm incurs an economic loss because the price is less than the average total cost. The economic loss is equal to the firm’s fixed cost. Firms will exit the market so in the long run the number of firms decreases. 7.

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

Chapter 15 . Perfect Competition

market demand, there must be 2,500,000 toys  1,500 toys per firm, or 1,667 firms. Use the following information to work Problems 8 and 9. California plans to crack down on the use of fumigants by growers of straw berries. The biggest burden will fall on Ventura County’s growers, who pro duce about 90 percent of the nation’s crop. 8.

Draw graphs of the U.S. strawberry market in long -run equilibrium before the pollution crackdown: one of the U.S. market and one of a California grower. Now show the short-run effects of the pollution crack down.

Figure 15.6 and Figure 15.7 show the initial U.S. market and a typical California grower. In Figure 15.6, the demand curve is D and the initial supply curve is S0 . The initial (assumed) equilibrium price is $1 per pound and the initial equilibrium quantity is 600 tons per year. Figure 15.7 shows an individual producer of strawberries. The initial marginal cost curve is MC0 , the initial average total cost curve is ATC 0 , and the initial marginal revenue curve is labeled MR0 . The firm initially produces 5 tons per year and makes zero economic profit because the price, $1 per pound, equals the average total cost. The rise in costs shifts the firm’s average total cost and marginal cost curve upward, as shown in Figure 15.7 by the shift from ATC0 to ATC 1 and from MC0 to MC1 . In the market, Figure 15.6 shows that the market supply decreases and the market supply curve shifts leftward to S1. The new equilibrium price is $1.50 per pound. At this price, Figure 15.7 shows that the firm decreases its production to 2.5 tons

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per year, where the (new) marginal cost curve, MC1 , intersects the new marginal revenue curve, MR1 . The firm incurs an economic loss because the price, $1.50 per pound, is less than its average total cost. 9.

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

Figures 15.8 and 15.9 show what happens in the long run. In the short run the higher costs mean that the firms incur economic losses. These economic losses lead to some firms exiting the market. As firms exit, the market supply decreases. Eventually the market supply decreases so that the market supply curve becomes S2 in Figure 15.8. (In the long run, the mar ket supply decreases so that the supply curve S0 shifts to the supply curve S2 .) The price rises to $2 per pound. In Figure 15.9, which shows a firm in the market, the higher market price of $2 per pound shifts the firm’s mar ginal revenue curve upward to MR2 . The firm produces where its marginal cost curve, MC1 , intersects its (new) marginal revenue curve, MR2 . In Figure 15.9, this firm produces 3 tons of strawberries in the long run. At this new equilibrium, the firm makes zero economic profit so there is no longer an incentive for firms to exit the market. Use the following information to work Problems 10 and 11. How Samsung's new Galaxy tablet compares to the iPad Pro Samsung launched its $599.99 Galaxy Tab S3 a few days ago, setting this price aimed at Apple's $698 iPad Pro (with touch pen). Equipped with a free S Pen, Samsung added a lot technological advances on this Galaxy Tab S3, resulting in the overall cost of Tab S3 lower than iPad Pro . © 2023 Pearson Education, Ltd.

Chapter 15 . Perfect Competition

Source: TIMES, March 22, 2017 10. Explain what’s the effect of Samsung’s new technological advance in its Tab S3, and why is the mobile market approaching perfectly competitive ? The mobile phone market is competitive with phones on the same price level having similar levels of quality. Firms with newly -developed costsaving production techniques will always have a lower cost than the market price, earning economic profit. They are willing to supply a given quantity at a lower price, or, equivalently, willing to supply a larger quantity at a given price. However, the market tends to be “flat” because the total market supply increases and the equilibrium price for mobiles decreases, so Samsung soon earns zero economic profit, and the new technology spreads among the mobile manufacturers, making the market more competitive. 11. Consider Samsung in a perfectly competitive market, please tell what determine the price for Samsung’s phone and what determines the quantity of the phones it sell using the knowledge in this chapter. See Figure 15.10 on page 428 We know that in a perfectly com petitive market, it is always efficient, so the price equals the minimum average total cost for single firms. If the price is different from this, there will be an economic profit or loss, resulting in entries and exits, and price will eventually come back to the minimum ATC. So, the prices of Samsung’s phones are determined by Samsung’s minimum ATC. As seen from the market supply-demand graph, the quantity of phones sold is determined jointly by the number of firms and the demand curve.

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 Multiple Choice Quiz 1.

In perfect competition, all the following situations arise except A. firms produce an identical good or service B. each firm chooses the price at which to sell the good it produces

C. firms can sell any quantity they choose to produce at the market price D. buyers know each seller’s price Answer: B Firms in perfect competition are price takers so they “take” the price determined in the market. 2.

A firm that is producing the quantity at which marginal cost exceeds both average total cost and the market price will increase its economic profit by . A. producing a larger quantity B. raising the price to equal marginal cost C. producing a smaller quantity D. producing the quantity that minimizes average total cost

Answer: C

The market price equals the firm’s marginal revenue. When a firm’s marginal cost exceeds its marginal revenue, the firm’s profit increases if it decreases its production.

A firm will shut down in the short run if at the profit-maximizing quantity, . A. total revenue is less than total cost B. marginal revenue is less than average fixed cost

C. average total cost exceeds the market price D. marginal revenue is less than average variable cost Answer: D The firm’s shutdown point is when price equals the minimum average variable cost. 4.

At the shutdown point, the firm

A. incurs an economic loss equal to total variable cost B. makes zero economic profit C. incurs a loss equal to total fixed cost D. stops production to decrease its economic loss Answer: C At the shutdown point, the firm’s economic loss is the same if it remains open or closes. If it closes, the economic loss is equal to the fixed cost, so the fixed cost is the economic loss at the shutdown point.

Chapter 15 . Perfect Competition

In the short run, the profit-maximizing firm will . A. break even if marginal revenue equals marginal cost B. make an economic profit if marginal cost is less than average total cost C. incur an economic loss if average fixed cost exceeds marginal revenue D. incur an economic loss if average total cost exceeds marginal revenue

Answer: D

Because the firm’s marginal revenue equals the price, if the average total cost exceeds marginal revenue, then average total cost exceeds price, which is the signal that the firm incurs an economic loss.

A firm’s short-run supply curve is the same as good.

if it produces the

A. its marginal revenue curve B. the upward-sloping part of its marginal cost curve C. its marginal cost curve above minimum average variable cost D. its marginal cost curve above minimum average total cost Answer: C 7.

Figure 15.5 in the text illustrates that answer C is correct.

A permanent increase in demand economic profit in the short run and some firms will in the long run. A. does not change; exit the market B. increases; enter the market

C. increases; raise their price D. does not change; advertise their good Answer: B The increase in demand leads to a higher price, which increases the firms’ economic profit. The economic profit influences other firms to enter the market. 8.

Perfect competition is efficient because all the following conditions hold except . A. total product is maximized B. firms maximize profit and produce on their supply curves C. consumers get a real bargain and pay a price below the value of the good

D. firms minimize their average total cost of producing the good Answer: A Although perfectly competitive firms produce at the minimum average total cost, that result does not mean that the firm’s total product is at its maximum. Each firm could produce more, albeit at a higher average total cost.

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Monopoly ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use the following information to work Problems 1 to 3. Elixir Spring produces a unique and highly prized mineral water. The firm’s total fixed cost is $5,000 a day, and its marginal cost is zero. The table shows the demand schedule for Elixir water. 1. On a graph, show the demand for Elixir water and Elixir Spring’s marginal revenue curve. What are Elixir’s profit-maximizing price, output, and economic profit? Elixir Spring’s marginal revenue curve and demand curve are illustrated in Figure 16.1. Also in the figure is Elixir’s marginal cost curve. The marginal cost curve runs along the horizontal axis because the marginal cost is zero. Elixir produces the quantity where the marginal cost curve intersects the marginal revenue curve, so Elixir produces 5,000 bottles a day. Elixir sets a price of $5 a bottle because that is the price at which 5,000 bottles a day is the quantity demanded. Elixir’s economic profit equals its reve nue, which is $5 a bottle  5,000, = $25,000 a day, minus its cost, which is its fixed cost of $5,000 a day. Elixir’s economic profit is $25,000  $5,000, which is $20,000 a day. 2.

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

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

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

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

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

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

Chapter 16 . Monopoly

Use the following information to work Problems 5 and 6 EpiPen scandal is a perfect example of crony capitalism The price of Epinephrine (EpiPen), a lifesaving medicine used in situations of severe allergic reactions, has increased 400 times. Producing a pack of EpiPen costs $10, but it now sells for $600 in the United States. This indicates a major problem—the existence of very few market forces and limited competition. In reaction to protests, a discount of about $300 is provided to special treated patients 5.

Source: The New York Times, August 25, 2016 Why did EpiPen’s price rise? Draw a graph to show EpiPen’s costs, demand, profits, and deadweight loss. EpiPen is an example of a government-caused monopoly. Its rising price is because it is operating at a monopoly profit instead of a competitive market. Figure 16.4 illustrates the case of EpiPen—its demand curve is relatively flat, and its monopoly price is $600. Price/pack

Deadweight $600

Economic profit

Demand

loss

ATC

MR Quantity/pack The market for EpiPen

The demand curve for lifesaving medicines is usually inelastic. Is the deadweight loss incurred by EpiPen large or small? And can you see the economical reason for it to give a $300 discount to special treated patients? The demand for EpiPen is inelastic. As shown in the graph, the demand curve becomes flatter (from 1 to 2), we see the area of the triangle representing deadweight loss in the graph gets smaller (from orange to blue triangle), so the deadweight loss is not so large. However, this would still cause fatal consequences to poorer families. EpiPen gives special discounts to special treated customers in order to price discriminate, which is to let the people whose can afford less pay less without affecting © 2023 Pearson Education, Ltd.

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its other products. It is raising its economic profit and exploiting customer surplus. From the clip, it appears that Mylan may be using this to take advantage of FDA policies and to prevent generic competitors from copying EpiPen. Deadweight loss1

Price/pack

Deadweight loss2 MC ATC

D1 MR1

MR2 Quantity/pack

The market for EpiPen

Use the following information to work Problems 7 and 8. Global med-tech firms, India locked in tussle after stent price sting The pricing regulator NPPA (National Pharmaceutical Pricing Authority) in India set a price-cap on the stents sold in India. That is INR 7,260 ($113) for the older generation and INR 29,600 ($461) for drug-releasing variants. Abbott Laboratories, Boston Scientific and other companies are lobbying against this new law, threatening to withdraw their stents since that is unviable, and may consider not implementing next generation med-tech products. But the government want to reduce the costs on its people. Source: Reuters, April 28, 2017 7.

What is the effect of India government’s new policy? Is there any deadweight loss? Please illustrate with a graph on the stent market. This new policy is a price-cap on stents (small wire-mesh structures used to treat blocked arteries). Under this policy, med-tech producers can sell whatever amount they want at the set price. Ideally, the economic profit for producers will become zero, and the quantity of stents sold will increase, the price will be decreased, and there is no deadweight loss. In the graph, the price decreased from the monopoly price to the price cap.

Chapter 16 . Monopoly

Price/set

Monopoly price

MC ATC

Price cap

Demand

MR The market for stents

Quantity/set

What are the conditions for this policy to be effective? What do you think about Abbott Laboratories and Boston Scientific’s threats (from different views)? The conditions are that the Indian government should precisely estimate the costs of production for med-tech firms to set the proper price cap, and put out in-time proper bills accordingly to maintain the existing stentselling firms and keep the investment level. Abbott Laboratories and Boston Scientific’s threats are not viable because from the economic point of view, the firms are making zero economic profit, but there are positive accounting profits for them that should induce them to stay. Also, giving up the India market is not a preferred choice for them. From the political point of view, there are bills preventing the firms from exiting from India entirely or wholly, and from the news, we gather that even limiting the existing stents amount is prohibited. Above all, ethically, it is not acceptable.

Use the following information to work Problems 9 and 10. Unfair postal competition With the rise of e-mail, the volume of snail mail has fallen precipitously, and the U.S. Postal Service has been losing billions of dollars. It is an unjustified © 2023 Pearson Education, Ltd.

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legal monopoly that is heavily subsidized and Congress should end it. Source: The Cato Institute, January 8, 2016 9. Why is the U.S. Postal Service not a natural monopoly? Explain why it could be efficient to keep it in operation with a subsidy. If the U.S. Postal System was a natural monopoly, then other firms would find it difficult or impossible to compete with it because the other firms would have higher average total costs if the amount they produce and sell is less than that of the U.S. Postal System. But, in reality other companies, such as FedEx and UPS, can successfully compete with the U.S. Postal System. That fact indicates that the U.S. Postal System is not a natural monopoly. 10. Draw a graph to illustrate the U.S. Postal Service’s price, quantity produced, consumer surplus, producer surplus, and deadweight loss. Figure 16.7 shows the U.S. Postal System as a monopoly. The firm delivers 200 million items a week because that the quantity sets MR equal to MC. The price per item is $0.75. The consumer surplus is equal to the light grey area labeled A; the producer surplus is equal to the medium grey area labeled B; and, the deadweight loss is equal to the dark grey area labeled C. 11. Read Eye on Microsoft on p. 429 and explain how Window’s price, quantity bought, consumer surplus, producer surplus, and deadweight loss would change if Microsoft was able to sell ads that appear every time a user opens a program. Illustrate your answer with a graph. If Microsoft was able to sell ads, the situation will be similar to Google, which sells ads as people search. Microsoft’s ads would lead to a lower price for Windows, an increased quantity, and an increased consumer surplus. If the price falls to equal the marginal cost, zero, the deadweight loss is eliminated. Microsoft’s producer surplus increases. Figure 16.8 shows the market for ads. Presuming Microsoft can perfectly price discriminate, Microsoft’s producer surplus is equal to the area of the entire grey triangle.

Chapter 16 . Monopoly

 Additional Problems and Applications Read Eye on Microsoft on p. 429, and then use the following information to work Problems 1 and 2. Microsoft: We're not gouging Europe on Windows 7 pricing Regulators in the European Union have charged Microsoft with illegally tying Internet Explorer (IE) to Windows and mandated that a version of Windows be offered stripped of IE. A news report suggested that when Microsoft launches Windows 7, it will charge a higher price for the IEstripped version than the price for a full version that includes IE. Microsoft denied this report but announced that it would offer the full version of Windows 7 at a lower upgrade price. Source: computerworld.com 1. How does Microsoft set the price of Windows and would it be in the firm’s self-interest to set a different price for a version stripped of IE? Microsoft sets the price of Windows at the amount that maximizes its profit. Stripping IE increases Microsoft’s fixed costs but has no effect on its variable cost or its marginal cost. Microsoft will set different prices if the marginal revenue of the two Windows versions are different. 2.

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

Use the following information to work Problems 3 and 4. Bobbie’s Hair Care is a natural monopoly. The Price Quantity Marginal cost (dollars per (haircuts (dollars per table shows the demand schedule (the first two haircut) per hour) hour) columns) and Bobbie’s marginal cost schedule 20 0 (the middle and third columns). Bobbie has 18 1 1 done a survey and discovered that she has four 16 2 4 types of customers each hour: one woman who is 14 3 8 willing to pay $18, one senior who is willing to 12 4 12 10 5 18 pay $16, one student who is willing to pay $14, and one boy who is willing to pay $12. Suppose that Bobbie’s fixed costs are $20 an hour and Bobbie’s price discriminates. 3. What is the price each type of customer is charged and how many haircuts an hour does Bobbie’s sell? What is the increase in Bobbie’s economic profit that results from price discrimination? If Bobbie price discriminates, she charges the woman $18, the senior citizen $16, the student $14, and the boy $12. If Bobbie price discriminates, she sells 4 haircuts an hour. Bobbie’s economic profit is her total revenue

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minus her total cost. If she does not price discriminate, she produces the quantity such that marginal revenue equals marginal cost. Bobbie’s marginal revenue when she produces 3 haircuts is equal to her marginal cost when she produces 3 haircuts. (Both are equal to $8.) So without price discrimination, Bobbie’s produces 3 haircuts an hour at a price of $14. In this case, her economic profit is her total revenue, $42, minus her total cost, $33 (the sum of the fixed cost plus the marginal costs), which is $9. If she price discriminates, her total revenue is $18 + $16 +$14 + $12, which is $60. Her total cost to produce 4 haircuts is $45, so her economic profit is $60  $45, which is $15. So her economic profit increases by $6. Who benefits from Bobbie’s price discrimination? Is the quantity of haircuts efficient? When Bobbie price discriminates, Bobbie benefits because her economic profit is higher. Because Bobbie is perfectly price discriminating, Bobbie is producing the efficient quantity of haircuts. With price discrimination, the boy willing to pay $12 benefits because he now gets a haircut. Society benefits because the deadweight loss is eliminated.

Use the following information to work Problems 5 through 10. Big Top is the only circus in the nation. The Price table sets out the demand schedule for circus (dollars per ticket) tickets and the cost schedule for producing 20 the circus. 18 5. Calculate Big Top’s profit-maximizing 16 price, output, and economic profit if it 14 charges a single price for all tickets. 12 Big Top’s total revenue and marginal 10 revenue schedules are in the second table 8 (on the next page), which is useful to an6 swer these questions. Big Top’s marginal 4

Quantity (tickets per show) 0 100 200 300 400 500 600 700

800 cost is constant and equal to $6 per ticket. Big Top’s marginal revenue equals its marginal cost when the quantity of tickets is 350 tickets per show and the price is $13 per ticket. The total revenue is 350 tickets  $13, which is $4,550. The total cost of 350 tickets is $3,100. So the economic profit equals $4,550  $3,100, which is $1, 450.

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

Total cost (dollars per show) 1,000 1,600 2,200 2,800 3,400 4,000 4,600 5,200 5,800

Chapter 16 . Monopoly

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

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

100

1800

200

3200

300

4200

400

4800

500

5000

600

4800

700

4200

800

3200

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

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

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

18 14 10 6 2 2 6 10

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10. Draw a graph to illustrate the circus market if regulators set a price cap that enables Big Top to break even. Show the deadweight loss in your graph. Figure 16.9 shows the situation if regulators set a price cap that allows Big Cap to break even. The price cap is a touch under $8 because this is the price at which the average total cost curve intersects the demand curve. The quantity of tickets sold is a bit more than 600. The deadweight loss is equal to the area of the grey triangle.

Chapter 16 . Monopoly

 Multiple Choice Quiz 1.

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

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

A single-price monopoly maximizes profit by producing the quantity at which . A. its total revenue will be as large as possible B. marginal revenue equals marginal cost and setting the price equal to marginal revenue C. marginal revenue equals marginal cost and setting the price equal to marginal cost D. marginal revenue equals marginal cost and setting the price equal to the most people are willing to pay for that quantity Answer: D Figure 16.4(b) illustrates that answer D is correct. 4.

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

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

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

Governments regulate natural monopoly by capping the price at . A. marginal revenue and allowing the monopoly to maximize profit B. marginal cost so that the monopoly is efficient and makes zero economic profit C. average total cost, which allows the monopoly to be inefficient but make zero economic profit D. the buyers’ willingness to pay, which makes the monopoly operate efficiently Answer: C Figure 16.12 illustrates the effects of using an average cost pricing rule to regulate the natural monopoly.

Chapter

Monopolistic Competition ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Are the shampoo market and the peanut market examples of monopolistic competition? The shampoo market is an example of monopolistic competition. There are many producers of shampoo with extensive product differentiation and competition with respect to quality, price, and marketing. The peanut market is not an example of monopolistic competition, but they are sold in a perfectly competitive market because there are many producers all producing an identical product

The four-firm concentration ratio for audio equipment makers is 30 and for electric lamp makers is 89. The HHI for audio equipment makers is 464 and for electric lamp makers is 2,850. Which of these markets is an example of monopolistic competition? The audio equipment market is an example of monopolistic competition.

Use the following information to work Problems 3 to 5. Just Eat and Hungryhouse merger faces competition probe London’s food delivery company Just Eat’s £200m plan to take over rival company Hungryhouse faces a hurdle. In December, it had announced plans to acquire Canada’s SkipTheDishes for £66.1m. Despite this merger, the food delivery sector is still very competitive, with Uber and Deliveroo operating in the market 3.

Source: BBC, May 19, 2017 Draw a graph to illustrate how Just Eat determined its production and pricing level before the merger in the short run.

price and cost /$

Just Eat's delivery market

quantity of delivery/service per day

Just Eat is in a monopolistic competitive market, though the products are not so different by themselves, but companies advertise to make them look different. It produces its delivery services at a quantity where marginal revenue equals marginal cost, and makes a positive economic profit. 4.

How would Just Eat’s demand and marginal revenue change after the merger? What is its effect on its total profit? Just Eat receives a larger market share by acquiring Hungryhouse and thus has a higher market demand and marginal revenue. As Just Eat enjoys economics of scale at its small production level, the increased demand raises its output and lowers its ATC, and it earns a higher economic profit.

In the short run, this food delivery market is like a monopolistic market. In the long run, this market has is similar to a perfectly competitive market. Briefly explain this phenomenon. © 2023 Pearson Education, Ltd.

The food delivery market is a monopolistic competitive market, as in the short-run it has a fixed number of firms each having some market power, so it is like a monopolistic market, with a downward sloping demand curve and a marginal revenue curve lower than the demand curve, and with excess capacity and markup price. In the long run, a monopolistic market is free to enter and exit, as it is like a competitive market because each firm is making zero economic profit and the ATC equals the price. Use Figure 17.2, which shows the demand curve, marginal revenue curve, and cost curves of Stiff Shirt, Inc., a producer of shirts in monopolistic competition, to work Problems 6 and 7. 6. In the short run, what is the quantity that Stiff Shirt produces, the price it charges, its economic profit, markup, and excess capacity? Stiff Shirt produces 100 shirts a week because this is the quantity at which marginal revenue equals marginal cost. The demand curve shows that Stiff Shirt charges a price of $60 a shirt. Stiff Shirt’s price is $60 a shirt and its average total cost is $50 a shirt. So Stiff Shirt makes an economic profit of $60 a shirt minus $50 a shirt, which is $10 a shirt. Stiff Shirt produces 100 shirts a week, so its weekly economic profit is $10  100, which is $1,000. Stiff Shirt’s price is $60 a shirt and its marginal cost is $20 a shirt. So, Stiff Shirt’s markup is $60 a shirt minus $20 a shirt, which is $40 a shirt. Stiff Shirt is producing at less than its efficient scale of 150 shirts per week, so Stiff Shirt has excess capacity of 50 shirts per week. 7.

In the long run, will new firms enter the shirt market or will firms exit from that market and will the price of a shirt rise or fall? Explain your answer. Stiff Shirt is making an economic profit, so firms will enter the market. As more firms enter the market, the demand for shirts from Stiff Shirt decreases and the price of a shirt falls.

Mike’s, a firm in monopolistic competition, produces bikes. With no advertising, Mike’s profit-maximizing output is 500 bikes a day and the price is $100 a bike. Now all firms begin to advertise. With advertising, Mike’s maximizes profit by producing 1,000 bikes a day and charging $50 a bike. How does advertising change Mike’s markup and excess capacity? Figures 17.3 and 17.4 (on the next page) show the general situation with no advertising and with advertising. With no advertising, Figure 17.3 shows that Mike produces 500 bikes a day, determined by the intersection of the MR curve and MC curve and sets a price of $100 for a bike. Figure © 2023 Pearson Education, Ltd.

17.4 shows Mike’s situation with advertising. Relative to the noadvertising situation in Figure 17.3, Mike’s average total cost is higher at every level of output. The demand for Mike’s bikes has become more elastic so the demand curve and marginal revenue curve have changed. Mike now produces 1,000 bikes a day, the quantity at which the marginal cost curve and new marginal revenue curve intersect. Mike sets a price of $50 for a bike. Mike’s markup is smaller with advertising and Mike has less excess capacity

Apple unveils iTunes Radio Apple Inc. will launch iTunes Radio with over 200 programmed channels and an opportunity for users to buy music direct from its iTunes Store. iTunes Radio joins a crowded streaming-music market in which Apple is playing catchup to its rivals, instead of creating something new. Source: The Wall Street Journal, June 11, 2013 With Apple’s sales so strong, why would Apple Inc. launch iTunes Radio? Explain how the economic profit of firms in the streaming-music market will likely change as competition intensifies. Apple is entering the streaming music market because it expects to make an economic profit by producing a differentiated product that consumers prefer. Ultimately, as competition heats up in the streaming music market, in the long run it is likely that Apple will only be able to make zero economic profit.

10. Read Eye on Smartphones on p. 453 and explain why smartphone producers offer such a large variety of their products. Draw a graph of a firm’s cost and revenue curves if all smartphones are identical. Use your graph to illustrate the effects of the firm introducing a new, differentiated smartphone. © 2023 Pearson Education, Ltd.

Smartphone producers offer a huge variety because it is inexpensive to offer the variety and consumers want to buy a smartphone that is differentiated according to their tastes. When the firm produces a smartphone with the features that many consumers desire, the firm can temporarily make an economic profit. Figure 17.5 shows the situation in the smartphone market for one firm if all smartphones are identical. In this case, the market is effectively perfectly competitive and, as the figure shows, the demand curve, DSAME, is horizontal and equal to the marginal revenue curve. In this case the firm produces 1,000 smartphones a day and the price is $150 per smartphone. The firm makes zero economic profit. If, however, the firm creates a new, differentiated smartphone, the demand curve changes to DDIFF with the marginal revenue curve MRDIFF. Now the firm maximizes its profit by producing the quantity that sets MRDIFF = MC, which is 875 smartphones per day. The price is $350 per smartphone and the producer makes an economic profit.

 Additional Problems and Applications 1.

It takes the Boeing Company 4 to 5 years, on average, to develop a new aircraft model, but it only takes around 3 months for Tide to put out a detergent product with a different scent, which is considered a new product. Why is the development faster? Are there more varieties of a detergent product than airplanes? There is more variety in detergents than in airplanes because for detergents the marginal benefit of new varieties easily exceeds the marginal cost. A new detergent fragrance can be developed by adding a new ingredient. However, producing different varieties of airplanes is much costlier. Fewer varieties of airplanes are produced because developing a new aircraft that is safe and unique requires long-term work and investment. It is hard for the marginal benefit from an additional variety to cover the marginal cost of creating the variety.

According to a report by research firm Analysys, the Chinese mobilegame development market is as follows: Tencent 40%; Netease game 28%; elex 5%; Perfect World 5%; and the rest of the market, 2%, is divided between smaller firms. Use HHI to explain whether this is a monopolistic competitive market or not. The HHI for the Chinese gaming market = 402 + 282 + 52 + 52 + 22 × 11 = 2,478; an HHI between 1,500−2,500 is seen as moderately competitive and an HHI exceeding 2,500 is seen as uncompetitive. This market is monopolistic competitive, but not highly competitive.

Use Figure 17.6, which shows the demand curve, marginal revenue curve, and cost curves of La Bella Pizza, a firm in monopolistic competition, to work Problems 3 and 4. 3. What is the quantity that La Bella Pizza produces, the price it charges, its markup, and its excess capacity? Is the market in short-run or long-run equilibrium? Explain your answer. La Bella produces 150 pizzas a day because this is the quantity at which marginal revenue equals marginal cost. La Bella charges a price of $13 a pizza. La Bella has a price markup because its price exceeds its marginal cost. The price is $13 per pizza and the marginal cost is $10 per pizza. La Bella has a $3 per pizza markup. La Bella is producing less than its efficient scale, so La Bella has excess capacity.

La Bella’s efficient scale of output is 210 pizzas, where the marginal cost curve intersects the average total cost curve. La Bella is producing only 150 pizzas, so it has excess capacity of 60 pizzas per day. The market is in its long-run equilibrium because La Bella is making zero economic profit. Other firms will not enter the industry nor will firms leave it. 4.

If La Bella advertises its pizza online and demand increases, how will the number of pizzas sold change? How will the price of a pizza and La Bella’s excess capacity change? Explain your answer. With the increase in demand, La Bella’s price and the quantity of pizzas it sells both increase. La Bella’s capacity changes because the advertising increases La Bella’s average total cost and shifts the ATC curve upward. Because advertising is a fixed cost, the upward shift of the ATC curve is larger the smaller the quantity, so the efficient scale (the quantity that minimizes the average total cost) increases. Because La Bella’s quantity and its capacity both increase the change in excess capacity is ambiguous.

Use the following information to work Problems 5 and 6. A new swing for female golfers Callaway and Nike, two of the leading golf-equipment manufacturers, recently released new clubs designed for women. They are the hottest innovation in golf. Source: Time, April 21, 2008 5. How are Callaway and Nike attempting to maintain economic profit? Draw a graph to illustrate Callaway’s or Nike’s short-run economic profit in the market for golf clubs for women. Callaway and Nike are innovating by creating golf clubs for women. They are producing a differentiated product— clubs designed for women. They expect that the demand for women’s clubs will be high and so they will be able to (temporarily) make an economic profit. Figure 17.8 shows the situation at Callaway or Nike. The firm produces 200,000 golf clubs per year and sets a price of $140 per club. The economic profit equals the area of the darkened rectangle labeled A in Figure 17.7.

Explain why the economic profit that Callaway and Nike make in this market is likely to be temporary. Draw a graph to illustrate their excess capacity in the long run. The economic profit is temporary because there are no barriers to entry. If Callaway and Nike are indeed able to make an economic profit, other firms will enter the market by producing women’s golf clubs. As more firms produce the clubs, the demand for Callaway and Nike clubs will decrease. As a result, the quantity and price of Callaway and Nike clubs will decrease, which lowers their economic profit. In the long run, the lack of entry barriers eliminates the economic profit. Figure 17.9 shows the long-run equilibrium for Callaway or Nike. The firm produces 150,000 golf clubs and sets a price of $130 per club. The firm makes zero economic profit because its price equals its average total cost. The firm’s excess capacity is 150,000 golf clubs, shown in the figure by the length of the grey arrow between the quantity the firm produces and the quantity that minimizes the firm’s average total cost

Some people happily pay more for Coke or Pepsi than they are willing to pay for a nonbranded cola. And some people happily pay more for Tylenol than they are willing to pay for generic acetaminophen. How do brand names help consumers? How do brand names change the behavior of producers? Why would it not be efficient to make brand names illegal? Brand names signal the consumer that a good or service has a high and consistent quality. Brand names give the producer the incentive to keep the quality of the good or service high and consistent. Brand names are efficient if the marginal benefit of brand names exceed the marginal cost of creating and maintaining brand names. In this case, banning brand names leads to inefficiency.

Use the following information to work Problems 8 and 9. Take a Look at Apple's New Special Edition iPhone 7 The mobile company Apple will release a new product in May 24, a special version of its iPhone 7 and 7 plus whose cover is red. The company says that this is to commemorate their cooperation with Red. And it is going to give a portion of profits from this product to this AIDS-fighting organization. Source: TIME, March 21, 2017

Consider the special features of a monopolistic competitive market, and explain why a change in the cover color would bring a big increase in Apple’s sales. Why are there so many varieties in the mobile industry? In a monopolistic competitive market, companies try to differentiate themselves and obtain a greater market share through innovation and advertisement. This red cover iPhone series is very differentiable from other phones, so it gets much market power and its demand curve shifts upward. There is more variety in the mobile phone industry because the marginal benefit of developing one of these varieties easily exceeds the marginal cost, so producers can add on a small feature to obtain a new variety.

Why would Apple spend so much on advertising, giving away some of its profits from selling its phones to Product Red, an organization that raises awareness and funds to help eliminate HIV/AIDS in eight African countries? Red and Apple may seem to be unrelated, but both benefit from this cooperation. Apple get more benefits than its cost of doing advertising by donating to Red. First, it gets inspiration for a new product design at a low cost. Apple also creates a socially-concerned brand name, which cultivates customer loyalty and raises this red iPhone’s demand and marginal revenue curves, making the demand curve more inelastic. Apple increases its sales and receives a larger market share.

 Multiple Choice Quiz 1.

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

The four largest firms in a market have the following market shares of total revenue: 20 percent, 15 percent, 10 percent, and 5 percent. The in this industry is . A. four-firm concentration ratio; 50 percent B. four-firm concentration ratio; 750 percent C. Herfindahl-Hirschman Index; 50 D. Herfindahl-Hirschman Index; 2,500 Answer: A The four-firm concentration ratio equals the sum of the market shares of the four largest firms in the market. 3.

A firm in monopolistic competition maximizes its profit by . A. differentiating its good and producing the quantity at which price equals marginal revenue B. producing the quantity at which marginal revenue equals marginal cost and then adding a markup C. raising its price and producing so that it always has excess capacity D. producing the quantity at which marginal cost equals marginal revenue and charging the highest price at which it can sell that quantity Answer: D Figure 17.1 shows how a monopolistically competitive firm maximizes its profit.

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

In the long run, each firm in monopolistic competition . A. makes zero economic profit B. makes as much economic profit as it would if it was a monopoly C. has the same markup and excess capacity as it would if the market was perfectly competitive D. creates the same deadweight loss as it would if it was a monopoly Answer: A The absence of barriers to entry mean the firm makes only zero economic profit in the long run.

If one firm advertises and other firms in the market don’t, then . A. the demand for the advertised good becomes more elastic B. the profit-maximizing quantity of the advertised good decreases because total fixed costs increase C. the average cost of producing a small quantity of the advertised good rises but the average total cost of producing a large quantity might fall D. the economic profit made from the advertised good increases Answer: D If only one firm advertises, the demand for its good increases, which raises the economic profit the firm can make. 7.

Each firm in monopolistic competition uses a brand name and advertising to achieve all of the following except to . A. differentiate its good from its competitors’ goods B. signal quality and reliability of its good C. signal its market share D. influence the demand for its good Answer: C The firm has no need to signal its market share.

Chapter

Oligopoly ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use the following information to work Problems 1 and 2. When the first automobiles were built in 1901, they were made by skilled workers using hand tools. Later, in 1913, Henry Ford introduced the moving assembly line, which lowered costs and speeded production. Over the years, the production line has become ever more mechanized, and today robots replace people in many tasks. 1. Sketch the average total cost curve and the demand curve for automobiles in 1901 and in 2020.

Figure 18.1 shows the average total cost curve and demand curve in 1901, when cars were made by hand. (The price and costs are in terms of what they would be today.) At the time the average total cost was high but

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reached its minimum after only a few cars were produced. In 2020, the use of robots raised the average total cost at low levels of production and lowered the average cost at higher levels of production. The number of cars before the average total cost reached its minimum increased. Figure 18.2 shows this situation. 2.

Describe the changing barriers to entry in the automobile industry and explain how the combination of market demand and economies of scale has changed the structure of the industry over the past 100 years. Initially the cost and demand allowed many firms to be in the market because the average total cost reached its minimum after only a few cars were produced. But then the evolving cost curves lead the market to become a natural oligopoly as the average total cost reaches its minimum after a large number of cars are produced. The barrier to entry is the very high average total cost when only a few cars are produced. If a firm wants to enter the market, it is necessary for it to have a large scale of production, which is difficult to achieve.

Use the following information to work Problems 3 to 5. Isolated Island has two taxi companies, one owned by Ann and the other owned by Zack. Figure 18.3 shows the market demand curve for taxi rides, D, and the average total cost curve of one of the firms, ATC. 3. If Ann and Zack produce the same quantity of rides as would be produced in perfect competition, what are the quantity of rides, the price of a ride, and the economic profit of Ann and Zack? Would Ann and Zack have an incentive to collude and raise their price? Explain why or why not. In perfect competition in the long run, price equals minimum average total cost. So if Ann and Zack produce as perfect competitors, the total quantity of rides is 30 a day, the price is $15 a ride, and both make zero economic profit. Ann and Zack have an incentive to collude and operate together as a monopoly. If they can do so, both of their profits would increase.

Chapter 18 . Oligopoly

If Ann and Zack form a cartel and produce the same quantity of rides as would be produced in monopoly, what are the quantity of rides, the price of a ride, and the economic profit of Ann and Zack? Would Ann and Zack have an incentive to break the cartel agreement and cut their price? Explain why or why not. A monopoly produces where marginal revenue equals marginal cost. The marginal revenue curve goes through the point with price of $10 and quantity of 20 rides. Each firm’s marginal cost curve is “half” the market marginal cost curve. That means that at every marginal cost, the market marginal cost curve has twice the quantity of each firm’s marginal cost curve. So the market marginal cost also goes through the point with price $10 and quantity of 20 rides. Therefore the marginal revenue curve intersects the marginal cost curve at $10 and quantity of 20 rides, so each firm produces 10 rides. The price, from the market demand curve, is $20 per ride. At this quantity, the average total cost is $17, so the firms make an economic profit per ride of $20 − $17, or $3. Each firm sells 10 rides, so each firm’s economic profit is $30 for a total economic profit of $60, the same as the monopoly economic profit. Ann and Zack both have an incentive to break the cartel agreement by cutting their price below $20 a ride. For each, the marginal revenue of an additional taxi ride exceeds the marginal cost, so each knows that if it, and it alone cheated, its profit would increase.

Suppose that Ann and Zack have two strategies: collude, fix the monopoly price, and limit the number of rides or break the collusion, cut the price, and produce more rides. Create a payoff matrix for the game that Ann and Zack play, and find the Nash equilibrium for this game if it is played just once. Do the people of Isolated Island get the efficient quantity of taxi rides? A payoff matrix is to the right. Calculating the profits Ann’s strategies when either Ann or Zack Collude Not collude break the collusive cartel agreement is difficult and $30.00 $50.00 the answer to the question Collude depends on these profits. $30.00 $10.00 Probably the most reasonaZack’s ble assumptions are that the strategies “cheater,” that is, the player $10.00 $0.00 who does not collude, Not collude makes a larger economic $5 0.00 $0.00 profit and that the “victim,” that is the player who does

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collude, incurs an economic loss because no one uses his or her higherprice rides. With these assumptions, the cheater makes an economic profit that exceeds $30 (assumed to be $50 in the payoff matrix), the victim incurs an economic loss (assumed to be $10 in the payoff matrix), and the sum of the economic profit plus the economic loss is less than $60, the total economic profit when both Ann and Zack comply with their agreement. In the payoff matrix, the entries are dollars of economic profit. The Nash equilibrium is for Ann and Zack to produce the same quantity of rides as would be produced in perfect competition. Both make $0 economic profit. The efficient quantity of taxi rides is produced. Use the following information to work Problems 6 and 7. Coke, Pepsi and the new front in the cola wars The cola wars between Coca-Cola and PepsiCo may become even tougher as consumers seek out healthier alternatives to sugary soft drinks. But both Coke and Pepsi are getting higher prices for soda, thanks to new 8-ounce cans replacing the standard 12-ounce size. Source: CBC News, February 12, 2015 6. Describe the cola wars that Coca-Cola and PepsiCo play as a game. What type of game is it? What are some of the strategies in the game? Coke and Pepsi are playing a marketing game. In this prisoners’ dilemma game, both have two strategies: They can sell new 8-ounce cans or sell 12 ounce cans. 7.

With two strategies—8-ounce can and 12-ounce can—and with assumed payoffs, create a payoff matrix for the game if the equilibrium outcome is for both firms to choose 8-ounce cans. The payoff matrix to the right Coke’s strategies has some assumed payoffs. Sell 8 ounce Sell 12 ounce Pepsi’s dominate strategy is to sell the new 8 ounce cans. Sell 8 $20 $10 Similarly, Coke’s dominate ounce strategy also is to sell the new $20 $90 8 ounce cans. Consequently Pepsi’s the equilibrium outcome is strategies for both companies to sell the $90 $40 8-ounce cans. Sell 12 ounce

$10

$40

Chapter 18 . Oligopoly

Read Eye on the Wireless Oligopoly on p.513 and explain why there is a significant oligopoly in the wireless market. How do we decide whether four firms are too few or enough for the smartphone plans market? Economies of scale and the network effect of big firms cause this oligopoly. It is more efficient with fewer service providers because of high setup costs and low marginal costs. Whether four firms are too few depends on the long-run average total cost curve of a single firm and the demand curve in the market. An oligopoly efficiency is achieved if each firm is operating at the lowest ATC, not when economic profit is zero. However, if the profit is high, we suspect that there is still market space.

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 Additional Problems and Applications 1.

Two Indian states, Uttar Pradesh and Rajasthan, produce milk. Suppose that they are the only milk producers in the market. If both set a low (competitive) price, economic profit for both is zero. If both set a high (monopoly) price, economic profit for Uttar Pradesh is $200 million and for Rajasthan is $100 million. If Uttar Pradesh sets low price and Rajasthan sets high price, Uttar Pradesh earns an economic profit of $250 million and Rajasthan incurs a loss of $50 million; if the situation is reversed, Rajasthan earns a profit of $200 while Uttar Pradesh incurs a loss of $100 million.  Create the payoff matrix for this game and find the equilibrium. The payoff matrix for this game is mentioned here in the figure. The equilibrium will be reached when both Uttar Pradesh and Rajasthan set the competitive price and earn zero economic profit.  Is the equilibrium efficient? This equilibrium is efficient because at that competitive equilibrium, the price is equal to the marginal cost, there is no markup or deadweight loss, and ATC is at the minimum.



Is the equilibrium practical? Why?

In practice, competitive equilibrium may not be the real case, because Uttar Pradesh and Rajasthan can set the price anywhere between competitive and monopolistic prices. There may be a Nash equilibrium reached. Uttar Pradesh’s strategies competitive price monopolistic price competitive price Uttar Pradesh $0m Uttar Pradesh Rajasthan $0m $100m Rajasthan’s Rajasthan $200m strategies monopolistic price Uttar Pradesh Uttar Pradesh $250m $200m Rajasthan -$50m Rajasthan $100m Use the following information to work Problems 2 and 3. Taskforce set up to implement tighter regulations on formula milk manufacturers The major manufacturers for formula milk in Singapore are Abbott and Danone. A recent report by the Competition Commission of Singapore shows that these giants are increasing their budget on R&D and marketing by up to 42% to make their products appear superior. This increases the costs and results in high prices in retail stores. Source: Channel News Asia, May 22, 2017 © 2023 Pearson Education, Ltd.

Chapter 18 . Oligopoly

TABLE 1 Abbott’s strategies market Danone’s strategies

Don’t market

Abbott $50m,

Abbott $30m,

Danone $50m

Danone $100m

Don’t

Abbott $100m,

Abbott $80m,

market

Danone $30m

Danone $80m

market

Table 1 shows the payoff matrix for the formula milk market concerning Abbott and Danone. Find the Nash equilibrium in the formula milk market. If Danone markets their products, Abbott will be better off marketing and earning $50m. If Danone does not do so, Abbott will be better off marketing and earning $100m. The same applies for Danone. Whether Danone markets their products or not, Abbott’s dominant strategy is to market their products. The Nash equilibrium is reached when both companies market and earn $50m

Explain why both companies increase their R&D and marketing budgets up to 42% and the potential bad effect of this deed. In Question 2, we know that whatever their competitors do, the dominant strategy for a formula milk company is to market its products. Researching valuable ingredients and telling their customers through marketing helps to create a premium brand image and fosters customer loyalty. This creates unnecessary differences in the formula milk market. The bad effect is that parents may be unaware of the implications and assume that these ingredients are necessary, and cheaper substitutes for these brands will be crowded out. .

Agile Airlines is making $10 million a year economic profit on a route on which it has a monopoly. Wanabe Airlines is considering entering the market and operating on this route. Agile warns Wanabe to stay out and threatens to cut the price to the point at which Wanabe will make no profit if it enters. Wanabe does some research and determines that

Agile High price

Low price

$7 m

$1 m

Enter $5 m

$0 m

Wanabe $10 m

Don’t enter $0 m

$5 m $0 m

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the payoff matrix for the game in which it is engaged with Agile is that shown above. Does Wanabe believe Agile’s assertion? Does Wanabe enter or not? Explain. Wanabe does not believe Agile’s assertion. If Wanabe does not enter, Agile’s best strategy is to set a high price. And, even if Wanabe enters the market, Agile’s best strategy is to set a high price because Agile has a larger payoff from setting a high price, 7, than by setting a low price, 1. So Wanabe has no reason to believe Agile’s assertion. Wanabe enters the market. If Wanabe does not enter, Wanabe receives a payoff of 0. If Wanabe enters, Agile sets a high price and Wanabe receives a payoff of 5. Use this information to work Problems 5 to 7. Kaspersky tones down threat of antitrust complaint against Microsoft Kaspersky lab in Russia filed an anti-trust complaint against Microsoft for expelling other anti-virus software makers. Kaspersky said the internet giant was forcing its own Defender anti-virus software on its Windows 10 user by its strong market power and reliable brand name. Kaspersky said it was talking to the U.S. Microsoft and after they made some changes, Kaspersky toned down its claim towards Microsoft. Source: Reuters, April 25, 2017 5. What’s the reason that the public sometimes protest Microsoft’s using its own Windows defender and Internet Explorer? The Windows operating system is provided only by Microsoft, but antivirus software and Internet Explorer are not provided solely by it. Microsoft is creating a monopoly in these fields through its strong market power in operating systems, using tying arrangements. This may harm the innovation process for better applications and result in a high price in these fields.

Chapter 18 . Oligopoly

Kaspersky has two options: to raise the suit or not, and Microsoft has two options: to agree the changes or not. Following is the payoff matrix faced by two firms. Find whether there is a Nash equilibrium. Kaspersky’s strategies

Microsoft’s strategies

Agree

Doesn’t agree

suit

Doesn’t suit

Kaspersky $100m, Microsoft $100m Kaspersky $100m, Microsoft $50m

Kaspersky $150m, Microsoft $150m Kaspersky $50m, Microsoft $300m

If Kaspersky launches a suit against Microsoft, then Microsoft is better off agreeing to Kaspersky’s requirements. If Kaspersky doesn’t launch a suit against Microsoft, then Microsoft is better off not agreeing to Kaspersky’s requirements. The same goes for Kaspersky. There is no dominant strategy for both parts, so there is no Nash equilibrium. Notice that the two companies are choosing the right top corner as the solution. 7.

In repeated games, a punishment strategy can lead to monopoly equilibrium outcome. Do you think Kaspersky’s punishment fit with this statement? And who benefit more from this suit? Kaspersky’s punishment doesn’t fit with this statement. Based on the chart given earlier, the situation where Kaspersky launches a suit and Microsoft agrees does not fit into a monopoly outcome. In fact, the monopoly outcome occurs when Kaspersky doesn’t file the suit and Microsoft doesn’t agree. However, this profit is not divided evenly among companies. Kaspersky benefits more from this suit, gaining a bigger market share.

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 Multiple Choice Quiz 1.

Which of the following statements is incorrect. In oligopoly . A. barriers to entry prevent new firms entering B. each firm’s profit is influenced by each other firms’ advertising C. each firm’s action is influenced by the actions and reactions of each other firm D. each firm is a price taker and the price is the monopoly profitmaximizing price Answer: D In oligopoly each firm sets its own price, which then influences its competitors’ profits.

If firms in oligopoly form a cartel, it will likely break down because . A. firms cannot agree on how to share the economic profit B. the price set by the cartel is too low C. with price exceeding marginal cost, a firm might expand production to increase its profit D. firms realize that their allocation of resources is inefficient Answer: C Each firm in the cartel has the incentive to expand its production beyond the quantity agreed upon because this action will boost the firm’s profit, at least as long as the other firms do not also boost their production.

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

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

Chapter 18 . Oligopoly

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

In an advertising prisoners’ dilemma game, . A. both firms will advertise and end up with lower profits than if neither advertises B. only one firm will advertise because the other firm sees the advertising expenditure as a waste C. the two firms agree on the total advertising budget and split it equally D. neither firm will advertise because both realize that it lowers profit Answer: A The advertising prisoners’ dilemma game has the usual prisoners’ dilemma outcome that each player, doing the best for himself or herself, winds up with a poor outcome.

Each of the following practices harms the market competition and is bad for market except____________. A. the deed to sell a disk to customer only if he buys the company’s CD player. B. cutting the price to occupy the market, and raising the price afterwards. C. an agreement between L'Oréal and P&G to sell the new cosmetics at a given price. D. using advertising to get larger market share. Answer: D Excessive advertising may raise the cost of production, but with every firm advertising, customers are better informed and competition increases. Companies don’t get larger market shares in the end.

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Markets for Factors of Production ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Modern candles are made of paraffin wax, which is extracted from petroleum. Suppose that 300g paraffin wax can be extracted from 1kg of oil, which is made into candle. Oil price falls from $6 per liter to $5 per liter, and the price of candles rises from $5 to $6. How would the value of marginal product (VMP) of oil change? By using the formula: 𝑉𝑀𝑃 = product price × marginal product, The price of candles rises from $5 to $6, and the marginal product of oil is 0.3 liters, so the VMP of oil changes from 1.5 to 1.8.

Through the 1990s, the percentage of high school students who decided to go to college increased. Draw a demand-supply graph to illustrate the effect of this increase on the market for college graduates. Explain its effect on the market for college professors. If the demand for college graduates does not increase, wage rates for college graduates fall and the number employed increases. This outcome is shown in Figure 19.1 in which the wage rate falls from $30 per hour to $20 per hour and the number employed increases from 3 million to 4 million. With more students, the demand for college professors increases. The salary of a college professor rises and the number of college professors employed increases.

Chapter

A new coffee shop opens and to maximize profit it hires 5 workers at the competitive wage rate. The price of a cup of coffee is $2 and the value of marginal product of workers in the coffee shop is $8 an hour. What is the marginal product of the coffee shop workers? How much does a coffee shop worker earn? The marginal product of the fifth worker is 4 cups of coffee an hour. The value of marginal product of the workers, $8, is equal to the price of a cup of coffee ($2 a cup) multiplied by the marginal product, which means that the marginal product must equal 4 cups an hour. To maximize its profit, the coffee shop hires enough workers so that the value of marginal product equals the wage rate, which means that the wage rate equals $8 an hour.

Consider the labor markets for junior staff members of hotels and hotel managers as two separate markets. Explain why hotel managers receive higher wages than junior hotel staff members. Hotel managers possess more experience and a wider skill portfolio than junior members of staff, so the VMP of hotel managers is higher than that of junior staff members. As the demand for labor is decided by VMP and managers have a higher demand curve, they receive higher wages than the junior staff members.

Suppose that Palm Island, the world’s largest grower of coconuts, plans to build its first airport on 100 acres of productive farm land. Palm Islanders expected the world price of coconuts to rise by 200 percent next year and remain high for the next decade. Explain the influence of these events on Palm Island’s labor market and land market. To build the airport construction workers are needed, so the demand for construction workers increases. The supply does not change, so the wage rate paid construction workers and the quantity of people employed as construction workers both increase. If the price of coconuts rises, the value of marginal product of coconut workers increases, so the demand for these workers increases. The supply does not change, so the wage rate paid coconut farm workers and the quantity of people employed on coconut farms both increase. When Palm Island decides to build an airport, the demand for land increases because the government needs the land to build the airport. The supply of land does not change. If the price of coconuts increases, the demand for land increases. If people believe they can earn a higher profit by growing coconuts, they demand more land that is lying fallow or being used in a different way. Once again, the supply of land does not change. For both reasons the demand for land rises so the price of land, that is, the rental rate of land, rises.

Suppose that Jack owns a crude oil well in his home town and is free to decide how much oil to supply. In 2018, the interest rate is 0.6 percent. Oil prices are expected to rise from $52 to $54 percent the following year. Should Jack sell his oil in 2018 or wait till the following year? The crude oil well owned by Jack is a nonrenewable natural resource. Jack is willing to sell any amount at the present price, which gives him the same profit as he expected to earn in the following year. Jack will earn $52 × (1 + 0.6%) = $52.03 if he sells his oil in 2018, which is less than $54, so Jack should wait till the next year.

Use the following information to work Problems 7 to 9. Robots, automation, artificial intelligence not as scary for workers as they seem Almost 27% of Australian business executors had implemented AI for business tasks, mostly in IT operations. Research by Infosys showed that 72% of workers affected by AI will either be redeployed in the same area within the organization or trained for a new area. Source: The Courier Mail, February 24, 2017 7. Explain the effects of artificial intelligence (AI) on the value of marginal product of Australian business companies’ capital, labor, and building land. The advanced robotic technology has taken the place of manual workers in Australian business companies. The value of marginal product of capital increased because this is a long-run change in the companies’ scale; the VMP of labor increased because workers are reduced and better educated; the VMP of building land also increased because the value of goods produced on the land increased due to technology advancements. 8.

Explain how the spread of AI will change the business companies’ labor markets in related departments. In departments like IT operations, robots will replace humans. The demand curve for labor will shift leftward, and wage rates and employment will fall. In departments like human resources, which require a human workforce, both demand and supply will increase. Wage rates are likely to rise, and employment will also increase.

Draw a graph to show the expected changes to the business companies’ rental rate for their factory sites. As the productivity of the business companies is now higher with the use of robots, the value of marginal product for factory sites is also higher, so the demand curve for land shifts upward, and the rental rate for factory sites increases.

Rent rate for factory site

D’ D Quantity of land/acre

10. Read Eye on the Coach on p. 535 and then draw demand-supply graphs to illustrate the markets for football coaches and economics professors. Explain the differences in the equilibrium wage rates and the quantities employed between coaches and professors. The higher equilibrium wage rates and lower employment of elite football coaches than economics professors in America is due to the higher supply curve and higher demand curve for football coaches. As shown in Figure XX, the cost it takes to be a professional football coach is higher than the cost of becoming an economics professor. The supply curve for coaches shifts upward. Due to the U.S. appreciation of sports and the shortage of high-quality coaches, the marginal product value of a top-caliber coach is very high. The demand curve shifts upward. Football coaches’ wages are higher, but employment is lower. Wage rate LSC LDC LSPROF

LDPROF

 Additional Problems and Applications 1.

Explain why the market for college football coaches is monopolistic competitive. Draw two graphs to show the different markets for Nick Saban, former American football coach for the Miami Dolphins, and a regular university coach. The market for college football coaches is a monopolistic competitive one because each coach is providing the same category of service: coaching, but each possesses slightly different measures and level of skills, so they face different demand curves. Nick Saban faces a higher demand curve due to his talents compared to a normal coach. The graphs are as following: Wage rate

Nick Saban

D 1

Wage rate

Quantity/person

A normal coach

D 1

Quantity/person

In the years after World War II, the birth rate increased and the so-called baby boom generation was created. That generation is now beginning to retire. Draw a demand-supply graph to illustrate the effects of this increase in the number of seniors on the market for medical services. Seniors use medical care more frequently than younger people. An increase in the number of senior citizens increases the demand for medical services and raises the price of these services. The increase in the price of medical services increases the value of marginal product of medical service providers so that the demand for medical service providers increases. Figure 19.4 shows the results. The demand curve for medical service providers shifts rightward. The wage rate paid these providers increases, from $30 per hour to $50 per hour in the figure, and the quantity of workers employed in this sector increases, from 6 million to 10 million in the figure.

Use the following information to work Problems 3 and 4. A new coffee shop opens and to maximize profit it hires 5 workers at the competitive wage rate. The price of a cup of coffee is $4 and the value of marginal product of workers in the coffee shop is $12 an hour.

What is the marginal product of the coffee shop workers? How much does a coffee shop worker earn? The marginal product of the fifth worker is 3 cups of coffee an hour. The value of marginal product of the workers, $12, is equal to the price of a cup of coffee ($4 a cup) multiplied by the marginal product, which means that the marginal product must equal 3 cups an hour. To maximize its profit, the coffee shop hires enough workers so that the value of marginal product equals the wage rate, which means that the wage rate equals $12 an hour.

If the price of a cup of coffee rises from $4 to $5 and the coffee shop continues to hire workers at the competitive wage rate, explain how the value of marginal product and number of workers hired will change. The firm will continue to maximize its profit by hiring enough workers so that the value of marginal product equals the wage rate. The increase in the price of a cup of coffee raises the value of marginal product so that it exceeds the wage rate. To maximize its profit, the firm hires additional workers since the value of their marginal product exceeds the wage rate. If the wage rate remains equal to $12 an hour, then to maximize its profit the firm hires workers until the value of marginal product is once again equal to $12.

Use the following information to work Problems 5 to 7. An ex-Google coder makes twice as much freelancing James Knight quit a well-paid job writing software for Google to go freelance and is now earning about double his Google pay as a freelancer. In a war for talent, companies are paying as much as $1,000 per hour for freelancers with the right skills. The demand for coders soared with the arrival of the iPhone in 2007. More recently, coders started working on software for fridges, watches, and clothing. The Bureau of Labor Statistics says the demand for coders will grow at more than twice the average jobs growth rate. Source: Bloomberg, January 19, 2016 5. Explain what happened to the value of marginal product of coders after 2007 and explain why it happened. The value of marginal product of coders soared after 2007. This change occurred because coders’ marginal product increased since after 2007 they could program for smartphones, fridges, watches, and clothing.

Explain what happened in the market for coders after 2007 to demand, supply, and the quantities demanded and supplied and draw a graph to show the changes that occurred in the market for coders. The increase in the value of marginal product of coders increased the demand for coders. As a result, the demand curve for coders shifted rightward from D0 to D1. The supply of coders did not change. Figure 19.5 shows that the increase in demand raised the wage rate paid coders (from $500 per hour to $250) and increased the quantity employed (from 200,000 to 300,000). The higher wage rate increased the quantity of coders supplied (that is, there was a movement upward along the supply curve of coders).

Explain how the Bureau of Labor Statistics expects the market for coders to change in the future and draw a graph to show the expected changes. The Bureau of Labor Statistics expects the demand for coders to continue to grow at a rapid clip. As long as the increase in demand exceeds any increase in supply, the salary paid coders will continue to increase. Figure 19.6 illustrates this market, assuming that the supply of coders does not change. In it the demand for coders has continued to increase so that the demand curve is D2. The equilibrium wage rate for coders has increased from $1,000 per hour to $1,250.

Suppose that Bananaland is the world’s largest grower of bananas. Bananaland plans to double its population in 3 years by hiring well-educated people from the United States. To increase the number of entrepreneurs, Bananaland encourages anyone with $1 million to immigrate. Explain the influence of these events on Bananaland’s labor market and land market. By hiring well-educated people and doubling its population, Bananaland increases its supply of high-skilled labor. By encouraging the immigration of entrepreneurs, Bananaland encourages the formation of new businesses. When new businesses are created, the demand for labor increases.

Both the supply of and the demand for labor increase, so employment definitely increases but the effect on the wage rate is ambiguous. The newly arrived immigrants from the United States likely demand land upon which to construct new houses. Similarly the newly arrived entrepreneurs likely demand land upon which to construct new businesses. The supply of land does not change. In this situation the rental rate of land increases and the equilibrium quantity does not change. 9. House prices aren’t the issue – land prices are To speed up post-war development, the British government allowed identities to purchase land at “existing use value” in 1947. But from 1961, the Government passed that landowners be paid at “hope value,” which include further development values. Landowners reap lots of profit from this policy shift. Source: The Guardian, November 18, 2017 Explain how landowners are making profits from shift from “existing use value” pricing to “hope value” pricing. The demand for land is a derived demand based on the VMP of land. When landowners buy land under “existing use value” pricing, the VMP of land is counted upon undeveloped land, which is low. As the supply of land is perfectly inelastic, the price of land is low. When landowners sell land under “hope value” pricing, the VMP of land is counted upon developed land and takes into account further development possibilities, which are high. So the price of land is high. Landowners make money by buying low and selling high.

 Multiple Choice Quiz 1.

A firm’s demand for labor is determined by . A. the market wage rate B. the price of the good that the firm produces and the wage rate it pays C. the marginal product of labor and the market wage rate D. the price of the good that the firm produces and the marginal product of labor Answer: D The firm’s demand for labor is determined by the value of marginal product, which equals the market price multiplied by the marginal product.

The value of marginal product of labor increases if . A. more labor is hired B. more of the good is produced C. the market price of the good produced rises D. using a new technology reduces the demand for labor Answer: C The value of marginal product equals the market price multiplied by the marginal product, so when the market price rises, the value of marginal product increases.

An individual’s supply of labor curve is . A. horizontal at the market wage rate B. upward sloping as the wage rate rises C. upward sloping at low wage rates but becomes downward sloping at high wage rates D. vertical at the standard number of hours a person works per day Answer: C Figure 19.3 illustrates an individual’s supply of labor curve.

In a competitive labor market for bakers, the equilibrium wage rate . A. rises if bakers become more productive B. falls if the supply of bakers decreases C. rises if the market price of bakery items falls D. rises if new technology makes it easier for anyone to be a baker Answer: A An increase in bakers’ productivity increases the demand for bakers, thereby raising bakers’ wage rates.

A union will if it can . A. raise the wage rate of its members; decrease the marginal product of its union members B. raise the wage rate of its members; introduce minimum qualifications, which will restrict membership of the union C. increase the number of union jobs; restrict membership of the union D. increase the number of union jobs; increase the union wage rate Answer: B By restricting its membership, the union decreases the supply of union help, thereby raising its members’ wage rate.

To maximize profit, a firm . A. uses the quantity of land at which the rental rate equals the value of marginal product of land B. balances the rental rate of capital against the wage rate of labor C. uses the quantity of capital at which the marginal revenue equals the value of marginal product of capital D. uses the quantity of capital at which the suppliers’ expected profit equals the value of marginal product of capital Answer: A To maximize its profit, a firm uses the quantity of all inputs that set the factor price equal to its value of marginal product. 7.

Which of the following statements about a nonrenewable natural resource market is incorrect? A. The demand for the resource is determined by its value of marginal product. B. The supply of the resource is perfectly elastic at the market price. C. The price of the resource is expected to rise over time at a rate equal to the interest rate. D. The supply of the resource is perfectly inelastic. Answer: D Answer D is wrong because the owners are willing to supply any quantity at a price that gives the same expected profit from holding the resource and selling it next year.

Economic Inequality

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

The table shows the distribution of money income in Australia. Calculate the cumulative distribution of income for Australia and draw the Lorenz curve for Australian income. In which country is the income distribution more unequal: Australia or the United States? The cumulative distribution of income is in the table below. The Lorenz curve is in Figure 20.1. Income is distributed more equally in Australia. For instance, compared to the United States, the lowest 20 percent of households have a greater percentage of the total income in Australia and the top 20 percent have a much smaller percentage of total income in Australia. More generally, the Lorenz curve for the United States lies farther from the line of equality than does the Lorenz curve for Australia. Households

Income (cumulative percentage)

Lowest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Highest 20 percent

100

Households

Money Income (percentage)

Lowest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Highest 20 percent

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Rich-poor gap worries Chinese planners In 1985, urban Chinese earned 1.9 times as much as people in the countryside, which is home to 60 percent of the population. By 2007, they earned 3.3 times as much according to the United Nations. Source: The New York Times, November 22, 2008 Explain how the Lorenz curve in China changed between 1985 and 2007? In China, during this period, the already high-income urban workers’ incomes increased more rapidly than did the poorer rural workers’ incomes, so income was distributed less equally in 2007 than in 1985. The Lorenz curve moved away from the line of equality.

Figure 20.2 shows the market for lowskilled workers. With on-the-job training, low-skilled workers can become highskilled workers. The value of marginal product of high-skilled workers at each employment level is twice the value of marginal product of low-skilled workers, but the cost of acquiring skill adds $2 an hour to the wage rate that will attract highskilled labor. What is the equilibrium wage rate of low-skilled labor and the number of low-skilled workers employed? What is the equilibrium wage rate of highskilled labor and the number of highskilled workers employed? The wage rate of low-skilled labor is $5 an hour and 5,000 hours of low-skilled labor are employed. The situation for high skilled workers is illustrated in Figure 20.3 on the next page.

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The demand curve for and the supply curve of high-skilled workers are in Figure 20.3. The figure shows that the equilibrium wage rate paid high-skilled workers is $8 an hour and the quantity of employment is 6,000 hours.

Why do economists think that discrimination in the labor market is an unlikely explanation for the persistent inequality in earnings between women and men and among the races? Discriminating firms operate at an economic disadvantage and so firms are unlikely to discriminate. In particular, by discriminating a firm faces higher costs than those firms that do not discriminate. Higher costs are a disincentive to discriminating because the discriminating firm’s profits are decreased and/or the discriminating firm goes out of business.

Use the table and the following information to work Problems 5 to 7. Suppose that the government redistributes income by taxing the 60 percent of households with the highest market incomes 10 percent, then distributing the tax collected as an equal benefit to the 40 percent with the lowest market income. 5. Calculate the distribution of income after taxes and benefits and draw the Lorenz curve (i) before taxes and benefits and (ii) after taxes and benefits.

Households

Market income (percentage)

Lowest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Highest 20 percent

For simplicity, assume that the total income is $100 so that the percentages given in the problem’s table are the same as the dollars of income. Then the total income for the 5 percentile groups is $100. The table in the next column above shows the calculations necessary to determine each group’s percentage share of the income after taxes and benefits.

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Households Lowest 20 percent Second 20 percent Third 20 percent Fourth 20 percent Highest 20 percent

Market income (dollars) 5.0 9.0 20.0 30.0 36.0

Tax paid (dollars) 0.0 0.0 2.0 3.0 3.6

Benefits received (dollars) 4.3 4.3 0.0 0.0 0.0

Income after tax and benefits Income (dollars) (percentage) 9.3 9.3 13.3 13.3 18.0 18.0 27.0 27.0 32.4 32.4

Figure 20.4 shows the Lorenz curves before and after taxes and benefits. To draw these Lorenz curves, calculate the cumulative percentage shares. For instance, after taxes and benefits, the lowest 20 percent have 9.3 percent of total income and the lowest 40 percent have 22.6 percent (9.3 + 13.3). The remaining the cumulative percentages are calculated similarly.

If the cost of administrating the redistribution scheme takes 50 percent of the taxes collected, what is the distribution of income after taxes and benefits?

Households Lowest 20 percent Second 20 percent Third 20 percent Fourth 20 percent Highest 20 percent

Market income (dollars) 5.0 9.0 20.0 30.0 36.0

Tax paid (dollars) 0.0 0.0 2.0 3.0 3.6

Benefits received (dollars) 2.2 2.2 0.0 0.0 0.0

Income after tax and benefits (dollars) 7.2 11.2 18.0 27.0 32.4

Income (percentage) 7.5 11.7 18.8 28.2 33.8

If the cost of administering the redistribution scheme takes 50 percent of the taxes collected, then of the $8.6 collected as taxes, only $4.3 is redistributed. The total income falls to $95.8 and the income shares of the different percentile groups is shown in the last column in the table above.

Chapter 20 . Economic Inequality

If the people whose market incomes are taxed cut their work hours and their market incomes fall by 10 percent, what is the distribution of income after taxes and benefits?

Households Lowest 20 percent Second 20 percent Third 20 percent Fourth 20 percent Highest 20 percent

Market income (dollars) 5.0 9.0 18.0 27.0 32.4

Tax paid (dollars) 0.0 0.0 1.8 2.7 3.24

Benefits received (dollars) 3.87 3.87 0.0 0.0 0.0

Income after tax and benefits (dollars) 8.87 12.87 16.20 24.30 29.16

Income (percentage) 9.7 14.1 17.7 26.6 31.9

If the tax decreases the incomes of those taxed by 10 percent, the total amount redistributed decreases because the taxable income decreases. The table above shows the income after tax and benefits. The total taxable income falls to $77.4 so the amount redistributed falls to $7.74. The income shares of the groups is shown in the last column in the table above. 8.

America’s racial wealth gap White Americans have 22 times the wealth of African-Americans and 15 times the wealth of Latinos and these gaps got larger during the Great Recession. Source: National Public Radio, April 30, 2013 What does the data in the news clip tell us about the wealth Lorenz curve and the way it changed during the Great Recession? The data tells us that the Lorenz curve for wealth lies relatively far from the line of equality. It also tells us that during the Great Recession, the wealth Lorenz curve moved farther away from the line of equality.

Read Eye on the global economy: Global inequality on p. 555, then explain global inequality using the wealth of the top 10 percent of richest people. What is the relationship between a country’s PPP (purchasing power parity) income and its welfare spending? The global economy is unequal; the top 10 percent of richest people own as much as 85 percent of the global assets, but 50 percent of the world's population owns less than 1 percent. The relationship between a country’s PPP income and its welfare spending is that developed countries tend to spend a higher percentage of its total GDP (gross domestic product) on social expenditures.

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 Additional Problems and Applications 1.

Which influence adds most, on average, to a household’s income: receiving college education, having a large bank deposit, having outstanding entrepreneurial skills, being a hard worker, or being a man? As human capital differences explain much of the income inequality that exists in our economies, receiving a college education adds most to a household’s income. However, this result may differ in different situations.

The table shows the income share for each household quintile and the cumulative shares. Provide the values for A, B, C, D, and E. A equals the sum of the percentages of income earned by the first and second quintiles, so A = 7.4 + 13.2 = 20.6 percent.

Households (quintile)

(%)

Income (cumulative %)

First

7.4

Second

13.2

Third

38.7

Fourth 25.0 B equals the share of income going to the D third quintile. This share, plus the cumu- Fifth lative share going to the first two quintiles (answer A) equals 38.7 percent, so 20.6 + B = 38.7, which means that B = 18.1 percent.

C E

C equals the sum of the percentages of income earned by the first, second, third, and fourth quintiles, so C = 7.4 + 13.2 + 18.1 + 25.0 = 63.7 percent. D equals the share of income going to the fifth quintile. The share of the first four quintiles is 63.7 percent, so the fifth quintile must have what is left, 36.3 percent.

E equals the sum of the percentages of income earned by all quintiles, so E = 100.0 percent. Professional Income The table shows the distribution of prize money golfers (percentage) among the top 20 professional golfers. Calculate the cumulative distribution of income of these Lowest 20 percent 15 golfers and draw the prize money Lorenz curve Second 20 percent 16 of these golfers. Which distribution is more Third 20 percent 18 unequal: the distribution of income of these golfersor that of the United States as a whole? Fourth 20 percent 20 The cumulative distribution of income is in the Highest 20 percent 31 second table and the Lorenz curve is in Figure 20.6, on the next page. The lowest 20 percent of golfers have a greater percentage of the total income than the lowest 20 percent of house-holds in the United States and the top 20 percent of golfers have a smaller percentage of total income

Professional Golfers

Income (cumulative percentage)

Lowest 20 percent

Bottom 40 percent

Bottom 60 percent

Bottom 80 percent

100 percent

100

Chapter 20 . Economic Inequality

Than the highest 20 percent of households in the United States. The distribution of income is more unequal in the United States than among professional golfers.

Suppose the cost of acquiring a skill increases and the value of marginal product of skill increases. Draw demand-supply graphs of the labor markets for high-skilled and low-skilled labor to explain what happens to the equilibrium wage rate of low-skilled labor, the equilibrium wage rate of highskilled labor, and the number of high-skilled workers employed.

Neither the labor supply curve nor the labor demand curve shift in the

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market for low-skilled labor. So the wage rate remains constant, at (an assumed) $15 per hour in Figure 20.7. In the market for high-skilled labor in Figure 20.8, supply decreases and the supply of labor curve shifts leftward, from LS0 to LS1. The demand for labor increases and the demand for labor curve shifts rightward, from LD0 to LD1. The wage rate rises to (an assumed) $35 dollars a day. If the increase in the demand for labor exceeds the decrease in the supply of labor, the equilibrium quantity of labor increases. If the increase in the demand for labor is less than the decrease in the supply of labor, the equilibrium quantity of labor decreases. And, if as Figure 20.8 illustrates, the increase in the demand for labor equals the decrease in the supply of labor, the equilibrium quantity of labor does not change. Use the following information to work Problems 5 and 6. In the United States in 2002, 130,000 aircraft mechanics and service technicians earned an average of $20 an hour whereas 30,000 elevator installers and repairers earned an average of $25 an hour. The skill and training for these two jobs are very similar. 5. Draw the demand and supply curves for these two types of labor. What feature of your graph accounts for the differences in the two wage rates and what feature accounts for the differences in the quantities employed of these two types of labor? Figure 20.8 shows the labor markets for aircraft mechanics and elevator installers. The wage rate paid to elevator installers is higher than that paid to aircraft mechanics because the supply of elevator installers is less than the supply of aircraft mechanics. As drawn, the demand for elevator installers is less than the demand for aircraft mechanics, but the difference in demand is less than the difference in supply, so the wage rate paid to elevator installers is greater than the wage rate paid to aircraft mechanics. In the figure, the supply of elevator installers is less than the supply of aircraft mechanics and the demand for elevator installers is less than the demand for aircraft mechanics. So, fewer elevator installers are employed than aircraft mechanics. One reason the supply curves differ is because the training to be an aircraft mechanic might be more available than the training to be an elevator installer. In addition, workers might enjoy repairing aircraft more than installing elevators. On both counts, the supply of aircraft mechanics exceeds that of elevator installers. One © 2023 Pearson Education, Ltd.

Chapter 20 . Economic Inequality

major reason the demand for labor curves differs is because of the size of the markets. As planes are required to undergo frequent servicing, there are many more planes that need to be repaired than elevators that need to be installed. Therefore, the demand for aircraft mechanics exceeds the demand for elevator installers. 6.

Suppose that a government law required both groups of workers to be paid $22.50 an hour. Draw a graph to illustrate what would happen to the quantities employed of the two types of labor. The law creates a shortage of elevator installers. As illustrated in Figure 20.8 by the horizontal line at the wage rate of $22.50 when the wage rate is $22.50 an hour, the quantity of elevator installers demanded exceeds the quantity of people willing to work as elevator installers, so the quantity employed is less than 30,000. In the market for aircraft mechanics, the law creates a surplus of aircraft mechanics. When the wage rate is $22.50 an hour, Figure 20.8 shows that the quantity of aircraft mechanics demanded is less than the quantity of people willing to work as aircraft mechanics, so employment is less than 130,000.

Use the following information to work Problems 7 to 11. California: The nation’s most unequal state In California, researchers found, it really matters where you live. Residents of Silicon Valley live more than four years longer than the average American, earn nearly double the income, and have nearly triple the number of graduate degrees. Residents of Central Valley live nearly a year less than the average American, earn barely more than a poverty-line income, and nearly four in ten failed to graduate from high school. Source: CNN, May 6, 2015 7. Explain why the first sentence of the news clip is not correct. The nationwide data show that residence has a small impact on income. The single-most important factor is education, which is mentioned in the second and third sentences of the news clip.

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8. Inequality in India: what's the real story. India is in being reported as one of the most unequal countries in the world, both in terms of income and wealth. In 2016, the richest 10% own 76.3% of the country’s wealth, while the poor fight for 4.1% of the national wealth. In 2000, the share of wealth of the richest 10 percent decreased to 65.9% Source: World Economic Forum, October 04, 2016. What might be the reason for India’s income and wealth inequality? The cause of huge income and wealth inequality in India is the financial and physical capital discrepancy, and discrimination. Firstly, people with more wealth receive higher incomes from interest and dividends payment and capital gains. Secondly, discrimination through India’s caste system is a barrier for economic mobility, both in the form of marriage and employment salaries. Use the following information to work Problems 9 to 11. Cost, necessity of education contributing to Boston area's income inequality Boston has been leading city in United States in income inequality. The Federal Reserve Bank of Boston’s economist said the increasing fees of advanced degree of education contributes a lot to income inequality. Boston has got a higher education system more heavily rely on private institutions than state colleges. Source: Boston Business Journal, Mar 29, 2017 9.

Explain how the labor markets in Boston translate education differences into earnings differences. Advanced education gives people higher human capital than lower education. High-skilled workers have a higher VMP compared to low-skilled workers. However, there is a cost to acquire advanced education, so at the same quantity of labor supplied, high-skilled workers demand higher wages as compensation. As a result, the incomes of high-skilled workers are higher than low-skilled workers.

10. Illustrate the labor markets for college graduates and high school graduates in Boston with a graph. The graph reflects the higher demand for high-skilled workers and the higher costs of supply for them. Blue lines represent low-skilled workers while green lines represent high-skilled workers. Note that the extremely high college fees make SH extra high, resulting in a higher wage rate and lower equilibrium quantity of high-skilled workers.

Chapter 20 . Economic Inequality

Wage rate (dollars per day)

20 15

SL 10 DH

DL 0

Labor (thousands of hours per day) 11. What policy can Boston government take to narrow this income inequality? Income taxes, income maintenance programs, and subsidized services are three major ways the Boston government can help to narrow income inequality. For example, it could start progressive taxation and income maintenance programs to redistribute income among income groups. Also, by subsidizing state-run colleges, the Government can reduce the cost for lower-earning families to receive advanced education.

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 Multiple Choice Quiz 1.

A Lorenz curve plots the . A. trend in the cumulative percentage of income received by each quintile against trend in the number of households B. average income received by each quintile against the number of households in the quintile C. percentage of total income received by each quintile against the percentage of households in the quintile D. cumulative percentage of income against the cumulative percentage of households Answer: D The definition and discussion of the Lorenz curve on page 513 shows that answer D is correct.

Which of the following statements is correct? A. The closer the Lorenz curve is to the line of equality, the more unequal is the distribution of income. B. The farther the Lorenz curve is from the line of equality, the more unequal is the distribution of income. C. If the Lorenz curve crosses the line of equality the distribution of income is more unequal at high income levels than at low income levels. D. The Lorenz curve for wealth is closer to the line of equality than the Lorenz curve for income. Answer: B Once again, the discussion on page 513 shows that answer B is correct. 3.

In recent years, as the gap between the rich and the poor has increased, the Lorenz curve has . A. shifted away from the line of equality B. not changed, but there has been a movement down along it C. shifted closer to the line of equality D. not changed, but there has been a movement up along it Answer: A As incomes become more unequal, the Lorenz shifts farther away from the Line of equality.

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Which of the following statements is incorrect? A. A proportional tax is one that taxes income at a constant rate, regardless of income. B. Subsidized services require an adult member of a household, receiving assistance, to work or perform community service. C. Most major modern political parties are satisfied with the current scale of redistribution D. Government can redistribute income by income taxes, income maintenance programs and subsidized services Answer: B Subsidized services are services provided by the government at prices far below the cost of production. Temporary Assistance for Needy Families (TANF) requires that an adult member of a household receiving assistance must work or perform community service. 5.

Economic inequality arises from all of the following except . A. inequality of human capital B. inequality of education attainment C. a shortage of high-skilled labor D. discrimination Answer: C A shortage of high-skilled labor raises the wage paid highskilled labor but is not a fundamental cause of economic independent. 6.

Income redistribution in the United States results in the income share of the rising and the income share of the falling. A. lowest quintile; other four quintiles B. two lowest quintiles; other three quintiles C. three lowest quintiles; other two quintiles D. four lowest quintiles; highest quintile Answer: D Figure 20.6 shows that answer D correct. 7.

When governments redistribute income, they . A. give every dollar collected in taxes to poor people B. are influenced by how people vote in elections C. improve economic efficiency D. set the tax and benefit rates that make everyone work and save more Answer: B The median voter theorem predicts that redistribution works to make the median voter as well off as possible.

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