INSTRUCTOR'S RESOURCE MANUAL for Microeconomics, 8th edition Glenn Hubbard, Anthony Patrick O'Brien by StudyGuide

Contents Part 1: Introduction Chapter 1 Economics: Foundations and Models

Appendix: Using Graphs and Formulas

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

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

Chapter 4 Economic Efficiency, Government Price Setting, and Taxes

Appendix: Quantitative Demand and Supply Analysis

Part 2: Markets in Action: Policy and Applications Chapter 5 Externalities, Environmental Policy, and Public Goods

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Chapter 6 Elasticity: The Responsiveness of Demand and Supply

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Chapter 7 The Economics of Health Care

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Part 3: Firms in the Domestic and International Economies Chapter 8 Firms, the Stock Market, and Corporate Governance

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Appendix: Using Present Value

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Appendix: Income Statements and Balance Sheets

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Chapter 9 Comparative Advantage and the Gains from International Trade

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Part 4: Microeconomic Foundations: Consumers and Firms Chapter 10 Consumer Choice and Behavioral Economics

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Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Chapter 11 Technology, Production, and Costs Appendix: Using Isoquants and Isocost Lines to Understand Production and Cost

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Part 5: Market Structure and Firm Strategy Chapter 12 Firms in Perfectly Competitive Markets

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Chapter 13 Monopolistic Competition: The Competitive Model in a More Realistic Setting

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Chapter 14 Oligopoly: Firms in Less Competitive Markets

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Chapter 15 Monopoly and Antitrust Policy

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Part 6: Labor Markets, Public Choice, and the Distribution of Income Chapter 16 The Markets for Labor and Other Factors of Production

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Chapter 17 Public Choice, Taxes, and the Distribution of Income

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Preface Features of this Instructor’s Manual Each chapter of this Instructor’s Manual contains the following elements:

 Chapter Summary: An overview of the main economic concepts covered and definitions of all key terms in the chapter.

 Learning Objectives: A list of the student learning goals listed at the beginning of each text chapter.

 Chapter Outline with Teaching Tips: Detailed descriptions of the economic concepts in the book, key term definitions, and teaching tip boxes.

 Extra Solved Problems: Each chapter of the main text has a Solved Problem to support two of the chapter’s learning objectives. This Instructor’s Manual includes extra Solved Problems that you can assign as homework or present during classroom lectures.

 Extra Economics in Your Life: Each chapter of the book opens and closes with a special feature entitled Economics in Your Life that emphasizes the connection between the material and the students’ personal experiences and questions. This Instructor’s Manual includes an extra Economics in Your Life for several chapters to present in class.

 Extra Apply the Concepts: Each chapter of the main text has two or more Apply the Concept features to provide real-world reinforcement of key concepts. This Instructor’s Manual includes extra Apply the Concepts to present in class. 

Solutions to Review Questions and Problems and Applications: Each chapter of this Instructor’s Manual includes solutions to all questions and problems in the main text: 

Solutions to the two Thinking Critically questions that accompany the An Inside Look newspaper feature located at the end of Chapters 1, 2, 3, and 4

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Solutions to the end-of-chapter Review Questions

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Solutions to the end-of-chapter Problems and Applications

CHAPTER 1 | Economics: Foundations and Models

Digital Assets & Assessment •

Videos by the Authors. o

Each chapter opens with a business case that provides a real-world context for learning, sparks students’ interest in economics, and helps unify the chapter. The authors prepared brief videos to summarize the key points of each of the 17 cases. There are 55 Apply the Concept features in the book that provide real-world reinforcement of key concepts. Each feature is accompanied by a two- or three-minute video of the author explaining the key point of that Apply the Concept. Related assessment is included with each video, so students can test their understanding. The goal of these videos is to summarize key content and bring the applications to life. In our experience, many students benefit from this type of online learning and assessment.

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Concept Checks. Each section of each learning objective concludes with a Concept Check that contains one or two multiple-choice, true/false, or fill-in questions. These checks act as ―speed bumps‖ that encourage students to stop and check their understanding of fundamental terms and concepts before moving on to the next section. The goal of this resource is to help students assess their progress on a section-by-section basis, so they can be better prepared for homework, quizzes, and exams.

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Animations of Figures. Graphs are the backbone of introductory economics, but many students struggle to understand and work with them. Most of the over 150 numbered figures have a supporting figure animation video to help students understand shifts in curves, movements along curves, and changes in equilibrium values. Graded practice exercises are included with the animations. In our experience, many students benefit from this type of online learning.

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Whiteboard Solved Problem Videos. Many students have difficulty applying economic concepts to solving problems. Each chapter includes between one and three Solved Problems that show students how to break an economic problem down step by step. Several of these Solved Problems are also available as whiteboard videos. The goals of the feature and whiteboard videos are to help students build skills they can use to analyze real-world economic issues they hear and read about in the news and also to help students apply basic problem-solving skills to homework, quizzes, and exams. Each Solved Problem includes at least one additional graded practice exercise for students.

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Graphs Updated with Real-Time Data from FRED. Select graphs are continuously updated online with the latest available data from FRED (Federal Reserve Economic Data), which is a comprehensive, up-to-date data set maintained by the Federal Reserve Bank of St. Louis. Students can display a pop-up graph that shows new data plotted in the graph. The goal of this digital feature is to help students understand how to work with data and understand how including new data affects graphs.

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New to this Updated Edition It’s customary for textbook authors to note that ―much has happened in the economy‖ since the last edition of their book appeared. To say that much has happened since we prepared our last edition in 2019 would be a major understatement. Never in the lifetimes of today’s students and instructors have events like those of 2020 and 2021 occurred. The U.S. and world economies had experienced nothing like the Covid-19 pandemic since the influenza pandemic of 1918. In the spring of 2020, the U.S. economy suffered an unprecedented decline in the supply of goods and services as a majority of businesses in the country shut down to reduce spread of the virus. Many businesses remained closed or operated at greatly reduced capacity well into 2021. Most schools, including most colleges, switched to remote learning, which disrupted the lives of many students and their parents. At the same time, total spending in the economy declined as the unemployment rate soared to levels not seen since the Great Depression of the 1930s. Reduced spending and closed businesses resulted in by far the largest decline in total production in such a short period in the history of the U.S. economy. Congress, the Trump and Biden administrations, and the Federal Reserve responded with fiscal and monetary policies that were also unprecedented. This Updated Edition covers all of these developments including the policy debates they initiated. Here is an overview of the revisions: 

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All the chapter openers feature either new companies or include updated information. Chapters 1, 2, and 4 include new An Inside Look features to help students apply economic thinking to current events and policy debates as they are presented in news articles Additional and updated news articles, analyses, and questions appear at the end of each chapter prior to the Conclusion section. There are 4 new Apply the Concept features, with accompanying video or audio, to help students tie economic concepts to current events and policy issues. The Apply the Concept features and videos retained from the previous edition have been updated. Many of these features discuss the effects of the Covid-19 pandemic on the economy and the government’s policy response. There are 3 new Solved Problems, and many of those retained from the previous edition have been updated. The Solved Problem feature uses real-world products, events, and policies to help students break down and answer economic problems step by step. Whiteboard videos of select Solved Problems bring these real-world problems to life with audio, background photos, and stepby-step construction of graphs and tables. All the figures and tables have been updated with the latest data available. Most of the figures are accompanied by a supporting video animation, and several are interactive real-time data graphs. The figures help students visualize the unprecedented changes in economic variables resulting from the pandemic. Many of the end-of-chapter Problems and Applications have been updated or replaced. In most chapters, one or two problems include graphs or tables for students to analyze. Select chapters have a category titled Real-Time Data Exercises, and we have updated some of those exercises.

Blog & Twitter Updates Follow the authors…

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CHAPTER 1 | Economics: Foundations and Models  

Instructors and students can visit http://hubbardobrieneconomics.com for podcast recordings with the authors and occasional guests discussing key economic topics in the news. The blog also includes new Apply the Concepts and Solved Problems, with assessment questions. Instructors and students can also follow the authors on Twitter: https://twitter.com/o_economics

Organizing Your Syllabus The Instructor’s Manual can be a valuable resource for both experienced and first-time instructors. Both the book chapters and this Instructor’s Manual provide comprehensive coverage of economic theory, monetary policy, fiscal policy, and real-world applications. The microeconomics chapters cover relatively new developments in the field, such as the economics of information (Chapter 7, ―The Economics of Health Care‖) and personnel economics (Chapter 16, ―The Markets for Labor and Other Factors of Production‖). The authors include business applications in each chapter and have a dedicated chapter on firms, the stock market, and corporate governance (Chapter 8, ―Firms, the Stock Market, and Corporate Governance‖). The comprehensive coverage of microeconomics and business topics allows instructors to select chapters for diverse groups of students. Most instructors will not want to cover indifference curve analysis, but those who wish to will find this topic covered in the appendix to Chapter 10, ―Consumer Choice and Behavioral Economics.‖ An appendix is available for instructors who wish to cover isoquant and isocost curves to accompany Chapter 11, ―Technology, Production, and Costs.‖ Chapter 14 of this instructor’s manual, ―Oligopoly: Firms in Less Competitive Markets,‖ includes coverage of the kinked demand curve that does not appear in the main book. First-time users of the textbook should be aware that some topics introduced in one chapter are applied in a later chapter. Chapter 4, ―Economic Efficiency, Government Price Setting, and Taxes,‖ introduces consumer, producer, and economic surplus to describe the impact of government-imposed price controls. The appendix to Chapter 4, ―Quantitative Demand and Supply Analysis,‖ explains in detail how consumer and producer surplus are calculated using linear demand and supply curves. Chapter 9, ―Comparative Advantage and the Gains from International Trade,‖ uses the same tools to measure the effect of tariffs and quotas on international trade.

CHAPTER 1 | Economics: Foundations and Models

The following chart helps you organize your syllabus based on your teaching preferences and objectives:

CORE

POLICY

Chapter 1: Economics: Foundations and Models

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

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

Chapter 5: Externalities, Environmental Policy, and Public Goods

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply Chapter 6: Elasticity: The Responsiveness of Demand and Supply Chapter 9: Comparative Advantage and the Gains from International Trade May be delayed until after Ch. 27. Chapter 11: Technology, Production, and Costs

OPTIONAL Chapter 1 Appendix: Using Graphs and Formulas Chapter 4 Appendix: Quantitative Demand and Supply Analysis Chapter 8: Firms, the Stock Market, and Corporate Governance

This chapter may be delayed until after Ch. 15.

Chapter 8 Appendix: Present Value

Chapter 7: The Economics of Health Care

Chapter 8 Appendix: Income Statements and Balance Sheets

Chapter 16: Public Choice, Taxes, and the Distribution of Income

Chapter 10: Consumer Choice and Behavioral Economics Chapter 10 Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior

Chapter 12: Firms in Perfectly Competitive Markets Chapter 13: Monopolistic Competition: The Competitive Model in a More Realistic Setting Chapter 14: Oligopoly: Firms in Less Competitive Markets Chapter 15: Monopoly and Antitrust Policy May be covered after Ch. 12. Chapter 16: The Markets for Labor and Other Factors of Production

Chapter 11 Appendix: Using Isoquants and Isocost Lines to Understand Production and Cost

CHAPTER 1 | Economics: Foundations and Models

Other Supplements Supplements Available to Instructors for Download at www.pearsonhighered.com

Features of the Supplement

Test Bank

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Authored by Randy Methenitis of Richland College

Each volume includes 4,000 multiple-choice, true/false, shortanswer, and graphing questions.

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Test questions are annotated with the following categories: Difficulty—1 for straight recall, 2 for some analysis, and 3 for complex analysis Type—multiple-choice, true/false, short-answer, essay Topic—the term or concept the question supports Learning outcome Special feature in the main book The Association to Advance Collegiate Schools of Business (AACSB) Guidelines, which propose learning experiences in the following categories of Assurance of Learning Standards: Written and Oral Communication; Ethical Understanding and Reasoning; Analytical Thinking; Interpersonal Relations and Teamwork, Diverse and Multicultural Work; Reflective Thinking; Application of Knowledge; and Integration of Real-World Business Experiences

Computerized TestGen

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Allows instructors to customize, save, and generate classroom tests.

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Instructors can edit, add, or delete questions from the Test Banks; analyze test results; and organize a database of tests and student results.

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Many options are available for organizing and displaying tests, along with search and sort features.

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The software and the Test Banks can be downloaded from www.pearsonhighered.com.

CHAPTER 1 | Economics: Foundations and Models Supplements Available to Instructors for Download at www.pearsonhighered.com PowerPoint Lecture Presentations

Features of the Supplement 

A comprehensive set of PowerPoint slides can be used by instructors for class presentations or by students for lecture preview or review. These slides include all the graphs, tables, and equations in the textbook. Two versions are available: step-bystep mode, in which you can build graphs as you would on a blackboard, and automated mode, in which you use a single click per slide.

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Student versions of the PowerPoint slides are available as .pdf files. This version allows students to print the slides and bring them to class for note taking.

Authored by Paul Holmes of Ashland University and K. Michael Casey of the University of Central Arkansas

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CHAPTER 1 | Economics: Foundations and Models

CHAPTER 1 | Economics: Foundations and Models Brief Chapter Summary and Learning Objectives 1.1

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

1.2

Because resources are scarce, people must make choices to attain their goals.

The Economic Problem That Every Society Must Solve Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? ▪

1.3

Because of scarcity, producing more of one good or service means that less of some other good or service will be produced.

Economic Models Explain how economists use models to analyze economic events and government policies. ▪

1.4

Economists use models—simplified versions of reality—to analyze real-world issues.

Microeconomics and Macroeconomics Distinguish between microeconomics and macroeconomics. ▪

1.5

Microeconomics is the study of how households and firms make choices, while macroeconomics is the study of the economy as a whole

Economic Skills and Economics as a Career Describe economics as a career and the key skills you can gain from studying economics. ▪

Individuals, managers, and government policymakers can all benefit from applying economic concepts when they make decisions.

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1.6

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A Preview of Important economic Terms Define important economic terms.

Appendix: Using Graphs and Formulas Use graphs and formulas to analyze economic situations.

Key Terms Allocative efficiency A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

Marginal analysis Analysis that involves comparing marginal benefits and marginal costs.

Centrally planned economy An economy in which the government decides how economic resources will be allocated.

Market economy An economy in which the decisions of households and firms as they interact in markets determine the allocation of economic resources.

Economic model A simplified version of reality used to analyze real-world economic situations. Economic variable Something measurable that can have different values, such as the number of people employed in manufacturing.

Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Economics The study of the choices people make to attain their goals, given their scarce resources.

Mixed economy An economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources.

Equity The fair distribution of economic benefits.

Normative analysis Analysis concerned with what ought to be.

Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

CHAPTER 1 | Economics: Foundations and Models

Positive analysis. Analysis concerned with what is. Productive efficiency A situation in which a good or service is produced at the lowest possible cost. Scarcity A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Trade-off The idea that, because of scarcity, producing more of one good or service means producing less of another good or service. Voluntary exchange A situation that occurs in markets when both the buyer and the seller of a product are made better off by the transaction.

Chapter Outline Does Apple Manufacture the iPhone in the United States? Although Apple designs the iPhone at its headquarters in Cupertino, California, most iPhones are assembled in China. Many products that were once manufactured in the United States are now manufactured overseas. Tariffs lead to higher prices for imported goods, making it more likely that U.S. and foreign companies will manufacture goods in the United States. In a market system, firms respond to economic incentives. In the case of Apple, lower wages earned by Chinese workers reduce the costs of assembling iPhones. Technological progress often creates incentives for firms to change how they produce goods and services. Firms also respond to changes in consumer tastes and to changes in government policy. In 2021, many U.S. firms were waiting to see the trade policies President Biden and Congress would enact.

Teaching Tips Here are special features in the textbook: 1. The introduction, or chapter opener, uses a real-world business example to preview the economic issues discussed in the chapter. Examples within the chapter often link back to that chapter-opening example. 2. At the end of each of the first four textbook chapters is a feature titled An Inside Look that consists of a recent news article plus analysis, graph, and questions. The article links back to a topic discussed in the chapter opener. Visit MyLab Economics for additional current news articles. 3. A boxed feature titled Economics in Your Life & Career complements the business example that opens the chapter. This feature poses questions that help students make a personal connection with the chapter theme. At the end of the chapter, the authors use the concepts described in the chapter to answer these questions. Extra Economics in Your Life & Career features are included in select chapters of this Instructor’s Manual. 4. A boxed feature titled Don’t Let This Happen to You alerts students to common pitfalls covered in that chapter. 5. There are between two and four Apply the Concept features in each chapter that provide real world reinforcement of key concepts by citing news stories that focus on business and policy issues. Extra Apply the Concept features appear in this Instructor’s Manual. 6. Solved Problems use a step-by-step process for solving economic problems. Extra Solved Problems are included in this Instructor’s Manual. Copyright © 2023 Pearson Education, Inc.

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7. Real-Time Data (RTDA) Exercises are included with problems at the end of macroeconomics chapters. These exercises refer to data and graphs that students will find at the web site of the Federal Reserve Bank of St. Louis (FRED). Many exercises require more elaborate calculations than other problems and the use of Excel spreadsheets. You can use these features as the basis for classroom discussion, homework assignments, and examination questions.

Teaching Tips Hubbard/O’Brien Blog Visit http://hubbardobrieneconomics.com for the following updates for instructors and students: ●

Frequently posted podcast recordings with authors Glenn Hubbard and Tony O’Brien, and occasional guests, discussing key economic topics in the news

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New Apply the Concepts and Solved Problems, with assessment questions

Hubbard/O’Brien on Twitter Instructors and students can follow the authors on Twitter: https://twitter.com/o_economics People must make choices as they try to attain their goals. The choices people make represent the trade-offs made necessary by scarcity. Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices people make to attain their goals, given their scarce resources.

Teaching Tips Students will better understand what scarcity means if given examples of things that are not scarce. Suggest examples of “free” resources—sand on a beach and fresh air—and ask your students to contribute their own examples. They will soon realize that the list of free resources is much shorter than the list of scarce resources.

Three Key Economic Ideas 1.1

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

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A. People Are Rational Rational consumers and firms use all available information as they act to achieve their goals. Although not everyone behaves rationally all the time, the assumption of rational behavior is useful in explaining most of the choices people make.

B. People Respond to Economic Incentives Economists emphasize that individuals and firms consistently respond to economic incentives.

C. Optimal Decisions Are Made at the Margin Economists use the word marginal to mean an extra or additional benefit or cost from making a decision. The optimal decision is to continue any activity to the point where the marginal benefit equals the marginal cost. Marginal analysis is analysis that involves comparing marginal benefits and marginal costs.

Extra Solved Problem 1.1A A Doctor Makes a Decision at the Margin A doctor receives complaints from patients that her office isn’t open enough hours. In response, the doctor asks her office manager to analyze the effect of keeping her office open 9 hours per day rather than 8 hours. The doctor’s office manager tells her: “Keeping the office open an extra hour is a good idea because the revenue from your practice will increase by $300,000 per year when the office is open 9 hours per day.” Do you agree with the office manager’s reasoning? What, if any, additional information would you need to decide whether the doctor should keep her office open an additional hour per day?

Solving the Problem Step 1:

Review the chapter material. This problem is about making decisions, so you may want to review the section “Optimal Decisions Are Made at the Margin” in the textbook.

Step 2:

Explain whether you agree with the office manager’s reasoning. We have seen that any activity should be continued to the point where the marginal benefit is equal to the marginal cost. In this case, the doctor should keep her office open up to the point where the additional revenue she receives from seeing more patients is equal to the marginal cost of keeping her office open an additional hour. The office manager has provided information on marginal revenue but not on marginal cost. The office manager has not provided enough information to make a decision, and you should not agree with the office manager’s reasoning.

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Step 3:

Explain what additional information you need. To make a correct decision, you would need information on the marginal cost of remaining open an extra hour per day. The marginal cost would include the additional salary to be paid to the office staff, any additional medical supplies that would be used, as well as any additional electricity or other utilities. The doctor would also need to take into account the nonmonetary cost of spending another hour working rather than spending time with her family and friends or in other leisure activities. The marginal revenue would depend on how many more patients the doctor can see in the extra hour. The doctor should keep her office open an additional hour if the marginal revenue of doing so is greater than the marginal cost. If the marginal cost is greater than the marginal revenue, then the doctor should continue to keep her office open for 8 hours.

Extra Solved Problem 1.1B The Marginal Benefit and Marginal Cost of Delivering Packages for Amazon The U.S. Postal Service (USPS) is an independent establishment within the federal government. When the USPS suffers a financial loss, the federal government is responsible for providing the funds to cover that loss. The USPS has many costs, including the salaries of its workers, the cost of operating post offices, and the cost of maintaining its trucks. The USPS doesn’t deliver mail to homes on Sundays except for packages sent by Amazon. In 2018, then President Donald Trump argued that the additional revenue the USPS receives from Amazon doesn’t cover all of the USPS’s costs. Managers at USPS have stated that while President Trump is correct, delivering Amazon packages on Sunday still reduces the USPS’s losses. Use marginal analysis to demonstrate how President Trump and the USPS managers may both be correct.

Solving the Problem Step 1:

Review the chapter material. This problem is about making decisions, so you may want to review the section “Optimal Decisions Are Made at the Margin.”

Step 2:

Discuss how we can determine whether delivering packages for Amazon on Sunday will increase or decrease the USPS’s losses. The USPS receives payments from Amazon for delivering packages on Sunday. These payments are the additional, or marginal, revenue from providing Amazon with the service. Because the USPS wouldn’t otherwise be sending out mail trucks and making deliveries on Sunday, it incurs additional costs such as the pay of mail carriers and the costs of gasoline and maintenance on its mail trucks. These costs are the marginal cost of providing Sunday delivery of packages for Amazon. Copyright © 2023 Pearson Education, Inc.

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To determine whether delivering packages for Amazon on Sunday will increase or decrease the USPS’s losses, we need to compare the marginal revenue received for the service with the marginal cost of providing it. If the marginal revenue is greater than the marginal cost, the USPS’s losses will be reduced as a result of providing the service. If the marginal revenue is less than the marginal cost, the USPS’s losses will be increased.

Step 3:

Use your analysis in step 2 to demonstrate that President Trump and the USPS managers may both be correct. If the marginal revenue from Sunday package delivery is greater than the marginal cost, then providing the service reduces the USPS’s losses. This position is the one held by USPS’s managers. President Trump may have been correct, though, that the revenue received from Amazon for this service doesn’t cover all of the USPS’s costs. For example, the USPS’s managers were taking into account only the marginal cost of using mail trucks to deliver packages on Sunday—the pay for the Sunday workers and the additional gasoline used and increased wear and tear on the trucks—and disregarding the original purchase price of the trucks and other costs that don’t change as a result of Sunday deliveries.

Extra Credit: As we have seen, optimal decisions are made at the margin. In this case, the managers at the USPS had the goal of reducing the USPS’s losses. In deciding whether to agree to deliver packages for Amazon on Sunday, the managers were correct to compare the marginal revenue received from Amazon to the marginal cost of providing Amazon with the service.

Sources: Nick Wingfield, “Is Amazon Bad for the Postal Service? Or Its Savior?” New York Times, April 4, 2018; and Paul Ziobro and Laura Stevens, “At Post Office, Amazon Isn’t the Only Big Shipper Getting Discounts,” Wall Street Journal, April 13, 2018.

Extra Analyze Does Health Insurance Give People an Incentive to Become the Concept Obese?

Obesity is a factor in a variety of diseases, including heart disease, stroke, diabetes, and hypertension, making it a significant health problem in the United States. Body mass index (BMI) is a measurement of a person’s weight relative to the person’s height. According to the U.S. Centers for Disease Control and

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Prevention (CDC), an adult with a body mass index (BMI) of 30 or greater is considered obese. For example, a 5'6" adult with a BMI of 30 is 40 pounds overweight.

The following two maps show the dramatic increase in obesity between 1994 and 2015. In 1994, in a majority of states only between 10 percent and 14 percent of the adult population was obese, and in no state was more than 20 percent of the adult population obese.

By 2015, in every state, at least 20 percent of the adult population was obese, and in 44 states, at least 25 percent of the adult population was obese. Many people who suffer from obesity have underlying medical conditions. For these people, obesity is a medical problem that they cannot control. The fact that obesity has increased, though, indicates that for some people, obesity is the result of diet and lifestyle choices. Potential explanations for the increase in obesity include greater intake of high-calorie fast foods, insufficient exercise, and a decline in the physical activity associated with many jobs. The CDC recommends that teenagers get a minimum of 60 minutes of aerobic exercise per day, a standard that only 15 percent of high school students meet. In 1960, 50 percent of jobs in the United States required at least moderate physical activity. Today, only 20 percent of jobs do. As a result, a typical worker today who may work at a computer is burning off about 130 fewer calories per workday than a worker in the 1960s who was more likely to have worked in a manufacturing plant.

In addition to eating too much and not exercising enough, could having health insurance be a cause of obesity? Obese people tend to suffer more medical problems and so incur higher medical costs. Obese people with health insurance that will reimburse them for only part of their medical bills, or who have no health insurance, must pay some or all of these higher medical bills themselves. People with health insurance that covers most of their medical bills will not suffer as large a monetary cost from being obese. In other words, by reducing some of the costs of obesity, health insurance may give people an economic incentive to gain weight. Copyright © 2023 Pearson Education, Inc.

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At first glance, this argument may seem implausible. Some people suffer from medical conditions that can make physical activity difficult or that can cause weight gain even with moderate eating, so they may become obese, regardless of which type of health insurance they have. The people who are obese because of poor eating habits or lack of exercise probably don’t consider health insurance when deciding whether to have a slice of chocolate cake or to watch Netflix instead of going to the gym. But if economists are correct about the importance of economic incentives, then we would expect that if we hold all other personal characteristics—such as age, gender, and income—constant, people with health insurance will be more likely to be overweight than people without health insurance.

Jay Bhattacharya and Kate Bundorf of Stanford University, Noemi Pace of the University of Venice, and Neeraj Sood of the University of Southern California, have analyzed the effects of health insurance on weight. Using a sample that followed nearly 80,000 people from 1989 to 2004, they found that after controlling for factors including age, gender, income, education, and race, people with health insurance were significantly more likely to be overweight than people without health insurance. Having private health insurance increased BMI by 1.3 points. Having public health insurance, such as Medicaid, which is a program under which the government provides health care to low-income people, increased BMI by 2.3 points. These findings do not mean that health insurance is the sole cause, or even the most important cause, of obesity. The findings do suggest that people respond to economic incentives even when making decisions about what they eat and how much they exercise. In Section 1.3, we will see that economists modify conclusions as they collect additional data.

Note: The exact formula for the body mass index is BMI = (Weight in pounds/Height in inches ) x 703. Sources: Centers for Disease Control and Prevention, “Prevalence of Self-Reported Obesity among U.S. Adults,” www.cdc. gov; Katherine M. Flegal, Margaret D. Carroll, Cynthia L. Ogden, and Lester R. Curtin, “Prevalence and Trends in Obesity among U.S. Adults, 1999–2008,” Journal of the American Medical Association, Vol. 303, No. 3, January 20, 2010, pp. 235–241; Jay Bhattacharya, Kate Bundorf, Noemi Pace, and Neeraj Sood, “Does Health Insurance Make You Fat?” in Michael Grossman and Naci H. Mocan, eds., Economic Aspects of Obesity, Chicago: University of Chicago Press, 2011; and Tara Parker-Pope, “Less Active at Work, Americans Have Packed on Pounds,” New York Times, May 25, 2011.

Teaching Tips You don’t need to spend a lot of class time explaining the material in this section; subsequent chapters will reinforce students’ understanding of markets and the “three key economic ideas.”

1.2

The Economic Problem That Every Society Must Solve

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System Learning Objective: Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Every society faces the economic problem that it has only a limited amount of economic resources, so it can produce only a limited amount of goods and services. Every society faces trade-offs. A trade-off is the idea that, because of scarcity, producing more of one good or service means producing less of another good or service. Every activity has an opportunity cost: The highest-valued alternative that must be given up to engage in an activity. Trade-offs force society to answer three fundamental questions: 1. What goods and services will be produced? 2. How will the goods and services be produced? 3. Who will receive the goods and services produced?

A. What Goods and Services Will Be Produced? The answer to this question is determined by the choices consumers, managers of firms, and government policymakers make. Each choice made has an opportunity cost.

B. How Will the Goods and Services Be Produced? Firms choose how to produce the goods and services they sell. For example, firms often face trade-offs between using more workers or more machines.

C. Who Will Receive the Goods and Services Produced? In the United States, who receives the goods and services produced depends largely on how income is distributed. An important policy question is whether the government should intervene to make the distribution of income more equal.

D. Centrally Planned Economies versus Market Economies Societies organize their economies in two main ways. A centrally planned economy is an economy in which the government decides how economic resources will be allocated. A market economy is an economy in which the decisions of households and firms interacting in markets determine the allocation of economic resources. Today, only North Korea has a completely centrally planned economy. In a market economy, the income of an individual is determined by the payments he or she receives for what he or she sells. Generally, the more extensive the training a person has received and the longer the hours the person works, the higher his income will be.

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The high rates of unemployment and business bankruptcies during the Great Depression of the 1930s caused a dramatic increase in government intervention in the economy in the United States and other market economies. Some government intervention is designed to raise the incomes of the elderly, the sick, and people with limited skills. In recent years, government intervention has expanded to meet goals such as protection of the environment, promotion of civil rights, and increased access to medical care. Some economists argue that the extent of government intervention makes it more accurate to refer to the economies of the United States, Canada, Japan and Western Europe as mixed economies rather than pure market economies. A mixed economy is an economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources.

F. Efficiency and Equity Market economies tend to be more efficient than centrally planned economies. There are two types of efficiency. Productive efficiency is a situation in which a good or service is produced at the lowest possible cost. Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Voluntary exchange is a situation that occurs in markets when both the buyer and the seller of a product are made better off by the transaction. Inefficiency arises from various sources. Sometimes governments reduce efficiency by interfering with voluntary exchange in markets. The production of some goods damages the environment when firms ignore the costs of environmental damage. In this case, government intervention can increase efficiency. Society may not find an efficient economic outcome to be desirable. Many people prefer economic outcomes they consider fair or equitable even if these outcomes are less efficient. Equity is the fair distribution of economic benefits. There is often a trade-off between efficiency and equity.

Teaching Tips Ask students for examples of government regulation of private markets in the United States. Responses may include: (1) restrictions on the number of diners allowed in a restaurant during a pandemic; (2) making the sale of cocaine and other addictive drugs illegal; (3) minimum age requirements for the purchase of alcoholic beverages and cigarettes; and (4) the prohibition of the sale of new drugs before their effectiveness is demonstrated through government supervised tests. Ask students whether one of these examples of government regulation promotes equity or fairness. The difficulty in defining equity will be apparent.

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To show how students may value equity less than they claim, an economics teacher at a college in Western New York once told her students at the beginning of her course that their grades would be auctioned to the highest bidders. Because grades are usually normally distributed, she offered to sell a few A grades, a few more B grades, and so on. Although the announcement produced shock and grumbling, the auction proceeded, with frenzied bidding for A grades. As prices for A grades rose, bidding switched to B grades. Because few students bothered to bid for C grades, one enterprising student bid on several such grades in the belief that those who lost out on getting an A or B would have to buy their C grades from him—for a higher price than he paid! After about a week, the instructor informed the class the auction was intended only as an economics lesson; they would have to earn their grades the old-fashioned way.

Extra Solved Problem 1.2 Advising New Government Leaders Suppose a country experiences a change in government leadership. Prior to this change, this country had a centrally planned economy. The new leaders are willing to try a different system if they can be convinced that it will yield better results. They hire an economist from a country with a market economy to advise them and will order their citizens to follow the economist’s recommendations for change. The economist suggests that a market economy replace central planning to answer the nation’s economic questions (what, how, and who?). What will the economist suggest the leaders order their citizens to do in order to change from a centrally planned economy to a market economy? Are there reasons why the leaders of this country might not accept the economist’s suggestions? Briefly explain.

Solving the Problem Step 1:

Review the chapter material. The problem is about different types of economic systems, so you may want to review the section “Centrally Planned Economies versus Market Economies” in the textbook.

Step 2:

What will the economist suggest the leaders order their citizens to do? Market economies allow members of households to select occupations and purchase goods and services based on self-interest and allow privately owned firms to produce goods and services based on their self-interests. Therefore, the economist would advise the leaders of the country to not issue any orders. Government officials should have no influence over individual decisions made in markets.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System Step 3:

Are there reasons why the leaders of this country might not accept the economist’s suggestions? Even democratically elected leaders may find it difficult to accept the economist’s suggestions. They may wonder how self-interested individuals will produce and distribute goods and services so as to promote the welfare of the entire country. This new system requires a significant reduction in government influence in people’s lives, but history has shown that most government officials are reluctant to give up this influence. Acceptance is most likely when the leaders have some knowledge and experience with the successful operation of a market economy in other countries. Ordinary citizens are more likely to accept the economist’s suggestions because they would have more freedom to pursue their own economic goals.

Extra Analyze It’s Saturday Afternoon: Why Aren’t You at the Game? the Concept For many students, attending college football games is an enjoyable way to spend Saturday afternoons in the fall. However, some colleges have experienced a decline in the number of students attending their games. What explains the decrease in the number of students willing to attend football games? Rising ticket prices are one reason for the decline. One student at the University of Michigan was quoted as saying: “People are looking to trim costs, and for a lot of folks, football is an easy thing to cut. It’s not essential to going to college.” Remember that the opportunity cost of engaging in an activity is the value of the best alternative that must be given up to engage in that activity. The opportunity cost of attending a college football game is not just the price of a ticket. If the price of a ticket to a game is $50, your opportunity cost is the ticket price plus the value you place on what else you could do if you don’t attend the game. At one time, relatively few college football games were televised, but today multiple cable networks broadcast games. If you attend your college’s games, you miss the opportunity to watch the games being broadcast at the same time—in high-definition with replays shown from multiple camera angles and expert commentary to clarify what is happening. When watching games in your room or at a sports restaurant, you can also post to Facebook, Instagram, or Twitter, read e-mail, surf the Web, and take or receive phone calls. Wi-Fi and cellular reception are often poor in college stadiums, making these activities difficult. So the opportunity cost of attending college football games has increased in recent years, not just because ticket prices have risen but because the number of alternative activities that students value

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highly has also increased. We expect that when the opportunity cost of engaging in an activity increases, people will engage in that activity less, as we’ve seen with student attendance at college football games. Colleges have responded to declining student attendance by reducing ticket prices, improving Wi-Fi and cellular service, and installing high-definition video boards that show replays as they appear on television. Whether these attempts to lower the opportunity cost of attending college football games enough to increase attendance at games remains to be seen. Sources: Jon Solomon, “College Attendance in 2016: Crowds Decline for the Sixth Straight Year,” CBSSports.com, December 16, 2016; Adam Rittenberg, “Attendance Challenges Big Deal for B1G,” espn.com, February 14, 2014; and Ben Cohen, “At College Football Games, Student Sections Likely to Have Empty Seats,” Wall Street Journal, August 27, 2014.

Economic Models 1.3

Learning Objective: Explain how economists use models to analyze economic events and government policies.

An economic model is simplified version of reality used to analyze real-world situations. To develop a model, economists generally follow five steps. 1. Decide on the assumptions to use. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well. 5. Retain the revised model to help answer similar economic questions in the future.

A. The Role of Assumptions in Economic Models Models are based on making assumptions because models must be simplified to be useful. When using models, economists make behavioral assumptions about the motives of consumers and firms. Economists assume consumers will buy goods and services that will maximize their satisfaction and firms will act to maximize their profits.

B. Forming and Testing Hypotheses in Economic Models An economic variable is something measurable that can have different values, such as the number of people employed in manufacturing. A hypothesis in an economic model is a statement that may be correct or incorrect about an economic variable. To test a hypothesis, we analyze statistics on the relevant economic variables. Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis.

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C. Positive and Normative Analysis Positive analysis is analysis concerned with what is. Normative analysis is analysis concerned with what ought to be. Economics is about positive analysis, which measures the costs and benefits of different courses of action.

D. Economics as a Social Science Because economics studies the actions of individuals, it is a social science. Economics considers human behavior in every context, not just in the context of business. Economists have played an important role in formulating government policies in areas such as the environment, health care, and poverty.

Extra Solved Problem 1.3 Snowfalls and Skiing Marsha Shawn is a college student and downhill skier who lives near The Ski Chalet, a ski resort located in Vermont. For a course project Marsha and four other students are required to develop an economic model. Marsha suggests that their model test the impact of snowfalls on the sale of ski equipment (skis, boots, poles) and snowboards at the six ski shops located within a ten-mile radius of The Ski Chalet. Marsha and the other students in her group agree that to have an impact on equipment sales a snowfall would have to result in at least four inches of new snow. How would you recommend that Marsha and the other students develop their model? Suggest an alternative model for Marsha in the event that the model fails to explain the data she uses to test her model.

Solving the Problem Step 1:

Review the chapter material. The problem is about how to use models to analyze economic issues, so you may want to review the section “Economic Models” in the textbook.

Step 2:

To develop and test a model of the relationship between snowfall and sales of ski equipment the students in Marsha’s group should follow these steps: 1. Decide on the assumptions to use in developing the model. For example: sales of ski equipment and snowboards are greater after snowfalls (four or more inches) than are sales at other times during the period that The Ski Chalet is open. 2. Formulate a testable hypothesis. Sales of ski equipment and snowboards at the six ski shops located near the Ski Chalet are higher (for example, by 5 percent or more) within one week following snowfalls of four or more inches than other weeks that The Ski Chalet is open. Copyright © 2023 Pearson Education, Inc.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 3. Use economic data to test the hypothesis. Marsha’s group must obtain sales data from the six Vermont ski shops and agree on the number of observations (including the number of times a snowfall of at least four inches is observed) required to test the hypothesis. 4. Revise the model if it fails to explain the economic data well. Suggest an alternative model. The model could fail if large numbers of skiers and snowboard owners buy their equipment prior to the months that The Ski Chalet is open, or if large numbers rent, rather than purchase, their equipment. One alternative model would compare the sales of lift tickets or rental equipment in weeks following snowfalls of four or more inches and other weeks during the time The Ski Chalet is open. 5. Retain the revised model to help answer similar economic questions in the future. If the data support the model, one can assume that there is a relationship between snowfalls and equipment sales. Tests of the model with data from different time periods or in different locations could either support or refute these results. Acceptance of a model is always tentative pending the acquisition of new data or additional statistical analysis.

1.4

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

Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Extra Solved Problem 1.4 Microeconomic and Macroeconomic Views Sports fans are used to watching events on television from different camera angles. For popular events such as the Olympics, the baseball World Series, and the Super Bowl, network coverage captures action from ground level as well as higher levels. Blimps with cameras are frequently flown above the stadiums and ballparks where the events take place. The aerial view of such a camera is visually appealing but is never broadcast for very long because the athletes are barely visible. Coverage of games includes a view from a mobile or “sideline” camera that can zoom in on individual players or fans sitting in the stands, a degree of detail much greater than that provided by the aerial view.

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How do the different camera angles help to explain the difference between microeconomics and macroeconomics?

Solving the Problem Step 1:

Review the chapter material. The problem concerns the differences between microeconomics and macroeconomics, so you may want to review the section “Microeconomics and Macroeconomics” in the textbook.

Step 2:

Compare the focus of microeconomics with television coverage of a sports event. Microeconomics focuses on how individual households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. This focus is similar to that of a sideline camera at a football game.

Step 3:

Compare the focus of macroeconomics with the television coverage of a sports event. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Macroeconomics does not study the decisions made by individuals but the consequences of actions taken by all decision makers in an economy. This is similar to the blimp’s aerial view of the venue where a sports event occurs. A sports fan can see the entire venue, but the blimp’s point of view is too far away to see any individual player or fan.

Economic Skills and Economics as a Career 1.5

Learning Objective: Describe economics as a career and the key skills you can gain from studying economics.

Economists describe how individuals, businesses and governments make choices and analyze the results of these choices. Many businesses, government agencies and non-profit organizations hire economists. Students who consider whether to pursue a career in economics may seek an internship with a firm or agency that employs economists.

1.6

A Preview of Important Economic Terms Learning Objective: Define important economic terms.

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

This section provides a brief definition and preview of terms students will see throughout the book: firm (company, or business), entrepreneur, innovation, technology, goods, services, revenue, profit, household, factors of production (economic resources or inputs), capital, and human capital.

Extra Economics in Your Life and Career: Is Cheating a Rational Decision? In their best-selling book Freakonomics, Steven D. Levitt and Stephen J. Dubner stated: “Who cheats? Well, just about anyone, if the stakes are right…Cheating…is a prominent feature in just about every human endeavor.” Evidence that some people cheat surfaced in the summer of 2011 when the superintendent of the board of the Atlanta school district resigned after a report documented widespread cheating on standardized tests that implicated officials from about 80 percent of Atlanta’s elementary and middle schools. In 2015, an Atlanta jury convicted 11 teachers as a result of the cheating scandal. Steven Levitt and other economists assume that decision-makers—students and non-students alike— are rational. They compare the benefits and costs of their options and make choices for which the expected benefits exceed the expected costs. The benefits of (successful) cheating may be monetary; for example, K-12 teachers in some states are eligible for bonus payments of up to $25,000 if their students perform well on standardized tests. New technology has made it easier for high school and college students to cheat. The widespread use of cell phones and Internet access makes it easier (less costly) to share exam answers and buy term papers. Sources: Steven D. Levitt and Stephen J. Dubner, Freakonomics New York: HarperCollins 2005, pages 24–25; Patrik Jonsson, “America’s biggest teacher and principal cheating scandal unfolds in Atlanta,” Christian Science Monitor, July 5, 2011; Mary Beth McCauley, “Atlanta school cheating: When teachers cheat, what do you tell the kids?” Christian Science Monitor, September 5, 2013; and Valerie Strauss, “How and Why Convicted Teachers Cheated on Standardized Tests,” Washington Post, April 1, 2015.

Question: For the sake of argument, let’s assume that you would never cheat. Under what circumstances are students in general more or less likely to cheat on an economics examination? Answer: Your economics instructor will be pleased if you would never cheat under any circumstances. But cheating is more likely when: (a) the positive consequences of receiving a high grade are significant (for example, a high grade is necessary to maintain a scholarship, gain admittance to medical school, or get a good job offer), and/or (b) the probability of getting caught is low (the instructor gives the same multiple-choice exam to all students in a large classroom with no supervision). Reducing the benefit and increasing the cost of getting caught will reduce the incidence of cheating. If appeals to personal integrity are not enough to convince students not to cheat, a more effective deterrent may be for potential employers to let students know that they fire dishonest employees.

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Appendix Using Graphs and Formulas Learning Objective: Use graphs and formulas to analyze economic situations.

Graphs simplify economic ideas and make the ideas more concrete so they can be applied to real-world problems.

Graphs of One Variable Figure 1A.1 in the textbook displays examples of two common types of graphs: bar graphs and pie charts. The height of the bars in the bar graph represents the market shares of automobile firms. The pie chart shows the same information with the market shares of each group of firms represented by the size of its slice of the pie. Information on economic variables can also be displayed in time-series graphs. These graphs are displayed on a coordinate grid. The vertical axis (y-axis) of a coordinate grid measures the value of one variable. The point where the vertical axis intersects the horizontal axis is the origin. The horizontal axis of a coordinate grid measures the value of another variable. The points in a coordinate grid represent the values of the two variables. Figure 1A.2 illustrates examples of time-series graphs.

Graphs of Two Variables We often use graphs to show the relationship between two variables. Figure 1A.3 illustrates the graph of a linear or straight-line demand curve where price is measured along the vertical axis and quantity is measured along the horizontal axis.

A. Slopes of Lines The slope of a straight line indicates how much the variable measured along the y-axis changes as the variable measured along the x-axis changes. Slope can be measured between any two points on the line because the slope of a straight line has a constant value. The slope can be expressed as the change in the value measured on the vertical axis divided by the change in the value measured on the horizontal axis; slope can also be expressed using the Greek letter delta (Δ) to stand for the change in a variable (slope = Δy/Δx). The slope is also referred to as the rise divided by the run.

Taking into Account More Than Two Variables on a Graph

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The demand curve in Figure 1A.4 shows the relationship between the price of pizza and the quantity of pizza sold, but the quantity of any good sold depends on more than just the price of the good. Allowing other variables to change will cause the position of the demand curve in the graph to change. The table in Figure 1A.5 shows the effect of a change in the price of hamburgers on the quantity of pizza demanded. By shifting the demand curve, we take into account the effect of changes in a third variable.

A. Positive and Negative Relationships Sometimes the relationship between two variables is negative, as in the case with the price of pizza and the quantity of pizza demanded. The relationship between two variables can be positive, as in Figure 1A.6 which shows values for disposable personal income and consumption spending in the United States for 2016–2019.

B. Determining Cause and Effect Inferring cause and effect relationships by observing graphs can lead to incorrect conclusions. One reason for this is that there may be an omitted variable that is not accounted for in the graph. A related problem in determining cause and effect is reverse causality; this occurs when we conclude that changes in variable X cause changes in variable Y, when changes in variable Y cause changes in variable X.

C. Are Graphs of Economic Relationships Always Straight Lines? The relationship between two variables is linear when it can be represented by a straight line. Few economic relationships are actually linear. However, it is often useful to approximate a nonlinear relationship with a linear relationship.

D. Slopes of Nonlinear Curves To measure the slope of a nonlinear curve at a particular point we must measure the slope of a tangent to the curve at that point. A tangent line touches the curve at only one point. The slope of a tangent is measured in the same way as the slope of any straight line.

Formulas A. Formula for a Percentage Change The formula for a percentage change between two variables for any two periods is: Percentage change 

Value in the second period  Value in the first period  100. Value in the first period

B. Formulas for the Areas of a Rectangle and a Triangle

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The formula for the area of a rectangle is Base × Height. The formula for the area of a triangle is: ½ × Base × Height.

C. Summary of Using Formulas Follow these steps when using a formula: 1. Make sure you understand the economic concept the formula represents. 2. Make sure you are using the correct formula for the problem you are solving. 3. Make sure the number you calculate using the formula is economically reasonable.

Teaching Tips You can assign the appendix as “on your own” reading. But don’t assume students will understand the formulas for computing a slope or a percentage change. Reviewing these formulas in class will be time well spent, either at this point in the course or when these formulas are first applied. In particular, students will need to use graphs of two variables and percentage changes often throughout the remainder of the text.

Solutions to End-of-Chapter Exercises Answers to Thinking Critically Questions 1. To develop a model, economists generally follow these 5 steps: Step 1: Decide on the assumptions to use. For this model, an example of an assumption would be that as the ―Buy American‖ program gets underway, the U.S. economy will start to improve. Step 2: Formulate a testable hypothesis. An example of a hypothesis for this model is the statement that the implementation of the ―Buy American‖ program has resulted in an increase in manufacturing employment. The hypothesis may be correct if manufacturing employment has increased once the program is implemented, or it may be incorrect if there is no change or a decrease in manufacturing employment despite the implementation of the program. Step 3: Use economic data to test the hypothesis. Examples of data that would need to be gathered include the number of manufacturers taking part in the ―Buy American‖ program and changes in employment in manufacturing. Testing this hypothesis could be tricky. Showing that employment in manufacturing increased as more firms choose to participate in the program would not necessarily be enough to demonstrate that the increase in the participation rate caused the increase in employment. Just because the ―Buy American‖ program and increases in manufacturing are correlated does not mean that one caused the other.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System Step 4: Revise the model if it fails to explain the economic data well. If statistical analysis is inconclusive or if it causes economists to reject the hypothesis, they should revise the model. Step 5: Retain the revised model to help answer similar economic questions in the future. Once economists revise the model so that it successfully explains the economic data, they can retain the model for possible future use.

2. Positive analysis is concerned with ―what is,‖ while normative analysis is concerned with ―what ought to be.‖ Positive economic analysis could show whether the Covid-19 pandemic was actually responsible for the entire decrease in manufacturing jobs in the United States or if other factors were also responsible for some of the job losses. Positive analysis could also show if the ―Buy American‖ program, if implemented, would likely increase the number of manufacturing jobs, but it is possible that other jobs could be lost due to the program. For example: (1) if the program resulted in companies having to charge higher prices and therefore hire fewer workers in other areas due to a loss in sales to non-government customers; (2) if other jobs tied to import markets were affected, or (3) if foreign governments respond by reducing their purchases of U.S. made manufacturing goods. In other words, the ―Buy American‖ program could result in both winners and losers in terms of domestic employment. Should the gains to the winners be valued more than the losses to the losers? The answer to this question involves normative analysis. Positive analysis can show the consequences of a particular policy such as the implementation of a ―Buy American‖ program, but it cannot tell us whether such a policy is a good or bad idea.

Three Key Economic Ideas 1.1

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

Review Questions 1.1

“People are rational” is the assumption that decision makers explicitly or implicitly weigh the benefits and costs of each action and then choose an action only if the benefits are expected to outweigh the costs. “People respond to economic incentives” by changing their behavior in response to an economic incentive. For example, if the federal government begins to tax firms an amount equal to the government benefits that their low-wage employees receive, firms are likely to hire fewer low-wage workers. “Optimal decisions are made at the margin” means that most decisions are not “all or nothing,” but instead involve doing a little more or a little less of an activity. Therefore, the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.

1.2

Scarcity is the situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices consumers, business managers, and government officials make to attain their goals. Scarcity is central to economics because scarcity requires people to make choices about how to use their resources to best fulfill their wants. In Copyright © 2023 Pearson Education, Inc.

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making choices, we must give up other alternatives that we value. What we give up (our secondbest choice) is called the opportunity cost of our choice.

Problems and Applications 1.3

Economists assume that people are rational in the sense that they use all available information as they act to achieve their goals. Rational individuals weigh the benefits and costs of each action, and they choose an action only if the benefits outweigh the costs. Economists do not assume everyone is a genius or always makes the “right” decision in every circumstance. Instead, economists assume that the actions of consumers and businesses reflect their attempts to achieve their goals.

1.4

We need information on the losses the typical bank suffers from a robbery and the cost of installing a bandit barrier or taking other actions, such as hiring a guard, to deter a robbery. The cost of installing a bandit barrier would include the cost of potentially losing customers who find bandit barriers off-putting. The fact that not many banks install bandit barriers indicates that these banks have found that the marginal cost of adding the additional security is greater than the expected marginal benefit from reducing the expected number of robberies.

1.5

a. Students face a scarcity of time, like everyone else, and respond to the incentives of the teacher’s grading system. Students have more incentive to put their efforts into the parts of the course that have the most weight in the grading system. b. If teachers put too little weight in the grading scale on outside readings, or similar assignments, students will have little incentive to read and master the material. Students will put less effort into the parts of the course that have little effect on their grades. c. Quizzes on assigned readings would give students an incentive to come to class having read the upcoming material. Some teachers give preparation assignments where students have to read and answer questions about the upcoming material, and over the course of the semester students have to successfully complete a certain percentage of the preparation assignments to qualify for a particular grade in the course.

1.6

a. As a result of changes in the federal student loan programs, the total amount students borrow should increase. The changes increase the incentive students have to borrow money under the programs because they limit the amount of the loans that must be repaid. b. If in 2016 President Obama was recommending further changes to the student loan program, then it’s likely that the 2011 changes to the program had results that were not expected. The most likely unexpected result is that because the 2011 changes required students to pay back less, students were borrowing more money than the president and his advisers had anticipated. So, in 2016, it’s likely that President Obama recommended changes that would increase the loan repayments borrowers would have to make. Copyright © 2023 Pearson Education, Inc.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System c. President Obama and his advisers may have failed to take into account that the 2011 changes to the program changed the incentives students faced. Because the incentive to increase the amount borrowed increased, President Obama and his advisers underestimated the increase in the amount the federal government would have to pay in loan subsidies.

1.7

a. Employees who have health problems incur higher medical costs than healthier employees. The higher medical costs increase the health insurance premiums that firms must pay for employer-provided health insurance, which raises the firms’ costs. These higher costs provide an incentive for universities and corporations to encourage employees to improve and maintain their health. b. Health insurance decreases the incentive of employees to improve or maintain their health, because employees with health insurance do not pay the full cost of their medical bills. c. If successful, a wellness program would decrease the premiums that an insurance company would charge. Healthier employees would have fewer health problems that would be covered by a university’s or a corporation’s insurance plan.

1.8

As stated in the text, under the act, firms whose employees received assistance from government benefits, including Medicaid and the Supplemental Nutrition Assistance Program (SNAP), would be required to pay a tax equal to cost of the assistance.

b. Firms that might otherwise have hired a low-wage worker may now be reluctant to do so because the firms could be liable for paying the tax. In effect, the act would raise the cost of employing low-income workers who receive government benefits. c. The sponsors of the legislation may have hoped that firms would raise the wages of lowincome workers, which would make it unnecessary for these workers to apply for government benefits. The sponsors may also have intended to call attention to the low wages being paid to some workers and may not have expected the act to actually become law. 1.9

By “incremental revenue” and “incremental cost,” the author means marginal revenue and marginal cost. “Incremental” means the same thing as “marginal.” The USPS’s total cost includes such things as the cost of purchasing delivery trucks and the cost of maintaining post office buildings and warehouses that are not affected by the number of packages that the USPS delivers. In determining whether delivering packages for Amazon will increase its overall profit or reduce its overall loss, the USPS should look only at the marginal (or incremental or additional) revenue and marginal cost of delivering packages for Amazon. If the marginal revenue exceeds the marginal cost, the USPS’s profit will increase (or its loss will decrease). If the marginal cost exceeds the marginal revenue, the USPS’s profit will decrease (or its loss will increase).

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Your friend is failing to think at the margin. It doesn’t matter how much time your friend has already spent studying psychology. What matters is the marginal benefit to be received from studying psychology relative to the marginal cost, where cost is the opportunity cost of lower grades in other subjects. If the course is required, that may raise the marginal benefit.

1.11

A complete explanation for the connection between majoring in economics and success in business would involve many factors. But we can say that economics teaches us how to look at the trade-offs involved in every decision we make. Those who do not make decisions by weighing the costs of an action against its benefits are unlikely to make good decisions. Climbing the corporate or governmental ladder requires making a wider and wider array of decisions.

The Economic Problem That Every Society Must Solve 1.2

Learning Objective: Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Review Questions 2.1

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

2.2

The three economic questions that every society must answer are (1) What goods and services will be produced? (2) How will the goods and services be produced? (3) Who will receive the goods and services produced? In a centrally planned economy, the government makes most of these decisions. In a pure market economy, almost all of these decisions are made by the decentralized interaction of households and firms in markets. In a mixed economy, most economic decisions result from the interaction of buyers and sellers in markets, but government may play a significant role in the allocation of resources.

2.3

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

2.4

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

xxviii CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 2.5

Yes, even Elon Musk faces scarcity because his wants exceed his resources. Even Musk has only 24 hours in a day, so he must make choices about how to spend his scarce time. Everyone faces scarcity because human desires are virtually unlimited. Your resources are limited, so the only way not to face scarcity would be to reduce your wants to be no greater than your resources— not something that most people are capable of doing!

2.6

Spending resources in a way that helps only one poor person is likely to be an ineffective way of helping poor people. How many poor people could be helped by using another method of helping the poor? The opportunity cost of using one method is the number of poor people that could be helped by using the best available alternative method.

2.7

Although many factors that affect the opportunity cost of attending college football games have changed over time, some of the most significant changes during the past decade involve technology. For example, more games are televised, games can be viewed online with enhanced features, and alternative sources of entertainment, such as streaming television shows and movies or interacting with friends on social media, have also become available. These changes increase the opportunity cost of watching football games in person and help to explain the decline in attendance over time.

2.8

Allocative efficiency occurs when production is in accordance with consumer preferences. Productive efficiency occurs when a good or service is produced at the lowest possible cost. Profit is the incentive for a firm in a market economy to be allocatively efficient and productively efficient. If a firm is not allocatively efficient and productively efficient, then it will eventually suffer losses and go out of business.

2.9

Productive efficiency refers to a situation in which a good or service is produced at the lowest possible cost. Allocative efficiency is a state in which production is in accordance with consumer preferences: Every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it. The test that Alberto Chong and his colleagues carried out was not designed to measure how much it would cost to send and return letters in various countries, but how often–and how quickly–the letters sent were returned. Each envelope mailed contained one page to limit the possibility that curious postal employees would be tempted to open the envelope to steal the contents. Written on each envelope was a request to “please return to sender if undeliverable.” Therefore, it was likely that the letter would either be returned or discarded. Because the experiment was testing which postal services were best at properly handling consumers’ letters, it is better viewed as an evaluation of allocative efficiency rather than productive efficiency.

2.10

Although the federal government’s Food and Drug Administration (FDA) must approve a vaccine or medical device before it is offered for sale, privately owned firms produce and sell these products. It would be more accurate to view markets for vaccines and medical devices as characteristic of a mixed economy: an economy in which most economic decisions result from

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

xxix

the interaction of buyers and sellers in markets but one in which the government plays a significant role in the allocation of resources. 2.11

As discussed in the chapter, equity, or the fair distribution of benefits, can be difficult to define. For some people, equity means a more equal distribution of income than would result from an emphasis on efficiency alone. Raising taxes on people with higher incomes to provide the funds for programs that aid the poor might increase equity, but may reduce the economic incentive of higher-income people to work hard, start new businesses, and save. Reducing these activities will reduce economic efficiency, which illustrates the trade-off between equality and efficiency. An economist can write an entire book on the subject because equality can be difficult to define and because it can be difficult to measure the extent to which efforts to promote equality can reduce efficiency. The trade-off involves complicated normative and positive issues.

2.12

If all of an economic system’s resources were devoted to providing health care, there would be other important goods and services, such as food, housing, clothing, and education that the economy could not provide. An economic system that provided its citizens with state-of-the-art health care but so little food that most were on the verge of starvation, no housing so that many were sleeping in streets and fields, and no schooling so most people were illiterate, would generally be regarded as inefficient and treating the population unfairly by depriving them of such important goods and services. A market economy restricts access to health care, just as it restricts access to all goods and services, by charging a price at which less than an unlimited quantity of health care is demanded.

2.13

a. The groups of students most likely to get the tickets will be those for whom the expected marginal benefit of going to the athletic department office on Monday morning is greater than the expected marginal cost. These would include students who have a relatively low opportunity cost of their time, such as those who have no Monday morning classes. Other students who are likely to stand in line are those who would have a large benefit from having the tickets: Those who love football and those who hope to sell their tickets (“scalpers”). b. The major opportunity cost of distributing the tickets this way is the cost to those students who attempt to get the tickets, such as: The activities the students can’t do while standing in line and the costs to students who stand in line but find that all the tickets are sold before their turn comes. There’s also the cost of the lost revenue to the college from giving away the tickets instead of selling them. c. This isn’t an efficient way to distribute the tickets because of the high cost in wasted time. It would be more efficient to sell the tickets to those willing to pay the highest prices d. Equity is hard to define. Some people will see this way of distributing tickets as equitable because students with low incomes can still get tickets, provided they are willing to pay the opportunity cost of waiting in line. Some people will see this way of distributing the tickets

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System as equitable because only those with the greatest desire to watch the game in person will put up with the hassle of getting the tickets. Some people might argue that this system is equitable because students are more deserving than nonstudent recipients of the tickets. Others may disagree, saying that students with a strong desire to obtain the tickets, but who are unable to be at the athletic department office at the designated time, would have no chance to get the tickets. Still others could argue that the system was not equitable because this way of distributing tickets generates no revenue for the athletic department, which could use the revenue to cover some of the costs of administering the college’s athletic programs.

Economic Models 1.3

Learning Objective: Explain how economists use models to analyze economic events and government policies.

Review Questions 3.1

Economists use models for the same reason that other scientists do—to make a complicated world simple enough that problems can be understood and analyzed and questions can be accurately answered. Useful models will generate testable predictions. If these predictions are consistent with economic data, the model isn’t rejected and can be used to understand the economy. Testing models with data can be very difficult, however, because the economy is always changing, and it is difficult to conduct controlled economic experiments.

3.2

Economists can create a useful model by following these five steps: (1) decide the assumptions to be used; (2) formulate a testable hypothesis; (3) use economic data to test the hypothesis; (4) revise the model if it fails to explain the economic data well; and (5) retain the revised model to help answer similar economic questions in the future.

3.3

Positive economic analysis is concerned with what is; that is, it deals with how the economy actually behaves. Normative economic analysis is concerned with what ought to be. Economics is mainly concerned with positive analysis—conceptualizing and measuring the costs and benefits of different courses of action. Decision makers, including voters and government officials, can use the trade-offs and costs and benefits identified by positive economic analysis to normatively decide what course of action they should take.

Problems and Applications 3.4

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xxxi

3.5

The problem with Dr. Strangelove’s theory is that it cannot be tested unless we can devise a way to measure the emission of these subatomic particles, which is impossible because such testing methods don’t exist. Because we cannot test the model’s predictions, we have no way of knowing if the theory might be true; therefore, the theory is not very useful.

3.6

a. This statement represents positive analysis, analysis concerned with “what is.” Positive analysis would use an economic model to measure the effect a tax on cigarettes has on teenagers’ purchases of cigarettes. b. This statement represents normative analysis, analysis concerned with “what ought to be.” Whether the federal government should or should not spend more on research to reduce opioid addiction cannot be determined based on positive analysis alone, but requires a normative judgment, or opinion. c. This statement represents positive analysis. This statement can be tested to determine whether it is correct. d. This statement represents normative analysis because it is an opinion or belief that the price of Starbucks coffee is too high.

3.7

Lowery is making a normative judgment regarding the policy: She believes that the federal government should guarantee everyone financial security. Normative analysis concerns what one person believes ought to be. You can agree or disagree with her opinion depending on your own views of the issue. There is no way to demonstrate that Lowery’s opinion is correct.

3.8

To evaluate the positive elements of this debate, it would be useful to have statistics on the effect similar import tariffs on other goods have had on sales of those imported goods and on employment in import-competing firms. It would also be useful to have forecasts of the likely effect a tariff imposed on imports from China would have on the prices of those goods in the United States and on employment in the U.S. industries that produce goods that compete with Chinese imports. Even if this information were available, it is unlikely that the normative issues involved in the debate would be resolved. People differ on how they evaluate the benefits of saving jobs in a domestic industry that would be protected by tariffs relative to the cost of the higher prices domestic consumers will have to pay because of the tariffs.

3.9 a. A tariff on imports will raise the prices of those imports making it likely that some U.S. consumers will buy domestically produced products instead of imports. b. i. The tariff will hurt U.S. automobile firms because steel is an input in the production of automobiles. ii. The tariff will hurt U.S. consumers because they will have to pay higher prices for goods, such as automobiles and washing machines, that use steel as an input.

xxxii CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System iii. The tariff will likely help workers at U.S. steel firms because sales of domestic steel will likely increase, increasing employment at domestic steel firms. In addition, steel firms may become more profitable and steel workers may be able to negotiate for higher wages. iv. If the tariff increases the profits of U.S. steel firms, the value of these firms may increase, which will help people who invested in these firms. c. People who benefitted from tariffs are likely to support them. We can’t say those people will necessarily support tariffs, though, because their support for free trade unrestricted by tariffs may supersede their monetary gains from a particular tariff. The people who are hurt by the tariffs are likely to oppose them, but we can’t say they will necessarily oppose them for two reasons: (1) Some of the people who lose from tariffs may not understand that tariffs inflicted losses on them. For example, a consumer who pays more for a washing machine may not understand that the price of the washing machine has increased because of the steel tariffs and (2) Some people who are hurt by the tariffs may still support them because, for example, they believe it is a good idea, on normative grounds, to protect jobs in the steel industry. 3.10

An economic model used to forecast the number of employees in manufacturing industries in 2029 should take the following three factors into account: (1) the expected growth of manufactured goods during this time period; (2) the effect of technology on manufacturing, because new technology, including the use of robotics, will affect the number of workers firms will hire; and (3) possible changes in economic policy enacted by the government, keeping in mind that estimates of the effects will be imprecise because Congress and the president must agree on some policy proposals before they become law and the outcome of that political process is uncertain.

3.11

a. The licensing system helps protect consumers by providing high-quality training for physicians. b. This licensing system allows physicians in a specialty to limit the number of physicians in that specialty. Increasing the number of physicians in a specialty is likely to reduce the incomes physicians earn. c. Occupational licensing, such as licensing doctors, is an important topic in economics. While the licensing requirements—in this case the control of the size of residency programs—help ensure high-quality training for physicians, they also are in the self-interest of physicians because the requirements help maintain physicians’ salaries. Given this trade-off, whether it is a good system is a normative question.

1.4

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System xxxiii Learning Objective: Distinguish between microeconomics and macroeconomics.

Review Question 4.1

Microeconomics is the study of how households and firms make choices, how they interact in specific markets, and how the government influences their choices. “Micro” means small, and microeconomics deals with individual decision makers. Macroeconomics is the study of the economy as a whole. “Macro” means large, and macroeconomics deals with economy-wide outcomes, such as the inflation rate, the unemployment rate, and the economic growth rate.

4.2

No, because many economic situations have both a microeconomic and a macroeconomic component. For example, the level of total consumption spending by households helps to determine how fast the economy grows—which is a macroeconomic issue. But to understand the amount of consumption spending by households, we have to analyze the incentives and constraints individual households face—this is a microeconomic issue.

Problems and Applications 4.3

a. and d. are microeconomic questions because they relate to specific industries. b. and c. are macroeconomic questions because they relate to economy-wide issues.

4.4

You should disagree with the assertion. Microeconomics deals with individual decision makers. Because the unemployment rate in any one city would be an issue for the economy of the entire city and not an individual, it is a macroeconomic issue rather than a microeconomic issue. The effect on teen smoking of an increase in the tax on cigarettes is better thought of as a microeconomic issue because it depends on the reactions of individuals to the increase in the tax.

Suggestions for the Thinking Critically Exercises CT1.1 Answers to this question will vary substantially and might include assertions that capitalism promotes greed or contributes to damaging the environment. Answers will likely depend on the background of the student. The main point is not correctness, but to help students connect the chapter to their prior knowledge. Whether students’ responses accomplish this goal is difficult for an instructor to evaluate. Finally, by connecting to their prior knowledge, students should learn this topic more deeply.

CT1.2 The key here is what incentive do you need to select to encourage you to train? Also, keep in mind that this question suggests that one is training now so it is also about additional training, or marginal analysis. Copyright © 2023 Pearson Education, Inc.

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

Solutions to Chapter 1 Appendix 1A.1

a. The relationship is negative because as price decreases, the quantity of pies purchased increases. b.

c. The slope = ∆y/∆x = rise/run = –1/1 = –1. 1A.2

1A.3

Year

Percentage Change

2007

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System xxxv 2008

[(5.4 – 6.6)/6.6+ × 100 = −18.2%

2009

[(4.9 – 5.4)/5.4] × 100 = − 9.3%

2010

[(5.5 – 4.9)/4.9] × 100 = 12.2%

2011

[(5.7 – 5.5)/5.5] × 100 = 3.6%

2012

[(5.7 – 5.7)/5.7] × 100 = 0.0%

2013

[(6.3 – 5.7)/5.7] × 100 = 10.5%

2014

[(6.3 – 6.3)/6.3] × 100 = 0.0%

2015

[(6.7 – 6.3)/6.3] × 100 = 6.3%

2016

[(6.7 – 6.7)/6.7] × 100 = 0.0%

2017

[(6.6 − 6.7)/6.7] × 100 = −1.5%

2018

[(6.0 − 6.6)/6.6] × 100 = −9.1%

2019

[(5.4 − 6.0)/6.0] × 100 = −10.0%

We can conclude that sales fell at the highest rate in 2008. 1A.4

[($19,092 billion − $18,688 billion)/$18,688 billion] × 100 = 2.2%

The percentage change in real GDP from one year to the next is the economy’s growth rate. 1A.5

xxxvi CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System b. At $2.50, the total revenue equals rectangles A + B = $250,000 (because $2.50 × 100,000 = $250,000). At $1.25, the total revenue equals rectangles B + C = $250,000 (because $1.25 × 200,000 = $250,000). 1A.6

The triangle’s area = (0.5) × (175,000 – 115,000) × ($2.25 − $1.50) = 0.5 × 60,000 × $0.75 = $22,500.

1A.7

The slope is calculated using the formula:

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

CHAPTER 2 | Trade-offs, Comparative Advantage,

and the Market System Brief Chapter Summary and Learning Objectives 2.1

Production Possibilities Frontiers and Opportunity Costs Use a production possibilities frontier to analyze opportunity costs and trade-offs. ▪

2.2

The model of the production possibilities frontier is used to analyze the opportunity costs and trade-offs that individuals, firms, and countries face.

Comparative Advantage and Trade Describe comparative advantage and explain how it serves as the basis for trade. ▪

2.3

Comparative advantage is the ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers.

The Market System Explain the basics of how a market system works. ▪

Markets enable buyers and sellers of goods and services to come together to trade.

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

Key Terms Absolute advantage The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

Circular-flow diagram A model that illustrates how participants in markets are linked.

Product market A market for goods—such as computers—or services—such as medical treatment.

Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.

Production possibilities frontier (PPF) A curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology.

Economic growth The ability of an economy to produce increasing quantities of goods and services.

Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

Entrepreneur Someone who operates a business, bringing together the factors of production—labor, capital, and natural resources—to produce goods or services.

Scarcity A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Trade The act of buying and selling.

Factor market A market for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability. Factors of production Labor, capital, natural resources, and other inputs used to make goods and services. Free Market A market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed. Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Chapter Outline Elon Musk and Tesla Motors Face a Trade-Off In 2019, Elon Musk, founder of Tesla Motors, hoped to sell his Model 3 automobile for $35,000. In early 2021, however, the least-expensive version of that vehicle was $37,990. The Model Y was even more expensive with a starting price of $49,900. Musk and Tesla’s managers faced an important trade-off: Should the firm increase the resources—machinery, workers, and research and development work— devoted to the Model 3 and Model Y to bring its costs down so the firm could earn a profit at a lower price.

As Tesla dealt with the trade-offs involved in allocating resources among its models, the federal government was phasing out a tax credit of up to $7,500 on the purchase of an electric car. The federal government faced its own trade-off: The tax revenue it gives up as a result of the tax credit isn’t available to fund other programs.

Production Possibilities Frontiers and Opportunity Costs 2.1

Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.

Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Goods and services are scarce, as are the resources used to make goods and services. A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology.

A. Graphing the Production Possibilities Frontier All combinations of products on a production possibilities frontier are efficient because all available resources are being used. Combinations inside the frontier are inefficient because maximum output is not obtained from available resources. Points outside the frontier are unattainable given the firm’s current resources. Opportunity cost is the highest-valued alternative that must be given up to engage in an activity.

B. Increasing Marginal Opportunity Costs A production possibilities frontier that is bowed outward illustrates increasing marginal opportunity costs, which occur because some workers, machines, and other resources are better suited to one Copyright © 2023 Pearson Education, Inc.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply use than to another. Increasing marginal opportunity costs illustrate an important concept: The more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity.

C. Economic Growth Economic growth is the ability of an economy to produce increasing quantities of goods and services. Economic growth can occur if more resources become available or if a technological advance makes resources more productive. Growth may lead to greater increases in production for one good than another.

Comparative Advantage and Trade 2.2

Learning Objective: Describe comparative advantage and explain how it serves as the basis for trade.

Trade is the act of buying and selling. Trade makes it possible for people to become better off by increasing both their production and their consumption.

A. Specialization and Gains from Trade PPFs show the combinations of two goods that can be produced if no trade occurs. We can also use PPFs to show how someone can benefit from trade even if she is better than someone else at producing both goods.

B. Absolute Advantage versus Comparative Advantage Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. If the two individuals have different opportunity costs for producing two goods, each individual will have a comparative advantage in the production of one of the goods. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Comparing the possible combinations of production and consumption before and after specialization and trade occur proves that trade is mutually beneficial.

C. Comparative Advantage and the Gains from Trade The basis for trade is comparative advantage, not absolute advantage. Individuals, firms, and countries are better off if they specialize in producing the goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.

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Teaching Tips A classic example of comparative advantage is the career of baseball legend Babe Ruth. Before he achieved his greatest fame as a home run hitter and outfielder with the New York Yankees, Ruth was a star pitcher with the Boston Red Sox. Ruth may have been the best left-handed pitcher in the American League during his years with Boston (1914–1919), but he was used more as an outfielder in his last two years with the team. In fact, he established a record for home runs in a season (29) in 1919. The Yankees acquired Ruth in 1920 and made him a full-time outfielder. The opportunity cost of this decision for the Yankees was the wins he could have earned as a pitcher. But because New York already had skilled pitchers, the opportunity cost of replacing him as a pitcher was lower than the cost of replacing Ruth as a hitter. No one else on the Yankees could have hit 54 home runs, Ruth’s total in 1920; the next highest total on the Yankees was 11. It can be argued that Ruth had an absolute advantage as both a hitter and pitcher for the Yankees in 1920—but he had a comparative advantage only as a hitter.

2.3

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

In the United States and most other countries, trade is carried out in markets. A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. A product market is a market for goods—such as computers—or services—such as medical treatment. A factor market is a market for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability. Factors of production are labor, capital, natural resources, and other inputs used to make goods and services.

A. The Circular Flow of Income A circular-flow diagram is a model that illustrates how participants in markets are linked. The diagram demonstrates the interaction between firms and households in both product and factor markets.

B. The Gains from Free Markets A free market is a market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed. Adam Smith is considered the father of modern economics. His book, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, was an influential argument for the free market system.

C. The Market Mechanism A key to understanding Adam Smith’s argument is the assumption that individuals usually act in a rational, self-interested way. This assumption underlies nearly all economic analysis. Copyright © 2023 Pearson Education, Inc.

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D. The Role of the Entrepreneur in the Market System Entrepreneurs are an essential part of a market economy. An entrepreneur is someone who operates a business, bringing together the factors of production—labor, capital, and natural resources—to produce goods or services. Entrepreneurs often risk their own funds to start businesses and organize factors of production to produce those goods and services that consumers want.

E. The Legal Basis of a Successful Market System The absence of government intervention is not enough for a market economy to work well. Government has to provide a legal environment that allows markets to operate efficiently. Property rights are the rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. To protect intellectual property rights, the federal government grants patents to inventors. A patent grants the exclusive right to produce and sell a new product for 20 years from the date the patent is filed. Books, films, and software receive copyright protection. Under U.S. law, the creator of a book, film, or piece of music has the exclusive right to use the creation during the creator's lifetime. The creator’s heirs retain this right for 70 years after the death of the creator.

Teaching Tips To initiate class discussion regarding intellectual property rights, ask students these questions: 1. How many of you have downloaded music from the Internet? 2. Should the government have the right to grant exclusive rights to musicians and other artists to produce and sell their creative works? 3. Should the government fine or prosecute people who illegally obtain music, books, movies, and other creative works in violation of property rights laws?

Extra Solved Problem 2.3 Adam Smith’s “Invisible Hand” The late economist Alan Krueger argued that Adam Smith was concerned that the invisible hand would not function properly if merchants and manufacturers convinced the government to issue regulations to help them. Source: Alan B. Krueger, “Rediscovering the Wealth of Nations,” New York Times, August 16, 2001.

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

What types of regulations might merchants and manufacturers seek from the government?

How might these regulations prevent the invisible hand from working?

Solving the Problem Step 1:

Review the chapter material. This problem is about how goods and services are produced and sold and how factors of production are employed in a free market economic system as described by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations, so you may want to review the section “The Gains from Free Markets.”

Step 2:

Answer part (a) by describing the economic system in place in Europe in 1776. At the time, governments gave guilds—associations of producers—the authority to control production. The production controls limited the output of goods such as shoes and clothing, as well as the number of producers of these items. Limiting production and competition led to higher prices and fewer choices for consumers. Instead of catering to the wants of consumers, producers sought favors from government officials.

Step 3:

Answer part (b) by contrasting the behavior of merchants and manufacturers under a guild system and in a market system. Because governments in a guild system gave producers the power to control production, producers did not have to respond to consumers’ demands for better quality, greater variety, and lower prices. In a market system, producers who sell poor quality goods at high prices suffer economic losses; producers who provide better quality goods at low prices are rewarded with profits. Therefore, it is in the self-interest of producers to address consumer wants. This is how the invisible hand works in a free market economy but not in most of Europe in the eighteenth century.

Extra Analyze An Elementary Case of Copyright the Concept The U.S. Congress provides copyright protection to authors to give them an economic incentive to invest the time and effort required to write books. While a book is under copyright, only the author—or whoever the author sells the copyright to—can legally publish a paper or digital copy of the book. Once the copyright expires, however, the book enters the public domain, and anyone is free to publish the book. Copies of classic books written in the 1800s, such as Mark Twain’s Huckleberry Finn and Charles Dickens’s Oliver Twist, are available from many publishers that do not have to pay a fee to the authors’ heirs. Copyright © 2023 Pearson Education, Inc.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply Arthur Conan Doyle was a doctor in England when he published his first story featuring the detective Sherlock Holmes in 1887. Anyone who wants to publish any of the Sherlock Holmes stories that Doyle wrote from 1887 through the end of 1922 is free do so. But the last 10 Sherlock Holmes stories that Doyle wrote from 1923 to 1927 remain under copyright protection. Doyle’s heirs argue that because the author continued to develop the personalities of Sherlock Holmes and his companion Dr. John Watson in the 10 stories that remain under copyright protection, the characters cannot be used in new books, films, or television shows without payment. Doyle’s heirs have asked anyone who wants to include Holmes in a new work to pay them a fee of $5,000 per use. The producers of two Sherlock Holmes films starring Robert Downey, Jr., and the producers of the television series Sherlock, starring Benedict Cumberbatch, and Elementary, starring Jonny Lee Miller, agreed to pay the fee, as have most authors of books using Holmes as a character. In 2011, when Leslie S. Klinger published A Study in Sherlock, a collection of new stories involving Sherlock Holmes, his publisher insisted that he pay the usual fee to Doyle’s descendants. But two years later, when Klinger decided to publish another collection, In the Company of Sherlock Holmes, he decided that rather than pay the fee he would sue Doyle’s descendants, hoping the federal courts would rule against their copyright claims. Federal Appeals Judge Richard Posner—who is also an economist—eventually ruled in favor of Klinger. He argued that copyright law did not allow authors or their heirs to require fees for the use of characters from stories in the public domain. He also noted that, “the longer the copyright term is, the less public-domain material there will be and so the greater will be the cost of authorship, because authors will have to obtain licenses from copyright holders for more material.” As a result of this ruling, for the first time since 1887, anyone can use Sherlock Holmes as a character in a book, television show, or movie without having to pay a fee. Sources: Jennifer Schuessler, “Appeals Court Affirms Sherlock Holmes Is in Public Domain,” New York Times, June 17, 2014; Jennifer Schuessler, “Conan Doyle Estate Told to Pay Legal Fees,” New York Times, August 5, 2014; Eriq Gardner, “Conan Doyle Estate Loses Appeal Over ‘Sherlock Holmes’ Rights,” Hollywood Reporter, June 16, 2014; and Leslie S. Kling v. Conan Doyle Estate, Ltd. (7th Cir. 2014), media.ca7.uscourts.gov.

Extra Analyze Managers at Feeding America Use the Market Mechanism the Concept to Reduce Hunger

Charitable giving doesn’t seem to have much to do with markets. When donors give money, clothing, or food to a charity, they typically don’t expect anything in exchange—beyond a possible tax deduction. In 1979, retired businessman John van Hengel started Feeding America. This charity collects donations of food from farmers, supermarkets, food processing plants, and governments and distributes the food to thousands of food pantries and food programs operated by churches, Copyright © 2021 Pearson Education, Inc.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply schools, and community centers around the country. These programs give the donated food away free or at a very low price to low-income families.

By 2004, Feeding America was providing 1.8 billion pounds of food per year to millions of lowincome people, but the organization’s managers realized that they could serve even more people if they could operate more efficiently. In particular, the managers were concerned that food was sometimes not allocated in ways that were consistent with the needs of local food programs. For example, potatoes might be shipped to food programs in Idaho—the country’s leading potato growing state—or milk might be shipped to food programs that lacked the refrigeration capacity to keep it fresh long enough to distribute. In 2005, Feeding America asked Canice Prendergast, Don Eisenstein, and Harry Davis, professors at the University of Chicago’s Booth School of Business, to design a more efficient way of allocating food to local food programs.

Feeding America had been allocating food by calculating how many low-income people lived in an area and then shipping a target number of pounds of food to food programs in the area. All food, whether fruit, bread, milk, or pasta, that weighed the same was treated the same in making allocations to local food programs. The food programs were not allowed to choose which foods they wanted to receive. Because Feeding America provided on average only about 20 percent of the total food donations local food programs received, it might ship food—for example, bread and breakfast cereal—the local program already had, while failing to ship food, such as fruits and vegetables, that the program needed.

The business professors advising Feeding American proposed changing the food allocation system to one that resembled a market. Each food program was given a number of “shares” that they could use in bidding against other food programs for the types of food that best met the needs of the lowincome people using their program. In addition, any local program that had surplus food was allowed to sell it to other local programs in exchange for shares. Although this new system does not involve money, it operates like a market—in which consumers determine prices by competing against each other in buying goods. Goods for which consumers have a greater preference tend to have higher prices than goods for which consumers have a lesser preference; for instance, in supermarkets, organic produce often sells for a higher price than nonorganic produce. Similarly, food programs turned out to have a stronger preference for fresh fruits and vegetables than for pasta. Under the previous system, a pound of fresh fruit would have been treated the same as a pound of pasta in calculating how much food Feeding America would allocate to a local program. But when under the new system local food banks were allowed to bid for food with shares, the price of a pound of fruit or vegetables was 116 times higher than the price of a pound of pasta.

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply Because under the new system food is allocated in a way that more closely fits the needs of local food programs, Feeding America is able to provide food to thousands more low-income people than was possible under the old system. In addition, because less food is wasted, people and organizations have been willing to donate more food to the program. Finally, Feeding America’s managers have used the knowledge of which types of foods local food programs prefer to guide the types of food they ask companies to donate. For instance, in addition to fruits and vegetables, programs are willing to pay more shares for peanut butter and frozen chicken because these foods are easy to store. Even many critics of using a market mechanism to allocate food donations eventually embraced the system, including the director of one Michigan food program whose initial reaction was: “I am a socialist. That’s why I run a food bank. I don’t believe in markets.” The success of Feeding America’s revised procedures for allocating food donations shows how powerfully market mechanisms can increase efficiency and raise living standards.

Sources: Sendhil Mullainathan, “Sending Potatoes to Idaho? How the Free Market Can Fight Poverty,” New York Times, October 7, 2016; Canice Prendergast, “The Allocation of Food to Food Banks,” Working Paper, University of Chicago, Booth School of Business, October 11, 2016; Ray Fisman and Tim Sullivan, “The Invisible Helping Hand,” slate.com, June 7, 2016; and feedingamerica.org.

Extra Economics in Your Life & Career: Economists Express Their Agreement on Free Trade During the summer of 2017, fifteen former leaders of the White House Council of Economic Advisors signed a letter to then President Trump urging him not to place tariffs on imports of steel into the United States. The letter notes that “Among us are Republicans and Democrats alike, and we have disagreements on a number of policy issues. But on some policies, there is near universal agreement. One such issue is the harm of imposing tariffs on steel imports.” Tariffs are taxes imposed by government on imports. Those who endorse tariffs and other barriers to free international trade believe that such barriers protect domestic industries and the jobs of their employees. Questions: (a) Why do many economists, including those who have served for both Republican and Democratic administrations, support free trade policies and oppose tariffs and trade barriers even if these barriers are designed to protect domestic workers from losing their jobs? (b) What types of jobs would be most vulnerable to job losses due to competition from imports?

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply Answers: (a) As you learned in this chapter, countries are better off if they specialize in producing goods and services in which they have a comparative advantage and trading with other countries for other goods and services. Tariffs prevent countries from taking full advantage of the benefits from free trade. The argument that economists who have worked for both Democratic and Republican governments made is based on positive economic analysis (analysis concerned with what is) rather than normative analysis (analysis concerned with what ought to be). Ben Bernanke, former chair of the Federal Reserve Board, has cited a study that examined the effect of international trade on income in the United States since World War II: “… the increase in trade… has boosted U.S. annual incomes on the order of $10,000 per household. The same study found that removing all remaining barriers to trade would raise incomes anywhere from $4,000 to $12,000 per household.” (b) Another study cited by Bernanke found that the 21 occupations in the United States that were most vulnerable to imports from foreign firms were primarily for relatively low-wage positions. In general, the greater the skill requirements for the job you hold, the less vulnerable you will be to losing your job due to competition from imports. Sources: Nick Timiraos, “Former White House Economists to Donald Trump: Don’t Impose Steel Tariffs,” Wall Street Journal, July 12, 2017; Ben Bernanke, “Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy,” The Federal Reserve Board, May 1, 2007. https://www.federalreserve.gov/boarddocs/speeches/2007/20070501/default.htm; and "Why Open Markets Matter," http://www.oecd.org/trade/understanding-the-global-trading-system/why-open-markets-matter/

Solutions to End-of-Chapter Exercises Answers to Thinking Critically Questions to accompany the Inside Look newspaper feature 1. In 2022, maximum production at Volvo is 150,000 C40 Recharge SUVs or 150,000 XC40 Recharge SUVs, so to gain 1 C40 Recharge SUV, 1 XC40 Recharge SUV must be given up. In 2026, Copyright © 2023 Pearson Education, Inc.

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply maximum production is 225,000 C40 Recharge SUVs or 150,000 XC40 Recharge SUVs, so to gain 1 C40 Recharge SUV, two-thirds of a XC40 Recharge SUV must be given up. Therefore:  

The opportunity cost of 1 C40 Recharge in 2022 is 1 XC40 Recharge SUV The opportunity cost of 1 C40 Recharge SUV in 2026 is two-thirds of a XC40 Recharge SUV.

2. The production alternative of 100,000 C40 Recharge SUVs and 140,000 XC40 Recharge SUVs lies outside the 2026 production possibilities frontier (PPF2026) and is therefore an unattainable production alternative. The PPF2026 represents maximum production in that year. According to the figure, the maximum number of total vehicles that can be produced in 2026 is 225,000. If Volvo filled the 100,000 C40 Recharge SUV orders, it would be able to produce only 125,000 XC40 Recharge SUVs. If Volvo filled the 140,000 XC40 Recharge SUV orders, the company would be able to produce only 85,000 C40 Recharge SUVs.

Production Possibilities Frontiers and Opportunity Costs 2.1

Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.

Review Questions 1.1

Scarcity is the situation in which wants exceed the limited resources available to fulfill those wants. There are some things that are available in such abundance that they exceed our wants. For example, for most people there is enough oxygen in the atmosphere that the amount they

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply want to inhale would not exceed the available amount—so oxygen isn’t scarce for them. Another example might be something undesirable, such as weeds in your garden.

1.2

The production possibilities frontier (PPF) is a curve showing all the attainable combinations of two products that can be produced with available resources and existing technology. Combinations of goods that are on the frontier are efficient because all available resources are being fully used, and the fewest possible resources are being used to produce a given amount of output. Points inside the PPF are inefficient because the maximum output is not being obtained from the available resources. A PPF will shift outward (to the right) if more resources become available for making the products or if technology improves so that firms can produce more output with the same amount of inputs.

1.3

Increasing marginal opportunity costs means that as more and more of a product is made, the opportunity cost of making each additional unit rises. This occurs because the first units of a good are produced with the resources that are best suited for making it, but as more and more of the good is produced, resources must be used that are better suited for producing something else. Increasing marginal opportunity costs imply that the production possibilities frontier (PPF) is bowed out—the slope of the PPF gets steeper and steeper as you move down the frontier.

Problems and Applications 1.4

a. The production possibilities frontiers in the figure are bowed outward because of increasing marginal opportunity costs. The drought causes the production possibilities frontier to shift to the left (see the graph in part (b)). b. The genetic modifications would increase the maximum soybean production, which we can show by shifting out where the PPF intersects the horizontal axis, but the maximum cotton production would be unchanged

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1.5

As shown in the following figure, increased safety will decrease the maximum range for one of Tesla’s electric vehicles. Trade-offs can be between physical goods, such as cotton and soybeans in problem 1.4, or between the features of a product, like the maximum range and the safety of an electric vehicle.

1.6

a. You should draw a figure like Figure 2.1 in the chapter that shows the trade-off Tesla faces between original models (Models S and X) and new models (Models 3 and Y) We can assume that the capacity in the Fremont factory is the same as the capacity assumed in Figure 2.1. b. Because Tesla’s factory in China produces only new models (Model 3 and Model Y) vehicles, its opening did not affect the quantity of original models the company produces. We can show this change on a production possibilities frontier (PPF) by keeping the maximum quantity of original models Tesla can produce per day fixed at 80, while pivoting the PPF to increase the maximum number of new model vehicles Tesla can produce per day. We don’t know how many additional new models Tesla produces in its new China factory. If the China factory has the same capacity as the Fremont factory, then the maximum quantity of new models Tesla can produce per day will increase from 80 to 160.

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1.7

You could argue that the price you pay for a book is a close approximation to the opportunity cost of buying a book, but consuming—that is, reading—the book could require many hours of leisure time that you could be spending on some other activity. The time you spend reading a book always has an opportunity cost.

1.8

a. The production possibilities frontier will be bowed out like Figure 2.2 because some economic inputs are likely to be more productive when making capital goods, and other inputs are likely to be more productive when making consumption goods.

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

c. Luxembourg will have more capital goods, such as machinery, equipment, and robots, so it is likely to experience more rapid growth in the future than Liechtenstein.

1.9

a. Point E is outside the production possibilities frontier, so it is unattainable. b. Points B, C, and D are on the production possibilities frontier, so they are efficient. c. Point A is inside the production possibilities frontier, so it is inefficient.

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply d. At point B, the country is devoting the most resources to producing capital goods, so production at this point is most likely to lead to the highest growth rate. The more capital goods the country produces, the greater the capacity of the country to produce goods and services in the future.

1.10

If you spend all 5 hours studying for your economics exam, you will score a 95 on the exam; therefore, your production possibilities frontier will intersect the vertical axis at 95. If you devote all 5 hours studying for your chemistry exam, you will score a 91 on the exam; therefore, your production possibilities frontier will intersect the horizontal axis at 91. b. The points for choices C and D can be plotted using information from the table given in the problem. Moving from choice C to choice D increases your chemistry score by 4 points but lowers your economics score by 4 points. Therefore, the opportunity cost of increasing your chemistry score by 4 points is the decline of 4 points in your economics score. c. Choice A might be sensible if the marginal benefits of doing well on the chemistry exam are low relative to the marginal benefits from doing well on the economics exam. For example, Copyright © 2023 Pearson Education, Inc.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply that choice might be sensible if: (1) you are majoring in economics and don’t care much about chemistry; or (2) if you already have an A grade sewn up in chemistry, but the economics professor will replace a low exam grade with this exam grade.

1.11

a. By reducing firms’ potential profits from selling new drugs and medical devices, price regulation may reduce the incentive firms have to devote resources to the research and development necessary to develop these products. b. From the point-of-view of the public, the opportunity cost of regulating the prices of pharmaceuticals and medical devices is the decline in the number of these products that firms will develop following the imposition of the price regulations. The public would be trading off lower prices today for less effective health care in the future. The presidential candidate may also want to consider whether implementing price regulations on pharmaceuticals and medical devices might lead Congress to impose price regulations on other goods and services. Doing so could interfere with the operation of the market system as described later in this chapter in Section 2.3.

1.12

State governments have limited budgets. Subsidies that state governments pay for prescription drugs under the Medicaid program use tax revenue that could otherwise be used to pay for other valuable goods and services, including highway and bridge repair and funding of schools. Nearly all state governments are required by their constitutions to balance their budgets. Therefore, increases in spending on one program require either a reduction in spending on other programs or an increase in taxes. Facing this trade-off, some states have subsidized expensive drugs only for patients with the most serious illnesses. How best to allocate a state government’s limited resources is a normative issue and depends on how governors and state legislators evaluate the trade-offs involved.

1.13

Resources used to reduce pollution are not available for other uses, such as saving lives through medical research. It is therefore more ethical to take the opportunity cost of reducing pollution into account than to ignore the cost.

1.14

Economic systems that do not allow people to keep most of the output they produce do not provide much incentive for people to work hard. Unfortunately, experience has shown that people are more self-interested and less altruistic than would be necessary for the system used in the Land of Oz to work in the real world.

Comparative Advantage and Trade 2.2

Learning Objective: Describe comparative advantage and explain how it serves as the basis for trade.

Review Questions

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2.1

Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors using the same amount of resources. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. It is possible for a country to have a comparative advantage in producing a good even if another country has an absolute advantage in producing that good (and every other good). Unless the two countries have exactly the same opportunity costs of producing two goods—the same trade-off between the two goods—one country will have a comparative advantage in making one of the goods and the other country will have a comparative advantage in making the other good.

2.2

The basis for trade is comparative advantage. If each individual or country specializes in making the product for which it has a comparative advantage, trading makes each of them better off. Each individual or country will be able to obtain the product made by its trading partner at a lower opportunity cost than it would be able to produce it without trade.

Problems and Applications 2.3

In the example illustrated in Figure 2.4, the opportunity cost of 1 pound of apples is 1 pound of cherries to you and 2 pounds of cherries to your neighbor. Any price of apples between 1 and 2 pounds of cherries will be a fair trading price. And, the price falls within this range because exchanging 10 pounds of apples for 15 pounds of cherries represents the same price as when exchanging 1 pound of apples for 1.5 pounds of cherries. We could take any other value in this range to complete the table. Let’s take, for example, 1.25 pounds of cherries per pound of apples. We will keep the pounds of apples traded as before at 10. The completed table will now be:

TABLE 2.1: A Summary of the Gains from Trade You

Your Neighbor

Apples (pounds)

Cherries (pounds)

Apples (pounds)

Cherries (pounds)

Production and consumption without trade

Production with trade

Consumption with trade

10 × 1.25 = 12.5

60 − 12.5 = 47.5

Gains from trade (increased consumption)

12.5 − 12 = 0.5

47.5 − 42 = 5.5

Note that both you and your neighbor are better off after trade than before trade. Note also that this rate of trading cherries for apples is better for your neighbor than the original rate of trading and worse for you. 2.4

As explained in this section of the chapter, when individuals, firms, or countries specialize in producing goods or services in which they have a comparative advantage, they are producing at the lowest cost. When McKenzie refers to goods that can be “made more cheaply abroad,” he Copyright © 2023 Pearson Education, Inc.

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply means the goods are being produced in countries that have a comparative advantage in producing them. The goods that can be “made more cheaply at home” are the goods in which the home country has a comparative advantage. As this section of the chapter shows, when countries specialize in producing goods in which they have a comparative advantage and trade for goods in which other countries have a comparative advantage, the incomes of all countries can increase.

2.5

a. Canada has a comparative advantage in making boots. Canada’s opportunity cost of making 1 boot is giving up 1 shirt. In the United States, the opportunity cost of making 1 boot is giving up 3 shirts. The United States has a comparative advantage in making shirts. In the United States, the opportunity cost of making one shirt is giving up 1/3 boot, but Canada’s opportunity cost of making 1 shirt is 1 boot. b. Neither country has an absolute advantage in making both goods. The United States has an absolute advantage in making shirts, but Canada has an absolute advantage in making boots. Remember that both countries have the same amount of resources. If each country puts all of its resources into making shirts, then the United States makes 12 shirts, but Canada makes only 6 shirts. If each country puts all of its resources into making boots, then Canada makes 6 boots, but the United States makes only 4 boots. c. If each country specializes in the production of the good in which it has a comparative advantage and then trades with the other country, both will be better off. Let’s use the case in which each country trades half of what it makes for half of what the other makes. The United States will specialize by making 12 shirts, and Canada will specialize by making 6 boots. Because each country gets half of the other country’s production, they both end up with 6 shirts and 3 boots. They are better off than before trading because they end up with the same number of boots, but twice as many shirts. Other trades will also make them better off.

2.6

a. By writing “China is always better than Spain” at producing textiles, the columnist means that China has an absolute advantage in producing textiles. b. Assuming that Spain has a comparative advantage in producing textiles (that is, it can produce textiles at a lower opportunity cost than China can), Spain can sell textiles to Chinese firms and consumers at a lower price than Chinese textile producers can charge even if China has an absolute advantage in producing textiles.

2.7

a. When the United Kingdom produces 1 more barrel of fish oil, it produces 1 less barrel of crude oil. When Norway produces 1 more barrel of fish oil, it produces 1 less barrel of crude oil. Therefore, neither country has a comparative advantage in either good. In both countries, the opportunity cost of 1 barrel of crude oil is 1 barrel of fish oil. Comparative advantage arises only if an individual, a firm, or a country has a lower opportunity cost of producing a good, but these two countries have the same opportunity cost. (Note, though, Copyright © 2021 Pearson Education, Inc.

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply that the United Kingdom has an absolute advantage in producing both goods because it can produce more of each than can Norway using the same amounts of capital and labor.) b. No, the countries can’t gain from trade. Trading across the border would result in the same trade-offs that can be made within each country.

2.8

a. When France produces 1 more bottle of wine, it produces 2 fewer pounds of cheese. When Germany produces 1 more bottle of wine, it produces 3 fewer pounds of cheese. Therefore, France’s opportunity cost of producing wine—2 pounds of cheese—is less than Germany’s— 3 pounds of cheese. When Germany produces 1 more pound of cheese, it produces 0.33 fewer bottles of wine. When France produces 1 more pound of cheese, it produces 0.50 fewer bottles of wine. Therefore, Germany’s opportunity cost of producing cheese —0.33 bottles of wine—is less than that of France—0.50 bottles of wine. We can conclude that France has a comparative advantage in making wine and that Germany has a comparative advantage in making cheese. b. We know that France should specialize where it has a comparative advantage and Germany should specialize where it has a comparative advantage. If both countries specialize, France will make 4 bottles of wine and 0 pounds of cheese, and Germany will make 0 bottles of wine and 15 pounds of cheese. After both countries specialize, France could then trade 3 bottles of wine to Germany in exchange for 7 pounds of cheese. France will have the same amount of wine as it initially had, but 1 more pound of cheese. Germany will have 3 bottles of wine and 8 pounds of cheese —that is, the same amount of wine, but 2 more pounds of cheese. Other mutually beneficial trades are possible.

2.9

No individual or a country can produce beyond its production possibilities frontier (PPF). The PPF shows the most that an individual or a country can produce for a given amount of resources and technology. Without trade, an individual or a country cannot consume beyond its PPF, but with specialization and trade each can consume beyond its PPF. We saw two examples in the chapter: In Figure 2.5, both you and your neighbor were able to consume beyond your PPFs. In Solved Problem 2.2, both Canada and the United States were able to consume beyond their PPFs.

2.10

Colombia could have a comparative advantage in producing coffee if Nicaragua has an even larger absolute advantage relative to Colombia at producing another product. If, for example, Nicaragua can produce four times more cashews than Colombia can using the same resources, then Colombia will have a comparative advantage in producing coffee.

2.11

Aaron Rogers and you are using absolute advantage, not comparative advantage, to decide what to do. Rogers has a comparative advantage at playing quarterback because even though he is five times better at selling Packers memorabilia than any other employee or player, he has an even larger absolute advantage in playing quarterback. You, as a creative and effective leader, have a comparative advantage in leading the organization. Your absolute advantage in leading is even larger than your absolute advantage in cleaning offices. Copyright © 2023 Pearson Education, Inc.

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2.12

Falling transportation costs allowed people to trade more easily and to specialize on the basis of comparative advantage. If people were able to specialize, they would be more productive and, in turn, earn more income.

2.13

Importing only products that could not be produced here would result in the United States producing—rather than importing—many goods for which it does not have a comparative advantage. These products would be produced at a higher opportunity cost than if they had been imported. The policy would result in a lower standard of living in the United States.

2.14

Even though you are better at unloading the dishwasher, you might be even better relative to the other members of the household at other household chores. You have an absolute advantage in unloading the dishwasher, but you might have an even larger absolute advantage at other household chores. Having an absolute advantage does not mean that you have a comparative advantage in unloading the dishwasher. Household production will be accomplished in fewer hours if each member of the household performs chores in which he or she has a comparative advantage.

2.15

The amount of time that family members spend on household chores has changed over the years for a number of reasons, including changes in the average number of children per household and the average age that couples marry. But the most important reason the number of hours of housework has fallen since 1965 is probably due to technological change. It takes the average household less time to do laundry, wash dishes, and perform other household chores. This reduction has allowed men and women more time to spend working outside the home or engaging in leisure activities without having to put up with messier homes.

2.3

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

Review Questions 3.1

The circular-flow diagram illustrates how participants in markets are linked. The diagram shows that in factor markets, households supply labor and other factors of production in exchange for wages and other payments from firms. In product markets, households use the payments they earn in factor markets to purchase the goods and services produced by firms.

3.2

The two main categories of market participants are households and firms. Households are consumers and are of greatest importance in determining what goods and services are produced. Firms make a profit only when they produce goods and services valued by consumers. Therefore, only the goods and services that consumers are willing and able to purchase are produced. Copyright © 2021 Pearson Education, Inc.

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3.3

A free market is a market with few government restrictions on how goods or services can be produced or sold and few government restrictions on how factors of production can be employed. In a free market economy, buyers and sellers in the marketplace make economic decisions. In a centrally planned economy, the government—rather than households and firms—makes almost all the economic decisions. Free market economies have a much better track record of providing people with rising standards of living.

3.4

An entrepreneur operates a business. Entrepreneurs play a key role in the economy by bringing together the factors of production—labor, capital, and natural resources—to produce goods and services for sale. Entrepreneurs decide what to produce and how to produce it. They put their own funds or borrowed funds at risk to start a business.

3.5

Firms are likely to produce more of a good or service if consumers want more of it. As consumer demand rises, price will rise, which will lead firms to produce more. If demand falls, price will fall, which will lead firms to produce less.

3.6

Private property rights are the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. If individuals and firms believe that property rights are not well enforced, they will be reluctant to risk their wealth by opening new businesses. Therefore, the enforcement of property rights and contracts is vital for the functioning of the economy. Independent courts are crucial for a well-functioning economy because property rights and contracts will be enforced only if judges make impartial decisions based on the law, rather than decisions that favor powerful or politically connected individuals.

Problems and Applications 3.7

a. An auto purchase takes place in the product market. The household (Tariq) demands the good, and the firm (Tesla Motors) supplies the good. b. The labor market is a factor market. Households supply labor, and the firm demands labor. c. The labor market is a factor market. The household (Tariq) supplies a factor of production (labor), while the firm (McDonald’s) demands it. d. The land market is a factor market. The household (Tariq) supplies a factor of production (land), and the firm (McDonald’s) demands it.

3.8

Firms typically are trying to make the most profit possible, while consumers are trying to spend their incomes in a way that gives them the greatest satisfaction. Neither firms nor consumers are directly interested in increasing economic efficiency or the standard of living of the average person. But the interaction of firms and consumers in markets produces outcomes that are economically efficient and that promote the economic growth that results in rising living standards. This idea is an important intellectual contribution for two reasons: (1) It is not Copyright © 2023 Pearson Education, Inc.

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CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply obvious that an outcome can result even though the people involved don’t intend for that outcome to occur and (2) this idea forms the basis for understanding the favorable economic outcomes that result from a market system.

3.9

It was not necessary for the managers of any of the firms that participated in the making of the pencils described in Leonard Read’s story to know how the components they produced were used to make pencils. Nor was it necessary for the chief executive officer of the Eberhard Faber Company to have this knowledge. All of the companies were motivated by their own selfinterest in providing the materials and services used to make pencils. This account is an illustration of Adam Smith’s “invisible hand” metaphor.

3.10

Adam Smith realized—as economists today realize—that people’s motives can be complex. But in analyzing people in the act of buying and selling, economists have concluded that in most instances, the motivation of financial reward provides the best explanation for the actions people take. Moreover, being self-interested—looking out for your own well-being and happiness—and being selfish—caring only about yourself—are not the same thing. Many successful businesspeople are, in fact, generous: Donating to charity, volunteering for charitable activities, and otherwise acting in a generous way. These actions are not inconsistent with making business decisions that maximize profits for their companies.

3.11

Whether self-interest is an “ignoble human trait” is a matter of opinion. There are certainly more noble traits than self-interest, but without at least some self-interest, a person wouldn’t survive. A market system encourages self-interest in the sense that it paradoxically allows people to enrich themselves by fulfilling the needs of others; that is, by producing goods and services that fulfill the wants of consumers.

3.12

a. “Psychic rewards” refer to the psychological benefits of, in this case, buying lottery tickets, which provide the excitement of playing the lottery and the chance of winning big. b. An entrepreneur might receive the psychic rewards of creating and running his or her own business along with the chance of making large profits. c. Answers will vary here. Elements of being an entrepreneur do appear to be similar to buying a lottery ticket with the psychic rewards of playing the game along with the possibility of large returns. Other elements may differ, such as the probability of success. Although a purchaser of a lottery ticket may know at least roughly the probability that he or she will win the lottery, the probability that an entrepreneur will earn a high return is much more difficult for someone to calculate.

3.13

a. Property rights—including intellectual rights to new products and the processes used to produce goods and services—refer to the rights of firms and individuals to have exclusive use of their property, including the right to buy or sell it. It is the responsibility of

xxvii CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply government to ensure that such rights are protected. Property rights provide incentives for people to maintain and increase the value of the property they own. b. By protecting private property rights, governments make it more likely that investments will be made in businesses that provide jobs and income for workers. This activity results in an increase in a country’s standard of living. It is difficult for a country to become rich without having secure property rights. c. Without secure property rights, farmers in Africa may be reluctant to make the investments in their farms that would raise the farms’ productivity. When farmers have secure property rights, they can borrow more easily by using their land as collateral, which means that if the farmer stops making payments on the loan, the bank or other lender can seize the land and sell it to get its money back. Without collateral, people with low incomes often have trouble getting loans. Using their land as collateral, farmers can borrow the funds they need to make investments that will raise their farms’ productivity. With secure property rights, farmers can also obtain funds by selling some of their land. 3.14

In a market system, an increase in demand for a good leads to an increase in the price of the good. The higher price provides a signal to producers that the good has become more profitable. Given that lithium prices are rising, mining firms are likely to switch some of their labor and capital from producing iron, copper, and cobalt to producing lithium.

3.15

The columnist is likely using the term socialism to refer to a centrally planned economy in which the government directly controls most production. U.S. socialists like Senator Bernie Sanders and Congresswoman Alexandria Ocasio-Cortez would be unlikely to accept the columnist’s definition of socialism. Their view of socialism is similar to that of the social democratic parties in Western Europe. These parties back an expanded role for government, particularly in the provision of services such as health care, but do not usually propose widespread government ownership of businesses.

Suggestions for the Thinking Critically Exercise

CT2.1 It will be difficult for a group to come up with a product made entirely by only one company because few companies are completely vertically integrated—although oil companies are one example. So, this question is about specialization. The text explores this idea in the Apply the Concept, “A Story of the Market System in Action: How Do You Make an iPad?” in Section 2.3.

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

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply Brief Chapter Summary and Learning Objectives 3.1

The Demand Side of the Market List and describe the variables that influence demand. ▪

3.2

The most important factor affecting the demand for a product is its price. Other factors include income, prices of related goods, tastes, population and demographics, expected future prices, and natural disasters and pandemics.

The Supply Side of the Market List and describe the variables that influence supply. ▪

3.3

The most important factor affecting the supply for a product is its price. Other factors include prices of inputs, technological change, prices of related goods in production, the number of firms in the market, expected future prices, and natural disasters and pandemics.

Market Equilibrium: Putting Demand and Supply Together Use a graph to illustrate market equilibrium.

3.4

▪

The intersection of demand and supply curves results in an equilibrium price and an equilibrium quantity.

▪

A surplus exists when the market price is above the equilibrium price. A shortage exists when the market price is below the equilibrium price.

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

An increase in demand increases the equilibrium price and equilibrium quantity. A decrease in demand decreases the equilibrium price and equilibrium quantity.

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An increase in supply decreases equilibrium price and increases the equilibrium quantity. A decrease in supply increases equilibrium price and decreases the equilibrium quantity.

Key Terms Ceteris paribus (“all else equal”) condition The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.

of a product rises, the quantity demanded of the product will decrease.

Competitive market equilibrium A market equilibrium with many buyers and sellers.

Law of supply A rule that states that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

Complements Goods and services that are used together.

Market demand The demand by all the consumers of a given good or service.

Demand curve A curve that shows the relationship between the price of a product and the quantity of the product demanded.

Market equilibrium A situation in which quantity demanded equals quantity supplied.

Demand schedule A table that shows the relationship between the price of a product and the quantity of the product demanded. Demographics The characteristics of a population with respect to age, race, and gender. Income effect The change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant. Inferior good A good for which the demand increases as income falls and decreases as income rises. Law of demand A rule that states that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price

Natural disaster (in an economic context) refers to a hurricane, flood, or similar act of nature that causes damage to stores, factories, or office buildings.

Normal good A good for which the demand increases as income rises and decreases as income falls. Pandemic (in an economic context) is a situation in which a disease becomes sufficiently widespread as to significantly affect economic activity.

Perfectly competitive market A market that meets the conditions of having (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.

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Quantity demanded The amount of a good or service that a consumer is willing and able to purchase at a given price. Quantity supplied The amount of a good or service that a firm is willing and able to supply at a given price. Shortage A situation in which the quantity demanded is greater than the quantity supplied. Substitutes Goods and services that can be used for the same purpose. Substitution effect The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. Supply curve A curve that shows the relationship between the price of a product and the quantity of the product supplied. Supply schedule A table that shows the relationship between the price of a product and the quantity of the product supplied. Surplus A situation in which the quantity supplied is greater than the quantity demanded. Technological change A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs.

Chapter Outline A Basketball Player Takes A Tumble—And So Does Nike The manufacture of athletic shoes dates to the mid-1800s. Initially, the shoes were expensive but by the late 1800s mass production made them available at prices comparable to those of other shoes. Today, Nike has the largest market share among athletic shoe firms. But in recent years, new entrants to the industry have offered shoes made of different materials or in different styles. Athletic shoes are manufactured primarily in Asia at relatively low cost, which eases the entry of new firms into the industry. As a result, competition is intense, and firms must respond to changes in consumer tastes. Although sales of athletic shoes were strong in 2019, there are no guarantees in a market system. In 2020, the Covid-19 pandemic led to a sharp decline in sales of athletic shoes. Longer term, will athletic shoes remain popular, allowing Nike, Adidas, and their competitors to continue earning substantial profits? Although competition is not always good news for firms, it is great news for consumers because it increases choices of available products and lowers prices consumers pay for those products.

3.1

The Demand Side of the Market Learning Objective: List and describe the variables that influence demand.

A perfectly competitive market is a market that meets the conditions of having (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. For most consumers, the primary factor in their buying decisions is the price of the product. The study of demand considers not what a consumer wants to buy, but what the consumer is willing and able to buy.

Demand Schedules and Demand Curves

A demand schedule is a table that shows the relationship between the price of a product and the quantity of the product demanded. The amount of a good or service that a consumer is willing and able to purchase at a given price is called the quantity demanded. A demand curve shows the relationship between the price of a product and the quantity of the product demanded. Market demand refers to the demand by all the consumers of a given good or service.

The Law of Demand

The law of demand is a rule that states that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. The law of demand holds for any market demand curve.

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What Explains the Law of Demand?

The law of demand is explained by the substitution and income effects of a change in price. The substitution effect is the change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. The income effect is the change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant. When the price of a good falls, the increased purchasing power of consumers’ incomes will usually lead them to purchase a larger quantity of the good. The substitution and income effects happen simultaneously whenever a price changes.

Holding Everything Else Constant: The Ceteris Paribus Condition

The ceteris paribus (“all else equal”) condition is the requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. If we allowed a variable other than price to change that might affect the willingness of consumers to buy a product, consumers would change the quantity they demand at each price. We can illustrate this by shifting the market demand curve.

Variables That Shift Market Demand

Other than price, the five most important variables that affect demand are: income, prices of related goods, tastes, population and demographics, expected future prices, and natural disasters and pandemics. Table 3.1 provides a visual summary of these variables. The income that consumers have to spend affects their willingness and ability to buy a good. A normal good is a good for which the demand increases as income rises and decreases as income falls. An inferior good is a good for which the demand increases as income falls and decreases as income rises.

Substitutes are goods and services that can be used for the same purpose. A decrease in the price of a substitute causes the demand curve for a good to shift to the left. An increase in the price of a substitute causes the demand curve for a good to shift to the right. Complements are goods and services that are used together. A decrease in the price of a complement causes the demand curve for a good to shift to the right. An increase in the price of a complement causes the demand curve for a good to shift to the left. Consumers can also be influenced by an advertising campaign for a product. Economists would say that the advertising campaign has affected consumers’ taste for the product. Taste is a catchall category that refers to many subjective elements that enter into a consumer’s decision to buy a product. When consumers’ taste for a product increases, the demand curve will shift to the right, and when consumers’ taste for a product decreases, the demand curve for the product will shift to the left. Copyright © 2021 Pearson Education, Inc.

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Demographics refer to the characteristics of a population with respect to age, race, and gender. As the demographics of a country or region change, the demand for particular goods will increase or decrease because different categories of people tend to have different preferences for those goods. Expected future prices can also affect demand. For example, if consumers believe that prices of athletic shoes will be lower during the holiday season, the demand for athletic shoes will decrease in October. If many consumers become convinced that the price of athletic shoes will be higher in August, the demand for athletic shoes may increase earlier in the summer as some consumers try to beat the expected price increase.

A Change in Demand versus a Change in Quantity Demanded

A change in demand refers to a shift in a demand curve. A shift will occur if there is a change in one of the variables, other than the price of the product, that affects the willingness of consumers to buy the product. A change in quantity demanded refers to a movement along the demand curve as a result of a change in the product’s price.

Teaching Tips There is no magic formula for helping students understand the difference between a change in quantity demanded and a change in demand. This difference needs to be reinforced through classroom discussion, use of examples of these changes, and homework assignments. Even good students mistake a movement along a demand curve with an increase or a decrease in demand. One way to help students avoid this error is to explain that only one variable can cause a change in quantity demanded (price), whereas a change in any one of the non-price factors results in a change in demand.

3.2

The Supply Side of the Market Learning Objective: List and describe the variables that influence supply.

The most important of the variables that influence the willingness and ability of firms to sell a good or service is price. Quantity supplied is the amount of a good or service that a firm is willing and able to supply at a given price. Holding other variables constant, when the price of a good rises, producing the good is more profitable and the quantity supplied will increase. When the price of a good falls, the good is less profitable and the quantity supplied will decrease. Devoting more resources to the production of a good results in increasing marginal costs. With higher marginal costs, firms will supply a larger quantity only if the price is higher.

Supply Schedules and Supply Curves

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A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve is a curve that shows the relationship between the price of a product and the quantity of the product supplied.

The Law of Supply

The law of supply is a rule that states that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. If only the price of a product changes, there is a movement along the supply curve, which is an increase or decrease in the quantity supplied. If any other variable that affects the willingness of firms to supply a good changes, then the supply curve will shift; this results in an increase or decrease in supply. When firms increase the quantity of a product they wish to sell at a given price, the supply curve shifts to the right. When firms decrease the quantity of a product they wish to sell at a given price, the supply curve shifts to the left.

Variables That Shift Market Supply

The most important variables that shift market supply are: prices of inputs, technological change, prices of related goods in production, the number of firms in the market, expected future prices, and natural disasters and pandemics. Table 3.2 provides a visual summary of these variables. The factor most likely to cause a supply curve to shift is a change in the price of an input. If the price of an input rises, the supply curve will shift to the left. If the price of an input declines, the supply curve will shift to the right.

Technological change is a positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs. A positive technological change will shift a firm’s supply curve to the right; a negative technological change will shift a firm’s supply curve to the left. Substitutes in production are alternative products that a firm could produce. If the price of a substitute in production increases, the supply of the product will shift to the left. Goods that are produced together are called complements in production. An increase in the price of a product will cause the supply curve for its complement to shift to the right. When firms enter a market, the supply curve shifts to the right; when firms exit a market, the supply curve shifts to the left. If a firm expects that the price of its product will be higher in the future, the firm has an incentive to decrease supply in the present and increase supply in the future.

A Change in Supply versus a Change in Quantity Supplied

A change in supply refers to a shift in the supply curve. The supply curve will shift when there is a change in one of the variables, other than the price of the product, that affects the willingness of suppliers to sell the product. A change in quantity supplied refers to a movement along the supply curve as a result of a change in the product’s price. Copyright © 2021 Pearson Education, Inc.

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Teaching Tips Be careful not to refer to an increase in supply as a downward shift or a decrease in supply as an upward shift. An increase in supply should be referred to as a shift to the right and a decrease in supply should be referred to as a shift to the left. Because demand curves are downward sloping, an increase in demand appears in a graph as an upward shift. Students will associate “upward” with “increase.” Little harm is done with respect to demand curves, but because supply curves are upward sloping, a decrease in supply appears in a graph as an upward shift. Referring to both changes in demand and supply as shifts to the right and shifts to the left will help to avoid confusion.

3.3

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

The interaction of buyers and sellers in markets results in firms producing goods and services most desired by consumers. Market equilibrium is a situation in which quantity demanded equals quantity supplied. A competitive market equilibrium is a market equilibrium with many buyers and sellers.

How Markets Eliminate Surpluses and Shortages

A surplus is a situation in which the quantity supplied is greater than the quantity demanded. When there is a surplus, firms have unsold goods piling up, which gives them an incentive to increase their sales by cutting the price. Cutting the price simultaneously increases the quantity demanded and decreases the quantity supplied. A shortage is a situation in which the quantity demanded is greater than the quantity supplied. When a shortage occurs, some consumers will be unable to obtain the product, and firms will realize they can raise the price without losing sales. A higher price will simultaneously increase the quantity supplied and decrease the quantity demanded. At a competitive market equilibrium, all consumers willing to pay the market price will be able to buy as much as they want, and all firms willing to accept the market price will be able to sell as much of the product as they want.

Demand and Supply Both Count

Neither consumers nor firms can dictate what the equilibrium price will be. No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.

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The Effect of Demand and Supply Shifts on Equilibrium 3.4

Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

The Effect of Shifts in Demand on Equilibrium

For a normal good, an increase in income will shift the market demand curve to the right, causing a shortage at the original equilibrium price. To eliminate the shortage, the equilibrium price and quantity rise. If the price of a substitute good were to fall, the demand for the good would decrease. This change would cause the demand curve to shift to the left, and both the equilibrium price and quantity would decrease.

The Effect of Shifts in Supply on Equilibrium

When the market supply curve shifts to the right, there will be a surplus at the original equilibrium price. The surplus is eliminated as the price falls to the new equilibrium and the quantity rises to a new equilibrium. If an existing firm exits the market, the supply curve will shift to the left, causing the equilibrium price to rise and the equilibrium quantity to fall.

The Effect of Shifts in Demand and Supply over Time

If both the demand and supply curves increase, whether the equilibrium price in a market rises or falls over time depends on whether demand shifts to the right more than supply does. When demand shifts more than supply, the equilibrium price rises. When supply shifts to the right more than demand, the equilibrium price falls.

Extra Solved Problem 3.4 Falling Demand for Housing and Rising Housing Prices? In early May 2020, as the coronavirus pandemic continued to affect the United States, an article in the Wall Street Journal quoted an economist at Zillow, a real estate data site, as stating that: ―Demand [for housing] absolutely just got a kick in the gut.‖ But the same article noted that: ―The median home price rose 8% year-over-year.‖ What explains this outcome? If the demand for a product declines, doesn’t the price always fall? Use a demand and supply graph showing the market for housing to illustrate your answer. Solving the Problem Step 1: Review the chapter material. This problem is about how shifts in demand and supply curves affect the equilibrium price, so you might want to review the section ―The Effect of Shifts in Demand and Supply over Time.‖ Copyright © 2021 Pearson Education, Inc.

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Step 2: Answer the question using demand and supply analysis. If the demand for housing had declined, shifting the demand curve for housing to the left, and the supply of housing had remained unchanged, the price of housing would definitely have fallen. The only way that the price of housing could have risen at the same time that demand for housing was falling was for the supply of housing to have also fallen, shifting the supply curve for housing to left. Your graph illustrating this outcome should look like this:

The housing market is initially in equilibrium at point A with price equal to P1 and quantity equal to Q1. The demand curve for housing then shifts to the left from D1 to D2, while the supply curve for housing shifts to the left from S1 to S2. If the demand curve and supply curve both shift to the left, the equilibrium quantity must decrease, but the equilibrium price may increase, decrease, or remain unchanged depending on whether the demand curve or the supply curve shifted further to the left. (See Table 3.3 in the Hubbard/O’Brien book) In this case, we have been told that the price of housing increased, so on the graph we show the new equilibrium in the housing market at point B with price rising from P1 to P2 and quantity declining from Q1 to Q2. For this result to hold, we know that while the demand for housing declined, the supply of housing must have declined even more. In fact, the Wall Street Journal article makes this point: ―While buyer demand has softened … the supply of homes on the market is contracting even faster.‖ The supply declined because many people were under government stay-at-home orders and weren’t in a position to put their homes up for sale. Source: Nicole Friedman, ―Why Home Prices Are Rising During the Pandemic,‖ Wall Street Journal, May 5, 2020.

Shifts in a Curve versus Movements along a Curve

When a shift in a demand curve or a supply curve causes a change in equilibrium price, the change in price does not cause a further change in demand or supply.

Teaching Tips Encourage your students to study Table 3.3, which summarizes all combinations of shifts in demand and supply over time and the effects of these shifts on price and quantity.

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Extra Solved Problem 3.4 Can We Predict Changes in the Price and Quantity of Organic Corn? A news article discussed how U.S. consumers have been increasing their demand for organically grown corn and other produce, which is grown using only certain government-approved pesticides and fertilizers. At the same time, imports of corn and other varieties of organic produce from foreign countries have increased the available supply.

Use demand and supply graphs to illustrate your answers to the following questions. a.

Can we use this information to be certain whether the equilibrium quantity of organically grown corn will increase or decrease? Illustrate your answer with a graph showing the market for organically grown corn.

Can we use this information to be certain whether the equilibrium price of organically grown corn will increase or decrease? Illustrate your answer with a graph showing the market for organically grown corn.

Solving the Problem Step 1:

Review the chapter material. This problem is about how shifts in demand and supply curves affect the equilibrium price, so you may want to review the section “The Effect of Shifts in Demand and Supply over Time.”

Step 2:

Answer part (a) using demand and supply analysis. The problem gives you information that consumer tastes have changed, leading to an increase in the demand for organically grown corn. So, the demand curve has shifted to the right. The problem also gives you the information that imports of organically grown corn have increased. So, the supply curve has also shifted to the right. The following graph shows both of these shifts.

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As Table 3.3 summarizes, if the demand curve and the supply curve both shift to the right, the equilibrium quantity must increase. Therefore, we can answer part (a) by stating that we are certain that the equilibrium quantity of organically grown corn will increase. Step 3:

Answer part (b) using demand and supply analysis. The graph we drew in step 2 shows the equilibrium price of organically grown corn increasing. But given the information provided, the following graph would also be correct.

Unlike the graph in step 2, which shows the equilibrium price increasing, the second graph shows the equilibrium price decreasing. The uncertainty about whether the equilibrium price will increase or decrease is consistent with what Table 3.3 indicates happens when the demand curve and the supply

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curve both shift to the right. Therefore, the answer to part (b) is that we cannot be certain whether the equilibrium price of organically grown corn will increase or decrease.

Extra Credit: During 2016, the equilibrium quantity of organically grown corn increased, while the equilibrium price decreased by 30 percent. We can conclude that both the increase in demand for organically grown corn and the increase in the supply contributed to the increase in consumption of organically grown corn. That the price of organically grown corn fell indicates that the increase in supply had a larger effect on equilibrium in the organically grown corn market than did the increase in demand.

Sources: Jacob Bunge, “Organic Food Sales Are Booming; Why Are American Farmers Crying Foul?” Wall Street Journal, February 21, 2017; and U.S. Department of Agriculture data.

Extra Apply the Lower Demand for Orange Juice-But Higher Prices? Concept

For many years, Florida orange growers used the advertising slogan “A morning without orange juice is like a day without sunshine.” And many Americans agreed, regularly drinking a glass of orange juice with their breakfast. In recent years, though, many consumers have replaced orange juice in their diets with bottled water, tea, coffee, smoothies, or energy drinks. Although assessments of the nutritional value of orange juice vary, some consumers have decided to switch to beverages with fewer calories and less sugar. Between 2011 and 2016, sales of orange juice in the United States declined by more than 15 percent. A 2017 Wall Street Journal article quoted an analyst at Deutsche Bank as saying, “People are shifting to low-calorie, natural products.”

Ordinarily, when demand for a product is falling, consumers who continue to buy it will pay a lower price. This outcome results from the demand curve shifting to the left, which causes a lower equilibrium price—provided that the supply curve doesn’t shift. In fact, though, in recent years the supply curve for orange juice has shifted to the left, largely because of problems in growing oranges in Brazil and the United States, the two leading orange growing countries. Orange groves in both Brazil and Florida had been suffering from an incurable disease called citrus greening, which causes oranges to shrivel and to produce bitter fruit. During the 2016–2017 growing season, Florida produced fewer oranges than in any year since the 1960s. Copyright © 2021 Pearson Education, Inc.

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The following figure shows the market for orange juice. Because of a change in consumer tastes, the demand curve has shifted to the left. Because of citrus greening reducing the orange crops in Brazil and Florida, the supply curve has also shifted to the left. In early 2017, a 64-ounce bottle of orange juice was selling for about $4.00, up from about $3.25 two years earlier. At the same time, total U.S. consumption of orange juice had fallen from the equivalent of 371 million bottles in 2015 to 338 million bottles in 2017.

In recent years, the orange juice market has experienced decreases in both demand and supply. If the decrease in demand had been larger than the decrease in supply, we would have seen the price of orange juice decline. Because the price of orange juice has actually increased, we know the decrease in supply must have been larger than the decrease in demand. (To convince yourself of this last point, try drawing another version of the figure in which the demand and supply curves both shift to the left, but the equilibrium price decreases.)

Sources: Ellen Byron, “Last on the Shelf: How Products Dwindle Out of Favor,” Wall Street Journal, January 10, 2017; Hayley Peterson, “Orange Juice Is Being Called a Massive Scam—And Now It’s Disappearing from Breakfast in America,” businessinsider.com, October 13, 2016; Fabiana Batista, “Too Much Water Is Diluting Juice from World’s No. 1 Orange Crop,” bloomberg.com, February 13, 2017; Arian Campo-Flores, “Florida Orange Production Forecast Lowered to 70 Million Boxes,” Wall Street Journal, February 10, 2017; and data from the U.S. Department of Agriculture.

Extra Economics in Your Life & Career

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Following devastating hurricanes that hit Texas, Florida, and Puerto Rico in 2017 Donald Boudreaux, a professor of economics at George Mason University, argued that high prices for water, gasoline, and airline fares would aid in the recovery from such disasters and criticized politicians who called for capping prices of essentials items to protect consumers from “price gouging” by sellers: …high prices are an essential way to ensure that resources get where they are desperately needed. Imposing artificially low prices creates shortages of vital supplies and makes it harder for people to recover from disasters. Question: Why would measures to prevent prices from rising in the aftermath of a hurricane make it more difficult for people to recover from the hurricane? Answer: Price increases for vital goods and services that follow natural disasters are the result of increased scarcity, rather than the actions of greedy producers. Donald Boudreaux explained “Price hikes prompt consumers to use fuel more judiciously…diminishing pressure on supplies… *and+ create a financial incentive for suppliers to move their product from outside the area to…high-demand zones. As supplies return to normal, so do prices.” Although people suffer significant hardships from hurricanes and other natural disasters, well-intentioned measures to protect consumers from paying higher prices may have the unintended result of making recovery from the disasters more difficult. Source: Donald J. Boudreaux, “‘Price Gouging’ After a Disaster Is Good for the Public,” Wall Street Journal, October 4, 2017.

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Solutions to End-of-Chapter Exercises Answers to Thinking Critically Questions to accompany the Inside Look newspaper feature 1. Reebok’s market is highly competitive. Adopting 3D printing technology to use in the production of its shoes is a way for Reebok to differentiate its products from competitors such as Nike, Adidas, and New Balance and to gain a competitive edge. As the Inside Look article states, both Nike and New Balance use 3D printing technology to produce shoes, which indicates the competitiveness of the athletic shoe industry and how important it is for managers to implement new technologies. 2. The improvement in technology will result in an increase in supply, shifting the supply curve to the right (from S1 to S2), which decreases equilibrium price and increases equilibrium quantity. The increase in consumers’ taste for these shoes will result in an increase in demand, shifting the demand curve to the right (from D1 to D2), which increases equilibrium price and increases equilibrium quantity. Because both shifts increase equilibrium quantity, equilibrium quantity will definitely increase. The shift in the supply curve, if demand curve were unchanged, would decrease equilibrium price. The shift in the demand curve, if the supply curve were unchanged, would increase equilibrium price. Therefore, the actual equilibrium price may increase, decrease, or remain unchanged. The result will depend on the magnitude of the shifts. The following figure illustrates an equilibrium price that has remained unchanged.

3.1

The Demand Side of the Market Learning Objective: List and describe the variables that influence demand.

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Review Questions 1.1

A demand schedule is a table showing the relationship between the price of a product and the quantity of the product demanded. A demand curve is a curve that shows the relationship between the price of a product and the quantity of the product demanded.

1.2

Ceteris paribus means “all else equal”—that is, holding everything else constant when examining the relationship between two variables.

1.3

A “change in demand” refers to a shift of a demand curve, while a “change in quantity demanded” refers to a movement along a demand curve as a result of a change in a product’s price.

1.4

The law of demand states that, holding all else constant, when the price of a product falls, the quantity demanded of the product will increase (and when the price of a product rises, the quantity demanded of the product will decrease). An increase in the price of a product raises the price of the product relative to other products, causing consumers to substitute away from the higher-priced product. The increase in the price of the product also causes a decrease in the real incomes of consumers and, assuming that the product is a normal good, leads consumers to buy less of the product.

1.5

The main variables that cause a demand curve to shift are: (1) changes in income—with the effect differing depending on whether the product is a normal good or an inferior good; (2) changes in the prices of a related good—a substitute or a complement; (3) changes in tastes; (4) changes in population or demographics; (5) changes in expected future prices; and (6) natural disasters and pandemics. The following table gives an example of how a change in each of these variables affects the demand curve. Variable causing the demand curve to shift

An example

1. Change in income

As consumers’ incomes rise, the demand curve for a normal good, like Nike athletic shoes, shifts to the right and the demand curve for an inferior good, like a store-branded athletic shoe, shifts to the left.

2. Changes in the price of a related good

As the price of Nike athletic shoes rises, the demand curve for Adidas athletic shoes, a substitute good, shifts to the right. As the price of hot dogs rises, the demand curve for hot dog buns, a complementary good, shifts to the left.

3. Changes in tastes

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health benefits of organic food, the demand curve for organic produce shifts to the right. 4. Changes in population or demographics

As the number of people over the age of 65 increases, the demand curve for health care services will shift to the right.

5. Changes in expected future prices

If consumers expect the prices of electric automobiles to decline in the future, the demand curve for electric automobiles will shift to the left.

6. Natural disasters and pandemics

The demand curves for most goods will shift to the left, although the demand curves for some goods, such as bottled water, may shift to the right.

Problems and Applications 1.6

a. Gary Becker is using the ceteris paribus condition when analyzing the demand for butter. Economists refer to the necessity of holding all variables other than price constant in constructing a demand curve as the ceteris paribus condition. Ceteris paribus means “all else equal” in Latin. By using this approach to analyzing the demand for butter, Gary Becker focuses on only the effects of a change in the price of butter on the quantity of butter demanded, holding all other variables, such as income, the price of margarine, and consumer preferences constant. b. The analysis of the demand for butter neglects thousands of other variables because these variables have only a very small effect on the demand for butter. As we discussed in Chapter 1, Section 1.3, economic models like the model of demand and supply are simplified versions of reality. In the model of demand and supply, we focus on the variables that are the most important in determining the demand for a product: income, price of substitutes and complements, taste for the good, population, the expected future price, and natural disasters and pandemics.

1.7

a. Substitutes, because both new cars and used cars serve the purpose of providing transportation. b. Complements, because when buying a house, many people will also buy a washing machine. c. Substitutes, because both are used as footwear. d. Unrelated, because they serve different purposes; neither good is a substitute for or a complement to the other good.

1.8

a. If many book readers consider print books and digital books to be substitutes, then an increase in the price of digital books will increase the demand for print books, shifting the demand curve for print books to the right. Copyright © 2021 Pearson Education, Inc.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes b. The findings of Nagaraj and Reimers show that digital and print copies of books are complements because the decrease in the price of digital books to zero is causing an increase in the quantity demanded for print copies of the same books. One possible reason for this observation is that as more books become available as free downloads, readers of these books recommend them to other readers, causing an increase in the demand for both the print and the digital versions of the books, particularly among readers who prefer to read a physical book. Less popular books might have no longer been widely known to readers before they became available as digital books. The increasing visibility of these books might have made it particularly likely that readers would buy physical copies.

1.9

No. Greg David’s statement is incorrect. An increase in the price of a product will cause a decrease in the quantity demanded of the product. It will not cause a decrease in the demand for the product. A decrease in demand for a product occurs only if a variable other than the price of the product changes.

1.10

a. Increasing confidence about future household incomes will cause a shift in the demand curve because the variable that changed was consumer confidence and not the price of the good. The demand curve would shift to the right because at every price of RVs, the quantity of RVs demanded would increase. b. The availability of low-interest loans will cause a movement down the demand curve for RVs because when consumers are able to borrow at a lower interest rate, the monthly payment they need to make to own an RV will decrease. c. Falling gasoline prices will cause a shift in the demand curve because the variable that changed was the price of a complement. The demand curve would shift to the right because for the same price of RVs, the quantity of RVs demanded would increase as gasoline prices fall. The total cost to a household of operating an RV has declined, making an RV a more desirable purchase. d. The glamping (or “glamorous camping”) trend will cause a shift in the demand curve because the variable that changed was not the price of the good. The demand curve would shift to the right because for the same price of RVs, the quantity of RVs demanded would increase as more households buy RVs and go glamping.

1.11

The demand for UGG boots decreased from 2021 to 2022, which could be caused by several factors, including: (1) a decrease in the price of leather boots, which are a substitute good (UGG boots are sheepskin boots); (2) a decrease in household incomes, assuming UGG boots are normal goods; or (3) a decrease in the taste (preference) for UGG boots as a result of a campaign by animal rights activists against using sheepskin to make boots.

1.12

A movement along the demand curve from point A to point B would be caused by a decrease in the price of traditional wings at Buffalo Wild Wings. The following are examples of factors that would cause a shift to the right of the demand curve from point A to point C: (1) an increase in the price of pizza or steak (substitutes for wings); (2) an increase in household incomes Copyright © 2021 Pearson Education, Inc.

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(assuming wings at Buffalo Wild Wings are normal goods); or (3) an increase in the taste (preference) for wings at Buffalo Wild Wings as a result of a successful advertising campaign. 1.13

As more and better free content becomes available on the Internet, the willingness of some consumers to pay for a cable television subscription has declined. Therefore, a decline in the number of cable TV subscriptions is most likely due to a decrease in the demand for cable TV, which we can represent as a shift in the demand curve for cable television to the left. To be certain that we are observing a decrease in demand, rather than a decrease in the quantity demanded, we would have to have information on changes (if any) in the price of cable television subscriptions.

1.14

Answers may vary, especially for the three goods chosen. China’s one-child policy, which is no longer in effect, increased the relative demand for goods and services consumed by the population over age 14 and increased the relative demand for goods and services consumed by boys relative to girls. The demand for children’s toys, children’s books, children’s clothing all decreased as there were fewer children age 14 and under. The demand for male clothing increased relative to the demand for female clothing.

1.15

a. The falling sales of traditional cans of tuna are the result of a shift in the demand curve for canned tuna to the left. We can reach this conclusion because the variable identified as the cause of the falling sales is the change in preferences of millennial and generation Z consumers. b. Firms would prefer fact (ii) more than fact (i) because it is easier for the traditional canned tuna producers to change their marketing strategy and also offer their tuna in pouches and trendy flavors than it is to change the minds of millennial and generation Z consumers about the desirability of eating tuna.

1.16

a. No, we cannot assume the demand curve is upward sloping. It’s much more likely that during 2018 there was an increase in demand for visits to the Metropolitan Museum of Art (Met). If the price of tickets had increased without an increase in demand, attendance would have fallen rather than increase. b. Yes, this additional information helps answer the question in part (a). The increase in the number of tourists increased the number of potential visitors to the Met. The great reviews of some of the exhibitions likely increased the desire of both tourists and New York City residents to visit the Met.

1.17 As a forecaster working for Allbirds, you should be concerned about points (a) and (b) because both limit the size of the market. On the one hand, very few people are celebrities, venture capitalists, or employees in technology startups. In addition, those groups might abandon the brand as tastes change. On the other hand, increased everyday comfort brought from the shoes may increase the demand for the shoes, causing an increase in sales.

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3.2

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The Supply Side of the Market Learning Objective: List and describe the variables that influence supply.

Review Questions 2.1

2.2.

A “change in supply” refers to a shift of the supply curve, while a “change in quantity supplied” refers to a movement along the supply curve as a result of a change in the product’s price.

2.3

The law of supply states that, holding everything else constant, an increase in price causes an increase in the quantity supplied (and a decrease in price causes a decrease in the quantity supplied). The main variables that cause a supply curve to shift are: (1) changes in the prices of inputs used to make the product; (2) technological change; (3) changes in the prices of related goods — substitutes or complements in production; (4) changes in expected future prices; (5) changes in the number of firms; and (6) natural disasters and pandemics. The following table gives an example of how a change in each of these variables affects the supply curve. Variable causing the supply curve to shift

An example

1. Changes in the prices of inputs used to make the product

If the price of electric batteries declines, the cost of producing electric cars will decrease, shifting the supply curve to the right.

2. Technological change

If there is positive technological change in producing smartphones, the cost of producing smartphones will decrease, and the supply curve will shift to the right.

3. Changes in the prices of a related good

If the price of 4K TVs increases, the supply curve for LED TVs, which are a substitute in production, will shift to the left. If the price of beef increases, the supply curve for leather, which is a complement in production, will shift to the right.

4. Changes in expected future prices

If firms believe that the price of copper will increase in the future, the supply curve for copper

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will shift to the left. 5. Changes in the number of firms.

As more firms enter the athletic shoe market, the supply curve for those shoes will shift to the right.

6. Natural disasters and pandemics.

During a disaster or pandemic, some buildings may be damaged and government distancing restrictions may keep some businesses from remaining open. The supply curve for the affected businesses will shift to the left.

Problems and Applications 2.4

a. Change in quantity supplied: The price increased so the quantity supplied increases, causing a movement up the supply curve. b. Change in supply: The number of firms in the market increased, so supply increases, causing the supply curve to shift to the right. c. Change in supply: The earthquake caused a negative technological change, so supply decreases, causing the supply curve to shift to the left.

2.5

a. Yes. A higher price of oil causes an increase in the quantity of oil supplied, which we show by a movement upwards along the supply curve for oil. b. Yes. The supply curve for oil may have shifted to the right, which is consistent with the quantity of oil supplied increasing. We know that expected future prices affect the supply curve. So, if suppliers expect the price of oil to decrease in the future, they will be more likely to increase the quantity of oil they supply today when prices are higher. Therefore, the fact that suppliers expect that oil prices will be lower in the future increases our confidence that the supply curve for oil has shifted to the right.

2.6

A movement along the supply curve from point A to point B would be caused by an increase in the price of traditional wings at Buffalo Wild Wings. A shift to the right of the supply curve from point A to point C could be caused by, for example, a decrease in the price of feed for chickens, a positive technological change in producing chicken wings, or an increase in the number restaurants that sell chicken wings.

2.7

The supply of UGG boots decreased from 2021 to 2022. The decrease in supply could be caused by, for example, an increase in the price of sheepskin (UGG boots are sheepskin boots), an increase in the price of the machines used to assemble the boots, or an increase in the price of other types of boots that UGG could produce.

2.8

a. A negative 25-cent price means that the seller has to pay the buyer 25 cents so that the buyer agrees to receive the product.

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CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes b. Firms continue to produce natural gas because it is a byproduct of producing oil. When firms operate an oil drill, natural gas is typically recovered along with the oil. So long as oil is profitable enough to cover the price of disposing of the natural gas, the firms will continue to produce it.

2.9

3.3

When cheese producers stored cheese in warehouses rather than offering it for sale, they decreased the supply of cheese. We can show this on a graph by shifting the supply curve for cheese to the left from S1 to S2, indicating that cheese producers were supplying a smaller quantity of cheese at each price.

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

Review Questions 3.1

Market equilibrium is the situation in which the quantity demanded equals the quantity supplied.

3.2

A shortage is a situation in which, at the current price, the quantity demanded is greater than the quantity supplied. A surplus is a situation in which, at the current price, the quantity demanded is less than the quantity supplied.

3.3

If the current price is above equilibrium, the quantity supplied will be greater than the quantity demanded, and there will be a surplus. A surplus causes the market price to fall toward Copyright © 2021 Pearson Education, Inc.

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equilibrium. If the current price is below equilibrium, the quantity demanded will be greater than the quantity supplied, and there will be a shortage. A shortage causes the market price to rise toward equilibrium.

Problems and Applications 3.4

You should disagree. The demand curve will not shift as a result of a shortage. If there is a shortage, firms will raise the prices they charge. The quantity supplied will increase, the quantity demanded will decrease, and equilibrium will be reached at a higher market price.

3.5

Begin by drawing two demand curves. Label one curve “Demand for diamonds” and the other curve “Demand for water.” Make sure that the water demand curve is much farther to the right than the diamond demand curve. Based on the demand curves you have just drawn, think about how it might be possible for the market price of water to be much lower than the market price for diamonds. The only way this result can occur is if the supply of water is much greater than the supply of diamonds. Draw on your graph a supply curve for water and a supply curve for diamonds that will result in an equilibrium price of diamonds that is much higher than the equilibrium price of water.

3.6

Begin by drawing two supply curves. Label one curve “Supply of Mantle autographs” and the other curve “Supply of Ford autographs.” Make sure that the Mantle supply curve is much farther to the right than the Ford supply curve. Based on the supply curves you have just drawn, think about how it might be possible for the market price of Ford autographs to be lower than the market price for Mantle autographs. The only way this can be true is if the demand for Mantle autographs is much greater than the demand for Ford autographs. Draw on your graph a demand curve for Mantle autographs and a demand curve for Ford autographs that will result in an equilibrium price of Mantle autographs that is higher than the equilibrium price of Ford autographs.

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3.7

The decrease in the price of pine lumber from $45 per ton to $14 per ton despite higher demand for lumber is caused by a much larger increase in the supply of pine lumber. In the following graph, the supply curve shifted from Supply, S1 to S2 at the same time that the demand shifted from Demand, D1 to D2. The price fell from $45 per ton to $14 per ton because the increase in supply was much larger than the increase in demand.

3.8

No. Equilibrium in a market only means that consumers who are willing to pay the equilibrium price are able to purchase the good, and sellers who are willing to accept the equilibrium price are able to sell the good. Consumers would have been happier paying less. And there are likely to be consumers who want the good but are not willing (or able) to pay the market price. Similarly, sellers would be happier to receive a higher price than the equilibrium price, and there may be sellers who are only willing to sell at a higher price and, therefore, do not participate in the market. Copyright © 2021 Pearson Education, Inc.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes xxvii 3.9

a. A glut is another term for a surplus. When a market experiences a glut, the quantity supplied exceeds the quantity demanded at the current price. b. The glut in the market will result in the decline in the equilibrium price of office space in this market. The lower rental price of office space will result in greater opportunities for office tenants. c. We expect that surpluses in a market will eventually disappear. In this situation, the rental price of offices will fall until the quantity of offices supplied equals the quantity of offices demanded, eliminating the glut.

The Effect of Demand and Supply Shifts on Equilibrium 3.4

Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

Review Questions 4.1

When the demand curve shifts to the right, the equilibrium price and equilibrium quantity both rise. The following graph on the left illustrates this case. When the supply curve shifts to the left, the equilibrium price rises, but the equilibrium quantity falls. The following graph on the right illustrates this case.

4.2

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

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

Problems and Applications 4.3

a. As stated in the Chapter Opener: “…there are no guarantees in a market system.” Even over short time periods, it is difficult to anticipate the effect that changes in consumer tastes, along with other factors, will have on the demand for athletic shoes. But the main reason for the decline in sales of athletic shoes and many other consumer products was the forced shutdown of the U.S. economy because of the Covid-19 pandemic. In 2019, it would have been extremely difficult, if not impossible, for forecasters to have anticipated the pandemic and its effect on the U.S. economy in 2020. It is important for businesses to forecast future sales of their products so that they can make plans to invest in inventories, buildings, and equipment and to know how many workers to hire. But business owners and managers know that economic forecasts, as well as forecasts of non-business events, are uncertain. b. You should agree with the statement. The increase in demand for athletic shoes causes the demand curve to shift to the right. By itself—without a shift in the supply curve for athletic shoes—the shift in the demand curve would result in an increase in the equilibrium price. But an increase in the number of firms producing athletic shoes results in an increase in supply—the supply curve will shift to the right. By itself—without a shift in the demand curve for athletic shoes—the shift in the supply curve would result in a decrease in the equilibrium price. The relative sizes of the shifts in the demand curve and the supply curve will determine whether the equilibrium price increases or decreases. The following two graphs illustrate this uncertainty. In the graph on the left, the increase in demand from D1 to D2 is larger than the increase in supply from S1 to S2, which results in an increase in the equilibrium price from P1 to P2. In the graph on the right, the increase in demand from D1 to D2 is smaller than the increase in supply from S1 to S2, which results in a decrease in the equilibrium price from P1 to P2.

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4.4

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a. Products such as phone grips and smartphones are complements because people who buy a smartphone may also buy a phone grip to help reduce the likelihood of dropping the phone. A smartphone case is another example of a complement to a smartphone because it helps protect the phone. b. Refer to the following figure. According to the law of demand, a decrease in the price of smartphones will result in an increase in the quantity of smartphones demanded. This increased quantity of smartphones will in turn cause an increase in the demand for phone grips from D1 to D2. The higher demand for smartphone grips will cause an increase in the equilibrium price of phone grips from P1 to P2 and an increase in the equilibrium quantity of phone grips from Q1 to Q2.

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4.5

Refer to the following figure. The increase in the supply of used cars will shift the supply curve to the right from S1 to S2. At the same time, the increase in the price of new cars, which are a substitute good for used cars, will shift the demand curve to the right from D1 to D2. Because both the demand curve and the supply curve are shifting to the right, we know that the equilibrium quantity will definitely increase. But we can’t be sure whether the equilibrium price of used cars will increase or decrease. If the demand curve for used cars shifts more than the supply curve, the equilibrium price of used cars will increase. If the supply curve for used cars shifts more than the demand curve, the equilibrium price of used cars will decrease. The following figure shows the supply curve shifting more than the demand curve, so the equilibrium price decreases.

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a. Yes. The decrease in the demand coupled with an increase in supply will result in a decrease in the price of coconut oil. This conclusion is illustrated in the following two graphs. The equilibrium price decreased in both graphs, regardless on whether the decrease in demand is larger than the increase in supply (refer on the graph on the left) or smaller (refer to the graph on the right). b. No. The decrease in demand coupled with an increase in the supply of coconut oil can result in an increase or a decrease in the equilibrium quantity, depending on whether demand or supply shifted the most. In the following graph on the left, the decrease in demand is larger than the increase in supply, so the equilibrium quantity decreases. In the graph on the right, the decrease in demand is smaller than the increase in supply, so the equilibrium quantity increases.

xxxii CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes 4.7

Draw a demand and supply graph for watermelon with two demand curves and two supply curves. Label the demand curves “Demand in winter” and “Demand in summer.” Label the supply curves “Supply in winter” and “Supply in summer.” Be sure that the winter supply curve is to the left of the summer supply curve and the summer demand curve lies to the right of the winter demand curve. Look at the following graph to see how the equilibrium price in the summer could be lower than the equilibrium price you have established for the winter. The only way for this to happen is for the summer supply curve to shift to the right by enough to cause the equilibrium price to be lower in the summer than it is in the winter despite the increase in demand. The demand for watermelon does increase in the summer compared with the winter, but the increase in the supply of watermelons in the summer is even greater, so the equilibrium price falls.

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Draw a demand and supply graph showing the market equilibrium before Labor Day. Label both the demand and supply curves “Before Labor Day,” and label the resulting equilibrium price PBefore Labor Day. Add to your graph the demand curve for “After Labor Day,” making sure it is to the left of the “Before Labor Day” demand curve, as the vacationers have gone home. Add to your graph the supply curve for “After Labor Day,” making sure it is to the right of the “Before Labor Day” curve because fishing conditions are good. Because the demand curve has shifted to the left and the supply curve has shifted to the right (or perhaps stayed the same, if the good fishing conditions are a continuation from the summer conditions), the equilibrium price will definitely decrease in the fall.

4.9

If the demand for homes increased and the supply did not change, both prices and sales would have increased. If the supply of homes increased and demand did not change, prices would have decreased and sales would have increased. Although it is possible that only the supply curve shifted, both curves could have shifted to the right, but we know that supply must have shifted more than demand because the price of homes declined. We illustrate this situation in the following graph.

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4.10

a. The apple producer was assuming that apples and bananas are substitutes. The lower priced bananas would lead people to substitute away from buying apples and toward buying bananas. b. In the following two graphs, the one on the left shows that the tariff on imported bananas shifts the supply curve for bananas to the left from SNo tariff to STariff, increasing the equilibrium price of bananas from P1 to P2 and decreasing the equilibrium quantity from Q1 to Q2. The graph on the right, drawn under the assumption that apples and bananas are substitute goods, shows that the higher price of bananas shifts the demand curve for apples to the right from D1 to D2, which increases the equilibrium price of apples from P1 to P2 and increases the equilibrium quantity from Q1 to Q2.

4.11

a. This scenario can account for the price and quantity of organic milk both falling. A decrease in demand and an increase in supply will both push the price lower. The decline in demand will push the quantity lower, but the increase in supply will push the quantity higher. If the decrease in demand is large enough relative to the increase in supply, the equilibrium quantity will decrease. b. This scenario can’t account for the outcome of the price and the quantity of organic milk both falling because an increase in demand and a decrease in supply will both push the price of organic milk higher. c. This scenario can’t account for the outcome of the price and the quantity of organic milk both falling because an increase in demand and supply will both push the quantity of organic milk higher. d. This scenario can account for the price and quantity of organic milk both falling. A decrease in demand and supply will both push the quantity lower. The decrease in demand will push Copyright © 2021 Pearson Education, Inc.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes xxxv the price lower, but the decrease in supply will push the price higher. If the decrease in demand is large enough relative to the decrease in supply, the equilibrium price will decrease. 4.12

a. This scenario can account for the quantity of coast-to-coast flights increasing at the same time that the price was decreasing. A decrease in demand and an increase in supply will both push the price lower. The decrease in demand will push the quantity lower, but the increase in supply will push the quantity higher. If the increase in supply is large enough relative to the decrease in demand, the equilibrium quantity will increase. b. This scenario can’t account for the quantity of coast-to-coast flights increasing at the same time that the price was decreasing because an increase in demand and a decrease in supply will both push the price higher. c. This scenario can account for the quantity of coast-to-coast flights increasing at the same time that the price was decreasing. An increase in demand and an increase in supply will both push the equilibrium quantity higher. The increase in demand will push the price higher, but the increase in supply will push the price lower. If the increase in supply is large enough relative to the increase in demand, the equilibrium price will decrease. d. This scenario can’t account for the quantity of coast-to-coast flights increasing at the same time that the price was decreasing because a decrease in demand and a decrease in supply will both push the quantity lower.

4.13

With the equilibrium price increasing and the equilibrium quantity decreasing, we know that the supply curve definitely shifted to the left from 2020 to 2021. It is possible that the demand curve also shifted. But if the demand curve had shifted to the right by more than the supply curve shifted to the left, then the equilibrium quantity would have increased rather than decreased. Similarly, if the demand curve had shifted to the left by more than the supply curve shifted to the left, then the equilibrium price would have decreased rather than increased. We can conclude that the supply curve must have shifted by more than the demand curve.

4.14

The student’s reasoning is incorrect. He should have said: “Increased production shifts the supply curve to the right and leads to a lower equilibrium price, but a higher equilibrium quantity, and therefore a larger quantity demanded. The increase in quantity demanded is a result of a supply curve shifting to the right and a movement along the demand curve, but the demand curve does not shift.

4.15

The student’s analysis is incorrect—the shift from D1 to D2 will not happen. (The following graph represents the student’s analysis.) There will be a movement along the demand curve, D1, due to the price change, but the demand curve will not shift. Recall that a shift in the supply curve causes a change in equilibrium price, but the change in price does not cause a further shift in demand. The whole effect of the decline in price on consumers’ willingness to buy premium bottled water is captured by the movement down the original demand curve, D1. For the

xxxvi CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes demand curve to shift, some factor, other than price, that affects consumers’ willingness to buy premium bottled water would have to change.

4.16

a. Scenario a. is shown in Graph 1. The demand for premium bottled water rises because a decrease in the supply of sports drinks will increase the price of sports drinks, which are substitutes for premium bottled water. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. b. Scenario b. is shown in Graph 4. The demand for premium bottled water falls when household incomes fall assuming premium bottled water is a normal good. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. c. Scenario c. is shown in Graph 3. An improvement in bottling technology reduces the cost of producing premium bottled water and shifts the supply curve for premium bottled water to the right. d. Scenario d. is shown in Graph 2. A rise in an input’s price, such as electrolytes, shifts the supply curve for premium bottled water to the left. Graph 1

Graph 2

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Graph 3

Graph 4

4.17

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

4.18

The graph with the demand curve shifting to the right, from D1 to D2, best represents the market for hotel rooms at a ski resort during the peak season of the winter months. If hotel rates stayed at their summer level of P1, there would be a shortage of hotel rooms during the winter months.

xxxviii CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes 4.19

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

Suggestions for the Thinking Critically Exercises

CT3.1 Students often have more difficulty with supply because they’re generally on the demand side of most markets. By working together, they will see this point and better understand supply curves as they talk to each other and describe what they find most difficult.

CT3.2 The order in which the three changes occur would be: (1) an external (or exogenous) event, (2) a curve shifting, and (3) a new equilibrium. Students sometimes have difficulty integrating these separate pieces in the correct order.

CHAPTER 4 | Economic Efficiency, Government Price Setting, and Taxes Brief Chapter Summary and Learning Objectives 4.1

Consumer Surplus and Producer Surplus Distinguish between the concepts of consumer surplus and producer surplus. ▪

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

4.2

Producer surplus measures the dollar benefit producers receive from selling goods and services in a market.

The Efficiency of Competitive Markets Explain the concept of economic efficiency. ▪

4.3

Equilibrium in a competitive market results in an economically efficient level of output where marginal benefit equals marginal cost and economic surplus is maximized.

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

4.4

▪

A price floor is a government attempt to aid sellers by requiring that a price be above equilibrium.

▪

A price ceiling is an attempt by a government to aid buyers by requiring that a price be below equilibrium.

The Economic Effect of Taxes Analyze the economic effect of taxes. ▪

A tax on the sale of a good or service results in a reduction of economic efficiency.

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

Key Terms Illicit market A market in which buying and selling take place at prices that violate government price regulations. Consumer surplus The difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer pays. Deadweight loss The reduction in economic surplus resulting from a market not being in competitive equilibrium.

Economic efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum. Economic surplus The sum of consumer surplus and producer surplus. Marginal benefit The additional benefit to a consumer from consuming one more unit of a good or service.

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

Marginal cost The change in a firm’s total cost from producing one more unit of a good or service. Price ceiling A legally determined maximum price that sellers may charge. Price floor A legally determined minimum price that sellers may receive. Producer surplus The difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. Tax incidence The actual division of the burden of a tax between buyers and sellers in a market.

Chapter Outline What Do Food Riots in Venezuela and the Rise of Uber in the United States Have in Common?

In Venezuela, the government’s attempts to control private businesses led to disruptions in the supply of many goods⸻ including food. When prices rose due to reductions in supply, the government kept prices from rising to their equilibrium levels, resulting in food shortages and riots. In New York and other cities, government limits on the supply of taxis pushed the prices of the medallions required to drive a cab legally to very high levels. The high prices provided Uber and other firms the opportunity to earn profits by using mobile technology to offer ride-sharing services at prices lower than taxis were charging. As a result, medallion prices decreased significantly.

What’s the connection between food riots in Venezuela and the rise of Uber in the United States? Both cases resulted from governments intervening to change equilibrium prices determined by the market? In a competitive market equilibrium, all consumers willing to pay the market price will be able to buy as much of a product as they want, and all firms willing to accept the market price will be able to sell as much of a product as they want. But consumers would prefer to pay a price lower than the market price, and producers would rather receive a higher price. In some cases, either buyers or sellers can convince the government to enact price controls, which are legally binding maximum or minimum prices.

Consumer Surplus and Producer Surplus 4.1

Learning Objective: Distinguish between the concepts of consumer surplus and producer surplus.

A price ceiling is a legally determined maximum price that sellers may charge. A price floor is a legally determined minimum price that sellers may receive.

A. Consumer Surplus Consumer surplus is the difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer pays. The demand curve can be used to measure total consumer surplus in a market. Consumers are willing to purchase a product up to the point where the marginal benefit of consuming a product is equal to its price. Marginal benefit is the additional benefit Copyright © 2023 Pearson Education, Inc.

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to a consumer from consuming one more unit of a good or service. The total amount of consumer surplus in a market is equal to the area below the demand curve and above the market price. This area represents the benefit to consumers in excess of the price they paid for a product.

B. Producer Surplus Supply curves show the willingness of firms to supply a product at different prices. Firms will supply an additional unit of a product only if they receive a price equal to the additional cost of producing that unit. Marginal cost is the change in a firm’s total cost from producing one more unit of a good or service. Often, the marginal cost of producing a good increases as more of the good is produced during a given time period. Producer surplus is the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price.

C. What Consumer Surplus and Producer Surplus Measure Consumer surplus measures the net benefit to consumers from participating in a market, rather than the total benefit. Similarly, producer surplus measures the net benefit received by producers from participating in a market.

4.2

The Efficiency of Competitive Markets Learning Objective: Explain the concept of economic efficiency.

A competitive market is a market with many buyers and sellers. An advantage of a market system is that it results in efficient economic outcomes.

A. Marginal Benefit Equals Marginal Cost in Competitive Equilibrium Equilibrium in a competitive market results in the economically efficient level of output, at which marginal benefit equals marginal cost.

B. Economic Surplus Economic surplus is the sum of consumer surplus and producer surplus. In a competitive market, with many buyers and sellers and no government restrictions, economic surplus is at a maximum when the market is in equilibrium.

C. Deadweight Loss Deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium.

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D. Economic Surplus and Economic Efficiency Consumer surplus measures the benefit to consumers from buying a particular product, and producer surplus measures the benefit to firms from selling a particular product. Equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service. Economic efficiency is a market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum.

Extra Apply the A History of Economic Inefficiency Concept People sometimes wonder how useful the concept of economic efficiency is when they observe that many real-world markets are not very competitive; these markets do not have many buyers and sellers. Government officials can take this line of thinking further and argue that if markets are not competitive, price controls can be justified to improve economic efficiency. But price controls typically result in more inefficiency, not less. History is replete with examples of price controls gone wrong. In 284 C.E., the Roman emperor Diocletian fixed the maximum prices of beef, grain, and other items and imposed the death penalty on anyone who charged higher prices. These controls ultimately failed, and the death penalty was rescinded. A more recent example of the inefficiency of price controls occurred at the end of World War II in occupied Germany. American “planners” imposed price controls on German markets with the usual result: chronic shortages of goods. This produced what must be one of the most unusual lectures ever given on the futility of controls, from Nazi leader Hermann Goering: “You are trying to control people’s wages and prices . . . no country can do that part way. I tried and failed. . . You are no better planners than we.” In 1948, German Economic Minister Ludwig Erhard finally ended price controls. As controls ended, so did the chronic shortages of German goods. Source: “Four Thousand Years of Price Control,” by Thomas DiLorenzo. http://mises.org/daily/1962.

Extra Solved Problem 4.2 What the American Colonies Gave up as Part of the British Empire Before the American Revolution, the British required that American colonies follow certain rules known as the Navigation Acts. One of these rules required that all imports to the colonies from outside of the British Empire be shipped first to Great Britain. For instance, a colonial business in New York importing

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wine from France had to have the wine shipped first from France to Great Britain before it could be shipped to New York. This requirement increased the cost of importing goods into the colonies. Draw a graph to show the loss in economic efficiency from the Navigation Acts on the importation of wine into New York.

Solving the Problem Step 1:

Review the chapter material. This problem is about economic efficiency, so you may want to review the section “The Efficiency of Competitive Markets” in the textbook.

Step 2:

Draw a demand and supply graph that illustrates the equilibrium price and quantity of imported wine to the Colonies with and without the trade restrictions imposed by the Navigation Acts.

Step 3:

Estimate the loss of consumer surplus and deadweight loss. The imposition of the Navigation Acts’ restrictions on trade caused the supply curve to shift to the left. As a result, the equilibrium price was greater, and the equilibrium quantity less, than they would have been in the absence of the restrictions. Areas A and B represent the loss of consumer surplus. Part of this area—area A—is transferred to producers in the form of higher revenue from selling Q2: (P2 − P1)  Q2. There is an overall gain in producer surplus (area A is larger than area C). But areas B and C indicate the deadweight loss, a net efficiency loss compared to the competitive equilibrium price and quantity (P1 and Q1). Robert Paul Thomas has estimated that the loss of consumer surplus was $605,000 in 1770. As the total

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income of the Colonies was only $130 million in 1770, the loss of consumer surplus was the equivalent of about $47 billion in today’s economy. Source: Robert Paul Thomas, “A Quantitative Approach to the Study of the Effects of British Imperial Policy on Colonial Welfare,” Journal of Economic History, Vol. 25, No. 4, December 1965, pp. 615–638.

Government Intervention in the Market: Price Floors and Price Ceilings 4.3

Learning Objective: Explain the economic effect of government-imposed price floors and price ceilings.

Not every individual is better off if a market is at its competitive equilibrium. Any producer would rather charge a higher price, and any consumer would rather pay a lower price than the equilibrium price. Producers or consumers who are dissatisfied with the competitive equilibrium price may lobby the government to legally require that a different price be charged.

A. Price Floors: Government Policy in Agricultural Markets During the Great Depression many farmers were unable to sell their products or could sell them only at very low prices. Farmers convinced the federal government to intervene to set price floors for agricultural products. Government intervention in agriculture has continued ever since. A price floor reduces economic efficiency. The federal government’s farm programs often have resulted in large surpluses of wheat and other agricultural products. The government has usually bought surplus food or paid farmers to restrict supply by taking some land out of cultivation. In 2019, the Congressional Budget Office estimated that the farm program would result in federal spending of more than $867 billion over the following 10 years.

B. Price Ceilings: Government Rent Control Policy in Housing Markets Support for governments setting price ceilings typically comes from consumers. New York is one of the cities that impose rent control, which puts a ceiling on the maximum rent that landlords can charge for an apartment. A price ceiling, such as rent control, reduces economic efficiency.

C. Illicit Markets and Peer-to-Peer Sites Because rent control leads to a shortage of apartments, renters who would otherwise not be able to find apartments have an incentive to offer landlords rents above the legal maximum. This can result in an Illicit market, a market in which buying and selling take place at prices that violate government price regulations. Peer-to-peer rental sites provide landlords and tenants a way to avoid rent controls. Landlords use these sites to convert a yearly rental into a series of short-term rentals for which they can charge rents that exceed the legal maximum rent. Tenants can use peer-to-peer sites to rent their apartments to others at rents higher than the legal maximum they pay.

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D. The Results of Government Price Controls: Winners, Losers, and Inefficiency When the government imposes price floors or price ceilings, some people win, some people lose, and there is a loss of economic efficiency. The winners with rent control are those who pay less for rent. Landlords may gain if they break the law by charging rents above the legal maximum and above what the equilibrium rents would be. The losers from rent control are the landlords who abide by the law, and renters who are unable to find apartments at the controlled price. Rent control reduces economic efficiency because fewer apartments are rented than would be rented in a competitive market.

E. Positive and Normative Analysis of Price Ceilings and Price Floors Economists are generally skeptical of government attempts to interfere with competitive market equilibrium. Our analysis of rent control and federal farm programs is positive analysis. Whether these programs are desirable or undesirable is a normative question.

Extra Apply the Price Controls Lead to Economic Crisis in Venezuela Concept In 2019 ⸻ even before the effects of the Covid-19 pandemic⸻ the Venezuelan economy was in a shambles. Although the government was no longer publishing accurate statistics, economists estimated that by the end of 2019, real GDP—the value of goods and services produced in Venezuela, corrected for inflation—would be 45 percent lower than in 2014. That decline was far worse than the worst years of the Great Depression of the 1930s in the United States. Venezuela’s inflation rate, a measure of how quickly prices are rising, was 10 million percent—one of the highest ever recorded in any country— which rendered the country’s paper currency worthless. The unemployment rate was above 35 percent, and Caracas, the country’s capital, had the highest murder rate of any capital city in the world and suffered from chronic electricity blackouts. As we saw in the chapter opener, some desperate people in Venezuela engaged in food riots at supermarkets. An estimated 3 million people, out of a population of 30.7 million, had fled the country.

Many economists believe the problems with the Venezuelan economy are due to the socialist economic policies of Hugo Chavez, who was elected president in 1999, and Nicolas Maduro, who became president following Chavez’s death in 2013. Under Chavez, the government seized control of thousands of private firms, including firms in the oil industry—the source of most of Venezuela’s exports. The government seized large farms and redistributed the land to low-income Venezuelans, many of whom had no experience in farming; lacked access to loans needed to finance purchases of seeds, fertilizers, and pesticides; and were not connected to distribution networks to sell their crops. One farmer was Copyright © 2023 Pearson Education, Inc.

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quoted as saying, “They encouraged me to seize this land from its previous owner, but now I can’t get loans, and the state agricultural store doesn’t have seeds, fertilizers or insecticides. How can I plant crops with nothing?” Disruptions to Venezuela’s agricultural sector led to a sharp reduction in food production.

For several years, the Venezuelan government was able to ensure that sufficient food would be available in supermarkets by using its oil revenues to buy imported food.

But a large decline in oil prices beginning in 2014 meant the government could no longer pay for food imports. The falling supply of food would ordinarily have resulted in price increases that would have increased the quantity of food grown domestically. But the Venezuelan government imposed price controls that kept prices well below their new equilibrium levels. In an interview, Nicholas Casey, a reporter for the New York Times, described the resulting shortages: [You] go outside as early as 5 a.m., sometimes 4:30, you see people lining up in front of stores to try to see what’s going to be there when they open their doors. And sometimes even these stores—after you’re waiting through a line that might be 500, 1,000 people sometimes . . . you get to the front of the line, and you find that they’ve only got cooking oil. They don’t have flour. They don’t have any of the basic things that you need there.

The price controls have resulted in a thriving Illicit market in many goods. Smallscale entrepreneurs buy up food and other groceries at the below-market controlled prices and resell them to consumers who would otherwise be unable to buy these goods. Consider the case of cornmeal, which is used to make arepa, a corn pancake that is an important part of most Venezuelans’ diet. A few years ago, the government price ceiling for a 2-pound bag of cornmeal was 190 bolivars, the Venezuelan currency (its symbol is Bs). The equilibrium market price of cornmeal in the absence of price Controls would have been about 975 bolivars, but few supermarkets had any for sale.

Many Venezuelans had to buy cornmeal on the Illicit market at a price of 3,500 bolivars. The figure below, which is similar to Figure 4.9, illustrates the situation.

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The figure shows that most consumers are worse off because of the price controls. Less cornmeal is available for sale (Q1 rather than the market equilibrium quantity Q2), and at the price ceiling, there is a shortage of cornmeal equal to Q3 - Q1. Although a few consumers may be able to buy cornmeal at the low price ceiling price of 190 bolivars, most supermarkets have no cornmeal available on their shelves, forcing many consumers to pay the Illicit market price of 3,500 bolivars.

The situation for many Venezuelan consumers is actually worse than the figure indicates because the rapid rise in inflation has made many sellers reluctant to accept domestic currency, insisting on being paid with U.S. dollars instead. Stores controlled by the government still accept bolivars, but their shelves are mostly empty. Venezuelans who are unable to obtain dollars must wait in long lines, hoping that they can buy enough food to keep their families from starving. Tragically, news reports indicate that hunger is widespread in Venezuela, and economists estimate that 90 percent of the population is living in poverty. Sources: Juan Forero, “Hyperinflation Shatters Venezuelan Manufacturing,” Wall Street Journal, March 5, 2019; Mary Beth Sheridan, “In Venezuela, Massive Blackout Continues as Maduro Blames U.S. for Outages,” washingtonpost.com, March 8, 2019; Nicholas Casey, “No Food, No Medicine, No Respite: A Starving Boy’s Death in Venezuela, New York Times, December 25, 2016; Peter Wilson, “Venezuelan Food Shortages Bode Ill for Chavez’s Re-election,” usatoday.com, August 13, 2012; and International Monetary Fund, “World Economic Outlook Database.”

4.4

The Economic Effect of Taxes Learning Objective: Analyze the economic effect of taxes.

When the government taxes a good or service, it affects the market equilibrium for that good or service. One result of a tax is a decline in economic efficiency.

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When a government taxes a good or service, less of that good or service will be sold. Demand and supply curves are used to describe the deadweight loss that results from a tax. The true burden of a tax is the amount consumers and producers pay the government and the deadweight loss from the tax. The deadweight loss from a tax is referred to as the excess burden of the tax. A tax is efficient if it imposes a small excess burden relative to the tax revenue that it raises.

B. Tax Incidence: Who Actually Pays a Tax? Tax incidence is the actual division of the burden of a tax between buyers and sellers in a market. The incidence of a tax does not depend on whether a tax is collected from the buyers of a good or from the sellers.

Extra Solved Problem 4.4 When Do Consumers Pay All of a Sales Tax Increase? A student makes the following statement: “If the federal government raises the sales tax on gasoline by $0.25, then the price of gasoline will rise by $0.25. Consumers can’t get by without gasoline, so they have to pay the whole amount of any increase in the sales tax.” Under what circumstances will the student’s statement be true? Use a graph of the market for gasoline to illustrate your answer.

Solving the Problem Step 1:

Review the chapter material. This problem is about tax incidence, so you may want to review the section “Tax Incidence: Who Actually Pays a Tax?” in the textbook.

Step 2:

Draw a graph like Figure 4.11 to illustrate the circumstances when consumers will pay all of an increase in a sales tax.

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Step 3:

Use the graph to evaluate the statement. The graph shows that consumers will pay all of an increase in a sales tax only if the demand curve is a vertical line. It is very unlikely that the demand curve for gasoline would look like this because we expect that for every good, an increase in price will cause a decrease in the quantity demanded. Because the demand curve for gasoline is not, in fact, a vertical line, the statement is incorrect.

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

Demand and Supply Equations The first step in a quantitative analysis of demand and supply is to supplement the use of demand and supply curves with demand and supply equations. Suppose that economists have estimated that the demand for apartments in New York City is: QD = 4,750,000 − 1,000P, and the supply of apartments is: QS = −1,000,000 + 1,300P, where QD represents the quantity of apartments demanded per month, QS is the quantity of apartments supplied per month, and P is the price, or rent. With no government intervention, at competitive market equilibrium quantity demanded must equal quantity supplied: QD = QS To solve for the equilibrium monthly apartment rent set the quantity demanded equal to the quantity supplied: 4,750,000 − 1,000P = −1,000,000 + 1,300P 5,750,000P = 2,300P

Substitute this price back into either the supply equation or the demand equation to find the equilibrium quantity of apartments rented: QD = 4,750,000 − 1,000P = 4,750,000 − 1,000 (1,500) = 2,250,000,

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or: QS = −1,000,000 + 1,300P = −1,000,000 + 1,300 (2,500) = 2,250,000. The demand equation and the supply equation can be used to determine the value for rent when the quantity demanded is equal to zero and when the quantity supplied is equal to zero. QD = 0 = 4,750,000 − 1,000P

and: QS = 0 = −1,000,000 + 1,300P

Teaching Tips The equations highlight an oddity of demand and supply analysis that is lost on students unless they have a solid background in mathematics. The dependent variable in most graphs is the “y variable,” the variable measured along the vertical axis, while the independent or “x variable” is measured along the horizontal axis. Economists assume that price changes cause changes in quantity, so quantity appears on the left-hand side of the demand and supply equations even though quantity is plotted on the horizontal axis in demand and supply graphs. In turn, the coefficient of the price terms in these equations equals the change in quantity divided by a one-unit change in price (ΔQ/ΔP). But price appears on the vertical axis and quantity on the horizontal axis in demand and supply diagrams. You may want to emphasize that the constant terms in the equations are not the vertical intercepts of the demand and supply curves and the coefficients of the price terms cannot be interpreted as the slopes of these curves.

Calculating Consumer Surplus and Producer Surplus We can use the values from the demand and supply equations to calculate the value of consumer surplus and producer surplus. Consumer surplus is the area below the demand curve and above the line representing price. This area forms a right triangle when the demand curve is linear. In this case (see Figure 4A.1), the area equals: ½

(2,250,000) (4,750 − 2,500) = $2,531,250,000.

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(2,250,000) (2,500 − 769) = $1,947,375,000.

The same analysis can be used to measure the impact of rent control on consumer surplus, producer surplus, and economic efficiency. Suppose the city imposes a rent ceiling of $1,500 per month. We can calculate the quantity of apartments that will be rented by substituting the rent ceiling of $1,500 into the supply equation: QS = −1,000,000 + (1,300 1,500) = 950,000. The price on the demand curve when the quantity of apartments is 950,000 can be determined by substituting 950,000 for quantity in the demand equation and solving for price: 950,000 = 4,750,000 − 1,000P

Compared with its value in competitive equilibrium, consumer surplus has been reduced by the area of the triangle B in Figure 4A.2, but increased by the area of the rectangle A. The area of B is: ½ (2,250,000 − 950,000)

(3,800 − 2,500) = $845,000,000.

The area A is: ($2,500 − $1,500) (950,000) = $950,000,000. The value of consumer surplus in competitive equilibrium is $2,531,250,000. As a result of the ceiling it will be: ($2,531,250,000 + $950,000,000) − $845,000,000 = $2,636,250,000. Compared to its value in competitive equilibrium, producer surplus has been reduced by a value equal to the area of triangle C and rectangle A. The area of C is: ½ (2,250,000 − 950,000) (2,500 − 1,500) = $650,000,000. The loss of economic efficiency - the deadweight loss - is equal to equal to the sum of areas B and C: $845,000,000 + $650,000,000 = $1,495,000,000.

Teaching Tips

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Many students are inclined to believe rent ceilings are justified because they “protect the poor” from paying the equilibrium price. The analysis above does not allow us to determine which consumers are able to rent the 950,000 apartments. We could argue that these apartments are not likely to be rented to a disproportionate number of poor tenants. However, the deadweight loss is unambiguous: both consumers and producers suffer a loss of economic efficiency when only 950,000 rather than 2,250,000 apartments are rented.

Solutions to End-of-Chapter Exercises Answers to Thinking Critically Questions to accompany the Inside Look newspaper feature 1. The total amount of wages that drivers will receive equals the wage multiplied by the quantity of hours drivers work at the wage. Prior to imposition of the minimum wage, this amount is equal to . After the imposition of the minimum wage, the total amount of wages drivers will receive equals £8.91 L2. The total amount of wages workers receive will primarily depend on how responsive Uber’s demand for workers is to changes in the wage the firm has to pay. 



If Uber’s demand is very responsive, then the increase in the wage from W1 to £8.91 will cause a large drop in the total hours of labor that Uber demands and the total amount of wages workers receive driving for Uber will fall. If Uber’s demand is not very responsive, then the increase in the wage will result in a small drop in the total hours of labor that Uber demands and the total amount of wages workers receive driving for Uber will rise.

Try drawing graphs with different demand curves to convince yourself that this analysis is correct. From the information given, we can’t conclude which of these situations is more likely to occur.

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2. If Uber drivers in the U.K. were classified as employees instead of workers, they would be entitled to additional benefits such as sick pay and employee leave. In that case, Uber would likely demand fewer hours of labor because its cost per hour worked would increase. Because Uber drivers would receive additional benefits, there would likely be more drivers seeking to work more hours. With the likely increase in the number of hours drivers seek to work at Uber and the likely decrease in the number of hours demanded by Uber, the surplus of hours desired by drivers would grow larger.

Consumer Surplus and Producer Surplus 4.1

Learning Objective: Distinguish between the concepts of consumer surplus and producer surplus.

Review Questions 1.1

Marginal benefit is the additional benefit to a consumer from consuming one more unit of a good or service. The demand curve shows consumers’ willingness to pay for a product. The amount that consumers are willing to pay for one more unit will equal the extra benefit they will receive from consuming the unit; therefore, the demand curve equals the marginal benefit curve for consumers.

1.2

Marginal cost is the additional cost to a firm from producing one more unit of a good or service. Supply curves show the willingness of firms to supply a product at different prices. The willingness to supply a product depends on the additional cost of producing the unit. The lowest price a firm is willing to accept is the additional cost of making an additional unit of the good; therefore, the supply curve equals the marginal cost curve. Copyright © 2023 Pearson Education, Inc.

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1.3

Consumer surplus is the difference between the highest price a consumer is willing to pay and the price the consumer actually pays. As the equilibrium price falls, consumer surplus grows both because the gap between the willingness to pay and the price grows and because consumers purchase a larger quantity. As the price rises, consumer surplus shrinks.

1.4

Producer surplus is the difference between the lowest price a firm would be willing to accept and the price it actually receives. As the equilibrium price of the good rises, producer surplus rises. As the price falls, producer surplus falls.

Problems and Applications 1.5

Consumer surplus is the difference between the highest price Sofia was willing to pay and the actual price she paid for the coat. We know that Sofia was willing to pay $79.95, but we don’t know if this was the maximum price she was willing to pay. The value of her consumer surplus is at least $15.99, but the value could be greater than this amount if the maximum she was willing to pay was higher than $79.95.

1.6

Consumer surplus is the difference between the highest price consumers are willing to pay for the new digital goods and the price they actually pay for them. Consumer surplus is unmeasured because when a consumer purchases a product, we can only infer that the maximum he or she is willing to pay for the product must be as large or larger than the price. In the case of digital goods, we don’t know exactly the maximum that each consumer is willing to pay because the prices of many digital goods, such as Twitter, Instagram, or Wikipedia, is zero.

1.7

On average, Netflix viewers are willing to pay $1,173 per year for the service. Currently, each viewer pays only $132 per year ($11 per month × 12 months). Taking the difference between the two numbers—$1,173 and $132—gives us an average consumer surplus of $1,041. Multiplying this average consumer surplus of $1,041 by 59 million subscribers gives us a total consumer surplus of $61,419,000,000, or $61.419 billion ($1,041 × 59,000,000 = $61,419,000,000 = $61,419 billion).

1.8

Although writer Annie Lowrey paid $34 more for her 1 a.m. ride than for her 10 p.m. ride, she was willing to pay the higher fare. Her willingness to pay was no less than $47, so she did not receive negative consumer surplus from this trip. At worst, she received 0 consumer surplus and may have received positive consumer surplus.

1.9

a. If the price of a bottle of premium bottled water is $1.50 per bottle, then the consumer surplus received by each consumer is: Jill:

$4.00 − $1.50 = $2.50

Jose:

$3.00 − $1.50 = $1.50

Josh:

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods Total consumer surplus = $2.50 + $1.50 + $0.50 = $4.50 Jordan would not buy premium bottled water at a price of $1.50, so he receives no consumer surplus.

b. If the price of a bottle of premium bottled water is $2.50 per bottle, then the consumer surplus received by each consumer is: Jill:

$4.00 − $2.50 = $1.50

Jose:

$3.00 − $2.50 = $0.50

Total consumer surplus = + $1.50 + $0.50 = $2.00 As shown in the graph for part (a) above, at a price of $2.50, neither Josh nor Jordan receives consumer surplus because the price is greater than either is willing to pay.

1.10

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

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1.11

a. In the following figure, a decrease in the costs of operating the supermarkets will shift the supply of groceries from Supply, S1 to S2, causing the equilibrium price to decrease from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2. The consumer surplus prior to the decrease in costs is area A. After the decrease in costs, the new consumer surplus is area A + B + C + D. b. In the following figure, prior to the decrease in costs, the producer surplus is area B + E. After the decrease in costs, the producer surplus is the area E + F + G. The producer surplus will increase only if area F + G is greater than area B. Although the decrease in costs will definitely increase consumer surplus, we can’t be certain that there will be an increase in producer surplus.

1.12

The equilibrium price and quantity occurs where the demand curves intersect the supply curve. The consumer surplus is larger with demand curve D1 than demand curve D2 because consumers are willing to pay a higher price for each unit of the good up to the equilibrium quantity where the two demand curves intersect. Producer surplus is the same with demand curve D1 as it is for demand curve D2 because the value for producer surplus depends on the equilibrium price and the supply curve, neither of which is affected in this example by which demand curve is used.

1.13

The vertical demand curve implies that there is no limit to the price consumers are willing to pay for a breast cancer-fighting drug, resulting in an infinite consumer surplus. In the markets we have studied up to this point, consumer surplus was always finite.

1.14

Consumer surplus for Uber rides equals the area of the blue triangle or ($65.17 − $13.30) × ½ × 111 million = $2,878.785 million, or $2.88 billion

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4.2

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The producer surplus in the market for tickets to this concert is a rectangle rather than a triangle (as is typical in most markets). The producer surplus equals P × 15,000, so all of the revenue is producer surplus because the marginal cost of supplying the concert is zero.

The Efficiency of Competitive Markets Learning Objective: Explain the concept of economic efficiency.

Review Questions 2.1

Economic surplus is the sum of consumer surplus and producer surplus. Deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium. Because economic surplus is the sum of the benefit to firms plus the benefit to consumers, it is the best measure we have of the benefit to society from the production and sale of a particular good or service. For this reason, it is appropriate to label economic surplus as social surplus.

2.2

Economic efficiency occurs when the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and where the sum of consumer surplus and producer surplus is maximized. Economists define economic efficiency this way because it is the best measure we have of the benefit to society from the production and sale of a particular good or service.

Problems and Applications 2.3

In the following figure, the decrease in the number of cattle raised as a result of the drought is illustrated as a shift in the supply curve to the left from Supply, S1, to S2. The shift in the supply curve will cause the equilibrium price of cattle to increase from P1 to P2 and the equilibrium quantity of cattle to decrease from Q1 to Q2. The decrease in supply will cause consumer surplus to decline from the area A + B + C + D to just the area A. The producer surplus will change from area E + F + G to area B + E. The producer surplus will increase if area B is greater than area F + G. The producer surplus will decrease if area B is less than area F + G.

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2.4

You should disagree because a lower price in a market doesn’t always increase economic efficiency. A price that is lower than the equilibrium price decreases economic efficiency in the market. When the price is below equilibrium, suppliers decrease the quantity supplied and the marginal benefit exceeds the marginal cost of an additional unit of the good. Therefore, economic efficiency will have decreased.

2.5

You should disagree. The first part of the statement is correct, but the second part is incorrect. If marginal cost is greater than marginal benefit, reducing output would increase economic surplus. So, there must be a deadweight loss when marginal cost is greater than marginal benefit.

2.6

In the following graph of the market for hamburgers, at the initial equilibrium price, P1, and quantity, Q1, consumer surplus equals the area ABP1 and producer surplus equals the area P1BD. Economic surplus equals consumer surplus plus producer surplus and is represented by the area ABD. Using only antibiotic-free meat raises the cost of selling hamburgers, so the supply curve shifts from S1 to S2. Consumers’ reaction to the antibiotic-free hamburgers causes the demand curve to shift from D1 to D2. At the new equilibrium price, P2, and quantity, Q2, consumer surplus equals the area FCP2 and producer surplus equals the area P2CE. Economic surplus equals the area FCE. As drawn in the graph, the area FCE is larger than the area ABD, so economic surplus has increased. But if we had drawn the supply curve shifting to the left by a larger amount and the demand curve shifting to the right by a smaller amount, then economic surplus would have decreased. We can conclude that we can’t determine whether economic surplus will increase or decrease without knowing how much demand and supply actually change.

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2.7

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

2.8

Before the increase in supply, consumer surplus was equal to area A and producer surplus was equal to the sum of areas B and E. After the increase in supply, consumer surplus equals the sum of areas A, B, C, and D and producer surplus equals the sum of areas E, F, and G. Consumer surplus increases by the sum of areas B, C, and D. Producer surplus increases by the sum of areas F and G but decreases by area B. So, producer surplus will increase if the sum of areas F and G is greater than area B. Economic surplus increases by the sum of areas C, D, F, and G.

2.9

You should disagree. Economic surplus increases as long as marginal benefit exceeds marginal cost for each additional unit of output. Economic surplus is greatest when the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production.

2.10

At Q1, marginal benefit is greater than marginal cost, so increasing output would increase economic surplus. At Q3, marginal cost is greater than marginal benefit, so reducing output would increase economic surplus.

4.3

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

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CHAPTER 5 | Externalities, Environmental Policy, and Public Goods price ceilings.

Review Questions 3.1

Some consumers gain from price controls because they can buy a product at a lower price, but other consumers are hurt by price controls because shortages mean they are unable to buy the product.

3.2

Producers tend to favor price floors that are set above the equilibrium price, but only if producer surplus rises—as would be the case when the price rises a lot as a result of the price floor but the quantity sold doesn’t fall much. Producers don’t like price ceilings that are set below the equilibrium price because the quantity sold and the price received by producers both fall, reducing producer surplus.

3.3

An Illicit market is one in which buyers and sellers violate government price regulations. An Illicit market will arise if there are gains to some buyers and some sellers from violating a price ceiling.

3.4

Economic analysis will show the trade-offs involved from imposing price ceilings and price floors, but it won’t provide a final answer to the appropriateness of the policy because people differ about the goals of such policies. Some people may have the goal of maximizing economic surplus, for example, but others may care mostly about the well-being of certain consumers or producers and be less concerned about the well-being of other consumers or producers.

Problems and Applications 3.5

a. 28 million crates b. A surplus of 6 million crates (QD = 28, QS = 34, Surplus = QS − QD = 34 − 28 = 6 million crates) c. The apple producers will benefit. Their revenue will increase from $8 × 30,000,000 = $240,000,000 to $10 × 28,000,000 = $280,000,000.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods xxvii 3.6

a. The equilibrium quantity is 100 million crates of kumquats per year and the equilibrium price is $20 per crate. Kumquat producers receive revenue of $2 billion.

b. Consumers will purchase 80 million crates of kumquats. Kumquat producers receive revenue of $2.4 billion: $30 × 80,000,000 = $2,400,000,000.

xxviii CHAPTER 5 | Externalities, Environmental Policy, and Public Goods c. Kumquat producers will receive the revenue of $2.4 billion in part (b) plus $30 × 100 million crates, or $3.0 billion, for a total of $5.4 billion. The government will spend $3.0 billion purchasing the 100 million crates of surplus kumquats. Or, we can calculate directly the total amount kumquat producers will receive as $30 × 180 million crates = $5.4 billion.

3.7

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

b. Economic surplus without a price floor = A + B + C + D + E. Economic surplus with a price floor = A + B + D.

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a. The total amount paid to workers equals the wage that workers receive multiplied by the quantity of hours they work. An increase in the minimum wage increases the wage that workers in low-wage jobs receive, but it also decreases the quantity of hours they work. If the decrease in the quantity of hours worked is relatively small, then an increase in the minimum wage will increase the total amount that workers in low-wage jobs receive. In the case of the increase in the minimum wage in Seattle, the decrease in the quantity of hours worked must have been large enough to reduce the total amount workers in low-wage jobs received. b. No. Workers who continued to work the same hours (or slightly fewer) hours than they worked before the increase in the minimum wage are better off because their total income (the wage multiplied by the quantity of hours they work) increased. Workers who lost their jobs as a result of the minimum wage or who had their hours substantially reduced were made worse off because their total income fell. c. The result reinforces the trade-off involved with the minimum wage: Some workers gain, while other workers lose. Supporters of increasing the minimum wage may consider the trade-off to be acceptable, while opponents of increasing the minimum wage may consider the trade-off to be a bad one. Positive analysis, as represented by the results of this study, contributes to the debate on economic policy but in many cases, such as the minimum wage, it cannot resolve the debate.

3.9

a. The supply curve shifts to the left because at every price of a taxi ride, the quantity of taxis available is lower because some taxis that would otherwise be available to offer rides are unable to do so because the city issues only a limited number of medallions and only taxis that have medallions may legally offer rides. We know that when a supply curve shifts to the left, the equilibrium price in the market will increase. b. In 2008, the taxi business was very profitable in San Francisco, resulting in an increase in the demand for the medallions. Given the small supply of medallions, the equilibrium price for a medallion increased to $250,000. By late 2018, the increased popularity of rideshare companies like Uber and Lyft made it possible for individuals to provide taxi service without purchasing a medallion. As a result, the demand for the medallion decreased so much that the equilibrium price is effectively zero. No medallions were sold because no one needed to purchase one to offer rides to passengers.

3.10

a. If someone is currently a renter, the law will probably make him or her better off, unless the landlord decides to remove the apartment from the market. b. Probably worse off because the person will likely have difficulty finding a vacant apartment. c. Worse off because the landlord will not be able to charge the competitive rent for apartments.

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CHAPTER 5 | Externalities, Environmental Policy, and Public Goods d. Probably better off because the landlord will be able to charge a higher rent than he or she would have been able to charge before the rent control law was passed. But the landlord may end up worse off if he or she gets caught and the penalty for breaking the law is significant.

3.11

The statement is correct. If a good is not scarce (there is more of a good available at a zero price than people want), then there cannot be a shortage of the good. But there is not a shortage of every scarce good. There is only a shortage of a scarce good when the price of the good is below the equilibrium price.

3.12

a. In the absence of rent control, the equilibrium price is $800 and the equilibrium quantity is 300,000. In this case, every renter who is willing to pay the market price of $800 will find an apartment, and every landlord willing to accept the market price of $800 will find a renter. The demand and supply curves are shown in the following figure, along with the equilibrium price (PE) and quantity (QE). b. At a price ceiling of $600, the quantity demanded is 350,000, but the quantity supplied is only 250,000, so there is a shortage of 100,000 apartments. c. If all landlords abide by the law, the number of apartments rented will fall to 250,000. As shown in the figure, consumer surplus with the price ceiling enforced is A + Β + D, producer surplus is F, and deadweight loss is C + E.

d. If landlords supply only 250,000 apartments and ignore the price ceiling, they can charge $1,000; $1,000 is the highest rent that consumers are willing to pay to rent 250,000 apartments.

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a. In an emergency, consumers may have no alternative to paying high prices for necessities such as food and bottled water. Many people view incidents of “price gouging” as examples of private businesses taking advantage of consumers at times when they are most vulnerable. Government officials often view regulations against price gouging as a way to protect people from being taking advantage of by business owners. b. In normal, non-emergency times, consumers benefit from competition among businesses that sell most products, including food and bottled water. If a firm were to sell a product at what is considered an unreasonably high price, consumers can buy a similar product from another firm at a lower price.

3.14

In the following graph of the market for chicken, a price ceiling, PC, set below the equilibrium price, P1, will cause consumers to increase their quantity demanded from the equilibrium quantity, Q1, to the quantity QDceiling. The quantity of chicken farmers supply decreases from the equilibrium quantity, Q1, to the quantity QSceiling. Consumers can only buy the quantity of chicken farmers offer for sale, so the quantity of beef they consume declines from Q1 to Qsceiling. This analysis explains why consumption of chicken (and beef and pork) declined during these years.

3.15

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

xxxii CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

3.16

a. The demand for hotels rooms, shown in the following graph on the left, increases during home football games. P1 is the equilibrium price during weekends without home football games. If prices for rooms are not allowed to rise above P1 during weekends with home football games, there will be a shortage of hotel rooms equal to QD minus QS, as shown in the graph on the right.

b. Out-of-town footballs fans will have trouble finding hotel rooms. They will have to try to secure hotel rooms far in advance, secure hotel rooms in neighboring communities, drive home after the games, or not attend the games. c. Over time, the supply of hotel rooms will most likely decline. With lower prices of hotel rooms reducing hotel owners’ economic profit, some hotels will exit the industry. The exit of hotels will increase the shortage of hotel rooms during home football game weekends.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods xxxiii d. Ski resorts and vacation spots have peak seasons. Laws limiting the prices hotels can charge during peak seasons would decrease the quantity of hotel rooms available and, therefore, also decrease the number of tourists who visit these communities and patronize local businesses. 3.17

The “deterioration of the housing stock” means that the apartments landlords offer for rent will become rundown and in need of repairs. Because rent controls keep rents below equilibrium, they increase the likelihood that landlords receive a return on their investment in apartment houses that is too low to cover the cost of properly maintaining the houses. Rent control also reduces how often apartments become available for rent because tenants are often reluctant to move from apartments on which they pay low rents. In New York City, some tenants have spent decades renting the same apartments and their children continue renting the apartments for additional decades. When vacancies rarely occur, landlords have less incentive to properly maintain apartments to attract new tenants.

3.18

a. After the decrease in supply, with no price ceiling, the equilibrium price would be $3.50, and the equilibrium quantity would be 40 million gallons. With a price ceiling of $2.50 and no Illicit market, the price will be $2.50, the quantity demanded will be 45 million gallons, and the quantity supplied will be 30 million gallons, resulting in a shortage of 15 million gallons. b. In the following graph, consumer surplus = A + B + C, producer surplus = D, and deadweight loss = E + F. c. Consumers are willing to pay, at most, $5.50 for the last gallon of gasoline suppliers are willing to supply at a price ceiling of $2.50. In the following graph, consumer surplus = A, producer surplus = B + C + D, and deadweight loss = E + F. d. Assuming there is no Illicit market, some consumers are made better off by the price ceiling because they can purchase gas at a lower price than they otherwise would. However, some consumers will not be able to find gas at a price of $2.50 and will be worse off. Consumer surplus without the price ceiling is A + B + E. With the price ceiling, consumer surplus would be A + B + C. The area of E is ½ × 10,000,000 × $2.00 = $10,000,000, while the area of C is $1.00 × 30,000,000 = $30,000,000 ⸻ so consumer surplus is greater as a result of the price ceiling.

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4.4

The Economic Effect of Taxes Learning Objective: Analyze the economic effect of taxes.

Review Questions 4.1

Tax incidence refers to the actual division of the burden of a tax between buyers and sellers in a market.

4.2

A tax is efficient if it imposes a small excess burden (deadweight loss) relative to the tax revenue it raises.

4.3

The person who officially sends the tax revenue to the government is not necessarily the person who actually bears the burden of the tax. For most taxes, the seller sends the money to the government, but buyers and sellers both pay part of the tax. The share paid by each is determined by the elasticities of the demand and supply curves and not on the person who is officially responsible for sending the tax to the government.

4.4

In market equilibrium, the marginal benefit to consumers equals the marginal cost of production of the last unit produced. A tax shifts the supply curve up vertically by the amount of the tax and leads to a lower equilibrium quantity. At this lower quantity, the marginal benefit to consumers exceeds the marginal cost of production of the last unit produced. The deadweight loss is the

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods xxxv reduction in units of output where the marginal benefit to consumers exceeds the marginal cost of production.

Problems and Applications 4.5

The deadweight loss is equal to ½ × (10 million − 9 million) × ($5.20 − $4.70) = $250,000. The tax revenue received by the government is equal to ($5.20 − $4.70) × 9 million = $4.5 million. 4.6

a. The sum of areas D and G represent the excess burden (deadweight loss) of the tax. b. The revenue collected by the government from the tax equals the amount of the tax (the vertical distance between S1 and S2) times the quantity sold after the tax is imposed (Q2), which equals the sum of areas B, C, E, and F. c. The efficiency of the tax is measured by the excess burden of the tax (the sum of areas D and G) relative to the tax revenue the tax raises (the sum of areas B, C, E, and F). This ratio of the excess burden to the tax revenue would have to be compared to the ratio of the excess burden to the tax revenue for other taxes to determine whether the tax on soft drinks is considered efficient.

4.7

a. The tax is $1.25 per pack, which is represented by the vertical distance between S1 and S2. b. Producers receive $5.25 per pack.

xxxvi CHAPTER 5 | Externalities, Environmental Policy, and Public Goods c. The government receives tax revenues of $1.25 tax per pack × 18 billion packs = $22.5 billion a year. d. Instead of the supply curve shifting up by the amount of the tax ($1.25), the demand curve would shift down by the amount of the tax ($1.25). e. The new equilibrium price that buyers pay producers would be $5.25 per pack because the demand curve would shift down by the amount of the tax and intersect the supply curve S1 at this price. f.

The total amount that cigarette buyers pay per pack would be the price of $5.25 plus the tax of $1.25 for a total of $6.50, which is the same amount that buyers pay when the tax is collected from sellers.

4.8

This reasoning is incorrect. The demand curve for pizzas slopes downward and the supply curve slopes upward, just as in other industries. As shown in the following figure, the tax will be split between the buyers and sellers. The tax shifts the supply curve up from S1 to S2. The price paid by the buyers increases from PE to PB, while the after-tax price received by the suppliers decreases from PE to PS. PB − $1 = PS.

4.9

a. The tax is technically paid by retail customers at the point of sale in the sense that the cash register receipt the customer receives when buying liquor will indicate that the customer paid a tax equal to 10 percent of the price of the liquor. The price is not 10 percent higher than it would be in the absence of the tax because the tax is actually paid partly by liquor sellers. So, the price the customer paid is higher than it would be if there were no tax, but it will be less than 10 percent higher. The buyer would pay all of the tax only in the unlikely case that the demand curve for liquor is vertical. b. No, the price that sellers receive (minus the amount of the tax) and the price that customers pay (including the tax) would be unchanged. The section titled “Does It Make a Difference Copyright © 2023 Pearson Education, Inc.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods xxxvii Whether the Government Collects a Tax from Buyers or Sellers?” explains that the price of a good (including the tax) doesn’t change if the government collects a tax from buyers rather than from sellers. 4.10

The payroll tax of $1 per hour of work decreases the demand for labor by $1 at every quantity of labor. With a vertical supply curve for labor, the wage rate drops by the full $1 tax. Workers bear the full burden of the payroll tax. In the following graph, the equilibrium wage declines by $1 from W1 to W2.

Suggestions for Critical Thinking Exercises CT4.1 Students may not think of efficiency as economists do. They might think of efficiency in terms of low prices for consumers. This question is designed to get them to think about how what they’ve learned compares to their preexisting thinking to make what they’re learned more salient.

CT4.2 After the mayor of New York removes the price ceiling, the marginal benefit and marginal cost of apartments should be equal. The student would need to describe this in everyday words instead of just parroting the terms from the text or the class.

CT4.3 There would have to be a price floor for there to be a long-lasting surplus. It might be difficult for students to recognize the correct concept from all of those found in this chapter.

xxxviii CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Solutions to Chapter 4 Appendix Exercises Appendix: Quantitative Demand and Supply Analysis Use quantitative demand and supply analysis. Review Questions 4A.1

In a linear demand equation, the intercept on the price axis represents the price at which the quantity demanded is zero. No consumer is willing to pay this price or above for the product. In a linear supply equation, the intercept on the price axis represents the price at which the quantity supplied is zero. No firm is willing to produce the good at this price or less.

4A.2

The price that maximizes economic surplus is the equilibrium price. At this price, there is no deadweight loss.

4A.3

Consumer surplus measures net benefit because consumers pay less than the maximum price they would be willing to pay for a good or service.

4A.4

Deadweight loss measures a net loss of economic surplus: The gains to consumers and producers that could have been realized but were lost as a result of a price control or other policy. Some policies result in a gain in surplus for one group that is transferred from some other group. A deadweight loss results in a loss of surplus by a group of producers and consumers that is not offset by a gain in surplus by another group of consumers or producers.

Problems and Applications 4A.5

The equilibrium wage can be found by setting LD equal to LS and solving for W: 100 − 4W = 6W, so 100 = 10W, and W = $10. The equilibrium quantity of labor is LS = 6 × 10 = 60 thousand workers. The labor surplus equals LS − LD at the minimum wage.  

Plugging $12 into the supply equation: LS = 6 × 12 = 72. Plugging $12 into the demand equation LD = 100 − (4 × 12) = 52.

So, the surplus is 72 − 52 = 20 thousand workers. 4A.6

The minimum wage will have a larger effect on employment in the top figure in the text, which is reproduced as the following graph on the left. Because the demand curve in this graph is relatively flat, employers will reduce the quantity of labor demanded considerably more than in the bottom figure in the text (reproduced here on the right).

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4A.7

We can use the fact that at equilibrium QD = QS to determine the equilibrium price and quantity: 45 − 2P = −15 + P 60 = 3P P = $20, Q = 45 − 2(20) = 5 So, the equilibrium price is $20, and the equilibrium quantity is 5. In the following figure, consumer surplus equals the area of A, or 0.5 × 5 × $2.50 = $6.25. Producer surplus equals the area of B, or 0.5 × 5 × $5 = $12.50.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

4A.8

a. In the following figure, the deadweight loss from the price floor equals C + E. C = 0.5 × $1 × 10,000 = $5,000 and E = 0.5 × $1 × 10,000 = $5,000. So, deadweight loss = $10,000. Or, we can calculate the area of the deadweight loss triangle directly: ½ (20,000 − 10,000) × (3 − 1) = $10,000. b. The price floor transfers area B from consumers to producers. The value of area B is $1 × 10,000 = $10,000. c. Producer surplus after the price floor is imposed is equal to areas B + D + F = ($1 × 10,000) + ($1 × 10,000) + (1/2 × $1 × 10,000) = $25,000. d. Consumer surplus after the price floor is imposed is equal to area A. The value of area A is ½ × $1.00 × 10,000 = $5,000.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 4A.9

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The totals are in millions of dollars.

Consumer surplus

Producer surplus

Deadweight loss

Competitive equilibrium

Rent control

Competitive equilibrium

Rent control

Competitive equilibrium

Rent control

$2,531

$3,120

$1,947

$985

$374

With a rent ceiling of $2,000, the quantity supplied will be −1,000,000 + (1,300 × 2,000) = 1,600,000. The willingness to pay can be found from the demand equation: 1,600,000 = 4,750,000 − 1,000P, so 1,000P = 3,150,000 and P = $3,150. Following Figure 4A.2, consumer surplus under rent control equals its value in competitive equilibrium plus the value of area A minus the value of area B, producer surplus equals D, and deadweight loss equals B + C. Area A = ($2,500 − $2,000) × 1,600,000 = $800,000,000 Area B = ½ × ($3,150 − 2,500) × (2,250,000 − 1,600,000) = $211,250,000, so Consumer surplus = ($2,531,250,000 + $800,000,000) − $211,250,000 = $3,120,000,000 Deadweight loss equals Area B + C = $211,250,000 + 0.5 × ($2,500 − $2,000) × (2,250,000 − 1,600,000) = $373,750,000. Producer surplus equals Area D = 0.5 × ($2,000 − $769) × 1,600,000 = $984,800,000. Copyright © 2023 Pearson Education, Inc.

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CHAPTER 5 | Externalities, Environmental Policy, and Public Goods Brief Chapter Summary and Learning Objectives 5.1

Externalities and Economic Efficiency Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

5.2

▪

A negative externality is a cost that affects someone not directly involved in the production or consumption of a good or service.

▪

A positive externality is a benefit that affects someone not directly involved in the production or consumption of a good or service.

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

5.3

If transactions costs are low, private bargaining can result in efficient solutions to externality problems.

Government Policies to Deal with Externalities Analyze government policies to achieve economic efficiency in a market with an externality. ▪

5.4

When private solutions to externalities are not feasible, government intervention in the form of a tax (negative externality) or subsidy (positive externality) can bring about an efficient level of output.

Four Categories of Goods Categorize goods on the basis of whether they are rival or excludable and use graphs to illustrate the efficient quantities of public goods and common resources. ▪

The four categories of goods are private, public, quasi-public, and common resources.

Coase theorem The argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. Command-and-control approach A policy that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices.

Public good A good that is both nonrival and nonexcludable. Rivalry The situation that occurs when one person’s consumption of a unit of a good means no one else can consume it. Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit.

Common resource A good that is rival but not excludable.

Social cost The total cost of producing a good or service, including both the private cost and any external cost.

Excludability The situation in which anyone who does not pay for a good cannot consume it.

Tragedy of the commons The tendency for a common resource to be overused.

Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

Free riding Benefiting from a good without paying for it. Market failureA situation in which the market fails to produce the efficient level of output. Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities. Private benefit The benefit received by the consumer of a good or service. Private cost The cost borne by the producer of a good or service. Private good A good that is both rival and excludable. Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

Chapter Outline Are NextEra Energy and Green Power the Future? The share of renewable energy sources used in generating electricity doubled between 2000 and 2018. NextEra Energy produces more electricity using solar and wind power than any other company in the world. The company’s success is the result of: (1) government subsidies, (2) state government requirements to use renewables for electricity generation, and (3) declining prices for renewable energy equipment. Many economists favor market-based policies rather than administrative rules (“commandand-control” policies) to reduce emissions of greenhouse gases. An example of a market-based policy is a carbon tax, under which the federal government would tax energy consumption based on the carbon content of energy. Some businesses oppose the carbon tax because they believe it will raise their costs of production. Other businesses favor the carbon tax because they believe it would be less costly and more effective than command-and-control policies.

Externalities and Economic Efficiency 5.1

Learning Objective: Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

An externality is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. An example of a negative externality is the generation of electricity by burning coal that generates carbon dioxide. The price paid for electricity does not include the cost of the damage carbon dioxide does to the environment. College educations are an example of a positive externality because people who do not pay for them benefit from the education others receive.

A. The Effect of Externalities A competitive market achieves economic efficiency by maximizing the sum of consumer and producer surpluses. But that result holds only if there are no externalities in production or consumption. An externality causes a difference between the private cost of production and the social cost, or the private benefit from consumption and the social benefit. A private cost is a cost borne by the producer of a good or service. A social cost is the total cost of producing a good or service, including both the private cost and any external cost. A private benefit is a benefit received by the consumer of a good or service. A social benefit is the total benefit from consuming a good or service, including both the private benefit and any external benefit. When there is a negative externality in the production of a good or service, too much of the good or service will be produced at market equilibrium. When there is a positive externality in consuming a good or service, too little of the good or service will be produced at market equilibrium.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

Market failure is a situation in which the market fails to produce the efficient level of output.

C. What Causes Externalities? Governments need to guarantee property rights for a market system to function well. Property rights are the rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. In certain situations, property rights do not exist or cannot be legally enforced. Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations.

Teaching Tips Industrial pollution is often cited as an example of a negative externality, but you can also use smoking as a classroom example. Most college students grew up in an era when smoking was much less socially acceptable than when their parents and grandparents were young. Students are often surprised to learn that smoking—by both students and instructors—was allowed in many college classrooms as late as the 1970s. Although few, if any, colleges allow smoking in classroom buildings now, many bars and restaurants have smoking sections. Ask your students (a) if they would be willing to pay smokers to not smoke while they are in the same restaurant or (b) if they would choose to sit in a restaurant’s smoking section to avoid a longer wait for a table in a nonsmoking section.

Extra Solved Problem 5.1 Smoking at Ike’s Bar-B-Q Pit As of 2019 two-thirds of the population of the United States, about 200 million people, lived in areas that had passed smoke-free laws for their restaurants and bars. Ike’s Bar-B-Q Pit is located in an area that still allows patrons and bars and restaurants to smoke. Some of Ike’s nonsmoking customers, including some who suffer from asthma, have asked Ike to adopt a no-smoking rule for his restaurant. But some of Ike’s other customers complained that they had smoked in the restaurant for years and would no longer patronize his Bar-B-Q Pit if he adopted the no-smoking rule. Ike is worried because he doesn’t want to lose business from either his smoking or nonsmoking customers.

Source: “Smoke-Free Restaurants and Bars Do Not Harm Business at Restaurants and Bars,” https://www.tobaccofreekids.org/assets/factsheets/0144.pdf

Draw a graph illustrating the externality associated with smoking in Ike’s Bar-B-Q Pit, and explain how this externality causes a deviation from economic efficiency in this market.

Solving the Problem

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Step 1:

Review the chapter material. This problem is about externalities, so you may want to review the section “Externalities and Economic Efficiency” in the textbook.

Step 2:

Draw a graph to illustrate the externality at Ike’s Bar-B-Q Pit. Smoking in this restaurant is a negative externality because there are external costs imposed on Ike’s nonsmoking customers as a result of their breathing second-hand smoke. These are costs that neither Ike nor his smoking customers have to pay.

Step 3:

Describe how the externality causes a deviation from economic efficiency. The economically efficient outcome for Ike’s restaurant is for the quantity of meals served to be Q2 and the price of the meals to be P2. (Ike’s has a varied menu with different meals with different prices. To simplify this problem, assume P2 is an average meal price.) This outcome would be economically efficient because it is where the market supply curve that represents social costs, including the negative health effects on nonsmokers, crosses the demand curve. At this point, the marginal benefit from Ike’s meals would equal the marginal social cost. However, because neither Ike nor his smoking patrons has to pay for the negative externality, the market supply curve represents only private costs. As a result, the equilibrium market price and quantity are P1 and Q1, and the marginal social cost from Ike’s meals exceeds the marginal benefit.

Private Solutions to Externalities: The Coase Theorem 5.2

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

It is possible for people to find private solutions to the problem of externalities. Ronald Coase made this argument in a 1960 article. Completely eliminating an externality is usually not economically efficient.

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A. The Economically Efficient Level of Pollution Reduction As pollution declines, society benefits, but the marginal benefit from eliminating another unit of pollution declines as emissions are reduced. As pollution declines, the marginal cost of further reductions rises. To maximize the net benefit to society, any type of pollution should be reduced to the point where the marginal benefit from another unit of reduction is equal to the marginal cost.

B. The Basis for Private Solutions to Externalities In arguing that private solutions to the problem of externalities were possible, Ronald Coase emphasized that when more than the optimal level of pollution occurs, the benefits from reducing the pollution to the optimal level are greater than the costs.

Extra Apply the The Fable of the Bees Concept Apple trees must be pollinated by bees to bear fruit. Bees need the nectar from apple trees (or other plants) to produce honey. James Meade, winner of the 1977 Nobel Prize in Economics, argued that there were positive externalities in both apple growing and beekeeping. The more apple trees planted, the greater the amount of honey that would be produced. And the more hives beekeepers kept, the larger the apple crops in neighboring apple orchards. Steven Cheung of the University of Washington showed that government intervention was not needed to increase economic efficiency in the markets for apples and honey because beekeepers and apple growers had long since arrived at private agreements. In other words, a “Coase solution” to the problem of positive externalities had been reached. Honeybees pollinate more than $15 billion worth of crops annually nationwide. According to the U.S. Department of Agriculture, there were 2.8 million of honeybee colonies in the United States in 2018, a 4.5 percent increase from the previous year. But this increase followed several years during which the honeybee population declined due to several factors, including what scientists refer to “colony collapse disorder.” The honeybee population has also been the victim of varroa mite, a parasite that lives in bee hives, as well as other insects. While some scientists have called for restricting or banning the use of the insecticides that many have claimed threaten bee colonies, other scientists are attempting to develop almond trees that require fewer bees to pollinate and a private company is attempting to commercialize a “blue orchard bee” that is stingless and works at colder temperatures than the honeybee.

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Sources: James E. Meade, “External Economies and Diseconomies in a Competitive Situation,” Economic Journal, Vol. 62, March 1952, pp. 54–67; Steven N. S. Cheung, “The Fable of the Bees: An Economic Investigation,” Journal of Law and Economics, Vol. 16, No. 1, April 1973, pp. 11–33; Alan Bjerga, “Bees Are Bouncing Back From Colony Collapse Disorder,” Bloomberg.com, August 1, 2017.

Question We know that owners of apple orchards and beehives are able to negotiate private agreements. Is it likely that as a result of these private agreements, the market supplies the efficient quantities of apple trees and beehives? Are there any real-world difficulties that might stand in the way of achieving this efficient outcome?

Answer It seems likely that private agreements will result in something close to the efficient quantities of apple trees and beehives. We know that private agreements are detailed and enforceable, so it is likely that the externalities can be internalized successfully. However, it is also likely that the transactions costs involved in negotiating the agreements results in the efficient quantities of apple trees and beehives not being attained exactly.

C. Do Property Rights Matter? Ronald Coase pointed out that the amount of pollution reduction will be the same whether polluters or the victims of pollution are legally liable for damages. Bargaining between the parties will result in the same reduction in pollution, where the marginal benefit of the last unit of reduction is equal to the marginal cost.

D. The Problem of Transactions Costs If many people suffer from the negative effects of pollution, bringing all the victims together with all the producers of the pollution to negotiate an agreement often fails due to high transactions costs. Transactions costs are the costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

E. The Coase Theorem The Coase Theorem is the argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. Private bargaining is most likely to reach an efficient outcome when the number of bargaining parties is small, all parties have full information about the costs and benefits associated with an externality and all are willing to accept a reasonable agreement.

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Extra Solved Problem 5.2 Ike’s Bar-B-Q Pit Reaches a Coase Solution Refer to Extra Solved Problem 5.1 in this Instructor’s Manual. Because Ike’s restaurant is not in a state that regulates smoking in public places, Ike decides to meet with his smoking and nonsmoking customers to accommodate both of their wishes regarding his smoking policy. Suggest a solution that would be consistent with the Coase Theorem.

Solving the Problem Step 1:

Review the chapter material. This problem is about the Coase theorem, so you may want to review the section “Private Solutions to Externalities: The Coase Theorem” in the textbook.

Step 2:

Describe the type of solution that would bring about an efficient outcome and be consistent with the Coase Theorem. Private bargaining between those who are the source of the externality and those who are affected by the externality could result in a solution that is satisfactory to both parties.

Step 3:

Suggest a solution that would enhance the well-being of Ike’s customers and increase economic efficiency. One possible solution is to construct a wall separating Ike’s restaurant into smoking and nonsmoking sections. This would raise the cost of providing meals at Ike’s and, in effect, shift to the left the supply curve that represents private costs from the graph in Extra Solved Problem 5.1. The cost of the wall could be passed on to either or both groups of customers. It would not matter if smokers or nonsmokers paid the cost , as long as the economically efficient rate of output was achieved where the marginal social cost equals the marginal benefit from the meals served at Ike’s restaurant.

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Government Policies to Deal with Externalities 5.3

Learning Objective: Analyze government policies to achieve economic efficiency in a market with an externality.

British economist A.C. Pigou was the first to analyze how governments should intervene when private solutions to externalities are not feasible.

A. Imposing a Tax When There Is a Negative Externality Pigou argued that to deal with a negative externality in production, the government should impose a tax equal to the cost of the externality, which would cause a producer to internalize the externality.

B. Providing a Subsidy When There Is a Positive Externality Pigou reasoned that the government can deal with a positive externality in consumption by giving consumers a subsidy equal to the value of the externality. Payment of the subsidy would allow consumers to internalize the externality. Pigovian taxes and subsidies are government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities. A Pigovian tax eliminates deadweight loss and improves economic efficiency.

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When you drive a car, you generate several negative externalities: You cause some additional air pollution, you increase the chances that other drivers will have an accident, and you cause some additional congestion on roads, causing other drivers to spend more time in traffic. The externalities may be particularly large in big cities. In 2019, the average speed of a car in midtown Manhattan in New York City was less than 5 miles per hour, about the same speed as someone jogging. New technology makes it possible to identify individual cars and track the routes they take. Beginning in 2019, the state of New York began using the technology to automatically bill any car from a ride-hailing service like Uber or Lyft a congestion fee, or tax, of $2.75 whenever the car traveled through midtown Manhattan.

a. Draw a graph showing the market for ride-hailing services in midtown Manhattan before the congestion fee was imposed. Indicate the efficient equilibrium quantity and the market equilibrium quantity.

b. Assume that the $2.75-per-ride tax results in the efficient quantity of rides from Uber, Lyft, and similar ride-hailing services. Illustrate this result using your graph from part (a). Will the price that consumers pay rise by $2.75? Briefly explain.

c. In pushing for the congestion fee, New York Governor Andrew Cuomo argued, “We have to pass a dedicated funding stream, so the [New York subway system] has the funding it needs. Congestion pricing is the only alternative.” Given that information, is it likely that the $2.75-per-ride tax will lead to an efficient equilibrium? Briefly explain by noting whether the demand curve for rides after the tax is imposed will be above or below the marginal social benefit curve and whether the equilibrium quantity will be larger or smaller than the efficient quantity.

Solving the Problem

Step 1:

Review the chapter material. This problem is about the government using a tax to deal with a negative externality, so you may want to review the section “Government Policies to Deal with Externalities.”

Step 2:

Answer part (a) by drawing a graph of the market for ride-hailing services. In this case, there is an externality in consumption of Uber and Lyft rides, so your graph should show Copyright © 2023 Pearson Education, Inc.

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the demand curve representing marginal social benefit being below the demand curve showing marginal private benefit. Your graph should also show the market equilibrium quantity of rides, QMarket, being greater than the efficient equilibrium quantity, QEfficient.

Step 3:

Answer part (b) by showing on your graph from part (a) that a tax of $2.75 per ride results in the efficient quantity of rides and by explaining the effect of the tax on the price that consumers pay. We can show the effect of the tax on consumers by shifting down the demand curve by the amount of the tax. Because we are told that the tax results in the efficient quantity of Uber and Lyft rides, the demand curve shifts down to D2, the marginal social benefit curve.

The graph shows that after the tax is imposed, consumers pay a price of P, which equals the efficient price PEfficient plus the $2.75 per ride tax. The price that consumers pay rises Copyright © 2023 Pearson Education, Inc.

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CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply from PMarket (which is the price they were paying before the tax) to P. The increase as shown in the graph by the vertical distance between the two prices is less than $2.75.

Step 4:

Answer part (c) by explaining why the tax will probably not result in an efficient equilibrium and by indicating the effect of the tax on the marginal social benefit curve and on the equilibrium quantity of rides. In part (b), we showed that a tax equal to the amount of the externality would shift down the demand curve for rides so that it is the same as the marginal social benefit curve. But Governor Cuomo was clear that in addition to reducing congestion, he wanted to use the tax to raise funds to repair the subway system. Therefore, the $2.75-per-ride tax is likely to be larger than the optimal tax. As a result, the demand curve will shift to being below the marginal social benefit curve. Therefore, equilibrium will move down the supply curve to a quantity that will be smaller than the efficient quantity (QEfficient).

C. Command-and-Control versus Market-Based Approaches A command-and-control approach to pollution is a policy that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices. Instead of a command-and-control approach, Congress decided to use a cap-and-trade system of tradeable emission allowances to deal with the problem of acid rain. The objective was to reduce emissions of sulfur dioxide to 8.5 million tons annually by 2010. The federal government gave electric utilities, the major sources of sulfur dioxide emissions that cause acid rain, allowances equal to the total amount of allowable emissions. The utilities were then free to buy and sell the allowances. Utilities that could reduce their emissions at a low cost did so and sold some or all of their allowances to utilities that could only reduce their emissions at a high cost. The program was successful not only in reducing emissions but in doing so at a much lower cost than had been expected.

D. The End of the Sulfur Dioxide Cap-and-Trade System Despite its success, the sulfur dioxide cap-and-trade system effectively ended in 2013. Research showed that illnesses caused by sulfur dioxide emissions were greater than previously had been thought. Although President George W. Bush proposed legislation to lower the cap on sulfur dioxide emissions, Congress did not pass the legislation. As a result, the Environmental Protection Agency (EPA) reverted to setting limits on sulfur dioxide emissions at the state or power plant level.

E. Are Tradable Emissions Allowances Licenses to Pollute? Some environmentalists have labeled tradable emissions allowances “licenses to pollute.” But this criticism ignores a central economics lesson: resources are scarce and trade-offs exist. Resources spent reducing pollution are not available for any other use. Because reducing acid rain using allowances cost Copyright © 2023 Pearson Education, Inc.

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utilities $870 million, rather than $7.4 billion as originally estimated, society saved more than $6.5 billion per year.

Teaching Tips Economists working for the private research group Resources for the Future (RFF) are among the strongest supporters of market-based systems, such as cap-and-trade systems or a carbon tax, to reduce pollution. In formulating environmental policy, it is often difficult to put a monetary value on environmental damage. For example, what is the dollar value of the breathing difficulty people with asthma experience due to sulfur dioxide pollution? Economists at RFF have pioneered techniques for measuring the value of things for which no market price exists. You can refer students interested in environmental economic issues to the RFF Web site: www.rff.org. RFF, located in Washington D.C., has internship programs that provide opportunities for undergraduates to do research with environmental economists.

Four Categories of Goods 5.4

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

Goods differ on the basis of whether their consumption is rival and excludable. Rivalry is the situation that occurs when one person’s consumption of a unit of a good means no one else can consume it. Excludability is the situation in which anyone who does not pay for a good cannot consume it. There are four categories of goods. A private good is a good that is both rival and excludable. A public good is a good that is both nonrival and nonexcludable. Free riding is benefiting from a good without paying for it. A quasi-public good is excludable but not rival. A common resource is a good that is rival but not excludable.

A. The Demand for a Public Good To arrive at a demand curve or marginal social benefit curve for a public good, we add the price each consumer is willing to pay for each quantity of the public good. This value represents the total dollar amount consumers as a group would be willing to pay for that quantity of the public good.

B. The Optimal Quantity of a Public Good The optimal quantity of any public good will occur where the marginal social cost equals the marginal social benefit. One difficulty with the market providing the economically efficient quantity of a public good is that the individual preferences of consumers are not revealed in this market. Because no consumer can be excluded from consuming the services provided by the good, no one has an incentive to reveal his or her preferences. Governments sometimes use cost–benefit analysis to determine the quantity of a public good that should be supplied. However, for many public goods, including national defense, the quantity supplied is determined by a political process involving Congress and the president. Copyright © 2023 Pearson Education, Inc.

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C. Common Resources In England during the Middle Ages, each village had an area of pasture, known as a commons, on which any family in the village was allowed to graze its cows or sheep without charge. Because the grass that one cow ate was not available to another cow, consumption was rival. But every family in the village had the right to use the commons, so it was nonexcludable and the commons would end up being overgrazed. The tendency for a common resource to be overused is called the tragedy of the commons. The source of the tragedy of the commons is the same as the source of negative externalities: a lack of clearly defined and enforced property rights. If the geographic area involved is limited and the number of people involved is small, access to the commons can be restricted through community norms and laws. If the geographic area or the number of people is large, legal restrictions on access to the commons are required.

Teaching Tips According to the U.S. Department of Agriculture, the average American consumes over 190 pounds of beef, pork, and chicken annually. Despite the continuing demand for these products, we do not see news reports of shortages of cows, pigs, and chickens. In contrast, there are occasional media reports of over-fishing and the potential extinction of some animal species. When resources are privately owned, the owners have incentive to manage their supplies, and producers have incentive to maintain the stocks of cows, pigs, and chickens. However, property rights to some parts of oceans, rivers, lakes, and habitat areas of endangered species are nonexistent or are poorly enforced.

Extra Economics in Your Life & Career How Can the Adverse Impact of a Carbon Tax be Minimized? In 2013, economists Marc Hafstead and Lawrence Goulder argued that a tax on carbon dioxide emissions would be an economically efficient means to reduce emissions while also generating billions of dollars annually for the U.S. government. But critics argued that a so-called “carbon tax” would fall disproportionately on lower income households who spend a large fraction of their income on energy. To reduce the adverse impact of higher taxes, tax advocates recommend rebating some of the revenue raised. But what type of tax rebate would be the most economically efficient? Hafstead and Goulder compared the potential effects of (a) cuts in taxes for businesses adversely affected by the carbon tax; (b) a lump-sum rebate to all households; and (c) marginal tax rate reductions. Marginal tax rates refer to the fraction of each additional dollar of income that must be paid in taxes. Source: Marc Hafstead and Lawrence H. Goulder, “Recycling Revenue from a Carbon Tax,” Common Resources, Resources for the Future, November 6, 2013.

Question: Which tax rebate would be the most economically efficient means to reduce the adverse impact of a carbon tax?

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Answer: Research by Hafstead and Goulder found that using revenue from a carbon tax to finance marginal tax rate cuts would significantly lower the cost of a carbon tax compared to lump-sum rebates. The impact of the tax would be even lower (the reduction in cost would be greater) if the government used the tax revenue to reduce tax rates of carbon-intensive industries such as coal mining, coal-fired electricity generation, and petroleum refining.

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Solutions to End-of-Chapter Exercises Externalities and Economic Efficiency 5.1

Learning Objective: Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

Review Questions 1.1

An externality is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Examples of positive externalities include (1) the benefits received by a passerby who enjoys a beautiful garden and (2) the benefit you receive from a reduced likelihood of catching influenza resulting from other people being vaccinated. Examples of negative externalities include the costs imposed on consumers from (1) the noise from a loud party or from a loud motorcycle exhaust and (2) the pollution emitted by a factory.

1.2

The private cost of producing a good will differ from the social cost when there is an externality. For example, the private cost of producing electricity includes the costs of the fuel and the operation of a power plant. The social cost includes the private costs plus the costs to consumers of the pollution emitted (a negative externality) of reduced visibility and possible health problems. The private benefit of consuming a good differs from the social benefit when there is an externality. For example, the private benefit from your college education includes your enjoyment of the experience and the increase in income you’ll receive as a college graduate. The social benefits include the benefits to third parties (a positive externality), such as to co-workers who benefit from your productivity and to people who receive more services from the government because you earn more income and pay more taxes.

1.3

Economic efficiency occurs when the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and where the sum of consumer surplus and producer surplus is maximized. Externalities generally reduce economic efficiency because buyers and firms ignore the external cost or benefit, which leads firms to either (1) produce more than the efficient quantity of the good if there is an external cost, or (2) produce less than the efficient quantity of the good if there is an external benefit.

1.4

Market failure is the failure of the market to produce the efficient level of output. Externalities, public goods, and common resources all cause market failure (as does monopoly, which will be covered in Chapter 15).

1.5

Externalities generally arise because of incomplete property rights or from difficulty in enforcing property rights.

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Problems and Applications 1.6

The neighbor’s barking dog serves as a positive externality when it makes you aware of or prevents a dangerous situation like a burglar entering your house. The barking dog serves as a negative externality when it barks constantly and disturbs you.

1.7

Obtaining human food often leads the bear to seek more human food, which causes the bear to be destroyed or removed from the park. For campers and hikers, the bear seeking human food could lead to the bear mauling or killing a camper or a hiker.

1.8

a. A positive externality arises from getting the flu shot because, in addition to the person getting the shot, other people receive benefits as well because they are less likely to catch the flu from someone who has received a flu shot. b. Because a positive externality arises from getting a flu shot, the efficient quantity (QEfficient) and price (PEfficient) are found by locating the point where the demand curve representing marginal social benefit (D2) and the market supply curve intersect. The gray shaded area represents the deadweight loss.

1.9

By an “economic incentive,” the writer is referring to an increase in profit that a corporation would receive from reducing pollution. Corporations lack an economic incentive to reduce pollution because they do not own the air or the water that they are polluting. (Although note the discussion in Section 5.2 of possible reasons why a corporation might be led to reduce pollution as a result of bargaining with those who are adversely affected by the pollution.) In the absence of government policies, such as taxes and limits to production discussed in Section 5.3, a corporation isn’t liable for the costs that it passes on to others when it pollutes.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

1.10

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

1.11

a. A positive externality arises from studying. b. Tom’s demand for studying is D2, the marginal social benefit curve, which adds together his marginal private benefit and the marginal external benefit to his potential children. He studies QT hours, which is the efficient number. Jacob’s demand for studying is D1, the marginal private benefit curve. Jacob studies only QJ hours, which is inefficient because at QJ hours the marginal social benefit from studying exceeds the marginal cost.

1.12

a. In the following graph on the left, we assume that dicamba has no external effects. Therefore, the supply curve represents the marginal private cost while the demand curve reflects the marginal private benefit. The introduction of dicamba reduces the cost of producing soybeans, so it shifts the supply curve to the right from S1 to S2, reducing the Copyright © 2023 Pearson Education, Inc.

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equilibrium price of soybeans from P1 to P2, and increasing the equilibrium quantity of soybeans from Q1 to Q2. b. In the following graph on the right, we now assume that dicamba causes damage to the crops of farmers growing soybeans that are not immune to this weed killer. Note that the analysis is complicated by two factors: First, in this market some suppliers (farmers using dicamba) are causing a negative externality while other suppliers (farmers not using dicamba) are not causing a negative externality. Second, those suffering from the effects of the externality are other suppliers, rather than consumers. In the graph, where the demand curve and supply curves S1 and S2 are reproduced from the graph on the left, the negative effect of dicamba on soybeans that are not immune to it causes the market supply curve to shift to the left from S2 to S3. Note that S3 now represents the marginal social cost of producing soybeans using dicamba because it includes the negative externality of lower soybean production from fields planted in soybeans that are not immune to the weed killer. c. Before dicamba was introduced, there was no externality in the soybean market, so the efficient price was the equilibrium price, P1, and efficient level of output was the equilibrium quantity Q1. The graph on the right shows that after dicamba is introduced the intersection between the demand curve (which represents marginal social benefit) and the supply curve representing marginal social cost, S3, occurs at a price of P3 and a quantity of Q3. (Note that the market equilibrium is an efficient equilibrium because some suppliers in the market bear the burden of the externality caused by the actions of other suppliers in the market.) As the curves have been drawn, efficient price has fallen and the efficient level of output has risen. It is possible, though, that the losses to farmer growing soybeans that are not immune to dicamba are larger than the gains to farmers using dicamba. In that case, supply curve S3 would be to the left of supply curve S1, the efficient price would have risen, and the efficient level of output would have fallen. We can’t be certain which outcome will occur.

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1.13

a. In relation to externalities, to “fix things” means that governments can enact policies that result in markets adjusting to so that the equilibrium quantity and price are efficient. To achieve this result, the market must produce at an output level where the marginal social cost equals the marginal social benefit. b. An unregulated market tends underproduce goods and services that exhibit positive externalities and overproduce goods and services that exhibit negative externalities. In a market with externalities, government policymakers can use laws and institutions to guide the market to produce at the socially efficient level of output.

Private Solutions to Externalities: The Coase Theorem 5.2

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

Review Questions 2.1

The economically efficient level of pollution is the quantity at which the marginal cost of eliminating another unit of pollution just equals the marginal benefit from eliminating it. In most cases, the economically efficient quantity of pollution isn’t zero. Eliminating all pollution would incur costs that are greater than the resulting benefits.

2.2

The Coase theorem argues that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. The parties involved have an incentive to reach an efficient solution because the benefits from reducing an externality are often greater than the costs.

2.3

Transactions costs are the costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. Private solutions to the problem of externalities are most likely to occur when it is easy to define and enforce property rights and when the costs of making a deal are low.

Problems and Applications 2.4

An increase in pollution could make society better off if the current level of pollution is below the efficient quantity. For example, government regulations could be so strict that they require pollution reductions to level A in the following figure. The marginal cost of the last unit of pollution reduction exceeds the marginal benefit, so society would be better off if pollution reduction was only at B—the efficient quantity.

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2.5

Yes, assuming that the marginal benefit does not drop to zero before all of that type of pollution is eliminated.

2.6

The marginal cost of reducing crime would include resources devoted to police, courts, and prisons. The marginal benefit from reducing crime would include the reduction in losses to crime victims, including losses due to personal injury, stolen goods, and anxiety. The marginal benefit from reducing murders and armed robberies is very high, but the marginal benefit from reducing littering is much lower. As with pollution, it would not be economically efficient to reduce the amount of crime to zero. In other words, there is an economically efficient level of crime where the marginal benefit from crime reduction equals the marginal cost.

2.7

As the level of pollution falls, further cleanup becomes increasingly costly because the marginal cost curve typically is upward sloping. Proven pollution reduction methods can be implemented at the beginning of the cleanup process, so air pollution resulting from automobile or factory emissions can be reduced. Because significant technological advances have already been made in these areas, the cost of implementation would be relatively low. Cleaning up the last 10 percent would be considerably more expensive because a low-cost method to completely eliminate air pollution in populated, urban areas has yet to be developed. An important tradeoff involves spending resources to develop a method to completely eliminate air pollution versus using those resources for other purposes, such as education.

2.8

a. No. The economically efficient level of ozone is the quantity at which the marginal cost of eliminating another unit of ozone just equals the marginal benefit from eliminating it. In most cases, the economically efficient quantity of pollution is not zero. b. No. As long as the Environmental Protection Agency (EPA) is not allowed to factor in the cost of environmental compliance when tightening its ozone standard, it’s likely that the EPA will require a level of ozone emissions that is below the economically efficient level. In other

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2.9

The policy is not likely to be economically efficient. Although the benefit to Mabel’s community from reducing the amount of illegal drug traffic from its (apparently) currently high levels would be substantial, at some point the additional benefit from reducing illegal drug use would likely be less than the additional cost.

2.10

The airline policy does not make it impossible to achieve an economically efficient outcome with respect to reclining seats. The Coase theorem is the argument that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. Suppose you’re an airline passenger who wants to recline your seat. You could ask for permission from the person seated behind. If that passenger objects to you reclining your seat, you could reach a compromise; for example, a partial recline or a complete recline for only part of the flight. Or the passenger behind you could pay you in exchange for agreeing to not recline your seat.

2.11

Preventing all seats from reclining is economically inefficient because for some passengers, the benefit of reclining their seats exceeds the cost they are imposing on the people in the seats behind them. Having a “no reclining” section on each flight could result in a socially efficient outcome because those who seriously object to having the seat in front of them recline can choose one part of the plane, while those who want to recline their seats (or who don’t care if the seat in front of them is reclined) choose a different part. The socially efficient outcome is dependent on whether the mix of reclining and non-reclining rows on a particular flight fits the preferences of passengers on that flight. In practice, it may be difficult for airlines to achieve the efficient mix.

Government Policies to Deal with Externalities 5.3

Learning Objective: Analyze government policies to achieve economic efficiency in a market with an externality.

Review Questions 3.1

A Pigovian tax aims to bring about an efficient level of output in the presence of externalities. The tax is set equal to the marginal external cost, which is the difference between the marginal social cost and the marginal private cost.

3.2

To internalize an externality means that the producer or consumer who creates the externality bears the costs or receives the benefits of the externality. A tax equal to the cost of a negative externality will cause producers to internalize the negative externality. A subsidy equal to the benefits of a positive externality will cause consumers to internalize a positive externality. A private solution along the lines of the Coase theorem would also internalize an externality. Copyright © 2023 Pearson Education, Inc.

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Many economists prefer market-based policies because they allow pollution to be reduced at the lowest cost. The firm that can reduce pollution cheaply will do so and sell its right to emit pollution to another firm whose costs of reducing pollution are high. The command-and-control approach is generally much costlier and, therefore, less efficient because it often forces firms to adopt expensive methods of pollution control.

Problems and Applications 3.4

a. To “restore market perfection” refers to policymakers using taxes and subsidies so that goods and services are produced at the socially efficient level. To achieve this efficient level, the market must produce the quantity of each good and service at which the marginal social cost equals the marginal social benefit. b. “Red tape” refers to government rules and regulations. It’s a pejorative term that implies that the rules and regulations impose an excessive burden on the households and firms that are required to follow them. If implemented correctly, Pigovian taxes and subsidies help the market reach the socially efficient outcome by making buyers and sellers take into account the true social cost or benefit of a good or service. When government policymakers rely on taxes and subsidies to deal with the problem of externalities, they can achieve economically efficient outcomes without the red tape involved in command-and-control policies.

3.5

a. If there were a positive externality in producing antibiotics, then the equilibrium in the market for antibiotics would not occur at the point where the marginal social benefit equaled the marginal social cost so that a government subsidy would be justified. It’s not clear why this positive externality in production would exist, though, at least for existing antibiotics. It is possible that the expense and uncertainty of developing new antibiotics might be very high, particularly given that the majority of pharmaceuticals developed turn out not to be effective and have to be abandoned before being brought to market—with heavy losses to pharmaceutical companies. If these costs and uncertainties make it difficult for pharmaceutical companies to obtain the funds to carry out research and development for new antibiotics, then a government subsidy might be justified, given the potentially catastrophic consequences that could result from diseases caused by antibiotic-resistant bacteria. b. Health insurance that covers some or all of the cost of prescriptions for antibiotics allows people to pay less “out of pocket” for these drugs. As a result, the demand for antibiotics is greater than it would be in the absence of health insurance coverage of these drugs. Holding all else constant, we would expect that the result would be that pharmaceutical companies will receive higher prices for antibiotics. These higher prices increase the incentives for pharmaceutical companies to develop new antibiotics and reduce the need for government subsidies. Whether this factor eliminates the need for government subsidies is difficult to determine. Copyright © 2023 Pearson Education, Inc.

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3.6

a. “Annoying people,” including babies who cry on buses and planes, cause a negative externality because they impose costs on the people around them. Taxing annoying people, including the parents of the crying children, may discourage people from being annoying (or encourage parents of crying babies to find alternative methods of keeping their children quiet). However, the administrative costs of monitoring crying babies and taxing their parents would be very high. In addition, many people might oppose such a tax because it would represent a government intrusion into what is usually considered a private matter. b. People who plant flowers cause a positive externality because they provide benefits (for instance, higher property values) to other neighborhood residents. Government subsidies may encourage more people to plant flowers, but the administrative costs of identifying beautiful gardens and deciding on the appropriate subsidy would be very large. c. Every negative externality should not be taxed, and every positive externality should not be subsidized. The government should compare the costs of imposing taxes and subsidies to the benefits. If the benefits associated with a Pigovian tax outweigh the costs, a Pigovian tax would reduce deadweight loss (and increase efficiency). In the cases discussed in parts (a) and (b) of this problem, administrative costs would likely be too high for taxes or subsidies to be an effective way of dealing with the externalities involved.

3.7

a. The “mortality effect” is the number of people who die prematurely. The number of people who die prematurely from being obese is less than the number of people who die prematurely from smoking. By living longer, people who are obese add more costs to society over their lifetimes. In particular, they are less likely than smokers to die before collecting much in Social Security and Medicare benefits. b. Far more people drink soda than smoke, so more people would notice (and be affected by) taxes on sodas. In addition, with so much discussion in the news over the years about the negative effects of smoking—including the effects on nonsmokers of “secondhand smoke”—more people are likely to accept taxes on cigarettes than on soda.

3.8

The following figure is similar to the one in Solved Problem 5.3 and shows the market for restaurant meals. D1 represents the marginal private benefit of the meals. The demand curve shifts downward because all diners recognize they are at risk of contracting the Covid-19 virus when eating in restaurants. D2 represents the marginal social benefit of restaurant meals. D1 may not shift enough to coincide with D2 if an externality remains, because even if diners correctly gauge the chances that they will contract Covid-19, they may not take into account that in contracting the virus from eating in a restaurant, they put at risk other people who may contract the virus from them. The effects of the externality is represented in the graph by the area of the deadweight loss. The size of the deadweight loss is reduced, but may not be eliminated.

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3.9

a. The tax should be the amount necessary to shift the supply curve from S1 to S2. That amount is $7.50 – $7.15 = $0.35 per item dry cleaned. b. The deadweight loss from excessive dry cleaning arises because the efficient number of items to dry clean is 600,000 per week, but the market equilibrium is 750,000 items per week. The following graph shows that the deadweight loss equals the amount by which the marginal social cost (S2) of cleaning the last 150,000 items exceeds the marginal benefit (the height of the demand curve for each of these items). The deadweight loss is shown by area A of the figure and has a value equal to: 0.5 × $0.35 × 150,000 = $26,250. (Note: We know that the base of the deadweight loss triangle must be $0.35 because S2 is parallel to S1, so the distance between them is constant.)

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3.10

The efficient level of toilet paper production will occur where the demand curve intersects the marginal social cost curve. So, the efficient level of production will be 350,000 tons, and the efficient price will be $150 per ton. If the government imposes a tax of $50 per ton (the difference between the marginal private cost and the marginal social cost), supply will shift from S1 to S2, resulting in the efficient price and quantity.

3.11

a. The federal government subsidizes electricity generated by wind turbines because electricity generated this way results in much lower pollution than does electricity generated from burning fossil fuels such as oil or coal. Without a subsidy, the market would under-produce electricity from wind turbines, creating an inefficiency that an appropriately sized subsidy could eliminate. b. The government could have used the command-and-control approach by requiring energy producers to generate a certain percentage of their total electricity production using renewable resources such as wind power.

3.12

a. The premise behind the Green New Deal is that climate change may cause substantial costs to the economy and the environment. b. Implementing the Green New Deal could be expensive because it includes proposals such as: (1) converting all power generation in the United States to clean, renewable, and zeroemission energy sources within 10 years; (2) upgrading all buildings to achieve maximum energy efficiency; (3) removing pollution and greenhouses gases from agriculture; and (4) overhauling the U.S. transportation system to remove pollution and greenhouse gas emissions. Each of these proposals is likely to prove very costly.

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c. An example of a market-based policy is a carbon tax, which increases the price of products that result in carbon dioxide emissions, thereby slowing climate change. The Green New Deal advocates a command-and-control approach under which carbon emissions and other sources of greenhouse gases would be reduced directly through government regulation. 3.13

a. A carbon tax would put a price on greenhouse gas emissions. Firms do not automatically pay a price when they emit gases because no one has a property right that would enable them to charge firms for the external costs of these gases. b. A carbon tax would result in higher prices for products, such as gasoline, whose use generate emissions of greenhouse gases. The higher prices would reduce consumption of these goods, thereby slowing global warming.

3.14

ExxonMobil would support a carbon tax because command-and-control proposals such as the Green New Deal would severely curtail or completely phase out the use of non-renewable resources like oil.

3.15

a. The following graph on the left shows that because burning coal generates a negative externality in the form of air pollution, the marginal social cost of producing electric power is greater than the marginal private cost that utilities pay. As a result, the efficient quantity (Qefficient) of coal used is less than the equilibrium quantity (Q1) in the absence of regulation. b. The following graph on the right shows that falling prices of renewable energy equipment will decrease the demand for coal, causing the demand curve to shift to the left from D1 to D2. The equilibrium quantity of coal declines from Q1 to Q2, which is closer to the efficient level (Qefficient).

5.4

xxx

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply Learning Objective: Categorize goods on the basis of whether they are rival or excludable and use graphs to illustrate the efficient quantities of public goods and common resources.

Review Questions 4.1

Rivalry occurs when one person’s consumption of a unit of a good means that no one else can consume it. Excludability occurs when anyone who doesn’t pay for a good cannot consume it. Goods that are both rival and excludable are called private goods, which are most of the goods we consume. Goods that are rival, but nonexcludable, are called common resources—such as fish in the sea. Goods that are both nonrival and nonexcludable are called public goods. Goods that are nonrival, but excludable, are called quasi-public goods.

4.2

Free riding is benefitting from a good without paying for it. A public good is nonrival and nonexcludable. Because anyone can get that good without paying for it once it has been produced—attempting to “free ride” —there is little incentive for firms to supply the good because they can’t cover their costs if people don’t pay for the good. Free riding will lead to market failure: Less than the economically efficient amount of a public good will be produced.

4.3

The tragedy of the commons is the tendency of a common resource to be overused. For example, in the Middle Ages, villagers would sometimes overuse common pastureland to the extent that the grass was largely consumed, so it no longer provided sufficient grass for the villagers’ cows. Similarly, today a sports field owned by a town may end up having its grass torn up from overuse. In both these cases, each individual user of a common resource fails to take into account the negative externality the person’s use may impose on other users. The tragedy of the commons can be avoided if there is a way to block overuse. One method is to give someone or some group a property right to the resource, which would give the person or group the incentive to use the resource efficiently. However, this won’t work well if the person or group cannot easily enforce the property right.

Problems and Applications 4.4

Because no one is prevented from riding on the merry-go-round, it is nonexcludable for those who visit the park. But the merry-go-round is rival because when one person is seated no one else can ride on the same seat. When the number of people who wish to ride on the merry-goround exceeds the number of seats, some people must wait for their turn. The merry-go-round is better classified as a common resource.

4.5

A public good is nonrival and nonexcludable. National parks such as Yosemite and Yellowstone are rival; as Margaret Walls suggests, the parks are subject to congestion problems when many people choose to visit them. It is possible to exclude visitors from national parks by charging higher fees during summer months. Since national parks are both rival and excludable (assuming that visitors must pay user fees to enter the parks), they are private goods. Visits to national parks result in negative externalities. Margaret Walls explains that damage to water and sewage Copyright © 2023 Pearson Education, Inc.

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systems, bridges, visitor centers, and other buildings are among the congestion problems park visitors cause. She recommends the parks increase user fees in order to cover these costs. 4.6

a. The optimal quantity of a public good is the quantity where the public’s marginal benefit from the good—as represented by the demand curve—is equal to the marginal cost of providing the good. To determine the optimal quantity, we need to know the demand curve for the city park and the marginal cost to the town of providing acres of parkland. To calculate the overall demand, we need to add the dollar amounts that Jill and Joe are willing to pay for each quantity:

The graph shows that the optimal size park—where marginal social cost equals marginal social benefit—is 4 acres. b. The marginal cost of supplying the second acre is $13. But the demand curve tells us that the marginal benefit Jill and Joe receive from the second acre is $21. Because the marginal benefit to society is well above the marginal cost, 2 acres cannot be the optimal size for the town park. 4.7

The tragedy of the commons is the tendency for a common resource to be overused. Because whales are a common resource, in the absence of agreements among governments to control whaling, several species have been hunted to near extinction. Chickens are not common resources but are instead raised in private markets where producers have an incentive to maintain the supply of chickens over time. Chickens are therefore not subject to near extinction.

4.8

a. Viewing elephants in a national park is a public good for two reasons. First, one person observing them doesn’t interfere with another person observing them. Second, no one with access to the park can be excluded from observing them. Elephants as trophy animals are not public goods because once a particular elephant is killed by a trophy hunter, it is no longer available to be hunted by someone else. In that sense, elephants are a rival good. b. Elephants cause a negative externality by damaging crops and injuring local inhabitants. If the inhabitants are no longer able to charge people to hunt elephants or to claim the meat from elephants that have been killed by hunting, they are less likely to want to preserve Copyright © 2023 Pearson Education, Inc.

xxxii CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply elephants. In effect, allowing local inhabitants to charge for killing elephants and to claim the meat of killed elephants gives those inhabitants a property right in the elephants. Without that property right, the inhabitants are unlikely to preserve elephants so tourists can enjoy observing the elephants in the national park. 4.9

Clean air and the village green are both common resources: They are rival and not excludable. Just as one farmer using the pasture leaves less grazing space for other farmers, one person polluting the air leaves less clean air for other people. Because they are not private goods, neither the pastureland nor the air can be excluded from being used.

4.10

a. Yes, “herd immunity” is a public good. Public goods are goods that are both nonrival and nonexcludable. As most people get vaccinated, it benefits everyone, even those who do not get vaccinated. Herd immunity is also nonexcludable because there is no mechanism to prevent someone not vaccinated from benefiting from herd immunity. b. A free rider receives a benefit from a good without paying for the good. The parent asking the question is apparently considering not getting his or her child vaccinated, hoping to free ride on the immunity of the other children who are vaccinated. If many parents attempt to free ride off other parents getting their children vaccinated, then “herd immunity” begins to break down, putting at risk children who have been vaccinated but who are susceptible to the disease because the vaccine wasn’t effective for them. c. Many people were vaccinated because they feared the serious effects that can result from contracting the Covid-19 virus. The government subsidized the development and manufacture of vaccines by pharmaceutical companies to increase their production and subsidized the price of the vaccines (typically making the vaccine available free), to reduce free riding.

4.11 Private Goods

Public Goods

Quasi-public Goods

Common Resources

(b) Home mail delivery (you’ll be excluded if you don’t use a stamp).

(a) A television broadcast (assuming that it is an over-the-air broadcast).

(a) A cable broadcast would be a quasi-public good because it is excludable but not rival.

(c) Education in a public school is a common resource—at least for people within the school district who won’t be excluded. Education is rival

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply xxxiii because as more students crowd into a classroom, the amount of attention the teacher gives to each student declines.

(d) Education in a private school

(g) An apple

4.12

(e) Hiking in a park surrounded by a fence is a quasi-public good because it is excludable but not rival.

(f) Hiking in a park without a fence

The village elders in Benin, Africa, were trying to prevent the tragedy of the commons. Their solution worked quite well given the small size of the village.

Suggestions for Critical Thinking Exercises

CT5.1 We hope students will offer up the idea of addressing externalities with Pigovian taxes. Or, they might use the Coase theorem and the situations in which it applies. In short, this question asks students to pick something they should have learned and to apply it to a general concept.

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

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CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply Brief Chapter Summary and Learning Objectives 6.1

The Price Elasticity of Demand and Its Measurement Define and calculate the price elasticity of demand. ▪

6.2

Price elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price.

The Determinants of the Price Elasticity of Demand List and explain the determinants of the price elasticity of demand. ▪

6.3

The key determinants of the price elasticity of demand are the availability of close substitutes, the passage of time, whether the good is a luxury or a necessity, the definition of the market, and the share of the good in the consumer’s budget.

The Relationship between Price Elasticity of Demand and Total Revenue Explain the relationship between the price elasticity of demand and total revenue. ▪

6.4

When demand is inelastic, price and total revenue move in the same direction. When demand is elastic, price and total revenue move in the opposite direction.

Other Demand Elasticities Define and calculate the cross-price elasticity of demand and the income elasticity of demand and explain their determinants. ▪

6.5

The cross-price elasticity of demand measures the responsiveness of the quantity demanded of one good to a change in the price of another good; the income elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in income.

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply xxxv Use price elasticity and income elasticity to analyze economic issues. ▪

6.6

Elasticity can help us understand why the family farm has become an endangered species and the effects of raising the federal government’s tax on gasoline.

The Price Elasticity of Supply and Its Measurement Define price elasticity of supply and explain its determinants and how it is measured. ▪

The price elasticity of supply measures the responsiveness of the quantity supplied to a change in price.

Key Terms Cross-price elasticity of demand The percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. Elastic demand The case where the percentage change in the quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value. Elasticity A measure of how much one economic variable responds to changes in another economic variable. Income elasticity of demand A measure of the responsiveness of the quantity demanded to changes in income, measured by the percentage change in quantity demanded divided by the percentage change in income. Inelastic demand The case where the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value. Perfectly elastic demand The case where the quantity demanded is infinitely responsive to

price and the price elasticity of demand equals infinity. Perfectly inelastic demand The case where the quantity demanded is completely unresponsive to price and the price elasticity of demand equals zero. Price elasticity of demand The responsiveness of the quantity demanded to a change in price, measured by dividing the percentage change in the quantity demanded of a product by the percentage change in the product’s price. Price elasticity of supply The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price. Total revenue The total amount of funds a seller receives from selling of a good or service, calculated by multiplying price per unit by the number of units sold. Unit-elastic demand The case where the percentage change in quantity demanded is

CHAPTER 6 | Elasticity: The Responsiveness of Demand and Supply

equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value.

Chapter Outline Do Soda Taxes Work? A number of cities, including San Francisco, Chicago, Berkeley, and Philadelphia, recently enacted taxes on soda. The tax can have positive effects on health because drinking sweetened beverages has been linked to health problems. The taxes also raise revenue for the cities that enact them. Governments have an incentive to determine how consumers will react to an increase in the price of a product following a tax increase. However, as the tax raises the prices consumers pay for sweetened beverages, grocery stores and supermarkets will sell a smaller quantity of these beverages. The greater the decline in the quantity of soda demanded, the greater the positive effect of the tax on health⸻ but the less revenue the city will raise from the tax. Under pressure from supermarkets and soda manufacturers as their sales of soda were declining, Chicago repealed its soda tax in 2017. The Philadelphia city council considered repealing the soda tax, but it was still in effect in mid-2021.

6.1

The Price Elasticity of Demand and Its Measurement Learning Objective: Define and calculate the price elasticity of demand.

Elasticity is a measure of how much one economic variable responds to changes in another economic variable. The price elasticity of demand is the responsiveness of the quantity demanded to a change in price, measured by dividing the percentage change in the quantity demanded of a product by the percentage change in the product’s price.

A. Measuring the Price Elasticity of Demand The slope of the demand curve is not used to measure elasticity because the measurement of slope is sensitive to the units chosen for quantity and price. Price elasticity of demand The price elasticity of demand is always negative. Because we are usually interested in the relative sizes of elasticities, we often compare their absolute values.

B. Elastic Demand and Inelastic Demand Elastic demand refers to the case where the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value. Copyright © 2023 Pearson Education, Inc.

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Inelastic demand refers to the case where the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value. Unit-elastic demand refers to the case where the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value.

C. An Example of Computing Price Elasticities In calculating the price elasticity between two points on a demand curve, we face a problem because we get a different value for price increases than for price decreases. The next section covers the formula economists use to avoid this problem.

D. The Midpoint Formula We can use the midpoint formula to ensure that we have only one value for the price elasticity of demand between two points on a demand curve. The midpoint formula uses the average of the initial and final quantities and the average of the initial and final prices. If Q1 and P1 are the initial quantity and price and Q2 and P2 are the final quantity and price, then the midpoint formula is: Price elasticity of demand

E. When Demand Curves Intersect, the Flatter Curve Is More Elastic When two demand curves intersect, the curve with the smaller slope (in absolute value) is more elastic, and the one with the larger slope (in absolute value) is less elastic.

F. Polar Cases of Perfectly Inelastic and Perfectly Elastic Demand If a demand curve is a vertical line, then it is perfectly inelastic. Perfectly inelastic demand is the case where the quantity demanded is completely unresponsive to price and the price elasticity of demand equals zero. If a demand curve is a horizontal line, then it is perfectly elastic. Perfectly elastic demand is the case where the quantity demanded is infinitely responsive to price and the price elasticity of demand equals infinity. Table 6.1 summarizes the different price elasticities of demand using the example of 2-liter bottles of soda. Note that the table uses the midpoint formula to calculate the elasticities.

Teaching Tips

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After illustrating a perfectly inelastic demand curve, ask your students to suggest examples. They may mention cigarettes, gasoline, or other goods that have relatively inelastic, but not perfectly inelastic, demands. Ask if the quantity demanded of the products they suggest would change if the price were not only higher but lower as well. Students who claim they would not buy less gasoline if the price rose are unlikely to argue that they would not buy more gasoline at lower prices. This discussion will help students understand that very few products have perfectly inelastic demand curves. You don’t need to spend much time discussing perfectly elastic demand. It should be sufficient for you to briefly mention perfect competition, a topic covered in Chapter 12.

Extra Apply the Rewriting the Elasticity Formula Concept Rewriting the elasticity formula may help students understand elasticity (E). Assume that we are interested in measuring the price elasticity of a linear demand curve. The midpoint elasticity formula in the textbook is:

We can drop both 2s from this equation. Recall that (Q2 − Q1) = ΔQ and (P2 − P1) = ΔP. Substituting, we have:

Because the elasticity equation divides one fraction by another fraction, you can rewrite this expression by multiplying the numerator by the inverse, or reciprocal, of the denominator. The associative property of multiplication allows us to divide ΔQ by ΔP and (P1 + P2) by (Q1 + Q2). Therefore:

Because the slope of a linear demand curve is constant and can be written as ΔP/ΔQ, we can write the elasticity formula as:

Writing the elasticity formula this way makes it clear that the elasticity is not the same as the slope of a demand curve. Along a linear demand curve, the slope will have a constant value, but the elasticity will Copyright © 2021 Pearson Education, Inc.

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not be constant. The formula highlights this fact and makes another important point. Because the law of demand tells us that high prices are associated with relatively low values of quantity demanded (and vice versa), the absolute values for elasticity will be high at high prices (demand is elastic) and relatively low at low prices (demand is inelastic). We can show this result by substituting in actual price and quantity values for a given demand curve into the rewritten formula and observing the change in the ratio of (P1 + P2) to (Q1 + Q2) as price is decreased.

6.2

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

There are five key determinants of the price elasticity of demand.

A. Availability of Close Substitutes The availability of substitutes is the most important determinant of the price elasticity of demand. In general, if a product has more substitutes, it will have a more elastic demand. If a product has fewer substitutes, it will have a less elastic demand.

B. Passage of Time The more time that passes, the more elastic the demand for a product becomes.

C. Luxuries versus Necessities The demand curve for a luxury is more elastic than the demand curve for a necessity.

D. Definition of the Market The more narrowly we define a market, the more elastic demand will be.

E. Share of a Good in a Consumer’s Budget In general, the demand for a good will be more elastic the larger the share of the good in the average consumer’s budget.

F. Some Estimated Price Elasticities of Demand Figure 6.2 lists some estimated short-run real-world price elasticities of demand. It is important to remember that estimates of the price elasticity of different goods vary depending on the data used and the time period over which the estimates were made.

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Teaching Tips Present each of the five determinants of the price elasticity of demand separately from the others. A product that consumes a small part of a consumer’s budget (this suggests demand would be relatively inelastic) may have several good substitutes (this suggests demand would be relatively elastic). Changes in the market price of any product will result in different values for price elasticity. Estimates of the price elasticity of demand use prices from particular time periods. Different market prices from different time periods will result in different elasticity estimates.

Extra Solved Problem 6.2 The Recession of 2007–2009 Batters Fancy Restaurants as Consumers Trade Down Among the victims of the 2007–2009 recession were luxury restaurants in large cities such as New York , San Francisco, and Chicago. Rubicon, a top-rated San Francisco restaurant, closed in August 2008. The Blue Water Grill in Chicago also closed. Other restaurants attempted to survive by offering discounts. High-end New York restaurant Jean Georges slashed prices for three- and four-course meals. Other restaurants followed suit, some offering three-course meals for less than $20. To avoid high labor costs, San Francisco’s Fifth Floor started an “Honor Bar” where customers placed money in a box on the honor system and poured their own wine. An article summarizing the woes of the restaurant industry commented: Currently, consumers appear to be “trading down,” choosing lower-priced restaurants than they used to. The National Restaurant Association projects sales, adjusted for inflation, will decline by 2.5% in full service restaurants in 2009, while it predicts quick service will grow by 0.4%. Stephen Hanson, who closed several of his once-successful restaurants in New York and Chicago, had better luck with restaurants that offered less expensive meals. Mr. Hanson explained the success of his big restaurants that earned a small profit from a large number of customers: “I’m in the volume business.” By 2010, business at upscale and other restaurants began to recover as the 2007–2009 recession ended. Sources: Katy McLaughlin, “What’s Not Cooking,” Wall Street Journal, January 23, 2009, and Kevin P. Casey, “From fast food to fine dining, business is up at restaurants,” USA Today, November 22, 2010.

a. What are the key determinants of the price elasticity of demand for meals served at high-end restaurants? b. Cite evidence that during the 2007–2009 recession high restaurant prices resulted in a lower quantity demanded and a substitution by consumers to lower-priced alternatives.

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Step 1:

Review the chapter material. This problem is about the determinants of the price elasticity of demand, so you may want to review the section “The Determinants of the Price Elasticity of Demand” in the textbook.

Step 2:

Answer part (a) by explaining the key determinants of the price elasticity of demand for meals served at high-end restaurants. The key determinants are the availability of close substitutes (for example, “quick service” restaurants that serve less expensive meals) and the share of restaurant meals in consumers’ budgets.

Step 3:

Answer part (b) by citing evidence that during the 2007–2009 recession high restaurant prices resulted in a lower quantity demanded and a substitution by consumers to lowerpriced alternatives. During the recession of 2007–2009, high-end restaurants had their worst downturn in decades. San Francisco’s Rubicon and the Blue Water Grill in Chicago closed in 2008 but sales at “quick service” restaurants increased. Steven Hanson, owner of several restaurants, reported that he had success with restaurants that charged low prices.

The Relationship between Price Elasticity of Demand and Total Revenue 6.3

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

Total revenue is the total amount of funds a seller receives from selling a good or service, calculated by multiplying price per unit by the number of units sold. When demand is inelastic, price and total revenue move in the same direction: An increase in price raises total revenue, and a decrease in price reduces total revenue. When demand is elastic, price and total revenue move inversely: An increase in price reduces total revenue, while a decrease in price raises total revenue. If demand is unit elastic a change in price is exactly offset by a proportional change in quantity demanded, leaving revenue unaffected.

A. Elasticity and Revenue with a Linear Demand Curve Along most demand curves, including linear demand curves, elasticity is not constant at every point. When the price is high and the quantity demanded is low, demand is elastic. When the price is low and the quantity demanded is high, demand is inelastic.

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Extra Determining the Price Elasticity of Demand through Market Apply the Experiments Concept Firms usually have a good idea of the price elasticity of demand for products that have been on the market for at least a few years. For new products, however, firms often experiment with different prices to determine the price elasticity. For example, Apple introduced the first-generation iPhone in June 2007, at a price of $599. But demand for the iPhone was more elastic than Apple had expected, and when sales failed to reach Apple’s projections, the company cut the price to $399 just two months later. Similarly, when 3D televisions were introduced into the U.S. market in early 2010, Sony and other manufacturers believed that sales would be strong despite prices being several hundred dollars higher than for other high-end ultra-thin televisions. Once again, though, demand turned out to be more elastic than expected, and by December firms were cutting prices 40 percent or more in an effort to increase revenue. Electronic books (e-books) became popular after Amazon introduced the Kindle e-reader om 2007, so firms experimented with different prices to determine the relevant price elasticity. Amazon had originally priced most best-selling e-books at $9.99, but when Apple introduced the iPad in 2010, Apple negotiated contracts with publishers that raised prices for e-books. Amazon and Barnes & Noble eventually signed similar contracts, and the prices for best-selling e-books rose from $9.99 to $12.99 or $14.99. Publishers hoped that a low price elasticity of demand for e-books would result in the price increase leading to higher revenues. Many buyers, however, claimed that rather than pay higher prices, they would go back to reading printed books. Joel Waldfogel, an economist at the University of Pennsylvania, raised the possibility that the higher prices might lead some readers to illegally download pirated e-books, in violation of the publishers’ copyrights. Although piracy has been a problem with music and movies, it had not yet been a problem with books. Waldfogel argued that, “I would be scared to death about a culture of piracy taking hold. I wouldn’t mess around with price increases.” Source: Daisuke Wakabayashi and Miguel Bustillo, “TV Makers Can’t Hold Line on 3-D Prices,” Wall Street Journal, December 20, 2010; Motoko Rich and Brad Stone, “Cost of an e-Book Will Be Going Up,” New York Times, February 11, 2010; and Kate Hafner and Brad Stone, “iPhone Owners Crying Foul Over Price Cut,” New York Times, September 7, 2007.

Question A publisher was quoted as saying the following about the pricing of e-books: “We may introduce *an ebook] at $14.95 for a year and then move the book to $9.99 when we would have put out the trade paperback edition. I suspect you’re going to see a fair amount of experimentation.” Why would issuing a paperback version of a book affect the price a publisher would charge for an e-book? Why did publishers experiment with the prices of e-books? Copyright © 2021 Pearson Education, Inc.

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Source: Motoko Rich and Brad Stone, “Cost of an e-Book Will Be Going Up,” New York Times, February 11, 2010.

Answer The paperback edition is a reasonably good substitute for the e-book edition. Publishers experimented with the prices of e-books because they were relatively new products, which made estimating price elasticity difficult.

Extra Apply the Why Does Amazon Care about Price Elasticity? Concept

Hachette is a large book publisher whose authors include James Patterson, J. K. Rowling, and J. D. Salinger. In 2014, Hachette and Amazon disagreed on what price to charge for e-books. Hachette was charging between $14.99 and $19.99 for its e-books, but Amazon wanted the publisher to lower the price to only $9.99. Amazon pressured Hachette by: (1) reducing discounts on the publisher’s hardcover books; (2) not allowing Amazon customers to preorder the publisher’s books; and (3) delaying shipping some of its books by two to three weeks.

But why did Amazon want Hachette to lower the price of e-books? In a posting on its Web site, Amazon asserted, “We’ve quantified the price elasticity of e-books from repeated measurements across many titles.” Amazon estimated that the price elasticity of demand for e-books is 1.35. The following table uses Amazon’s estimate to show how sales revenue would change in response to a decrease in the price of e-books.

Amazon concluded, “At $9.99, even though the customer is paying less, the total pie is bigger and there is more to share amongst *Amazon, Hachette, and the author of the book+.” If Amazon’s analysis is correct, why would Hachette resist cutting the prices of e-books? Hachette believed that while the demand for bestsellers by authors such as James Patterson and J. K. Rowling might be price elastic, the demand for other e-books it published by less-well-known authors or on obscure subjects was price inelastic. For those books, cutting the price would reduce Hachette’s revenue. In addition, Hachette believed that lower prices on e-books might come at the expense of sales of hardcover copies of those Copyright © 2021 Pearson Education, Inc.

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books, on which the publisher made higher profits. Eventually, Amazon and Hachette reached an agreement that allowed Hachette to determine the prices its e-books would sell for on Amazon’s site. Amazon signed similar agreements with other publishers. In the following years, prices of e-books increased on Amazon. The results of the higher prices, though, weren’t what the publishers had hoped for, as they were accompanied by falling revenue. The Wall Street Journal quoted an executive at a publishing company as observing, “The new business model for e-books is having a significant impact…. There’s no question that publishers’ net receipts have gone down.” Amazon appeared to be correct about the demand for ebooks being price elastic. The publishers, though, believed they would still gain from higher e-book prices pushing more consumers toward buying hardcover editions of those books.

Sources: Jeffrey A. Trachtenberg, “E-Book Sales Fall after New Amazon Contracts,” Wall Street Journal, September 3, 2015; The Amazon Books Team, “Announcement Update re: Amazon/Hachette Business Interruption,” Amazon.com, July 29, 2014; Farhad Manjoo, “Amazon Wants Cheaper E-books. But Should It Get to Enforce Prices?” New York Times, August 1, 2014; Tom Ryan, “Amazon Explains Digital Pricing Elasticity,” retailwire.com, August 4, 2014; David Streitfeld, “Amazon and Hachette Resolve Dispute,” New York Times, November 13, 2014; and Brent Kendall, “Supreme Court Turns Away Apple Appeal in Ebooks Antitrust Case,” Wall Street Journal, March 7, 2016.

Solved Problem 6.3 Price and Revenue Don’t Always Move in the Same Direction In 2013, New York City officials believed they needed more revenue to maintain 35 city-owned recreation centers. To raise the additional revenue, the city’s parks department increased the annual membership fee to use the centers from $75 to $150. According to an article in the New York Times, “the department had hoped to realize $4 million in new revenue, but in fact, it lost about $200,000.”

The article also explained that the parks department had expected a 5 percent decline in memberships due to the price increase.

a. What did the parks department believe about the price elasticity of demand for memberships in its recreation centers? b. Is demand for memberships actually elastic or inelastic? Briefly explain. Illustrate your answer with a graph showing the demand curve for memberships as the parks department believed it to be and as it actually is.

Solving the Problem

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Step 1:

Review the chapter material. This problem deals with the effect of a price change on a firm’s revenue, so you may want to review the section “The Relationship between Price Elasticity of Demand and Total Revenue” in the textbook.

Step 2:

Answer part (a) by explaining how the parks department viewed the demand for memberships. Based on the following table, we can conclude that managers at the parks department must have thought the demand for memberships was inelastic because they believed that revenue would increase if they raised the price. The managers estimated that the quantity of memberships demanded would fall by 5 percent following the 100 percent price increase. Therefore, they must have believed that the price elasticity of demand for memberships was 5%/100% = 0.05.

Step 3:

Answer part (b) by explaining whether the demand for memberships is actually elastic or inelastic and by drawing a graph to illustrate your answer. Because revenue fell when the parks department raised the membership price, we know that demand for memberships must be elastic. In the following graph, D1 shows the demand for memberships as the parks department believed it to be. Moving along this demand curve from point A to point B, an increase in the price from $75 to $150 causes a decline of only Q1 to Q2 in the quantity of memberships demanded. D2 shows the demand curve as it actually is. Moving along this demand curve from point A to point C, the increase in price causes a much larger decline of Q1 to Q3 in memberships demanded.

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Source: Lisa W. Foderaro, “Public Recreation Centers Looking to Stem Exodus,” New York Times, February 15, 2013.

Other Demand Elasticities 6.4

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

In addition to price elasticity, two other demand elasticities are important: the cross-price elasticity of demand and the income elasticity of demand.

A. Cross-Price Elasticity of Demand The formula for the cross-price elasticity of demand is:

The cross-price elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. An increase in the price of a substitute will lead to an increase in quantity demanded, so the cross-price elasticity of demand will be positive. An increase in the price of a complement will lead to a decrease in the quantity demanded, so the crossprice elasticity of demand will be negative.

B. Income Elasticity of Demand

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The income elasticity of demand of demand is a measure of the responsiveness of the quantity demanded to changes in income, measured by the percentage change in the quantity demanded divided by the percentage change in income:

If the quantity demanded of a good increase as income increases, then the good is a normal good. Normal goods are often further subdivided into luxuries and necessities. The income elasticity of demand for a necessity is positive but less than 1. The income elasticity of demand for a luxury is greater than 1. A good is inferior if the quantity demanded falls as income increases.

Teaching Tips Many students confuse one type of elasticity with another. Ask your students to solve the following problem. Assume that the absolute value of the price elasticity of demand for oranges is 2.5. Are oranges a normal good? Answer: You cannot determine whether oranges are a normal good or inferior good by knowing its price elasticity. You need to know the income elasticity of demand for oranges to answer this question.

Extra Solved Problem 6.4 A Subway Fare Increase and an Economic Boom Affect the Taxi Business Assume that two separate events affect the market for taxi rides in New York City: a. There is a 20 percent increase in New York subway fares. As a result, the price of a taxi ride increases by 5 percent. b. An economic expansion causes a 5 percent increase in the incomes of tourists visiting New York City. As a result, the price of a taxi ride increases by 2 percent. Describe the cross-price and income elasticity formulas and use the formulas to determine the values of these elasticities for taxi rides.

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Solving the Problem Step 1:

Review the chapter material. This problem is about the determinants of the cross-price elasticity and income elasticity of demand, so you may want to review the section “Other Demand Elasticities” in the textbook.

Step 2:

State the cross-price elasticity formula and determine the value of this elasticity for taxi rides. The cross-price elasticity formula is:

Because a 20 percent increase in subway fares raised the quantity demanded of taxi rides by 5 percent, the value of the cross-price elasticity is

The elasticity is positive, so subway and taxi rides are substitutes. Step 3:

State the income elasticity formula and determine the value of this elasticity for taxi rides. The income elasticity is:

Because a 5 percent increase in income led to a 2 percent increase in taxi rides, the value of the income elasticity is:

The elasticity is positive but less than 1. Therefore, a taxi ride is a normal good and a necessity.

6.5

Using Elasticity to Analyze the Disappearing Family Farm Learning Objective: Use price elasticity and income elasticity to analyze economic issues.

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From 1950 to 2020, the number of farms in the United States decreased from about 5.6 million to about 2.1 million, and the number of people who lived on farms fell from 23 million to fewer than 3 million. Rapid growth in farm output and low price and income elasticities combined to make family farming difficult in the United States. In 1950, the average wheat farmer harvested about 17 bushels from each acre. By 2020, the average wheat farmer harvested 50 bushels per acre. This increase in wheat production resulted in a substantial decline in prices because: (1) the demand for wheat is price inelastic and (2) the income elasticity of demand for wheat is low.

Extra Solved Problem 6.5 Using Price Elasticity to Analyze Policy toward Illegal Drugs An ongoing policy debate concerns whether to legalize the use of drugs such as marijuana and cocaine. (Since 2012, 16 states in the United States have legalized recreational marijuana for people over age 21. And 36 states have legalized medical marijuana). Some researchers estimate that legalizing cocaine would cause its price to fall by as much as 95 percent. Proponents of legalization argue that legalizing drug use would lower crime rates by eliminating the main reason for the murderous gang wars that plague many big cities and by reducing the incentive for drug addicts to commit robberies and burglaries. Opponents of legalization argue that lower drug prices would lead more people to use drugs. a. Suppose the price elasticity of demand for cocaine is −2. If legalization causes the price of cocaine to fall by 95 percent, what would be the percentage increase in the quantity of cocaine demanded? b. If the price elasticity is −0.02, what would be the percentage increase in the quantity demanded? c. Discuss how the size of the price elasticity of demand for cocaine is relevant to the debate over its legalization.

Solving the Problem Step 1:

Review the chapter material. This problem deals with applications of the price elasticity of demand formula, so you may want to review the sections “Using Elasticity to Analyze the Disappearing Family Farm,” and “Measuring the Price Elasticity of Demand” in the textbook.

Step 2:

Answer part (a) using the formula for the price elasticity of demand. Price elasticity of demand

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We can plug into this formula the values given for the price elasticity and the percentage change in price:

Therefore: The percentage change in quantity demanded = −2 × −95% = 190% Step 3:

Use the same method to answer part (b). We only need to substitute −0.02 for −2 as the price elasticity of demand: The percentage change in quantity demanded = −0.02 × −95% = 1.9%

Step 4:

Answer part (c) by discussing how the size of the price elasticity of demand for cocaine helps us to understand the effects of legalization. The higher the absolute value of the price elasticity of demand for cocaine, the greater the increase in cocaine use that would result from legalization. If the price elasticity is as high as in part (a), legalization will lead to a large increase in use. If, however, the price elasticity is as low as in part (b), legalization will lead to only a small increase in use.

Extra Credit: One estimate puts the price elasticity for cocaine at −0.28, which suggests that even a large fall in the price of cocaine might lead to only a moderate increase in its use. However, even a moderate increase in cocaine use would have costs. Some studies have shown that cocaine users are more likely to commit crimes, to abuse their children, to have higher medical expenses, and to be less productive workers. Moreover, many people object to the use of cocaine and other narcotics on moral grounds and would oppose legalization even if it led to no increase in use. Ultimately, whether the use of cocaine and other drugs should be legalized is a normative issue. Economics can contribute to the discussion but cannot decide the issue.

Source for estimate of price elasticity of cocaine: Henry Saffer and Frank Chaloupka, “The Demand for Illicit Drugs,” Economic Inquiry, Vol. 37, No. 3, July 1999, pp. 401–411. Source for states that have legalized marijuana: https://www.businessinsider.com/legal-marijuana-states-20181#:~:text=Since%202012%2C%2016%20states%20and,marijuana%2C%20whether%20medically%20or%20recreationally.

The Price Elasticity of Supply and Its Measurement 6.6

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

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To measure how much quantity supplied increases when price increases, we use the price elasticity of supply.

A. Measuring the Price Elasticity of Supply The price elasticity of supply is the responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price. We calculate the price elasticity of supply using percentage changes:

Because of the law of supply, the price elasticity of supply will be a positive number. If the price elasticity of supply is less than 1, then supply is inelastic. If the price elasticity of supply is greater than 1, then supply is elastic. If the price elasticity of supply is equal to 1, supply is unit elastic.

B. Determinants of the Price Elasticity of Supply Whether the supply curve is elastic or inelastic depends on the ability and willingness of firms to alter the quantity they produce as price increases. The supply curve for most products will be inelastic if we measure it over a short period of time, but increasingly elastic the longer the period of time over which we measure it.

C. Polar Cases of Perfectly Elastic and Perfectly Inelastic Supply It is possible for supply to fall into one of the polar cases of price elasticity. If a supply curve is a vertical line, it is perfectly inelastic. If a supply curve is a horizontal line, it is perfectly elastic. Table 6.5 summarizes the different price elasticities of supply using the example of 2-liter bottles of soda. Note that the table uses the midpoint formula to calculate the elasticities

D. Using Price Elasticity of Supply to Predict Changes in Price When demand increases, the amount that price increases depends on the price elasticity of supply. When the supply is inelastic, a change in demand results in a larger increase in price than when the supply is elastic.

Extra Solved Problem 6.6 The Supply of New York City Taxi Medallions from 2013 to 2017 Taxi companies in New York City are required by law to purchase a medallion. In 2013, some of those medallions cost $1 million each. In fall of 2017, the medallions were worth less than $400,000 each. The New York City Taxi and Limousine Commission limits the number of medallions to 13,587. Because of Copyright © 2021 Pearson Education, Inc.

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the limit placed on the number of medallions, as demand for taxis and medallions rose from 1980 to 2013, the price of a medallion increased by about 1,000 percent. The number of medallions did not change from 2013 to 2017, but competition from ride-sharing companies such as Uber and Lyft was responsible for most of the decline in the price of medallions. Sources: Jared Mayer, “New York’s Taxi King Is Going Down,” the Federalist, October 26, 2015; Ilya Marritz, “NYC Taxi Medallions Fetch ‘Unbelievable’ Returns,” National Public Radio, November 15, 2011; and “NYC Taxi Medallions Sell for $1.1 Million,” Economic Policy Journal, March 18, 2013. Winnie Hu, “Taxi Medallions, Once a Safe Investment, Now Drag Owners Into Debt,” New York Times, September 10, 2017.

a. What was the value of the price elasticity of supply of New York City taxi medallions between 2013 and 2017? b. Why hasn’t competition from ride-sharing companies such as Uber and Lyft affected the elasticity supply of New York City taxi medallions?

Solving the Problem Step 1:

Review the chapter material. This problem is about the determinants of the elasticity of supply, so you may want to review the section “The Price Elasticity of Supply and Its Measurement” in the textbook.

Step 2:

Answer part (a) by determining the value of the price elasticity of supply of New York City taxi medallions between 2013 and 2017. The price elasticity of supply formula is:

Because the quantity supplied of medallions did not change between 2013 and 2017, the percentage change in the quantity supplied of medallions was zero, as was the price elasticity of supply. The medallion supply curve was vertical at the quantity of 13,587 medallions. Step 3:

Answer part (b) by explaining why competition from ride-sharing companies such as Uber and Lyft hasn’t affected the elasticity of supply of New York City taxi medallions. Competition has not affected the elasticity of supply because the New York City Taxi and Limousine Commission determines the number of medallions. As the price of medallions fell from 2013 to 2017, the quantity supplied of medallions remained the same. Competition from ride-sharing companies has caused a significant decrease in the demand for medallions, which has reduced the price drivers and taxi companies have been willing to pay for them.

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Extra Economics in Your Life & Career: Can Knowledge of Elasticities Make You Rich? Question: After studying the material in this chapter, you should understand why it’s important for managers of firms to know the income and price elasticities of their products. But what if you are not a manager or owner of a firm? If, for example, you were interested in investing some of your hard-earned savings in the stock market, how would knowing income and price elasticities help you? Answer: The best advice for success in the stock market is still “buy low, sell high.” But what you learned about elasticity also may be helpful, at least in a general way. Firms that sell products with high income elasticities—for example, houses and automobiles—experience especially large fluctuations in sales as the overall economy moves through the business cycle. Consumers are reluctant to buy expensive products during a recession, especially if they must take out loans to do so. But sales of these same items tend to increase rapidly when the economy moves into an expansion.

Solutions to End-of-Chapter Exercises 6.1

The Price Elasticity of Demand and Its Measurement Learning Objective: Define and calculate the price elasticity of demand.

Review Questions 1.1

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

1.2

The price elasticity of demand for Cheerios =

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In calculating the percentage change in price and quantity, the midpoint formula divides the change in price and the change in quantity by the average of their starting and ending values.

Percentage changes can also be calculated by using the starting value or the ending value without averaging. However, unlike the midpoint formula, these methods give different results depending on whether the starting or ending value is used. 1.4

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

Problems and Applications

1.5

You should disagree because the choice of the words is not precise. Economists define the price elasticity of demand as the responsiveness of the quantity demanded of a good to a change in the good’s price, not the responsiveness of the demand for the good. We use the phrase “change in quantity demanded” when there is a change in the amount of a good or service that consumers are willing and able to purchase as a result of a change in the price of the good. We use the phrase “change in demand” when there is a change in the amount of a good or service that consumers are willing and able to purchase as a result of a change in a variable that is not the price of the good. Copyright © 2021 Pearson Education, Inc.

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1.6

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

Because the price elasticity of demand is greater than 1 (in absolute value) the demand for soda is price elastic.

1.7

b. Yes. The calculation in part (a) assumes that the demand for orange juice did not change, so the change in the quantity demanded of orange juice resulted only from a change in the price. If consumers’ tastes also changed, then the demand curve for orange juice shifted and the 5.1 percent decline in orange juice consumption is partly due to the shift in the demand curve and partly due to a movements along the demand curve resulting from a change in price. With this additional information, we know that the price elasticity of demand must be smaller in absolute value (that is, closer to zero) than −1.96. 1.8

a. First, note that selling 6.5 times as many Tea Forté samplers means that the quantity demanded increased by 550 percent.

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

1.9

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. This value is a much smaller than the value in (a).

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

Percentage change in price = So: = Notice that this value is significantly different from the values calculated in (a) and (b).

1.10

For D1: Percentage change in quantity demanded =

Percentage change in price =

Elasticity = For D2: Percentage change in quantity demanded =

Percentage change in price =

Elasticity = 1.11

At a higher price of $119, quantity demanded for Amazon Prime services will decrease, so the total revenue (price × quantity sold) will increase by less than $2 billion. Only in the very unlikely case in which the demand for the Amazon Prime services is perfectly inelastic would the business website’s analysis be correct. Copyright © 2021 Pearson Education, Inc.

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

Review Questions 2.1

The most important determinant of the price elasticity of demand is usually the availability of substitutes for the product. If there are close substitutes, elasticity will be high because people can switch to buying another good as the product’s price rises. Other factors determining the price elasticity of demand for a product include: (1) the passage of time; (2) whether the good is a necessity or a luxury; (3) how narrowly the market for the good is defined; and (4) the share of the good in the consumer’s budget.

2.2

The demand for most agricultural goods is inelastic. Food is a necessity, and the demand for necessities tends to be less elastic than the demand for luxuries.

Problems and Applications 2.3

Milk (a), gasoline (c), and prescription medicine (d) are likely to be price inelastic due to the lack of substitutes, but frozen cheese pizza (b) is likely to be price elastic because it is not a necessity and has good substitutes, such as freshly prepared pizza served in restaurants.

2.4

As more competitors enter the coffee house market, consumers have more choices for coffee. As a result, the demand for coffee house services will become more price elastic. If Starbucks raises its price by one percent, the company will experience a larger percentage decrease in quantity demanded when it has more competitors than when it had fewer competitors.

2.5

Price elasticity of demand:

Because the price elasticity of demand is less than one (in absolute value), the demand for bus rides is price inelastic. The five determinants of the price elasticity are: (1) the availability of substitutes; (2) the passage of time; (3) whether the good is a luxury or a necessity; (4) the definition of the market; and (5) the share of the good in a consumer’s budget. For many people who do not own an automobile, there are no good substitutes for bus transportation, which is more of a necessity than a luxury. These are probably the most important reasons why demand was price inelastic. 2.6

The more narrowly a market is defined, the more elastic demand will be because there are more available substitutes. The price elasticity of Coca-Cola (or any specific brand of soda) will be Copyright © 2021 Pearson Education, Inc.

CHAPTER 7 |The Economics of Health Care xxvii higher than for soda as a product because there are more substitutes available for a specific product like Coca-Cola than there are for a product category such as soda.

2.7

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

Solving for the percentage change in price, we get:

So, for the quantity demand to decline by 1 percent, the price must increase by 50 percent. b. We would expect the price elasticity of demand for gasoline to become larger (in absolute value) in the long run. It usually takes some time for consumers to adjust their buying habits as prices change. As time passes, consumers will be better able to find substitutes to driving their own cars, such as riding the bus or subway or carpooling. And some consumers will switch to more fuel-efficient vehicles, including electric cars, resulting in a larger decrease in the quantity demanded for a given increase in price. 2.8

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

6.3

xxviii CHAPTER 7 | The Economics of Health Care Learning Objective: Explain the relationship between the price elasticity of demand and total revenue.

Review Questions 3.1

If demand for orange juice is inelastic, an increase in price will increase revenue because the price will increase proportionally more than the quantity sold will decrease.

3.2

The marketing analyst believes that the demand for clothes sold by these stores is price inelastic.

b. If the demand for clothes is indeed price inelastic, increasing the prices of the clothes stores sell will result in an increase in the stores’ total revenue. When demand is price inelastic, a given percentage increase in price will result in a smaller percentage decrease in the quantity demanded. As a result, the stores will increase their revenue by selling a smaller quantity at a higher price.

Problems and Applications 3.3

Raising entrance fees to national parks would increase revenue only if the demand for visiting those parks is price inelastic. If the demand is price elastic, increasing entrance fees will reduce revenue. As Margaret Walls suggests, the price elasticity of demand is likely to be different for different parks. The elasticity of demand will also be different for groups of visitors based on factors such as their incomes and ages.

3.4

a. If Apple’s total revenue from iPhone sales increased when the quantity decreased, the price of the iPhone must have increased. b. Because revenue increased when price increased, we can conclude that the demand for iPhones is price inelastic.

3.5

A decrease in the prices on food and beverage by 50 percent resulting in an increase in the total revenues by 16 percent indicates that the demand for food and beverages in the stadium is price elastic. In order to draw this conclusion, we have to assume that all other variables that might affect the demand for food and beverages, other than the prices, stayed constant.

3.6

a. Because Pampers and Bounty are P&G’s most popular brands, the firm apparently believes that the demand curves for these goods are price inelastic. When a firm raises the prices of goods that have price inelastic demand, the firm’s total revenue increases. b. “Industrywide pricing moves” are price increases or decreases that are made by most firms in an industry at about the same time. In this case, the article is indicating that when P&G raises its prices, the other firms in the market do as well. Competitors’ raising their prices

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will make the demand for Pampers and Bounty less elastic (more inelastic) than if the competitors don’t raise their prices. Because the relative price of Pampers and Bounty compared with competing brands will remain about the same, fewer consumers are likely to switch from Pampers and Bounty to the other brands when P&G raises prices. 3.7

a. We can calculate the price elasticity along D1 between points A and C as follows: Percentage change in quantity demanded =

Percentage change in price =

So, the price elasticity of demand = Similarly, the price elasticity of demand along D2 between points A and B can be calculated as follows: Percentage change in quantity demanded =

Percentage change in price =

So, the price elasticity of demand = Because the quantity response is much larger for the same price change, demand curve D1 is much more elastic than D2. b.

3.8

Along D1, revenue increases from $3 × 200 = $600 to $2.50 × 300 = $750. Revenue rises by $150 as the price is cut because this demand curve is elastic between these prices. Along D2, revenue falls from $600 to $2.50 × 225 = $562.50. Revenue falls by $37.50 as the price is cut because D2 is inelastic between these prices. a. For the strategy of the Metropolitan Transportation Authority (MTA) to be successful, the demand for subway passes must be price inelastic so that the price increase will lead to an increase in revenue.

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CHAPTER 7 | The Economics of Health Care b. If MTA’s strategy does not succeed, the demand for subway passes must be price elastic. In the following graph, the demand curve D1 is relatively elastic and the demand curve D2 is relatively inelastic. In this example, the graph shows that at a price of $121, the MTA sells 310,000 monthly subway passes. MTA’s revenue from monthly subway tickets would equal $121 × 310,000 = $37,510,000. In this example, when the price is raised to $127, the graph shows that the quantity demanded along D1 will equal 100,000 passes and will equal 300,000 passes along D2. The following table summarizes the effect of the price change on the MTA’s revenue if the relevant demand curve is D1 and, alternatively, if the demand curve is D2. Price × Quantity = Value of Area A

$121 × 100,000 = $12,100,000

$121 × 200,000 = $24,200,000

$121 × 10,000 = $1,210,000

$6 × 100,000 = $600,000

$6 × 200,000 =$1,200,000

If the demand curve is D1, then MTA’s revenue would be: A + E = $12,100,000 + $600,000 = $12,700,000. This amount is less than the $37,510,000 revenue received by the MTA if the price stayed as $121, so demand is elastic. If the demand curve is D2, then MTA’s revenue would be: A + B + E + F = $12,100,0000 + 24,200,000 + $600,000 + $1,200,000 = $38,100,000. This amount is greater than the $37,510,000 revenue received by the MTA if the price stayed as $121, so demand is inelastic.

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a. The article implies that Chicago previously had not been taxing soda. Therefore, enacting a 1-cent-per-ounce tax on soda would result in an increase in tax revenues from zero to a positive number regardless of whether the demand for soda is price elastic or price inelastic. But given that policymakers in Chicago were expecting a substantial amount of revenue to be raised from the tax, they most likely believed that the demand for soda was price inelastic. b. Because the tax generated less revenue than anticipated, the demand for soda turned out to be more elastic than policymakers had anticipated. The increase in the price of soda caused by the tax resulted in a larger decrease in quantity demanded than policymakers had expected, causing the tax revenue raised to be less than policymakers had expected. c. The city would have been more successful in discouraging soda consumption with a 1-centper-ounce tax on soda if the demand for soda were more price elastic. A 1-cent-per-ounce tax on soda would have generated more tax revenue for the city if the demand was more price inelastic because the tax would have discouraged fewer people from purchasing soda. The policymakers’ goals were in conflict because improving public health required having the decline in people buying soda be as large as possible, whereas raising revenue required having the decline in people buying soda be as small as possible. Because policymakers repealed the tax after it failed to raise the expected revenue, it seems likely that the policymakers were more interested in raising revenue than in discouraging the consumption of soda.

3.10

Hulu assumed that the demand for its services was price elastic. Lowering the price of its streaming service was intended to raise its total revenue. Hulu dropped its prices when Netflix raised its because Hulu considers its service to be a substitute for Netflix’s streaming services.

3.11

a. The UPS CEO apparently believed that the demand for UPS’s package delivery service was inelastic. In other words, higher prices would lead to a relatively small decrease in quantity demanded for the company’s service (“large retailers have a way to spread that [price increase] across [larger sales] and nobody knows”), so higher prices would result in greater revenue from the service. The head of the consulting firm, however, assumed that demand for the delivery service was elastic since higher prices would have a much greater effect on quantity demanded (“This *price increase+ is devasting to retailers.”). b.

3.12

Because UPS’s price increases occurred during the Covid-19 pandemic, shoppers were using delivery services much more than they would if they were able to shop in stores without fearing they would contract the Covid-19 virus. This fact likely made the demand for UPS’s delivery service more inelastic than it was prior to the pandemic and will likely be after the pandemic.

a. For the Route 22 bridge:

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Percentage change in quantity demanded =

Percentage change in price =

Therefore, the price elasticity of demand = For the Interstate 78 bridge: Percentage change in quantity demanded = Percentage change in price = 66.7%. Therefore, the price elasticity of demand = c. Revenue in November was (519,337 + 728,022) × $0.50 = $623,679.50. In December total revenue increased to (433,691 + 656,257) × $1 = $1,089,948. The increase occurred because the demand at both bridges is price inelastic.

Other Demand Elasticities 6.4

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

Review Questions 4.1

Cross-price elasticity of demand equals the percentage change in quantity demanded of one good divided by the percentage change in the price of another good. If the cross-price elasticity is negative, then the goods are complements. If the cross-price elasticity is positive, then the goods are substitutes.

4.2

Income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. If the income elasticity is greater than 0, then the good is normal; if the income elasticity is less than 0, then the good is inferior. Goods with income elasticities between 0 and 1 are often called necessities, and goods with income elasticities greater than 1 are often called luxuries.

Problems and Applications

CHAPTER 7 |The Economics of Health Care xxxiii 4.3

a. Lettuce has the higher price elasticity because the percentage change in quantity demanded following a price increase is much larger for lettuce than for bread. b. Positive. As the price of lettuce rises, the quantity demanded of the other green vegetables rises, so they are substitutes.

4.4

a. In Chile, a cross-price elasticity of 0.25 between milk and soda indicates that soda and milk are substitutes because a cross-price elasticity that is positive implies that a higher price of soda will cause an increase in the quantity demanded of milk. A cross-price elasticity between soda and candy equal to 0 indicates that the two goods are unrelated. Changes in the price of soda do not change the quantity demanded of candy. Because soda and candy are often consumed together, it is surprising that the cross-price elasticity of demand between these two goods is 0. b. If the cross-price elasticity of demand between soda and milk is 0.25, then an increase in the price of soda by 10 percent will increase the quantity demanded of milk by 2.5 percent (that is, 10% × 0.25 =2.5%). If the cross-price elasticity of demand between soda and candy is 0, then an increase in the price of soda by 10 percent will result in an increase in the quantity demanded of candy by 0 percent (that is, 10% × 0 = 0%).

4.5

To find the cross-price elasticity, divide the percentage change in the quantity demanded of buns by the percentage change in the price of hot dogs. At the initial price of buns ($1.20), the quantity demanded rises from 10,000 to 12,000, which is the change in quantity demanded that should be used. Percentage change in the quantity demanded =

Percentage change in the price of hot dogs =

So, the cross-price elasticity = Because the cross-price elasticity of demand is negative, we know these two goods are complements. 4.6

(a) and (c) are substitutes, so the cross-price elasticities will be positive; (b) and (d) are complements, so the cross-price elasticities will be negative.

4.7

The most likely order is: (a) Bread, (b) Pepsi, (d) laptop computers, (c) Mercedes-Benz automobiles. A normal good that is considered a necessity (such as food and clothing) has an income elasticity that is positive and less than 1. Normal goods that are considered luxuries Copyright © 2021 Pearson Education, Inc.

xxxiv CHAPTER 7 | The Economics of Health Care (such as laptop computers and Mercedes-Benz automobiles) have income elasticities that are positive and greater than 1. The items are ranked from consumers who are most likely to consider them necessities to consumers who are most likely to consider them luxuries. 4.8

The more narrowly we define a market, the more price elastic demand will be. So, if data for only one brand of beer is used instead of multiple brands, demand for beer will likely be more elastic, which may not be an accurate estimate of the price elasticity for beer as a product.

4.9

During recessions, falling consumer incomes can cause firms selling luxury goods (goods with an income elasticity of demand greater than 1) to see their sales decrease the most. During recessions, falling consumer incomes can cause firms selling inferior goods (goods with an income elasticity of demand less than 0) to see their sales increase the most. Therefore, in a recession Firm C will experience the largest decline in sales of the three firms and Firm A is likely to experience the largest increase in sales.

6.5

Using Elasticity to Analyze the Disappearing Family Farm Learning Objective: Use price elasticity and income elasticity to analyze economic issues.

Review Questions 5.1

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

Problems and Applications 5.2

a. (Percentage change in price) × (price elasticity of demand) = percentage change in quantity demanded: 50% × −0.25 = −12.5%. So, the quantity of cigarettes demanded should decline 12.5% from its current level of 360 billion cigarettes per year; 12.5% of 360 billion is 45 billion. b. It may be possible that because cigarettes have been around for more than 100 years, while e-cigarettes were introduced much more recently (around 2003), more people are familiar with and prefer cigarettes to other ways of consuming tobacco. Also, nicotine from cigarettes is addictive, which often makes it difficult for cigarette smokers to quit smoking Copyright © 2021 Pearson Education, Inc.

CHAPTER 7 |The Economics of Health Care xxxv even when the price of cigarettes increases substantially. As a result, the demand for conventional cigarettes is price inelastic. The demand for e-cigarettes is more price elastic because they were recently introduced to the market and are less likely to be addictive. If ecigarettes have more elastic demand, a tax that raises the price of e-cigarettes will result in a larger decrease in the quantity of e-cigarettes demanded compared to the effect of a similar tax on conventional cigarettes. 5.3

a. We can plug into the midpoint formula the values given for the price elasticity, the original price of $3.00, and the new price of $3.70 (= $3.00 + $0.70):

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

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

The federal government would collect an amount equal to the tax per gallon multiplied by the number of gallons sold: $1 per gallon × 125.40 billion gallons = $125.4 billion.

5.4

Farm incomes decrease when the total revenue that the farms receive from selling their crops decreases. Increasing farm productivity shifts the supply curve for crops to the right, lowering the equilibrium price. Because the demand for crops is price inelastic, a lower price reduces the revenue that farmers received from selling their crops.

5.5

For the government policy to be effective, the demand for bribes must be elastic. The more elastic the demand curve, the more effective the policy will be. On the following graph, the burden of corruption before the policy is enacted is represented by the area 0Q1AP1. The burden of corruption after the policy is enacted is represented by the area 0Q2BP2. In effect, this problem is applying the result that a price increase will result in an increase in revenue if demand is inelastic but a decrease in revenue if demand is elastic.

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5.6

The head of the United Kumquat Growers’ reasoning is correct: Because the demand for kumquats is elastic, a price increase resulting from the implementation of a price floor will decrease the revenue received by kumquat producers.

5.7

Imposing a price ceiling causes the market quantity to decline from Q1 to Q2 and the price to decline from P1 to PC. We measure the loss of efficiency by the deadweight loss. When demand is elastic (D2), the deadweight loss in the figure is A. When demand is inelastic (D1), the deadweight loss is A + B. Therefore, the loss of economic efficiency from a price ceiling is greater when demand is price inelastic.

CHAPTER 7 |The Economics of Health Care xxxvii

The Price Elasticity of Supply and Its Measurement 6.6

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

Review Questions 6.1

The price elasticity of supply = (percentage change in quantity supplied)/(percentage change in price). In this case, the elasticity of supply = 9%/10% = 0.9. The dividing point between elastic and inelastic is 1.0, so the price elasticity of supply for frozen pizzas is inelastic.

6.2

Time is the main determinant of the price elasticity of supply. The longer the time period, the more firms are able to adjust the quantity they supply to a change in price. So, we would expect that as the time period increases, the price elasticity of supply will increase. An exception to this rule is products that require use of a resource that is in fixed supply, such as wine from a particular region in France.

Problems and Applications 6.3

a. The limitation on the number of taxi medallions means that the supply of medallions is perfectly inelastic or has a price elasticity of supply equal to zero. b. Because of surge pricing, the supply of Uber rides is more price elastic than the supply of taxis because the quantity of Uber rides supplied increases as the price of rides increases. When the price of a ride increases, more Uber drivers will be willing to supply rides. When the price of a ride decreases, fewer Uber drivers will be willing to supply rides. c. The limit on licenses decreases the quantity of rides that Uber and Lyft drivers offer, thereby increasing the price of Uber and Lyft rides in New York City. This outcome benefits taxi drivers, who now face less competition, and harms consumers, who pay higher prices for fewer rides. Current Uber and Lyft drivers benefit from being able to charge higher prices for rides and because their pay can’t fall below the city’s pay floor. But the increase in prices results in a smaller quantity of rides demanded. If the demand for Uber and Lyft rides is inelastic, the total amount drivers receive will rise, but if the demand is elastic, the total amount drivers receive will fall. People who would like to be Uber or Lyft drivers but who are unable to do so because they can’t obtain a city license will also lose as a result of this change in the market.

6.4

A small decrease in the supply of oil will lead to a large increase in price because the demand for oil is price inelastic.

xxxviii CHAPTER 7 | The Economics of Health Care 6.5

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

6.6

To find the price elasticity of supply, divide the percentage change in quantity supplied by percentage change in price. In panel (a) of Figure 6.6, the percentage change in quantity supplied = , and the percentage change in price = the price elasticity of supply = quantity supplied =

. So,

In panel (b) of Figure 6.6, the percentage change in , and the percentage change in price =

So, the price elasticity of supply = 6.7

The following graph assumes that the supply of chocolate is completely inelastic for one year following an increase in demand (from D1 to D2). As a result, the price of chocolate rises from P1 to Pyr1. The supply of chocolate becomes more elastic after 4 years (Syr1 to Syr4), which results in a lower price (Pyr4) and greater quantity (Qyr4). Therefore, all else equal, the price of chocolate would be greater after 1 year than after 4 years.

CHAPTER 7 |The Economics of Health Care xxxix 6.8

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

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

Percentage change in the price =

Therefore, the price elasticity of supply = The fact that the elasticity doesn’t have a negative sign is a reminder that with an upwardsloping supply curve, increases in price lead to increases in the quantity supplied, so the price elasticity of supply must be positive. The supply of roses is price elastic given that the value of the elasticity is greater than 1. 6.9

a. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. In this case, the percentage change in quantity supplied is 0, because the quantity supplied by the university is always 15,000 and so does not change in response to a change in price. Copyright © 2021 Pearson Education, Inc.

CHAPTER 7 | The Economics of Health Care b. As shown in the following graph, when the demand curve for basketball tickets shifts from D1 to D2, the equilibrium price of tickets increases from $15 to $20, but there is no change in the equilibrium quantity.

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

Suggestions for Critical Thinking Exercises

CT6.1 The actual values will vary by group and the portion of students that decides that the results make sense (or don’t make sense) will vary as well. However, sometimes students will blindly calculate values and report them without determining whether they are sensible.

CT6.2 Students can only calculate income elasticity from the second table. The first table could not be used to calculate either income or price elasticity because both the price of the good and income vary, and to calculate these elasticities, we need to hold everything else (apart from either price or income) constant. Giving data of varying types can often confound students because they typically expect data of exactly the type they need to answer the questions in class or on exams.

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CHAPTER 7 | The Economics of Health Care Brief Chapter Summary and Learning Objectives 7.1

The Improving Health of People in the United States Use data to discuss trends in U.S. health care over time. ▪

7.2

The health of the average person in the United States improved significantly during the nineteenth and twentieth centuries and continues to improve today.

Health Care around the World Compare the health care systems and health care outcomes in the United States and other countries.

7.3

▪

In many countries the government supplies health care directly or pays for most health care expenses. This complicates cross-country comparisons of health care outcomes.

▪

Health care spending per person in the United States is higher than in other countries.

Information Problems and Externalities in the Market for Health Care Define information problems and externalities and explain how they affect the market for health care. ▪

7.4

The market for health care is affected by asymmetric information, adverse selection, moral hazard, and the principal–agent problem.

The Debate over Health Care Policy in the United States Explain the major issues involved in the debate over health care policy in the United States. ▪

The rising cost of health care led President Obama and Congress to pass the Affordable Care Act (ACA) in 2010. Some critics of the ACA believe that the government should provide health care directly through the Medicare for All program, while other critics favor marketbased reforms of health care.

Adverse selection The situation in which one party to a transaction takes advantage of knowing more than the other party to the transaction.

Socialized medicine A health care system under which the government owns most of the hospitals and employs most of the doctors.

Affordable Care Act (ACA) Health care reform legislation passed by Congress and signed by President Barack Obama in 2010. Asymmetric information A situation in which one party to an economic transaction has less information than the other party. Fee-for-service A system under which doctors and hospitals receive a payment for each service they provide. Health care Goods and services, such as prescription drugs, consultations with doctors, and surgeries, that are intended to maintain or improve a person’s health. Health insurance A contract under which a buyer agrees to make payments, or premiums, in exchange for the provider’s agreeing to pay some or all of the buyer’s medical bills. Market-based reforms Changes in the market for health care that would make it more like the markets for other goods and services. Moral hazard Actions people take after they have entered into a transaction that make the other party to the transaction worse off. Principal–agent problem A problem caused by an agent pursuing the agent’s own interests rather than the interests of the principal who hired the agent. Single-payer health care system A system, such as the one in Canada, in which the government provides health insurance to all of the country’s residents.

Chapter Outline Covid-19 and the U.S. Health Care System

The Covid-19 pandemic presented the U.S. health care system with its greatest challenge since the 1918 influenza pandemic. It is too early to assess how well the U.S. system performed relative to the health care systems in other high-income countries. In mid- 2021, total deaths in the United States per million population were higher than in most—but not all—other high-income countries. But it was unclear to what extent the higher death rate was attributable to problems with the U.S. health care system or to factors such as: (1) flawed government policies; (2) the U.S. population having a larger fraction of people who were at greater risk of dying from the disease; or (3) differences across countries on how Covid-19 deaths were counted. A strength of the U.S. health care system was shown by the speed with which U.S.-based pharmaceutical firms Pfizer, Moderna, and Johnson & Johnson developed effective vaccines that helped to end the worst of the pandemic.

One important aspect of the U.S. health care system is that only a small percentage of people in the United States receive medical care from a doctor who works for the government or at a governmentowned hospital. For decades, more people have enrolled in insurance plans run by private health insurance companies than in government-run plans like Medicare. Despite the reliance of many people on private health insurance, will the federal government soon eliminate such plans?

7.1

The Improving Health of People in the United States Learning Objective: Use data to discuss trends in U.S. health over time.

Health care refers to goods and services, such as prescription drugs, consultations with doctors, and surgeries, that are intended to maintain or improve a person’s health. In the United States, doctors and hospitals that supply most health care are mostly private firms. The government provides some services through the Veterans Administration and indirectly through Medicare and Medicaid. The Affordable Care Act (ACA) refers to health care legislation passed by Congress and signed by President Barack Obama in 2010.

A. Changes over Time in U.S. Health The health of the average person in the United States improved significantly during the 1800s and 1900s. Individuals in the United States today are taller, live much longer, and are much less likely to die Copyright © 2023 Pearson Education, Inc.

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in the first months of life than was true 170 years ago. (Note that life expectancy declined in 2020 because of the Covid-19 pandemic.) Over time, people in the Unites States have, on average, become taller, indicating that their nutritional status has improved.

B. Reasons for Long-Run Improvements in U.S. Health Life expectancy at birth in the United States increased from 47.3 years in 1900 to 78.7 years in 2018. The overall mortality rate decreased by more than 28 percent between 1981 and 2018. The decline in death rates after 1981 was due to changes in lifestyle and advances in new diagnostic equipment, prescription drugs, and surgical techniques. Improving health shifts out a country’s production possibilities frontier and higher incomes allow the country to devote more resources to research and development, including medical research. (Note that all of these data refer to the period before the Covid-19 pandemic in the United States.)

Health Care around the World 7.2

Learning Objective: Compare the health care systems and health care outcomes in the United States and other countries.

In the United States, private firms, either through doctors’ practices or hospitals, provide most health care. The main exception is the care the government provides through hospitals operated by the Veterans Health Administration. Governments in most countries outside the United States have a more substantial direct role in paying for or providing health care.

A. The U.S. Health Care System Most people in the United States have health insurance that helps them to pay their medical bills. Health insurance is a contract under which a buyer agrees to make payments, or premiums, in exchange for the provider’s agreeing to pay some or all of the buyer’s medical bills. In 2019, about 56 percent of people received health insurance through their employers, and about 12 percent purchased an individual or family health insurance policy from an insurance company. About 34 percent of people receive health insurance from government programs, including Medicare and Medicaid or the program run the Department of Veterans Affairs. In 2020, 99 percent of firms employing at least 100 workers and 56 percent of all firms offered health insurance as a fringe benefit. Some health insurance plans reimburse doctors and hospitals on a fee-forservice basis: A system under which doctors and hospitals receive a payment for each service they provide. About 8 percent of people were not covered by health insurance in 2019. This percentage represented more than 26 million uninsured people. Some young people opt out of employer-provided health insurance because they are healthy and do not believe the cost of the premiums their employers charge for the insurance is worth the benefit of having the insurance. The uninsured must pay for their Copyright © 2023 Pearson Education, Inc.

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medical bills out-of-pocket, or receive care from doctors or hospitals either free or below the normal price.

B. The Health Care Systems of Canada, Japan, and the United Kingdom A single-payer health care system, such as the one in Canada, is a system in which the government provides health insurance to all of the country’s residents. Socialized medicine is a health care system, such as the one in the United Kingdom, under which the government owns most of the hospitals and employs most of the doctors. Table 7.2 summarizes the key features of the health care systems of Canada, Japan, and the United Kingdom.

C. Comparing Health Care Outcomes around the World Typically, the higher the level of income per person in a country, the higher the level of spending per person on health care. Health care spending per person in the United States is higher than in other countries. Comparing health care outcomes among members of the Organization for Economic Cooperation and Development (OECD), the United States does relatively poorly in terms of life expectancy and infant mortality. People in the United States are more likely to be obese, which can lead to diabetes and other health problems. The United States rates well in the availability of medical equipment that can be used to diagnose and treat illness. People in the United States have a lower rate of cancer deaths.

D. How Useful Are Cross-Country Comparisons of Health Outcomes? Difficulties in making cross-country comparisons in health care outcomes include:    

Data problems Problems with measuring health care delivery Problems with distinguishing health care effectiveness from lifestyle choices Problems with determining consumer preferences

Information Problems and Externalities in the Market for Health Care 7.3

Learning Objective: Define information problems and externalities and explain how they affect the market for health care.

The health care market is affected by the problem of asymmetric information: A situation in which one party to an economic transaction has less information than the other party.

A. Adverse Selection and the Market for “Lemons” The seller of a used car has more information on the true condition of the car than potential buyers. Used car buyers don’t know whether any particular car offered for sale is a good car or a lemon. The Copyright © 2023 Pearson Education, Inc.

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sellers do know. As sellers of lemons take advantage of knowing more about the cars they are selling than buyers do, the used car market will fall victim to adverse selection: The situation in which one party to a transaction takes advantage of knowing more than the other party to the transaction. Adverse selection reduces the total quantity of used cars bought and sold in the market because few good cars are offered for sale.

B. Asymmetric Information in the Market for Health Insurance Asymmetric information problems occur in markets for all types of insurance. Insurance companies provide risk pooling when they sell policies to households. An insurance company can pool the risk of your house burning down by selling fire insurance to thousands of other homeowners. For the insurance company to cover its costs, the total amount it receives in premiums must be greater than the amount it pays out in claims to policyholders.

Insurance companies face an adverse selection problem. Sick people are more likely to want health insurance than healthy people. If companies have trouble determining who is healthy and who is sick, they may sell policies to more sick people than they expect. As a result, the premiums they charge will be too low to cover their costs. If the company tries to increase the premiums it charges adverse selection could make the problem worse if younger, healthier people drop their insurance. One way to deal with adverse selection is to require individuals to buy health insurance. This would increase the ability of insurance companies to engage in risk pooling. The Affordable Care Act (ACA), passed in 2010, originally included an individual mandate, which required residents of the U.S. to buy insurance or pay a fine. Congress repealed this provision in 2017. Insurance markets are also subject to moral hazard: Actions people take after they have entered into a transaction that make the other party to the transaction worse off. Moral hazard in the insurance market occurs when people change their behavior after becoming insured. Normally, there are two parties to a transaction: the buyer and the seller. The insurance company becomes a third party to the purchase of medical services because the company pays for some or all services. Traditional health insurance is a third-party payer system. This means that consumers of health care do not pay a price that reflects the full cost of providing the service. Third-party payer health insurance can lead to a principal–agent problem, a problem caused by an agent pursuing the agent’s own interests rather than the interests of the principal who hired the agent. Doctors can pursue their own interests rather than the interests of their patients. Because health insurance pays most of the bills for medical procedures, patients are more willing to accept them. The fee-for-service aspect of health insurance can make the principal–agent problem worse because doctors and hospitals are paid for each service performed, whether or not the service is effective. Insurance companies can reduce adverse selection and moral hazard problems by using deductibles and coinsurance. Someone applying for an individual health insurance policy is usually required to submit his Copyright © 2023 Pearson Education, Inc.

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or her medical records. Insurance companies have frequently offered limited coverage for preexisting conditions. Critics argue that by excluding or limiting coverage of preexisting conditions, insurance companies force people with serious illnesses to pay the entire amount of large medical bills or to go without medical care. The companies argue that if they do not exclude coverage of preexisting conditions, then adverse selection problems might make it difficult to offer any health insurance policies or force companies to charge premiums so high as to cause healthy people to not renew their policies.

C. Externalities in the Market for Health Care Some goods or services involve an externality, which is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. There are several aspects of health care that economists believe involve externalities. For example, anyone vaccinated against a communicable disease like Covid-19 protects not just himself or herself but also reduces the chances that people who have not been vaccinated will contract the disease.

D. Should the Government Run the Health Care System? Economists categorize goods on the basis of whether they are rival and excludable. A public good is both nonrival and nonexcludable. Public goods are often supplied by the government. Economists differ on whether health care is a public good. More than one person cannot consume the same operation and someone who will not pay for an operation can be excluded from consuming it. But there are aspects of health care that have convinced some economists that government intervention is justified. Certain types of health care, such as vaccinations, generate positive externalities. Information problems can also be important in the market for private health insurance which may raise the costs to insurance companies when the pool of insured people is small. This can make insurance companies less willing to offer health insurance to consumers that the companies suspect may file too many claims. Many economists believe that market-based solutions are the best approach to improving the health care system. It is an open question whether the U.S. health care system will continue to move toward more government intervention or whether market-based reforms will be implemented.

Extra Solved Problem 7.3 If You Are Young and Healthy, Should You Buy Health Insurance? New York Times columnist David Brooks wrote about the implementation of the Affordable Care Act (ACA) and described a possible adverse selection cascade: “the young may decide en masse that it is completely irrational for them to get health insurance that subsidizes others.” a. Why might it be irrational for young and healthy people to buy health insurance? b. In what sense do young and healthy people who buy health insurance provide a subsidy to people who are older or who are ill? Copyright © 2023 Pearson Education, Inc.

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance c. What do you think Brooks meant by an adverse selection cascade? How might the actions of young and healthy people contribute to adverse selection problems in the health insurance system?

Solving the Problem Step 1:

Review the chapter material. This problem is about adverse selection, so you may want to review the sections “Adverse Selection in the Market for Health Insurance” and “How Insurance Companies Deal with Adverse Selection and Moral Hazard” in the textbook.

Step 2:

Answer (a) by explaining why a young and healthy person might decide not to buy health insurance. When you buy health insurance, you (or your employer on your behalf) make premium payments to an insurance company. If you are healthy and rarely visit the doctor or buy prescription medicines, you are likely to pay more in premiums—possibly much more—than you receive back in benefits. Therefore, a young and healthy person might rationally decide that he or she would be better off not buying health insurance. People who don’t buy health insurance, though, risk having to pay big medical bills if they are in an accident or develop an unexpected medical problem.

Step 3:

Answer (b) by explaining why young people who buy health insurance may be providing a subsidy for people who are older or who are ill. The basis of insurance is risk pooling, with insurance companies pooling the risks of a catastrophic event, such as injuries from a car accident or expensive treatment for disease, across many people. The people who benefit most from insurance are those who have the greatest likelihood of making an insurance claim for payment of large medical bills. These people are likely to receive more in benefits than they pay in insurance premiums. Young and healthy people are in the opposite situation of being likely to pay more in premiums than they receive in benefits. The only way an insurance plan can make payments to people who are ill and make many claims is to have healthy people enrolled in the insurance plan who do not make many claims. In that sense, young and healthy people provide a subsidy to other people in the plan.

Step 4:

Answer part (c) by explaining how the actions of young people might lead to an adverse selection cascade in the health insurance system. Brooks is referring to a process sometimes called an adverse selection “death spiral.” If young and healthy people who pay premiums but make few claims drop out of an insurance Copyright © 2023 Pearson Education, Inc.

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system, then companies have to raise premiums on the people remaining in the plan. But higher premiums make the insurance an even worse deal for healthy people, causing even more of them to drop out of the plan. Over time, the ratio of ill people to healthy people in the insurance plan continues to increase, undermining the risk pooling services the plan can provide. Extra Credit: The authors of the ACA law were well aware of the potential for adverse selection problems in the health insurance system, particularly because the law sharply limits the ability of insurance companies to deny coverage to people with preexisting conditions. The law attempted to reduce adverse selection problems by requiring that everyone have health insurance, although there is currently no penalty for people who do not have health insurance. Source: David Brooks, “Health Chaos Ahead,” New York Times, April 25, 2013.

Questions An article in the Economist magazine argued that the real problem with health insurance is the healthy people who decide not to buy insurance out of rational self-interest and who turn out to be right. By not buying insurance, those largely young and healthy people will fail to subsidize the people insurance is meant for—the people who end up getting sick. a. Why is it rational for healthy people not to buy health insurance? b. Do you agree that health insurance is meant for people who end up getting sick? c. Why is the situation described here a problem for a system of health insurance? If it is a problem, suggest possible solutions. Source: “Romney on Health Care: To Boldly Go Where He Had Already Been Before,” Economist, May 13, 2011.

Answers a. Healthy people may not want to purchase health insurance because they expect the costs to be greater than the benefits. b. The statement is true in the same sense that fire insurance is meant for people whose houses burn down. No one can predict with absolute certainty whether he will become sick or not, so having health insurance will reduce out-of-pocket expenses if he becomes sick. c. This situation is a problem for a system of health insurance because of adverse selection. If people only buy health insurance when they are already ill, insurance companies are unable to supply the service of risk pooling and the system cannot operate efficiently. Solutions to this problem might include limiting coverage of preexisting conditions or requiring individuals to buy health insurance. In passing the ACA, Congress and the president decided to use the second of these solutions.

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The Debate over Health Care Policy in the United States 7.4

Learning Objective: Explain the major issues involved in the debate over health care policy in the United States.

A. The Rising Cost of Health Care Spending on health care in the U.S. was less than 6 percent of GDP in 1965 but rose to 18.5 percent in 2019 and is projected to continue rising. Most people pay for health care by relying on third-party payers, such as employer-provided health insurance or government-provided Medicare or Medicaid. Out-of-pocket spending on health care has declined from 48 percent of all health care spending in 1960 to about 10 percent today. As average incomes rise, consumers might be expected to spend a rising share on health care. But because consumers do not pay the full cost of increases in health care spending, they may be buying more health care than they would if they had to pay the full price. Medicare and Medicaid began in 1965. By 2019, spending on these programs⸻ combined with spending on the Children's Health Insurance Program (CHIP), which provides health coverage to children not eligible for Medicaid⸻ had grown to 6.7 percent of GDP. That percentage is expected to more than double over the next 40 years unless health care costs grow at a slower rate.

B. Explaining Increases in Health Care Spending Health care spending has grown faster than the economy as a whole for several decades. Because the U.S. health care system relies on many independent hospitals and insurance companies, some observers argue that it generates more paperwork and waste than systems in other countries. But this cannot account for health care’s increasing share of GDP unless paperwork and waste are increasing each year. Although it is relatively easy for patients in the United States to sue doctors and hospitals for damages, payments to settle malpractice lawsuits plus the premiums doctors pay for malpractice insurance amount to less than 1 percent of health care costs. Between 1 percent and 4 percent of health care costs are due to uninsured patients receiving treatments at hospital emergency rooms, not enough to account for much of the increase in health care as a percentage of GDP. Medicine requires face-to-face meetings between doctors and patients. As wages rise in industries in which productivity increases rapidly, service industries in which productivity rises less rapidly must match these wage increases or lose workers. Growth in labor productivity in health care has been less than half as fast as labor productivity growth in the economy as a whole. The aging of the U.S. population and the introduction of higher cost drugs and medical equipment interact to drive up spending on health care. Health care spending on people over age 65 is six times

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greater than spending on people aged 18 to 24. The number of people receiving Medicare is expected to grow from 62 million in 2020 to 78 million by 2030. Some of the increase in health care spending results from consumers choosing to spend more on health care as their incomes rise. Consumers also demand a greater quantity of health care services than they would if they paid a price that represented the cost of providing the services. Health care providers have a reduced incentive to control costs because they know that an insurance company will pick up most of the bill. By disguising the true cost of routine expenses, health insurance encourages overuse of health care services.

C. The Continuing Debate over Health Care Policy The Affordable Care Act (ACA) was signed into law by President Barack Obama in 2010. Provisions of the act include: 

 



Individual mandate. With limited exceptions, every resident of the United States had to have health insurance that met certain basic requirement; those who did not acquire insurance were subject to a fine. Congress repealed this mandate in 2017. State health insurance marketplaces. Each state was required to establish an Affordable Insurance Exchange. Employer mandate. Every firm with more than 200 full-time employees must offer health insurance to its employees and automatically enroll them in the plan. Firms with 50 or more full-time employees must offer health insurance that meets certain requirements or pay a fee to the government for every employee who receives a tax credit for obtaining health insurance. Regulation of health insurance. Insurance companies are required to participate in a highrisk pool that will insure individuals with preexisting medical conditions who have been unable to buy health insurance for at least six months. Changes to Medicaid. Eligibility for Medicaid was expanded to persons with incomes up to 138 percent of the federal poverty line. Since 2012 states have been able to opt out of this requirement. Taxes. Workers earning more than $200,000 pay higher Medicare payroll taxes and a new 3.8 percent tax on their investment income. Beginning in 2022, a new tax is scheduled to be imposed on employer-provided health insurance plans.

Extra Solved Problem 7.4 Did Demand for Health Care Slow in 2018? Writing in 2018 on bloomberg.com, economist Noah Smith noted, “As economic growth has slowed, growth in demand for health care has slowed. . . . But at the same time, prices have risen.” Use a graph showing the demand and supply for health care services to analyze what Smith said was happening in this market. Your graph should include a demand curve labeled D2016, a demand curve labeled D2018, a supply curve labeled S2016, and a supply curve labeled S2018. Be sure to show the direction of the shifts in

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the demand and supply curves during those years and changes in the equilibrium price and quantity. Briefly explain why you shifted the curves the way you did.

Solving the Problem

Step 1: Review the chapter material. This problem is about explaining changes in health care spending, so you may want to review the section “Explaining Increases in Health Care Spending.”

Step 2: Answer the problem by drawing a graph of the market for medical services that illustrates the points Noah Smith made and by explaining the shifts in the curves. Smith indicated that demand for health care was continuing to increase but at a slower rate. We can show this development on the graph by shifting the demand curve for medical services to the right, from D2016 to D2018. Smith also indicated that the price of medical services had increased. As we saw in Chapter 3, Section 3.4, if the demand curve shifts to the right, it is possible for the equilibrium price to increase, regardless of what happens to the supply curve. As we’ve seen in this chapter, the cost of providing medical care has continued to increase. We show an increase in the cost of supplying a good or service by shifting the supply curve to the left, in this case from S2016 to S2018. The graph shows the equilibrium quantity increasing from Q2016 to Q2018 and the equilibrium price increasing from P2016 to P2018. (Note that if the supply curve shifts to the right by less than the demand curve, the equilibrium price will also increase. You should check this point by drawing a graph showing the supply curve shifting to the right and the equilibrium price increasing.)

Your graph should look like the one below.

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance

Source: Noah Smith, “Health-Care Costs Are Still Eating the U.S. Economy,” bloomberg.com, October 29, 2018.

D. Market-Based Reforms Some economists and policymakers support market-based reforms, which involve changing the market for health care so that it becomes more like the markets for other goods and services.

Extra Economics in Your Life & Career: Asymmetric Information and NFL Player Contracts Question: Although star NFL players like Tom Brady and Matt Ryan have had long and lucrative careers in professional football, the career of the average NFL player ends in less than four years. In an article in Forbes magazine, David Parnell explains that about 80 percent of NFL players go bankrupt or “… are under financial stress within two years of retirement due to joblessness and/or divorce.” Few professional athletes negotiate the contracts they sign with their teams; agents are hired to negotiate on their behalf. The NFL requires agents (or “contract advisors”) to represent the interests of their clients in negotiating contracts. Parnell argues that “As a result, most agents ONLY negotiate the player’s contracts and nothing more.” As a consequence, Parnell argues that these circumstances result in “… massively asymmetric information.” How does the relationship between professional football players and their agents result in asymmetric information? Answer: Experienced agents negotiate many contracts, but each player is only familiar with the terms of his own contract. Therefore, it is difficult for the player to judge the quality of his agent’s negotiating skills. Agents earn more revenue by negotiating more contracts; therefore, there is an incentive to spend less time than might be needed to negotiate the best deal for each of his clients. Parnell argues that the large salaries that athletes earn and the complexity of legal and business issues suggest that a player would be best represented by a business law firm, rather than a sports agency or agent, which “… has hundreds of highly qualified partners” with expertise in financial planning, celebrity endorsements and other areas that can help their client avoid the problems many athletes have faced after their retirement from profession football. Source: David J. Parnell, “NFL Bankruptcies, Moral Hazard and The Evolution of Sports Agents,” Forbes, December 6, 2013.

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Solutions to End-of-Chapter Exercises 7.1

The Improving Health of People in the United States Learning Objective: Use data to discuss trends in U.S. health over time.

Review Questions 1.1

Health care is provided through markets, so there is a demand for health care and a supply of health care. However, health care in the United States is supplied not just by private firms (doctors and hospitals) but also by government, both directly (through the U.S. Department of Veterans Affairs) and indirectly (through the Medicare and Medicaid programs). Furthermore, the market for health care is different from the markets for other goods and services in that, because of insurance, the typical consumer does not pay the full price of the health care he or she purchases.

1.2

Over the last 170 years, the average person in the United States has become taller, lives much longer, is less likely to suffer from a variety of diseases, and is less likely to die in the first months of life.

1.3

Better health allows people to be more productive, which in turn raises a country’s total income. Increases in a country’s income lead to better sanitation, a larger food supply, a better system for distributing food, and more resources devoted to medical research. These factors, in turn, lead to better health.

Problems and Applications 1.4

Improvements in health have led to a more productive labor force, which shifts the U.S. production possibilities frontier outward (to the right). Generally speaking, when there is a decline in resources, such as labor, there is a decrease in the productive capabilities of an economy. The 1918 influenza epidemic increased mortality rates in the United States, reducing what would otherwise have been the size of the labor force, and shifted the production possibilities frontier inward compared with where it would otherwise have been.

1.5

Improvements in technology shift a country’s production possibilities frontier outward. Similarly, improving health also shifts out a country’s production possibilities frontier. Better health makes it possible for people to work harder as they become taller, stronger, and more resistant to disease.

1.6

The average height of residents in a country is highly correlated with income because a higher income allows the consumption of more—and more nutritious—food; makes it less likely that people will suffer from childhood diseases that can result in lower adult heights; and reduces the likelihood of stunting, which refers to an individual being unusually short as a result of either Copyright © 2023 Pearson Education, Inc.

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a lack of nutrition or of having suffered from certain childhood diseases. But genetics also plays a role in determining the average height of a population. To the extent that differences in height are the result of poorer childhood nutrition or exposure to disease, U.S. policymakers should be concerned. To the extent that the difference in heights reflects differences in the genetic makeup of the Dutch and U.S. populations, policymakers need not be concerned.

Health Care around the World 7.2

Learning Objective: Compare the health care systems and health care outcomes in the United States and other countries.

Review Questions 2.1

a. Health insurance is a contract under which a buyer agrees to make payments, called premiums, in exchange for a provider agreeing to pay some or all of the buyer’s medical bills. b. Fee-for-service is a system under which doctors and hospitals receive a separate payment for each service they provide. c. A single-payer health care system is a system, such as the one in Canada, in which the government provides health insurance to all of the country’s residents. d. Socialized medicine is a health care system, such as the one in the United Kingdom, under which the government owns most hospitals and employs most doctors.

2.2

Private insurance, mainly through employers, is the largest source of health insurance in the United States. The government, through Medicare, Medicaid, and programs administered by the Department of Veterans Affairs, is another significant source of health insurance.

2.3

Canada has a single-payer system, in which the government provides health insurance to all residents. In the United States, private insurance is the largest source of health insurance. Both Canada and the United States have a fee-for-service system. Japan has a universal health insurance system in which preventive care, such as annual physical exams, is not covered. In the United States, preventive care is generally covered by health insurance. Both Japan and the United States have many privately owned hospitals and doctors who are not government employees. Unlike the United States, the United Kingdom has a system of socialized medicine in which the government owns most of the hospitals and employs most of the doctors.

2.4

Health outcomes generally address how healthy a country’s citizens are, as measured by factors such as life expectancy. Although the United States does relatively poorly in terms of life Copyright © 2023 Pearson Education, Inc.

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CHAPTER 8 | Firms, the Stock Market, and Corporate Governance expectancy at birth, infant mortality, and obesity, it does relatively well in the availability of medical equipment and cancer treatment. Cross-country comparisons in health outcomes are difficult to make because of problems with data, measuring health care delivery, distinguishing health care effectiveness from lifestyle choices, and determining consumer preferences.

Problems and Applications 2.5

a. “Free at the point of delivery” means that patients pay nothing when they receive health care services. In the United Kingdom, the National Health Service (NHS) supplies health care services without charging patients directly for its services because it receives funding from taxes. Health care is not actually free to U.K. residents because they pay for it through their taxes. b. When they are not charged for an appointment, patients have less incentive to take care of themselves and to avoid making appointments for conditions, such as colds, where medical treatment is ineffective. With patients having more appointments than they would have if they were charged for the appointments, the National Health Service requires more doctors and staff, and therefore greater funding. It’s difficult to know with certainty why people in the United Kingdom are reluctant to pay a fee for visiting the doctor. Some may be afraid that once one type of health care requires paying a fee, eventually all types of health care will require paying fees. People may also believe that they have already paid (indirectly) for health care when they paid their income taxes and resent having to pay an additional amount.

2.6

There is no single readily available statistic that measures the quality of a health care system as there is to measure, for example, the number of automobiles sold in a month or a year. Some health care outcomes⸻ including life expectancy, infant mortality, and diseases arising from obesity⸻ are, in part, the result of patients lifestyle choices or societal problems, rather than being directly attributable to a health care system. Some statistics, even with respect to outcomes such as infant mortality rates, are not always standardized across countries, which can make comparisons difficult. The quality of the health care system also has normative aspects because it can be based on how different people weight the features of a system. Is the number of days to see a specialist a more important indicator of the quality of health care than the number of miles a patient needs to travel to get medical care? Are inexpensive prescription drugs more important than having a private room in a hospital? Is a health care system that doesn’t make patients pay a fee to visit a doctor but in which there are long delays in scheduling the visit better than a system with short waits to schedule appointments but in which fees are charged for the appointments? People will have different answers to these questions, and different people value different aspects of health care differently. This is why it is difficult to determine which country provides the best health care.

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2.7

Collecting data on how soon after surgery patients get back to work would be expensive because patients would have to be tracked after they leave the hospital and surveyed about how quickly they returned to work. The expense may be the key reason governments don’t currently collect the data. The data could be useful in evaluating how successful surgeries are, given that the goal of surgery is usually to allow the patient to return to a normal life. Better measures of health care outcomes are needed to properly evaluate the effectiveness of a country’s health care system.

2.8

Changes of the type Butler proposes might increase well-being, for the reasons he states. But it seems unlikely that the changes would improve the health outcomes that policymakers typically focus on. Many of those outcomes are focused on curing diseases or injuries after people have already experienced them. If, for example, the government pushes to have nursing homes install non-slip carpeting and design safer bathrooms, it is difficult to count the number of people who did not break a hip or did not slip on the floor. Related to this issue is the fact that countries are unlikely to gather data on these policy changes in a consistent way. Butler’s proposals highlight again the difficulty in comparing health outcomes across countries.

2.9

Widely adopting artificial intelligence (AI) in the U.S. health care sector will more likely result in employment of fewer workers as some tasks could be automated that are currently carried out by health care workers. The result would be an increase in labor productivity in health care as the same level of output would be produced with fewer workers. If this outcome occurs, the trend highlighted in the Apply the Concept in Section 7.2 would reverse, as the employment and spending in the health care system decreases relative to other sectors such as manufacturing and retail trade.

Information Problems and Externalities in the Market for Health Care 7.3

Learning Objective: Define information problems and externalities and explain how they affect the market for health care.

Review Questions 3.1

a. Asymmetric information is the situation in which one party to an economic transaction has less information than the other party. b. Adverse selection occurs when one party to a transaction takes advantage of having more information than the other party to the transaction. c. Moral hazard occurs when the actions people take after they have entered into a transaction make the other party to the transaction worse off.

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance d. The principal–agent problem is caused by agents pursuing their own interests rather than the interests of the principals who hire them.

3.2

The asymmetric information problems in the market for health insurance include adverse selection (buyers know more about their health status than insurance companies do) and moral hazard (buyers run up bigger medical bills after being insured).

3.3

Insurers reduce adverse selection by screening applicants to avoid providing insurance to people who are likely to file many claims (although under the Affordable Care Act (ACA), insurance companies cannot refuse to sell health insurance to people with pre-existing conditions). Insurance companies also offer group policies, such as the group health insurance policies offered to the employees of large firms or colleges. This “risk pooling” helps insurance companies better estimate the number of claims they are likely to receive when they are setting insurance premiums. Insurers reduce moral hazard by using deductibles and coinsurance (or copayments), which result in people with insurance paying part of the cost of their health care. Deductibles and copayments give people with insurance an incentive not to overuse health care by, for example, visiting a doctor for treatment of a cold.

3.4

An externality is a benefit or a cost that affects someone who is not directly involved in the production or consumption of a good or service. Positive externalities in the market for health care include vaccinations against diseases, which benefit other people in addition to those who receive the vaccine. Negative externalities include obesity because people who are not obese pay for some of the health care of those who are obese.

Problems and Applications 3.5

You are facing the “lemons problem” that the seller of the car is likely to know more about its reliability than you are. Therefore, you should buy the car only if (1) the advertisement is placed by a car dealer with a good reputation or by an individual you know well enough to trust; (2) if you can cheaply determine that it isn’t a lemon (for example, by an inspection); or (3) if you’ll receive a warranty from the seller against defects.

3.6

The “lemons problem” in the used car market occurs when the seller of a used car, who has more information about the condition of the car than the buyer, is able to take advantage of this asymmetric information. The lemons problem also exists in the market for health insurance because the buyers of health insurance policies know more about the condition of their health than do insurance companies. As a result, people who are likely to need medical care are more likely to buy health insurance than are people who are in better health and who are unlikely to need much medical care.

3.7

When, for example, you buy fire insurance you are pooling or sharing the risk of a house fire with the other people who buy fire insurance. Each of you has contributed to the funds the insurance company will use to pay someone whose house burns down. Each of you trades Copyright © 2023 Pearson Education, Inc.

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paying an insurance premium in exchange for the insurance company promising to pay you the cost of building a new house if you experience a fire. Adverse selection occurs when people who buy insurance policies are more likely to experience the insured against event—like a house fire—than are people who don’t buy insurance. Adverse selection undermines the ability of insurance companies to provide risk pooling services. Risk pooling can only occur if all the people who buy insurance policies face about the same risk of having their house burn down. Risk pooling does not occur when the only people who buy insurance policies are people whose houses are likely to burn down. 3.8

Social Security has some aspects of an insurance program and other aspects that differ from a typical insurance program. From one perspective, Social Security is not an insurance program because it does not involve offering insurance against difficult-to-predict events like a fire or an illness. From this perspective, Social Security can instead be thought of as a system of forced saving for retirement. On the other hand, Social Security does insure a worker against outliving his or her savings due to the difficulty workers have in predicting how long they are likely to live after retiring.

3.9

You should disagree with the statement because it confuses moral hazard and adverse selection. Adverse selection refers to what happens when two parties enter into a transaction. Moral hazard refers to actions taken after a transaction is made.

3.10

The student’s reply of “Your spouse doesn’t bring you flowers anymore!” is an example of moral hazard in marriage. The person who bought flowers before marriage stops buying flowers for his or her spouse after marriage. Moral hazard refers to actions that occur after a transaction (marriage in this example) has occurred.

3.11

Most people in the United States have health insurance, and the superfluous tests that some doctors prescribe are part of a moral hazard problem. Insurance results in a moral hazard problem because many patients have insurance that covers most or all of the cost of unnecessary procedures and the patients are more likely to agree to treatments than if they had to pay the full cost from their own funds. Some doctors practice defensive medicine by ordering tests that may be unnecessary because they want to reduce the chance that patients will sue them for malpractice. This is a moral hazard issue because the insured patients act differently when they have insurance. There is also an asymmetric information problem with health insurance. Patients generally rely on the opinion of their doctors because many patients do not understand the purposes of the tests prescribed for them. In addition, some health care providers have an incentive to prescribe unnecessary tests or treatments for patients in order to increase their incomes if they are able to bill insurance companies (or the government) for the tests. Distinguishing necessary from unnecessary tests can be difficult, however, so economists have not been able to fully measure the extent of the problem in the U.S. health care system.

3.12

With health insurance covering most of the cost, consumers demand a larger quantity of health care services than they would if they paid a price that better reflected the cost of providing the Copyright © 2023 Pearson Education, Inc.

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CHAPTER 8 | Firms, the Stock Market, and Corporate Governance services. In other words, moral hazard exists in health care because insured patients act differently than they would if they did not have insurance. Doctors and other health care providers also have a reduced incentive to control costs because they know that an insurance company will pick up most of the bills, and they generally work under a system (fee-for-service) under which they receive a separate payment for each service they provide, whether the service was actually medically necessary or not. In other words, a principal-agent problem exists. The principals are the insurance companies that pay for the medical bill, and the doctors are the agents tasked to provide service to patients. The objective of the agents (the doctors) is to maximize profit and guard against malpractice suits, whereas the objective of the principals (the insurance companies) is to minimize the cost of providing a given level of health care. While insurance companies try to avoid reimbursing physicians for medically unnecessary tests and other procedures, distinguishing necessary from unnecessary medical procedures can be difficult.

3.13

a. Healthy people may not want to purchase health insurance because they expect the marginal cost of health insurance (the insurance premiums they pay) to be greater than the marginal benefit (the medical services they receive). b. The statement is true in the sense that someone who never becomes sick will not have needed health insurance just as someone whose house never burns down will not have needed fire insurance. Health insurance does allow people to pool the risk of becoming sick. Because no one can predict with certainty whether he or she will become sick or injured, having health insurance benefits the insured by reducing the person’s out-of-pocket expenses if the person does become sick or injured. c. This situation is a problem for a health insurance system because of adverse selection. If people only buy health insurance when they are ill, insurance companies will be unable to supply the service of risk pooling and the system cannot operate efficiently. If most insured people have poor health, insurance companies are forced to raise insurance premiums to cover the cost of medical care. Rising premiums discourage individuals with good health to purchase insurance, which makes the adverse selection problem worse. Solutions to this problem include limiting coverage of preexisting conditions and requiring all individuals to buy health insurance. In passing the Affordable Care Act (ACA), Congress and the president decided to use the second of these solutions through the individual mandate, although Congress repealed this provision in 2017.

3.14

Disagree. Health care programs like vaccinations have positive externalities not only because those who receive vaccinations are protected against disease, but because those who are not vaccinated are less likely to contract the disease. The existence of positive externalities does not mean that health care is a public good because (as discussed in Chapter 5) public goods are both nonrivalrous and nonexcludable; health care has neither characteristic.

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The Debate over Health Care Policy in the United States 7.4

Learning Objective: Explain the major issues involved in the debate over health care policy in the United States.

Review Questions 4.1

The Affordable Care Act (ACA) is health care legislation passed by Congress and signed into law by President Barack Obama in 2010. The major provisions of the ACA included (1) an individual mandate (which Congress repealed in 2017); (2) state health exchanges; (3) an employer mandate; (4) regulation of health insurance; (5) Medicaid expansion; and (5) new taxes.

4.2

Health care spending in the United States has increased from less than 6 percent of GDP in 1965 to 17.8 percent of GDP in 2019. Spending on health care has grown faster in the United States than in many other high-income countries. Because the federal and state governments in the United States pay for a significant fraction of health care spending, increases in health care spending place strain on government budgets.

4.3

The rapid increase in health care spending in the United States is due to slow rates of growth of labor productivity in health care; the population becoming older; improvements in medical technology; new prescription drugs; the tax treatment of private health insurance; and the reliance on third-party payers.

4.4

Some economists and policymakers believe the government should increase its role in the U.S. health care system because: 

Some types of health care, such as vaccinations, have positive externalities, and without government intervention, may be under produced.



Health care exhibits information problems that make it difficult for the market to operate without government intervention.



In most other countries, the government has a larger role in the health care system and those countries achieve comparable health care outcomes at a lower per capita cost.

Other economists and policymakers believe the government should rely on market mechanisms more than the ACA does and more than Medicare for All or the public option proposed by President Biden does because: 

Markets provide incentives for innovation in patient care and medical equipment.



Market prices better convey information on consumer demand and supplier costs.



The ACA artificially lowers the prices of health care, causing consumers to increase the quantity of health care they demand beyond the economically efficient level.



Current tax laws exempt from their taxable income the compensation employees receive in the form of health insurance. As a result, employees demand more generous health care Copyright © 2023 Pearson Education, Inc.

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CHAPTER 8 | Firms, the Stock Market, and Corporate Governance plans than they would if they had to pay taxes on the value of the plans. Equalizing the tax treatment of employer-provided health care plans, individually purchased plans, and out-ofpocket health care spending might reduce unnecessary health care spending without reducing the quality of care received.

4.5

Your wages would likely rise. The Congressional Budget Office study discussed in the chapter showed that replacing employment-based health care with a government-run system could reduce employers’ payments for their workers’ insurance, but the amount that they would have to pay in overall compensation would remain essentially unchanged. The competition among firms for workers would result in an increase in workers’ wages equal to the reduction in health insurance benefits that employers pay for their workers.

Problems and Applications 4.6

The Congressional Budget Office estimates that most of the increase in federal spending on the Medicare and Medicaid programs will be due to increases in the cost of providing health care. Cost increases are expected to result from low productivity in the health care sector and higher prices for new prescription drugs and medical equipment.

4.7

It is difficult to predict the effect any improvement in medical technology will have on health care expenditures without knowing the nature of the new technology and how it will affect people’s health. If life expectancy improves because of a cure for a disease–breast cancer, for example–then the cost of treating the disease will decline. But because the new technology will allow people to live longer, they are likely to require treatment for other medical conditions over the additional years they live.

4.8

a. Instead of demand and supply determining who receives the benefits from new medical technologies, as happens with most goods and services in a market economy, the “rationing decisions” would be left to a board of experts who would determine whether the new medical technologies are worth their higher costs. If the experts think these new medical technologies are not worth their costs, Medicare would not pay for them. This approach would be rationing in that not everyone who wanted to use these new technologies would have access to them. b. Higher-income individuals would receive fewer Medicare benefits, and some individuals would pay higher premiums and copayments. Because beneficiaries would have to pay more of the cost of health care, the quantity of health care they demand would decline, thereby restraining the growth of Medicare spending. Premium supports would involve subsidies to some (presumably lower income) beneficiaries. c. Congress and the president should be concerned about the growth of Medicare spending. If Medicare spending continues to grow at its current rate, the result will be either significant cutbacks in other types of government spending or significantly higher taxes. Both approaches to restraining Medicare costs have benefits and drawbacks. A board of experts Copyright © 2023 Pearson Education, Inc.

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would be one way to avoid the expenditure of substantial funds on medical procedures that may be only marginally effective. However, some people are reluctant to have medical decisions made by a board of experts rather than by doctors and patients. Many economists and policymakers favor market-oriented reforms of the Medicare system that would result in beneficiaries paying more of the cost of their health care. Other economists and policymakers are skeptical that Medicare costs would respond much to market-oriented reforms because they doubt that beneficiaries’ demand for health care will be very sensitive to increases in premiums or out-of-pocket costs. Some combination of the two approaches—using a body of experts to approve medical procedures or having beneficiaries pay more of the cost combined with premium supports for low-income recipients—might end up being adopted as a way to restrain the growth of spending on Medicare. 4.9

a. If Fogel is correct, then policymakers should be less concerned with increases in health care spending because such increases reflect the choices of consumers rather than other factors. b. As discussed in the chapter, other factors, such as the favorable tax treatment of private health insurance, may also be driving the increase in health care spending. Because of favorable tax treatment and because government and private health insurance act as thirdparty payers for many consumers, the choices consumers make about health care may be distorted to a greater extent than Fogel’s position suggests.

4.10

If employees were taxed on the value of the employer-provided health insurance, the total compensation employers pay employees would not change. Labor markets determine the equilibrium level of total compensation, which includes wages and fringe benefits. The value of health insurance provided by employers would most likely decrease because these benefits would no longer be tax-free and the wages paid to employees would increase.

4.11

a. P2 is the equilibrium price where the demand for medical services when consumers pay only a fraction of the true cost of medical services, D2, intersects the supply of medical services, S. b. Q1 is the efficient quantity of medical services where the demand for medical services if consumers paid the full price of medical services, D1, intersects the supply of medical services, S. c. P3, which equals the equilibrium market price, P2, minus the amount covered by health insurance, is the price consumers pay for medical services. d. Area B represents the deadweight loss that results from consumers not paying the full cost of medical services. The marginal cost of producing the quantity Q2 – Q1 as indicated by the supply curve S, exceeds the marginal benefit consumers receive from these medical services, as indicated by the demand curve D1.

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4.12

As the cost of providing health care decreases, the supply curve for medical services will shift to the right. As using MEMSs results in more people discovering health care problems, the demand for medical services will shift to the right. The combined effects of an increased supply and increased demand will increase the equilibrium quantity, but the effect on the equilibrium price depends on the relative sizes of the increases in demand and supply. The following figure illustrates the two cases. The graph on the left shows a larger shift in the demand curve than in the supply curve. As a result, the new equilibrium price, P2, is higher than the old equilibrium price, P1. The graph on the right shows a smaller shift in the demand curve than in the supply curve, so the new equilibrium price, P2, is lower than the old equilibrium price, P1. Both graphs also show that the new equilibrium quantity increases, regardless of whether the shift of the demand curve is larger or smaller than the shift of the supply curve.

4.13

a. These are the main problems that a public option and Medicare for All attempt to solve:   

Currently, not all citizens are insured. Excessive costs due to paperwork and “red tape” incurred by patients, physicians, and administrators. High costs for prescriptions and medical services. With a public option and Medicare for All, the government would have more bargaining power to negotiate prices with hospitals, physicians, and pharmaceutical companies.

b. A public option would co-exist with a system of private health insurance. The public option would be similar to Medicare but available to anyone, not just those 65 year of age and older. Those enrolled in the public option would pay premiums below those charged by private insurance companies on the Affordable Care Act’s state health insurance marketplaces. Medicare for All (MFA) would provide health care for everyone in the United States, using Medicare as a model. MFA would be a single-payer plan where only the federal government would offer health insurance. People would not pay deductibles or coinsurance. Patients would pay no fees for medical tests, surgeries, or doctor visits. Copyright © 2023 Pearson Education, Inc.

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance xxvii c. Market-based reforms would make the market for health care similar to the markets for other goods and services. Unlike the public option or MFA, prices would be used to communicate information on the demand and cost of medical procedures. Competition among doctors, hospitals, and other health care providers would reduce costs and increase economic efficiency. Some advocates for market-based reforms suggest making the tax treatment of employer-provided health insurance the same as that of individually purchased health care. These advocates argue that this reform would reduce health care spending without decreasing the effectiveness of the health care people receive. Where the public option and MFA would pay for all medical procedures, some economists recommend that health insurance be used to pay for large medical bills and let consumers pay prices close to the cost of routine medical care. 4.14

Some of the benefits of abolishing private health insurance and having the government offer insurance to everyone are as follows:   

Universal coverage because everyone will be insured. Less paperwork for patients, physicians, and administrators because the federal government will be responsible for paying all medical bills. Cost savings because the government will have more bargaining power in negotiating prices with hospitals, physicians, and pharmaceutical companies.

Some of the potential problems from abolishing private health insurance and having the government offer pay for all medical care are as follows:    

4.15

The “Medicare for All” proposal is likely to be costly, with some estimates being as high as $32 trillion over 10 years. Less flexibility because all procedures across the country will be standardized. Less medical innovation because the lower prices that the government imposes on pharmaceutical products and manufacturers of medical devices will reduce their incentive to bring new products to market. Increased moral hazard because deductibles and coinsurance would be eliminated, leading to overuse of the health care system.

Health care plans with high deductibles discourage employees from using their plans to cover the costs of relatively minor injuries and illnesses because their costs must be paid “out of pocket” up to the limit of their annual deductibles. High deductibles should result in fewer visits by employees to their doctors and a reduction in the quantity of other health care services employees demand. If the federal government were to require employer health plans to have deductibles no greater than $200 per year, employees would seek more medical care for minor injuries and illnesses than they would with high deductible plans. This outcome would likely make employees better off if they were made healthier as a result, but the cost of their health care plans would be higher. Whether this change would result in all employees being made “better off” is complicated. Less healthy employees who use more medical care would benefit more than employees who required little medical care. And it is possible that some employees would be less careful about maintaining their health through diet, exercise, and other good Copyright © 2023 Pearson Education, Inc.

xxviii CHAPTER 8 | Firms, the Stock Market, and Corporate Governance habits because more of their medical expenses would be covered by their plans. A key point is that labor markets determine the equilibrium level of total compensation, which includes wages and fringe benefits. The value of health insurance provided by employers (a fringe benefit) would increase because of the requirement to have low deductibles, so the wages paid to employees would have to decrease to keep the value of total compensation the same. Therefore, employers would not be greatly affected by the change, apart from the cost of having to adjust their compensation plans.

Suggestions for Critical Thinking Exercises

CT7.1 First, you and your manager must be concerned with adverse selection and moral hazard. Second, in a competitive market total employee compensation should be roughly comparable across firms.

CT7.2 Clearly, the responses depend upon the articles that students select. In addition, the chances for passage of legislation will vary depending upon the political environment that exists when the legislation is proposed.

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Corporate Governance Brief Chapter Summary and Learning Objectives 8.1

Types of Firms Categorize the major types of firms in the United States.  There are three legal categories of firms: sole proprietorships, partnerships, and corporations.  Owners of sole proprietorships and partnerships have unlimited liability. Owners of corporations have limited liability.

8.2

How Firms Raise Funds Explain how firms raise the funds they need to operate and expand.  Owners of small businesses obtain funds for expansion by reinvesting profits, taking on partners, or borrowing from relatives, friends, or banks. Copyright © 2023 Pearson Education, Inc.

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 Firms raise external funds from financial intermediaries or through financial markets.

8.3

Using Financial Statements to Evaluate a Corporation Describe the information corporations include in their financial statements.  An income statement summarizes a firm’s revenues, costs, and profit over a period of time. A firm’s balance sheet summarizes its financial position on a particular day.

Appendix: Present Value Explain the concept of present value.

Appendix: Income Statements and Balance Sheets Describe the information contained on a firm’s income statement and balance sheet.

Key Terms Accounting profit A firm’s net income, measured as revenue minus operating expenses and taxes paid. Asset Anything of value owned by a person or a firm. Balance sheet A financial statement that sums up a firm’s financial position on a particular day, usually the end of a quarter or year. Bond A financial security that represents a promise to repay a fixed amount of funds. Corporate governance The way in which a corporation is structured and the effect that structure has on the corporation’s behavior. Corporation A legal form of business that provides owners with protection from losing more than their investment should the business fail.

Coupon payment An interest payment on a bond. Direct finance A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange. Dividends Payments by a corporation to its shareholders. Economic profit A firm’s revenues minus all of its implicit and explicit costs. Explicit cost A cost that involves spending money. Implicit cost A nonmonetary opportunity cost. Income statement A financial statement that shows a firm’s revenues, costs, and profit over a period of time. Indirect finance A flow of funds from savers to borrowers through financial intermediaries such

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as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers).

rather than the interests of the principal who hired the agent.

Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed.

Risk The degree of uncertainty in the return on an asset.

Liability Anything owed by a person or a firm. Limited liability A legal provision that shields owners of a corporation from losing more than they have invested in the firm. Opportunity cost The highest-valued alternative that must be given up to engage in an activity. Partnership A firm owned jointly by two or more persons and not organized as a corporation. Principal–agent problem A problem caused by an agent pursuing the agent’s own interests

Separation of ownership from control A situation in a corporation in which the top management, rather than the shareholders, controls day-to-day operations. Sole proprietorship A firm owned by a single individual and not organized as a corporation. Stock A financial security that represents partial ownership of a firm. Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) Legislation passed during 2010 that was intended to reform regulation of the financial system.

Key Terms—Appendix Present value. The value in today’s dollars of funds to be paid or received in the future.

Chapter Outline Investing in Lyft, a Company That Has Never Earned a Profit?

In 2012, John Zimmer and Logan Green cofounded their ride-hailing company Lyft. The Lyft app is available in hundreds of cities. Because their investments have been costly, in 2019 Zimmer and Green decided that Lyft should become a public firm. Doing so would enable the firm to sell stock to investors in financial markets. When Lyft had its initial public offering (IPO) of stock, its executives assured investors that the firm could reduce its spending and increase revenue enough to become profitable⸻ something the firm was not able to do when it was privately owned. The ability of firms like Lyft to raise funds in financial markets is critical to the health of the overall economy. In mid-2021, the company’s stock market value was more than $20 billion, despite suffering losses of more than $1.5 billion during the previous year, partly due to the effects of the Covid-19 pandemic on the demand for ride-hailing services.

8.1

Types of Firms Learning Objective: Categorize the major types of firms in the United States.

In the United States, there are three legal categories of firms. A sole proprietorship is a firm owned by a single individual and not organized as a corporation. A partnership is a firm owned jointly by two or more persons and not organized as a corporation. Most law and accounting firms are partnerships. Most large firms are organized as corporations. A corporation is a legal form of business that provides owners with protection from losing more than their investment should the business fail.

A. Who Is Liable? Limited and Unlimited Liability The owners of sole proprietorships and partnerships have unlimited liability, which means that there is no legal distinction between the personal assets of the owners and the assets of the firm. An asset is anything of value owned by a person or a firm. In the early 1800s, state legislatures in the United States began to pass general incorporation laws that allowed firms to be more easily organized as corporations. Under the corporate form of business, the owners have limited liability. Limited liability is a legal provision that shields owners of a corporation from losing more than they have invested in the Copyright © 2023 Pearson Education, Inc.

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firm. The personal assets of the owners of the firm are not affected if the firm fails. Limited liability makes it possible for corporations to raise funds by issuing shares of stock to a large number of investors. Corporations have some disadvantages. Corporate profits are taxed twice—once at the corporate level and again when investors receive a share of corporate profits. Corporations are generally larger than sole proprietorships and partnerships and, therefore, more difficult to organize and run.

B. Corporations Earn the Majority of Revenue and Profits Although only 18 percent of all firms are corporations, they account for the majority of revenue and profits earned by all firms—as shown in Figure 8.1

C. The Structure of Corporations and the Principal–Agent Problem Corporate governance is the way in which a corporation is structured and the effect that structure has on the corporation’s behavior. Unlike the owners of family businesses, the management of a corporation usually does not own a large share of the firm’s stock. Separation of ownership from control is a situation in which the top management, rather than the shareholders, controls day-to-day operations. The conflict between the interests of shareholders and the interests of top management is called the principal–agent problem: A problem caused by an agent pursuing the agent’s own interests rather than the interests of the principal who hired the agent. To reduce the effects of the principal– agent problem, many boards of directors in the 1990s began to tie the salaries of top managers to the firm’s profit or to the price of the firm’s stock.

Teaching Tips Corporations are “publicly owned.” Be sure your students do not mistakenly believe this phrase means “government owned.”

Extra Solved Problem 8.1 The Risks of Private Enterprise: The “Names” of Lloyd’s of London The world-famous insurance company Lloyd’s of London got its start in London in the 1600s. Ship owners would come to Edward Lloyd’s coffeehouse to find someone to insure (or “underwrite”) their ships and cargo for a fee. Coffeehouse customers—merchants and ship owners themselves—who agreed to insure ships would make payments from their personal funds if a ship was lost at sea. By the late 1700s, each underwriter would recruit investors known as “Names” and use the funds raised to back insurance policies sold to a wide variety of clients. By the 1980s, 34,000 people around the world had invested in Lloyd’s as Names. A series of disasters in the 1980s and 1990s—such as earthquakes and oil spills—resulted in huge payments made on Lloyd’s insurance policies. It had become clear that Lloyd’s was not a corporation and the Names did not have Copyright © 2023 Pearson Education, Inc.

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the limited liability that a corporation’s stockholders have. Many Names lost far more than they had invested. Some of those who invested in Lloyd’s had the financial resources to absorb their losses, but others did not. Tragically, as many as thirty Names may have committed suicide as a result of their losses. By 2015, only about 770 Names remained invested in Lloyd’s. New rules allow insurance companies to underwrite Lloyd’s policies for the first time, and Names now provide less than 15 percent of Lloyd’s funds. a. What characteristic of Lloyd’s of London’s business organization was responsible for the financial losses suffered by the Names who had invested in Lloyd’s? b. In the early 2000s, corporations such as Enron and WorldCom suffered severe losses after it was discovered that executives of the firms had falsified financial statements to deceive investors. How were the losses suffered by Enron and WorldCom stockholders different from the losses suffered by Lloyd’s of London’s Names?

Solving the Problem Step 1:

Review the chapter material. This problem is about firms and corporate governance, so you may want to review the section “Types of Firms” in the textbook.

Step 2:

Answer (a) by explaining what characteristic of Lloyd’s of London’s business organization was responsible for the financial losses suffered by the Names who had invested in Lloyd’s. Lloyd’s of London was a partnership. A disadvantage of partnerships, as well as sole proprietorships, is the unlimited personal liability of the owners of the firm. The liability Lloyd’s partners, or Names, incurred went beyond the amount of funds they invested in the company. Therefore, when the insurance company was hit with a series of financial losses some of the Names suffered severe financial losses.

Step 3:

Answer (b) by explaining how the losses suffered by Enron and WorldCom stockholders were different from the losses suffered by Lloyd’s of London’s Names. Enron and WorldCom were corporations, so their stockholders had limited liability. Their losses were limited to the amount they had invested in these firms.

8.2

How Firms Raise Funds Learning Objective: Explain how firms raise the funds they need to operate and expand.

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To earn a profit, a firm must raise funds to pay for its operations. If a small business is successful and the owner decides to expand, it can obtain funds in three ways. First, the firm can reinvest its profits, called retained earnings. Second, the owner can take on additional owners to invest in the firm to increase the firm’s financial capital. Third, the owner can borrow funds from relatives, friends, or a bank.

A. Sources of External Funds Unless firms rely on retained earnings, they must raise the external funds they need from others. The economy’s financial system transfers funds from savers to borrowers—directly through financial markets or indirectly through financial intermediaries such as banks. Firms raise external funds in two ways. Indirect finance refers to a flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers). Direct finance refers to a flow of funds from savers to firms through financial markets, such as the New York Stock Exchange.

A bond is a financial security that represents a promise to repay a fixed amount of funds. A coupon payment is an interest payment on a bond. The interest rate is the cost of borrowing funds, usually expressed as a percentage of the amount borrowed. The interest rate on a bond, or the coupon rate, is an interest payment on a bond divided by the amount borrowed. For example, if the annual interest payment on a $1,000 bond is $40, then the interest rate is: $40  0.04, or 4% . $1,000

Many bonds that corporations issue have maturities of thirty years. The higher the default risk on a bond, the higher the interest rate. A stock is a financial security that represents partial ownership of a firm. When a corporation sells stock, it is increasing its financial capital by bringing additional owners into the firm. A shareholder is entitled to a share of the corporation’s profits. Many small investors buy shares of mutual funds rather than buying stocks issued by individual companies. Mutual funds sell shares to investors and use the funds to invest in a portfolio of financial assets. Exchange-traded funds (ETFs) can be bought and sold to other investors, just like individual stocks or bonds. Corporations generally keep some of their profits as retained earnings. Remaining profits are distributed to shareholders as dividends. Dividends are payments by a corporation to its shareholders. A corporation must make promised payments to bondholders before it can make dividend payments to shareholders.

B. Stock and Bond Markets Provide Capital—and Information There is no single place where stocks and bonds are bought and sold. Some trading takes place in buildings called exchanges. Computer technology has spread trading to securities dealers outside of exchanges. Copyright © 2023 Pearson Education, Inc.

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These dealers comprise the over-the-counter market. Shares of stock represent claims on the profits of firms that issue them. Changes in the prices of stocks, bonds, and other securities reflect investors’ future expectations. Bonds represent claims to receive coupon payments and one final payment of principal. A bond that was issued in the past may have its price increase or decrease, depending on whether the coupon payments being offered on newly issued bonds are higher or lower than on existing bonds. The price of a bond will also be affected by changes in default risk, which reflects investors’ expectations of the issuing firm’s ability to make coupon payments. Changes in the value of stocks and bonds provide information for a firm’s managers as well as investors. An increase in the stock price means that investors are more optimistic about the firm’s profit prospects, and the firm might want to expand as a result. A decrease in the firm’s stock price indicates that investors are less optimistic about the firm’s profit prospects, so management might want to shrink the firm’s operations. Changes in the value of a firm’s bonds imply changes in the cost of external funds to finance the firm’s investment in research and development or in new factories.

C. The Fluctuating Stock Market Stock market indexes are averages of stock prices, with the value of the index set equal to 100 in the base year. The three most widely followed U.S. stock indexes are: (1) the Dow Jones Industrial Average; (2) the Standard and Poor’s (S&P) 500; and (3) the National Association of Securities Dealers Automated Quotations (NASDAQ) composite index. All three indexes follow a roughly similar pattern: Increases in stock prices during expansion and declines in stock prices when the U.S. economy is in a recession.

D. Why Is It So Hard to Beat the Market? Stock prices are difficult to predict. Investment professionals spend a great deal of effort gathering information about the future profitability of firms. As a result, all of the current information about these firms is already reflected in their stock prices. Only new information about future profitability will cause stock prices to change. Stocks are much riskier than bonds. Economists measure risk as the degree of uncertainty in the return on an asset. Because stock prices fluctuate more than bond prices, the return on stocks is more uncertain than the return on bonds.

Teaching Tips The double taxation of corporate profits⸻ once from the corporate profits tax and again from the income tax on shareholders’ dividends⸻ gives corporations the incentive to raise funds more through debt (bonds) than equity (stocks). Some economists criticize the corporate profit tax for the incentive it gives corporations to incur debt solely for the tax consequences of doing so.

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Extra Apply the Why Are Many People Poor Stock Market Investors? Concept

You’ve probably heard this standard advice about investing: “Buy low and sell high.” That is, you should buy shares of stocks and other financial assets when their prices are low and sell them when their prices are high. Unfortunately, many people do the opposite. For instance, many people bought shares of Tesla stock when it was selling for more than $70 per share in November 2018 and sold when it was below $40 per share in May 2019…only to regret the sale when the price soared to $790 per share in January 2021.

Stock prices are difficult to predict, but many people convince themselves that a stock whose price has been rising will continue to rise and that a stock whose price has been falling will continue to fall. As a result, people end up buying high and selling low rather than the reverse. Studies have shown that individual investors consistently earn lower returns on their investments when they frequently buy and sell stock hoping to predict changes in stock prices.

But why are stock prices so difficult to predict? The key reason is that stock prices are based less on the current profitability of firms than on their expected future profitability. After all, few investors would be willing to pay a high price for a stock that was profitable today but was expected to suffer large losses tomorrow. Similarly, investors in the summer of 2021 were willing to pay $61 per share for Snap even though the firm was suffering losses because they expected it would earn profits in the future. If you look carefully at Figure 8.3, Movements in Stock Market Indexes (below), you can see that stock prices start to rise when investors begin to expect that an economic recovery will soon begin rather than after the recovery has already begun.

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Many Wall Street investment professionals spend a lot of time and money gathering all possible information about the future profitability of firms, hoping to buy stock in the most profitable firms. As a result, all of the information about a firm that is available in newspapers, financial magazines, cable business shows, and online is reflected in the firm’s stock price. For example, if at the end of a particular day, Lyft is selling for $61 per share, that price reflects all the information available about Lyft’s future profitability. What might cause Lyft’s stock price to change? Only new information about its future profitability. For example, if Lyft releases new data showing that its advertising sales on Snapchat have been lower than investors had expected, its stock price will fall.

Even highly paid professional investors cannot consistently predict stock prices. The managers of mutual funds and ETFs who try to earn high returns by frequently buying and selling stocks are rarely able to beat the stock market averages, such as the S&P 500. One study found that, in a typical year, only onethird of mutual fund managers were able to earn their investors a higher return than a small investor could earn by investing in an index mutual fund that buys only the stocks in the S&P 500. Only 10 percent of mutual fund managers earned a higher return than an index fund for two consecutive years. Whichever way you—or Wall Street professionals—predict stock prices will move in the future, you are as likely to be wrong as you are to be right. Sources: Morgan Housel, “Three Mistakes Investors Keep Making Again and Again,” Wall Street Journal, September 12, 2014; Chris Dieterich, “Hedge Fund Short Bets Are Going the Wrong Way . . . Again,” Wall Street Journal, February 7, 2017; and Howard Gold, “Almost No One Can Beat the Market,” marketwatch.com, October 25, 2013.

8.3

Using Financial Statements to Evaluate a Corporation Learning Objective: Describe the information corporations include in their financial

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Before a firm can sell new issues of stocks or bonds, it must provide investors with information about its finances. In most high-income countries, government agencies require firms that want to sell securities to disclose financial information to the public. In the United States, the Securities and Exchange Commission (SEC) requires publicly owned firms to report their performance according to generally accepted accounting principles. Some private companies (for example, Moody’s Investor Service and Standard and Poor’s) collect information from businesses and sell it to subscribers. Investors and the managers of firms need information regarding the firm’s revenues and costs, as well as information regarding the value of the property and other assets the firm owns and the firm’s debts or other liabilities it owes to others. A liability is anything owed by a person or a firm. The information investors need to decide whether to buy a firm’s stocks or bonds is contained in the firm’s financial statements.

A. The Income Statement An income statement is a financial statement that shows a firm’s revenues, costs, and profit over a period of time. The income statement starts with a firm’s revenue and subtracts its operating expenses and taxes. Accounting profit is a firm’s net income, measured as revenue minus operating expenses and taxes paid. Economic profit is the firm’s revenues minus all of its implicit and explicit costs. Because economic profit takes into account all costs it provides a better indication than accounting profit of how successful a firm is. Economists always measure cost as opportunity cost. Opportunity cost is the highest-valued alternative that must be given up to engage in an activity. An explicit cost is a cost that involves spending money. An implicit cost is a nonmonetary opportunity cost. The firm’s most important implicit cost is the opportunity cost to investors of the funds they have invested in the firm. The minimum amount that investors must earn on the funds they invest, expressed as a percentage of the funds invested, is called a normal rate of return. If a firm fails to provide at least a normal rate of return, it will not remain in business over the long run.

B. The Balance Sheet A balance sheet is a financial statement that sums up a firm’s financial position on a particular day, usually the end of a quarter or year. A balance sheet summarizes a firm’s assets and liabilities. Subtracting the value of a firm’s liabilities from the value of its assets leaves its new worth. Net worth is what the firm’s owners would be left with if the firm were closed, its assets sold, and its liabilities paid off.

C. Problems in Corporate Governance

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Firms disclose financial statements in periodic filings to the federal government and in annual reports to shareholders. Top managers have an incentive to maximize profit reported on their income statements and net worth reported on their balance sheets. At some firms, top managers have inflated profits and concealed liabilities that should have been listed on their balance sheets. To guard against actions managers might take that are contrary to the interests of their shareholders, Congress passed the Sarbanes-Oxley Act in 2002. The act requires that CEOs to personally certify the accuracy of financial statements and financial analysts and auditors to disclose conflicts of interest that would limit their independence in evaluating a firm’s financial condition.

During the financial crisis of 2007-2009, some investors complained that they weren’t aware of the riskiness of some of the assets on the balance sheets of financial firms. In 2010, Congress passed the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), a law intended to reform regulation of the financial system. The act established (1) the Consumer Financial Protection Bureau to write rules to protect consumers in their borrowing and investing activities and (2) the Financial Stability Oversight Council to identify and act on risks to the financial system.

Teaching Tips Although it is a macroeconomic topic, your students may be interested in the role stock prices play as an admittedly imperfect leading economic indicator. Changes in stock prices reflect firms’ expected future performance. A sustained rise or decline in stock prices (as reflected in the Standard and Poor’s average of 500 stocks or the Dow-Jones Industrial Average of 30 stocks) over several weeks or months can indicate a turning point in the business cycle from recession to expansion or expansion to recession, respectively.

Appendix Using Present Value Learning Objective: Explain the concept of present value.

The Concept of Present Value If you own shares of stock or a bond, you will receive payments in the form of dividends or coupons over a number of years. Most people value funds they already have more highly than funds they will receive in the future. Present value is the value in today’s dollars of funds to be paid or received in the future. For example, assume that you are willing to lend $1,000 today if you are paid back $1,100 one year from now. In this case, you are charging 10 percent on the funds you have loaned. Economists would say that $1,000

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today is equivalent to the $1,100 to be received one year in the future. $1,100 can be written as $1,000 (1 + 0.10). Or: $1,000 × (1 + 0.10) = $1,100. If we divide both sides of this equation by (1 + 0.10), we can rewrite this as: $1,000 =

$1,100 . (1+ 0.10)

This formula states that the present value is equal to the future value to be received in one year divided by one plus the interest rate. Writing the formula more generally: Present Value 

Future Value1 (1  i)

The present value of funds to be received in one year—Future Value1—can be calculated by dividing the amount of those funds to be received by 1 plus the interest rate. The formula can be expanded to calculate the value of funds to be received more than one year in the future. Suppose you are asked to lend $1,000 for two years and are promised 10 percent interest per year. After two years, you will be paid back $1,100 (1 + 0.10) or $1,210. Or: $1,210 = $1,000 (1 + 0.10) (1 + 0.10), Or: $1,210 = $1,000 (1 + 0.10)2. The equation can be rewritten as:

$1,000 

$1,210 (1  0.10) 2

We can generalize the concept to say that the present value of funds to be received n years in the future equals the amount of funds to be received divided by the quantity 1 plus the interest rate raised to the nth power. Or, more generally,

Present Value 

Future Valuen (1  i)n

where Future Valuen represents funds that will be received in n years.

A. Using Present Value to Calculate Bond Prices The price of a financial asset, such as a bond, should be equal to the present value of the payments to be received from owning the asset. The relevant interest rate used by investors in the bond market to

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calculate the present value and, therefore, the price of an existing bond is usually the coupon rate on comparable newly issued bonds. The general formula for the price of a bond is:

Bond Price 

Coupon n Coupon1 Coupon 2 Face Value ,   ...   2 (1  i) (1  i) (1  i) n (1  i) n

where Coupon1 is the coupon payment to be received after one year, Coupon2 is the coupon payment to be received after two years, up to Couponn, which is the coupon received in the year the bond matures. The ellipsis takes the place of the coupon payments received between the second year and the year the bond matures. Face Value is the face value of the bond to be received when the bond matures. The interest rate on comparable newly issued bonds is i.

B. Using Present Value to Calculate Stock Prices The price of a share of stock should be equal to the present value of the dividends investors expect to receive as a result of owning the stock. The general formula for the price of a stock is: Stock Price =

Dividend1 Dividend 2 + +… (1+ i) (1+ i)2

Unlike a bond, a stock has no maturity date, so the stock price is the present value of an infinite number of dividend payments. Another difference between the stock formula and the bond price formula is that you don’t know for sure what the dividend payments from owning stock will be.

C. A Simple Formula for Calculating Stock Prices It is possible to simplify the formula for determining the price of a stock if we assume that dividends grow at a constant rate: Stock Price =

Dividend . (i  Growth Rate)

Dividend is the dividend investors expect to receive one year from now, and Growth Rate is the rate at which dividends are expected to grow.

Appendix Income Statements and Balance Sheets Describe the information contained on a firm’s income statement and balance sheet.

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Key sources of information about a corporation’s profitability and financial position are its principal financial statements—the income statement and the balance sheet.

A. Analyzing Income Statements A firm’s income statement summarizes its revenues, costs, and profit over a period of time. Listed first are the revenues the firm earned. Listed next are operating expenses, including the cost of revenue, which is commonly known as cost of sales or cost of goods sold. The difference between a firm’s revenues and its costs is its profit. A firm’s operating income is the difference between its revenue and its operating expenses. Most corporations have interest expenses and income from investments, such as government and corporate bonds. The federal government taxes the profits of corporations. The net income that firms report on their income statements is referred to as their after-tax accounting profit.

B. Analyzing Balance Sheets A firm’s balance sheet summarizes its financial position on a particular day, usually the end of a quarter or year. Subtracting the value of a firm’s liabilities from the value of its assets leaves its net worth. Because a corporation’s stockholders are its owners, net worth is often listed as stockholders’ equity. Stockholders’ equity is the difference between the value of a corporation’s assets and the value of its liabilities, which is also known as net worth. The value of a firm’s assets must equal the value of its liabilities plus the value of stockholders’ equity. An important accounting convention holds that balance sheets should list assets on the left side and liabilities and net worth, or stockholders’ equity, on the right side. This means that the value of the left side of the balance sheet must always equal the value on the right side. Included on the asset side of the balance sheet are current assets, which are assets that the firm can convert into cash quickly, and goodwill, which represents the difference between the purchase price of a company and the market value of its assets. Current liabilities are short-term debts such as accounts payable, which is money owned to suppliers for goods received but not yet paid for, or bank loans that will be paid back in less than one year. Long-term bank loans and the value of outstanding corporate bonds are long-term liabilities.

Teaching Tips Although the principal–agent problem is a serious one, managers who pursue their own goals at the expense of the firm’s best interests invite the scrutiny of institutional investors such as mutual funds and pension funds. Unlike many shareholders who have modest stock holdings, institutional investors often hold a significant percentage of a firm’s outstanding shares. These large investors can demand that a board of directors make strategic and personnel changes if a firm’s performance is unsatisfactory, and they can cause a drop in share prices by selling some or all of their stock holdings.

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Solutions to End-of-Chapter Exercises 8.1

Types of Firms Learning Objective: Categorize the major types of firms in the United States.

Review Questions 1.1

The three major types of firms in the United States are sole proprietorships, partnerships, and corporations. A sole proprietorship is owned by a single individual who controls the firm with no layers of management. A partnership is owned jointly by two or more persons who share the work and share the risks. Both a sole proprietorship and a partnership have unlimited personal liability and limited ability to raise funds. A corporation is a legal form of business that provides a firm’s owners with limited liability and a greater ability to raise funds. A corporation has more layers of management and is costly to organize.

1.2

Limited liability is a legal provision that shields owners of a corporation from losing more than they have invested in the firm. The government grants this privilege to corporations because investors are more likely to buy stock in a firm—thereby becoming part owners—if the investors’ losses are limited to the amount they invest. Because, unlike with a sole proprietorship or a partnership, most investors in a corporation will not have a role in managing the firm, they will be reluctant to become part owners if they face unlimited liability for the corporation’s losses. Most economists believe that limited liability laws increase investment and the rate of economic growth. Because the stockholders of a corporation can never lose more than the amount they invested in the firm, a firm can raise more funds from a large number of investors if it is organized as a corporation.

1.3

Shares of stock represent partial ownership in large corporations, so someone who owns shares of stock in a corporation owns a (typically small) part of the firm and shares in the firm’s profits. Control of the corporation is possessed by members of its board of directors who select managers responsible for the day-to-day operations of the firm. Although stockholders legally own a corporation, they typically do not control it. The principal–agent problem results when an agent pursues his or her own interests rather than the interests of the principal who hired him or her. In a corporation, the managers of a firm (the agents) may choose to pursue policies that benefit themselves rather than the firm’s stockholders (the principals). Stockholders are interested in higher profits, but managers may be more concerned with paying themselves higher salaries and building luxurious corporate offices, which reduce profits. Because most shareholders are not aware of the daily operations of the firm, they may be unaware of the choices managers make.

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Problems and Applications 1.4

How you organize your business depends on the type of business you are entering. Incorporation has the advantage of limited liability but the disadvantage of additional taxes. If you choose not to form a corporation, then your choice between a sole proprietorship and a partnership will depend on whether you will gain enough by bringing in a partner or partners and sharing control and profits with them. A young entrepreneur who starts a firm for the first time often chooses to organize the firm as a sole proprietorship.

1.5

Before the incorporation law was passed, owners of all businesses established in Connecticut had unlimited liability. If a firm failed, the personal assets of firm owners were at risk. Under the corporate form of business, if a firm fails owners will not lose more than the amount they invested in the firm.

1.6

The person making this argument does not understand that stockholders in a corporation have limited liability. Limited liability is the legal provision that shields owners of a corporation from losing more than they have invested in the firm. Therefore, this person will not be responsible for any other losses the firm may experience. Holding stocks is risky because the value of the stocks may go up or down, but the risk is limited to the amount invested.

1.7

When states required their legislatures to pass special laws to grant firms permission to become corporations, it increased the cost to incorporate. The increase in time and effort for firms had two disadvantages: (1) having to have a special law passed by the legislature in order to operate limited the number of firms that could become corporations; and (2) the difficulty of getting a special law passed by the legislature prevented many small firms with fewer resources from becoming corporations. In addition, the need to have a state legislature pass a law helping a particular firm opened the door for firms to bribe legislators to speed the process of passing a law or for legislators to favor firms that had made contributions to the legislators’ political campaigns. General incorporation laws allow more firms to experience the benefits of incorporation and ultimately allow for greater competition in markets. The laws also reduce opportunities for corruption. One disadvantage of general incorporation laws is that firms are no longer exposed to greater scrutiny from their legislatures when they try to incorporate. This scrutiny may have weeded out some firms that intended to sell unsafe or fraudulent goods and services.

1.8

a. New firms are often formed to introduce new technology and business methods that the firms’ founders have developed. The founders may believe they can profit more from the new technology by keeping control of it rather than by selling it to an existing firm. Entrepreneurs who believe they have a better way of making a good or marketing it may find it difficult to find existing firms willing to buy from them the legal rights to unproven business methods.

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b. Most economists recognize that new, innovative firms are vital to the future health of the U.S. economy. In recent years, there has been a decrease in the number of new business startups. This trend concerns economists because fewer startups could be one reason the U.S. economy is experiencing a slowdown in technological progress. 1.9

a. Occupational licensing makes it harder to enter an occupation, including hairdressing or teaching yoga, because earning an occupational license often requires passing a test and paying a fee. These requirements will result in fewer people entering an occupation or starting a small business that requires a license. If Senator Klobuchar’s suggested restrictions on occupational licensing were enacted, more small businesses would likely be formed because fewer small businesses would be subject to occupational licensing requirements. b. Occupational licenses are usually justified on the grounds that having unqualified people perform a service may harm consumers. This rationale makes sense for physicians and dentists but is less plausible for barbers or yoga instructors. In those cases, the government may be requiring occupational licenses so that fewer people will enter the occupation, thereby protecting the earnings of people who are already in the occupation.

1.10

The principal is the person who wants to get something done and hires an agent to do the job. In the classroom, the students are the principals, along with a state’s taxpayers, at least at public universities. In effect, students hire the instructor to do a job that they can’t easily do by themselves—to teach them about a subject such as economics. The principal–agent problem arises if the instructor has her own best interests in mind, rather than those of the students or the taxpayers. For example, the instructor might give exams and assignments that are too easy or too hard from the point of view of the students or spend time playing video games rather than preparing for class.

1.11

Sales personnel have an incentive to receive the highest income possible for the least amount of effort. The owner of the business would like his or her employees to make as many sales as possible. Paying sales personnel by commission better aligns the objectives of the employees, whose activities are often difficult to monitor, with the objectives of the owner than does paying a straight hourly wage. When paid by commission, the harder sales personnel work, the larger their incomes.

1.12

Private equity firms do reduce problems of corporate governance by helping to establish a market for corporate control, which can reduce principal–agent problems by providing a means to remove top management that is failing to carry out the wishes of shareholders.

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8.2

How Firms Raise Funds Learning Objective: Explain how firms raise the funds they need to operate and expand.

Review Questions 2.1

Direct finance occurs when a firm obtains funds directly from savers through the stock or bond market. Indirect finance occurs when firms obtain funds from savers indirectly through an intermediary such as a bank. Borrowing money from a bank to buy a car is indirect finance, as the bank channels the funds from its depositors to you. Borrowing money from your friend to buy a car would be direct finance.

2.2

A bond is a loan because the firm promises to pay back the principal and interest to the bondholder. A share of stock is not a loan but is instead the purchase of partial ownership of a company itself. Unlike with a loan, the firm isn’t obligated to return the funds of an investor who purchases the firm’s stock. The investor owns a share of the firm’s assets and has a claim on the firm’s profits. A corporation must issue some shares because someone must own the corporation. When a corporation needs to raise more money, it will issue bonds if it believes it will be cheaper to borrow the money than to promise a share of the future profits to an expanded number of owners.

2.3

Stock and bond markets provide information that helps investors anticipate what will happen to the firm. If investors are optimistic and think the firm will earn higher profits, they will bid up the price of its stock. If investors are pessimistic, the price of the stock will fall. If they are pessimistic and fear that the firm might suffer financial losses and default on its bond payments, investors will be less willing to buy the firm’s bonds and the prices of the bonds will fall. Optimism about the firm will increase the prices of the firm’s bonds. So, the successes and failures of the firm will result in rising or falling prices for the firm’s stocks and bonds. Changes in investor expectations about the firm’s likely future profitability will also affect the prices of the firm’s stocks and bonds. Businesses can use these fluctuations in the prices of their stocks and bonds to gauge investors’ views of the businesses’ prospects. In that way, stock and bond markets provide information to businesses.

Problems and Applications 2.4

You would rather own the bonds because a firm losing money is unlikely to pay a dividend, and if the firm goes bankrupt, the bondholders would be paid before the stockholders.

2.5

Lyft’s initial public offering (IPO) occurred in the primary market because Lyft sold newly issued stocks directly to the public. The IPO was an example of direct finance because Lyft acquired external funds through financial markets, as opposed to going through a financial intermediary, such as a bank. Copyright © 2023 Pearson Education, Inc.

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a. S&P’s highest rating is AAA. This rating is given to firms that have a strong ability to meet their financial obligations. S&P cuts, or lowers, the bond rating of a firm if the firm’s ability to meet its obligations decreases or if the probability of the firm filing for bankruptcy increases. b. A lower debt rating would imply that there is a higher risk that JetBlue might not repay its debt. The lower debt rating would increase the interest rate the firm would need to pay investors to get them to buy its bonds. The higher interest rate compensates investors for the greater risk that JetBlue will be unable to pay the interest and principal on its bonds.

2.7

Moody’s, S&P, and Fitch don’t sell their services to investors because that would create a “free rider” problem. For example, an investor who bought the ratings services of S&P for Apple’s bonds would be free to share this information with other investors. Because of free riding, the ratings services would be unlikely to sell their ratings to enough investors to cover their costs.

2.8

a. Google’s stock price will fall because its expected future revenues and profits will have fallen. b. Google’s stock price will rise because its after-tax profit will rise. c. Google’s stock price will fall because expected future profits will fall. In these circumstances, the board of directors is not likely to provide independent supervision of top management, which will make the principal–agent problem worse. d. Google’s stock price will rise because expected revenues and profits will rise. e. Google’s stock price will fall because its profit was lower than expected. The higher expected profit was already reflected in Google’s stock price, so the lower actual profit will cause its stock price to fall.

2.9

The statement is false. These shares of Microsoft stock were traded in the secondary market (the NASDAQ), so the money went from the investors who had owned these shares to the investors who bought the shares in the market. The money didn’t go to Microsoft.

2.10

a. Long-term returns are described as “expected” because the future is uncertain and the returns are based on predictions about the future. Most analysts make conjectures about what will most likely happen in the future and calculate expected returns with the assumption that their conjectures will hold true. The returns in the stock market are not certain because they depend on the future prices of stocks and the dividends that firms will pay in the future. The prices of stocks fluctuate and firms can usually change the dividends they pay without notice. b. Money that you will need as soon as two years from now should not be invested in the stock market because the values of stocks can fluctuate substantially over short periods. For example, between October 2007 and March 2009, the value of the S&P 500 declined by Copyright © 2023 Pearson Education, Inc.

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CHAPTER 9 | Comparative Advantage and the Gains from International Trade more than 50 percent. Stocks are generally good investments if you do not need the funds for 10 years or more. Funds you will need in two years are better kept in either a bank certificate of deposit (CD) or in a money market fund.

2.11

a. Lyft and Uber are examples of firms that have disrupted an existing market—in this case the market for ride-hailing in cities—in a way that could earn them substantial profits. b. By a “great business,” the financial adviser likely meant a business that is profitable. Lyft incurred substantial losses through 2021. Lyft faces two important obstacles to becoming profitable: (1) Increased government regulation in some cities, including New York City, which may increase Lyft’s operating costs, particularly if the regulations mandate higher pay for Lyft’s drivers; and (2) to become profitable, Lyft will have to significantly raise prices, and it’s not clear that the quantity of rides demanded will remain high if Lyft and Uber raise prices above those charged by conventional taxi services.

2.12

a. A “tech unicorn” is a new firm, or startup, in the technology sector that is valued by investors at more than $1 billion. b. A “clear road to profitability” means a feasible way that Lyft can move from suffering losses to becoming profitable. In addition to significant competition from conventional taxis, Uber, and other ride-hailing firms, Lyft faces the threat of government regulations that may force the firm to raise the salaries of its drivers and possibly to limit the areas in which it can operate or the number of cars it can have operating in an area during a particular time. In addition, Lyft will likely have to raise prices to eventually become profitable and it’s uncertain whether most of its current customers will be willing to pay substantially more than they currently do for its service.

2.13

Warren Buffett advises individual (non-professional) investors to concentrate on buying shares of mutual funds that charge relatively low fees. There are three key advantages to mutual funds: (1) they allow individuals to diversify their investments so that a decline in the price of a single stock or bond can be offset by price increases for other stocks or bonds; (2) they are professionally managed by fund managers who are well informed about the companies whose securities they trade and have an incentive to earn high returns for their customers; and (3) they allow individuals—particularly those buying index mutual funds that hold a large portfolio of stocks or bonds—to earn long-run returns from investing in financial markets without having to acquire specialized knowledge about firms or markets.

2.14

a. Stock prices do reflect the expected future profitability of the firms that issue stocks, but prices can and do fluctuate in the short run because of the desire by speculators to profit by buying and selling stocks over brief time periods. b. In recent years, online trading apps that do not charge commissions for trading securities have made it easier for investors to trade stocks in hopes of earning short-run profits. These

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speculative trades increase the volatility of stock prices in the short run, but in the long run prices will reflect firms’ profitability.

2.15

a. “Salting away money” refers to buying and holding stocks and bonds over long periods of time. b. An index fund is a portfolio of stocks that represents a number of companies that are listed in the index, such as the S&P 500. Index funds are designed to provide a long-run return to investors, rather than an opportunity to “get rich quick” from speculating on buying and selling individual securities, such as GameStop stock, over a short time period. c. For people investing for their retirement, their children’s education, and other long-run goals, an index fund that invests in a portfolio of securities is less risky than investing in an individual stock. In the long run, growth in the value of the index mutual fund will mirror the growth of the overall financial market and the U.S. economy.

Using Financial Statements to Evaluate a Corporation 8.3

Learning Objective: Describe the information corporations include in their financial statements.

Review Questions 3.1

An asset is anything of value that a firm owns (such as a building). A liability is a debt or obligation owed by a firm (such as an unpaid electric bill).

3.2.

A firm’s balance sheet is a snapshot of the firm’s assets and liabilities on a particular day (such as the end of a quarter). A firm’s income statement summarizes its revenues, costs, and profit over a period of time (such as a year).

3.3

An explicit cost is a cost that involves spending money. An implicit cost is a nonmonetary opportunity cost. A firm has both explicit costs, such as the rent it pays for a warehouse, and implicit costs, such as the opportunity cost of the services a sole proprietor supplies to his or her own firm. Accounting profit is a firm’s revenue minus its operating expenses and taxes paid (explicit costs). Economic profit is a firm’s revenue minus all of its implicit and explicit costs.

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3.4

Regardless of its accounting profit, a firm making a negative economic profit is not likely to survive in the long run because it is not covering all of its implicit costs, such as the minimum amount that investors must earn on the funds they have invested in the firm.

3.5

Corporate governance refers to how a corporation is structured and the effect the structure has on the firm’s behavior. The focus of corporate governance should be to promote the interests of the firms’ owners, who are the firms’ shareholders. Shareholders are the individuals who stand to gain the most when the corporation makes a profit, and they have the most to lose when the corporation incurs a loss.

Problems and Applications 3.6

If Paolo were to keep the money invested in bonds, he would earn an interest rate of 4 percent per year, which would be the opportunity cost of using the funds from selling his bonds to start his restaurant. Paolo is correct in stating that selling the bonds would be a less costly option than taking out a loan that has a 6 percent interest rate. But it is not true that he doesn’t have to “pay anything” (that is, incur any cost) to use the funds he receives from the sale of his bonds. If he sells the bonds to open a restaurant, Paolo will incur an opportunity cost of 4 percent a year—the amount of interest he will have to give up by using the $100,000 to start a restaurant rather than keeping it invested in bonds.

3.7

Paolo’s and Alfredo’s costs are the same. Even though Alfredo receives the pizza ovens for free, as the owner of the restaurant he incurs an opportunity cost by using the ovens in his own business. There is an opportunity cost because he is giving up the funds he could receive by leasing the ovens or by selling them to another pizza restaurant owner. Paolo’s costs of using the ovens are the same as Alfredo’s. Once Paolo has purchased the ovens, his decision as the restaurant owner to use the ovens in his own restaurant means he incurs an opportunity cost equal to the funds he gives up by not leasing or selling the ovens. As an individual, Alfredo is better off than Paolo because he received the ovens for free and didn’t have to buy them. But as a restaurant owner, Alfredo’s costs are no lower than Paolo’s.

3.8

a. Accounting profit = revenues - explicit costs. Explicit costs are those that involve spending money, which include $75,000 paid to assistants and $10,000 for utilities. Accounting profit = $200,000 - $85,000 = $115,000. b. Economic profit = revenue - opportunity costs (explicit costs + implicit costs). Implicit costs for Dane include $200,000 in forgone wages; $20,000 in forgone rent on his duplex; and interest forgone by not selling his $1,000,000 in extraterrestrial gear and investing the funds. His economic profits are negative because his opportunity costs exceed his revenues.

3.9

a. The key principal-agent problem that exists in some corporations is that the firm’s top management—the agents—may pursue their own interests rather than the interests of the shareholders of the corporation—the principals. Copyright © 2023 Pearson Education, Inc.

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b. The board of directors are responsible to the shareholders because the shareholders own the firm and members of the board are expected to act in the interests of the shareholders. c. Governance failures refers to situations in which a firm’s top managers fail to act in the interests of the firm’s shareholders. Because the boards of directors are responsible for ensuring that the top managers act in the interests of the shareholders, the failure the columnist is referring to is the failure of the directors to properly supervise the actions of top managers. The failure may occur because the outside directors are not involved in the daily operations of the firm, so they may have difficulty deciding whether the actions top managers take really are in the best interests of shareholders. In addition, top managers are sometimes able to influence outside directors, particularly if the outside directors have a relationship with the firm by, for instance, being CEOs of suppliers to the firm. 3.10

a. When the entrepreneurs who found a firm own the stock with the most voting power, they are freer to make decisions that will raise the long-term profitability of the firm at the expense of lower profits in the short term. When investors hold the majority of the voting power, they may push the founders to take actions that will increase the short-term profitability of the firm but reduce its long-term profitability. Founders may have more information on the likelihood that certain actions will raise the firm’s long-term profitability than will investors whose only connection with the firm is to own its stock. b. The problem with a corporate structure such as Lyft’s is that it can involve a significant principal-agent problem because the investors who lack voting power are dependent on the founders to make decisions that increase the value of the firm. The longer the structure leaves most of the voting power with the founders, the more likely it is that the founders will start to act in ways that benefit them but that may not be in the best interests of the other investors.

Suggestions for Critical Thinking Exercises

CT8.1 It is likely that at least some students have little familiarity with the details of stocks, bonds, and corporations.

CT8.2 Any reasonable answer will probably suffice for this question. Non-business students will likely have a difficult time with assets and liabilities so many will find this a challenging question.

CT8.3 The answer to this question will clearly depend upon the article that the student selects.

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Solutions to Chapter 8 Appendices Exercises Appendix | Present Value Learning Objective: Explain the concept of present value.

Review Questions 8A.1

Money received at some future date is worth less than money received today because if you have the money today, you can use it today to buy goods and services and receive benefits from them. In addition, prices are likely to rise, so money received later will have less purchasing power. Finally, there is some risk that you will not receive the money in the future. Present value = Future value/(1 + interest rate). So, if the interest rate rises, the present value decreases.

8A.2

Present Value

8A.3

The present value of bond payments is generally much more certain. The coupon payments and the face value are part of the bond contract, but the future dividends of the firm are not known with certainty. In addition, bond payments are spread out over a specific number of years, but stock dividends extend out toward infinity (or the life of the firm). The main similarity is that both sets of future payments are discounted by dividing by (1 + interest rate) raised to the number of years in the future that the payment will be received.

Problems and Applications 8A.4

To find the present value of the bond, you must find the present value of each payment and then add the payments. At an interest rate of 10 percent, the present value of the bond is:

8A.5 a. The author of the article arrived at $54 million as the value of the contract simply by adding up the salary Alexander receives each year. This approach is incorrect because it does not discount the value of salaries received in the future and assumes that the value of a dollar in 2022 is the same as a dollar in 2019. If we calculate the net present value of the contract, the value of the contract would be significantly less than $54 million.

CHAPTER 9 | Comparative Advantage and the Gains from International Trade xxvii b. If the interest rate is 10 percent, then the present value is:

= $42,549,074.51 c.

8A.6

If the interest rate is 5 percent, then the present value is:

a. No, the lottery statement is not accurate. The lottery only adds the values of winnings in every year and fails to calculate the present value of payments received in the future. b. At an interest rate of 10 percent, the present value of the 30 payments would be calculated as the sum of the present value of each of the 30 payments: 

$25,000,000

1  0.1



$25,000,000

1  0.1



$25,000,000

1  0.1



$25,000,000

1  0.130

 $22,727, 272.73  $20,661,157.02  $18,782,870.02  ...  $1, 432,713.83  $235,672,861.67

c. At an interest rate of 5 percent, the present value of the 30 payments would be calculated as the sum of the present value of each of the 30 payments:



$25,000,000

1  0.05



$25,000,000

1  0.05



$25,000,000

1  0.05



$25,000,000

1  0.0530

 $23,809,523.81  $22,675,736.96  $21,595,939.96  ...  $5,784, 436.22  $384,311, 275.67

d. Using the RATE function in Excel, the interest rate needed to get the present value of the 30 payments to equal $465,500,000 is approximately 3.4 percent. 8A.7

The decision of which is more valuable depends on the rate of interest used in calculating the present value. At a 10 percent interest rate, the present value in 2011 of the 25 one-year payments of $1,193,248.20 would equal:

xxviii CHAPTER 9 | Comparative Advantage and the Gains from International Trade $1,193, 248.20 $1,193, 248.20 $1,193, 248.20    2 3 1  .10  1  .10  1  .10 



$ 1,193, 248.20

1  .10 

= $10,831,162. The present value in 2000 of this $10,831,162 in 2011 would equal: $10,831,162

1  0.10 11

 $3,786, 256.

So, at a 10 percent interest rate, Bonilla would have been wise to take the $5.9 million lump sum in 2000. At a 5 percent interest rate, the present value in 2011 of the 25 one-year payments of $1,193,248.20 would equal $16,817,573.98. The present value in 2000 of this $16,817,573.98 in 2011 would equal $9,832,887. At a 5 percent interest rate, Bonilla would have been wise to take the 25 one-year payments.

8A.8

8A.9

Dividend $2.00   $2/0.08 = $25. If the interest rate is 5 percent, (i  Growth Rate) (0.10  0.02) then the maximum price you would pay is $2/(0.05 0.02) = $2/0.03 = $66.67. Stock prices will rise when interest rates fall because the present value of the dividends investors receive will increase. Interest rates on newly issued bonds are likely to rise as a result of inflation. This increase in interest rates on newly issued bonds will cause the price of your bond to fall. Stock price 

Appendix | Income Statements and Balance Sheets Learning Objective: Describe the information contained on a firm’s income statement and balance sheet. 8B.1

Operating income = revenue – operating expenses. Operating income differs from net income because it excludes both investment income (or loss) and income taxes. Net income and after-tax accounting profit are equivalent terms.

8B.2

An income statement reflects the revenues, costs, and profits of a firm during one year (or some other period of time). A balance sheet reflects the assets, liabilities, and equity of a firm at one moment in time. Assets are listed on the left side of a balance sheet; liabilities and stockholders’ equity are listed on the right side.

8B.3

Interest rates on newly issued bonds are likely to rise as a result of inflation. This will cause the price of your bond to fall.

8B.4

Values are in millions of dollar Revenue from company restaurants

$ 10,013

CHAPTER 9 | Comparative Advantage and the Gains from International Trade Revenue from franchised restaurants

11,012

Total revenue from sales

21,025

Operating Expenses Cost of operating company-owned restaurants

8,266

General and administrative costs

1,963

Franchised restaurants operating expenses

1,973

Total operating expenses

12,202

Income from operations (operating income)

8,823

Interest expense

1,007

Income before income taxes

7,816

Income taxes

1,892

Net income (accounting profit)

8B.5

$ 5,924

Values are in millions of dollars.

Assets Current assets

Liabilities $12,494

Current liabilities

$5,684

Property and equipment

5,929

Long-term liabilities

10,523

Goodwill

3,542

Other liabilities

6,776

Other assets

2,191

Total liabilities

22,983

Total assets

$24,156

Stockholder’s equity

1,173

Total liabilities and stockholder’s equity

$24,156

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8B.6

The current ratio is equal to a firm's current assets divided by its current liabilities. Twitter's $7,111  4.7. current ratio on as of December 31, 2018 was $1,516 Firms with a low current ratio—lower than 1.5—may have difficulty raising cash quickly if they need to pay off their current liabilities.

CHAPTER 9 | Comparative Advantage and the Gains from International Trade Brief Chapter Summary and Learning Objectives 9.1

The United States in the International Economy Discuss the role of international trade in the U.S. economy. ▪

9.2

The United States is the world’s leading exporter, but international trade is more important to most other countries.

Comparative Advantage in International Trade Explain the difference between comparative advantage and absolute advantage in international trade. ▪

9.3

Countries are better off specializing in producing the goods for which they have a comparative advantage and trading for the goods for which other countries have a comparative advantage.

How Countries Gain from International Trade Explain how countries gain from international trade. ▪

9.4

By trading, countries are able to consume more than they could without trade.

Government Policies That Restrict International Trade Analyze the economic effects of government policies that restrict international trade. ▪

International trade helps consumers but hurts firms that are less efficient than foreign competitors; these firms and their workers often support government policies that restrict trade. Copyright © 2023 Pearson Education, Inc.

CHAPTER 9 | Comparative Advantage and the Gains from International Trade

9.5

xxxi

The Debate over Trade Policies and Globalization Evaluate the debate over trade policy and globalization. ▪

Globalization is the movement for countries to become more open to foreign trade and investment.

Key Terms Absolute advantage The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. Autarky A situation in which a country does not trade with other countries. Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Dumping Selling a product for a price below its cost of production. Exports Goods and services produced domestically and sold in other countries. External economies Reductions in a firm’s costs that result from an increase in the size of an industry. Free trade Trade between countries that is without government restrictions.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity. Protectionism The use of trade barriers to shield domestic firms from foreign competition. Quota A numerical limit that a government imposes on the quantity of a good that can be imported into the country. Tariff A tax imposed by a government on imports. Terms of trade The ratio at which a country can trade its exports for imports from other countries. Voluntary export restraint (VER) A restriction on the quantity of a good that can be imported by one country from another country. World Trade Organization (WTO) An international organization that oversees international trade agreements.

Globalization The process of countries becoming more open to foreign trade and investment. Imports Goods and services purchased domestically that are produced in other countries.

Chapter Outline

Tariffs, “Buy American,” or Free Trade?

Shortly after he took office in January 2021, President Joe Biden signed an executive order strengthening the federal government’s “Buy American” program. The executive order was intended to reduce the quantity of imported goods the federal government buys and increase the quantity of goods made within the United States. The Buy American program strikes many people as reasonable. But several foreign governments argued that the program violated the commitment of the United States under the World Trade Organization to allow foreign firms to compete in selling goods to the federal government. Some economists also pointed out that the likely result of the program would be to raise the prices the federal government pays, meaning that taxpayers would be stuck with a bigger bill. In addition, government policies that interfere with international trade can end up hurting firms the policies were designed to help. For example, Whirlpool is a home appliance maker that complained to the U.S. International Trade Commission (ITC) that it suffered “serious injury” from imports. After the ITC approved the complaint in 2018, President Trump imposed a tariff on the value of imported washing machines. But in addition to raising the tariff on washing machines, the Trump administration raised tariffs on imports of steel and aluminum, which are used to make washing machines. This raised Whirlpools costs and the firm raised its prices to cover these costs. Other washing manufacturers raised their prices as well. Many economists are critical of actions, like tariffs, that interfere with trade in goods and services among countries. They argue that low tariffs benefit U.S. consumers by reducing the prices they pay for many goods.

9.1

The United States in the International Economy Learning Objective: Discuss the role of international trade in the U.S. economy.

The increase in international trade over the past fifty years is the result of falling shipping costs, the spread of inexpensive and reliable communications, and changes in government policies. Over this period, tariff rates have fallen. A tariff is a tax imposed by a government on imports. Imports are goods and services purchased domestically that are produced in other countries. Exports are goods and services produced domestically and sold in other countries.

A. The Importance of Trade to the U.S. Economy Since 1970, both imports and exports have tended to increase as a fraction of U.S. gross domestic product (GDP). World trade declined sharply during the recession of 2007–2009 and has grown Copyright © 2023 Pearson Education, Inc.

CHAPTER 10 | Consumer Choice and Behavioral Economics

relatively slowly since. The Covid-19 pandemic of 2020 led to a sharp decline in world trade. Overall, as a percentage of GDP U.S. exports and imports more than doubled between 1970 and 2020. International trade does not affect all sectors of the U.S. economy equally. For example, consider agricultural products. Each year, the U.S. exports about 50 percent of its wheat and rice cops and 20 percent of its corn crop. Many U.S. manufacturing industries also depend on trade. About 20 percent of U.S. manufacturing jobs depend directly or indirectly on exports.

B. U.S. International Trade in a World Context The United States is the world’s second-largest exporter. The rapid growth of the Chinese economy over the past 35 years has made it the largest exporter. International trade is less important to the United States than it is to most other countries.

9.2

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

People trade because it makes them better off, whether the buyer and seller live in the same city or in different countries.

A. A Brief Review of Comparative Advantage Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Opportunity cost is the highest-valued alternative that must be given up to engage in an activity.

B. Comparative Advantage and Absolute Advantage Comparative advantage explains why people pursue different occupations and why countries produce different goods and services. Countries are better off if they specialize in producing the goods for which they have a comparative advantage and trade for the goods for which other countries have a comparative advantage. Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources.

9.3

How Countries Gain from International Trade Learning Objective: Explain how countries gain from international trade.

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A. Increasing Consumption through Trade The terms of trade is the ratio at which a country can trade its exports for imports from other countries. International trade allows production of a good to shift to the more efficient country—the one with the comparative advantage in producing the good. Countries gain from specializing in producing goods in which they have a comparative advantage and trading for goods in which other countries have a comparative advantage. Table 9.4, “Gains from Trade for China and the United States,” illustrates how countries gain from specializing.

B. Why Don’t We See Complete Specialization? We don’t see complete specialization in the real world for three reasons: (1) not all goods and services are traded internationally; (2) production of goods involves increasing opportunity costs; and (3) tastes for products differ.

C. Does Anyone Lose as a Result of International Trade? When trade takes place between two countries, both countries benefit because each experiences an increase in total consumption. But countries do not produce goods—firms do. Firms that do not produce a good for which they have a comparative advantage can lose revenue, and their workers can lose their jobs as a result of international trade. The losers from trade often try to persuade their governments to interfere with trade by barring imports of the competing products or by imposing high tariffs on them.

D. Where Does Comparative Advantage Come From? Among the main sources of comparative advantage are climate and natural resources; relative abundance of labor and capital; technology; external economies. External economies are reductions in a firm’s costs that result from an increase in the size of an industry.

Extra Apply the Leaving New York City is Risky for Financial Firms Concept The name “Wall Street” is shorthand for the whole U.S. financial system of banks, brokerage houses, and other financial firms. Wall Street is, of course, an actual street in the New York City borough of Manhattan. The New York Stock Exchange is located on Wall Street, and many financial firms have their headquarters in Manhattan. There are also many financial firms located outside Manhattan, but several of the largest firms believe that there are advantages to being located close to Wall Street. Copyright © 2021 Pearson Education, Inc.

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Some financial firms have moved operations out of Manhattan only to move them back. As one manager of a new hedge fund put it: “There were enough roadblocks to establishing a new fund that I didn’t want to create another” by not being in Manhattan. He was hardly alone: In recent years more than 90 percent of new hedge funds have been located in Manhattan.

The original concentration of financial firms in Manhattan was something of an historical accident. In colonial times and through the early nineteenth century, Philadelphia and Boston were at times close rivals to New York City as business and financial centers. Philadelphia had a larger population than New York City and was the headquarters of the federal government’s first two central banks. New York City received a boost in its rivalry with other cities when the Erie Canal was completed in upstate New York in 1825. The canal resulted in crops and raw materials being shipped to New York City rather than to other ports. This inflow led to the development of banking, insurance, and other financial firms. Coupled with the gradual increase in trading on the New York Stock Exchange, the increase in business resulting from the completion of the canal established New York City as the leading financial center in the country. But the Erie Canal has long since ceased to operate, and most stock trading takes place electronically rather than on the floor of the New York Stock Exchange. So, why has New York continued to see a high concentration of financial firms? The answer is that financial firms benefit from the external economies of being located in New York City. Even in the Internet age, many financial deals are still conducted faceto-face, so not having a physical presence in Manhattan can put a firm at a disadvantage. Many people pursuing careers in finance also want to be physically located in Manhattan because that is where most of the highest-paying financial jobs are. Firms that have moved out of Manhattan have had more difficulty attracting and retaining the most productive workers. In addition, Manhattan also has a large concentration of firms that provide support services, such as software programming for running financial firms’ computer systems. Large financial firms located outside Manhattan, particularly those that heavily trade securities or attempt to make deals that involve mergers between firms, may have higher costs than firms located in Manhattan. Having many financial firms originally located in Manhattan was a historical accident, but external economies gave the area a comparative advantage in providing financial services once the industry began to grow there. Sources: Juliet Chung, “Hedge Funds’ Manhattan Migration,” Wall Street Journal, January 14, 2012; Brett Philbin, “UBS Shifts Staff to New York,” Wall Street Journal, July 13, 2011; and Charles V. Bagli, “Regretting Move, Bank May Return to Manhattan,” New York Times, June 8, 2011.

9.4

Government Policies That Restrict International Trade

CHAPTER 10 | Consumer Choice and Behavioral Economics

Learning Objective: Analyze the economic effects of government policies that restrict international trade. Free trade is trade between countries that is without government restrictions. Free trade helps consumers but hurts firms that are less efficient than foreign competitors. As a result, these firms and their workers often support government policies that restrict trade. These policies usually take one of two forms: (1) tariffs and quotas and (2) voluntary export restraints.

A. Tariffs Tariffs are taxes governments impose on goods imported into a country. Like any other tax, a tariff increases the cost of selling a good. After a government imposes a tariff, there is a reduction in consumer surplus and an increase in producer surplus. The government collects revenue equal to the tariff multiplied by the quantity of the imported good. Some of the loss of consumer surplus is a deadweight loss, so there is a loss of economic efficiency.

B. Quotas and Voluntary Export Restraints A quota is a numerical limit that a government imposes on the quantity of a good that can be imported into the country. A quota has an effect similar to a tariff. For many years, Congress has imposed a quota on sugar imports to protect U.S. sugar producers. A voluntary export restraint (VER) is a restriction on the quantity of a good that can be imported by one country from another country. The main purpose of most tariffs and quotas is to reduce the foreign competition faced by domestic firms.

C. Measuring the Economic Effect of the Sugar Quota A quota increases the domestic price of the good for which the quota is imposed, resulting in an increase in producer surplus and a loss of consumer surplus. A license from the U.S. government is required to import goods under a quota system. The licenses are distributed to foreign producers. As with tariffs, there is a loss of economic efficiency. Partly as a result of the sugar quota, total employment of U.S. chocolate and candy firms that use sugar as an input declined by one-third between 1996 and 2020.

D. The High Cost of Preserving Jobs with Tariffs and Quotas Although jobs are saved in industries subject to tariffs and quotas, the jobs are saved at a high cost to consumers. Many countries use tariffs and quotas to try to protect jobs. When one industry receives tariff or quota protection, jobs will be lost in other domestic industries that must pay higher prices for the goods that receive protection.

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E. Gains from Unilateral Elimination of Tariffs and Quotas It is easier to gain political support for reducing or eliminating a tariff or quota if it is done as part of an agreement with other countries. But the U.S. economy would experience a gain in economic surplus from the elimination of tariffs and quotas even if other countries did not reduce their tariffs and quotas.

F. Other Barriers to Trade Governments sometimes erect other barriers to trade. For example, a government may impose strict health and safety requirements on imports to shield domestic firms from foreign competition. Many governments also restrict imports of certain products on national security grounds.

9.5

The Debate over Trade Policies and Globalization Learning Objective: Evaluate the debate over trade policies and globalization.

Debate over whether the U.S. government should regulate international trade has continued since the founding of the country. In 1930, the United States passed the Smoot-Hawley Tariff, which raised tariff rates to nearly 60 percent. After World War II, government officials from the United States and Europe established the General Agreement on Tariffs and Trade (GATT) in 1948 to reduce tariffs and revive international trade. Countries that joined GATT agreed not to impose new tariffs or import quotas. The GATT was replaced by the World Trade Organization in 1995. The World Trade Organization (WTO) is an international organization that oversees international trade agreements.

A. Why Do Some People Oppose the World Trade Organization? After World War II, many low-income countries erected trade barriers. When the barriers failed to produce much economic growth, many of these countries decided in the 1980s to become more open to foreign trade and investment and joined the WTO. Globalization is the process of countries becoming more open to foreign trade and investment. Opposition to globalization increased in the 1990s from three sources. 1. Some opponents are specifically against the globalization that began in the 1980s and became widespread in the 1990s. 2. Other opponents wanted to erect trade barriers to protect domestic firms from foreign competition. 3. Some critics support globalization in principle but believe the WTO favors high-income countries at the expense of low-income countries. The traditional argument against free trade is known as protectionism. Protectionism is the use of trade barriers to shield domestic firms from foreign competition. Though protectionism causes losses to consumers and eliminates jobs in the domestic industries that use the protected product, it is usually

CHAPTER 10 | Consumer Choice and Behavioral Economics

justified on the basis of one of the following reasons: saving jobs, protecting high wages, protecting infant industries, or protecting national security.

B. Dumping Dumping is selling a product for a price below its cost of production. Using tariffs to offset the effects of dumping is controversial because it is difficult to calculate the true production costs of a good.

C. Positive versus Normative Analysis (Once Again) Many economists do not support interferences with trade, such as the sugar quota. But the opposite view is intellectually respectable. Measuring the effect of the sugar quota on the U.S. economy is an example of positive analysis. Asserting that the sugar quota is bad public policy is normative analysis. It is possible for someone to understand the cost of tariffs and quotas but still believe that they are good ideas, perhaps because free trade would cause disruption to the economy. The success that industries have in getting government to erect trade barriers depends partly on some members of the public knowing the costs of the barriers but supporting them anyway. Two other factors are at work. First, the costs of tariffs and quotas are large in total but relatively small per person. Second, the jobs lost to foreign competition are easy to identify, but the jobs created by foreign trade are harder to identify.

Extra Solved Problem 9.5 Sunlight—Unfair Competition? Arguments over international trade are nothing new. Alexander Hamilton called for the protection of socalled “infant industries” in the United States, and farming interests have long favored trade restrictions to prevent consumers from buying cheaper food products from abroad. Although the countries and industries change over time, the arguments over trade restrictions have not. The nineteenth century French economist, Frédèric Bastiat, satirized French opponents of free trade in writing a petition to the French government supposedly from the manufacturers of “candles, waxlights, lamps, candlesticks, street lamps …generally of everything connected with lighting.” Bastiat’s “petition” has been reprinted many times and often appears in textbooks because of its clever theme as well as its applicability to the arguments of twenty-first century “petitioners.” Here is a brief excerpt from the “petition:” We are suffering from the intolerable competition of a foreign rival, placed, it would seem, in a condition so superior to ours for the production of light that he absolutely inundates our national market with it at a price fabulously reduced. The moment he shows himself, our trade leaves us—all consumers apply to him; and a branch of native industry, having countless ramifications, is all at once rendered completely stagnant. This rival…is no other than the sun… What we pray for is, that it may please you to pass a law ordering the shutting up of all windows, skylights, dormer-windows, outside and inside shutters, curtains, blinds…all openings, Copyright © 2021 Pearson Education, Inc.

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CHAPTER 10 | Consumer Choice and Behavioral Economics holes, chinks, clefts, and fissures by or through which the light of the sun has been in use to enter houses, to the prejudice of the meritorious manufacturers with which we flatter ourselves we have accommodated our country—a country which, in gratitude, ought not to abandon us now to strife so unequal.

Source: Frédèric Bastiat, Social Fallacies, translated by Patrick James Stirling, Santa Anna, CA: Register Publishing, 1944, pp. 60-61.

Cite arguments from Chapter 9 that are similar to those raised in Bastiat’s petition.

Solving the Problem Step 1:

Review the chapter material. This problem is about arguments over trade policies, so you may want to review the section “The Debate over Trade Policies and Globalization” in the textbook.

Step 2:

Cite arguments from chapter 9 that are similar to those raised in Bastiat’s petition. In describing protectionism, the textbook states: “For as long as international trade has existed, governments have attempted to restrict it to protect domestic firms…protectionism causes losses to consumers and eliminates jobs in domestic industries that buy the protected product…supporters of protectionist policies argue that free trade reduces employment by driving domestic firms out of business… jobs are lost, but jobs are also lost when more-efficient domestic firms drive less-efficient domestic firms out of business … No economic study has ever found a long-term connection between the total number of jobs available in the United States as a whole and the level of tariff protection for domestic industries.” (p. 303) As Bastiat might have said: “plus ça change, plus c’est la même chose.” (“The more things change, the more they stay the same.”)

Extra Apply the

The Unintended Consequences of Banning Goods Made with Child Labor

Concept In many developing countries, such as Indonesia, Thailand, and Peru, children as young as seven or eight years old work 10 or more hours a day. Reports of very young workers laboring long hours to produce goods for export have upset many people in high-income countries. In the United States, many people Copyright © 2021 Pearson Education, Inc.

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xiii

assume that if child workers in developing countries weren’t working in factories making clothing, toys, and other products, they would be in school, as are children in high-income countries. In fact, children in developing countries usually have few good alternatives to work. Schooling is frequently available for only a few months each year, and even children who attend school rarely do so for more than a few years. Poor families are often unable to afford even the small costs of sending their children to school. Families may rely on the earnings of very young children to survive, as poor families once did in the United States, Europe, and Japan. There is substantial evidence that as incomes begin to rise in poor countries, families rely less on child labor. The United States eventually outlawed child labor, but not until 1938. In developing countries where child labor is common today, jobs producing export goods are usually better paying and less hazardous than the alternatives. As preparations began in France for the 1998 World Cup, there were protests that Baden Sports—the main supplier of soccer balls—was purchasing the balls from suppliers in Pakistan that used child workers. France decided to ban soccer balls made by child workers. Bowing to this pressure, Baden Sports moved production from Pakistan, where the balls were hand-stitched by child workers, to China, where the balls were machine-stitched by adult workers in factories. There was some criticism of the boycott of hand-stitched soccer balls at the time. In a broad study of child labor, three economists argued: Of the array of possible employment in which impoverished children might engage, soccer ball stitching is probably one of the most benign... [In Pakistan] children generally work alongside other family members in the home or in small workshops... Nor are the children exposed to toxic chemicals, hazardous tools or brutal working conditions. Rather, the only serious criticism concerns the length of the typical child stitcher’s work-day and the impact on formal education. In fact, the alternatives to soccer ball stitching for child workers in Pakistan turned out to be extremely grim. According to Keith Maskus, an economist at the University of Colorado and the World Bank, a “large proportion” of the children who lost their jobs stitching soccer balls ended up begging or in prostitution. Sources: Tom Wright, “Pakistan Defends Its Soccer Industry,” Wall Street Journal, April 26, 2010; Drusilla K. Brown, Alan V. Deardorff, and Robert M. Stern, “U.S. Trade and Other Policy Options to Deter Foreign Exploitation of Child Labor,” in Magnus Blomstrom and Linda S. Goldberg, eds., Topics in Empirical International Economics: A Festchrift in Honor of Bob Lispey, Chicago: University of Chicago Press, 2001; Tomas Larsson, The Race to the Top: The Real Story of Globalization, Washington, DC: Cato Institute, 2001, p. 48; and Eric V. Edmonds and Nina Pavcnik, “Child Labor in the Global Economy,” Journal of Economic Perspectives, Vol. 19, No. 1, Winter 2005, pp. 199–220.

Extra Economics in Your Life & Career: Baseball—The (Inter)national Pastime

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The controversy over the outsourcing of jobs from the United States to India, China, and other countries has hardly touched professional baseball. Although baseball has long been known as the National Pastime, Major League Baseball (MLB) has taken on an increasingly international look. On the first day of the 2021 season, 258 of the 906 players on MLB team rosters were born outside of the 50 U.S. states. The number of foreign-born players equaled 28.5 percent of the total. The Dominican Republic, with a population of just under 11 million people, accounted for 98 major league players, the most of any foreign country. Venezuela had the next highest total (64) followed by Cuba (19. Question: Why aren’t baseball fans concerned about the outsourcing of jobs by Major League Baseball? Answer: Apparently, baseball fans accept the proposition that the best qualified players deserve roster spots, regardless of their country of origin. However, Major League teams employ fewer than 1,000 players, hardly enough to overcome a more important concern for fans: their favorite teams earning a trip to the postseason playoffs. Source: “MLB Foreign-Born Players Drop Slightly for 4th Straight Year,” Associated Press. April 2, 2021.

CHAPTER 10 | Consumer Choice and Behavioral Economics

Solutions to End-of-Chapter Exercises 9.1

The United States in the International Economy Learning Objective: Discuss the role of international trade in the U.S. economy.

Review Questions 1.1

Since the mid-1970s, the value of U.S. exports has been smaller than the value of U.S. imports. In recent years, U.S. exports and imports were both more than twice as large as a percentage of GDP than they were in 1970. Figure 9.1 in the text shows that U.S. exports and imports were both under 6 percent of GDP in 1970 and have since grown as a percentage of GDP.

1.2

Although the United States is the world’s second largest exporter, Figure 9.3 shows that exports and imports as a share of total output (GDP) are smaller for the United States than for most other high-income countries. Because the United States has a large and diverse economy, the gains from trading with other economies probably aren’t as great as they would be if the U.S. economy were smaller and less diversified, like the economies of Belgium or the Netherlands.

Problems and Applications 1.3

If the United States were to stop trading goods and services with other countries, agriculture would likely see the largest decline in sales, although many manufacturing industries would also be affected. Many service industries, such as haircuts and medical services, would not be affected much because the United States does not export these types of services.

1.4

You should disagree with the statement. As Figure 9.3 shows, Japan is less heavily involved in international trade than countries such as Great Britain and Germany. As shares of its GDP, Japan’s and China’s exports and imports were both less than 20 percent of their GDP, while Belgium’s and the Netherland’s exports and imports each exceed 70 percent of their GDP. Similarly, France, Germany and the United Kingdom all have exports and imports greater than 30 percent of their GDP.

1.5

Smaller countries generally do not produce as large and as diverse a group of goods and services as larger countries do. Smaller countries are therefore more likely than larger countries to export and import larger fractions of their GDP.

Comparative Advantage in International Trade 9.2

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Review Questions 2.1

Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Comparative advantage, not absolute advantage, determines whether a country will be an exporter of a good, so a country will not necessarily be an exporter of a good in the production of which it has an absolute advantage.

2.2

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

Problems and Applications 2.3

The author of this book about the Roman Empire is illustrating the economic concept of comparative advantage. This economic concept is used to demonstrate the gains to an individual, a firm, or a country from specialization in production. By specializing in the production of goods and services for which an individual, a firm, or a country has a lower opportunity cost than another producer, trade can make both parties better off than if they were self-sufficient. Romans got better pots and better defense by allowing professionals to provide these products because the professionals produced them at lower opportunity costs than the non-professional Romans could. If the Romans were not benefiting from getting these goods and services by trading with others, they wouldn’t have made the trades.

2.4

If China’s comparative advantage is in low-end manufacturing, China has a lower opportunity cost in producing low-end manufacturing goods compared to other countries. This observation is not the same as asserting that China is able to produce more low-end manufactured goods per hour worked than can factories in the United States because doing so suggests that China has an absolute advantage rather than a comparative advantage in low-end manufacturing. A country with a comparative advantage in the production of a good or a service does not necessarily have an absolute advantage in the production of that good or service, and vice versa.

2.5

If Mr. Halperin could proofread catalogs and advertisements and grade coins better than any of the employees of Heritage Auctions, he would have an absolute advantage is performing these tasks. As co-chairman of Heritage Auctions, we can assume he also has an absolute advantage relative to other employees at performing his executive duties. But he likely has only a comparative advantage as a co-chairman because his opportunity cost of proofreading catalogs and advertisements and grade coins would be greater than his opportunity cost of being a co-

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chairman of Heritage House. It would not make economic sense for him to perform his prior activities. 2.6

a. In order for both countries to be better off from trade when the United States sells movies to Bangladesh and buys T-shirts from that country, the United States must have a lower opportunity cost of producing movies compared to Bangladesh, while Bangladesh must have a lower opportunity cost of producing T-shirts compared to the United States. b. No, we can’t be certain this conclusion is correct. We can’t be certain that Bangladesh manufactures T-shirts using fewer hours of work per T-shirt because having a comparative advantage in producing T-shirts does not mean that Bangladesh necessarily has an absolute advantage in producing T-shirts. Although Bangladesh has a comparative advantage in manufacturing T-Shirts compared with the United States, it is possible that workers in the United States can manufacture T-shirts using fewer hours of work. Even if the United States could manufacture T-shirts using fewer hours of work, using those hours to manufacture Tshirts would be inefficient because the United States doesn’t have a comparative advantage in producing that product. The opportunity cost of producing T-shirts in the United States— what the U.S. economy has to give up to produce T-shirts—is higher than the opportunity cost of producing T-shirts in Bangladesh.

2.7 Opportunity Costs Olive Oil (quarts)

Pasta (pounds)

Greece

0.5 pound of pasta

2 quarts of olive oil

Italy

2 pounds of pasta

0.5 quart of olive oil

2.8

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

2.9

You should disagree with Buchanan’s argument. U.S. textile firms produce their goods at a higher opportunity cost than do the corresponding firms in China. By moving resources out of the textile industry, the United States can experience higher average incomes by freeing up resources to produce the goods in which it has a comparative advantage. These goods can then be traded for goods that can be produced at a lower opportunity cost elsewhere. A country increases its income by specializing in products for which it has a comparative advantage, even if

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CHAPTER 10 | Consumer Choice and Behavioral Economics doing so means giving up production of products for which it has an absolute advantage but not a comparative advantage.

9.3

How Countries Gain from International Trade Learning Objective: Explain how countries gain from international trade.

Review Questions 3.1

International trade increases a country’s consumption because it allows the country to specialize in the goods and services that it can produce at the lower opportunity cost and trade for goods and services in the production of which it has a higher opportunity cost than other countries have. As the example in Table 9.4 shows, international trade on the basis of comparative advantage can raise incomes and consumption.

3.2

A country specializes in the production of a good when it produces all of the good that is consumed in the country, not importing any of the good. It is not typical for a country to completely specialize for three key reasons: (1) not all goods and services are traded internationally; (2) the production of most goods involves increasing opportunity costs, which means that before complete specialization is reached, a country may have lost its comparative advantage in producing a good; and (3) tastes for products differ across countries, so different countries may have comparative advantages in different types of the same good.

3.3

The main sources of comparative advantage are climate and natural resources, the relative abundance of various types of labor and capital, technology and know-how, and external economies.

3.4

Not everyone gains from international trade. Imports can result in some domestic firms being forced out of business and their workers losing their jobs. On balance, the losses due to international trade are more than offset by the gains, so, on average, incomes rise as a result of international trade. But behind the averages, some people are made worse off while others gain.

Problems and Applications 3.5

a. A country has an absolute advantage over another country when it can produce more of a good using the same resources. Chile has an absolute advantage in the production of both hats and beer because it can produce more of both goods (8 hats; 6 barrels of beer) than can Argentina (1 hat; 2 barrels of beer) with the same amount of labor input. b. A country has a comparative advantage when it can produce a good at a lower opportunity cost. To produce 8 hats, Chile must give up 6 barrels of beer. Therefore, the opportunity Copyright © 2021 Pearson Education, Inc.

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cost to Chile of producing 1 hat is 6/8, or 0.75 barrel of beer. Argentina must give up 2 barrels of beer to produce 1 hat, so its opportunity cost of producing 1 hat is 2 barrels of beer. Chile has a comparative advantage in the production of hats because its opportunity cost is lower. To produce 6 barrels of beer, Chile must give up 8 hats, so its opportunity cost of producing 1 barrel of beer is 8/6, or 1.33 hats. Argentina must give up 1 hat to produce 2 barrels of beer, so its opportunity cost of producing 1 barrel of beer is 0.5 hat. Argentina has a comparative advantage in the production of beer because its opportunity cost is lower than Chile’s. c. As part (b) shows, Chile should specialize in producing hats, and Argentina should specialize in producing beer. By specializing, Chile can produce 8,000 hats (1,000 labor hours × 8 hats per hour), and Argentina can produce 2,000 barrels of beer (1,000 labor hours × 2 barrels of beer per hour). If Chile trades 700 hats to Argentina for 700 barrels of beer, the countries will end up with: Hats

Beer

Chile

7,300

700

Argentina

700

1,300

Both countries are better off than they were before specializing and engaging in trade. 3.6

The commentator is confusing absolute advantage and comparative advantage. Absolute advantage is the ability to produce more of a good or service than competitors when using the same amount of resources. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Every country, no matter how poor, will have a comparative advantage in producing some good. One reason some countries are poor is that they limit trade with other countries.

3.7

No, we can’t conclude that the United States benefited more from trading with Canada than Canada benefitted from trading with the United States from the data provided in the table. What we can conclude is that both countries benefited from trading with each other or individuals and firms would not have made the purchases that resulted in the import and export totals in the table. For us to determine how much each country benefited from trade, we would need to know the opportunity cost to each country from not trading with the other. There might, for instance, be some goods or services that Canada (or the United States) would not be able to obtain from a third country if it was unable to trade with the United States (or the United States was unable to trade with Canada). Or there might be goods or services that Canada (or the United States) could only produce domestically at significantly higher cost than the prices Canadian households or firms paid U.S. firms for the products (or that the U.S. households or firms paid Canadian firms for the products).

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3.8

When two countries take advantage of differences in opportunity costs and trade with one another, the goods that they export do not need to be greatly different from the goods that they import. It is possible that the differences in the opportunity costs would cause a country like the United States to export automobiles to Canada and import minivans from Canada. Moreover, some consumers in the United States are willing to purchase a car that is made in Germany even if a less expensive car is made in the United States because the German car may be more reliable or have better styling. In this case, trade is based on consumers’ preference for variety and may reflect comparative advantage in producing a particular variety of a product rather in producing all varieties of that product.

3.9

You should agree with both of Hal Varian’s observations. Opening up markets to trade allows a country to benefit by specializing in the goods for which it possesses a comparative advantage. By specializing and altering the mix of goods that it produces, the country can use trade to obtain a combination of goods that it cannot produce on its own—reaching a point beyond its own production possibilities frontier. In this sense, a country can “produce more with less” and consumers are able to obtain greater benefits. Table 9.4 in the textbook shows how international trade can benefit consumers.

3.10

a. Tanzania produces 8,000 bushels of cashew nuts, which is point B on the following graph. b. Tanzania will receive 1,500 bushels of mangoes in exchange for the 3,000 bushels of cashew nuts. Because point C (5,000 bushels of cashew nuts and 1,500 bushels of mangoes) on the following graph is beyond Tanzania’s production possibilities frontier, the country is better off with trade than without trade. c. With trade, Tanzania is producing on its production possibilities frontier but consuming beyond its production possibilities frontier.

3.11

Although both the United States and Colombia would gain from the trade agreement, not every person or company in each country would “win.” Some domestic suppliers and their workers

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lose if they are driven out of existing markets (and have to move into new markets) by lowerpriced imports. 3.12

a. “China’s explosive rise” refers to the surge in China’s exports to the rest of the world over the last 35 years, making China the world’s leading exporting country. b. There could be many reasons economists and policymakers underestimated the economic effect of imports from China. For example: (1) They may have believed that a country still transitioning away from a command economy could not dramatically increase its exports, or (2) they may have believed that China’s comparative advantage might be limited, given that the country did not have the technology and skilled workforce needed to compete with established industries in countries like the United States, Japan, and Canada.

3.13

Boudreaux can claim that “trade is not a job killer” because the 2.4 million jobs that were lost between 1999 and 2011in the United States as a result of trade with China are small compared to the total number of jobs lost in the United States during those years. Boudreaux points out that the average number of jobs lost in the United States during non-recession months since 2006 averaged 1.75 million per month, or 21 million per year. During the Great Recession of 2007-2009, this number rose to 2.57 million jobs lost per month. To get a better sense of why “trade is not a job killer,” consider that if the United States lost approximately 21 million jobs per year, then in the 12 years from 1999-2011, the total jobs lost would have been 12 years × 21 million jobs = 252 million jobs lost. Losing 2.4 million jobs due to trade is less than 1 percent of all total jobs lost in the same time period. Finally, as discussed in the chapter, at the same time that trade destroys jobs in some industries, it creates jobs in other industries.

3.14

Boulder, Colorado benefits from external economies, which refer to the reduction in a firm’s costs that result from an increase in the size of an industry, particularly in a specific geographic area. It would be difficult for a natural food firm located elsewhere to compete with similar firms located in Boulder, but a firm could overcome Boulder’s advantages if it could convince consumers that the quality and variety of the goods it sells and the services it offers to consumers are worth paying higher prices for. Boulder’s advantages are likely to persist over time because few, if any, other areas will be able to offer new firms the advantages that result from external economies.

Government Policies That Restrict International Trade 9.4

Learning Objective: Analyze the economic effects of government policies that restrict international trade.

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4.1

A tariff is a tax a government imposes on imports. A quota is a numerical limit a government imposes on the quantity of a good that can be imported into a country. Non-tariff barriers include governmental rules—for example, health or safety regulations—that favor domestic firms over foreign firms.

4.2

The winners from tariffs are domestic firms protected by the tariffs, the firms’ workers, and the government, which collects revenue from the tariff. The losers are domestic consumers and domestic firms that use as an input the product that is protected by the tariff or quota; for example, the U.S. candy industry loses as a result of the U.S. sugar quota. The winners from quotas are domestic firms protected by the quotas, the firms’ workers, and whoever holds import licenses that result from quotas.

4.3

As we saw in Chapter 4, deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium. A tariff results in a loss of consumer surplus because consumers buy a smaller quantity of the good and have to pay a higher price for the good. This decline in consumer surplus is a deadweight loss. A tariff results in an additional deadweight loss because more of the good is produced by less-efficient, higher-cost domestic firms and less of the good is produced by more-efficient, lower-cost foreign firms. The higher price that results from the tariff increases the producer surplus of domestic firms, but this increase will be less than the deadweight loss, as shown by Figure 9.6 in the chapter.

Problems and Applications 4.4

Economic nationalism in this context refers to using tariffs, quotas, and non-tariff barriers to protect domestic industries. As explained in the text, a country benefits from free trade even if other countries do not engage in it. A country gains because by trading it can obtain goods and services at lower opportunity costs than if it produced the goods and services domestically.

4.5

a. Both administrations endorsed Buy American policies because domestic firms and their workers would benefit from less competition from foreign firms. Although other firms and workers, as well as consumer who pay higher prices for domestically produced goods, are harmed by these policies, these costs are widely spread throughout the economy and would be difficult for the public to attribute to Buy American policies.

b. Many studies have found that restrictions on international trade result in higher consumer prices and deadweight losses in markets affected by the restrictions. For example, U.S. tariffs on imports of women’s shoes and rubber shoes have been estimated to cost U.S. consumers $300,000 per year for each job saved. Another study estimated that tariffs first imposed on imports of tires from China in 2009 have resulted in U.S. consumers spending about $1.1 billion more per year on tires. The tariff on tires has saved an estimated 1,200 jobs in the U.S. tire industry at a cost of $900,000 per job saved. Mary Amiti of the Federal Copyright © 2021 Pearson Education, Inc.

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Reserve Bank of New York, Stephen Redding of Princeton University, and David Weinstein of Columbia University have analyzed the effects of a trade war that began in 2018. They concluded that by the end of 2018, because the tariffs resulted in higher prices in the United States, they “were costing U.S. consumers and the firms that import foreign goods an additional $3 billion per month.” In addition, the United States was experiencing “another $1.4 billion per month in deadweight welfare (efficiency) losses.” Amiti and colleagues note that although the U.S. tariffs on steel and aluminum may have preserved some jobs in those industries, the cost per job saved was nearly $200,000 per year—well above the average steel worker’s salary of $52,500. 4.6



Before the tariff, the quantity of beef sold by U.S. producers is Q1; after the tariff, the quantity of beef sold by U.S. producers is Q3.

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Before the tariff, the quantity of beef imported = Q2 – Q1; after the tariff, the quantity of beef imported = Q4 – Q3.



Before the tariff, the price of beef in the U.S. is Pw and after the tariff the price of beef is PW+tariff.

c. The winners from the tariff are domestic producers of beef and the government, which collects the tariff revenue. The losers are domestic consumers of beef, U.S. firms—such as McDonald’s—that use beef as an input, and foreign suppliers. 4.7

A 25 percent tariff on imports raises their cost as, for instance, the tariff on washing machines raised the cost to Best Buy of selling imported washing machines or the tariff on clothing imports from China raised the cost to Walmart of selling clothing imported from China. In that sense, a tariff acts like a tax, and just as with a tax, a tariff raises the price of the good the tariff is levied on. We saw in Chapter 4, Section 4.4 that consumers do not bear all of the burden of a tax provided that the demand curve is not vertical. Some of the burden of the tariff will be borne by sellers, although studies of the incidence of tariffs have shown that most of the burden is borne by consumers.

4.8

a. Area D. Consumers cut back on the quantity of plastic combs purchased at the higher U.S. price with the tariff and lose the consumer surplus they were receiving from these purchases. b. Area B. U.S. producers increase the quantity of plastic combs supplied at the higher U.S. price with the tariff but are less efficient than foreign producers, as reflected by the U.S. supply curve being above the world price over this range of production. c. Area B plus Area D. The tariff reduces consumer surplus by the sum of areas A, B, C, and D. Area A is the increase in producer surplus to U.S. producers, area C is tariff revenue to the government, and areas D and B are deadweight loss.

4.9

a. The gain in consumer surplus equals the sum of areas A, B, C, and D. Areas A, B, and C show the gain to consumers of paying the lower world price on the quantity of canned tuna that they were previously purchasing at the higher U.S. price caused by the tariff, and Area D shows the gain to consumers of purchasing more canned tuna at the lower world price. b. Area A shows the loss in producer surplus, both from U.S. firms selling canned tuna at the lower world price and from their reducing the quantity they supply. c. Area C shows the loss in government tariff revenue, which equaled the quantity of imports multiplied by the tariff. d. Area B plus area D show the gain in economic surplus. Consumer surplus increased by the sum of areas A, B, C, and D. Producer surplus decreased by area A and government tariff revenue decreased by area C, leaving a net gain of area B plus area D.

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a. Sugar prices in the United States are higher than the sugar prices in other countries because the United States has imposed a quota on imports of sugar. As shown in Figure 9.7 in the text, the effect of the quota has been to raise the price of sugar in the United States above the world price of sugar. A “free-trade regime” means a situation in which sugar can be imported into the United States free from government-imposed restrictions, such as quotas and tariffs. b. Domestic sugar producers successfully lobbied Congress to enact a quota on sugar imports to protect them against foreign competition. Domestic sugar producers do not want a freetrade regime for sugar because they would struggle to compete against foreign producers if the United States allowed an unlimited quantity of imported sugar to enter the country. c. Domestic sugar producers and their workers gain as a result of the sugar quota because they are able to sell more sugar at a higher price than they would in a free-trade regime. Consumers lose because they pay a higher price for sugar. U.S. firms that use sugar as an input, such as candy companies, also lose because their costs increase. The U.S. economy suffers an efficiency loss because some sugar output from more-efficient, low-cost foreign producers is replaced by sugar output from less-efficient, high-cost domestic producers.

4.11

You can refer to the graph in Solved Problem 9.4 in the textbook for guidance in filling out the table. Without Quota

With Quota

World price of kumquats

$0.75

U.S. price of kumquats

$0.75

$1.00

Quantity supplied by U.S. firms

4 million

6 million

Quantity demanded

13 million

12 million

Quantity imported

9 million

6 million

A+B+C+D+E+F

A+B

C+G

None

D+F

Area of consumer surplus Area of domestic producer surplus Area of deadweight loss 4.12

a. If the government imposes a tariff, area C shows the government’s tariff revenue, which equals the quantity of imports multiplied by the tariff. b. If the government imposes a quota, area C shows the gain to foreign producers who can sell canned peaches in the United States at a price above the world price. c. As a consumer, you probably don’t care because the price is the same with either the tariff or the quota. But as a taxpayer, you probably prefer the government receiving the tariff revenue, instead of the gain going to foreign producers.

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4.13

A 25 percent tariff on steel will preserve some jobs in the U.S. steel industry by raising the cost of imported steel. The tariff will raise the price of steel, increasing the costs of firms, including automobile, washing machine, and construction equipment manufacturers, that use steel as an input. Higher costs will result in higher prices for these goods, leading to lower sales and, potentially, lost jobs. We can conclude that a tariff on steel saves some jobs in the U.S. steel industry but costs jobs in other U.S. industries that use steel as an input.

4.14

Tariffs on imported shoes from China will hurt employment at shoe stores in the United States because the tariffs raise the price that consumers pay for imported shoes, resulting in a decrease in the quantity of shoes demanded. As consumers buy fewer shoes, retail shops will decrease the number of workers they hire. When Congress imposed tariffs on imported shoes, its main objective was to save or preserve jobs in the U.S. shoe manufacturing industry. While Congress may have succeeded in saving some jobs in shoe manufacturing, during the years since the passage of the Smoot-Hawley tariff in 1930, employment in the U.S. shoe manufacturing industry has fallen from 275,000 workers to fewer than 15,000 for two key reasons. First, even given the effects of the tariff, the opportunity cost of manufacturing shoes in the United States is very high compared with other countries, such as Vietnam. Second, as with other manufacturing industries, advances in technology have made it efficient to produce shoes using fewer workers and more machines. We can conclude that Congress failed in its attempt to preserve a substantial number of jobs in U.S. shoe manufacturing by imposing a tariff on imported shoes. In addition, to the extent that the tariff raised the prices of shoes, resulting in a decline the quantity of shoes sold, the tariff has probably reduced the number of jobs at shoe retailers.

9.5

The Debate over Trade Policies and Globalization Learning Objective: Evaluate the debate over trade policies and globalization.

Review Questions 5.1

The collapse of world trade during the Great Depression and the desire to create a stable, prosperous world economy after World War II led to the General Agreement on Tariffs and Trade (GATT) under which countries agreed to not impose new tariffs or quotas on trade in goods. The WTO eventually replaced the GATT when member countries decided that a new agreement was necessary that would cover trade in services and intellectual property rights, as well as trade in goods.

5.2

Globalization is the process of countries becoming more open to foreign trade and investment. Some people oppose globalization because they believe it will make them worse off or will harm other people they care about—especially poor workers in developing countries. Some Copyright © 2021 Pearson Education, Inc.

CHAPTER 10 | Consumer Choice and Behavioral Economics xxvii opponents of globalization believe that it undermines local cultures, especially in developing countries. Protectionism is the use of trade barriers to shield domestic companies and their workers from foreign competition. The beneficiaries are the protected domestic firms and their workers. The losers are domestic consumers and domestic firms who cannot buy imported inputs as cheaply. The main arguments for protectionism are that it: (1) saves jobs and protects high wages; (2) allows “infant industries” a chance to get started and grow; and (3) protects national security. It is important to weigh the benefits of each of these arguments against its costs. 5.3

Firms engage in dumping when they sell a good in a foreign country at a price below the good’s cost of production. The losers from dumping are domestic competitors of the firm that dumps. Consumers are the beneficiaries. The biggest problem in implementing anti-dumping laws is that it is difficult to measure firms’ costs, so it is difficult to determine if firms are dumping. Also, there are often sound economic reasons for selling goods below the cost of production. Domestic firms do this, so it is unclear why foreign firms should not.

Problems and Applications 5.4

a. An infant industry is a newly established industry whose costs may be too high to enable it successfully to compete with imports produced by foreign firms that have been operating for much longer. b. It is possible that over time, an infant industry may improve its methods of production sufficiently to be able to compete with established foreign producers. In that case, the domestic industry will have shown that it has a comparative advantage in producing the good—that is, it can produce it at a lower opportunity cost than can foreign firms. Without tariff protection, the infant industry may not have the time to improve its methods and lower its costs enough to compete with foreign producers. If a domestic infant industry fails, despite having a comparative advantage in the long run, then the domestic economy will suffer an efficiency loss. c. Many infant industries, including the sugar industry in the United States, that receive tariff or quota protection fail to lower their costs enough to be competitive with foreign producers. Even though protection of the sugar industry has been in place since the 1930s, the industry still has protection in the form of a quota on imports. The inability to compete after decades of protection makes it clear that U.S. sugar firms lack a comparative advantage in sugar production. Therefore, they do not qualify for protection under the infant industry argument, and continuing the sugar quota results in an efficiency loss to the U.S. economy.

5.5

When the U.S. government puts a tariff on steel imports, it protects steelworkers in West Virginia at the expense of steelworkers in South Korea (and elsewhere) by artificially increasing the demand in the United States for steel produced by U.S. firms. Landsburg is expressing an opinion of how things ought to be, so he is making a normative statement. In expressing an Copyright © 2021 Pearson Education, Inc.

xxviii CHAPTER 10 | Consumer Choice and Behavioral Economics opposing opinion, Redburn is also making a normative statement. Which of the two arguments you find most convincing depends on your assessment of whether U.S. economic policy should be focused solely on the well-being of U.S. residents or whether policy should also take into account the interests of people outside of the United States. 5.6

You should disagree with the statement because it doesn’t take into account the whole process of international trade. Buying a less expensive good from Brazil leaves a consumer with more money to spend on other domestic goods. In addition, buying a good from Brazil provides Brazilians with funds to buy goods from the United States. Importing goods does not affect the total number of jobs in the United States. Buying only American-made products and limiting imports results in higher prices for the American-made products, which makes these products more expensive for American buyers. When the United States imports products for which it does not have a comparative advantage, it is able to purchase these imports more cheaply, which in turn helps U.S. consumers. In the smartphone and wheat example, the U.S. decision to import smartphones and export wheat expanded world production and consumption of these two goods and left employment in the United States unchanged.

5.7

a. Answers will vary. Foreign trade helps an economy increase its standard of living over time by specializing in the goods and services in which it has a comparative advantage and trading those goods and services for the goods and services in which it does not have a comparative advantage. Even though foreign trade raises the standard of living of a country, domestic industries that do not have a comparative advantage (and their workers) will be hurt, particularly in the short run as the firms lose sales to foreign competitors. b. During an economic recession, the general public is understandably concerned about jobs and may see foreign trade as the reason their jobs are disappearing. This concern is not as apparent during an expansion, when unemployment rates are low and incomes are rising. c. Younger people have a greater chance to train and acquire skills that prepare them for jobs in the industries in which the United States has the comparative advantage. Older people, especially those who have held the same job for many years, may find it harder to find a new job if they lose their current one.

5.8

Globalization, the process of countries becoming more open to foreign trade and investment, enables some foreign firms to better respond to changes in consumer demand for digital photography than Kodak responded. The outcome in Rochester was not “good” for Kodak workers who lost their jobs, but it was beneficial to consumers of digital cameras. The outcome also showed the movement of resources—Kodak’s old buildings—out of an industry that no longer had a comparative advantage and into new industries that do.

5.9

A trade war is a situation where a country raises tariffs and other countries retaliate by raising tariffs on the first country’s exports. The trade war in 2018 started when the Trump administration enacted tariffs on some imports from China. The United States later raised tariffs on imports of some goods from other countries. China, along with some other countries raised Copyright © 2021 Pearson Education, Inc.

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tariffs on imports from the United States in retaliation against the U.S. tariffs. The trade war began because during the 2016 presidential campaign, Donald Trump argued that China and some other countries were taking advantage of the United States as a result of existing trade deals and that result was a decline in U.S. manufacturing jobs. The actions the Trump administration took in 2018 that led to the trade war were consistent with some of the campaign pledges Donald Trump made during the 2016 campaign. 5.10

a. During the Great Depression of the 1930s the United States and other countries imposed tariffs and other trade restrictions on imported goods. The trade restrictions reduced overall foreign trade and worsened the effects of the world-wide economic decline. After World War II, many countries recognized the damage that was done and began negotiations to reduce trade barriers to international trade. b. Liberalizing trade means reducing or eliminating tariffs and other restrictions on imported goods and moving closer to free international trade. Countries wanted to liberalize trade because they recognized the damage that the trade wars of the 1930s did to their economies. Consumers benefit from trade liberalization because of lower prices for both imported and domestically produced goods that result from free trade. Firms and their workers that experience an increase in their exports gain, but other firms and workers that are harmed by imports can lose from trade liberalization.

Suggestions for Critical Thinking Exercises

CT7.1

It might be challenging for students to explain the concept of comparative advantage to someone not taking this course without reverting to using tables and numbers. Students should consider the ideas of the limited resources and limited time everyone has when making decisions and explain how performing an activity in which someone is the most efficient is the best use of those resources and time. The hint in the textbook of describing the concept of using just two people or two businesses that trade goods or services with each other should help students.

CT7.2

Sources of comparative advantage between people include education, experience, and interests.

CT7.3

No, we can’t directly use the tools of demand and supply to illustrate comparative advantage. Because comparative advantage highlights production and opportunity costs, production possibilities frontier (PPF) graphs are a more useful tool than demand

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CHAPTER 10 | Consumer Choice and Behavioral Economics and supply graphs. The idea behind this question is that students often see ideas in isolation and they have a difficult time seeing which tool is used for a given issue.

CHAPTER 10 | Consumer Choice and Behavioral Economics Brief Chapter Summary and Learning Objectives 10.1 Utility and Consumer Decision Making Define utility and explain how consumers choose goods and services to maximize their utility. ▪

To maximize utility, a consumer must equate the marginal utility per dollar spent on each good and spend all of his or her income.

10.2 Where Demand Curves Come From Use the concept of utility to explain the law of demand. ▪

Total utility, marginal utility, and the budget constraint are used to explain the law of demand.

10.3 Social Influences on Decision Making Explain how social influences can affect consumption choices. ▪

Economists have begun to study how social factors influence consumer choice.

▪

Firms may give up profits in the short run to increase their profits in the long run.

10.4 Behavioral Economics: Do People Make Rational Choices? Describe the behavioral economics approach to understanding decision making. ▪

Behavioral economics studies situations in which people do not appear to be making rational choices.

Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Use indifference curves and budget lines to understand consumer behavior.

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Key Terms Behavioral economics The study of situations in which people make choices that do not appear to be economically rational.

Marginal utility (MU) The change in total utility a person receives from consuming one additional unit of a good or service.

Budget constraint The limited amount of income available to consumers to spend on goods and services.

Network externality A situation in which the usefulness of a product increases with the number of consumers who use it.

Endowment effect The tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

Income effect The change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant. Law of diminishing marginal utility The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

Substitution effect The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. Sunk cost A cost that has already been paid and cannot be recovered. Utility The enjoyment or satisfaction people receive from consuming goods and services.

Key Terms—Appendix Indifference curve. A curve that shows the combinations of consumption bundles that give the consumer the same utility. Marginal rate of substitution (MRS) The rate at which a consumer would be willing to trade off one good for another.

Chapter Outline What Happened to Sears and the Other Department Stores? After the end of World War II, Sears became the largest department store in the United States. By 2021, Sears had gone through bankruptcy and closed all but 60 of its stores. Other department stores were also struggling. The clothing that department stores sell has become less fashionable, so consumers have less reason to go to malls; this reduces the sales of all stores in the malls. The number of shopping malls peaked at 1,200 at the end of the 1990s. There may be only 500 malls still on operation in the United States. Firms must understand consumer behavior to determine what strategies are likely to be most effective in selling their products.

Teaching Tips Advertising is a good subject for classroom discussion because students are familiar with celebrities who appear in print and broadcast ads. Some of your students may claim that advertising increases the costs of marketing products, which are passed on to consumers in higher prices. Another attribute of advertising is that it provides information. Online, magazine, and newspaper ads provide consumers with valuable information, including dates and locations of special sales. Often, firms must incur advertising costs to convey information that helps consumers make better choices.

Utility and Consumer Decision Making 10.1

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

A. An Overview of the Economic Model of Consumer Behavior

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The economic model of consumer behavior predicts that consumers will choose to buy the combination of goods and services that makes them as well off as possible from among all the combinations that their budgets allow them to buy.

B. Utility How much satisfaction you get from consuming a particular combination of goods and services depends on your tastes or preferences. Utility is the enjoyment or satisfaction people receive from consuming goods and services. Although economists no longer use the word util as an objective measure of utility, the economic model of consumer behavior is easier to understand if we assume that utility, like temperature, is directly measurable.

C. The Principle of Diminishing Marginal Utility Economists use the term marginal utility (MU) to refer to the change in total utility a person receives from consuming one additional unit of a good or service. The law of diminishing marginal utility is the principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

D. The Rule of Equal Marginal Utility per Dollar Spent The limited amount of income available to consumers to spend on goods and services is a budget constraint. A key principle to remember is that optimal decisions are made at the margin. The key to making the best consumption decision is to follow the rule of equal marginal utility per dollar spent: As you decide how to spend your income, you should consume additional units of each good to the point where the last unit of each good gives you the same utility per dollar. This is the first condition necessary for you to maximize your utility. The second condition is that total spending on all goods must equal the amount available to be spent.

E. What If the Rule of Equal Marginal Utility per Dollar Does Not Hold? Assume that you met your budget constraint, but the marginal utility per dollar of one good (Coke) was greater than the marginal utility of another good (pizza). You could raise your total utility by buying less pizza and more Coke.

F. The Income Effect and Substitution Effect of a Price Change A change in price has two effects on the quantity demanded. The income effect is the change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant. The substitution effect is the change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.

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Teaching Tips The assumption that utility can literally be measured, as if a mechanism strapped to a consumer would register “10 utils” on a digital display after eating a hamburger is, of course, nonsensical. But it is realistic to assume a consumer prefers a certain amount of one product to an amount of another or that a consumer is indifferent about consuming two different products. Economists do not believe in “cardinal utility”—utility measured in utils. They do believe in “ordinal utility”—that consumers can rank products, or combinations of products, based on their preferences. You can find cardinal and ordinal measurements on a newspaper’s sports page. A list of baseball teams’ won-loss records from first to last is an ordinal ranking. Baseball standings also include the number of games teams are behind the firstplace team. This is a cardinal ranking because it provides information regarding how far from first place each team is.

Extra Apply the The Diminishing Marginal Utility of Eggs Concept Luke: “I can eat fifty eggs.” Dragline: “Nobody can eat fifty eggs.” Society Red: “You just said he could eat anything.” Dragline: “Did you ever eat fifty eggs?” Luke: “Nobody ever eat fifty eggs.” Prisoner: “Hey, Babalugats. We got a bet here.” Dragline: “My boy says he can eat fifty eggs, he can eat fifty eggs.” Loudmouth Steve: “Yeah, but in how long?” Luke: “An hour.” Society Red: “Well, I believe I’ll take part of that wager.” This dialog is from the 1967 movie Cool Hand Luke, starring Paul Newman and George Kennedy. In one of the movie’s most memorable scenes, Luke (Newman’s character), a prisoner in a Florida prison camp, claims he can eat fifty eggs in one hour. There is no better illustration of diminishing marginal utility than Luke downing the last of the eggs. Notice that the character of Loudmouth Steve makes a critical point when he asks how long it would take for Luke to eat the eggs. None of the prisoners would bet against Luke eating fifty (hard-boiled) eggs in a month or a year. By the way: Luke and Dragline win the Copyright © 2023 Pearson Education, Inc.

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bet. George Kennedy, who played Dragline, received an Academy Award for this performance. You can view the egg eating scene on YouTube https://www.youtube.com/watch?v=sAkzEusQLBw

10.2

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

A market demand curve is constructed by adding horizontally the individual demand curves of consumers of a particular good. According to the law of demand, market demand curves always slope downward. This is because the income and substitution effects of a fall in price cause consumers to increase the quantity of the good they demand. But there is a complicating factor. Only for normal goods will the income effect result in consumers increasing the quantity of the good they demand when the price falls. The income effect for an inferior good leads consumers to decrease the quantity of the good they demand. The substitution effect results in consumers increasing the quantity they demand of both normal and inferior goods when the price falls. When the price of an inferior good falls, the income and substitution effects work in opposite directions. The income effect for an inferior good would have to be greater than the substitution effect for a demand curve to be upward sloping.

Extra Solved Problem 10.2 Jake, Wings, and Dogs We can use the rule of equal marginal utility per dollar (MU/P) to analyze how consumers adjust their buying decisions in response to price changes. The following table shows Jake’s utility from his two favorite foods: chicken wings (each order contains 10 wings) and chili dogs.

Chicken Wings

Chili Dogs

Orders

MU per Order of Chicken Wings

Orders

MU per Order of Chili Dogs

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Assume that Jake has $20, the price of chicken wings is $4 per order and the price of chili dogs is $2. The following table shows the MU/P for wings and chili dogs at their initial prices, as well as the MU/P of chili dogs after the price increases to $4. Chicken Wing

MU/P

Orders

(Price = $4)

Chili Dogs

MU/P

(Price = $2)

(Price = $4)

a. Using the rule of equal marginal utility per dollar spent, how many orders of wings and how many orders of chili dogs will Jake consume when the price of chili dogs is $2? b. How many orders of wings and how many orders of chili dogs will Jake consume when the price of chili dogs is $4? c. What is the substitution effect of the change in the price of chili dogs? What is the income effect? d. How does Jake’s response to the increase in the price of chili dogs illustrate the law of demand?

Solving the Problem Step 1:

Review the chapter material. This problem involves utility and the law of demand, so you may want to review the section “Where Demand Curves Come From” in the textbook.

Step 2:

Answer part (a) by calculating Jake’s optimal consumption of wings and chili dogs when the price of chili dogs is $2. Jake will first consume two chili dogs because the MU/P of the first and second chili dog is greater than the MU/P of the first order of wings. Jake will then consume one order of wings. Because the MU/P for the second order of wings and a third chili dog are equal (20), Jake will consume one more of each. At this point, Jake will have spent $14. With his remaining $6, he will consume a third order of wings and a fourth chili dog. Jake will now have spent his $20, and the MU/P of both goods will be equal (10). Copyright © 2023 Pearson Education, Inc.

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Step 3:

Answer part (b) by calculating Jake’s optimal consumption of wings and chili dogs when the price of chili dogs is $4. After the price of chili dogs rises, the MU/P for this good falls. Jake will first buy an order of wings, next he will then buy an order of wings and a chili dog (the MU/P for both equals 20). At this point, he will have spent $12. Next, Jake will buy another chili dog for $4. Because the MU/P (10) for the third chili dog and third order of wings is the same, Jake will be indifferent about these two choices. Assume that he buys a third chili dog. Jake will now have spent his $20.

Step 4:

Answer part (c) by analyzing the substitution and income effects of the change in the price of chili dogs. When the MU/P for chili dogs falls because of the price increase, the opportunity cost of consuming each chili dog rises. As a result, Jake will substitute toward wings, holding constant the income effect of the price change. This is the substitution effect. After the price increase, Jack would need $28 to buy the same number of chicken wings (3 × $4 = $12) and chili dogs (4 × $4 = $16) as he bought before the price increase. Because Jake’s purchasing power, or real income, has declined, he will buy fewer chili dogs because of the income effect if chili dogs are a normal good. If chili dogs are inferior goods, Jake will buy more chili dogs and fewer wings because of the income effect. Because the income effect is small, the net effect of the price increase is to decrease the quantity demanded of chili dogs.

Step 5:

Answer part (d) by explaining how Jake’s response to the change in the price of chili dogs illustrates the law of demand. The change in the price caused a decrease in the quantity demanded of chili dogs. According to the law of the demand, as the price of a product increases, the quantity demanded will decrease. Jake’s response to the price increase for chili dogs is consistent with this law.

10.3

Price

Quantity Demanded of Chili Dogs

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

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Although economists have traditionally seen such factors as culture, customs, and religion as relatively unimportant, some economists have begun to study how social factors influence consumer choices.

A. The Effects of Celebrity Endorsements If consumers believe that movie stars or professional athletes use a product, then demand for the product will often increase. Demand increases partly because consumers believe public figures are particularly knowledgeable about certain products, but also because they feel more fashionable and closer to famous people if they use the same products they do.

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B. Network Externalities A network externality is a situation in which the usefulness of a product increases with the number of consumers who use it. Some economists raised the possibility that network externalities might result in consumers buying products that contain inferior technologies because network externalities can create switching costs related to changing products; that is, once a product becomes established, consumers may find it too costly to switch to a new product that contains a better technology. The selection of products may be path dependent; that is, because of switching costs, the technology that was first available may have advantages over better technologies that were developed later. Some economists have argued that because of path dependence and switching costs, network externalities can result in market failure. If so, government intervention in these markets might improve economic efficiency. Other economists who have studied cases of network externalities argue that there is no good evidence that the alternative technologies are superior.

C. Does Fairness Matter? There is evidence that people like to be treated fairly, and they usually attempt to treat others fairly, even if doing so makes them worse off financially. Economists have used experiments to increase their understanding of the role that fairness plays in consumer decision making. One consequence of the importance of fairness to consumers is that firms will sometimes not raise the prices of their goods and services, even when there is a large increase in demand, because they are afraid customers will consider the price increases unfair. Sometimes firms will give up some profits in the short run to keep their customers happy and increase their profits in the long run.

Teaching Tips The automobile market provides a good example of network externalities. Prior to the 1970s, owners of foreign-made automobiles often had difficulty locating parts for their cars and mechanics who could repair them. Owners of foreign cars had to buy hard-to-find metric wrenches to do even simple repair work. The rapid increase in oil and gasoline prices beginning in 1973 caused a surge in demand for the smaller, more fuel-efficient automobiles Japanese and German automakers offered. By the late twentieth century, foreign manufacturers had gained significant market share in the United States. The availability of parts or mechanics was no longer a problem for buyers of foreign-made cars.

Extra Apply the Is Uber Price Gouging? Concept The Uber mobile app has become very popular. Rather than call or flag down a taxi for a ride home after a party or a football game, many people use the app to summon a driver who uses his or her own car to Copyright © 2023 Pearson Education, Inc.

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provide rides. Many consumers prefer Uber because they believe Uber drivers are more reliable in responding and arrive faster than taxis, particularly in smaller cities where taxi service is not always dependable. In addition, some consumers find Uber’s payment system to be convenient. Because the user’s credit card information is loaded into an app, the price of a trip is automatically billed to the card, and the driver does not have to be tipped. Travis Kalanick and Garrett Camp founded Uber in San Francisco in 2009. They believed that the restrictions many local governments placed on taxi services meant that an inefficiently small quantity of taxi rides were being supplied in many markets. Because Uber relies on individuals driving their own cars, it is not legally a taxi service, and so it is not subject to government regulations on taxis. Taxi companies in many cities, though, have protested against Uber because it usually charges prices lower than the local governments allow the taxi companies to charge. Typically, Uber charges lower prices than taxi companies charge—but not always. Uber sets prices based on the number of people who request rides at a given time in a given area, and it raises prices as demand increases. This “surge pricing” can more than triple normal prices when demand is very high. One rider used Uber to call for a ride on New Year’s Eve only to find that instead of the expected price of $35, the charge would be $262. Kalanick argues that consumers should think of Uber prices the same way they think of airline ticket prices: “You know that if you buy a flight on the day before Christmas, it’s probably 10 times more expensive than two weeks after Christmas.” In addition, he argues that increasing prices when demand increases gives drivers—whose pay increases with prices—an incentive to provide rides at busy times, such as New Year’s Eve or at a stadium at the end of a football game. But as the research of Kahneman, Knetsch, and Thaler has shown, consumers see it as more fair for firms to raise prices after an increase in costs than as a result of an increase in demand. Not surprisingly, Uber has come under criticism on Facebook and other social networking sites as a result of its surge pricing. Financial writer James Surowiecki suggests that firms such as Uber can avoid the criticism that surge pricing is unfair if they label the surge price the normal price and the lower non-surge price as a discount price. Just as movie theaters label the price they charge for tickets in the evening—when demand is high—the normal ticket price and the price they charge in the afternoon—when demand is low—as a discount from the normal price. Sources: “Uber Uber Alles,” Economist, March 11, 2015; “Pricing the Surge,” Economist, March 19, 2014; Douglas MacMillan, “Uber CEO: Surge Pricing Is Here to Stay,” Wall Street Journal, January 7, 2014; James Surowiecki, “In Praise of Efficient Price Gouging,” technologyreview.com, August 19, 2014; and Daniel Kahneman, Jack Knetsch, and Richard Thaler, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market,” American Economic Review, Vol. 76, No. 4, September 1986, pp. 728– 741.

Extra

Who Made the Most Profit from the Broadway Musical Apply the Hamilton?

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Concept

For the year 2016, the answer to the question is not Lin-Manuel Miranda, the star and creator of the musical on the life of Alexander Hamilton, nor the rest of the cast. Nor is it the show’s producers, nor the people who provided the financing for the show, nor the owners of the Richard Rodgers Theatre where the Broadway show is performed. The people who made the most profit from Hamilton were scalpers—people who buy tickets at their original price and then resell them at a higher price.

For as long as there have been ticketed sporting events, concerts, and plays, there have been ticket scalpers. In ancient Rome, the Roman Colosseum seated 50,000 spectators for gladiatorial contests and other events. Although the Roman government distributed tickets for free, enterprising people would accumulate as many as they could and resell them for cash or goods. Before the Internet, scalpers typically waited outside a sports arena, concert hall, or theater, eyeing the crowd for people who seemed as if they needed tickets, hoping to make a deal for cash on the spot. At one time, scalping tickets was illegal in many cities and states, so scalpers needed to avoid police officers stationed outside events.

Today, most ticket reselling has moved online, to popular sites such as StubHub and SeatGeek, and most local governments have repealed their bans on scalping. These sites have provided an easy way for people who find they can no longer attend an event to resell their tickets. But professional ticket resellers have also used the sites to boost their profits. Using sophisticated software programs called “ticket bots,” professional resellers buy large blocks of tickets the moment they are available for sale. The professional resellers then list the tickets on StubHub or other sites at several times their face value. Although use of ticket bots is illegal in most states, theaters and other venues can have difficulty identifying whether a particular purchase has been made by a human or a bot.

A column in the New York Times gathered data on the last 100 performances before Lin-Manuel Miranda left the cast of Hamilton on July 9, 2016. The average face value of tickets was $189, while the average resale ticket sold for $1,120—or nearly six times as much. The average resale price for a ticket to Miranda’s last performance on July 9 was $10,900.

Performance

Average face

Average resale price 1

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ticket

100 performances before Lin-Manuel Miranda left

$189

$ 1,120

Miranda’s last performance

$189

$10,900

For the last 32 performances before July 9, ticket resellers made a profit of $10.5 million—or nearly four times the $2.7 million profit the show’s producers earned.

Why didn’t the producers just raise ticket prices so that the quantity demanded equaled the 1,321 tickets (which is the number of seats in the Richard Rodgers Theatre) available for each performance? The producers did raise ticket prices beginning in January 2017. The price for a ticket to the best seats increased from $475 to $849, and prices for most other seats increased from a range of $139 to $177 to arange of $179 to $199. But these increases still left prices far below what tickets were selling for on the resale market. The producers were reluctant to raise ticket prices any higher because they were afraid of a negative reaction among theater fans.

Original Ticket Price New Ticket Price (s) January 2017 Best seats

$475

$849

Most other seats $139 to $177

$179 to $199

As the research of Kahneman, Knetsch, and Thaler has shown, consumers see it as more fair for firms to raise prices after an increase in costs than as a result of an increase in demand. The costs for staging Copyright © 2023 Pearson Education, Inc.

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Hamilton were no higher than for other musicals, so increasing ticket prices would have been based only on the high demand for the show. The owners of the theater, the show’s producers, and the show’s cast all intend to be involved with shows in the future and were reluctant to raise prices to the levels necessary to equate the quantity of tickets demanded to the quantity supplied for fear of damaging their reputations. To make sure they could earn profits from future shows, the producers of Hamilton had no good alternative but to let scalpers earn a sizable profit from their show.

Sources: Tiff Fehr, “How Scalpers Make Their Millions with ‘Hamilton,’” New York Times, July 29, 2016; “The War on Ticket Bots Is Unlikely to Be Won,” Economist, January 5, 2017; Michael Paulson, “‘Hamilton’ Raises Ticket Prices: The Best Seats Will Now Cost $849,” New York Times, June 8, 2016; Keith Veronese, “Pottery Shards Were the First Ever Ticket Stubs,” io9.gizmodo.com, April 27, 2012; and Daniel Kahneman, Jack Knetsch, and Richard Thaler, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market,” American Economic Review, Vol. 76, No. 4, September 1986, pp. 728–741.

Behavioral Economics: Do People Make Rational Choices? 10.4

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

Behavioral economics is the study of situations in which people make choices that do not appear to be economically rational. The most obvious reason why people might not act rationally is that they do not realize that their actions are inconsistent with their goals.

A. Pitfalls in Decision Making Consumers commonly commit the following three mistakes when making decisions: 1. They take into account monetary costs but ignore nonmonetary opportunity costs. 2. They fail to ignore sunk costs. 3. They are overly optimistic about their future behavior. Opportunity cost is the highest-value alternative that must be given up to engage in an activity. Behavioral economists believe that consumers’ failure to take into account the nonmonetary opportunity costs of their decisions is related to the endowment effect. The endowment effect is the tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it. Nonmonetary opportunity costs are just as real as monetary costs, so people should take them into account when making decisions. A sunk cost is a cost that has already been paid and cannot be recovered. Once you have paid money and can’t get it back, you should ignore that money in any later decisions you make.

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Many people in the United States are overweight. One explanation for this is that people eat a lot today because they expect to eat less tomorrow. But they never do eat less, and so they end up overweight. Economists who have studied issues like overeating and getting lung cancer from smoking argue that many people have preferences that are not consistent over time. People can avoid these problems by being realistic about their future behavior.

B. “Nudges”: Using Behavioral Economics to Guide Behavior Economist Richard Thaler has popularized the idea of using “nudges” to lead people to make better decisions. At the suggestion of behavioral economists, many firms automatically enroll employees in 401(k) retirement plans. Although employees have long-run plans to save for retirement, many spend more – and save less – than is consistent with this goal. Automatically enrolling employees in a 401(k) plan means that leaving the plan forces employees to confront the inconsistency between their shortrun spending and their long-term goal of a comfortable retirement. Rather than confront their inconsistency, most employees choose to remain in their plans. Suggestions from behavioral economists have also been used to improve health care.

C. The Behavioral Economics of Shopping A typical shopping trip for a family of four could involve the purchase of 25 or more products. Economists are divided in deciding whether it matters if consumers do not make optimal choices. Those who think it does not matter believe that assumptions in most scientific models are not literally correct and unrealistic assumptions are needed to simplify a complex reality. These economists believe that models are judged by the success of their predictions rather than the realism of their assumptions. Behavioral economists believe it does matter that consumers don’t usually make optimal choices. People often make choices based on limited information and often use rules of thumb that may not produce optimal choices. Behavioral economists use the word anchoring to describe one way consumers assess whether a price is “high” or “low.” When uncertain about the value of a product they often relate—or anchor—that value to another known value. Stores can take advantage of consumers’ lack of information about prices to anchor their estimates by marking a high “regular price” on a product which makes a discounted sales price appear to be a bargain.

Extra Solved Problem 10.4 How Do You Convince People to Save More of Their Income? Under 401(k) retirement plans, firms can send some of a worker’s pay to a mutual fund or other investment, where its returns will accumulate tax free until the worker retires. Partly because of research by behavioral economists into what determines people’s saving behavior, Congress included in the Pension Protection Act of 2006 a provision that made it easier for companies to automatically enroll

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employees in a 401(k) plan. As a result, participation rates in 401(k) plans at large companies increased from 67 percent to 85 percent. a. Why would more people participate in a retirement plan when they are automatically enrolled than when they have to fill out a form to enroll? b. One unintended consequence of the change in the law was a decline in the savings rate among employees in 401(k) plans. Most plans automatically enrolled employees at a savings rate of 3 percent of their salary. One study indicated, though, that 40 percent of employees would have enrolled at a higher savings rate if they hadn’t been automatically enrolled at the 3 percent rate. Why wouldn’t employees enrolled at the 3 percent rate who wanted to save at a higher rate simply tell their employers that they wanted to save at a higher rate (which is easy to do under the plans)? Source: Anne Tergesen, “401K Law Suppresses Saving for Retirement,” Wall Street Journal, July 7, 2011.

Solving the Problem Step 1:

Review the chapter material. This problem is about people not always being realistic about their future behavior, so you may want to review the section “Being Unrealistic about Future Behavior” in the textbook.

Step 2:

Use your understanding of consumer decision making to answer part (a). Some people appear to have acted irrationally by not taking the minor action of filling out a form to enroll in a retirement plan when they would voluntarily stay in the plan if automatically enrolled. Here is one possible explanation for this puzzle that is consistent with what we have seen about many people being unrealistic about their future behavior: Some people spend money today that they should be saving for retirement because they expect to increase their saving in the future. If people who act in this way are not automatically enrolled in a plan, they are unlikely to take the steps to enroll because they expect—possibly unrealistically—that in the future they will enroll or save money for retirement in other ways. However, if they are automatically enrolled, then taking the step of opting out of the plan would make it more obvious to them that they are behaving in a way that is inconsistent with their long-term goal of saving for retirement. So, once automatically enrolled, most people choose to stay enrolled, even if they would not have taken the necessary action to enroll themselves.

Step 3:

Answer part (b) by explaining why some employees don’t raise their saving rate above the default rate of 3 percent. The answer is similar to the answer to part a. Presumably, people who would have chosen a saving rate of 5 percent or 10 percent if they had not been automatically enrolled at 3 percent intend to raise their saving rate in the future. Some may actually do so, but for Copyright © 2023 Pearson Education, Inc.

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others the fact that they are at least saving something may disguise the fact that they are spending too much in the present and saving too little to meet their long-run saving goals.

Extra Apply the Can Behavioral Economics Improve Financial Decision Making? Concept Dan Ariely and Jeff Kreisler are co-authors of a book titled Dollars and Sense: How We Misthink Money and how to Spend Smarter, which applies principles from behavioral economics to financial planning. An article in the Wall Street Journal summarized some of these principles. The authors explain that consumers often ignore the opportunity costs of their choices. Here are five points from the book: 1. Consumers would benefit from converting the opportunity costs of their financial decisions into their monetary equivalents: “For instance, we can translate dollars into time—how many hours of wages, or months of salary, we must work to pay for something.” 2. They also claim that people can be misled by relative prices and suggest that when considering the purchase of something that is on sale, they would be better off not considering what the original price was but how much the sale price is. 3. People should not compartmentalize their money. “Every dollar is the same…If we find ourselves splurging…because in our mind the money belongs to the ‘bonus’ or ‘winnings’ account-we need to…remind ourselves that it’s just money. Our money.” 4. They also believe that consumers should not avoid the negative consequences of spending money: “Feeling the pinch of paying helps us … consider the value of our options and the opportunity costs.” Paying with cash, rather than with a credit card, is one way to feel the pain of paying. 5. People should not automatically repeat past decisions in the future: “We should avoid doing something, like getting a $4 latte, just because we’ve always done it before…. Those of us who don’t learn from our own spending histories are doomed to repeat them.” Source: Dan Ariely and Jeff Kreisler “Smart Remedies for Foolish Spenders,” Wall Street Journal, November 17, 2017.

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Question: The late Gary Becker was one of first economists to reconsider the traditional theory of consumer choice, which assumes that consumers choose among various combinations of goods and services based on their money prices. Instead, Becker assumed that consumers engage in activities that require the expenditure of their time as well as the expenditure of money for one or more goods and services. Although a consumer’s time does not command a money price, time has an opportunity cost. Let’s say you wanted to attend a basketball game. This consumption activity could require the purchase of a ticket, a program, food and drinks while at the game, and parking in a nearby lot. Also, let’s say you will need to give up four hours of your time (including travel) to attend the game. The total money price of the ticket, program, and related purchases is $50. The opportunity cost of the time spent attending the game may be greater than the money cost, and the opportunity cost of time will be different for different people. When would your opportunity cost of watching a basketball game be especially high? Who would have a higher opportunity cost of their time: someone with a high income or someone with a low income? Answer: Although the total time spent to attend the game, four hours, would not change, the value of time per hour will vary greatly depending on what you would sacrifice to watch the game. If you had a midterm exam that same evening, or the next day, then your opportunity cost would be high. If your best forgone alternative was to watch television or do your laundry, then the cost would be lower. Generally, high-income consumers have a greater opportunity cost of time than low-income consumers. This explains why business executives are willing to pay higher money prices to fly between cities than to travel by bus or car. Source: Gary S. Becker, Economic Theory (Alfred A. Knopf: 1971) 45–50.

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Appendix Using Indifference Curves and Budget Lines to Understand Consumer Behavior Learning Objective: Use indifference curves and budget lines to understand consumer behavior.

Consumer Preferences Rather than assuming utility is measured in utils, it is more realistic to assume that consumers rank different combinations of goods and services in terms of how much utility they provide. If a consumer is presented with two alternative consumption bundles (A and B), we assume there are three possibilities. The consumer will prefer A to B, prefer B to A, or be indifferent between A and B. For consistency, we also assume the consumer’s preferences are transitive. This means that if she prefers A to B and B to C, then she must prefer A to C.

A. Indifference Curves An indifference curve shows the combinations of consumption bundles that give the consumer the same utility. An indifference curve assumes that consumption bundles consist of various amounts of only two goods. Each possible combination of two goods (for example, cans of Coca-Cola and slices of pizza) has an indifference curve passing through it. A consumer is indifferent among all the consumption bundles that are on the same indifference curve. In a graph of indifference curves, the further to the right a curve is, the greater the utility it represents.

B. The Slope of an Indifference Curve The marginal rate of substitution (MRS) is the rate at which a consumer would be willing to trade off one good for another. The MRS decreases as an indifference curve becomes less steep as one moves down the curve; indifference curves are bowed in or convex.

C. Can Indifference Curves Ever Cross? Indifference curves do not cross. If two curves did cross, it would violate the assumption that consumer preferences are transitive.

The Budget Constraint A consumer’s budget constraint is the amount of income she has available to spend on goods and services. In an indifference curve graph, the budget constraint is represented by a straight downwardsloping line. Any consumption bundle on or inside the line is affordable. Any bundle that lies outside the

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line is unaffordable. The slope of the budget constraint is constant because the budget constraint is a straight line. The slope of the budget constraint is equal to the ratio of the price of the good on the horizontal axis divided by the price of the good on the vertical axis multiplied by –1.

Choosing the Optimal Consumption of Pizza and Coke To maximize utility, a consumer needs to be on the highest indifference curve, given his budget constraint. Utility maximization occurs at the point of tangency between the consumer’s budget line and an indifference curve.

A. Deriving the Demand Curve The change in a consumer’s optimal consumption as the price of a good changes explains why demand curves slope downward. A fall in the price of a good will rotate the budget constraint outward and make it possible for a consumer to reach higher indifference curves. As a result, the consumer will increase the quantity of the good demanded. An increase in price will rotate the budget line inward and force the consumer to a lower indifference curve. As a result, the consumer will decrease the quantity of the good demanded.

B. The Income Effect and the Substitution Effect of a Price Change We can use indifference curves to analyze the income effect and the substitution effect of a price change. Assume that a consumer is maximizing utility at the tangency of a budget line and indifference curve I1. Assume a change in the price of pizza from $2 to $1. The budget line rotates outward to represent the price change and the line’s new slope. The consumer maximizes utility at the tangency of the new budget line and indifference curve I2. Drawing a line parallel to the new budget line (that is, with the new line’s slope) tangent to I1 allows the substitution effect of the price change to be illustrated: It is the change in consumption of pizza along I1. The change in consumption from the tangency of the line parallel to the new budget line and I1 to the tangency of the new budget line and I2 illustrates the income effect of the change in price.

C. How a Change in Income Affects Optimal Consumption An increase in income allows the consumer to buy more of both goods; for example, Coke and pizza. This is shown by a parallel shift of the budget line outward. The new budget line is tangent to a higher indifference curve.

The Slope of the Indifference Curve, the Slope of the Budget Line, and the Rule of Equal Marginal Utility per Dollar Spent At the point of optimal consumption, the MRS is equal to the ratio of the price of the product on the horizontal axis to the price of the product on the vertical axis. The slope of the indifference curve tells us the rate at which a consumer is willing to trade off one good for the other. The slope of the budget Copyright © 2023 Pearson Education, Inc.

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constraint tells us the rate at which the consumer is able to trade off one good for the other. Only at the point of optimal consumption is the rate at which a consumer is willing to trade off one good for the other equal to the rate at which he can trade off one good for the other. This condition is equivalent to stating that consumers maximize utility when they consume each good up to the point where the marginal utility per dollar spent is the same for every good.

A. The Rule of Equal Marginal Utility per Dollar Spent Revisited The rule of equal marginal utility per dollar spent states that if consumers spend their income so that the last dollar spent on each product gives them the same marginal utility, they will maximize their utility. Indifference curves and budget constraints can be used to show why this rule will hold. Assume that a consumer (Dave) consumes Coke and pizza. Dave’s indifference curves and budget lines are illustrated in a graph with cans of Coke (per week) measured on the vertical axis and slices of pizza (per week) measured along the horizontal axis. When Dave consumes less Coke by moving down an indifference curve, he loses utility equal to: . At the same time, he consumes more pizza so he gains utility equal to: . Because Dave moves along an indifference curve, the loss in utility from consuming less Coke equals the gain in utility from consuming more pizza. The change in utility can be written: –(Change in the quantity of Coke x MUCoke) = (Change in the quantity of pizza x MUPizza) Rearranging terms yields: .

Note that: .

is the slope of the indifference curve (the marginal rate of substitution, multiplied by –1). Therefore, we can write:

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The slope of Dave’s budget constraint equals the price of pizza divided by the price of Coke, multiplied by – 1. At the point of optimal consumption, the slope of the indifference curve is equal to the slope of the budget line. Therefore: .

We can rewrite this to show that at the point of optimal consumption: .

This expression is the rule of equal marginal utility per dollar spent.

Teaching Tips If you assign or discuss the derivation of the rule of equal marginal utility per dollar, consider substituting simple values for changes in quantities and marginal utilities. Students will find it easier to understand the derivation with numbers rather than just words.

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Solutions to End-of-Chapter Exercises Utility and Consumer Decision-Making 10.1

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

Review Questions 1.1

Utility is the enjoyment or satisfaction that people receive from consuming goods and services. It is not possible to measure utility or to compare it across people.

1.2

Marginal utility is the extra utility a person receives from consuming one additional unit of a good or service. The law of diminishing marginal utility states that consumers will experience reductions in additional satisfaction as they consume more of a good or service during a given period of time. Marginal utility is more useful than total utility in consumer decision making because consumption decisions are usually made at the margin and therefore a consumer is deciding whether to consume a little bit more or a little bit less of a product.

1.3

A budget constraint is the limited amount of income available for a consumer to spend on goods and services. The rule of equal marginal utility per dollar spent states that a consumer will make the optimal consumption decision by allocating his or her budget so that the marginal utility per dollar spent is the same for all goods and services consumed.

1.4

There is a change in the quantity demanded of the product due to the effect of the change in price on consumer purchasing power (the income effect) and due to the change in price making the good more or less expensive relative to other goods (the substitution effect).

Problems and Applications 1.5

The law of diminishing marginal utility might not hold true in every case and might not hold over certain ranges of consumption. One example would be the increasing marginal utility you would experience if you were to increase the dosage of a medication you take from only a half a dose to a full dose.

1.6

In recent years, the NFL has broadcast games on Thursday, Monday, and Sunday nights as well as “double header” games on Sunday afternoons. The NFL has also increased the number of playoff games that determine the teams that compete in the Super Bowl. In addition, there are several pre-game and post-game programs. For fans, the utility of watching one more televised game—the marginal utility—eventually diminishes. This increased number of football telecasts

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CHAPTER 11 | Technology, Production, and Costs is likely why economist Patrick Rishe believes that diminishing marginal utility is leading to falling television ratings.

CHAPTER 11 | Technology, Production, and Costs xxvii 1.7

a. Economics

Psychology

Hours

Score

Marginal Score

Hours

Score

Marginal Score

—

You should allocate your time so that the last hour devoted to studying each subject results in the same additional number of points. In other words, you should equalize your marginal scores, subject to the constraint that you have only 6 hours to study. The table above shows that this result occurs when you devote 4 hours to studying economics and 2 hours to studying psychology. b. In this case, you need to triple the marginal scores for the psychology exam. Maximum utility now occurs when you spend 2 hours studying economics and 4 hours studying psychology. The marginal scores are not exactly equalized, but this is as close as you can get given the budget constraint of 6 hours. Economics

Psychology

Hours

Marginal Score

—

xxviii CHAPTER 11 | Technology, Production, and Costs 6 1.8

Joe will maximize his utility if he spends his $16 so that the marginal utility of Twinkies divided by the price of Twinkies is equal to the marginal utility of Ho-Hos divided by the price of Ho-Hos. We can make the analysis easier by constructing the following table. Twinkies

Ho-Hos

Quantity

MU/P

—

Joe will maximize utility by buying 4 packs of Twinkies and 6 packs of Ho-Hos. At this combination, the marginal utility of each good divided by its price equals 4. 1.9

José has $55 to spend. To maximize utility, he needs to equalize marginal utility per dollar for both apples and oranges.

For apples:

per dollar.

For oranges:

per dollar.

José is spending $25 on apples (50 apples × $0.50) and $30 on oranges (40 oranges × $0.75), so he is spending a total of $55 on fruit. Therefore, José is maximizing his utility because he has

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spent his $55 and the marginal utility of each good divided by its price is the same: 40 utils per dollar. 1.10

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

1.11

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

1.12

The student’s understanding of the income effect is incorrect. The income effect analyzes the effect on a consumer’s quantity demanded of a change in the consumer’s purchasing power— how much more or less a consumer can buy—as a result of a price change, holding constant the consumer’s money income. The situation that the student is describing, however, involves a change in the money income, not a change in the price, so the student is not describing the income effect.

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10.2

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

Review Questions 2.1

When the price of a good falls, a consumer will adjust his or her purchases because the marginal utility per dollar spent will no longer be the same for all goods. The lower price will lead to a substitution effect and an income effect, both of which will cause the quantity demanded of the good to rise when the good is a normal good. If the good is an inferior good, the income effect of a price decline will lead the consumer to buy less of the good. But because the substitution effect is almost always larger than the income effect, the consumer will also buy more of an inferior good following a price decline. (See the answer to problem 2.3 for the unusual case when a price decline leads a consumer to buy less of an inferior good.)

2.2

The market demand curve is derived by horizontally adding individual demand curves. For each price, the quantities demanded for each buyer are added together to get the total quantity demanded in the market.

2.3

For a demand curve to be upward sloping, the good would have to be an inferior good with an income effect larger than its substitution effect. In this case, a decline in price would lead to the consumer buying less of the good, and an increase in price would lead to the consumer buying more of the good. This is the case of the Giffen good.

Problems and Applications 2.4

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

2.5

If the price of an inferior good falls, the income effect will decrease the quantity demanded while the substitution effect will increase the quantity demanded. So, in this case, the income effect and substitution effect work in opposite directions.

2.6 Price

Tiago

Terrell

Tim

Market demand

Quantity demanded

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2.7

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(cones per week)

$1.75

1.50

1.25

1.00

0.75

Neither the statement by Marty nor the statement by Ann is correct. You can explain to Marty that along downward-sloping market demand curves quantity demanded increases as price decreases for two reasons: (1) consumers who are willing to buy a product at a high price are willing to buy more at a lower price because they receive less marginal utility for each additional unit they consume, and (2) some consumers who are not willing to buy a product at a high price will begin to buy the product as the price falls. Both groups of consumers make decisions “at the margin.” That is, these consumers compare the additional or marginal utility they will receive from buying one more unit of a product to the additional cost. If the price falls to zero, consumers will buy additional units until the last unit purchased yields zero marginal utility. Remind Marty that at home his parents do not make him pay for an additional hot dog (the price to him is zero), and he will eat one more hot dog if the marginal utility is positive. He will stop eating hot dogs when the marginal utility of the last hot dog is zero. You should explain to Ann that she is confusing demand with supply. She is correct in stating that a producer would not be willing to sell a product at a zero price, but quantity demanded refers to the amount of a Copyright © 2023 Pearson Education, Inc.

xxxii CHAPTER 11 | Technology, Production, and Costs product that a consumer is willing to buy at a certain price, not how much a producer is willing to offer to sell at a certain price. 2.8

No, when the price of pizza falls, the marginal utility per dollar spent on pizza will not always equal the marginal utility per dollar spent on Coke. However, the marginal utilities per dollar spent for the last slice of pizza and the last cup of Coke will eventually become equal (or as close to equal as possible) as the consumption of pizza and Coke changes. As the price of pizza falls, the quantity demanded of pizza will rise due to the income and substitution effects.

2.9

A Giffen good is an inferior good that has a larger income effect than a substitution effect in response to a change in price. Imposing a minimum price on alcohol in the United Kingdom above the current price will raise the price of alcohol for U.K. consumers. If alcohol were a Giffen good, a higher price of alcohol would cause consumers to increase the quantity of alcohol they consume. If some heavy drinkers cut back on everything else they buy in order to buy more alcohol when the price of alcohol increases, alcohol would be a Giffen good for these consumers.

2.10

a. Giffen behavior means that as the price of the good increases, the quantity demanded of the good will increase as well, leading to an upward-sloping demand curve. b. For a good to be a Giffen good, it must be an inferior good and consumers must spend a large portion of their incomes on it so that the income effect is greater than the substitution effect. The poorest of the poor have very low incomes to start with, so for these consumers the income effect might not be greater than the substitution effect. c. Unless the good makes up a large portion of a consumer’s budget, the income effect cannot be greater than the substitution effect. For example, when the price of an inferior good increases, the average consumer will spend only a small fraction of his or her budget on the good. The income effect will be very small relative to the substitution effect and the consumer will buy a smaller quantity of the good following the price increase.

2.11

a. If nothing changes other than the price of gasoline having risen and the result is an increase in consumption of gasoline, then gasoline must be a Giffen good. All Giffen goods are inferior goods, so we can conclude that gasoline is not a normal good. b. Consumers will decrease their consumptions of any good, whether it is a normal good or an inferior good, when its price increases unless the good is a Giffen good. We can’t conclude that gasoline is an inferior good or a normal good because of a change in price. A good is normal or inferior based on how consumers respond to a change in income, not a change in price. c. We can conclude that gasoline is not a Giffen good because if it were a Giffen good, households would increase their consumption of it following a price increase.

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10.3

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

Review Questions 3.1

Social influences will probably be greater in choosing a restaurant than in choosing a brand of toothpaste because choosing a restaurant is observable by many other people, while the choice of which toothpaste to buy isn’t.

3.2

Network externalities exist when the usefulness of a product increases with the number of consumers who use it. For example, the more people who use smartphones or tablet computers, the more useful smartphones and tablet computers become. Path dependence occurs when high switching costs mean that technology that was available first has advantages over better technologies that were developed later.

3.3

Because consumers apparently value fairness, businesses will sometimes set their prices below their equilibrium levels, giving up some profits in the short run to keep their customers happy and increase their profits in the long run.

Problems and Applications 3.4

Network externalities arise when the usefulness of a product increases with the number of consumers who use it. This is very likely true for smartphones, LCD, and 3D televisions because more programing that uses these technologies will be available. Network externalities may also arise for board games because they are more interesting if all your friends are playing them, too. Network externalities do not arise for dog food because as long as your dog likes the food, it doesn’t matter whether other dogs do.

3.5

There is a network externality in the consumption of a product if the usefulness of the product increases with the number of consumers who use it. The more people who post photos and messages to Facebook, the more useful the app will be to other people because they will be more likely to find posts by their friends and family. The situation with Google is more subtle because the greater the number of people who use its search engine, the more Google can charge for advertising, and the more funds the company will have to invest in improving its services by providing more thorough and complete searches. Improved services will attract more users, which will allow Google to earn even more advertising revenue.

3.6

a. Fast-fashion clothes are clothes that are designed quickly in response to changes in consumer preferences. These clothes are produced in smaller quantities and sold in smaller stores, unlike traditional mass-produced clothing sold in large department stores such as J.C. Penney and Macy’s.

xxxiv CHAPTER 11 | Technology, Production, and Costs b. Department stores have difficulty competing with fast-fashion retailers because department stores carry large quantities of traditional clothes, which are difficult to sell when fashions change. This inability to adapt to changes in fashion makes it difficult for department stores to attract shoppers. Fast-fashion retailers, on the other hand, have fewer clothes in inventory and are better able to adapt to changing styles to match changes in their buyers’ preferences. 3.7

a. The prices that Hamilton’s producer charges for tickets are lower than the prices that ticket bot operators sell the tickets for. Because the demand for the play’s tickets has been so great, many theater goers have been willing to pay high ticket prices rather than to wait— possibly for many months—to attend a performance. Therefore, people earn a profit by using bots to buy tickets at their original prices and sell them for higher prices. b. Hamilton’s producer could reduce the waiting list for tickets, and the incentive for those who control the ticket bots to buy tickets, by charging higher ticket prices. Apparently, the producer is reluctant to charge higher prices because he fears that theatergoers will blame the producer—rather than the ticket bots—for “unfairly” raising prices. If the producer’s reputation is damaged as a result of unfavorable publicity arising from charging high ticket prices, it may reduce his popularity and ability to produce financially successful shows in the future.

3.8

a. Scalpers are professional ticket resellers. They buy tickets at the original value, as printed on the ticket, and sell the tickets for much higher prices. For a scalper to make a profit, the prices he pays for the tickets must be below the equilibrium price of the ticket. b. Taylor Swift’s strategy for selling tickets made it difficult for scalpers and their bots to purchase the tickets in large quantities. Swift’s system required buyers to be “verified fans,” and those fans were able to buy the tickets at a 25 percent discount. The other tickets were sold to the general public, including scalpers, without the discount. The benefit to Taylor Swift was that her fans were able to buy tickets at the original price instead of the price that scalpers charged for them. The system increased the revenue Swift earned from her tour because most of the tickets were sold at the higher price. The drawback of the system was that there were fewer tickets sold, and her concerts were no longer sold out. As an alternative, Swift could have sold all the tickets in an auction so that those people who most wanted to attend (and who had sufficient income to afford high ticket prices) would buy the tickets. The downside to this approach would be that many people view it as unfair for stars to charge very high ticket prices. This could have damaged Swift’s reputation.

3.9

a. If Tesla auctioned off the right for employees to park in the lot at its Fremont, CA factory, the number of parking spaces would still be the same. If the auction was conducted fairly and all employees were able to bid for parking spaces, the spaces would be allocated to those most willing to pay for them. Tesla would not need to encourage employees to seek other means of transportation—the employees would make their own decisions about Copyright © 2023 Pearson Education, Inc.

CHAPTER 11 | Technology, Production, and Costs xxxv whether they wanted to drive or get to work by bike, public transportation, or shuttle bus. However, Tesla management might offer employees who did not successfully bid on parking spaces additional assistance. For example, Tesla could subsidize bus travel or arrange for a shuttle service from a remote “park-and-ride” location. This type of assistance might reduce potential resentment from those who did not have parking spaces and considered the auction to be unfair. b. Auctioning parking spaces would be more efficient than offering employees free parking. Auctioning would ensure that those most willing to pay for spaces (those for whom the marginal benefit would exceed or equal the marginal cost) would receive them. As noted in the answer to part (a), the number of spaces would be the same regardless of the allocation method Tesla employs. If parking spaces are “free,” by default the allocation method is “first come, first served.” Those who want parking spaces have an incentive to arrive as early as possible to find spaces. c. Apparently, Tesla is reluctant to charge employees for parking because it believes employees consider this allocation method to be unfair. If employees are upset by having to pay for parking, their productivity may decline or they may leave the firm.

Behavioral Economics: Do People Make Rational Choices? 10.4

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

Review Questions 4.1

Being economically rational means that individuals, firms, or policymakers take actions that are appropriate to reach their goals, given the available information.

4.2

Behavioral economics studies situations in which people act in ways that appear not to be economically rational. This field of study examines common mistakes that individuals make, including ignoring nonmonetary opportunity costs, failing to ignore sunk costs, and being overly optimistic about their future behavior. Someone may fail to take into account nonmonetary opportunity costs by purchasing a product because it has a mail-in rebate, but then not mailing in the rebate card. A person has failed to ignore sunk costs when she buys a nonrefundable ticket to a Broadway show and is later offered a free ticket to a Yankees game (which she would much rather attend) the same night as the Broadway show, but decides to attend the Broadway show. And someone who smokes regularly but expects to be able to give up smoking sometime in the near future is being unrealistic about his future behavior.

xxxvi CHAPTER 11 | Technology, Production, and Costs 4.3

Using rules of thumb will probably decrease the likelihood that a consumer makes an optimal choice. For example, if a consumer makes a decision based on outdated information, for example, shopping at a store this week because last week this store had the lowest prices, the consumer may not be making an optimal choice.

4.4.

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

Problems and Applications 4.5

Marvin’s behavior is inconsistent because he was unwilling to buy a ticket in Section 212 for $75 for a basketball game, but also unwilling to sell a ticket in the same section for $75. Economists refer to this type of behavior as the endowment effect: the tendency of people to be unwilling to sell a good they already own even if they are offered a price they would be willing to pay to buy the good if they didn’t already own it. In this example, the endowment effect is illustrated in a slightly different way because Marvin is unwilling to accept a price for his ticket that is more than the value he placed on it before he bought the ticket.

4.6

The endowment effect refers to the tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it. Thaler states that he was not planning to sell the wine, and now that he is being paid for his loss by his insurance company, he will not take this money to replace the stolen bottles of wine. Not being willing to sell the wine he already owned, while at the same time, not being willing to repurchase the wine with the insurance payment is inconsistent behavior.

4.7

You would be irrational if you are not willing to sell the Harry Potter book if someone offered you more than $200 for it. The most you are willing to pay for the book is $200, but if someone offers you $250 the nonmonetary opportunity cost of owning the book becomes $250.

4.8

The columnist’s analysis is correct. The opportunity cost of continuing to own the townhouse is the price you could sell the townhouse for. In that sense, by not selling the townhouse, the person is, in effect, buying it. The price the owner originally paid for the townhouse is a sunk cost and is, therefore, irrelevant to the decision about whether to sell it.

4.9

a. The word “rational” is in quotation marks because in the context of the sentence, the word is used to describe someone who would act in a way that is consistent with attaining his or her goals. But many people who consider themselves intelligent and well-informed and believe their actions are consistent with good decision-making sometimes act in a way that is not, strictly speaking, rational. The quotation marks emphasize that people often act in a way that doesn’t meet the definition of rational.

CHAPTER 11 | Technology, Production, and Costs xxxvii b. The membership fee is a sunk cost and gym members should ignore it in deciding whether to go to the gym. An individual should go to the gym only if his marginal benefit from being at the gym exceeds his marginal cost. The sunk cost of gym membership has no effect on the marginal cost of attending the gym on a particular day. 4.10

The high salary the Jaguars paid quarterback Blake Bortles should not matter in deciding whether to keep him on the team’s roster. Bortles’s salary for the 2019 season was guaranteed and, therefore, a sunk cost. The Jaguars should choose their quarterback by determining whether Bortles or another quarterback on the team would give them a better chance of winning games. The salary they are paying Bortles is irrelevant to this decision because they will have to pay Bortles $16.5 million whether they play him or release him from the team.

4.11

The $3,000 in recent refinancing fees is a sunk cost and should be ignored.

4.12

From the information given, the only conclusion we can make is that Andrea’s tastes—and, therefore, the utility she receives from meat products and vegetables—have changed. It is likely that “social influences” affected her decision, but it is also possible she made her decision to become a vegetarian entirely for her own reasons.

4.13

By “long-run self,” O’Donoghue and Rabin mean a person’s long-run objectives, such as succeeding in school or remaining thin. Two examples of pursuing immediate gratification at the expense of longer-run goals are: (1) Going to the movies rather than studying, and (2) eating donuts rather than sticking to a healthy diet.

4.14

a. As the text explains, price anchoring describes one way consumers evaluate prices. If they are uncertain whether a price for an item they have not purchased before seems “high” or “low,” they often anchor, or relate, the value of the item to another item with which they are familiar. The known value may, in fact, be irrelevant in accurately assessing the value of the unfamiliar item. b. Placing a $10,000 watch next to a $2,000 watch provides an anchor price for consumers who have not previously purchased an expensive watch. A consumer may believe that the $2,000 price is a bargain compared to the $10,000 watch. In contrast, if the same $2,000 watch was placed next to a $500 watch, the consumer would likely use the lower price as an anchor and consider the $2,000 watch to be overpriced.

4.15

CEO Ron Johnson’s mistake was that by replacing frequent sale prices with “everyday prices” he left consumers without a reference point, or “anchor,” to interpret the prices being offered. Even if the everyday price was as low as a sale price was under J.C. Penney’s previous pricing system, consumers may not have realized that was the case.

4.16

a. In behavioral economics, an anchor is a reference point to which consumers can relate. In the case of pricing, anchoring involves relating the price of a product that is unfamiliar to the price of a product that is familiar. Copyright © 2023 Pearson Education, Inc.

xxxviii CHAPTER 11 | Technology, Production, and Costs b. By changing from sale prices and coupons to an “everyday-low-prices” strategy, J.C. Penney “pulled up the anchor” by no longer showing a retail price that consumers could use as an anchor to judge the discount they were receiving. c. Then-CEO Ron Johnson claimed that Penney changed to this strategy to help consumers by eliminating a confusing pricing system and to cut costs by not having employees constantly put new price tags on merchandise. The strategy backfired, as Penney’s sales dropped 25 percent in 2012. Johnson was fired in 2013 after serving as CEO for only 17 months.

Suggestions for Critical Thinking Exercises

CT10.1 Anchoring explains the location of the expensive jacket. By displaying such an expensive jacket on the rack, the store might be trying to anchor customer’s expectations for a rain jacket. The situation described actually occurs at some stores selling outdoor goods.

CT10.2 No. This observation about the level of this person’s happiness is confusing total with marginal utility. Each additional trip may increase utility by a smaller amount than the last trip. Yet, total utility is still increasing.

CT10.3 Clearly, the results will vary by student and group. The reports should be evaluated on their thoroughness and completeness.

Solutions to Chapter 10 Appendix Exercises Review Questions 10A.1 The two key assumptions economists make about consumer preferences are: 1. A consumer can always rank any two bundles of goods, saying which he or she prefers or if he or she is indifferent between the bundles. 2. Preferences are transitive. If a consumer prefers A over B and B over C, then he or she will prefer A over C.

CHAPTER 11 | Technology, Production, and Costs xxxix 10A.2 An indifference curve shows combinations of consumption bundles that give the consumer the same utility. A consumer’s budget constraint is the amount of income he or she has available to spend on goods and services. 10A.3 Condition 1 is incorrect. The consumer has a budget constraint and it will prevent him from buying the maximum amount of both goods. The consumer will allocate his budget such that the marginal utility per dollar spent on one good is equal to the marginal utility per dollar spent on another good. Condition 2 is correct. A consumer who is maximizing utility would choose a bundle of goods that would put her on the highest indifference curve possible, given her budget constraint. Condition 3 is incorrect. A consumer would not aim for the lowest indifference curve because a lower indifference curve means less utility. Condition 4 is incorrect. The consumer will allocate his budget such that the marginal utility per dollar spent on one good is equal to the marginal utility per dollar spent on another good. Though possible, it is unlikely that this allocation will result in equal amounts of the two goods bought.

Problems and Applications 10A.4 a.

b. The indifference curve must be drawn so that it is tangent to the budget constraint at point A, as in the graph above. c. The budget constraint rotates inward (that is, the vertical intercept is lower). The new optimal consumption point will likely consist of more bottles of smartwater and fewer ice cream cones, such as point B, so draw an indifference curve that is tangent at such a point, as in the graph above. Make sure that the indifference curves do not cross.

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10A.5 a.

b. The income increase causes a parallel outward shift in the budget constraint. Because ice cream and smartwater are both normal goods, higher income leads to greater consumption of both goods, shown by the move from the initial point of consumption, A, to a point like B in the graph above. c. If ice cream is an inferior good, then consumption of it will fall as income rises, moving Jacob from point A to a point like C in the graph above. Indifference curves I2 and I3 may cross because they represent situations where Jacob’s tastes are different. 10A.6 a. Calvin’s indifference curves won’t be curved like the indifference curves in the appendix. The curves will be straight lines with a slope of negative one—showing that Calvin is always willing to trade-off one can of Coke for one can of Pepsi. b. Because Pepsi and Coke taste exactly the same to Calvin, he’ll buy whichever drink has the lower price. 10A.7 a. The prices of the goods can be found by dividing Nikki’s budget by the maximum amount that she can buy of each good. The price of tops = $200/5 = $40. The price of pants = $200/10 = $20. b. Four tops and two pants cannot be the optimal point because the indifference curve going through this point isn’t tangent to Nikki’s budget constraint. She can reach higher indifference curves at points between the two intersections of her budget constraint and the indifference curve that is shown. 10A.8 If Marilou and Hunter are both choosing optimally, at their consumption point their marginal rate of substitution between milk and doughnuts will be the same because they pay the same Copyright © 2023 Pearson Education, Inc.

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prices for the two goods. We know the prices are the same because they buy the goods in the same store. The marginal rate of substitution is the slope of the indifference curve. Each consumer selects a point where his or her highest attainable indifference curve is tangent to his or her budget constraint, but these budget constraints must have the same slope because the prices they pay are identical. In the figure, Marilou has a higher income than Hunter. The slope of IH at point H is the same as the slope of IM at point M.

10A.9 Because prices and incomes are unchanged for the typical consumer, the budget constraint doesn’t change. Instead, tastes change so the indifference curves change. The initial point of tangency was at a very low level of prune juice consumption, point A. But the new point of tangency is at a much higher level of prune juice consumption, point B.

10A.10 First, draw the budget constraint, indifference curve, and point of optimal consumption for the original prices. The budget constraint runs from 30 pizzas to 30 movies, the indifference curve is I1, and the point of optimal consumption is A. At the new prices, Dave can buy a maximum of 25 Copyright © 2023 Pearson Education, Inc.

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CHAPTER 11 | Technology, Production, and Costs pizzas or 50 movies. These are the endpoints of his new budget constraint. Both his old and his new budget constraints pass through the consumption bundle at point A. This consumption bundle is no longer optimal, however, because with the new prices, it is possible for him to reach an indifference curve that is higher than I1. Draw in the new highest indifference curve he can reach, I2, and show the new optimal consumption bundle, point B. As the figure shows, because Dave can now reach a higher indifference curve, I2 at point B, he is better off than he was before the price change.

10A.11 a. Based on the initial prices and income, the optimal consumption bundle for Yolanda is illustrated by point A. If the price of oranges doubles, then the maximum number of oranges that Yolanda can purchase falls from 50 to 25. So, the new budget constraint rotates inward where it intersects the oranges axis at 25 and the apples axis at 50. b. The indifference curve I2 is tangent to the new budget constraint at point B reflecting an optimal consumption bundle for Yolanda of more apples and fewer oranges (compared to point A). c. Since the maximum number of oranges that Yolanda can now buy is 25, it is not possible for the new optimal consumption bundle to contain more than the 30 oranges that were part of combination A.

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10A.12 a. The student has correctly drawn the original budget constraint. b. The student has incorrectly drawn the new budget constraint. Because the price of burgers is unchanged, the budget constraint should have rotated outward, as in Figure 10A.5, with the maximum number of burgers that the consumer can purchase remaining unchanged at 20. c. The student has shown the quantity of gasoline purchased declining following a decline in price. This result indicates that gasoline must be a Giffen good⸻ but it isn’t.

CHAPTER 11 | Technology, Production, and Costs Brief Chapter Summary and Learning Objectives 11.1 Technology: An Economic Definition Define technology and give examples of technological change. ▪

A firm’s technology is the processes it uses to turn inputs into outputs.

11.2 The Short Run and the Long Run in Economics Distinguish between the economic short run and the economic long run. ▪

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In the long run, the firm is able to vary all of its inputs, adopt new technology, and change the size of its physical plant.

11.3 The Marginal Product of Labor and the Average Product of Labor Explain and illustrate the relationship between the marginal product of labor and the average product of labor. ▪

The marginal product of labor is the additional output a firm produces as a result of hiring one more worker.

▪

The average product of labor is the total output produced by the firm divided by the total number of workers.

11.4 The Relationship between Short-Run Production and Short-Run Cost Explain and illustrate the relationship between marginal cost and average total cost. ▪

Marginal cost is the change in a firm’s total cost from producing one more unit of a good.

▪

If marginal cost is below average total cost, average total cost falls; if marginal cost is above average total cost, average total cost rises.

11.5 Graphing Cost Curves Graph average total cost, average variable cost, average fixed cost, and marginal cost. ▪

The marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves are all U shaped, and the MC curve intersects ATC and AVC at their minimum points.

11.6 Costs in the Long Run Explain how firms use the long-run average cost curve in their planning. ▪

Many firms experience economies of scale, which means the firm’s long-run average costs fall as it increases the quantity of output it produces.

▪

Minimum efficient scale is the level of output at which all economies of scale have been exhausted.

Appendix: Using Isoquants and Isocost Lines to Understand Production and Cost Use Isoquants and isocost lines to understand production and cost.

Average fixed cost, Fixed cost divided by the quantity of output produced. Average product of labor, The total output produced by a firm divided by the quantity of workers. Average total cost, Total cost divided by the quantity of output produced.

Long-run average cost curve, A curve that shows the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed. Marginal cost, The change in a firm’s total cost from producing one more unit of a good or service.

Average variable cost, Variable cost divided by the quantity of output produced.

Marginal product of labor, The additional output a firm produces as a result of hiring one more worker.

Constant returns to scale, The situation in which a firm’s long-run average costs remain unchanged as it increases output.

Minimum efficient scale, The level of output at which all economies of scale are exhausted.

Diseconomies of scale, The situation in which a firm’s long-run average cost rises as the firm increases output.

Opportunity cost, The highest-valued alternative that must be given up to engage in an activity.

Economies of scale, The situation in which a firm’s long-run average cost falls as it increases the quantity of output it produces.

Production function, The relationship between the inputs employed by a firm and the maximum output the firm can produce with those inputs.

Explicit cost, A cost that involves spending money.

Short run, The period of time during which at least one of a firm’s inputs is fixed.

Fixed costs, Costs that remain constant as output changes.

Technological change, A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs.

Implicit cost, A nonmonetary opportunity cost. Law of diminishing returns, The principle that, at some point, adding more of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline. Long run, The period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant.

Technology, The processes a firm uses to turn inputs into outputs of goods and services. Total cost, The cost of all the inputs a firm uses in production. Variable costs, Costs that change as output changes.

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Key Terms—Appendix Expansion path A curve that shows a firm’s cost-minimizing combination of inputs for every level of output. Isocost line All the combinations of two inputs, such as capital and labor, that have the same total cost. Isoquant A curve that shows all the combinations of two inputs, such as capital and labor, that will produce the same level of output. Marginal rate of technical substitution (MRTS) The rate at which a firm is able to substitute one input for another while keeping the level of output constant.

Chapter Outline Fracking Lowers the Cost of Oil and Revolutionizes the World Market

The technique known as hydraulic fracturing—fracking—involves pumping water, sand, and chemicals into shale rock formations to extract oil and natural gas. By 2008, most firms were using fracking techniques when drilling new oil wells in the United States. During the Covid-19 pandemic that began in early 2020, worldwide oil demand fell as air travel declined and many companies asked employees to work from home. Despite this drop in demand, in 2021, U.S. energy firms were producing more than twice as much oil as they had in 2008, and the United States had passed Saudi Arabia and Russia to become the leading oil-producing country in the world. The increased supply of oil lowered prices, which helped consumers but put pressure on the government budgets of major oil-exporting countries. The costs of drilling for oil can be divided into fixed costs and variable costs. In deciding how much oil to pump from a well, companies look at the marginal cost of pumping one more barrel.

11.1

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

Technology refers to the processes a firm uses to turn inputs into outputs of goods and services. A firm’s technology depends on many factors, including the skills of its managers, the training of its workers, and the speed and efficiency of its machinery and equipment. Technological change refers to a positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs. Positive technological change allows a firm to produce more output using the same inputs or the same output using fewer inputs. Positive technological change can occur when a manager rearranges the layout of a store to improve efficiency or starts to use faster or more reliable machinery. A firm experiences negative technological change if, for example, it hires less-skilled workers or if a hurricane damages its facilities.

Teaching Tips Students can confuse technological change and invention. An invention or new information, such as the discovery of a mathematical formula, is not technological change. Technological change results from the application of new or old knowledge to a production process.

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Innovation and Technological Change Decades can pass before a new idea is developed to the point where it can be widely used. For example, the Wright brothers first achieved self-propelled flight at Kitty Hawk, North Carolina, in 1903. But their plane was very crude, and it wasn’t until the introduction of the DC-3 by Douglas Aircraft in 1936 that regularly scheduled intercity flights became common in the United States. Similarly, the development of the first digital electronic computer—the ENIAC—occurred in 1945. But the first IBM personal computer was not introduced until 1981. It wasn’t until the 1990s that widespread use of computers began to have a significant effect on the productivity of American business. Hershey Foods is the manufacturer of Hershey’s bars and Reese’s Peanut Butter Cups. In 1999, the company, installed a new software program designed by the German company SAP to coordinate almost all of the company’s operations. But it took Hershey many months to get the software to work properly. During the period when the software was not working well, Hershey failed to send out some shipments and other shipments contained less candy than what some buyers ordered. Software problems made it difficult for Hershey to keep track of what it shipped and to whom. The company lost $150 million worth of sales before the problem was corrected and the software began to work as intended. Sources: For DC-3 and ENIAC, David Mowery and Nathan Rosenberg, “Twentieth Century Technological Change,” in Stanley L. Engerman and Robert Gallman, eds., The Cambridge Economic History of the United States, Vol. III: The Twentieth Century (Cambridge: Cambridge University Press, 2000). For Hershey: Emily Nelson and Evan Ramstad, “Trick or Treat: Hershey’s Biggest Dud Has Turned Out to Be Its New Technology,” Wall Street Journal, October 29, 1999 and “Hershey Foods Warns 1999 Earnings Will Be Worse Than Initially Feared,” Dow Jones Business News, December 28, 1999.

a. Define technology and technological change. b. Was the Wright Brothers’ 1903 flight at Kitty Hawk an example of technological change? Was the development of the ENIAC computer an example of technological change? c. Explain why the widespread use of computers in the 1990s resulted in positive technological change. d. Did Hershey’s use of a new software program in 1999 result in positive or negative technological change?

Solving the Problem Step 1:

Review the chapter material. This problem is about technology and technological change, so you may want to review the section “Technology: An Economic Definition” in the textbook.

Step 2:

Answer part (a) by defining technology and technological change.

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A firm’s technology is the process it uses to turn inputs into outputs of goods and services. Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs. Step 3:

Answer part (b) by explaining whether the Wright Brothers’ 1903 flight at Kitty Hawk and the development of the ENIAC computer are examples of technological change. Neither the Wright Brothers’ 1903 flight at Kitty Hawk nor the development of ENIAC represents technological change because they had no effect on the ability of firms to produce output with a different quantity of inputs.

Step 4:

Answer part (c) by explaining why the widespread use of computers in the 1990s resulted in positive technological change. The widespread use of computers did lead to an improvement in productivity and, therefore, resulted in positive technological change. By using computers, many firms have been able to produce the same output of goods and services with fewer inputs or more output with the same quantity of inputs.

Step 5:

Answer part (d) by explaining whether Hershey’s use of a new software program in 1999 resulted in either positive or negative technological change. The initial use of the software produced negative technological change because Hershey’s output was less with the same quantity of inputs. After the “bugs” were eliminated from the software, it produced positive technological change for Hershey Foods.

Extra Apply the

Would You Please Be Quiet? Technological Change at Segment.com

Concept

Segment.com is a firm located in San Francisco that develops and sells enterprise software. This software allows companies to (1) gather data on customers; (2) track the data across computers, smartphones, and other devices; and (3) manage the companies’ social media presence. Segment’s office is located in what was once a warehouse. With 20,000 square feet of space, 30-foot ceilings, and an industrial appearance, the space has a very cool look that has helped the firm attract millennial software engineers. And like many tech firms that occupy similar facilities, Segment uses an open-office approach, in which, rather than having individual offices, most of its roughly 100 employees work from desks that are not divided by walls from the other desks in the workspace.

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But CEO and co-founder Peter Reinhardt discovered that the office layout was causing a problem. “Focus” is one of Segment’s four core values—naturally enough for a firm that needs its software engineers to devote concentrated attention to often difficult programming issues. But many engineers complained that they had trouble focusing because they were distracted by noise. Reinhardt considered asking employees to talk less, “But demanding ‘be quiet!’ is horrible in a collaborative work environment.” He was also puzzled as to why clients visiting the office sometimes remarked on how quiet it was—the opposite of what his engineers were telling him.

Reinhardt asked the engineers to design an app to record decibel levels and install the app on iPads around the office. Data from the app showed that because of the acoustics of the building, the level of noise differed significantly in different areas. Where the engineers were working turned out to be the loudest area, while the entrance area where clients were greeted was the quietest. Reinhardt decided to rearrange where his employees worked: The engineers and product development people were moved to the quietest area, while people in sales and marketing, who often talked on the phone, were moved to the loudest area.

According to Reinhardt, the result of the rearranged work areas was an increase in output equivalent to hiring 10 to 15 additional workers. Put another way, Segment.com was able to produce more output with the same number of workers. The firm had experienced positive technological change, not by installing faster computers or other hardware but by reorganizing its workplace.

Sources: Peter Reinhardt, “Improving Our Focus by Measuring Sound Levels,” segment.com, October 19, 2016; and Rachel Feintzeig, “How One Firm Lowered Its Open-Office Noise,” Wall Street Journal, November 15, 2016.

Extra Apply the Improving Inventory Control at Wal-Mart Concept Inventories are goods that have been produced but not yet sold. For a retailer such as Wal-Mart, inventories at any point in time include the goods on store shelves as well as goods in warehouses. Inventories are an input into Wal-Mart’s output of goods sold to consumers. Having money tied up in holding inventories is costly, so firms have an incentive to hold as few inventories as possible and to turn over their inventories as rapidly as possible by ensuring that goods do not remain on the shelves long.

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Holding too few inventories, however, occasionally results in stockouts—that is, sales being lost because the goods consumers want to buy are not on shelves. Improvements in inventory control meet the economic definition of positive technological change because they allow firms to produce the same output with fewer inputs. Many firms use just-in-time inventory systems in which firms accept shipments from suppliers as close as possible to the time the goods will be needed. The just-in-time system was pioneered by Toyota, which used it to reduce the inventories of parts in its automobile assembly plants. Wal-Mart has been a pioneer in using similar inventory control systems in its stores. Wal-Mart actively manages its supply chain, which stretches from the manufacturers of the goods it sells to its retail stores. Entrepreneur Sam Walton, the company’s founder, built a series of distribution centers across the country to supply goods to Wal-Mart stores. As goods are sold in the stores, the point-of-sale information is sent electronically to the firm’s distribution centers to help managers determine what products will be shipped to each store. Depending on a store’s location relative to a distribution center, managers can use Wal-Mart’s trucks to ship goods overnight. This distribution system allows Wal-Mart to minimize its inventory holdings without running the risk of many stockouts occurring. Because Wal-Mart sells 15 percent to 25 percent of all the toothpaste, disposable diapers, dog food, and many other products sold in the United States, it has been able to involve many manufacturers in its supply chain. For example, Procter & Gamble, one of the world’s largest manufacturers of products such as toothpaste, laundry detergent, and toilet paper, receives Wal-Mart’s point-of-sale and inventory information electronically. Procter & Gamble uses that information to help determine its production schedules and the quantities it ships to Wal-Mart’s distribution centers. Technological change helped Wal-Mart’s become one of the largest firms in the world, but to maintain its position Wal-Mart needs to improve its performance in online retailing. Amazon has taken a substantial lead over Wal-Mart in online retailing in part because of Amazon’s network of warehouses, some of which use robots to retrieve goods from shelves and box them for shipment. In response, WalMart began shipping some goods to online buyers from its retail stores rather than from dedicated warehouses. Because two-thirds of the U.S. population lives within five miles of a Wal-Mart store, the company was able to reduce shipping costs by filling online orders from store inventories. Note that when the Covid-19 pandemic disrupted many firms’ supply chains, some firms began to move towards holding larger inventories of goods so that they could more easily meet consumer demand from the goods they already had on hand. Source: Shelly Banjo, “Wal-Mart’s E-Stumble with Amazon,” Wall Street Journal, June 19, 2013.

Question The 7-Eleven chain of convenience stores in Japan reorganized the timing of truck deliveries of food to their stores, as well as the routes the trucks traveled. This reorganization led to a sharp reduction in the Copyright © 2023 Pearson Education, Inc.

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number of trucks the company had to use, while increasing the amount of fresh food on store shelves. Someone discussing 7-Eleven’s new system argues: “This is not an example of technological change because it did not require the use of new machinery or equipment.” Briefly explain whether you agree with this argument. Answer You should disagree with this argument because it is incorrect. The firms can now produce more output (greater sales) with fewer inputs (fewer trucks). Therefore, this is indeed an example of technological change.

11.2

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

The short run is the period of time during which at least one of a firm’s inputs is fixed. The long run is the period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant. The actual length of calendar time for the short run and the long run will vary from firm to firm.

A. The Difference between Fixed Costs and Variable Costs Total cost is the cost of all the inputs a firm uses in production. Variable costs are costs that change as output changes. Fixed costs are costs that remain constant as output changes. Since all of a firm’s shortrun costs are either fixed or variable costs, we can write: Total cost (TC) = Fixed cost (FC) + Variable cost (VC).

B. Implicit Costs versus Explicit Costs Economists always measure cost as opportunity cost, which is the highest-valued alternative that must be given up to engage in an activity. Costs may be explicit or implicit. An explicit cost is a cost that involves spending money. An implicit cost is a nonmonetary opportunity cost. Explicit costs are sometimes called accounting costs. Economic costs include both accounting costs and implicit costs.

C. The Production Function A production function is the relationship between the inputs employed by a firm and the maximum output the firm can produce with those inputs. The production function represents the firm’s technology.

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Average total cost (ATC) equals total cost divided by the quantity of output produced. In a graph, the ATC curve is U shaped.

Teaching Tips Distinguishing a short-run and a long-run production function is easier for students if you give them examples that illustrate the difference. Consider a local theater, a stadium, or an auditorium. During a typical year, concerts, plays, and sporting events are held at these venues, some of which may sell out while others do not. The size of the facility is a fixed input because variations in crowd size can be accommodated by changes in the use of variable inputs, such as ticket takers, ushers, parking attendants, and food at refreshment stands. The owners of these venues will not increase or decrease the capacity of the facility unless they expect a permanent change in average expected attendance. This could be the result of a change in the population served by the facility or the acquisition or loss of a permanent tenant; for example, a sports franchise or a philharmonic orchestra.

Extra Solved Problem 11.2 Steel Manufacturers Respond to the Recession of 2007–2009 Manufacturers of stainless steel products experienced a sharp drop in revenue during the recession of 2007–2009. Demand for steel typically falls sharply during economic downturns as firms revise their investment plans and consumers reduce their spending on automobiles and other products containing steel. But the response of some steel firms to the 2007–2009 recession was different from past recessions: They raised their prices. Dennis Oates, CEO of Universal Stainless and Alloy Products, Inc. claimed: “We are raising our prices because of increased costs of operating our mills at lower levels.” The costs of some equipment can’t be reduced when demand falls. For example, a Universal plant uses a “preheater” to shoot air heated to 2,300 degrees Fahrenheit to hold melted steel in a large ladle. Shutting the preheater down would cause bricks inside the ladle to disintegrate, so the firm keeps it running even when steel isn’t being made. The firm also keeps a “baghouse”—a device that vacuums pollutants—running continuously because turning its motors on and off would damage them. Though some of Universal’s customers balked at paying higher prices, steel service centers—middlemen who sell steel to manufacturers—believed that they could pass the price increases on to their own customers. The steel service centers had fewer opportunities to buy from Universal’s foreign competitors. Tight credit conditions and uncertainty made foreign orders difficult. John E. Lichtenstein, managing director of Accenture’s Metal Industry Group, explained: “You have no idea what the market is going to be 50 to 90 days from now. The last thing you want to do is pay for steel today and have the margin drop 20% to 30% once you get it.” Source: Robert Guy Matthews, “Fixed Costs Chafe at Steel Mills,” Wall Street Journal, June 10, 2009.

Answer the following questions, keeping in mind the response to the decline in demand for steel sold by Universal Stainless and Alloy Products, Inc. during the 2007-2009 recession. Copyright © 2023 Pearson Education, Inc.

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CHAPTER 12 | Firms in Perfectly Competitive Markets a. Is the time period referred to in this example a short run or a long run period? b. The example mentions that Universal operated its preheater even when the firm wasn’t making steel. Under what circumstances would Universal stop be operating its preheater?

Solving the Problem Step 1:

Review the chapter material. This problem is about the economic short run and the long run, so you may want to review the section “The Short Run and the Long Run in Economics” in the textbook.

Step 2:

Answer part (a) by explaining whether the time period referred to is a short run or a long run period. This example is a short-run period. In the short run, at least one of a firm’s inputs is fixed. Because Universal operates its preheater and baghouse even when it’s not making steel, both are fixed inputs.

Step 3:

Answer part (b) by explaining under what circumstances Universal would stop operating its preheater. Universal would stop operating its preheater if the firm’s executives decided it could no longer sell its product and the firm should go out of business. Universal could also decide to replace the preheater if it no longer operated efficiently. The company could decide to invest in additional preheaters, baghouses, and other inputs that are fixed in the short run if the demand for the firm’s products increased. The firm would then be operating in the long run, a period of time in which all inputs can be varied, the size of a firm’s physical plant can be changed, and new technology can be adopted.

The Marginal Product of Labor and the Average Product of Labor 11.3

Learning Objective: Explain and illustrate the relationship between the marginal product of labor and the average product of labor.

The marginal product of labor is the additional output a firm produces as a result of hiring one more worker. Labor is often considered a variable factor of production. Capital—buildings and equipment—is often considered a fixed factor in the short run. As a firm hires its first few workers, increases in marginal product result from the implementation of a division of labor and specialization.

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The law of diminishing returns is the principle that, at some point, adding more of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline. This result occurs as the gains from specialization lessen as more of the variable unit is used. Although no firm would purposely do so, the marginal product of the variable factor could eventually become negative.

B. Graphing Production The data in Table 11.3 and graphs in Figure 11.2 illustrate a typical short-run production function and diminishing returns to labor.

C. The Relationship between Marginal Product and Average Product The average product of labor is the total output produced by a firm divided by the quantity of workers. The average product of labor is the average of the marginal products of labor. The marginal product of labor equals the average product of labor for the quantity of workers for which the average product of labor is at its maximum value.

D. An Example of Marginal and Average Values: College Grades The relationship between the marginal product of labor and the average product of labor is the same as the relationship between the marginal and average values of any variable. For example, your grade point average (GPA) in one semester—the marginal GPA—affects your cumulative GPA—or average GPA. If your marginal GPA is greater (less) than your average GPA, your average GPA rises (falls). See Figure 11.3 for an illustration.

Extra Solved Problem 11.3 A 0.750 Marginal Batting Performance Raises Ted Williams’ Batting Average to 0.406 in 1941 Fans of major league baseball who can’t explain the terms marginal product and average product likely can explain batting averages and how they are computed. In fact, the formula for the average product of labor is very similar to the formula for batting average. And, the behavior of a batting average from game to game is determined by a player’s “marginal batting performance” (MBP) in much the same way that the behavior of the marginal product of labor influences the average product of labor. We can demonstrate MBP by using the experience of Boston Red Sox outfielder Ted Williams near the end of Copyright © 2023 Pearson Education, Inc.

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the 1941 season, when Williams became the last major league player with a batting average over .400 for an entire season. The following is Williams’ own account of this feat: It came down to the last day of the season…I was down to .39955…I’d slumped…from a high of .436 in June… .402 in late August, then up to .413 in September. In the last ten days of the season, my average dropped. . . Now it was barely .400. In a doubleheader played on the last day of the regular season, Williams had 6 hits in 8 at bats. His batting average for the year was computed by dividing his total number of hits (185) by the total number of his at bats (456), which equals 0.406. The average product of labor is computed in a similar manner: total output produced by a firm divided by the total quantity of workers. Williams’s “marginal batting performance,” or MBP, can be computed by dividing the change in the number of his hits (6, on the last day in 1941) by the change in the number of his at bats (8), or 0.750. The marginal product of labor equals the change in output produced by a firm divided by the change in the quantity of workers. Source: Ted Williams with John Underwood. My Turn at Bat: The Story of My Life. 2nd edition (New York: Simon & Schuster, 1988).

a. What was the effect of Williams’s MBP on his batting average (BA) at the end of the 1941 season? b. Compare the relationship between MBP and BA with the relationship between the marginal and average product of labor.

Solving the Problem Step 1:

Review the chapter material. This is an example of the relationship between marginal and average values, so you may want to review the section “An Example of Marginal and Average Values: College Grades.”

Step 2:

Answer part (a) by explaining the effect of Williams’s MBP on his batting average (BA) at the end of the 1941 season. (1) Williams’s BA peaked at 0.436 in June and fell to 0.402 in late August. During this period, Williams’s MBP was less than his initial BA of 0.436. (2) Williams’s BA rose from 0.402 to 0.413 in September. His MBP was greater than his initial BA of 0.402. (3) Over the last ten days of the season, Williams’s BA fell from 0.413 to 0.39955. His MBP was less than his initial BA. (4) On the last day of the season, Williams’s BA rose from 0.400 to 0.406. His MBP was greater than his BA before the doubleheader.

Step 3:

Answer part (b) by comparing the relationship between MBP and BA with the relationship between the marginal and average product of labor.

CHAPTER 12 | Firms in Perfectly Competitive Markets

When the marginal product of labor and the MBP are below their respective averages, the averages fall. When the marginal product of labor and the MBP are above their respective averages, the averages rise. When the marginal product of labor and the MBP equal their respective averages, the averages remain the same.

The Relationship between Short-Run Production and Short-Run Cost 11.4

Learning Objective: Explain and illustrate the relationship between marginal cost and average total cost.

A. Marginal Cost Marginal cost is the change in a firm’s total cost from producing one more unit of a good or service. Marginal cost (MC) can be expressed mathematically as: MC 

TC , Q

where Δ represents “change in,” TC is total cost, and Q is output.

B. Why Are the Marginal and Average Cost Curves U Shaped? When the marginal product of labor is rising, the marginal cost of production will be falling. When the marginal product of labor is falling, the marginal cost of production will be rising. The relationship between marginal cost and the average total cost is another example of the relationship between marginal and average values. As long as marginal cost is below average total cost, average total cost will fall. When marginal cost is above average total cost, average total cost will rise. Marginal cost will equal average total cost when average total cost is at its lowest point. The average total cost curve has a U shape because the marginal cost curve has a U shape.

Graphing Cost Curves 11.5

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

Several related average cost measures can be described mathematically:

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Average total cost = ATC 

TC . Q

Average fixed cost (AFC) equals fixed cost divided by the quantity of output produced: AFC 

FC . Q

Average variable cost (AVC) equals variable cost divided by the quantity of output produced: AVC 

VC . Q

The MC, ATC, and AVC curves are all U shaped, and the MC curve intersects the AVC and ATC curves at their minimum points. When MC is above AVC or ATC, it causes them to increase. When MC equals AVC or ATC, AVC and ATC must be at their minimum points. AFC gets smaller and smaller as output increases, and the difference between ATC and AVC (this is equal to AFC) gets smaller.

Teaching Tips When MC, AVC, ATC, and AFC are drawn in the same graph, students can have difficulty distinguishing them. Drawing each of the curves one at a time, starting with MC, in class, will improve your students’ understanding of the interrelationships among the curves. There are a number of definitions of costs in this chapter. Students will be using these definitions will in later chapters, so encourage them to look at Table 11.4, “A Summary of Definitions of Cost.”

Extra Solved Problem 11.5 Bill Johnson’s Copy Store Figure 11.5 in the textbook summarizes the behavior of output and costs for Jill Johnson’s Restaurant in the short run. Draw and label the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC) curves for Bill’s Copy Store, which is owned by Bill Johnson. Bill’s Copy Store makes photocopies of his customers’ documents. Diminishing returns to Bill’s variable input (labor) begin at an output of 1,000 copies. At this output, marginal cost equals $0.10. In solving this problem, use your knowledge of the shapes of, and relationships among, short-run cost curves and make appropriate assumptions where necessary.

Solving the Problem Step 1:

Review the chapter material.

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This problem is about graphing cost curves, so you may want to review the section “Graphing Cost Curve” in the textbook. Step 2:

Draw the MC curve for Bill’s Copy Store. Start drawing MC at the point where the two dotted lines meet. Draw the right half of a U, then go back to the starting point and draw the left half of the U. Label the MC curve.

Step 3:

Draw the AVC curve for Bill’s Copy Store. Start drawing the AVC curve by selecting a point on the MC curve you drew. Draw the right half of another U from this point, then go back to the starting point and draw the left half of the U representing AVC. Note that each half of this U is drawn upward, to the right and to the left, so that the lowest point of the U is on the MC curve. Label the AVC curve.

Step 4:

Draw the ATC curve for Bill’s Copy Store.

xviii

CHAPTER 12 | Firms in Perfectly Competitive Markets Repeat the procedure from Step 3, but be careful to (a) select a starting point on MC that is above the starting point for AVC; (b) be sure that the right half of the U becomes closer to AVC as this half of ATC is drawn to the right; and (c) be sure that the left half of the U becomes farther away from AVC as this half of ATC is drawn to the left. Label this curve ATC.

Step 5:

Draw the AFC curve for Bill’s Copy Store. Begin the AFC curve by selecting a cost well above 0.10 and near, but not touching, the vertical axis. This curve will slope downward and will approach, but not touch, the quantity axis far to the right of 1,000. Label this curve AFC. Note that the difference between ATC and AVC will equal the height of AFC at the same quantity.

11.6 Costs in the Long Run

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

In the long run, all costs are variable; there are no fixed costs in the long run. Total cost equals variable cost and average total cost equals average variable cost. Managers of successful firms decide simultaneously how they can run their current stores or offices in the short run, and whether in the long run it would be more profitable if their firms became larger or smaller.

A. Economies of Scale A long-run average cost curve is a curve that shows the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed. Many firms experience economies of scale, the situation in which a firm’s long-run average cost fall as it increases the quantity of output it produces. Managers can use long-run average cost curves for planning because they show the effect on cost of expanding output by building a larger or smaller factory or store.

B. Long-Run Average Cost Curves for Automobile Factories Firms may experience economies of scale for several reasons. The firm’s technology may make it possible to increase production with a smaller proportional increase in at least one input. Workers and managers can become more specialized, enabling them to become more productive. Firms may be able to purchase inputs at lower costs than their smaller competitors. Finally, as a firm expands, it may be able to borrow money at a lower interest rate. But economies of scale do not continue forever. The long-run average cost curve in most industries has a flat segment. Constant returns to scale is the situation in which a firm’s long-run average costs remain unchanged as it increases output. The level of output at which all economies of scale are exhausted is known as minimum efficient scale. Diseconomies of scale refer to the situation in which a firm’s long-run average cost rises as the firm increases output. Diseconomies of scale may result when managers have difficulty coordinating the operation of a firm as it grows in scale.

Extra Solved Problem 11.6 Using Long-Run Average Cost Curves to Understand Business Strategy

Pon Holdings is a maker of Santa Cruz bicycles. In 2017, the company proposed buying Accell Group, maker of Raleigh bicycles. At the time of the proposed deal, Pon was selling about 800,000 bicycles per year, and Accell was selling about 1.5 million. (In the end, the deal did not take place.)

CHAPTER 12 | Firms in Perfectly Competitive Markets a. What must have been true of Pon Holdings’s position on its long-run average cost curve for the company to have expected to benefit from this deal? b. Use a long-run average cost curve for Pon to illustrate the effect the company expected from purchasing Accell. Can we determine whether Pon would have reached minimum efficient scale as a result of this deal? Briefly explain.

Solving the Problem

Step 1:

Review the chapter material. This problem is about the long-run average cost curve, so you may want to review the material in the section “Costs in the Long Run.”

Step 2:

Answer part (a) by explaining where Pon must have been on its long-run average cost curve at the time it proposed purchasing Accell Group. Pon expected that its increase in scale from purchasing Accell would have reduced its average cost. Therefore, Pon must have been producing a quantity that is below minimum effect scale.

Step 3:

Answer part (b) by drawing a long-run average cost graph for Pon and explaining whether it would be possible to determine if the firm would have reached minimum efficient scale as a result of the deal. For Pon’s strategy to be successful, it must have been below minimum efficient scale. In the following graph, we assume that Pon was currently producing at point A on its long-average cost curve, where its bicycle output equals 800,000 and average cost equals Average cost1. By purchasing Accell, Pon would have expanded production to point B, where it would be producing 2,300,000. Pons’s average total cost would have been reduced to Average cost2.

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As drawn, the graph shows that Pon is still below minimum efficient scale at point B. It is possible that the purchase of Accell would have pushed Pon to minimum efficient scale at point C or beyond minimum efficient scale at point D. In both cases, Pon would have reduced its average cost to Average cost3. We don’t have enough information to know with certainty whether Pon expected the deal to result in its being at point B, point C, or point D. All we can say is that Pon expected its average cost to fall, and the company expected to move down its long-run average cost curve ⸻ but it did not expect to become so large that it would have experienced diseconomies of scale.

Source: Ben Dummett, “Dutch Deal Would Unite Biking Brands,” Wall Street Journal, April 11, 2017.

Teaching Tips Long-run average cost are drawn as smooth U-shaped curves. Warn your students not to confuse these curves with short-run average total cost curves. The reasons for the U shape of the short-run and longrun curves are different. The smooth LRAC is similar to the optical illusion of a motion picture. A movie is essentially a series of still photographs that when projected sequentially give the viewer the illusion of live, continuous motion. Similarly, the LRAC is made up of a series of short-run ATC curves, each of which contributes a small portion (one point) to the LRAC.

Extra Economics in Your Life & Career: When Is the Best Time to Quit? Question: Many entrepreneurs are stubborn by nature. The late Dave Thomas, founder of Wendy’s Old Fashioned Hamburgers, often recounted how many of his friends and advisors recommended that he not start Wendy’s because the United States already had plenty of fast-food restaurants. Many new Copyright © 2023 Pearson Education, Inc.

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businesses fail, and knowing when to get out of a business can be as important as when to keep going. Let’s say that you begin a software design business after graduating from college. Accounting profit in your first year is $25,000. Should you continue in the business or should you quit after one year? Answer: A good but inadequate answer to many economic questions is “It depends.” An accounting profit of $25,000 will likely be less than the opportunity cost of your time and any funds you would use to start your business. But it takes time to establish a business, learn how to market your product, and compete effectively with more established firms. There may be other special reasons for your low firstyear accounting profit. Weak marketing or an anemic economy are two examples. Economists typically assume that entrepreneurs want to maximize their profits, but many entrepreneurs will tell you that they have different motives, such as to control their own destiny. There are sound reasons for you to continue beyond the first year, but eventually you must be able to earn enough to equal the opportunity cost of your time and money to justify staying in business.

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Appendix Using Isoquants and Isocost Lines to Understand Production and Cost Learning Objective: Use isoquants and isocost lines to understand production and cost.

Isoquants Firms usually have a choice about how they will produce their output. Firms search for the costminimizing combination of inputs that will allow them to produce a given level of output. The costminimizing combination of inputs depends on technology and input prices.

A. An Isoquant Graph A graph is used to indicate the different levels of output produced using different combinations of two inputs: labor (measured along the horizontal axis) and capital (measured along the vertical axis). The curves in the graph are called isoquants. An isoquant is a curve that shows all the combinations of two inputs, such as capital and labor, that will produce the same level of output. The higher an isoquant is— the further to the northeast on the graph—the more output the firm produces.

B. The Slope of an Isoquant The marginal rate of technical substitution (MRTS) is the rate at which a firm is able to substitute one input for another while keeping the level of output constant. The slope of an isoquant becomes less steep as we move downward along it. Therefore, isoquants are bowed in, or convex. This shape is a consequence of diminishing returns.

Isocost Lines Any firm wants to produce a given level of output at the lowest possible cost. We can show the relationship between the quantity of inputs used and the firm’s total cost by using an isocost line, which shows all the combinations of two inputs, such as capital and labor, that have the same total cost.

A. Graphing the Isocost Line The isocost line intersects the vertical axis at the maximum amount of capital a firm can purchase for a given amount of money. The same line intersects the horizontal axis at the maximum number of workers that can be hired for the cost. Any combination of inputs along the line can be purchased for the same total cost.

B. The Slope and Position of the Isocost Line

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The slope of the isocost line is constant and equals the change in the quantity of capital divided by the change in the quantity of labor. The slope is also equal to the ratio of the price of the input on the horizontal axis divided by the price of the input on the vertical axis, multiplied by 1. The position of the isocost line depends on the level of total cost. Higher levels of total cost shift the isocost line outward, and lower levels of total cost shift the isocost line inward.

Choosing the Cost-Minimizing Combination of Capital and Labor The lowest cost combination of inputs that can be used to produce a given level of output is determined where an isocost line is tangent to an isoquant. At this point, the slopes of the isocost line and the isoquant are equal.

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A. Different Input Price Ratios Lead to Different Input Choices If the production technology changes, the isoquants will be affected and the choice of inputs may change. If input prices change, the choice of inputs may also change.

B. Another Look at Cost Minimization Because at the point of cost minimization the isoquant and isocost line are tangent, the MRTS is equal to the price of labor (the wage rate) divided by the price of capital (the rental price). Moving along an isoquant, the quantity of inputs used changes, but output stays the same. The marginal product of capital (MPK) equals the change in output from using an additional unit of capital. The marginal product of labor (MPL) equals the change in output from using an additional unit of labor. Moving down an isoquant results in a loss of output equal to: Change in the quantity of capital  MPK ,

but a gain in output equals to: Change in the quantity of labor  MPL .

So, the change in output from moving down an isoquant is equal to:  Change in the quantity of capital  MPK  Change in the quantity of labor  MPL . Rewriting this equation as: MPL Change in the quantity of capital .  Change in the quantity of labor MPK

Because

Change in the quantity of capital Change in the quantity of labor

is the slope of the isoquant, or MRTS, we can write: MPL Change in the quantity of capital .  MRTS  Change in the quantity of labor MPK

The slope of the isocost line equals the wage rate (w) divided by the rental price of capital (r). At the point of cost minimization, the slope of the isoquant is equal to the slope of the isocost line. Therefore: MPL w  . MPK r

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We can rewrite this to show that at the point of cost minimization:

MPL MPK  . w r The last equation shows that to minimize cost, a firm should hire inputs up to the point where the last dollar spent on each input results in the same increase in output.

CHAPTER 12 | Firms in Perfectly Competitive Markets xxvii

The Expansion Path The point where each isoquant is tangent to an isocost line determines the cost-minimizing combination of capital and labor for producing that level of output. An expansion path is a curve that shows a firm’s cost-minimizing combination of inputs for every level of output. The expansion path represents the least-cost combination of inputs to produce a given level of output in the long run when the firm is able to vary the levels of all of its inputs. The firm’s minimum total costs of production are lower in the long run than in the short run.

Extra Apply the The Changing Input Mix in Walt Disney Film Animation Concept The inputs used to make feature-length animated films have changed dramatically over the last several decades. Prior to the early 1990s, the Walt Disney Company dominated the market for animated films. Disney’s films were produced using hundreds of animators drawing scenes by hand. Each film would contain as many as 170,000 individual drawings. Then, two developments dramatically affected how animated films are produced. First, in 1994, Disney had a huge hit with The Lion King, which cost only $50 million to produce but earned the company more than $1 billion in profit. As a result of this success, Disney and other film studios began to produce more animated films, increasing the demand for animators and more than doubling their salaries. The second development came in 1995, when Pixar Animation Studios released the film Toy Story. This was the first successful feature-length film produced using computers, with no hand-drawn animation. In the following years, technological advance continued to reduce the cost of the computers and software necessary to produce an animated film.

As a result of these two developments, the price of capital—computers and software—fell relative to the price of labor—animators. As the following figure shows, the change in the price of computers relative to animators changed the slope of the isocost line and resulted in film studios producing animated films using many more computers and many fewer animators than in the early 1990s. In 2006, Disney bought Pixar, and within a few years, all the major film studios had converted to computer animation, now referred to as CGI animation.

Sources: “Magic Restored,” Economist, April 17, 2008; and Laura M. Holson, “Disney Moves Away from Hand-Drawn Animation,” New York Times, September 18, 2005.

xxviii CHAPTER 12 | Firms in Perfectly Competitive Markets Question During the eighteenth century, the American colonies had much more land per farmer than did Europe. As a result, the price of labor in the colonies was much higher relative to the price of land than it was in Europe. Assume that Europe and the colonies had access to the same technology for producing food. Use an isoquant–isocost line graph to illustrate why the combination of land and labor used in producing food in the colonies would have been different from the combination used to produce food in Europe.

Answer

In the American colonies, with land cheap and labor expensive, the cost-minimizing input combination was point A. In Europe, where land was expensive and labor was cheap, the cost-minimizing input combination was point B, with more labor and less land.

Solutions to End-of-Chapter Exercises 11.1

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

Review Questions

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xxix

1.1

Technology is the process a firm uses to turn inputs into outputs of goods and services. Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs.

1.2

Technological change could be negative. Two examples are when a natural disaster damages factories and stores or government restrictions during a pandemic causes them to be operated below capacity, as happened as happened during the Covid-19 pandemic, or when a firm hires less-experienced workers. In both these examples, the firm would produce a lower level of output with the same quantity of inputs.

Problems and Applications 1.3

Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs. The use of iSteer by oil and gas producer EOG is an example of positive technological change because iSteer enables the firm to recover more oil and gas with the same inputs than was possible with previous technology.

1.4

Choices (b), (c), and (d) are examples of positive technological change because they enable a firm to produce more output with the same quantity of inputs. Choice (a) describes a change in production costs that is the result of a change in the price of an input, not a change in technology. Choice (e) is not an example of technological change because the same quantity of inputs is used to produce the same quantity of output.

1.5

a. Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs. If Segment improved employee productivity by moving from text messaging to email communications, that move is an example of a positive technological change. b. An increase in the salaries of software engineers would not be an example of negative technological change. The increase in salaries would not affect Segment’s ability to produce a given amount of output with a given quantity of inputs.

1.6

If the United Airlines app allows flight attendants to access information about customers more efficiently and makes them more productive in helping passengers—perhaps by knowing whether a passenger needs a special diet or help getting on and off the plane—the app results in a positive technological change. But if customers dislike the app enough that they switch to another airline or get into lengthy arguments with flight attendants, the app will turn out to have been a negative technological change.

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11.2

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

Review Questions 2.1

In the short run, at least one of the firm’s inputs is fixed, while in the long run, the firm can vary all of its inputs, adopt new technology, and change the size of its physical plant. The amount of time that it takes a firm to move from the short run to the long run varies from firm to firm.

2.2

Fixed costs are costs that remain constant as output changes. An example of a fixed cost is the lease payment for a factory or retail store. Variable costs are costs that change as output changes. An example of a variable cost is the cost of raw materials such as pizza dough purchased by a pizza restaurant.

2.3

Implicit costs are nonmonetary opportunity costs, such as the wages the owner of a firm could have earned if he or she worked for someone else. Explicit costs involve spending money.

2.4

The production function shows the relationship between the inputs employed by a firm and the maximum output the firm can produce with those inputs. The short-run production function holds constant fixed inputs, such as the number of ovens in Jill’s pizza restaurant in the example in the chapter.

Problems and Applications 2.5

A fixed cost is a cost that remains constant as output changes. A variable cost is a cost that changes as output changes. The new fees UPS charged because of the surge in online shopping are variable costs for a firm that ships packages because the firm would pay either a $3 or a $4 fee for each package shipped by ground or air, respectively.

2.6

Changing the size of a firm’s physical plant, as with Sears changing the size of its stores, takes place in the economic long run.

2.7

No, we cannot conclude that Apple is making a profit of $609 on each iPhone 11 Pro Max. The article states that each phone has a cost of materials equal to $490 Not included in the cost of materials are other costs Apple incurred, including: (1) labor costs; (2) research and development costs; (3) advertising; and (3) a return on the investment Apple’s owners made in the firm. To calculate economic profit, all implicit and explicit costs relating to the production of the iPhone must be subtracted from the total revenue earned from selling the phones.

2.8

a. A firm will have no money coming in if its sales are zero. Therefore, the phrase “the amount of money that will go out even if none at all comes in…” describes the firm’s fixed cost

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because the firm incurs fixed cost even when it is producing and selling a quantity equal to zero. b. Fixed costs can include rent for a store or warehouse, payments for online advertising, or a payment to the city for a permit to operate the business. 2.9

Choices (a), (d), and (e) are fixed costs because they do not change as the quantity of pizzas produced changes. Choices (b) and (c) are variable costs because they increase as the quantity of pizzas produced increases. The time period under consideration is important. In the long run, all of these costs are variable.

2.10

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

2.11

2.12

Quantity of Workers

Quantity of Cars per Month

Fixed Cost

Variable Cost

Total Cost

Average Total Cost

$6,000

—

6,000

$4,000

10,000

$500

6,000

8,000

14,000

467

6,000

12,000

18,000

450

6,000

16,000

22,000

440

6,000

20,000

26,000

473

Jill’s reasoning is faulty. If she could rent out her current building for $4,000 per month, then she would incur an opportunity cost of that amount by using the building herself. Therefore, by moving to the suburbs, Jill’s costs would actually drop by $1,000 per month, which is the difference between the implicit rent of $4,000 she is paying now, which she forgoes by not renting the building, and the cash rent of $3,000 she would pay if she moved.

xxxii CHAPTER 12 | Firms in Perfectly Competitive Markets 2.13

The report included DuPont chemical company’s expected earnings as a loss because the return on the investment represents the opportunity cost of the funds the company had invested. In this case, the expected earnings were an implicit cost that DuPont subtracted from revenue when calculating its economic profit or loss.

The Marginal Product of Labor and the Average Product of Labor 11.3

Learning Objective: Explain and illustrate the relationship between the marginal product of labor and the average product of labor.

Review Questions 3.1

Marginal product normally increases at first due to specialization and division of labor, but it eventually decreases because of the law of diminishing returns. The amount of capital per worker declines as more labor is hired to work with a fixed amount of capital. Therefore, the marginal product of labor falls. When the marginal product of labor is greater than the average product of labor, the average product of labor increases. When the marginal product of labor is less than the average product of labor, the average product of labor decreases. The marginal product of labor is equal to the average product of labor when the average product of labor is at its maximum value. 3.2

The law of diminishing returns is the principle that, at some point, adding more of a variable input⸻ such as labor⸻ to the same amount of a fixed input⸻ such as capital⸻ will cause the marginal Copyright © 2019 Pearson Education, Inc.

CHAPTER 12 | Firms in Perfectly Competitive Markets xxxiii product of the variable input to decline. This principle doesn’t apply in the long run because in the long run none of the inputs is fixed; all inputs can vary.

Problems and Applications 3.3

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

3.4 Quantity of Workers

Total Output

Marginal Product of Labor

Average Product of Labor

—

400

900

500

450

1,500

600

500

1,900

400

475

2,200

300

440

2,400

200

400

2,300

–100

329

xxxiv CHAPTER 12 | Firms in Perfectly Competitive Markets 3.5

3.6

The student’s analysis is incorrect. The data in Table 11.3 represent the effects of specialization and division of labor and the law of diminishing returns at Jill’s pizza restaurant, rather than the varying quality of the workers. We assume that the quality of the workers remains the same as Jill hires more workers.

3.7

Gains from specialization are not limited to the production of physical goods. In retail stores, for example, there is a division of labor among workers who stock shelves, help customers in the aisles, and operate cash registers.

3.8

As long as Sally’s GPA for a semester is below her cumulative GPA, her cumulative GPA will fall. The current semester’s GPA is her marginal GPA, while her cumulative GPA is her average GPA. Even if her marginal GPA goes up, her average GPA will go down if her marginal GPA is below her average GPA at the beginning of the semester.

3.9

a. AP = Q/L = 24/4 = 6 pizzas per worker

CHAPTER 12 | Firms in Perfectly Competitive Markets xxxv b. MP = ΔQ/ΔL = (28 − 24)/(5 − 4) = 4/1 = 4 pizzas c. If we add the marginal product of the second worker (6 pizzas) to the number of pizzas produced when 1 worker is hired (5 pizzas), then the total number of pizzas produced when 2 workers are hired is 6 pizzas + 5 pizzas = 11 pizzas. d. The law of diminishing returns sets in when the marginal product of labor first starts to fall. In this case, it sets in with the fourth worker hired, where marginal product falls to 5.

The Relationship between Short-Run Production and Short-Run Cost 11.4

Learning Objective: Explain and illustrate the relationship between marginal cost and average total cost.

Review Questions 4.1

The average total cost of production is the firm’s total cost divided by the quantity of output a firm produces. The marginal cost of production is the change in a firm’s total cost from producing one more unit of a good or service.

4.2

If the marginal product of labor is rising, it means that each additional worker is contributing more additional output than the previous worker, so the cost for each additional unit produced is less than the cost of the previous unit. Marginal product and marginal cost are mirror images of each other: When marginal product increases, marginal cost falls; when marginal product falls, marginal cost increases.

4.3

When marginal cost is below average total cost, marginal cost pulls average total cost down, so we are on the downward-sloping section of the U-shaped average total cost curve. When output expands enough, marginal cost rises to equal, and then exceed, average total cost. When marginal cost is above average total cost, marginal cost pulls average total cost up, so we are on the upward-sloping section of the U-shaped average total cost curve. Therefore, at the point where marginal cost equals average total cost, the average total cost curve stops sloping downward but hasn’t begun sloping upward. The average total cost curve is at its lowest point when the marginal cost curve equals (or intersects) it.

Problems and Applications 4.4

xxxvi CHAPTER 12 | Firms in Perfectly Competitive Markets 4.5

Costs incurred from exploring for new oil fields are part of Parsley Energy’s fixed costs because these costs do not change as the quantity of oil the firm produces changes. Parlsey Energy’s marginal cost of producing oil is unaffected by changes in its fixed costs. Therefore, if the firm cuts back on oil exploration, its marginal cost of producing oil won’t change.

4.6

Yes. As long as marginal cost is below average total cost, average total cost will be decreasing, even if marginal cost is increasing.

4.7

a. No. In this case, average total cost is also always increasing. We can be sure of this conclusion because in this case the firm has no fixed costs, so there is no (decreasing) average fixed cost component of average total cost. b. Because each unit costs an additional $5 to produce, average total cost will also be $5 for each unit. The average total cost curve and the marginal cost curve will be a straight line parallel to the quantity axis at $5. Note that this result depends on the assumption stated at the beginning of the problem that the firm has no fixed costs.

4.8

a. Quantity of Workers

Quantity of Copies per Day

Fixed Cost

Variable Cost

Total Cost

Average Total Cost

Marginal Cost

$40

—

600

$0.133

$0.067

1,100

120

0.109

0.080

1,500

120

160

0.106

0.100

1,800

160

200

0.111

0.133

2,000

200

240

0.120

0.200

2,100

240

280

0.133

0.400

b. The average total cost curve is U shaped, which means that it falls initially and then rises. (Note that in this example, we only get the U shape for the average total cost curve if we compute average total cost to three decimal places. At two decimal places, the average total cost of producing 1,100, 1,500, and 1,800 copies is $0.11, so the average total cost curve will have a flat section.) The marginal cost curve, on the other hand, rises continuously, rather than being U shaped.

CHAPTER 12 | Firms in Perfectly Competitive Markets xxxvii

4.9

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

4.10

Average total cost is total cost divided by total output. In this case, average total cost is $75,002/20,001 = $3.75. Marginal cost is the change in total cost divided by the change in output. In this case, marginal cost is $2/1 = $2. As the following graphs show, when average total cost is greater than marginal cost, marginal cost may be either increasing (as shown in graph (i)) or decreasing (as shown in graph (ii)). Therefore, Jill is wrong to say that her marginal cost “must” be increasing because it may or may not be increasing. Copyright © 2023 Pearson Education, Inc.

xxxviii CHAPTER 12 | Firms in Perfectly Competitive Markets i.

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

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

4.11

a. ΔVC = wΔL

c. If w = $750 and MPL is 150, then MC = $750/150 = $5.

CHAPTER 12 | Firms in Perfectly Competitive Markets xxxix If the wage falls to $600 and MPL is unchanged, then MC = $600/150 = $4. If the wage is $750 and MPL rises to 250, then MC = $750/250 = $3.

Graphing Cost Curves 11.5

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

Review Questions 5.1

The marginal cost curve intersects the average variable cost curve and the average total cost curve at their minimum points.

5.2

The difference between average total cost and average variable cost is average fixed cost. Average fixed cost decreases as output increases, so the difference between average total cost and average variable cost must also continuously decrease. Using symbols: ATC = AVC + AFC, so ATC − AVC = AFC. As AFC continuously decreases, so must ATC − AVC.

CHAPTER 12 | Firms in Perfectly Competitive Markets

Problems and Applications 5.3

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

5.4

a. Variable cost = total cost – fixed cost. So, $30,000 − $10,000 = $20,000. b. AVC = VC/Q = $20,000/10,000 = $2 AFC = FC/Q = $10,000/10,000 = $1 c. The gap must get smaller as output rises because ATC = AVC + AFC, and AFC falls as output rises. So, the dollar difference between ATC and AVC is greater when the output of tennis balls is 10,000. Copyright © 2019 Pearson Education, Inc.

CHAPTER 12 | Firms in Perfectly Competitive Markets 5.5

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

5.6

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

5.7

a. Quantity of Students Taking the Course

Average Total Cost

Average Variable Cost

Average Fixed Cost

Marginal Cost

xlii

CHAPTER 12 | Firms in Perfectly Competitive Markets 1,000

$220

$20

$200

$20

10,000

20,000

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

5.8

a. $15 b. Total cost = ATC × Q = $30 × 1,000 = $30,000. c. Variable cost = AVC × Q = $20 × 1,000 = $20,000. d. Fixed cost = Total cost – Variable cost = $30,000 − $20,000 = $10,000.

5.9

The AFC curve should be downward sloping, not U shaped. Because AFC = FC/Q and because total fixed cost does not change, AFC will always decrease as quantity increases. ATC should be above AVC. Because ATC = AFC + AVC, the ATC curve will always be above both the AFC and AVC curves. Copyright © 2019 Pearson Education, Inc.

CHAPTER 12 | Firms in Perfectly Competitive Markets 5.10

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

11.6

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

Review Questions 6.1

In the short run, Total cost = Variable cost + Fixed cost. In the long run, however, Total cost = variable cost because there are no fixed costs in the long run.

6.2

Minimum efficient scale is the lowest level of output at which all economies of scale have been exhausted. In other words, minimum efficient scale is where the long-run average cost curve stops sloping downward. In the long run, if Apple’s car business doesn’t reach minimum efficient scale, it will have higher average costs than competitors that do reach minimum efficient scale. In that case, Apple will probably be driven out of the car business. (However, if Apple can differentiate its cars in a way that appeals to consumers, it could cars sell at higher prices and still survive. The textbook discusses this last point in Chapter 13.)

6.3

Economies of scale exist when a firm’s long-run average costs fall as the firm increases output. Firms may experience economies of scale because: (1) a firm’s technology may allow it to increase production with a smaller proportional increase in at least one input; (2) both workers and managers can become more specialized as output expands; (3) large firms may be able to purchase inputs at lower costs than smaller firms can; and (4) as a firm expands, it may be able to borrow money at a lower interest rate, thereby lowering its costs.

6.4

Diseconomies of scale exist when a firm’s long-run average costs rise as the firm increases output. Diseconomies of scale eventually arise because managing a store or a factory above a certain size becomes more complicated and costly.

6.5

Because short-run average cost includes at least one input that is fixed in quantity, short-run average cost can never be less than long-run average cost (where there are no fixed inputs or fixed costs). Copyright © 2023 Pearson Education, Inc.

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CHAPTER 12 | Firms in Perfectly Competitive Markets

Problems and Applications 6.6

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

6.7

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

CHAPTER 12 | Firms in Perfectly Competitive Markets

6.8

xlv

a. Jill’s average total cost will be lower with a smaller restaurant. b. Jill’s average total cost will be lower with a larger restaurant. c. Economies of scale often take the form of a larger store or restaurant allowing for lower average cost for a large quantity, but actually higher average total cost for a small quantity. The larger restaurant may use larger ovens, more tables, or other capital that isn’t efficiently used if Jill is only able to sell a smaller quantity of pizzas.

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CHAPTER 12 | Firms in Perfectly Competitive Markets

6.9

a. Refer to the following figure. To simplify, we assume that T-Mobile and Sprint were equal in size and were approximately the size of AT&T when they merged. We also assume that AT&T has achieved minimum efficient scale. Because T-Mobile and Sprint were smaller, their long-run average costs were higher than AT&T’s long-run average cost. When T-Mobile and Sprint merged, they became similar in size to AT&T and their long-run average cost decreased to the level of AT&T’s average total cost. This last situation is illustrated in the graph that follows the answer to part b.

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

CHAPTER 12 | Firms in Perfectly Competitive Markets

xlvii

6.10

Ford would have ended up as the only automobile producer. Other producers would have had higher average costs and, therefore, would not have been able to match Ford’s price cuts without suffering losses that would have eventually driven them out of business.

6.11

a. That the smaller jets are easier to fill with passengers indicates that airlines can sell tickets on these jets at prices low enough that typically all (or nearly all) the tickets for a given flight are sold. Apparently, the airlines need to charge higher prices on flights with larger jets, which makes it harder to sell all the tickets on these flights. The implication is that the average cost of flying a passenger on a smaller jet is lower than the average cost of flying a passenger on a larger jet. b. The answer to part a. does not mean that there are no economies of scale with respect to jets. It does indicate that because technological change has made it possible for firms manufacturing jets to use carbon fiber parts and more efficient engines, the minimum efficient size of jets is smaller than it had been. In these circumstances, building larger jets may lead to diseconomies of scale.

6.12

Pickens was describing diseconomies of scale. Diminishing returns applies in the short run when at least one of the firm’s inputs is fixed. Diseconomies of scale apply in the long run when a firm can vary all of its inputs, adopt new technology, and vary the size of its facility. Pickens refers to firms that encounter increases in their long-run average total cost as the scale of their operations expand.

6.13

The student confused diminishing returns, which refers to the behavior of costs in the short run, with diseconomies of scale. The student should have realized that the relatively poor performance of Wells Fargo Bank was a symptom of diseconomies of scale.

Suggestions for Critical Thinking Exercises CT11.1 The answers will depend on the firms that a student selects. Here is an example from an online Wall Street Journal search for “Mesa Airlines” a regional airline that is publicly traded:

Mesa Air Group, Inc. operates as a holding company, which engages in the provision of regional air carrier and passenger transportation services. Its fleet includes American Eagle and United Express flights. The company was founded in 1982 and is headquartered in Phoenix. Employees: 3,412 (pilots, maintenance personnel, flight attendants, corporate officers, etc.) Sector: Passenger Airlines

xlviii CHAPTER 12 | Firms in Perfectly Competitive Markets Although the exercise doesn’t directly call for it, students can find additional information regarding this firm by doing an online search for “Mesa Airlines.” Because Mesa Airlines is a publicly traded company, its financial statements are available online as well.

CT11.2 The answer is yes. The firm should expand production because marginal revenue exceeds marginal cost. This chapter explains why, in general, business decision-makers compare the additional benefit from an action to its additional cost. Business decision-makers (sole proprietors, partners or corporate managers) will often be able to make explicit dollar estimates of the marginal benefit (revenue) and marginal cost, while consumers and other decision makers typically make implicit estimates of these measures. Few students will have had experience with terms such as “marginal revenue,” “marginal benefit,” and “marginal cost” prior to taking their first economics course. However, by this point in the course, greater familiarity with these terms should help students better understand the logic behind comparing MB (or MR) and MC in order to make rational decisions in business and in their personal day-to-day lives.

This question helps tie together marginal thinking across the course and gives a preview of profit maximization in the coming chapters. By seeing a topic more than once and by having to think hard about it, in principle a student can learn a concept more deeply (the former is called “spacing” and the latter is “desirable difficulties”).

CT11.3

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

CT11.4

One clear reason for the expansion in the number of beer brewers is likely due to a change in technology leading to minimum efficient scale occurring at a lower level of output. A second reason, from Chapter 10, is that beer drinkers’ tastes might have changed and they now prefer beer manufactured by smaller, craft brewers. Note: This question does not have a definite answer but it does ask students to use ideas from two chapters (Chapter 10 and Chapter 11).

CHAPTER 12 | Firms in Perfectly Competitive Markets

ONLINE Appendix |

xlix

Using Isoquants and Isocost Lines to Understand Production and Cost

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

Solutions to Chapter 11 Appendix Exercises Review Questions 11A.1 An isoquant is a curve that shows all the combinations of two inputs, such as capital and labor, that will produce the same level of output. The slope of an isoquant is the rate at which a firm can substitute one input for the other while keeping output constant, or the marginal rate of technical substitution (MRTS). 11A.2 The isocost line shows all the combinations of two inputs, such as capital and labor, that have the same total cost. The slope of the isocost line is equal to the ratio of the price of the input on the horizontal axis divided by the price of the input on the vertical axis, multiplied by –1. 11A.3 The firm wants to minimize the cost of producing any level of output, which occurs where the isoquant and isocost lines are tangent or the MRTS equals the ratio of the input prices.

Problems and Applications 11A.4

CHAPTER 12 | Firms in Perfectly Competitive Markets

11A.5 a. If total cost is $2,000 and the wage rate and rental price of machines both equal $100, the isocost line’s endpoints are at 20 and 20. Along this isocost curve, the cost-minimizing point for producing 5,000 units is point A. b. If the wage rate is one-fourth the rental price of machines, we must be on the isocost line whose endpoints are where capital = 10 and labor = 40, because we can buy four times as much labor with a total cost of $1,000. Along this isocost curve, the cost-minimizing point for producing 5,000 units is point B. c. In this case, the isocost line’s endpoints are at 40 and 40, so the cost-minimizing point for producing 12,000 units is point C. 11A.6

In the American colonies, with land cheap and labor expensive, the cost-minimizing input combination in the graph would be point A. In Europe, where land was expensive and labor was cheap, the cost-minimizing input combination would be point B, with more labor and less land.

CHAPTER 12 | Firms in Perfectly Competitive Markets

11A.7 To minimize costs, Jill should be at a point where Plugging in the numbers into our equation, we get pizzas per dollar and

pizzas per dollar.

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

11A.8 At point A, the slope of the isocost = − w/r = −1/2 ovens per worker, while the slope of the isoquant = MRTS = −1 oven per worker (w = wage rate; r is unit capital rate). Because the slope of the isoquant is greater than the slope of the isocost in absolute value, Jill should employ more workers and fewer ovens (represented by point B) to minimize cost for Q = 20,000 pizzas per week.

11A.9

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CHAPTER 12 | Firms in Perfectly Competitive Markets

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

Jill Johnson’s pizza restaurant exhibits economies of scale between 20,000 and 45,000 pizzas per week and diseconomies of scale between 45,000 and 60,000 pizzas per week.

CHAPTER 12 | Firms in Perfectly Competitive Markets

liii

11A.12 The isoquant curve shows that there are many combinations of workers and machines that can pick the same quantity of oranges per day. In the United States, firms select a point like A— using a lot of capital and very little labor—because the isocost curves they face are very steep. In the United States labor has a relatively high price in comparison with capital. In Brazil, firms select a point like B—using lots of labor and very little capital—because the isocost curves they face are very flat; the price of labor is low in comparison with the price of capital.

11A.13 Jill Johnson is producing where the MRTS equals the ratio of input prices. Because the ratio of input prices is $600/$2,000, the ratio of the marginal product of labor to the marginal product of capital must be the same. So, $600/$2,000 = MPL/12,000, or MPL = 3,600 pizzas. 11A.14 If Massey and Thaler are correct, the team that has the first pick in the draft should trade it to another team for a lower draft pick. The players chosen with the first few picks of the first round of the draft tend to be paid salaries that are much higher relative to their marginal products than is true for players taken later in the first round. A typical team with a high draft pick would increase its ability to win football games at the constant cost represented by the salary cap if it traded for lower draft picks. The 2011 agreement that limits the salaries that drafted players can receive will mean lower overall salaries, so a team with the first pick should still trade it to another team for a lower pick. 11A.15 a. The new isocost line is shown in the following graph. The line has shifted in to reflect the fact that at the same level of total cost, the firm can now rent a maximum of 40 machines or hire as many as 40 workers. b. The new combination is labeled B on the graph. Copyright © 2023 Pearson Education, Inc.

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CHAPTER 12 | Firms in Perfectly Competitive Markets c. Compared to point A, we can be sure that point B uses fewer workers and fewer machines. After both the wage rate and the rental price of machinery doubled, the isocost line shifted in with new intercepts of 40 machines and 40 workers. Because the original combination of capital and labor that minimized the firm’s cost was 40 machines and 40 workers (point A), the new combination (point B) would have to use fewer workers and fewer machines.

CHAPTER 12 | Firms in Perfectly Competitive Markets Brief Chapter Summary and Learning Objectives 12.1 Perfectly Competitive Markets Explain what a perfectly competitive market is and why a perfect competitor faces a horizontal demand curve. ▪

In a perfectly competitive market, there are many buyers and sellers, all firms sell identical products, and there are no barriers to new firms entering the market.

12.2 How a Firm Maximizes Profit in a Perfectly Competitive Market Explain how a firm maximizes profit in a perfectly competitive market. ▪

To maximize profit, a firm produces an output where the difference between total revenue and total cost is as large as possible.

CHAPTER 12 | Firms in Perfectly Competitive Markets

12.3 Illustrating Profit or Loss on the Cost Curve Graph Use graphs to show a firm’s profit or loss. ▪

The relationship between a firm’s price (P) and average total cost (ATC) determines whether it will earn a profit.

12.4 Deciding Whether to Produce or to Shut Down in the Short Run Explain why firms may shut down temporarily. ▪

In the short run, a firm experiencing a loss can continue to produce or stop production by shutting down temporarily.

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

If firms earn short-run economic profits, other firms will enter the market. If firms suffer short-run losses, some firms will exit the market. In the long run, entry and exit result in the typical firm breaking even.

12.6 Perfect Competition and Economic Efficiency Explain how perfect competition leads to economic efficiency. ▪

Perfect competition results in productive efficiency and allocative efficiency.

Economic loss The situation in which a firm’s total revenue is less than its total cost, including all implicit costs. Economic profit A firm’s revenues minus all of its implicit and explicit costs. Long-run competitive equilibrium The situation in which the entry and exit of firms has resulted in the typical firm breaking even.

CHAPTER 12 | Firms in Perfectly Competitive Markets

Long-run supply curve A curve that shows the relationship in the long run between the market price and the quantity supplied. Marginal revenue (MR) The change in total revenue from selling one more unit of a product. Perfectly competitive market A market that meets the conditions of having (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. Price taker A buyer or seller that is unable to affect the market price. Productive efficiency The situation in which a good or service is produced at the lowest possible cost. Profit Total revenue minus total cost. Shutdown point The minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short run. Sunk cost A cost that has already been paid and cannot be recovered.

Chapter Outline Are Cage-Free Eggs the Road to Riches? More than 65,000 farms in the United States specialize in producing eggs. Although most farmers raise chickens in cages that restrict their movement, some farmers have begun selling eggs using “cage-free” methods. Some consumers are willing to pay more for eggs from cage-free chickens. The costs of raising chickens this way are higher, but by 2015 farmers were able to sell cage-free eggs for as much as double the price of eggs produced using conventional methods. By 2019, however, the profitability of cage-free eggs declined even though consumer demand had led firms like Panera Bread, Dunkin’ Donuts, and McDonald’s to pledge to begin using only cage-free eggs. The supply of cage-free eggs had grown more rapidly than the demand, causing the premium over the price of conventional eggs to shrink. In early 2021, U.S. farms had more than 82 million cage-free chickens, which was about 26 percent of all egglaying chickens in the United States. Some egg farmers have turned to selling “pastured eggs” laid by chickens that are allowed to roam freely outside. These eggs are more expensive to produce than either conventional or cage-free eggs. In 2021, farmers could sell pastured eggs for prices much higher than they could get for cage-free eggs. But would that price premium last, or would it decline to the point that pastured eggs were no more profitable than cage-free or conventional eggs?

Perfectly Competitive Markets 12.1

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

A perfectly competitive market meets the conditions of having (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. Firms in perfectly competitive markets are unable to affect the prices of the goods they sell and are unable earn economic profits in the long run.

A. A Perfectly Competitive Firm Cannot Affect the Market Price Prices in perfectly competitive markets are determined by the intersection of market demand and supply curves. Consumers and firms must accept the market price if they want to buy and sell in a competitive market. A price taker is a buyer or seller that is unable to affect the market price. Each buyer and seller in a perfectly competitive market is too small to affect the market price.

B. The Demand Curve for the Output of a Perfectly Competitive Firm

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

Because the firm is a price taker, it can sell as much output as it wants at the market price. Although the market demand curve has the normal downward shape, the demand curve for a perfectly competitive firm is horizontal at the market price.

Teaching Tips To help students understand a perfectly elastic demand curve, draw a series of demand curves passing through the same point that are increasingly more elastic ⸻ but not perfectly elastic. With each of these curves, the response of quantity demanded to a given price change becomes greater and greater, and the most elastic of these curves will still have a slight downward slope. You can then explain why the demand curve for a perfectly competitive firm is perfectly elastic.

Extra Solved Problem 12.1 The Competitive Market for Amazon Stock Amazon.com has long dominated the market for online retail commerce. Shares of Amazon common stock are sold in a competitive market. On a typical business day in July 2021, about 75 million shares of Amazon stock were sold from about 504 million outstanding shares. Because each share is exactly the same, buyers and sellers of the stock are “price takers.” All buyers and sellers must accept the stock price established by the market. In July 2021, this price was about $3,500 per share. Source: www.wsj.com

a. What are the characteristics of a perfectly competitive market? b. Explain why the market for Amazon stock is perfectly competitive. c. Explain why sellers of Amazon stock face a horizontal demand curve.

Solving the Problem Step 1:

Review the chapter material. This problem is about the characteristics of a perfectly competitive firm, so you may want to review the section “Perfectly Competitive Markets” in the textbook.

Step 2:

Answer part (a) by describing the characteristics of a perfectly competitive market. In a perfectly competitive market: (1) there are many buyers and sellers; (2) all firms sell identical products; and (3) there are no barriers to new firms entering the market.

Step 3:

Answer part (b) by explaining why the market for Amazon stock is perfectly competitive.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

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There are many thousands of buyers and sellers of Amazon stock. In July 2021, if a single trader bought or sold 100,000 shares, this quantity is less than one percent of the total number of outstanding shares. Each share of common stock is exactly the same as any other, and there are no barriers to new firms (sellers of stock) entering the market. Sellers are those who own stock and brokers who trade on their behalf. Step 4:

Answer part (c) by explaining why sellers of Amazon stock face a horizontal demand curve. The price of Amazon stock is determined by the market, or overall demand and supply. Fluctuations in price are caused by changes in expectations of the firm’s future performance, but once the market price is established, no individual buyer or seller can alter the price. Therefore, the demand curve for Microsoft stock the typical seller faces is horizontal at the market price.

12.2

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

It is reasonable to assume that the objective for most firms is to maximize profit, which is equal to total revenue minus total cost. To maximize profit, a firm must produce that quantity of output where the difference between total revenue (TR) and total cost (TC) is as large as possible.

A. Revenue for a Firm in a Perfectly Competitive Market A firm’s average revenue (AR) is equal to total revenue divided by the quantity of the product sold. Average revenue is also equal to the market price. Marginal revenue (MR) is the change in total revenue from selling one more unit of a product. For a firm in a perfectly competitive market, price is equal to both average revenue and marginal revenue.

B. Determining the Profit-Maximizing Level of Output The marginal revenue curve for a perfectly competitive firm is the same as its demand curve. As long as marginal revenue is greater than marginal cost, the firm’s profits are increasing, and it will expand production. When marginal revenue is equal to marginal cost, the firm will make no additional profit by increasing production, so it will have maximized its profits. The profit-maximizing level of output is also where the difference between total revenue and total cost is greatest. Because price is equal to marginal revenue for a perfectly competitive firm, price equals marginal cost at the profit-maximizing level of output.

Teaching Tips

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Remind your students that a normal return for the owner of a firm is included in the cost of production, so the revenue earned from the profit-maximizing unit of output is just enough to compensate the firm’s owner(s) for the cost of producing that unit.

Extra Solved Problem 12.2 Cost and Revenue for “Apples R’ Us” Sally Borts owns “Apples R’ Us,” an orchard located in Washington state. Sally is one of over 7,000 apple producers in the United States who produced about 11.4 billion pounds of apples in 2021. Sally believes she will be able to sell her apples for or $300 per thousand pounds. The following table shows Sally’s estimates of her revenue and costs of production for various quantities of apples.

Total Output (1,000 lbs.)

Total Cost

Marginal Cost

Total Revenue

Marginal Revenue (Price per 1,000 lbs.)

$ 50

—

150

$100

300

$300

225

600

300

275

900

300

375

100

1,200

300

525

150

1,500

300

725

200

1,800

300

1,025

300

2,100

300

1,425

400

2,400

300

Source: US Apple Facts

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

b. Explain how Sally will decide how much to produce.

Solving the Problem Step 1:

Review the chapter material. This problem is about how a firm maximizes profit, so you may want to review the section “How a Firm Maximizes Profit in a Perfectly Competitive Market” in the textbook.

Step 2:

Answer part (a) by explaining whether “Apples R’ Us” is a perfectly competitive firm. Sally is one of thousands of apple producers, and her output is a small fraction of the total number of apples produced. Within each variety of apples (such as Red Delicious, McIntosh, and Granny Smith), apple growers sell an identical product, and new firms are free to enter the market. Therefore, “Apples R’ Us” is a perfectly competitive firm. The table provides additional evidence that “Apples R’ Us” is a perfectly competitive firm because it shows that the price Sally receives stays the same no matter how many apples she sells. Therefore, the demand curve for her apples is horizontal.

Step 3:

Answer part (a) by explaining how Sally will decide how much to produce. Sally should increase her production of apples so long as the marginal revenue exceeds her marginal cost of production. Sally’s marginal revenue equals the $300 price for a thousand pounds of apples. If her estimates are accurate, Sally should produce 7 thousand pounds of apples because her marginal cost for this quantity of output also equals $300.

12.3

Illustrating Profit or Loss on the Cost Curve Graph Learning Objective: Use graphs to show a firm’s profit or loss.

Because profit equals total revenue (TR) minus total cost (TC), and TR equal price multiplied by quantity, then: Profit = (P × Q) – TC. If we divide both sides of this equation by Q, we have:

or:

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

This equation tells us that profit per unit equals price minus average total cost. We obtain the expression for the relationship between total profit and average total cost by multiplying through by Q: Profit = (P – ATC) × Q.

A. Showing Profit on the Graph In a graph, the firm’s profit is equal to the area of a rectangle with a height of (P – ATC) and a base equal to Q.

B. Illustrating When a Firm Is Breaking Even or Operating at a Loss Whether a firm makes a profit depends on the relationship of price to average total cost. There are three possibilities: (1) P > ATC, which means the firm makes a profit. (2) P = ATC, which means the firm breaks even. (3) P < ATC, which means the firm experiences a loss.

Teaching Tips Here are three tips students can use to learn from the graphs in this section: 1. If the ATC curve crosses the firm’s demand curve, price must exceed ATC at the level of output where profit is maximized. 2. To show a firm suffering losses, the ATC curve is drawn so that it is above the demand curve for every level of output. 3. Always draw the demand curve and the MC curve first to determine the profit-maximizing output. This will make it easier to identify ATC and AVC for this same output.

Extra Apply the Losing Money in the Medical Screening Industry Concept

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

In a market system, a good or service becomes available to consumers only if an entrepreneur brings the product to market. Thousands of new businesses open every week in the United States. Each new business represents an entrepreneur risking his or her funds to trying earning a profit by offering a good or service to consumers. Of course, there are no guarantees of success, and many new businesses experience losses rather than earn the profits their owners hoped for. In the early 2000s, technological advances reduced the price of computed tomography (CT) scanning equipment. For years, doctors and hospitals have prescribed CT scans to diagnose patients showing symptoms of heart disease, cancer, and other disorders. The declining price of CT scanning equipment convinced many entrepreneurs that it would be profitable to offer preventive body scans to apparently healthy people. The idea was that the scans would provide early detection of diseases before the customers began experiencing symptoms. Unfortunately, the new firms offering this service ran into several difficulties:   

First, because the CT scan was a voluntary procedure, it was not covered under most medical insurance plans. Second, very few consumers used the service more than once, so there was almost no repeat business. Finally, as with any other medical test, some false positives occurred, where the scan appeared to detect a problem that did not actually exist.

Negative publicity from people who had expensive—and unnecessary—medical procedures as a result of false-positive CT scans also hurt these new businesses. As a result, the demand for CT scans was less than most of these entrepreneurs had expected, and the new businesses operated at a loss. For example, the owner of California HeartScan would have broken even if the market price had been $495 per heart scan, but he suffered losses because the actual market price was only $250. Why didn’t California HeartScan and other medical clinics just raise the price to the level they needed to break even? We have already seen that any firm that tries to raise the price it charges above the market price loses customers to competing firms. By fall 2003, many scanning businesses began to close. Most of the entrepreneurs who had started those businesses lost their investments. Source: Patricia Callahan, “Scanning for Trouble,” Wall Street Journal, September 11, 2003.

Question Suppose the medical screening firms ran an effective advertising campaign that convinced a large number of people that yearly CT scans were critical for good health. How would this have changed the fortunes of these firms? Illustrate your answer with a graph showing the situation for a representative firm in the industry. Be sure your graph includes the firm’s demand curve, marginal revenue curve, marginal cost curve, and average total cost curve. Answer

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Demand in the industry will shift to the right, which will cause the demand and marginal revenue curves faced by the representative firm in the industry to shift up. The following graph illustrates this as the price increases from $250 per scan to $495 per scan and demand shifts from Demand1 to Demand2, causing the representative firm to move from making losses to breaking even.

12.4

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

In the short run, a firm that is suffering losses has two choices: (1) Continue to produce, or (2) Stop production by shutting down temporarily. During a temporary shutdown, a firm must still pay its fixed costs. If by producing the firm would lose an amount greater than its fixed costs, it should shut down. We assume that the firm’s fixed costs are sunk costs. A sunk cost is a cost that has already been paid and cannot be recovered. The firm should treat its sunk costs as irrelevant to its decision making. One option the firm does not have is to raise its price. If a perfectly competitive firm raises its price, it would lose all its customers and sales would drop to zero.

A. The Supply Curve of a Firm in the Short Run If the price the firm can charge drops below average variable cost, the firm will have a smaller loss if it shuts down and produces no output. The firm’s marginal cost curve is its supply curve for prices at or above average variable cost. Because the marginal cost curve intersects the average variable cost curve where the average cost curve is at its minimum point, the firm’s supply curve is its marginal cost curve above the minimum point of the average variable cost curve. The shutdown point is the minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short run.

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B. The Market Supply Curve in a Perfectly Competitive Industry The market supply curve in a perfectly competitive industry is determined by adding up the quantity supplied by each firm in the market at each price.

Extra Solved Problem 12.4 When to Pull the Plug on a Movie In the summer of 2013, Walt Disney released The Lone Ranger, starring Johnny Depp and produced by Jerry Bruckheimer. The film bombed at the box office: Worldwide, the film earned about $245 million in revenue⸻ well below the $375 million it cost to produce and market. Before Disney completed the film, executives became concerned that it might not be successful. They were disappointed in the early work on the film and temporarily stopped production. According to media reports, Disney executives took several factors into account as they considered whether to continue with production: Depp and Bruckheimer had made the very successful Pirates of the Caribbean for the studio; Depp and Bruckheimer agreed to accept smaller salaries if Disney agreed to finish the film; and Disney had already spent tens of millions of dollars on the film. How should Disney have decided whether to finish The Lone Ranger and release it to theaters? What role should the money Disney executives had already spent on the film have played in their decision?

Solving the Problem Step 1:

Review the chapter material. This problem is about the role of sunk costs in business decision making, so you may want to review the section “Deciding Whether to Produce or to Shut Down in the Short Run” in the textbook.

Step 2:

Use the concept of sunk cost to analyze Disney’s decision about whether to finish the film. In this case, Disney was not considering whether to shut down the company but whether to shut down production of this particular film. Disney had already invested millions of dollars in The Lone Ranger at the time they were considering whether to finish the film. It is tempting to argue that unless Disney completed the film, these millions of dollars would be lost. It is important to see, however, that the millions already spent were a sunk cost. Whether Disney shut down the film or finished it and released it to theaters, the company would not be able to earn back the funds it had already invested. Therefore, these millions of dollars were irrelevant to Disney’s decision. Instead, Disney should have made the decision based on comparing the additional cost of completing and releasing the film to the revenue the film was expected to earn. In other words, Disney should have completed the film if marginal revenue was expected to be greater than marginal cost, and it should have shut down the film if marginal cost was expected to be greater than marginal revenue. Copyright © 2023 Pearson Education, Inc.

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CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting Although Disney knew the marginal cost of completing and releasing the film, the company had to estimate the marginal revenue based on its forecasts of ticket sales and later sales of DVDs and streaming video. Disney decided to finish the film. The additional cost to complete the film was more than $300 million, but it earned only about $245 million at the box office. With hindsight, Disney made the wrong decision. On the basis of the past success of the Pirates of the Caribbean films Depp and Bruckheimer made together, Disney overestimated ticket sales.

Sources: Lucas Shaw, “‘Lone Ranger’ Fallout: Jerry Bruckheimer May Lose Final Cut on ‘Pirates 5,’” Reuters, August 7, 2013; Brooks Barnes, “Masked Lawman Stumbles at the Gate,” New York Times, July 7, 2013; and Mike Fleming, Jr., “Shocker! Disney Halts ‘Lone Ranger’ with Johnny Depp and Gore Verbinski,” www.dealince.com August 12, 2011.

Question Suppose you decide to open a copy store. You rent store space (signing a one-year lease to do so), and you take out a loan at a local bank and use the money to purchase 10 copiers. Six months later, a large chain opens a copy store two blocks away from yours. As a result, the revenue you receive from your copy store, while sufficient to cover the wages of your employees and the costs of paper and utilities, doesn’t cover all your rent and the interest and repayment costs on the loan you took out to purchase the copiers. Should you continue operating your business?

Answer You should continue running the copy store as long as the revenue you earn covers your variable costs. The rent and interest and repayment on the loan are fixed costs that you cannot avoid paying even if you shut down. Therefore, you should ignore those costs in the short run (until the year’s lease expires).

Teaching Tips Your students may confuse the decision to shut down with the decision to go out of business. Many firms that shut down sell goods or services only in certain seasons. Examples include ski resorts, retail stores near summer resorts, and Christmas tree vendors.

“If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit 12.5 of Firms in the Long Run Learning Objective: Explain how entry and exit ensure that perfectly competitive firms earn

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

zero economic profit in the long run.

In the long run, unless a firm can cover all of its costs, it will shut down and exit the industry.

A. Economic Profit and the Entry or Exit Decision Economic profit is equal to a firm’s revenues minus all of its implicit and explicit costs. A firm is unlikely to earn an economic profit for very long. Other firms that are just breaking even have an incentive to enter the market so they also can earn economic profits. The more firms there are in an industry, the further to the right is the market supply curve. Entry into the market will continue until all firms are just breaking even. Firms can suffer economic losses in the short run. An economic loss is the situation in which a firm’s total revenue is less than its total cost, including all implicit costs. As long as price is above average variable cost, a firm suffering a loss will continue to produce in the short run. But in the long run, firms will exit an industry if they are unable to cover all their costs.

B. Long-Run Equilibrium in a Perfectly Competitive Market Economic profits induce firms to enter an industry. The entry of firms forces the market price down until the typical firm is breaking even. Economic losses cause some firms to exit an industry. The exit of firms raises the market price until the typical firm is breaking even. This process results in a long-run competitive equilibrium. Long-run competitive equilibrium is the situation in which the entry and exit of firms has resulted in the typical firm breaking even. The long-run equilibrium price is at a level equal to the minimum point on the typical firm’s average total cost curve.

C. The Long-Run Supply Curve in a Perfectly Competitive Market The long-run supply curve is a curve that shows the relationship in the long run between the market price and the quantity supplied. In the long run, a perfectly competitive market will supply whatever amount of a good consumers demand at a price determined by the minimum point on the typical firm’s average total cost curve.

D. Increasing-Cost and Decreasing-Cost Industries Any industry in which the typical firm’s average costs do not change as the industry expands production will have a horizontal long-run cost curve. Industries where this result holds true are called constant-cost industries. If an input used in producing a good is available in only limited quantities, the cost of the input will rise as the industry expands. In this case, the long-run supply curve will slope upward. Industries with upward-sloping long-run supply curves are called increasing-cost industries. In some cases, the typical firm’s average costs fall as the industry expands, and the long-run supply curve will Copyright © 2023 Pearson Education, Inc.

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slope downward. Industries with downward-sloping long-run supply curves are called decreasing-cost industries.

Extra Solved Problem 12.5 Adam Smith and the Natural Price Adam Smith explained how economic profits and losses in a competitive market result in the entry and exit of firms. Smith described what he called the natural price, or the long-run equilibrium price, in this passage from his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations: When the price of any commodity is…sufficient to pay the rent of land, the wages of labour, and the profits of the stock employed in…bringing it to market, the commodity is then sold for …its natural price… The commodity is then sold precisely for what it is worth, or for what it really costs the person who brings it to market; for though in common language what is called the prime cost of any commodity does not comprehend the profit of the person who is to sell it…The natural price… is…the central price, to which the prices of all commodities are continually gravitating… When by an increase in…demand, the market price of some commodity… *rises above+ the natural price…*producers of the commodity+ are generally careful to conceal this change. If it were commonly known, their great profit would tempt so many rivals…the market price would soon be reduced to the natural price…Secrets of this kind, however…can seldom be long kept; and the extraordinary profit can last little longer than they are kept… The market price…can seldom continue long below its natural price…the persons affected would immediately feel the loss, and *some producers+ would immediately withdraw…the quantity brought to the market would soon be no more than sufficient to supply the effectual demand. Its market price, therefore, would soon rise to the natural price. Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations. Book One, Chapter VII. http://www.adamsmith.org/

a. What did Smith mean by the “prime cost” of a commodity? b. How did Smith explain how the entry of firms in a perfectly competitive market ensures that firms earn zero economic profit in the long run? c. How did Smith explain how the exit of some firms occurs in a perfectly competitive market to ensure that firms remaining in the market earn zero economic profit in the long run?

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Solving the Problem Step 1:

Review the chapter material. This problem is about the entry and exit of firms in the long run, so you may want to review the section “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run” in the textbook.

Step 2:

Answer part (a) by explaining what Smith meant when he referred to the “prime cost” of a commodity. Smith noted that those who use the term “prime cost” do not “comprehend the profit of the person who sells it.” Smith meant that the prime cost excludes the firm’s implicit costs of production, including the owner’s opportunity cost.

Step 3:

Answer part (b) by discussing Smith’s explanation of how the entry of firms in a perfectly competitive market ensures that firms earn zero economic profit in the long run. When the market price rises above its natural price, or the long-run equilibrium price, Smith argued that the resulting short-run economic profit “would tempt so many rivals…the market price would soon be reduced to the natural price.” Smith wrote that producers are “careful to conceal this change” but “Secrets of this kind…can seldom be long kept; and the extraordinary profit can last little longer than they are kept…” Smith meant that there are no barriers to entry in a perfectly competitive market, and economic profits are eliminated when long-run equilibrium is reached.

Step 4:

Answer part (c) by discussing Smith’s explanation of how the exit of some firms occurs in a perfectly competitive market to ensure that firms remaining in the market earn zero economic profit in the long run. When Smith wrote “The market price…can seldom continue long below its natural price…” he meant that when the market price is less than the long-run equilibrium price, firms suffer short-run economic losses. As some firms leave the market, the market price will “rise to the natural price.” In other words, as some firms exit the market, the supply curve shifts to the left. The market price rises until the losses are eliminated.

Extra In the Apple App Store, Easy Entry Makes the Long Run Pretty Apply the Short Concept

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One reason for the popularity of Apple’s iPhones and iPads is the section of Apple’s iTunes music and video store devoted to applications (or “apps”). By 2017, sales of apps on iTunes approached $30 billion. Major software companies, as well as individuals writing their first software programs, have posted games, calendars, dictionaries, and many other types of apps to the App Store, for which they receive 30 percent of the revenue their app generates.

But competition in the App Store is intense, particularly for games, with about 750 new games being added to the store per day. Let’s consider how the makers of three App Store games have fared:

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App Store Games Tiny Invaders Candy Crush Saga Clash of Clans

Hogrocket, a three-person company, developed the game “Tiny Invaders” and began selling it in the App Store in 2011. Initially, the company was successful in selling the app for $2.99. As we have seen, though, when firms earn an economic profit in a market, other firms have a strong economic incentive to enter that market. Competition from new games forced Hogrocket to lower the price of its game to $0.99. At that price, the company was unable to sell enough downloads to break even, and the firm had to shut down. Game Tiny Invaders

Developer Hogrocket

Initial Price

Lower Price

Outcome

$2.99

$0.99

Developer shut down

With so many games to choose from, many people are unwilling to download one unless it’s free. Some app designers have tried the strategy of allowing apps to be downloaded for free while attempting to earn revenue by forcing users to see advertisements before the app opens or while it runs. Many people find these advertisements annoying, though, so developers have begun offering free apps that lack advertisements but where the developers earn revenue from users making in-app purchases. For instance, in the popular game “Candy Crush Saga,” players are given free turns. After using up the turns, players can wait 30 minutes for another free turn or they can pay a small amount to immediately receive five more turns. Still, only about 3 percent of people who play these games make any in-app purchases. That leaves developers dependent on “whales,” who make $50 to $100 per month in in-app game purchases. Only the best games can attract whale players and survive the intense competition of the App Store.

But even the most popular games eventually find their profitability undermined by competition. For instance, in Supercell’s “Clash of Clans” game, players can slowly build up their villages’ defenses and their armies for free or they can make an in-app purchase of “gems” to speed up the process. By 2017, Supercell’s revenues from in-app purchases had begun to decline, which an article in the Wall Street Journal attributed to “fierce competition in the mobile gaming industry.” Supercell also was suffering revenue declines from “Clash Royale,” its follow-up game to “Clash of Clans.” Other firms, including Copyright © 2023 Pearson Education, Inc.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

Rovio (maker of “Angry Birds”) and Nintendo (maker of “Super Mario Run”), also experienced disappointing revenues from their mobile games. In a competitive market, earning an economic profit in the long run is extremely difficult. And the ease of entering the market for smartphone and tablet apps has made the long run pretty short.

Sources: Dan Gallagher, “Why Super Mario’s Run Was Short,” Wall Street Journal, January 2, 2017; Matthias Verbergt, “‘Clash of Clans’ Maker Posts Revenue Fall amid Pokémon Competition,” Wall Street Journal, February 15, 2017; Adam Satariano, “Angry Birds Maker Rovio May Cut Jobs in Revamp of Functions,” bloomberg.com, February 15, 2017; and Sarah E. Needleman, “Mobile-Game Makers Try to Catch More ‘Whales’ Who Pay for Free Games,” Wall Street Journal, May 10, 2015.

12.6

Perfect Competition and Efficiency Learning Objective: Explain how perfect competition leads to economic efficiency.

A. Productive Efficiency In a market system, the forces of competition will drive the market price to the minimum average cost of the typical firm. Productive efficiency is a situation in which a good or service is produced at the lowest possible cost. Managers of firms strive to earn an economic profit by reducing costs. But in a perfectly competitive market, other firms quickly copy ways of reducing costs, so in the long run only consumers benefit from cost reductions.

B. Allocative Efficiency Competitive firms not only produce goods and services at the lowest possible cost, but they also produce the goods and services that consumers value most. Perfect competition achieves allocative efficiency, a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Productive efficiency and allocative efficiency are useful benchmarks against which to compare the actual performance of the economy.

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Teaching Tips Critics of the perfectly competitive model complain that few industries feature buyers and sellers of identical products made by firms that are all price takers. This criticism fails to recognize what an economic model is and how models are used by economists. Although not perfectly competitive, many markets are very competitive and experience entry and exit in response to short-run profits and losses. The markets for televisions, calculators, personal computers, and automobiles have changed over time as firms earned short-run profits or new technologies forced firms to adapt. The steel and coal industries experienced exit by firms in response to short-run losses, much as the model of perfect competition predicts.

Extra Economics in Your Life & Career: Is Perfect Competition Perfect? Question: In this chapter, she saw that perfectly competitive firms produce the goods and services consumers value most at the lowest possible cost. These are very good results for consumers. But we also saw that firms that develop new technologies are not able to achieve economic profits in the long run. Competition and the lack of entry barriers quickly eliminate profits. Does competition encourage or discourage the development of new technologies? Answer: Perfect competition is not well-suited to convert new ideas into new goods and services. But the lack of any competition tends to stifle innovation because successful firms may feel little need to continually innovate if there is no other firm trying to develop better products. An ideal market structure for encouraging innovation consists of firms large enough to fund research and development (and absorb the costs of failures) and smaller firms that push the larger firms to continue to develop new technologies.

Solutions to End-of-Chapter Exercises Perfectly Competitive Markets 12.1

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

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1.1

Perfectly competitive markets share three characteristics: (1) there are many buyers and sellers, (2) all firms sell identical products, and (3) there are no barriers to firms entering the market.

1.2

A price taker is a buyer or seller who is unable to affect the market price. Firms in perfectly competitive markets are price takers. Because a firm in a perfectly competitive market is very small relative to the market, and because it is selling exactly the same product as every other firm, it can sell as much as it wants to without having to lower its price. If the firm raises its price, the firm will sell nothing.

1.3

The graph should look like Figure 12.2. The following graph on the left below shows the market demand and supply curves for corn. The graph on the right shows the demand for corn produced by farmer Parker, an individual corn farmer.

Problems and Applications 1.4

(a) is perfectly competitive because there are many tomato growers selling the same product; (b) is not perfectly competitive because coffee shops do not sell identical products; (c) is not perfectly competitive because there are only a few automobile sellers, the products being sold are not identical, and there are barriers to new firms entering the market; and (d) is not perfectly competitive primarily because new homes are not identical.

1.5

No. “Fierce competition” does not imply a horizontal demand curve because horizontal demand curves are found only in perfectly competitive markets. Perfectly competitive markets are markets that have: (1) many buyers and sellers; (2) the sellers are selling a product or service that is identical; and (3) there are no barriers to firms entering the market. The market for streaming services is not perfectly competitive because the streaming services sold by different firms are not identical. Services offered by Paramount+ are not the same as those offered by Netflix or any other service provider. If Netflix or any of the other firms charges a higher price, Copyright © 2023 Pearson Education, Inc.

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that firm will not lose all of its sales. A firm that faces a horizontal demand curve in a perfectly competitive industry would lose all of its sales if it raised prices. 1.6

Not many markets meet the requirements for being perfectly competitive. But a model does not have to be realistic to be useful. The model of perfect competition is important as a benchmark—a market with the maximum possible competition—that economists use to evaluate actual markets that are not perfectly competitive. A further quotation from George Stigler helps us to understand why economists use the model of perfect competition: “…if a science is to deal with a large class of phenomena, clearly it cannot work with concepts that are faithfully descriptive of even one phenomenon, for then they will be…undescriptive of others.” As we discussed in Chapter 1, Section 1.3, all sciences, including social sciences like economics, rely on abstract models.

1.7

The remark confuses the market demand for wheat with the demand facing one farmer selling wheat. Remember that the units used in drawing the market demand curve are much larger than the units used in drawing the individual farmer’s demand curve. The market demand curve for wheat is downward sloping, while the demand curve for any wheat farmer is a horizontal line.

1.8

The XYZ Company described in the problem is a price taker because it is in a “very competitive industry.” The company should charge the market price.

1.9

If the beer industry were perfectly competitive, firms would sell an identical product, so there would be no reason for consumers to care about where beer was brewed.

12.2

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

Review Questions 2.1

A firm in a perfectly competitive market is a price taker and can sell as many units as it wants to at the market price P. In other words, the firm faces a horizontal demand curve for its product. By selling an additional unit, the firm receives additional (or marginal) revenue of P. Because each unit is sold at P, the average revenue will also equal P, and we get the result P = MR = AR.

2.2

As long as marginal revenue is greater than marginal cost (MR > MC), a firm should continue to expand production because selling another unit of the product adds more to the firm’s total revenue than to its total cost, thereby increasing the firm’s total profit. When a firm reaches the level of output at which marginal revenue equals marginal cost (MR = MC), it has reached the point where producing that last unit of output will add as much to its total revenue as it does to Copyright © 2023 Pearson Education, Inc.

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CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting its total cost, which means that total profit (TR – TC) cannot be increased further and, therefore, must be at a maximum.

2.3

In a perfectly competitive market, marginal revenue = price (MR = P) making these two conditions for the profit-maximizing level of output equivalent.

Problems and Applications 2.4

You should disagree with the student’s argument. A firm maximizes profit by selling where marginal revenue is equal to marginal cost. If a firm stops producing a quantity for which marginal revenue is greater than marginal cost, then it could increase its profit by producing more. Firms do not want to maximize their profit per unit sold; they want to maximize their total profit.

2.5

Revenue is the total dollar amount of a firm’s sales. Firms are interested in what they have left over from their revenues after they have paid all of the costs of producing the goods they sell. Profit is what remains when you subtract total cost from total revenue. That is why firms maximize profit rather than revenue. A revenue-maximizing firm is likely to produce more output than if it were maximizing profit because, for the typical firm, revenue increases beyond the quantity where profit starts to decline.

2.6

Farmer Parker will produce where MR = P = MC, which in this case is 6 bushels. Profit = total revenue − total cost = ($5.50 × 6) − $29.00 = $4.00.

2.7

Assuming a market price of $7 a bushel, Farmer Parker will still produce 7 bushels because marginal revenue is now exactly equal to the marginal cost of $7.00.

2.8

Farmer Parker’s fixed cost is $10. The increase in fixed cost to $20 will not affect marginal cost, so profit is still maximized at 7 bushels of wheat because that is where marginal revenue equals marginal cost. Farmer Parker’s profit, however, would now be $3.50 instead of $13.50 because of the $10 increase in his fixed cost.

12.3

Illustrating Profit or Loss on the Cost Curve Graph Learning Objective: Use graphs to show a firm’s profit or loss.

Review Questions 3.1

The graph should look like the graph in Step 4 of Solved Problem 12.3 (which is reproduced here) showing the situation of a firm in the perfectly competitive market for basketballs. Copyright © 2023 Pearson Education, Inc.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

3.2

xxv

The graph should look like the graph in Step 6 of Solved Problem 12.3 (which is reproduced here) showing the situation of a firm in the perfectly competitive market for basketballs.

Problems and Applications 3.3

a. To maximize profit, Frances will produce the level of output where marginal revenue is equal to marginal cost. She will charge the market price of $1.80. Her profit-maximizing output is 6 pencils. She should expand output up to the point where MR = MC, but remember that in a competitive market MR = P. The sixth pencil’s marginal cost is $1.60 (see the final column of the following table that lists values for marginal cost at each level of output). This marginal cost is less than the marginal revenue of $1.80 that she receives from selling it. The seventh pencil’s marginal cost is $1.90, which is slightly more than the marginal revenue of $1.80 from selling it. We can conclude that producing the sixth pencil increases Frances’s profit, but producing the seventh pencil would reduce her profit. Frances’s profit = Total revenue – total cost = (price × quantity) – total cost = ($1.80 × 6) − $6.80 = $4.00. Copyright © 2023 Pearson Education, Inc.

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

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting xxvii c.

3.4

If the price of pencils falls to $0.25, Frances should shut down because this price is less than the minimum point on her AVC curve. Her loss will be equal to her fixed cost of $1. If the price of basketballs fell to $2.50, Andy would shut down and not produce any basketballs. The price would be less than average variable cost at all output levels, as is shown in the table in Solved Problem 12.3 in the chapter (that table is reproduced below). If Andy shuts down, his loss would equal his fixed cost of $10.00. Output per Day (Q)

Total Cost (TC)

Fixed Cost (FC)

Variable Cost (VC)

Average Total Cost (ATC)

Average Variable Cost (AVC)

Marginal Cost (MC)

$10.00

$0.00

—

20.50

10.00

10.50

$20.50

$10.50

24.50

10.00

14.50

12.25

7.25

4.00

28.00

10.00

18.00

9.33

6.00

3.50

34.00

10.00

24.00

8.50

6.00

43.00

10.00

33.00

8.60

6.60

9.00

55.50

10.00

45.50

9.25

7.58

12.50

72.00

10.00

62.00

10.29

8.86

16.50

93.00

10.00

83.00

11.63

10.38

21.00

119.00

10.00

109.00

13.22

12.11

26.00

3.5

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

3.6

The goal for the Ford Motor Company, and most other firms, is to maximize its profit. Because profit is calculated by taking the difference between total revenue and total cost, a firm can have lower revenue in one quarter than in the previous quarter but still have a larger profit if its costs declined by enough. In this case, because Ford was able to increase its profit by $3.4 billion from the third to the fourth quarter of 2020 despite declining revenue, we know that the firm’s total costs must have decreased. A firm will typically not maximize revenue at the output level that maximizes its profit. If a firm maximized its revenue, it would typically produce a larger quantity than if it maximized its profit.

xxviii CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 3.7

In the following graphs, the one on the left represents the wheat market, while the one on the right represents the typical wheat farm. In the graph on the left, the initial market price (P1) and quantity (Q1) are determined by the intersection of the market demand curve (D1) and the market supply curve (S). Because the typical firm is a price taker, it sells quantity q1 where P1 is equal to its marginal cost, MC, shown by point C in the graph on the right. Because it is assumed that the farm is initially suffering a loss, P1 is less than the farm’s average total cost, or ATC; the value of ATC at this quantity is labeled B. The farm’s total loss is equal to its total revenue (P1 × q1) minus its total cost (ATC × q1). The loss is equal to the area ABCP1. The release of the scientific study results in an increase in the market demand for wheat, shown in the graph on the left by a shift from D1 to D2. The increase in demand increases the market price to P2 and the market quantity to Q2. Because the farm is a price taker, its demand curve in the graph on the right shifts up from D1 to D2. The farm can sell all that it wants to at the market price, so its demand curve also represents its marginal revenue (MR) curve. The firm maximizes its profit by increasing its output from q1 to q2. At q2, the farm’s total revenue (equal to area P2Fq20) exceeds its total cost (area EGq20). This short-run economic profit will lead to new farms entering the market, so that in the long run all wheat farms will break even.

3.8

a. To maximize profit, Marguerite should produce at the level of output for which MR = MC. Referring to the figure in the book, she should produce 100 caps because this is the quantity where the MC curve intersects the MR curve. b. At 100 caps: TR = $11.00 × 100 = $1,100 and TC = $9 × 100 = $900.

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Marguerite will therefore earn a profit of $1,100 − $900 = $200. c. If Marguerite decides to shut down, she will incur a loss equal to her total fixed cost. Fixed cost = (ATC – AVC) × Q. So, in this case, fixed cost, or the amount of her loss, is ($9 –$6) × 100 = $300.

12.4

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

Review Questions 4.1

In the short run, a firm will shut down if price falls below the minimum point on its average variable cost curve. In the long run, a firm will shut down (and exit the industry) if the price is below the minimum point on its average total cost curve. In the short run, the firm is willing to accept losses because it cannot do anything about its fixed costs—and must pay those costs whether or not it is producing anything. In the long run, however, the firm will close down and exit the industry if it expects continued losses.

4.2

The perfectly competitive firm’s supply curve can be directly derived from its marginal cost curve. The firm will produce where P = MC if price is at or above the shutdown point at the minimum point on the AVC curve.

4.3

The market supply curve is derived by adding up the quantity supplied (using marginal cost curves) by each firm in the market at each price.

Problems and Applications 4.4

Situation 1: Total cost = $5,000 + $5,000 = $10,000. Average total cost = $10,000/1,000 = $10. Therefore, price, marginal revenue, marginal cost, and average total cost will all equal $10, and the firm will produce 1,000 units of output and break even. Situation 2: Total cost = $5,000 + $6,000 = $11,000. By producing an output of 1,000, where price equals marginal cost, the firm will earn $10,000, which is less than its total cost of $11,000. Because the firm can cover all of its variable cost and part of its fixed cost, it will produce in the short run although it suffers a $1,000 loss. Situation 3: Total cost = $5,000 + $11,000 = $16,000. If the firm were to produce 1,000 units, the level of output where price equals marginal cost, the revenue of $10,000 it would earn would be less than its variable cost ($11,000). Therefore, the firm will shut down in the short run because its loss of $6,000 when producing is greater than its loss of $5,000 (its fixed cost) when shut down. Copyright © 2023 Pearson Education, Inc.

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4.5

a. Output per Week

Total Cost

AFC

AVC

ATC

$100

—

150

$100.00

$50.00

$150.00

$50.00

175

50.00

37.50

87.50

25.00

190

33.33

30.00

63.33

15.00

210

25.00

27.50

52.50

20.00

240

20.00

28.00

48.00

30.00

280

16.67

30.00

46.67

40.00

330

14.29

32.86

47.15

50.00

390

12.50

36.25

48.75

60.00

460

11.11

40.00

51.11

70.00

540

10.00

44.00

54.00

80.00

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

a. Output per Week

Total Cost

AFC

AVC

ATC

$100.00

—

155.70

$100.00

$55.70

$155.70

$55.70

205.60

50.00

52.80

102.80

49.90

253.90

33.33

51.30

84.63

48.30

304.80

25.00

51.20

76.20

50.90

362.50

20.00

52.50

72.50

57.70

431.20

16.67

55.20

71.87

68.70

515.10

14.29

59.30

73.59

83.90

618.40

12.50

64.80

77.30

103.30

745.30

11.11

71.70

82.81

126.90

900.00

10.00

80.00

90.00

154.70

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Using the MR = MC rule, Matt should produce 7 pairs of boots per week at a price of $100 per pair. If he produces 7 pairs of boots, his total revenue will be $700 and his total cost will be $515.10. Therefore, Matt’s profit will be $184.90.

If price falls to $65, Matt should produce 5 pairs of boots per week. By producing 5 pairs of boots per week and charging a price of $65 per pair, Matt will earn total revenue of $325. Because Matt’s total cost of producing 5 pairs of boots is $362.50, he will incur a loss of $37.50. Because this loss is less than his fixed cost of $100, Matt should continue to produce in the short run.

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

4.8

If a firm spends more to produce oil than it receives in revenue from selling the oil, that firm is suffering a loss. But a firm should continue to produce in the short run provided that it can cover its variable costs. Whether a firm produces in the short run or shuts down, it must still pay its fixed costs. As long as the loss it incurs by operating is less than its fixed costs, a firm should Copyright © 2023 Pearson Education, Inc.

xxxii CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting continue to produce. In the long run, a firm has to at least break even by covering all of its costs. It seems likely that the oil firms referred to in the article were covering their variable costs. That banks were willing to lend these firms money despite their losses indicates that the oil firms (and the banks) expected the firms would eventually be able to at least break even. 4.9

You should continue running the copy store as long as the revenue you earn covers your variable costs. The rent and interest and repayment on the loan are fixed costs that you cannot avoid paying even if you shut down. Therefore, you should ignore those costs in the short run (until the year’s lease expires).

4.10

a. Sunk costs are costs that a firm has already paid and cannot recover. Some of the sunk costs that the oil companies incur are: (1) the costs of preparing the land for drilling; (2) the cost of drilling the oil wells; and (3) the costs they incur to get the proper permits and licenses necessary to drill in a particular area.

b. With large sunk costs, a firm will continue to operate a well only if the firm’s total revenue from the well is larger than the variable costs of operating the well. As long as revenue exceeds variable cost, the firm is covering the cost of operating the well with some revenue left over to pay at least some of its fixed costs. c. No, because in the long run a firm will have to cover all of its costs. There are no sunk costs in the long run. If an oil firm finds that in the long run it can’t break even pumping oil from a well, it will close down the well. A firm that fails in the long run to at least break even on its operations will close down and go out of business. 4.11

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

“If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of 12.5 Firms in the Long Run Learning Objective: Explain how entry and exit ensure that perfectly competitive firms earn

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting xxxiii zero economic profit in the long run.

Review Questions 5.1

When firms in an industry are earning economic profits, new firms will enter the industry. When firms in an industry are suffering economic losses, some of those firms will exit the industry.

5.2

A firm earning zero economic profit will continue to produce, even in the long run, because the firm’s owners are earning as much as they would earn elsewhere. In other words, the owners are covering the opportunity cost of their investment.

5.3

The long-run supply curve in a perfectly competitive market will be a horizontal line if it is a constant-cost industry—that is, if the typical firm’s average cost curves are unchanged as the industry expands or contracts. If the firm is in an increasing-cost industry, the long-run supply curve will slope upward. If the firm is in a decreasing-cost industry, the long-run supply curve will slope downward. The following graph, which is similar to Figure 12.10 (b), shows how a perfectly competitive constant cost industry—in this example, the egg industry—adjusts to a permanent decrease in demand.

Problems and Applications 5.4

To find this ex-professor’s economic profit, we need to subtract the opportunity cost of her time (the $75,000 salary she had been earning as an economics professor) and the opportunity cost

xxxiv CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting of the funds she is investing in her business ($3,000 in interest she had been earning on a bank CD) from her accounting profit of $80,000: $80,000 − $75,000 − $3,000 = $2,000. 5.5

a. The chapter opener states that according to U.S. Department of Agriculture (USDA) data, in early 2021 U.S. farms had more than 82 million cage-free chickens, which was about 26 percent of all egg-laying chickens in the United States. If the market for cage-free chickens was in long-run equilibrium, new farms would not be entering the market to produce cagefree eggs. But the USDA is projecting that by 2026, 64 percent of hens in the United States will be cage-free. We can conclude that although the market in 2021 was moving toward long-run equilibrium where cage-free chicken farmers would break even, it was not yet at this point. b. The hope of earning a short-run economic profit should still lead to an increase in the number of farmers who produce cage-free eggs. As a result, the supply of cage-free eggs will continue to increase, and in the long run, the price will fall. c. If adopted, the more stringent FDA guidelines will increase the cost of producing pastureraised eggs. This increase, in turn, will cause the price of pasture-raised eggs to increase in order for egg farmers to be able to break even in the long run. With a higher price, the quantity of pasture-raised eggs produced will be smaller than it would have been without the adoption of the guidelines.

5.6

Because the egg market is perfectly competitive, when the market price falls to $1.75, Sacha must match it or her sales will fall to zero.

5.7

The following two graphs depict the demand curve and the supply curve in the palm oil market (on the left) and the demand curve for a farm producing palm oil tree fruit (on the right). To simplify the graphs, we assumed that the price of palm oil is the same as the price of palm oil tree fruit. An increase in demand shifts the demand curve in the graph on the left from D1 to D2. Because we assume that the markets for palm oil and palm tree fruit are perfectly competitive, the demand curve for the palm tree firm is perfectly elastic--farm owners are price takers. Because the increase in demand causes the equilibrium price of palm oil to double, so does the price of palm tree fruit. The increase in the price of palm oil will increase firms’ profits in the short run, but this will result in an increase in the number of firms producing palm oil in the long run. The increase in the number of firms causes the supply curve in the graph on the left to shift from S1 to S2. Assuming that other things (including the price of resources used to produce palm oil) do not change, the price of palm oil decreases from 2P back to P in the long run. The price of palm oil tree fruit also decreases from 2P to P in the graph on the right.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting xxxv

5.8

a. O’Hayer’s decision limits his company, Vital Farms, by reducing the number of chickens he can raise on a given amount of land. Pasture-raised chickens move around more and will therefore eat more chicken feed than those raised in small cages. They are also more likely to be injured or killed by being pecked by other chickens. These factors make it more costly to raise chickens in large outdoor spaces than in cages and limit O’Hayer’s ability to expand his company. b. Vital Farms’ profit depends on the premium consumers are willing to pay for pastured eggs relative to eggs that have been produced in the conventional way and on the number of other farmers producing pastured eggs. Over time, we would expect that competition among farmers will result in the premium consumers pay for pastured eggs declining until it is just enough to cover the additional cost to farmers from producing eggs this way. The result will be that Vital Farms and other farms selling pastured eggs will be just breaking even, which means that they will be earning zero economic profit.

5.9

An increase in the demand for gluten-free spaghetti will lead to an increase in its price in the short run. The higher price will increase the short-run profit from producing this type of spaghetti. But that profit will attract new firms to the industry, shifting the industry supply curve to the right and causing the price of gluten-free spaghetti to return to $3.50 in the long run. The entry of new firms causes the long-run equilibrium quantity to be more than 4 million boxes. Therefore, you should choose (b) as your answer. The answer assumes that gluten-free spaghetti is a constant-cost industry, which seems likely because it does not rely on an input that is available in only a limited quantity.

5.10

In the following graph on the left, the increase in the demand for laptop computers causes the demand curve to shift from D1 to D2, temporarily driving the price up to P3. As the production of laptops increases, more orders are placed for laptop displays. As production of laptop displays increases, their cost and price fall because of economies of scale. As shown in the graph on the right, with increased demand and lower average and marginal costs, the firms that assemble Copyright © 2023 Pearson Education, Inc.

xxxvi CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting laptops can make economic profits at P3. The result is that new firms enter the industry, the industry supply curve shifts from S1 to S2, driving down the price to P2 and eliminating economic profits. Because the price of laptop computers declines as output increases, the long-run supply curve is downward sloping. This is a decreasing-cost industry.

5.11

Professor Dixit is illustrating a fact emphasized in this chapter: In a market system, firms will supply to every consumer willing to pay a price equal to the long-run average cost of production all of a good or service the consumer wishes to purchase. Although the coffee shop doesn’t know when Professor Dixit will arrive (or whether on a particular day he will come at all), the shop expects that at the current equilibrium price, enough buyers will be available to buy the coffee they are selling. Coffee shops are ready and willing to serve coffee to anyone willing to pay the equilibrium price, which is the price that will cover all of their costs—including the opportunity cost of the funds the owners have invested in the firm.

5.12

a. There are 400,000 farms that produce, on average, 350,000 bushels of corn each. Therefore, each farm produced 0.0025% (= (350,000/14,000,000,000) × 100) of the total output of corn. The following graphs assume that the corn market is in long-run equilibrium.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting xxxvii

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

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

xxxviii CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting price is now equal to average total cost, ATC, the representative farmer is breaking even from growing corn.

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12.6

Perfect Competition and Economic Efficiency Learning Objective: Explain how perfect competition leads to economic efficiency.

Review Questions 6.1

If consumers want more of a product, the market will supply it. As demand increases, the price of the product increases, and the profits firms earn rise. Higher profits lead existing firms to expand production and new firms to enter the industry. If consumers want less of a product, the market will supply less of it. As demand decreases, the price of the product falls and firms begin to suffer losses. Losses lead existing firms to reduce production and some firms to leave the industry. In this way, consumers are able to dictate to firms the quantities of each good or service the firms produce.

6.2

Allocative efficiency is the state of the economy in which production reflects consumer preferences; specifically, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Productive efficiency is the situation in which a good or service is produced at the lowest possible average cost. Productive efficiency refers to how a good or service is produced, while allocative efficiency refers to producing the goods and services that consumers value most.

6.3

Consumers purchase output up to the point where price equals marginal benefit. Under perfect competition, firms produce up to the point where price equals marginal cost. Perfect competition, therefore, generates an equilibrium output where marginal benefit equals marginal cost, which represents allocative efficiency. In a perfectly competitive industry, free entry and exit ensures that, in the long run, firms are producing where average costs are minimized, thereby ensuring that productive efficiency also is achieved.

Problems and Applications 6.4

The student is correct to note that a firm’s goal is to maximize its profit and not maximize consumer welfare. However, consumers will not purchase past the quantity where marginal benefit equals price. And given that firms produce up to the quantity where price equals marginal cost, we get the efficient outcome the text states. Efficiency is achieved despite consumers and producers acting in their own self-interests.

6.5

a. Because at the profit-maximizing level of output P = ATC, Karl is earning zero economic profit. b. Karl’s firm illustrates both productive and allocative efficiency. Productive efficiency occurs when a firm operates at the lowest possible cost, and Karl’s firm is operating at the lowest point on its ATC curve. Allocative efficiency occurs when a firm operates where MR (or price) is equal to MC, and Karl’s firm is producing at that point. Copyright © 2023 Pearson Education, Inc.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

6.6

In perfectly competitive markets, firms may temporarily earn greater profits from a reduction in costs. However, in the long run, these profits will lead to new firms entering the market. New firms entering the market will shift the supply curve to the right, resulting in lower prices. Lower prices benefit consumers but leave the typical firm just breaking even in the long run.

6.7

A law limiting the price companies can charge for pencils would be inadvisable because, in the long run, competition will force the price of pencils to the economically efficient level. When firms earn a profit, new firms will enter the industry. New firms entering the industry will cause the supply curve to shift to the right, which will lower prices and eliminate economic profits. In the long run, without a law being passed, prices will be equal to the average total cost of production, which means that firms will break even.

6.8

a. This is a fair analogy. In the long run, competition among firms in a competitive market forces firms that incur losses to shut down. The firms that survive are those that can produce at minimum long-run average cost while producing goods and services that consumers are willing and able to buy. b. Firms that are best able to respond to changing consumer tastes and are best able to use new technologies to reduce their costs gain from competition, which eliminates rival firms. As a group, consumers win from competition because competition forces firms to produce at the lowest cost those goods and services that match consumer wants. It’s possible that some consumers may lose if they prefer products that most consumers no longer want and which, as a result, firms are no longer able to produce while covering their costs.

6.9

There are more firms competing in the Chinese auto market because the market includes most firms that sell cars in the United States in addition to local Chinese auto manufacturers. Having more firms competing, however, does not guarantee productive efficiency or allocative efficiency. That the Chinese government must provide support for local Chinese automakers indicates that they are otherwise unable to sell cars at a price that will cover all of their costs. Therefore, these firms are not productively efficient. Government support also prevents the market from achieving allocative efficiency because local manufacturers that receive subsidies may continue to produce cars that are not in line with consumer preferences and therefore the marginal cost to society of these cars may exceed the marginal benefit.

6.10

a. Allocative efficiency is achieved when production of goods and services reflects consumer preferences and the last unit of each good and service produced provides a marginal benefit to consumers equal to the marginal cost of producing it. From Hedrick Smith’s comments about shopping in Moscow in the 1970s, it seems clear that the Soviet Union did not achieve allocative efficiency in the production of textbooks, ballet shoes, or men’s shoes. If the country had achieved allocative efficiency, Smith would have been able to purchase size 8 ballet shoes, sixth grade textbooks, and a pair of shoes that were the correct size for his feet.

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b. It is not possible to determine whether the textbooks, ballet shoes, and men’s shoes that were produced during the time Smith lived in the Soviet Union were produced at the lowest possible cost. Therefore, we cannot state whether productive efficiency was achieved in the production of any of these goods.

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CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting

Suggestions for Critical Thinking Exercises CT12.1 The supply curve is perfectly elastic, while the demand curve can have any type of elasticity. This question asks students to apply elasticity to a new topic and to understand how demand and supply are different in this market in the long run. CT12.2 The ATC and AFC curves for the perfectly competitive firm will shift downward, but the marginal cost curve will be in the same place. Therefore, output stays the same but profits will increase. This question is designed to see if students can understand the different types of costs and how they interact. CT12.3 Barriers to entry deter people from entering a profession such as hair cutting or hair braiding and therefore increase the profits of people who are already in these professions. Barriers to entry are covered in Chapter 14, “Oligopoly,” so this question serves both as an introduction to this topic and allows students to explore the details of perfect competition.

CHAPTER 13 | Monopolistic Competition: The Competitive Model in a More Realistic Setting Brief Chapter Summary and Learning Objectives 13.1 Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves. ▪

A monopolistically competitive firm must cut its price to sell more, so its marginal revenue curve will slope downward and be below its demand curve.

13.2 How a Monopolistically Competitive Firm Maximizes Profit in the Short Run Explain how a monopolistically competitive firm maximizes profit in the short run. ▪

All firms maximize profits by producing where marginal revenue is equal to marginal cost. A monopolistically competitive firm will maximize profits where price is greater than marginal cost. Copyright © 2023 Pearson Education, Inc.

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13.3 What Happens to Profits in the Long Run? Analyze the situation of a monopolistically competitive firm in the long run. ▪

When a monopolistically competitive firm makes a short-run economic profit, entrepreneurs will enter the market, causing the firm’s demand curve to shift to the left and become more elastic. In the long run, a monopolistically competitive firm will break even.

13.4 Comparing Monopolistic Competition and Perfect Competition Compare the efficiency of monopolistic competition and perfect competition. ▪

Unlike perfectly competitive firms, monopolistically competitive firms charge a price greater than marginal cost and do not produce at minimum average total cost.

13.5 How Marketing Differentiates Products Define marketing and explain how firms use it to differentiate their products. ▪

Firms use brand management and advertising to differentiate their products.

13.6 What Makes a Firm Successful? Identify the key factors that determine a firm’s success. ▪

A firm can be profitable if it can differentiate its product or if it can produce its product at a lower average cost than competing firms.

Key Terms Brand management The actions of a firm intended to maintain the differentiation of a product over time. Marketing All the activities necessary for a firm to sell a product to a consumer. Monopolistic competition A market structure in which barriers to entry are low and many firms compete by selling similar, but not identical, products.

Chapter Outline The Coffee Industry: From Supermarket Cans to Third Wave Coffeehouses Standard restaurant or home-brewed coffee is called “first wave coffee.” Beginning in the 1980s, the popularity of Starbucks and competing coffeehouse chains like Peete’s, shook up the coffee market with “second wave coffee.” In 1995, the opening of a small chain of coffeehouses named Intelligentsia helped launch “third wave coffee.” Third wave coffeehouses buy coffee beans directly from growers rather than from wholesalers. This allows third wave coffeehouses to differentiate themselves from Starbucks and other “second wave” chains. The owners of third wave coffeehouses argue that they make bettertasting coffee because they roast beans and serve coffee soon after the beans are harvested. Generally, these coffeehouses charge higher prices that do Starbucks and other large chains.

13.1

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

Monopolistic competition is a market structure in which barriers to entry are low and many firms compete by selling similar, but not identical, products.

A. The Demand Curve for a Monopolistically Competitive Firm An increase in the price of a monopolistically competitive firm’s product reduces the quantity sold.

B. Marginal Revenue for a Firm with a Downward-Sloping Demand Curve When a firm cuts its price, one good thing happens: The firm will sell more, which is called the output effect. But one bad thing happens when the price is cut: The firm will receive less revenue for each unit of output it could have sold at the higher price, which is called the price effect. When the firm lowers its price, marginal revenue will be positive when the additional revenue from selling one more unit of output is greater than the revenue lost from receiving a lower price. Marginal revenue will be negative when the additional revenue from selling one more unit of output is less than the revenue lost from receiving a lower price.

Teaching Tips The retail market for gasoline is an example of monopolistic competition you can use with your students. Gas stations display their prices so drivers can see them. Ask your students why they would Copyright © 2023 Pearson Education, Inc.

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets

buy from a certain station. One possible response, especially for stations located on busy highways, is: “I buy from a station on the right side of the street so I don’t have to make two left turns.” Students will understand why someone would pay only a slightly higher price for this convenience.

13.2

How a Monopolistically Competitive Firm Maximizes Profit in the Short Run Learning Objective: Explain how a monopolistically competitive firm maximizes profit in the short run.

All firms use the same approach to maximize profits: They produce where marginal revenue is equal to marginal cost. Unlike a perfectly competitive firm, a monopolistically competitive firm will produce where P > MC. Figure 13.4, “Maximizing Profit in a Monopolistically Competitive Market,” illustrates how a Blue Bottle coffeehouse maximizes profit.

What Happens to Profits in the Long Run? 13.3

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

A. How Does the Entry of New Firms Affect the Profits of Existing Firms? When firms earn economic profits, entrepreneurs have an incentive to enter the market and establish new firms. The demand curve of an established firm will shift to the left and become more elastic. Eventually, the demand curve will shift until it is tangent to the firm’s average total cost curve. A firm may suffer economic losses in the short run. In the long run, firms will exit an industry if they suffer economic losses. The exit of some firms will cause the demand curve for the output of a remaining firm to shift to the right. Eventually, the representative firm will charge a price equal to average total cost and break even.

B. Is Zero Economic Profit Inevitable in the Long Run? Owners do not have to accept breaking even. Firms try to continue earning a profit by reducing their costs, providing exceptional service, or by convincing consumers that their products are different from their competitors’ products.

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Extra Apply the Is “Clean Food” A Sustainable Market Niche for Panera? Concept

For generations, a typical meal for many teenagers and young adults consisted of a burger, French fries, and a soft drink or a pizza and soft drink. Today, however, many people view these traditional fast-food meals as unhealthy. “Fast-casual” restaurants such as Panera Bread have benefitted from that view. Steve Ells, the founder of Chipotle Mexican Grill, recognized that there was a market for restaurants that serve healthier food than fast-food restaurants and provide speedier service than traditional tableservice restaurants.

But Chipotle and some other fast-casual restaurants have had problems attracting consumers hoping to eat healthier foods because many of their menu items are high in calories. A 20-year-old woman who is moderately active can consume about 2,200 calories per day without gaining weight. According to an article in the New York Times, a single Chipotle meal of a carnitas burrito, chips and guacamole, and a Coke would amount to nearly that many calories. Because Panera offers many soups, salads, and sandwiches, its offerings tend to be lower in calories. Panera promoted this advantage by becoming the first fast-casual chain to prominently show calorie counts on its menus and on display boards in the area where cashiers take orders.

Many restaurant chains, including Chipotle, McDonald’s, and Olive Garden, have reduced or eliminated artificial ingredients in favor of locally grown produce and meat and eggs from farmers who raise animals using more humane methods. Panera’s move in 2017 to serve only “clean food” was an attempt to further appeal to consumers who are concerned about the ingredients in traditional restaurant food. In an interview with the Wall Street Journal, then Panera CEO Ron Shaich explained “clean food” as follows: “It means zero artificial flavors, preservatives, sweeteners or colors from non-naturally occurring sources in any food in our restaurants in the U.S.”

But the changes Panera made to its ingredients increased the cost of preparing many menu items and led the restaurant to increase some prices, including the price of turkey sandwiches. Panera’s strategy of using “clean food” as a means of continuing to earn a profit in the intensely competitive fast-casual restaurant business will succeed only if (1) consumers’ demand for food prepared this way is strong enough for them to be willing to pay higher prices and (2) if Panera’s competitors can’t effectively copy its strategy. In April 2017, the German firm JAB Holding Company was convinced that Panera had Copyright © 2019 Pearson Education, Inc.

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developed what would be a long-lived competitive advantage when it agreed to buy the restaurant chain for $7.5 billion. This price assumed that Panera would continue to earn an economic profit for many years.

But is that assumption correct? Some food scientists questioned whether many of the ingredients Panera has removed from its foods actually are harmful. And, just as is true of competing chains, while some of Panera’s menu items are low in calories, other popular offerings aren’t. For instance, someone ordering a lunch consisting of a steak and cheddar panini sandwich, a bowl of New England clam chowder, and an iced caffè mocha would be consuming over 1,900 calories. Some of Panera’s offerings are also high in sodium and saturated fat. Finally, many competing chains are also moving to cut back on additives and other artificial ingredients. Whether consumers will find Panera’s “clean food” approach significantly different from what competitors were offering is an open question.

Like firms in every other monopolistically competitive industry, Panera has to continually innovate by offering new products and new marketing strategies as it tries to differentiate its products from those of its many competitors.

Sources: Julie Jargon, “What Panera Had to Change to Make Its Menu ‘Clean,’” Wall Street Journal, February 20, 2017; Craig Giammona, “Panera Becomes First Chain to Label Added Sugar in Beverages,” bloomberg.com, March 31, 2017; Kavin Senapathy, “Should Customers Fall for Panera’s New Gimmick? Food Scientists Weigh In,” forbes.com, September 13, 2016; Kevin Quealy, Amanda Cox, and Josh Katz, “At Chipotle, How Many Calories Do People Really Eat?” New York Times, February 17, 2015; and information on the panerabread.com Web site.

Comparing Monopolistic Competition and Perfect Competition 13.4

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

There are two important differences between long-run equilibrium in monopolistic competition and perfect competition. Monopolistically competitive firms charge a price greater than marginal cost and they do not produce at minimum average total cost.

A. Excess Capacity under Monopolistic Competition

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets

A monopolistically competitive firm has excess capacity because it maximizes profit at an output level that is not at the minimum point of its average total cost curve. If the firm increased its output, it could produce at a lower average cost.

B. Is Monopolistic Competition Inefficient? In a monopolistically competitive market, neither productive efficiency nor allocative efficiency is achieved. Economists have debated whether this results in a significant loss of well-being to society in these markets compared with perfectly competitive markets.

C. How Consumers Benefit from Monopolistic Competition The demand curve for a monopolistically competitive firms slopes downward because the good or service the firm is selling is differentiated from the goods or services sold by competing firms. Firms differentiate their products to appeal to consumers. When firms are successful in differentiating their products, this indicates that some consumers find these products preferable to the alternatives. Consumers, therefore, are better off than they would have been had these companies not differentiated their products. Consumers face a trade-off when buying the product of a monopolistically competitive firm: Consumers pay a price greater than the marginal cost, and the product is not produced at minimum average cost, but consumers benefit from being able to purchase a product that is more closely suited to their tastes.

Teaching Tips An example of consumers’ willingness to pay for greater convenience is the supermarket express checkout line. Supermarkets have express lines for consumers who have just a few items to buy. Supermarkets incur higher costs to maintain the extra lines, but most shoppers don’t mind paying somewhat higher prices to avoid waiting in line.

Extra Solved Problem 13.4 Markets Offer Consumers More Choices In one of its Annual Reports, the Federal Reserve Bank of Dallas commented on the growing variety of choices available to consumers: Just since the 1970s, there’s been an explosion of choice in the marketplace—the assortment of new [automobile] models have risen from 140 to 260, soft drinks from 20 to more than 87… over-the-counter pain relievers from 17 to 141. The U.S. market offers 7,563 prescription drugs, 3,000 beers, 1,174 amusement parks, 340 kinds of breakfast cereal, 50

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets brands of bottled water…Today’s consumers have access to more book titles, more movies and more magazines… This proliferation of products, models and styles isn’t capitalism run amok. Variety shouldn’t be dismissed as extravagance. It’s a wealthy, sophisticated society’s way of improving the lot of consumers. The more choices, the better. A wide selection of goods and services increases the chance each of us will find, somewhere among all the shelves and showrooms, products that meet our requirements.

Source: W. Michael Cox and Richard Alm, “The Right Stuff: America’s Move to Mass Customization.” Federal Reserve Bank of Dallas 1998 Annual Report, pp. 3–5. www.dallasfed.org

a. Compare the long-run equilibrium positions of firms in perfect competition and monopolistic competition. b. Evaluate the efficiency of producing products in monopolistically competitive markets rather than in perfectly competitive markets.

Solving the Problem Step 1:

Review the chapter material. This problem compares perfect competition and monopolistic competition, so you may want to review the section “Comparing Monopolistic Competition and Perfect Competition” in the textbook.

Step 2:

Answer part (a) by comparing the long-run equilibrium positions of firms in perfect competition and monopolistic competition. Perfect

Monopolistic

Competition

Equal to marginal cost

Greater than marginal cost

Equal to average total cost

Equal to minimum average total cost

Greater than minimum average total cost

Allocative efficiency

Is achieved

Is not achieved (price > marginal cost)

Productive efficiency

Is achieved

Is not achieved (excess capacity)

Firms charge a price:

Step 3:

Answer part (b) by evaluating the efficiency of goods produced in monopolistically competitive markets rather than in perfectly competitive markets.

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets

Although monopolistically competitive firms do not achieve allocative or productive efficiency, these firms achieve success in the marketplace by offering consumers products that better match their tastes than the standardized products offered by perfectly competitive firms.

How Marketing Differentiates Products 13.5

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

Firms can differentiate their products through marketing, which refers to all the activities necessary for a firm to sell a product to a consumer. Marketing includes activities such as determining which product to produce, designing the product, advertising and distributing the product, and monitoring how consumer tastes affect the market for the product. Firms use two marketing tools to differentiate their products: brand management and advertising.

A. Brand Management Brand management refers to the actions of a firm intended to maintain the differentiation of a product over time. Firms use brand management to postpone the time when they will no longer be able to earn economic profits.

B. Advertising When a firm advertises a product, it tries to shift the demand curve to the right and to make the demand curve more inelastic. But advertising also increases costs. If the increase in revenue that results from advertising is greater than the increase in costs, the firm’s profits will increase.

C. Defending a Brand Name To defend a brand name, a firm can apply for a trademark, which grants legal protection against other firms using its product’s name. Legally enforcing trademarks can be difficult. Each year, U.S. firms lose billions of dollars in sales worldwide as a result of unauthorized use of their trademarked brand names.

Teaching Tips Kleenex has been a registered trademark of the Kimberly-Clark Corporation since 1924. Yet, consumers often use the term Kleenex to refer to any facial tissues. The use of Kleenex to refer to any facial tissue is so widespread that the Oxford and Merriam-Webster dictionaries define Kleenex as “A paper tissue” or “A cleansing tissue.”

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13.6

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

A firm’s owners and managers can control some of the factors that allow it to make economic profits. Examples include the firm’s ability to differentiate its product and produce a product at a lower average cost than competing firms. Some factors that affect a firm’s profitability are not directly under the firm’s control; for example, increases in input prices. Sheer chance also plays a role in the success of a business.

Extra Apply the Is Being the First Firm in the Market a Key to Success? Concept

Some business analysts argue that the first firm to enter a market can have important first-mover advantages. By being the first to sell a particular good, a firm may find its name closely associated with the good in the public’s mind, as, for instance, Amazon is closely associated with online shopping or eBay is associated with online auctions. This close association may make it more difficult for new firms to enter the market and compete against the first mover.

Surprisingly, though, recent research has shown that the first firm to enter a market often does not have a long-lived advantage over later entrants. Consider the market for pens. Until the 1940s, the only pens available were fountain pens that had to be refilled frequently from an ink bottle and used ink that dried slowly and smeared easily. In October 1945, entrepreneur Milton Reynolds introduced the first ballpoint pen, which did not need to be refilled. When it went on sale at Gimbels department store in New York City, it was an instant success. Although the pen had a price of $12—the equivalent of about $160 at today’s prices—hundreds of thousands were sold, and Milton Reynolds became a millionaire. Unfortunately, it didn’t last. Although Reynolds had guaranteed that his pens would write for two years—later raised to five years—in fact, the pens often leaked and frequently stopped writing after only limited use. Sales began to collapse, the flood of pens returned under the company’s guarantee wiped out its profit, and within a few years, Reynolds International Pen Company stopped selling pens in the United States. By the late 1960s, firms such as Bic, selling inexpensive—but reliable— ballpoint pens, dominated the market.

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What happened to the Reynolds International Pen Company turns out to be more the rule than the exception. For example, Apple’s iPod was not the first digital music player to appear on the U.S. market. Both SaeHan’s MPMan and Diamond’s Rio PMP 300 were released in the United States in 1998, three years before the iPod. The Japanese firm NTT DoCoMo introduced the first widely adopted smartphone in 1999, and BlackBerry introduced a smartphone in the United States shortly thereafter. By 2016, neither firm was still producing smartphones. Similarly, although Hewlett-Packard currently leads the market for laser printers, with a market share of more than 35 percent, it did not invent the laser printer. Xerox invented the laser printer, and IBM sold the first commercial laser printers, although neither firm is important in the market today. As another example, Procter & Gamble was not the first firm to sell disposable diapers when it introduced Pampers in 1961. Shakey’s Pizza was the first franchised pizza chain in the United States, but it went into decline following competition from later entrants such as Domino’s, Pizza Hut, and Little Caesars, which offered consumers lower prices and had more effective marketing. Google’s Chrome was not the first web browser; before Chrome, there was Internet Explorer; before Internet Explorer there was Netscape; before Netscape, there was Mosaic; and before Mosaic, there were several other web browsers that for a time looked as if they might dominate the market. In 2004 Microsoft introduced the SPOT smartwatch, but the company discontinued it in 2008, when it failed to find many buyers. In all these cases, the firms that were first to introduce a product ultimately lost out to other companies that arrived on the scene later but did a better job of providing consumers with products that were more reliable, less expensive, more convenient, or otherwise provided greater value.

Question: A firm that is first to market with a new product frequently discovers that there are design flaws or problems with the product that were not anticipated. For example, the ballpoint pens made by the Reynolds International Pen Company often leaked. What effect do such problems cause for the innovating firm, and how do these unexpected problems create possibilities for other firms to enter the market?

Answer: A firm that develops a new product has to trade off the gains from being first to market against the possibility, as happened with Reynolds’s ballpoint pens, that the product has some undiscovered defects. The more innovative the product and the more important the consumer need that the product fulfills, the more leeway that the firm may have with the product having some flaws. But if the flaws are too great, then consumers may form a very negative view of the product, which the firm may have difficulty overcoming. This result is what happened with Reynolds. The ballpoint pen was a big advance over existing pens and the need for an improved pen was great because nearly all consumers used one. But the pen Reynolds brought to market was so defective that consumers were unwilling to buy later, better pens that Reynolds offered. Other firms can take advantage of the problems of the first firm by offering a more reliable product and are able to benefit from the first firm having made consumers aware of a product that didn’t previously exist.

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Extra Solved Problem 13.6

Factors Affecting the Success of Craft Breweries A firm’s owners and managers can control some of the factors that can enable them to earn economic profits, but other factors are outside of the firm’s control. List some of the controllable and uncontrollable factors for a craft brewery, such as D. G. Yuengling and Son, Inc., headquartered in Pottsville, Pennsylvania.

Solving the Problem Step 1:

Review the chapter material. This problem is about the factors that determine a firm’s profitability, so you may want to read the section “What Makes a Firm Successful?” in the textbook.

Step 2:

Controllable factors. Controllable factors for the firm include the ability to differentiate its product. For craft breweries, such factors include the types of beer brewed and the ingredients used to brew them.

Step 3:

Uncontrollable factors. Uncontrollable factors include: (1) Prices of inputs. For craft breweries these included the prices for malt, hops, labor, and utilities. (2) Shifts in consumer tastes, causing shifts in demand. (3) Marketing efforts of rival firms.

Extra Economics in Your Life & Career: Competition at the Gas Pump Question: People often observe that the price of gasoline may differ from one seller to another despite the product being similar and there being many sellers. Collusion refers to an agreement among producers not to compete with one another. How can the similarity of gasoline prices be used as evidence of a competitive, rather than an uncompetitive, market? Answer: The easiest way to answer this question is to ask how motorists would respond if one gasoline station charged substantially more (let’s say 0.50 cents per gallon) than another nearby station. The station charging the lower price would have long lines, while the other station would quickly see its business vanish. Because there is little difference in the product offered by each station, the price

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets

difference would quickly disappear. A more convenient location or different services (“more pumps, no waiting!”) may explain a much smaller difference in price.

Solutions to End-of-Chapter Exercises

13.1

Review Questions 1.1

In both perfectly competitive and monopolistically competitive markets, there are many firms and low barriers to entry. However, while products are identical in perfectly competitive markets, products are similar—but not identical—in monopolistically competitive markets. Wheat and many raw materials are sold in perfectly competitive markets. Haircuts and restaurant meals are sold in monopolistically competitive markets.

1.2

A local McDonald’s faces a downward-sloping demand curve for Quarter Pounders because if it increases its price, customers will substitute away from Quarter Pounders and buy something else—such as burgers at Wendy’s or Burger King. If a local McDonald’s raises its prices, it won’t lose all of its customers, however, because it might be located more conveniently than other restaurants for some people or some people might prefer Quarter Pounders to similar products.

1.3

Average revenue is equal to total revenue divided by quantity sold (TR/Q). Because total revenue is price multiplied by quantity (P × Q), dividing by quantity leaves just price. So, average revenue is equal to price (AR = P). Note that price equals average revenue for every firm, not just for monopolistically competitive firms. For any firm that is a price setter, marginal revenue is less than price because when the firm lowers price to sell an additional unit, it must lower the price on all units—not just the last unit.

Problems and Applications 1.4

a. If the wine industry in Napa Valley was perfectly competitive there would be many firms, all of which would be small relative to the total market for wine. All firms would sell identical Copyright © 2019 Pearson Education, Inc.

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CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets products. The quantity demanded for Chip Case’s Wine Emporium would decrease to zero if Chip tried to raise his prices because consumers would switch to buying (identical) wine from other sellers. b. If the wine industry in Napa Valley was monopolistically competitive, the quantity demanded of Chip’s wine would decrease—but not to zero. Chip can convince some of his customers to buy his wine at the higher price by differentiating his product by, for example, using different varieties of grapes to make his wine and by advertising. The demand curve for his wine is downward sloping, but relatively elastic because there are many sellers of a similar product. Napa Valley’s wine industry is, in fact, an example of monopolistic competition, not perfect competition.

1.5

A firm can earn an economic profit either by offering a service, such as selling books, at a lower cost than other firms can or by differentiating its products. CEO James Daunt recognizes that Barnes & Noble cannot sell popular books at a lower cost than can larger firms such as Walmart and Target. And Daunt cannot convince consumers that books written by best-selling authors, such as Stephen King and John Grisham, are any different when purchased from a Barnes & Noble store than when purchased from Walmart or Target. But Barnes & Noble stores can differentiate their booking selling service by offering consumers a different selection of books, including those written by local authors.

1.6

If Sealy’s advertising campaign is successful and consumers start believing that the company’s mattresses maintain support four times better than other brands, the demand curve for its mattresses would become steeper; that is, the demand curve would become less elastic. In other words, Sealy’s customers would become less sensitive to price changes. If Sealy were to increase the price of its mattresses, many of its customers would continue to buy them.

1.7 Snow Skiing

Total

Average

Marginal

Lessons per

Price

Revenue

Day (Q)

(P)

(TR = P × Q)

(AR = TR/Q)

(MR = ∆TR/∆Q)

$80.00

—

75.00

$75.00

70.00

140.00

70.00

65.00

195.00

65.00

55.00

60.00

240.00

60.00

45.00

55.00

275.00

55.00

35.00

50.00

300.00

50.00

25.00

45.00

315.00

45.00

15.00

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets 8

40.00

320.00

40.00

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5.00

1.8

All wheat farms sell identical goods. But restaurants do not sell identical goods. If a wheat farmer raises his price above the market price, he will lose all of his buyers. A Starbucks coffeehouse can raise its prices without losing all of its buyers because it is selling products that are not identical to the products sold by other similar coffeehouses.

1.9

In a perfectly competitive market, marginal revenue is equal to price, so marginal revenue cannot be negative because price cannot be negative. Because the marginal revenue curve is downward sloping for a monopolistically competitive firm, at a high enough level of output marginal revenue will become negative. However, as we saw in Chapter 12, “Firms in Perfectly Competitive Markets,” firms produce where marginal revenue equals marginal cost. Because marginal cost is never negative, a monopolistically competitive firm would never produce where marginal revenue is negative.

1.10

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

1.11

a. Sally’s revenue from selling 100,000 tomatoes at $5.00 each is $500,000. Her revenue from selling 200,000 tomatoes at $3.25 each is $650,000. Therefore, her marginal revenue is equal to the change in her revenue divided by the change in her output, or: ($650,000 − $500,000) / (200,000 − 100,000) = ($150,000/100,000) = $1.50. b. The output effect is the change in revenue as a result of Sally lowering the price of tomatoes sold at her vegetable stand from $5.00 to $3.25. This amount is equal to the increase in the quantity of tomatoes sold as a result of lowering price multiplied by the new price: 100,000

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CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets × $3.25 = $325,000. The price effect is equal to the revenue lost as a result of lowering the price for the consumers who were willing to buy tomatoes at $5.00: ($5.00 − $3.25) × 100,000, or $1.75 × 100,000 = $175,000. Therefore, Sally’s total revenue increases by ($325,000 − $175,000) or $150,000 as a result of lowering the price of tomatoes to $3.25. As we saw in part (a), her marginal revenue from the price cut is $1.50.

How a Monopolistically Competitive Firm Maximizes Profit in the Short Run

13.2

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

Review Questions 2.1

Because P > MR for a monopolistically competitive firm, a profit-maximizing monopolistically competitive firm producing where MR = MC will necessarily produce where P > MC. In other words, a monopolistically competitive firms will have produced more than the profit-maximizing level of output if it produces where P = MC.

2.2

If, by grooming another dog, Isabella adds $68.50 to her costs and only $60.00 to her revenues, her profit will fall by $8.50.

2.3

Profit = Revenue – Cost = Quantity × (price – average cost) = 350 × ($3.25 – $3.00) = $87.50.

Problems and Applications 2.4

The Metro’s revenue will increase, but its operating deficit will decline. The second part of the statement is incorrect. Revenue will increase as the subway system runs more trains. But because the marginal cost of running the additional trains exceeds the marginal revenue from the additional passengers, the Metro’s deficit will increase, not decrease.

ii. The Metro’s revenue and operating deficit will both decline. Both parts of this statement are incorrect. The Metro’s total revenue will increase as it runs more trains. But the marginal cost of running more trains exceeds the marginal revenue from those additional trains, so the deficit will increase, not decrease. iii. The Metro’s revenue and operating deficit will both increase. Copyright © 2021 Pearson Education, Inc.

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This statement is correct. As the Metro runs more trains, its total revenues will increase. The marginal cost of running additional trains exceeds the marginal revenue from the additional passengers, so the Metro’s deficit will also increase. iv. The Metro’s revenue will decline, but its operating deficit will increase. The first part of the statement is incorrect. The Metro’s total revenues will increase, not decrease as it runs more trains. The second part of the statement is correct. The marginal cost of running additional trains exceeds the marginal revenue from the additional passengers, so the Metro’s deficit will increase. 2.5

We need to calculate marginal revenue and marginal cost at the bakery, which we can do by adding three new columns to the table: Marginal Revenue, Total Cost, and Marginal Cost: Ciabatta Bread

Total Revenue

Marginal Revenue

Total Cost

(TR)

(MR)

(TC)

Marginal Cost

Sold per Hour (Q)

Price

$6.00

—

$ 3.00

—

5.50

$ 5.50

$5.50

7.00

$4.00

5.00

10.00

4.50

10.00

3.00

4.50

13.50

3.50

12.50

2.50

4.00

16.00

2.50

14.50

2.00

3.50

17.50

1.50

16.00

1.50

3.00

18.00

0.50

17.00

1.00

2.50

17.50

–0.50

18.50

1.50

2.00

16.00

–1.50

21.00

2.50

(P)

(MC)

a. Maria should sell 5 loaves of ciabatta bread. At this quantity, MC = MR. She should charge a price of $3.50 per loaf of bread. Her profit will equal TR − TC, or $17.50 – $16.00 = $1.50. b. The marginal revenue from selling the profit-maximizing loaf of bread is $1.50, which is the same as the marginal cost of selling this loaf of bread. 2.6

Jerry is correct. We cannot determine the profit-maximizing number of lamps without knowing the revenue that would be earned from selling lamps. Minimizing average costs is not the same as maximizing profit. The profit-maximizing level of output is typically not the same output that would minimize average costs.

2.7

Assuming that these changes did lower the cost of selling coffee, your graph should look like the following graph. When Starbucks streamlined its operations, its MC and ATC curves shifted down, from MC1 to MC2 and from ATC1 to ATC2, respectively. Lower costs caused Starbucks to reduce the price of cappuccinos from P1 to P2, which increased the quantity of cappuccinos that Copyright © 2019 Pearson Education, Inc.

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets it sold from Q1 to Q2. Starbucks’s profit before streamlining is represented by the rectangle with a height equal to the difference between the price, P1, and the average total cost, ATC1, and a base equal to the quantity of cups sold, Q1. On the graph, this amount equals P1ACATC1. After the reduction in cost, Starbucks earned a profit equal to the area of rectangle P2BDATC2.

2.8

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

b. Book publishing executive Germano seems to be assuming that demand is perfectly elastic and that the book publishing industry is perfectly competitive, so that by increasing the

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price of the book, sales would fall to zero. If a publisher does not raise the price of a book following an increase in its production cost, its marginal revenue from the last few copies of the book sold will be less than the marginal cost—so the publisher will earn a smaller profit than it would at a higher price. c. If demand for books is relatively inelastic, a higher price should result in a relatively small decrease in the quantity demanded. Raising a book’s price to cover higher costs will result in a smaller decrease in profit when demand is relatively inelastic than when demand is relatively elastic. 2.9

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

$440  $360  $400, 2 and the average of the initial and final quantities is:

So, the percentage change in the quantity demanded is:

800, 000  500, 000 100  46.2%, 650, 000 and the percentage change in the price is:

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

c. Profit = Revenue – Cost. $60,000,000 = $288,000,000 – (ATC × 800,000); therefore, to earn a profit of $60,000,000, the ATC for making 800,000 cars must be $285. ATC for 500,000 Model Ts: Total Cost = Revenue – Profit = $220,000,000 – $60,000,000 = $160,000,000. Therefore, ATC = $160,000,000/500,000 = $320. So, the ATC of producing 800,000 Model Ts was lower than the ATC of producing 500,000 Model Ts. d. Yes. If the profit is the same and Ford is selling more cars, he must be making a smaller profit per car. We can check this conclusion by calculating the profit per car (price minus Copyright © 2019 Pearson Education, Inc.

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CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets ATC): For 500,000 cars, profit per car = $440 – $320 = $120 per car; for 800,000 cars, profit per car = $360 – $285 = $75 per car.

2.10

a. TR = P × Q. Because the price at the profit-maximizing level of output of 1,700 is $3.20, Elijah’s TR = $3.20 × 1,700 = $5,440. Total cost = ATC × Q, so his total cost = $2.40 × 1,700 = $4,080. b. Profit = TR – TC, so Elijah’s profit = $5,440 − $4,080 = $1,360

What Happens to Profits in the Long Run? 13.3

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

Review Questions 3.1

New firms entering an industry cause the demand curves for the products of existing firms to shift to the left. Existing firms will sell less at every price, so their profits will decline.

3.2

Economic profit takes into account some nonmonetary opportunity costs that accounting profit does not. So, economic profit will typically be smaller than accounting profit. If a firm has zero accounting profit, it will incur an economic loss, while a firm with zero economic profit will earn a positive accounting profit.

3.3

In monopolistic competition, a firm needs to differentiate its products from the products of other firms if it hopes to earn an economic profit. Consumers will buy a product if they believe that it meets a need that is not met by the products of other firms. Firms that fail to continually differentiate their products from the products of competitors will be unable to earn an economic profit in the long run.

Problems and Applications 3.4

Any firm that earns an economic profit will attract competitors as long as there are no significant barriers to entering the firm’s market. Competition from new entrants will lower the price for the product and reduce the firm’s economic profit to zero. A firm can only hope to earn a profit in the long run if it is able to continually find new ways to differentiate its product.

3.5

a. As defined in Chapter 1, Section 1.6, an innovation is the practical application of an invention. For example, in 1936, the Douglas Aircraft company introduced the DC-3 airplane,

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which took the principles of aviation developed by the Wright Brothers in 1903 and used them in manufacturing a plane capable of making regular intercity passenger flights. b. Innovations dwindle when a firm produces fewer new products or fails to develop lower cost ways of producing existing products. c. Firm can successfully compete only by introducing new goods and services or better ways of producing existing goods and services. Firms that fail to do either of these things will, at best, find their economic profit competed away, and may well be driven out of business by other firms that introduce innovative new goods and services or innovative production methods. 3.6

JAB hopes that few other firms will be selling cold-brewed coffee. As a result, JAB will face limited competition and be able to charge prices that will allow it to earn an economic profit despite the other high costs of making and distributing this type of coffee. JAB is following a strategy of differentiating its product from those offered by competing firms. Ten years from now, we would expect that competing firms will also be offering cold-brewed coffee and that this increased competition will drive down prices, resulting in JAB’s economic profits falling to zero.

3.7

a. To maximize profit, Angelica should sell sandwiches up to the quantity where MC = MR. She should sell 55 beef brisket sandwiches at a price of $4.50 each. b. Angelica’s loss is equal to the difference between price and average total cost, multiplied by quantity = ($4.50 − $5.50) × 55 = −$55.00. Because the price is greater than her average variable cost, she should continue to produce in the short run even though she is suffering a loss. c. No, because she is suffering a loss. If such losses persist, she should shut down her store and exit the industry.

3.8

The analysis is incorrect. The student has forgotten that economic costs include a normal rate of return on the owners’ investment in the firm. Therefore, firms will not leave the industry when they earn zero economic profit. Also, in the long run, the price will be equal to average total cost—which is the breakeven point—not above average total cost as the student mentioned.

3.9

Your graph should look similar to the following graph. We are assuming that the Best Buy store’s average costs and marginal costs stay the same. When Microsoft’s stores closed, customers needed to purchase Xbox game consoles from a new retailer. Some of these customers will have bought the consoles from this Best Buy store. As a result, the demand curve shifts to the right from D1 to D2. When the demand curve shifts, the marginal revenue curve will also shift from MR1 to MR2. Because Best Buy’s marginal cost and average total cost stay the same, the increase in demand causes the profit-maximizing quantity of Xbox game consoles sold in a Best Buy store to increase from Q1 to Q2, while the price that it charges also increases from P1 to P2. The higher Copyright © 2019 Pearson Education, Inc.

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CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets price and quantity raise the profits of a typical Best Buy store from the rectangle P1BDATC1 to P2ACATC2. (Or, if the store had previously been breaking even on its Xbox game console sales, the store will now begin to earn an economic profit from selling them.)

3.10

The strategies Starbucks, Blue Bottle Coffee, and other coffeehouses have used allowed them to earn an economic profit in the short run. But all of these strategies—such as Blue Bottle offering cold-brewed coffee or Starbucks building Reserve Roastery coffeehouses—can eventually be copied by competitors. A firm can’t earn an economic profit in the long run using strategies that competitors can easily copy. The firms are aware of this conclusion but hope to earn short-run profits by periodically introducing new products or new ways of selling their existing products. As long as a firm can stay a step ahead of its competitors, it can continue to earn an economic profit, even though those profits would eventually disappear if it were to stop innovating.

3.11

Your graph should look like the following graph. Installing Just Walk Out technology in a convenience store lowers both the fixed cost and the marginal cost of selling a quart of milk. We can show these lower costs by shifting down the marginal cost curve from MC1 to MC2 and the average total cost curve from ATC1 to ATC2. With the lower costs, the store’s profit-maximizing quantity increases from Q1 to Q2 and its profit-maximizing price decreases from P1 to P2. The store’s profit before installing Just Walk Out technology is represented by the rectangle P1ACATC1. This area increases to P2BDATC2 after installing Just Walk Out technology.

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3.12

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a. Competition among the vegetable stands prevents any one of the stands from charging prices that would enable it to earn an economic profit for more than a brief period of time. Certainly, in the long run, the stands will break even rather than earn a profit. b. Supermarkets have higher costs, including investments in buildings and refrigerators, that are required to offer customers a wider variety of products than those sold by the street vendors. It is unlikely that supermarkets would be able to cover their costs of selling their vegetables if they charged prices similar to, or lower than, the prices charged by the vegetable stands.

Comparing Monopolistic Competition and Perfect Competition 13.4

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

Review Questions 4.1

In the long run, a perfectly competitive firm charges a price equal to marginal cost, and it produces the quantity that minimizes average total cost. A perfectly competitive firm is allocatively efficient and productively efficient. A monopolistically competitive firm charges a price that is above marginal cost (so it is not allocatively efficient), and it produces a quantity that is less than the amount that minimizes average total cost (so it is not productively efficient). Despite these differences, perfectly competitive and monopolistically competitive firms both earn zero economic profits in the long run.

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4.2

A monopolistically competitive firm is not productively efficient because it does not produce at minimum average total cost. Excess capacity stems from the fact that when a monopolistically competitive firm produces where MR = MC, it produces a level of output that is below the quantity for which average total cost is minimized.

4.3

A monopolistically competitive firm is not allocatively efficient because it charges a price that is greater than marginal cost.

4.4

Monopolistic competition probably doesn’t cause a significant loss in economic well-being to society. Consumers experience increased economic well-being when they are able to buy products that are more closely suited to their tastes. Monopolistically competitive firms are only successful in differentiating their products when the differentiation improves consumer wellbeing. Monopolistically competitive firms have higher costs as a result of not being productively efficient and, therefore, charge higher prices. Because consumers buy products offered by monopolistically competitive firms, they reveal that these products increase their well-being – despite having higher prices.

Problems and Applications 4.5

There is no contradiction between producing where price is greater than marginal cost and zero profit. Zero profit occurs when price equals average total cost, which holds in the long run for both perfectly competitive and monopolistically competitive firms.

4.6

a. The graph in the problem shows a monopolistically competitive firm. We know this because the firm faces a downward-sloping demand curve and a downward-sloping marginal revenue curve. A perfectly competitive firm’s demand curve would be horizontal and is the same as its marginal revenue curve. b. The graph in the problem shows a short-run equilibrium because the price is greater than average total cost, so the firm is earning an economic profit. Monopolistically competitive firms earn only an economic profit in the short run. c. If the firm were perfectly competitive, it would produce the quantity where the ATC is at its minimum. On the graph, this quantity is 7.

4.7

a. By having a different website and packaging for each of its nine restaurants, Green Summit is differentiating its product to better appeal to consumers with different tastes. Although food is prepared in a single kitchen, consumers may believe that the food is “high quality”— in part—because of this differentiation. Green Summit must believe that the differentiation increases its revenue by more than the additional costs it incurs. b. Green Summit’s strategy would not result in greater costs of food preparation because food is cooked in a central location, but the company incurs greater promotion and packaging costs. Therefore, Green Summit’s strategy decreases productive efficiency. However, the Copyright © 2021 Pearson Education, Inc.

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets xxvii company increases allocative efficiency and customer well-being because production of food is more in accordance with consumer preferences. 4.8

a. Profit = TR − TC. Because at the profit-maximizing level of output of 1,200, TR = $24,000 and TC = $24,000, the firm is earning zero economic profit. b. Because the firm is not operating at the lowest point on its ATC curve, it is not productively efficient. And because the firm is not producing the level of output where P = MC, it is not allocatively efficient.

4.9

a. Intelligentsia is unlikely to achieve productive efficiency. By offering a large number of coffees, it is likely the firm is producing each of these coffee varieties at a higher cost per unit because the firm is not taking full advantage of economies of scale in production. Economies of scale occur when the cost per unit decreases in the long run as a firm increases the quantity it produces. b. As consumers purchase the new types of coffee Intelligentsia offers, they are benefiting from product differentiation. We can make this inference because in the act of buying these new types of coffee, consumers are revealing that they prefer them to the other coffees that were already available. So, Intelligentsia may be doing a better job of responding to consumers’ preferences than if it produced conventional coffee in a productively efficient way.

How Marketing Differentiates Products 13.5

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

Review Questions 5.1

Marketing consists of all the activities that are necessary for a firm to sell a product to consumers. Marketing is not limited to advertising. For example, product placement and defending a brand name are also forms of marketing.

5.2

Firms are concerned about brand management because maintaining their product’s unique identity and its good reputation help to decrease the likelihood of losing customers to competitors.

Problems and Applications

xxviii CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets 5.3

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

5.4

Looking at what consumers are already buying is a good way to find out what customers want, but it probably isn’t a good way to make an economic profit because other firms already have this information and are selling products to these customers. Entering the market with products exactly like your competitors will only work if your firm somehow has lower costs than the other firms. Firms that discover new information about what customers want can temporarily make a profit supplying a new product until new firms enter the market and competition drives the firm’s profit to zero.

5.5

Producing “content” may be cheaper for firms to create because companies do not need to pay for advertising on TV and in print media such as newspapers and magazines. The volume of content of this type a firm can afford is likely to be greater than the volume of traditional advertising. Firms can also reach an audience, particularly younger consumers, who do not watch many conventional TV programs or read print newspapers and magazines. Some firms have encountered problems, though, with this type of content. Because editors or producers aren’t checking the content for accuracy, age-appropriateness, or societal concerns, it’s easier for questionable or inaccurate content to be made public. A number of firms have encountered problems when a Tweet, an Instagram post, or YouTube video offended some viewers or was later revealed to be inaccurate.

5.6

Thermos was originally a brand name for a particular type of vacuum flask, but by the 1960s, other firms had begun selling “thermos” containers. Although the Thermos company sued, a court decision declared that “thermos” had become a generic term that any firm could use, provided the word was spelled with a lower case “t” to avoid confusion with the Thermos company. Once the courts have declared a company’s brand name generic, there is not much the company can do. Rebranding the product would lose the name recognition the firm had built up over time. Another famous example of a product image mishap is Reebok’s Incubus Copyright © 2021 Pearson Education, Inc.

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running shoes for women. Reebok was surprised to learn that in medieval legend an incubus was a male demon who preyed on sleeping women. In response to the negative publicity, Reebok changed the shoe’s name.

13.6

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

Review Questions 6.1

A monopolistically competitive firm’s profitability depends on its ability to differentiate its product (to make it seem more desirable than its competitors’ products) and to produce its product at a lower average total cost than competing firms.

6.2

A monopolistically competitive firm can earn an economic profit only if it always stays one step ahead of its competitors by continually differentiating its product or lowering its costs.

Problems and Applications 6.3

Typically, both luck and managerial skill are involved in a firm’s success. Scott Crane was lucky that when he began expanding Smashburger the recession of 2007–2009 had lowered real estate prices, thereby reducing the cost of buying land to build new outlets. Even in that case, though, Crane had to be alert enough to realize that an opportunity was available. He also had to realize that consumer tastes for casual dining may have changed as a result of the recession. Crane’s emphasis on serving burgers made from fresh meat, rather than frozen meat, was successful in part because of a general change in consumer tastes toward food made from fresh ingredients. Crane benefitted from evolving consumer tastes, but he also needed to be able to recognize that the change in tastes was occurring. We can conclude that Crane’s success with Smashburger was partly due to his skill as a manager and partly due to luck. Determining whether luck or his skill was most important in the firm’s success would be difficult.

6.4

Restaurants face problems earning an economic profit in the long run because barriers to entering the restaurant industry are low. In the case of Ground Round, there was nothing to stop other restaurants from also offering juicy hamburgers and unlimited popcorn. Once other restaurants began doing so, the demand for the food offered by Ground Round declined. We can illustrate this outcome on a graph by shifting the demand curve for the firm’s product to the left until it touches the average total cost curve at the profit maximizing quantity, with the result that Ground Round’s economic profit falls to zero.

6.5

If barriers to entry into a market are low, owners of successful firms will know that economic profits earned in the short run will diminish as new firms enter the market in the long run. Firm owners and managers will need new strategies to earn economic profits in the future.

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6.6

In the same industry, a large firm is more likely to reach minimum efficient scale (MES) than a small firm. The large firm would then be able to produce at a lower average cost than the small firm. In this case, to earn an economic profit, the small firm would have to use product differentiation to offer consumers a product they would be willing to pay a higher price for than the price charged by the small firm’s larger rivals.

6.7

The analyst probably meant that “the right idea” is a new good or service that appeals to enough consumers for a firm to earn an economic profit. Successful entrepreneurs often mention that because interest rates and other production costs are relatively low during a recession, such as the recession caused by the Covid-19 pandemic, a recession can be a good time to start a new business. But unless there are barriers to entering the market the new small business is in, the “right idea” will not result in long- run economic profit. As stated in the textbook: “Firms try to continue earning a profit by reducing costs, by improving their products, by providing exceptional customer service, or by convincing consumers that their products are indeed different from what competitors offer.”

Suggestions for Critical Thinking Exercises

CT13.1 a. The cost curves would stay the same, but the demand curve would be downward sloping and the MR curve would separate from the demand curve and would be downward sloping. b. Presumably the firm would have greater short-run profits as it decided to make this move, but it would earn only a normal profit (zero economic profit) in the long run. CT13.2 Answers will vary. While this exercise is open-ended, it connects general ideas from the text to a topic that some students will be interested in. CT13.3 Answers will depend on the sources students find. Some students will likely mention weekend stayovers, seat position (an isle or middle seat), and how many bags passengers can check without being charged a fee.

CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets Brief Chapter Summary and Learning Objectives 14.1 Oligopoly and Barriers to Entry Show how barriers to entry explain the existence of oligopolies. Copyright © 2021 Pearson Education, Inc.

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Most economists believe that a four-firm concentration ratio greater than 40 percent indicates that an industry is an oligopoly.

14.2 Game Theory and Oligopoly Use game theory to analyze the strategies of oligopolistic firms. ▪

The interactions among firms in an oligopoly determine each firm’s profitability.

14.3 Sequential Games and Business Strategy Use sequential games to analyze business strategies. ▪

Sequential games are used to analyze situations in which one firm acts first and then other firms

respond.

14.4 The Five Competitive Forces Model Use the five competitive forces model to analyze competition in an industry. ▪

Michael Porter of the Harvard Business School developed a model that shows how five competitive forces determine the overall level of competition in an industry.

Supplemental Content: The Kinked Demand Curve ▪

The kinked demand curve model uses a demand curve and cost curves to determine the profit-maximizing level of output and price for an oligopolist.

Key Terms Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits.

Cooperative equilibrium An equilibrium in a game in which players cooperate to increase their mutual payoff.

Business strategy A set of actions that a firm takes to achieve a goal, such as maximizing profits.

Dominant strategy A strategy that is the best for a firm, no matter what strategies other firms use.

Cartel A group of firms that collude by agreeing to restrict output to increase prices and profits.

Economies of scale The situation in which a firm’s long-run average cost falls as it increases the quantity of output it produces.

Collusion An agreement among firms to charge the same price or otherwise not to compete.

Game theory The study of how people make decisions in situations in which attaining their

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goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of a firm depend on its interactions with other firms. Nash equilibrium A situation in which each firm chooses the best strategy, given the strategies chosen by other firms. Noncooperative equilibrium An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Oligopoly A market structure in which a small number of interdependent firms compete. Patent The exclusive legal right to produce a product for a period of 20 years from the date the patent application is filed with the government. Payoff matrix A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Price leadership A form of implicit collusion in which one firm in an oligopoly announces a price change and the other firms in the industry match the change. Prisoner’s dilemma A game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off.

Chapter Outline Apple, Spotify, and the Music Streaming Revolution By the mid-1990s, the music industry faced a serious threat from German engineers who developed a new way of storing music. MP3 files compressed information on a CD small enough to make downloading songs from the Internet feasible. In 2001, Apple introduced the iPod, the first successful portable MP3 player. Most record companies were willing to sell music in Apple’s iTunes store, which allowed people to legally download songs for $0.99 each. Although Apple gave record companies 70 percent of the share of revenue from downloads, this did not replace what the companies and musicians were losing from the decline in CD sales. Apple’s success did not put an end to digital piracy. This digital piracy became worse in 1999 when Shawn Fanning developed software called Napster that allowed peer-to-peer sharing of song files between anyone with a computer anywhere in the world. By 2015, many consumers were switching from buying individual songs to streaming songs from YouTube or other sites without purchasing them. Spotify, a music streaming service based in Sweden, and Alphabet’s Play music began offering subscription plans that allow unlimited streaming without advertisements. In 2015, Apple offered Apple Music and in 2016, Amazon launched Amazon Unlimited Music. An industry like music streaming, with only a few firms, is an oligopoly.

Teaching Tips See the end of this Instructor's Manual chapter for coverage of the kinked demand curve, including several graphs, that does not appear in the textbook. If you would like to cover this material in class, feel free to post these pages to your online course site page or photocopy and distribute them to your students.

14.1

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

An oligopoly is a market structure in which a small number of interdependent firms compete. One measure of the extent of competition in an industry is the concentration ratio. Four-firm concentration ratios measure the fraction of an industry’s sales accounted for by its four largest firms. Most economists believe that a four-firm concentration ratio of 40 percent indicates an industry is an oligopoly. The ratios do not include exports to the United States by foreign firms and are calculated for the national market, even though competition in some markets is mainly local. Concentration ratios provide a general idea of the extent of competition in an industry. (Some economists prefer a measure of competition known as the Herfindahl-Hirschman Index, which we cover in Chapter 15, Section 15.6)

CHAPTER 15 | Monopoly and Antitrust Policy

A. Barriers to Entry New firms have difficulty entering an oligopoly because of barriers to entry. A barrier to entry is anything that keeps new firms from entering an industry in which firms are earning economic profits. The most important barrier to entry is economies of scale. Economies of scale refer to the situation in which a firm’s long-run average cost falls as it increases the quantity of output it produces. Another type of barrier to entry is ownership of a key input. Examples of government-imposed barriers are patents, licensing requirements, and barriers to international trade. A patent grants the exclusive legal right to produce a product for a period of 20 years from the date the patent application is filed with the government. The government restricts competition through occupational licensing, the justification for which is to protect the public from incompetent practitioners. But by restricting the number of people who can enter licensed professions the laws raise prices. Governments also impose barriers through tariffs and quotas on foreign competition.

Teaching Tips Table 14.1 lists the four-firm concentration ratio of oligopolies in retail trade and manufacturing. Concentration ratios change over time. Industries with high ratios in one year may have lower ratios in a subsequent year and vice versa. Current and historic values for concentration ratios are available from the Web site of the U.S. Census Bureau: http://www.census.gov/econ/concentration.html

Extra Solved Problem 14.1 Entry Barriers in the Beer Industry in the United States and Germany Table 14.1 in the textbook lists beer as one of the most concentrated manufacturing industries in the United States. The concentration ratio in this industry has increased dramatically from 25 percent in 1958 to 88 percent in 2012. Two key reasons for this increase are: (1) National brewers increased their market share at the expense of regional and local breweries through television advertising, and (2) Economies of scale resulted from technological change in the form of automation of brewing and packaging. Packaging in bottles has become faster, but packaging in aluminum cans has become faster still. These changes have created substantial advantages for existing brewers and created large entry barriers in the industry. The proliferation of craft breweries since the 1980s has not reduced the national concentration ratio because craft breweries produce relatively small quantities of beer for local or regional markets. In contrast, the concentration ratio in the German beer industry was about 37 percent in 2014, though this represented a substantial increase from 12 percent in 1958. Three key reasons for the lower level of concentration in the German beer industry are: (1) Unlike the United States, Germany does not allow its lagers to be produced with preservatives; without preservatives, the lagers are more perishable, which limits the advantages of large-scale brewing; (2) Most German beer is sold in bottles rather than in cans. Bottled beer is more costly to transport in Germany because bottles are reusable and must be returned Copyright © 2023 Pearson Education, Inc.

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to the brewery; and (3) Germans traditionally have preferred local beers to beers brewed in other regions. This preference has been reinforced by the greater cost of transporting beers brewed without preservatives: “…strong brand loyalties permit hundreds of small… breweries to survive serving very limited local markets…” Sources: William James Adams, “Beer in Germany and the United States,” Journal of Economic Perspectives, Vol. 20, No. 1, Winter 2006, pp. 198–205; and https://www.statista.com/statistics/575229/brewery-groups-market-share-germany/

a. How did the popularity of television beginning in the 1950s enable beer manufacturers such as Anheuser-Busch (now Anheuser-Busch InBev) to increase its market share at the expense of local and regional breweries? b. Assume that the German government passed a law that allowed German firms to use preservatives in the brewing of their beers. What effect would this law have on the concentration ratio for beer in Germany?

Solving the Problem Step 1:

Review the chapter material. This problem is about barriers to entry, so you may want to review the section “Oligopoly and Barriers to Entry” in the textbook.

Step 2:

Answer part (a) by explaining how the popularity of television beginning in the 1950s led to increased concentration in the beer industry. Advertising on television enabled beer manufacturers to reach a national audience. The increased name brand recognition that resulted from advertising allowed these firms to expand sales and to gain a cost advantage over local and regional manufacturers. Firms such as Anheuser-Busch were able to achieve economies of scale and produce more beer at lower prices than smaller firms could. As a result, many local and regional breweries went out of business.

Step 3:

Answer part (b) by describing the likely effects of the hypothetical German law. As a result of the law, German firms that used preservatives would be able to sell their beer throughout the country at a lower cost by taking advantage of economies of scale, but the impact on the concentration ratio in the German beer industry is uncertain. The “strong loyalties” that Germans have had for local beers could mean they would still buy local beers, even if the price of the local beer was greater than the price of a national brand. The concentration ratio would increase only if Germans were willing to buy a national brand that was produced using preservatives.

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Extra Apply the Hard Times in Atlantic City Concept In the early twentieth century, Atlantic City, New Jersey, was a booming resort town and vacation destination with many hotels built along the city’s famed boardwalk. (The properties in the Monopoly board game are named after streets in Atlantic City.) By the 1950s, Atlantic City was in economic decline because low-priced airline travel made it possible for people in northeastern states to travel to vacation destinations such as Miami and the Caribbean. At that time, casino gambling was illegal in the United States everywhere outside of Nevada. In an attempt to attract visitors back to Atlantic City, in 1976 New Jersey voters passed a referendum to legalize gambling. Several gambling casinos opened in Atlantic City beginning in 1978 and were initially very profitable, attracting people from the Mid-Atlantic and Northeastern states. Entrepreneurs in these states were unable to compete with the Atlantic City casinos because casino gambling was illegal in their states. In effect, the government had imposed legal barriers to entry into the casino gambling industry. Eventually, though, other eastern states repealed their laws against casino gambling, and entrepreneurs opened new casinos in those states. By 2014, casino gambling was legal in Pennsylvania, New York, Connecticut, Delaware, and Maryland. The entry of these new casinos caused a sharp decline in the demand for Atlantic City casinos. Gamblers in the large New York City market now had several casinos that were closer than those in Atlantic City. By 2014, the revenues of Atlantic City casinos, which had peaked at $5.2 billion in 2006, had fallen to $2.5 billion. In 2014, 4 of the city’s 12 gambling casinos announced that they would be closing. Most shockingly, one of the four was the Revel Casino Hotel, which had opened only two years before, at a cost of $2.4 billion. Several other casinos were also in danger of failing. The casino industry in Atlantic City prospered when government regulations limited the competition they faced. As governments began to remove these legal barriers to entry, the profitability of the casinos sharply declined. Sources: Emily Brennan, “In Time for Memorial Day, Atlantic City Attempts a Turnaround,” New York Times, May 8, 2015; Charles V. Bagli, “Owner of Revel Casino in Atlantic City Files for Bankruptcy Protection,” New York Times, June 19, 2014; Josh Dawsey and Heather Haddon, “Revel Casino, Still Shiny and New, Teeters on the Edge,” Wall Street Journal, July 10, 2014; and Daniel Kelley, “Atlantic City Casino Workers Fear Bleak Future,” (Allentown) Morning Call, July 14, 2014.

14.2 Game Theory and Oligopoly

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Learning Objective: Use game theory to analyze the strategies of oligopolistic firms.

Game theory is the study of how people make decisions in situations in which attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of a firm depend on its interactions with other firms. Games share three characteristics: rules that determine what actions are allowable; strategies that players employ to attain their objectives in the game; and payoffs that are the results of the interactions among the players’ strategies. A business strategy is a set of actions that a firm takes to achieve a goal, such as maximizing profits.

A. A Duopoly Game: Price Competition between Two Firms A payoff matrix is a table that shows the payoffs that each firm earns from every combination of strategies by the firms. One strategy that firms may use is to collude. Collusion is an agreement among firms to charge the same price or otherwise not to compete. Collusion is against the law in the United States. A dominant strategy is a strategy that is the best for a firm, no matter what strategies other firms use. A Nash equilibrium is a situation in which each firm chooses the best strategy, given the strategies chosen by other firms.

B. Firm Behavior and the Prisoner’s Dilemma Sometimes an equilibrium reached between two firms is not satisfactory. Cooperation may result in a better outcome. A cooperative equilibrium is an equilibrium in a game in which players cooperate to increase their mutual payoff. A noncooperative equilibrium is an equilibrium in a game in which players do not cooperate but pursue their own self-interest. A prisoner’s dilemma is a game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off.

C. Can Firms Escape the Prisoner’s Dilemma? The prisoner’s dilemma seems to show that cooperative behavior breaks down, but that result assumes the game is played only once. Most business situations are repeated; in a repeated game, the losses from not cooperating are greater than in a game played only once, and players can employ retaliation strategies against those who don’t cooperate. As a result, cooperative behavior is more likely. Price leadership is a form of implicit collusion in which one firm in an oligopoly announces a price change and the other firms in the industry match the change.

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Concept

Coordinating prices is easier in some industries than in others. Fixed costs in the airline industry are very large, and marginal costs are very small. The marginal cost of flying one more passenger from Chicago to New York is no more than a few dollars: the cost of another snack served and a little additional jet fuel. As a result, airlines often engage in last-minute price cutting to fill the remaining empty seats on a flight. Even a low-price ticket will increase marginal revenue more than marginal cost. As with other oligopolies, if all airlines cut prices, industry profits will decline. Airlines therefore continually adjust their prices while at the same time monitoring their rivals’ prices and retaliating against them for either cutting prices or failing to go along with price increases.

In recent years, mergers in the airline industry have increased the possibility of implicit collusion. In 2019, just four airlines—American, Delta Airlines, United, and Southwest—flew 80 percent of all passengers, a sharp increase from their 40 percent share in 2007. Smaller airlines, such as JetBlue, Spirit Airlines, and Allegiant Air, provided competition on some routes, but the four big airlines were the only ones offering service between many pairs of cities. In 2013, when American was merging with US Airways, the U.S. Department of Justice (DOJ) threatened to go to court to block the merger unless the airlines agreed to give up landing slots at some airports to smaller competitors. When the airlines agreed to this condition, the DoJ approved the merger. Two years later, though, the DoJ began investigating whether the big four airlines were illegally colluding.

In particular, the DoJ was concerned when top managers of all four major airlines publicly stated that they intended to undertake only modest increases in capacity by buying additional planes or flying additional routes. Adding more capacity would mean having more tickets to sell, which would increase the likelihood of price cutting to fill the seats. Were these announcements an example of implicit price collusion, or were they just routine discussions by top managers of their firms’ future plans? As one airline industry analyst put it, “If you’re listening as a Justice Department attorney, you’d say, ‘Wait a minute, these guys are all saying the same thing, and that can’t just happen naturally, can it?’” But a lawyer who defends firms accused of collusion was skeptical that the DoJ could prove its case without evidence of an explicit agreement, which he doubted had occurred: “I’d be shocked if they got together in a smoke-filled room and agreed to cut capacity.” This analysis appears to have been correct because in early 2017, the DoJ decided that it had been unable to find sufficient evidence to bring charges against the airlines for collusion. Copyright © 2023 Pearson Education, Inc.

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Some economists and policymakers remain concerned about the level of competition in the U.S. airline industry. Although JetBlue and other smaller airlines provide vigorous competition at some airports, other airports are dominated by one or two carriers that often avoid price competition. For instance, the merger of American and US Airways gave the combined company a greater than 75 percent share of flights originating in Philadelphia. American’s ticket prices rose sharply after the merger. The federal government does not allow airlines with more than 25 percent foreign ownership to operate flights between U.S. cities, reducing potential competition. Europe has looser restrictions of foreign airlines, which may help explain why airline fares are lower per mile in Europe than in the United States. In 2018, Southwest and American each paid millions of dollars to settle consumer lawsuits that accused them of colluding with United and Delta to raise airline fares. Both airlines denied that they had colluded and stated that they were settling the lawsuits only to avoid the expense of a court trial. Some airline passengers wonder whether the big four airlines are colluding by all adopting a charge for checked luggage and by practicing overbooking—selling more tickets for a flight than there are seats on the plane. Airlines have also increased the number of airfare classes they use beyond the traditional first class, business class, and economy to include economy plus, premium economy, premium select, and other classes that offer amenities such as seating toward the front of the plane, free checked baggage, or more leg room. These additional airfare classes may help reduce price competition among airlines because they make it more difficult for passengers to compare fares. As we will see in Chapter 15, Section 15.6, the federal government can have difficulty deciding whether firms in an oligopoly are colluding. When collusion occurs, consumers pay higher prices and receive inferior service.

D. Cartels: The Case of OPEC In the United States, firms cannot legally meet to agree on what prices to charge and how much to produce. The example of the Organization of Petroleum Exporting Countries (OPEC), a 14-member cartel, suggests that collusion is not always successful. A cartel is a group of firms that collude by agreeing to restrict output to increase prices and profits. OPEC has had difficulty sustaining high oil prices. Once the price has been driven up, each OPEC member has an incentive to stop cooperating and earn higher profits by increasing output beyond its quota.

Extra Solved Problem 14.2 Is Advertising a Prisoner’s Dilemma for Coca-Cola and Pepsi? Coca-Cola and Pepsi both advertise aggressively, but would they be better off if they didn’t? Their commercials are usually not designed to convey new information about their products, but to capture each other’s customers. Construct a payoff matrix using the following hypothetical information:

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If neither firm advertises, Coca-Cola and Pepsi both earn profits of $750 million per year. If both firms advertise, Coca-Cola and Pepsi both earn profits of $500 million per year. If Coca-Cola advertises and Pepsi doesn’t, Coca-Cola earns profits of $900 million and Pepsi earns profits of $400 million. If Pepsi advertises and Coca-Cola doesn’t, Pepsi earns profits of $900 million and Coca-Cola earns profits of $400 million.

a. If Coca-Cola wants to maximize profit, will it advertise? Briefly explain. b. If Pepsi wants to maximize profit, will it advertise? Briefly explain. c. Is there a Nash equilibrium to this advertising game? If so, what is it?

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Solving the Problem Step 1:

Review the chapter material. This problem uses payoff matrixes to analyze a business situation, so you may want to review the section “A Duopoly Game: Price Competition between Two Firms” in the textbook.

Step 2:

Construct the payoff matrix.

Step 3:

Answer part (a) by showing that Coca-Cola has a dominant strategy of advertising. If Pepsi doesn’t advertise, then Coca-Cola will make $900 million if it advertises but only $750 million if it doesn’t. If Pepsi advertises, Coca-Cola will make $500 million if it advertises but only $400 million if it doesn’t. Therefore, advertising is a dominant strategy for CocaCola.

Step 4:

Answer part (b) by showing that Pepsi has a dominant strategy of advertising. Pepsi is in the same position as Coca-Cola, so Pepsi also has a dominant strategy of advertising.

Step 5:

Answer part (c) by showing that there is a Nash equilibrium for this game. Both firms advertising is a Nash equilibrium. Given that Pepsi is advertising, Coca-Cola’s best strategy is to advertise. Given that Coca-Cola is advertising, Pepsi’s best strategy is to advertise. Therefore, advertising is the optimal decision for both firms, given the decision made by the other firm.

Extra Credit: This is another example of the prisoner’s dilemma game. Coca-Cola and Pepsi would be more profitable if they both refrained from advertising, thereby saving the enormous expense of television and radio commercials and newspaper and magazine ads. Each firm’s dominant strategy is to advertise, however, so they end up in an equilibrium where both advertise and their profits are reduced.

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Extra Apply the Is There a Dominant Strategy for Bidding on eBay? Concept An auction is a game in which bidders compete to buy a product. The payoff in winning an auction is equal to the difference between the subjective value you place on the product being auctioned and the amount of the winning bid. On the online auction site eBay, more than 100 million people buy and sell more than 360 million items annually. Many items on eBay are sold in second-price auctions, where the winning bidder pays an amount equal to the bid of the second-highest bidder. If the highest bid for a Morgan 1886 silver dollar is $500, and the second-highest bid is $480, the highest bidder wins the auction and pays $480. It may seem that your best strategy when bidding on eBay is to place a bid well below the subjective value you place on the item in the hope of winning it at a low price. In fact, bidders on eBay have a dominant strategy of entering a bid equal to the maximum value they place on the item. Suppose you are looking for a present for your parents’ anniversary. Your parents are fans of bluegrass singer Alison Krauss, and someone is auctioning a pair of tickets to an Alison Krauss concert. If the maximum value you place on the tickets is $200, then that should be your bid. To see why, consider the results of strategies of bidding more or less than $200. There are two possible outcomes of the auction: Either someone else bids more than you do or you are the highest bidder. First, suppose you bid $200 but someone else bids more than you do. If you had bid less than $200, you would still have lost. If you had bid more than $200, you might have been the highest bidder, but because your bid would be for more than the value you place on the tickets, you would have a negative payoff. Second, suppose you bid $200 and you are the highest bidder. If you had bid less than $200, you would have risked losing the tickets to someone whose bid you would have beaten by bidding $200. You would be worse off than if you had bid $200 and won. If you had bid more than $200, you would not have affected the price you ended up paying—which, remember, is equal to the second-highest bid. Therefore, a strategy of bidding $200—the maximum value you place on the tickets—dominates bidding more or less than $200. Even though making your first bid your highest bid is a dominant strategy on eBay, many bidders don’t use it. After an auction is over, a link leads to a Web page showing all the bids. In many auctions, the same bidder bids several times, showing that the bidder had not understood his or her dominant strategy. Question We argued that a bidder on an eBay auction has a dominant strategy of bidding only once, with that bid being the maximum the bidder would be willing to pay.

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a. Is it possible that a bidder might receive useful information during the auction, particularly from the dollar amounts that others are bidding? If so, how does that change a bidder’s optimal strategy? b. Many people recommend the practice of “sniping,” or placing your bid at the last second before the auction ends. Is there a connection between sniping and your answer to part (a)? Answer a. The analysis in the text assumes that the auction is a private value auction, which means that each person’s value of the good is independent of other bidders’ values. But this may be wrong: You may learn about the value of a good through other people’s bids. This would be the case if, for example, you are thinking of buying U2 concert tickets in order to resell them. In that case you want to find out the market value of the tickets and the other bids may disclose some of this information. Or, if you were interested in a collectible, the fact that a well-known collector or dealer was bidding more than your highest bid might lead you to reevaluate how valuable the collectible was to you. b. Sniping can allow you to learn the market value of a good without disclosing your private information. Many dealers looking for undervalued collectibles use automated sniping programs so that collectors and other dealers are not able to use their private information about the true value of the collectible.

Extra Apply the With Price Collusion, More Is Not Merrier Concept Coordinating prices is easier in some industries than in others. Fixed costs in the airline industry are very large, and marginal costs are very small. The marginal cost of flying one more passenger from Chicago to New York is no more than a few dollars: The cost of another snack served and a small amount of additional jet fuel. As a result, airlines often engage in last-minute price cutting to fill the remaining empty seats on a flight. Even a low-price ticket will increase marginal revenue more than marginal cost. As with other oligopolies, if all airlines cut prices, industry profits will decline. Therefore, airlines continually adjust their prices while monitoring their rivals’ prices and retaliating against them for either cutting prices or failing to go along with price increases. Mergers in the airline industry have increased the possibility of implicit collusion by reducing the number of airlines flying between two cities. Often only one or two airlines will fly on a particular route. Southwest Airlines and JetBlue, however, have undertaken an aggressive campaign to enter many airports, thereby increasing competition. Before Southwest entered Washington, DC’s Dulles Copyright © 2023 Pearson Education, Inc.

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International Airport in October 2006, United and Continental Airlines were the only major airlines serving the airport. But would increasing the number of airlines on a route from two to three have much effect on the ability of the airlines to engage in price collusion? Austan Goolsbee and Chad Syverson of the University of Chicago studied the effects of Southwest’s entering airline markets over an 11-year period. They found that when Southwest began flying a particular route, ticket prices dropped by an average of 29 percent. These price declines indicate that airlines may have been practicing implicit price collusion before Southwest’s entry into the market. Goolsbee and Syverson found that more than half of the price decline occurred after it became likely that Southwest would enter a market but before Southwest actually began flying planes on the route. One possibility is that airlines already in the market lowered prices to keep frequent flyers from switching to Southwest. JetBlue has had a similar effect on airline fares. For example, when JetBlue entered the Chicago-to-New York market in 2006, United and American, which had previously dominated the route, slashed fares by 65 percent, to $108 for a round-trip ticket. For several years, the airlines had trouble reestablishing the implicit price collusion they had practiced before JetBlue entered. In September 2011, a round-trip ticket from Chicago to New York had a price of $106 on United and American, and $101 dollars on JetBlue. In the airline industry, it apparently doesn’t take much competition to greatly reduce opportunities for price collusion. But does the effect of increased competition continue indefinitely? We might expect that the longer the same firms compete in a market, the more likely they are to eventually reestablish implicit price collusion, particularly if other factors, such as rising costs and increasing demand, put upward pressure on prices. Something like this outcome occurred in the Chicago-to-New York market. Following increases in jet fuel costs and rising demand as the U.S. economy recovered from the 2007– 2009 recession, in July 2013 round-trip ticket prices had risen to $321.80 on JetBlue, $327.80 on American, and $343.80 on United. Sources: Austan Goolsbee and Chad Syverson, “How Do Incumbents Respond to the Threat of Entry? Evidence from the Major Airlines,” Quarterly Journal of Economics, Vol. 123, No. 4, November 2008, pp. 1611–1633; Julie Johnson, “Rude Welcome Awaits JetBlue,” Chicago Tribune, November 6, 2006; and route pricing data from www.orbitz.com

Question The following appeared in an article in the Wall Street Journal: “Last week, true to discount roots dating to 1971, Southwest [Airlines] launched a summer fare sale on domestic flights, with one-way prices as low as $49. As in the past, major competitors were forced to follow suit.” Why would other airlines be “forced” to follow Southwest’s fare decrease? Does your answer change if you learn that this fare decrease took place during an economic recession, when incomes and the demand for airline travel were falling? Briefly explain. Source: Mike Esterl, “Southwest Airlines CEO Flies Uncharted Skies,” Wall Street Journal, March 25, 2009.

Answer The airline industry is an oligopoly, and as game theory demonstrates, the other airlines were “forced” into lowering their fares in order to compete with Southwest. By matching Southwest’s lower fares, the Copyright © 2023 Pearson Education, Inc.

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other airlines were choosing the best strategy for maximizing profits given Southwest’s strategy. Your answer would not change if the fare decrease took place during a recession because the airlines would still be choosing the best strategy given Southwest’s strategy. It is particularly difficult for airlines to avoid price cutting during a recession, however, because demand has declined and a failure to match competitors’ price cuts would likely result in planes flying with many empty seats. Question Until the late 1990s, airlines would post proposed changes in ticket prices on computer reservation systems several days before the new ticket prices went into effect. Then the federal government took action to end this practice. Now airlines can post prices on their reservation systems only for tickets that are immediately available for sale. Why would the federal government object to the old system of posting prices before they went into effect? Source: Scott McCartney, “Airfare Wars Show Why Deals Arrive and Depart,” Wall Street Journal, March 19, 2002.

Answer By posting prices before they went into effect, an airline could see what the reaction of its competitors to the price change would be. If firms matched a price cut or failed to match a price increase, the airline could cancel the price change before it had actually taken effect, which might be to the disadvantage of consumers.

14.3

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

In many business situations, one firm will make a decision and other firms will respond. We can use sequential games to analyze strategies designed to deter entry by new firms and to analyze bargaining between firms.

A. Deterring Entry We can analyze a sequential game by using a decision tree, which contains decision nodes and terminal nodes. Decision nodes are points when firms must make decisions. Terminal nodes show the results of decisions made by firms.

B. Bargaining The success many firms have depends on how well they bargain with other firms, such as their suppliers. Managers use decisions trees to provide a systematic way of thinking through the implications of a strategy and of predicting the reactions of rivals. Copyright © 2023 Pearson Education, Inc.

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Extra Apply the An Xs and Os Game Concept Economists often use games that do not involve business decisions to help students understand how business-related decisions are made. These examples are useful because the strategy used in one type of game is often similar to that used in another. The textbook explains sequential games by using examples of a game with two players. Other sequential games with two players include tic-tac-toe, checkers, and chess. Although tic-tac-toe is a simple game, it has a complex decision tree. According to economists Avinash Dixit and Susan Skeath: “To illustrate *the game+ with a decision tree, we would have to show that the first player has nine possible actions at the initial node, the second player has eight possible actions at each of the nine decision nodes and then the first player ….has seven possible actions at each of 7 × 8 × 9 * = 504+ nodes.” The complexity for even a simple game arises because the winning strategy for players to follow is to anticipate where their initial moves will lead and to use this information to determine the best choice; this reasoning is called “looking forward and reasoning back.” For a more complex game, such as chess, the calculations required to describe all possible moves are too complicated for all but the most advanced computers. As a result, expert chess players anticipate their own and their opponent’s next few moves from their own experience in playing the game in order to compose a winning strategy. Source: Avinash Dixit and Susan Skeath, Games of Strategy, New York: W.W. Norton & Co. 1991, pp. 64–67.

The Five Competitive Forces Model 14.4

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

Michael Porter of the Harvard Business School has developed a model that shows how five competitive forces determine the level of competition in an industry.

A. Competition from Existing Firms When there are only a few firms in a market, it is easier for them to collude and to charge a price close to the monopoly price. Competition can be in the form of advertising, better service, or longer warranties.

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Firms face competition from other firms that might enter the market. Managers often take actions aimed at deterring entry.

C. Competition from Substitute Goods or Services Firms are vulnerable to competitors that introduce a new product that fills a need better than a current product does.

D. The Bargaining Power of Buyers If buyers have enough bargaining power, they can insist on low prices and higher quality products. For example, Walmart has required its suppliers to alter their distribution systems.

E. The Bargaining Power of Suppliers If many firms can supply an input and the input is not specialized, the suppliers are unlikely to have the bargaining power to limit a firm’s profits. However, with a single supplier, the purchasing firm may have to pay a high price for an input.

Extra Solved Problem 14.4 Competition in the Automobile Industry Before the 1970s, the automobile industry in the United States was dominated by the “Big Three”— Ford, General Motors, and Chrysler. There was little competition from foreign manufacturers, in part, because buyers of foreign cars found it difficult to find mechanics when their cars needed repairs. As the price of gasoline rose in the 1970s and 1980s, more American consumers were attracted to the smaller, fuel-efficient cars that foreign manufacturers specialized in producing. The Big Three began to lose market share to firms such as Toyota, Volkswagen, and Nissan. Here are the major costs of automobile manufacturing:     

Labor costs. Although machines and robots have replaced labor for some tasks, labor costs are still significant for designing, engineering, and manufacturing vehicles Materials. Most inputs, including steel, aluminum, dashboards, and tires are purchased from suppliers Advertising. Automakers spends billions on print, broadcast, and online ads annually Market research. This research is designed to anticipate changes in consumer tastes. Research and development of new car models.

The automobile market has become an increasingly global market. American firms have extensive overseas operations, and it has become easier for foreign manufacturers to enter North American markets. While most car sales are to individual buyers, automakers also make large-volume fleet sales to Copyright © 2023 Pearson Education, Inc.

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government agencies and businesses, including rental car firms. These sales are typically made at discount prices. Automobiles have a high income elasticity of demand, so sales fluctuate widely as the economy moves through the business cycle. During the 2007–2009 recession, for example, sales of new cars plunged. Even when interest rates were low, many consumers were reluctant to commit themselves to car loans that may take four or five years to pay off. Source: https://www.investopedia.com/features/industryhandbook/automobile.asp

Analyze the competitiveness of the automobile industry using Michael Porter’s Five Competitive Forces model.

Solving the Problem Step 1:

Review the chapter material. This problem is about Porter’s five competitive forces model, so you may want to review the section “The Five Competitive Forces Model” in the textbook.

Step 2:

Discuss competition from existing firms. In addition to competition among the traditional Big Three firms—Ford, Chrysler, and General Motors—these firms also face significant competition from foreign firms, several of which have factories in the United States—including Honda and Toyota. Auto firms use rebates, financing, and long-term warranties to lure consumers away from their competitors.

Step 3:

Discuss the threat from new entrants. There are high costs to entering the automobile market. In addition to capital costs, firms must spend large amounts on materials, advertising, market research, design, and engineering. Foreign automakers have shown they have the resources needed to establish manufacturing facilities in the United States.

Step 4:

Discuss competition from substitute goods or services. Although many automobile owners are reluctant to substitute toward alternative means of transportation, some consumers can use alternatives such as bus, train, and airplane travel. Public transportation is an especially important substitute in cities with large populations. When energy prices have risen, consumers have shown a willingness to reduce their automobile travel. Consumers can delay the purchase of a new automobile by using previously purchased automobiles for longer periods of time.

Step 5:

Discuss the bargaining power of buyers.

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During the glory years of the Big Three, consumers had few alternatives to choose from, and only government agencies and large companies could negotiate significantly lower prices for high volume purchases. Since the 1970s, foreign manufacturers have offered individual consumers more choices and more bargaining power. Step 6:

Discuss the bargaining power of suppliers. There are many firms that supply materials to automakers. Most suppliers rely on a small number of buyers for the majority of their sales. As a result, most suppliers have little bargaining power.

Extra Economics in Your Life & Career: How Big Is Too Big? Question: The textbook mentions that a four-firm concentration ratio of 40 percent or higher can be used to classify an industry as an oligopoly. Economists believe that competition in markets with lower concentration ratios is usually sufficient to ensure that firms do not engage in collusion or otherwise not compete with rival firms. But for oligopoly markets, how can you evaluate whether firms are using market power to charge high prices and avoid competition that would benefit consumers? Answer: Although a high concentration ratio is enough to suggest that firms may charge high prices and engage in collusion, this does not mean that collusion will actually occur. In addition to looking at concentration ratios, you should consider other factors: (1) Does high concentration persist over time? In growing industries, it is often the case that an industry that initially is highly concentrated becomes less concentrated over time. Slow-growing industries are more likely to remain highly concentrated. (2) Are the smallest firms in the industry as profitable as the largest firms in the industry? If profit rates are similar, this may be evidence that large firms do not have lower average costs due to economies of scale. Smaller firms benefit from the prices the larger firms charge and may be reluctant to engage in a price war with the largest firms. (3) Is the rate of profit in this industry greater than the profit rates in less concentrated industries? If the profit rate is greater in high concentration industry, is this due to lower costs and better quality products or to a lack of competition? Big might be “bad” but firms may become large, and an industry concentrated because they have been successful at providing goods and services that consumers want. In this case big can be “good”—for consumers.

Supplemental Content The Kinked Demand Curve

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Another approach to analyzing oligopoly is known as the kinked demand curve model. To understand this approach, first suppose that Toyota is considering offering a $3,000 rebate on its Highlander sports utility vehicle (SUV). This should cause sales of Highlanders to increase, but its total costs will also increase as Toyota produces more SUVs. We know from the analysis in Chapters 12 and 13 that Toyota’s profits will rise if the marginal revenue earned from selling the additional Highlanders is greater than the marginal cost of producing them. To calculate marginal revenue and marginal cost, Toyota must accurately forecast the effect of the rebate on sales. But this may not be easy to do, because the effect of the rebate on Toyota’s sales will depend on whether Toyota’s competitors also offer rebates. Figure 1 on the next page illustrates the problem facing Toyota. If Toyota offers the $3,000 rebate and the other car companies ignore it, Toyota will have succeeded in lowering the price of the Highlander relative to the prices of competing SUVs. This situation is represented by demand curve D1. The price of Highlanders falls from $31,000 to $28,000, and sales rise from 60,000 per year to 72,000. But suppose that the other car companies do not want to lose sales to Toyota, so they all decide to also offer $3,000 rebates. In that case, Toyota will not have lowered the price of the Highlander relative to other SUVs, because they will all now be $3,000 cheaper. This situation is represented by demand curve D4. Toyota’s sales will now rise from 60,000 to 61,000. Of course, Toyota may find that some, but not all, other companies match its rebate. Demand curve D2 shows what happens if a few firms match the rebate, and demand curve D3 shows what happens when most firms match the rebate. Notice that the more firms that match the rebate, the more price inelastic Toyota’s demand curve becomes. Figure 1 What Does the Demand Curve for an Oligopolist Look Like?

How many Highlander SUVs Toyota sells after a price cut depends on how the other car companies react? If no other companies match the price cut, Toyota faces demand curve D1, and cutting the price of Highlanders from $31,000 to $28,000 will increase sales from 60,000 SUVs per year to 72,000. At the other extreme, if all its competitors match the price cut, then Toyota faces demand curve D4, and its sales will increase only from 60,000 to 61,000. Demand curves D2 Copyright © 2023 Pearson Education, Inc.

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and D3 show intermediate cases where some, but not all, of Toyota’s competitors match the price cut.

Clearly, how effective the rebate is in increasing sales depends upon how many of Toyota’s competitors decide to match it. Toyota is facing the basic problem of oligopoly: it can only estimate its demand curve by accurately predicting its competitors’ reactions to a price change. How can the managers of a company accurately predict their competitors’ reactions? Economists, marketing managers, and business strategists have struggled with this problem for many years. One approach is the kinked demand curve model, which uses a demand curve and cost curves to determine the profit-maximizing level of output and price. As we will see, the kinked demand curve model suffers from the drawback that it can accurately predict the behavior of oligopolistic firms only in certain situations. To begin our analysis of the kinked demand curve model, suppose, as we showed in Figure 1, that Toyota is currently selling 60,000 Highlanders per year at a price of $31,000 each. How should Toyota take into account the reactions of its competitors if it changes the price of Highlanders? One possibility is that a company in an oligopolistic industry will expect other firms to react differently to a price cut than to a price increase. For instance, Toyota might expect all of its competitors to match a rebate, because they don’t want to lose sales to Toyota, but to ignore a price increase, because they hope to gain some of Toyota’s customers. If these expectations are correct, Toyota will face the strange looking demand curve shown in Figure 2 on the next page. If Toyota’s competitors ignore any change it makes in the price of Highlanders, then it faces the more elastic demand curve, D1. Price increases will cause many potential buyers of Highlanders to buy a competing SUV, and price cuts will attract many customers who might have bought a competing SUV. But if Toyota’s competitors match any price change, then the effect of the price change on Highlander sales is fairly small. In this case, Toyota faces the less elastic demand curve, D2. But if Toyota’s competitors ignore price increases and match price cuts, the company will face the kinked demand curve shown by the solid line in Figure 2, made up of the segment of D1 above the current price of $31,000 and the segment of D2 below $31,000. Figure 2 A Kinked Demand Curve

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If an oligopolist’s competitors ignore its price changes, it faces demand curve D1. If an oligopolist’s competitors match its price changes, it faces demand curve D2. If its competitors match its price cuts and ignore its price increases, then it will face a kinked demand curve made up of demand curve D1 for prices above the current price and demand curve D2 for prices below the current price.

What difference will a kinked demand curve make to Toyota’s decision about how many Highlanders to produce and what price to charge? Figure 3 helps provide the answer by adding marginal revenue and marginal cost curves.

Figure 3 A Kinked Demand Curve Leads to Stable Prices

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Because of the kink in the oligopolist’s demand curve, the marginal revenue curve will have a gap in it, shown by the vertical line between points A and B. As long as marginal cost stays within this gap and demand doesn’t change, the firm will continue to produce the same amount and charge the same price.

Because the demand curve for Highlanders is composed of segments of two demand curves, the marginal revenue curve will be composed of the corresponding segments of two marginal revenue curves. As Toyota moves down demand curve D1, MR1 will be the marginal revenue curve. When it reaches the kink—at output of 60,000—and starts to move down demand curve D2, MR2 becomes the marginal revenue curve. But notice that there is a gap between the two segments, shown in the figure by the vertical line between points A and B. At point A, marginal revenue drops from MR1 down the vertical line to point B on MR2. So, the marginal revenue curve for Highlanders consists of a segment of MR1, the gap or vertical line between A and B, and a segment of MR2. (To prove to yourself that there must be a gap in the marginal revenue curve, try drawing this figure. Keep in mind that for a linear, or straight-line, demand curve, the marginal revenue curve will be twice as steep as the demand curve.) Remember from Chapters 12 and 13 that to maximize profits a firm will produce the level of output where marginal revenue equals marginal cost. Figure 3 shows that to maximize profits, Toyota should produce 60,000 Highlanders and charge a price of $31,000. The gap in the marginal revenue curve leads to the following interesting result: increases and decreases in marginal cost may not lead to changes in the output and price combination that maximizes profits. As long as the marginal cost curve intersects the marginal revenue curve somewhere between A and B, a quantity of 60,000 and a price of $31,000 still maximizes profits even if marginal cost has increased or decreased. This result is different from what we saw in Chapter 12, where a change in marginal cost changed the profit maximizing level of output for a perfectly competitive firm. It also differs from what we saw in Chapter 13, where a change in marginal cost changed both the profit-maximizing level of output and the profit-maximizing price. The kinked demand curve model helps to explain why firms in oligopolistic industries keep their prices constant in circumstances where firms in more competitive industries would raise or lower them. But the model falls short of being a complete story of oligopoly for two reasons: 1. In our example, it does not explain how Toyota initially decided to produce 60,000 Highlanders and charge a price of $31,000. The analysis focuses instead on explaining why, once the firm has already decided on a combination of output and price, it may not change output and price very frequently. 2. The assumption that all competitors match price cuts and all competitors ignore price increases is hard to justify. It happens some of the time in some industries, but it cannot be used as a general rule. Economists have turned away from trying to fully explain the behavior of oligopolies using graphs like Figure 3. Instead, they use the game theory approach described here in Chapter 14.

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Solutions to End-of-Chapter Exercises 14.1

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

Review Questions 1.1

Oligopoly is a market structure in which a small number of interdependent firms compete. Examples of oligopoly industries include: cigarettes, beer, aircraft, breakfast cereals, automobiles, music streaming, and pet food.

1.2

Barriers to entry keep new firms from entering an industry, which limits the extent of competition. The most important reason industries such as music streaming are dominated by just a few firms is economies of scale. If the music streaming industry had many firms of similar size, the firms would all have higher costs than the few firms that are in the industry today.

1.3

Government-imposed barriers to entry include patents, occupational licenses, barriers to international trade (such as tariffs and quotas), and public franchises. There are two primary reasons governments are willing to erect barriers to entering an industry: (1) These barriers may improve the standard of living in the long run. For example, granting patents encourages pharmaceutical companies and other researchers to develop new products and new technologies. (2) Policymakers may erect barriers to entry to intentionally reduce competition in order to aid certain firms and their employees in exchange for political support.

Problems and Applications 1.4

Economic structure refers to whether there are economies of scale in the industry, whether one or more firms owns a key input or raw material, and whether there are government-imposed barriers to entry or competition. Generally, when there are low barriers to new firms entering an industry, competition is intense, and when there are high barriers to new firms entering an industry, competition is less intense. Most economists agree that economic structure is the main determinant of the intensity of competition in an industry, but other factors, such as the personalities of the managers and members of the boards of directors of different companies, that determine a company’s strategies, can also play roles.

1.5

a. Economies of scale exist when a firm’s long-run average costs fall as the firm increases output.

CHAPTER 15 | Monopoly and Antitrust Policy xxvii b. When a firm attains economies of scale before competing firms in the industry, that firm’s average cost will be lower than its competitors. A lower average cost means that the firm can sell its products at a lower price than its competitors, thereby attracting some of the other firms’ customers. c. No, because there are no significant economies of scale in the restaurant industry. As an individual restaurant becomes larger, it’s unlikely that its average cost will decline by much. Even if there are some economies of scale, they are likely to be exhausted at a relatively low level of output. As a result, other restaurants will be able to enter the market and compete against you while producing at about the same average cost. 1.6

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

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

ii. To compete with Apple in smartphones, a firm would need to invest in substantial research and development to offer a product that would have features as least as good as those found on the iPhone. iii. Facebook benefits from large network externalities—people want to be on Facebook because so many other people want to be on Facebook. To compete with Facebook, a firm would have to develop a social media app that was so compelling that people would want to take time away from Facebook to be on it. iv. To compete with Amazon in online retailing, a firm would have to develop a nationwide system of warehouses to make it possible to quickly deliver packages to consumers. b. Rapidly changing technology may create opportunities for new firms to offer goods and services that better serve their customers’ wants. Google, Apple, Facebook, and Amazon have all recognized that they need to develop products and services that embody new technology in order to maintain dominant positions in their respective industries. 1.7

Some entrepreneurs hope to increase profitability by creating “big businesses” that might face less competition and be able to charge consumers high prices. But unless there are significant economies of scale, these entrepreneurs will not be successful. In the following figure, firms producing Q1 have the lowest average costs (AC1). If a firm tries to grow to a larger size in order to produce Q2, its average costs will rise—from AC1 to AC2 in this case. The firm will be unable to

xxviii CHAPTER 15 | Monopoly and Antitrust Policy compete against smaller firms that have lower costs. An entrepreneur in this industry will be most competitive if it chooses to produce Q1 with a relatively small-scale company.

1.8

The position of the market demand curve plays a critical role in this market because market demand determines the total number of cars that buyers are willing to buy at various prices. That, in turn, limits the available strategies for the firm, and it limits the extent to which it can take advantage of economies of scale. It may help to think of the market demand curve as a constraint on the firm. a. There would be one or more firms like Little Auto. Because the demand curve slopes downward, we know the firm(s) will achieve the lowest ATC by building assembly lines the size of Little Auto. At output less than 1,000 units, the ATC of Big Auto is greater than the ATC of Little Auto. b. A single firm like Big Auto will dominate the market. In this range, the ATC of Big Auto is less than the ATC of Little Auto. c. There will probably be two or more firms like Big Auto, depending on the position of the demand curve (the quantity at which it intersects the horizontal axis). Note that no firm will build an assembly line with a capacity greater than 10,000 autos because the ATC increases for quantities above 10,000.

1.9

As Chandler suggests, there are many firms in these industries because smaller firms can produce at a lower long-run average cost than larger firms. Diseconomies of scale occur when long-run average cost increases as firm size increases, and firms in these industries would experience diseconomies of scale at relatively low levels of output.

1.10

a. If the Florida legislature were to repeal the requirement that only licensed dietitians provide nutritional advice, the supply of the service provided by dietitians would increase, shifting

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the supply curve to the right. This shift would decrease the equilibrium price and increase the equilibrium quantity of nutritional services. b. A lower equilibrium price and a higher equilibrium quantity will result in an increase in the consumer surplus in the market and increase the well-being of consumers in the market. This conclusion assumes that people who are supplying nutritional advice after the Florida legislature repeals the licensing requirement are capable of providing advice as good as that which had been provided by licensed dietitians. If some of the advice isn’t useful, or is even dangerous to the consumers’ health, then some of the gain to well-being from the lower price and larger quantity of advice will be lost.

Game Theory and Oligopoly

14.2

Learning Objective: Use game theory to analyze the strategies of oligopolistic firms.

Review Questions 2.1

a. Game theory is the study of how people make decisions in situations in which attaining their goals depends on their interactions with other people. b. A cooperative equilibrium is one in which players in a game cooperate to increase their mutual payoff. c. A noncooperative equilibrium is one in which players don’t cooperate but instead pursue their own individual self-interests. d. A dominant strategy is one that is best for a player, no matter what strategies other players choose. e. A Nash equilibrium is a situation in which each player chooses the best strategy for him or her, given the strategies the other player or players choose. f.

2.2

Price leadership is a form of implicit collusion in which one firm in an oligopoly announces price changes and the other firms in the industry match the changes.

Because there are so few firms in oligopoly markets, each firm must pay attention to the moves (such as pricing and marketing strategies) of the other firms, just as players do in actual games, such as poker or Monopoly. Game theory is the methodology that examines situations in which attaining one’s goals depends on interactions with others, so it is natural to use game theory when studying oligopoly.

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2.3

Explicit collusion involves firms making an agreement to not compete. An example of explicit collusion would be the managers of the only two pizza restaurants in a town agreeing to charge the same price for a medium cheese pizza. A cartel is a group of firms that collude by agreeing to restrict output to increase prices and profits. In implicit collusion, firms do not reach a formal agreement, but they tacitly avoid competing with each other. An example of implicit collusion is a firm advertising it will match a competitor’s lower price.

2.4

A prisoner’s dilemma is a game played only once in which pursuing dominant strategies results in a noncooperative equilibrium that leaves everyone worse off than they would have been had they achieved the cooperative equilibrium. The outcome of noncooperative pricing (competition, in other words) will leave firms worse off than if they cooperated and set higher prices. The outcome of a repeated game, however, can be cooperation, especially if there is some enforcement mechanism that punishes a player who doesn’t cooperate.

Problems and Applications 2.5

b. Confessing is a dominant strategy for Bob. c. Confessing is a dominant strategy for Tom. d. They will both confess and each serve 10-year sentences. This outcome is difficult to avoid because both Bob and Tom have a strong incentive to confess, but if they had both refused to confess, each would have served only a three-year sentence. For many years, organized crime practiced a “code of silence” under which any member of the organization knew that if he testified against another member, he was likely to be killed. In game theory terms, the code of silence helped organize crime avoid the prisoner’s dilemma when their members were arrested.

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2.6

Some colleges continue to use early decision plans because doing so is a dominant strategy in the competitive situation they find themselves in. In effect, colleges are caught in a noncooperative equilibrium that makes them all worse off. If College A has an early admission plan and College B does not, College B stands to lose out on enrolling talented students. The result is that College B has a dominant strategy of implementing an early decision plan. Students may be better off if these schools did not offer early admission because students would have more time to make the best decision regarding which college best fits their education goals and needs. But the dominant strategy for the colleges is to offer early admission plans to be able to attract the most talented students. In game theory terms, the colleges face a prisoner’s dilemma.

2.7

If just one student had taken the exam, other students would have taken the exam so this strategy of boycotting the exam would not have worked. In effect, the students were facing a prisoner’s dilemma, so game theory would predict that their strategy of boycotting the exam would not work. But if there is a way to ensure that no one would take the exam, like standing outside the classroom using social pressure to ensure that other students did not go in to take the exam, then this outcome is not unreasonable (as long as the professor honored the established class grading policy).

2.8

The argument is incorrect. The best strategy for each player is to not cooperate, no matter what the other player does. In a game that is played only once (the assumption in the prisoner’s dilemma game), there is no reason for a player to assume that the other player will cooperate.

2.9

a. Yes, Coca-Cola should advertise to maximize its profits. If Pepsi advertises and Coca-Cola does not advertise, Coca-Cola will earn a profit of $400 million; however, if Pepsi and CocaCola both advertise, Coca-Cola will earn a bigger profit of $500 million. If Pepsi does not advertise, Coca-Cola will earn a bigger profit by advertising ($900 million) than if it does not advertise ($750 million). b. Yes, Pepsi should advertise to maximize its profits. If Coca-Cola advertises and Pepsi does not advertise, Pepsi will earn a profit of $400 million; however, if Coca-Cola and Pepsi both advertise, Pepsi will earn a bigger profit of $500 million. If Coca-Cola does not advertise,

xxxii CHAPTER 15 | Monopoly and Antitrust Policy Pepsi will earn a bigger profit by advertising ($900 million) than if it does not advertise ($750 million). c. Both firms advertising is a Nash equilibrium. If Coca-Cola advertises, Pepsi is better off by advertising. If Pepsi advertises, Coca-Cola is better off by advertising. 2.10

a. Yes. Homes and Balwani face a prisoner’s dilemma: A game played only once in which pursuing dominant strategies results in a noncooperative equilibrium that leaves everyone worse off than they would have been had they achieved a cooperative equilibrium. Each person has an incentive to cooperate with prosecutors and provide evidence to convict the other party in order to receive a reduced prison sentence. Assuming that if both confess, neither would receive a reduced sentence, they would be better off not “pointing fingers” at each other—that is, they would be better off in a cooperative equilibrium. b. The following matrix assumes that either Holmes or Balwani would receive a 2-year sentence if only one of them testifies against the other. If both agree not to testify. each would receive a 2-year sentence. If each testifies against the other, each receives a 10-year sentence.

2.11

Game theory can explain why both British and German soldiers during World War I ceased firing on Christmas Eve of 1914. The ceasefire represented a cooperative equilibrium in which troops from both sides benefited—they were not at risk of being killed by enemy fire—given the strategy chosen by the other side. If it was known to both sides that they would face the same troops the following Christmas Eve, there was a fear among commanding officers that a second “Christmas Truce” might occur. By rotating troops to the front, the officers increased the probability that if one side stopped firing they could not be sure that the other side would do the same, which could lead to a disastrous result. The officers created a “prisoner’s (or soldier’s) dilemma”—a game in which pursuing dominant strategies results in noncooperation that leaves all worse off: Instead of enjoying a few days of peace, fighting continued throughout the remaining Christmas seasons during World War I.

2.12

It appears that consumers would benefit from Via’s announcement because it means that they would not have to pay more for a ride using Via than for one using Uber or Lyft. But Via’s

CHAPTER 15 | Monopoly and Antitrust Policy xxxiii announcement about price matching may end up raising the prices that they charge. Via’s announcement signals to Uber and Lyft that it (Via) intends to punish them if they fail to cooperate by automatically matching its (Via’s) price. By announcing a price guarantee, Via reduces the incentive Uber and Lyft might otherwise have to compete by charging a lower price. 2.13

Best Buy’s policy is likely to result in higher prices for the products it sells in competition with Amazon and local brick-and-mortar stores. When Best Buy posted its price matching strategy, it discouraged competitors from lowering their prices because Best Buy would match the lower prices. Best Buy attempted to change the payoff matrix so that other firms knew that if they cut prices, Best Buy would automatically match the price cuts. Best Buy’s announcement that it would match price cuts would ensure that other firms knew they would end up in a prisoner’s dilemma, which is a noncooperative equilibrium.

2.14

a. With only four major airlines, the industry could be considered a “natural oligopoly” because the firms are interdependent, which means that a decision by one of the major airlines to change its prices or to add or eliminate any of its routes would have a significant effect on the other three airlines. The analyst may also have been referring to the fact that the cost structure and barriers to entry in the airline industry have made it unlikely that more than a few airlines can succeed in providing nationwide service. b. Airline executives would not need to openly collude, which would be illegal and subject the colluding parties to criminal prosecution. Firms in an oligopoly industry can engage in implicit collusion—price leadership is one example—which is not illegal.

2.15

a. A dominant strategy is a strategy in which a player is better off regardless of which strategy the other player chooses. To analyze Delta’s strategy: Suppose Delta knew that United was going to charge a high price. In that case, Delta could also charge a high price and receive a payoff of $20,000, or it could charge a low price and receive a payoff of $30,000. Clearly, Delta would be better off charging a low price if it knew United was going to charge a high price. Now suppose that Delta knew that United was going to charge a low price. In that case, Delta could charge a high price and receive a payoff of −$10,000, or it could charge a low price and receive a payoff of $0. Clearly, Delta would be better off charging a low price if it knew United was going to charge a low price. Because Delta’s best strategy is to charge a low price regardless of what United does, charging a low price is a dominant strategy for Delta. To analyze United’s strategy, first suppose that United knew that Delta was going to charge a high price. In that case, United could also charge a high price and receive a payoff of $20,000 or it could choose a low price and receive a payoff of $30,000. United would be better off charging a low price if it knew Delta was going to charge a high price. Now suppose United knew that Delta was going to charge a low price. In that case, United could charge a high price and receive a payoff of −$10,000, or it could charge a low price Copyright © 2023 Pearson Education, Inc.

xxxiv CHAPTER 15 | Monopoly and Antitrust Policy and receive a payoff of $0. United would be better off charging a low price if it knew Delta was going to charge a low price. Because United’s best strategy is to charge a low price regardless of what Delta does, charging a low price is a dominant strategy for United. Each firm has a dominant strategy of charging a low price, so the equilibrium of the game is the outcome in the bottom right quadrant of the payoff matrix that appears in the problem. b. A prisoner’s dilemma exists when there is a possible outcome that makes both players better off, but the players end up with a different outcome. In this game, there is a prisoner’s dilemma because the outcome in the upper left quadrant (both firms charging a high price) results in a higher payoff for both firms. However, this outcome will not occur because each firm has an incentive to change strategies. Delta has an incentive to switch from charging a high price to charging a low price to increase its payoff from $20,000 to $30,000. United has the same incentive to charge a low price rather than a high price; the equilibrium is one in which both firms charge a low price and each has a payoff of $0. Charging a low price leads to a worse outcome for both airlines. This game is a prisoner’s dilemma. c. Repeated playing would add the possibility of punishing the other firm for charging a low price and increase the prospects of cooperation—through, for example, advertising a willingness to match a certain fare, which in this case would correspond to the “high” fare, with high prices (and profits) for both firms. 2.16

a. To ensure that higher prices would be charged by all firms, the firms would need to decrease the quantity of chicken they produce. With a smaller quantity of chicken produced, consumers would bid up the price of chicken. If production were not decreased, at least one of the firms would have an incentive to lower its own price to increase its sales at the expense of the other firms. b. As stated in the Apply the Concept: “According to the DoJ, several chicken producers colluded when bidding for the business of large restaurant chains…The DoJ alleged the practice—referred to as ‘bid rigging’—lasted from 2012 to early 2019.” c. If artificially increasing prices through bid rigging did occur, the firms that engage in this activity had reasons to deny guilt and avoid leaving any incriminating evidence. The firms also were able to offer an alternative explanation of high prices. They claimed that: “…rather than bid rigging, the high price of chicken was the result of increasing demand … and the high prices the firms paid for grain used as chicken feed.”

2.17

a. A dominant strategy is a strategy where a player is better off playing regardless of which strategy the other player chooses. To analyze Microsoft’s strategy: Suppose Microsoft knew that Apple was going to charge a high price. In that case, Microsoft could also charge a high price and receive a payoff of $1 billion, or it could choose to charge a low price, and receive a payoff of $8 billion. Microsoft would be better off charging a low price if it knew Apple was Copyright © 2023 Pearson Education, Inc.

CHAPTER 15 | Monopoly and Antitrust Policy xxxv going to charge a high price. Now suppose that Microsoft knew that Apple was going to charge a low price. In that case, Microsoft could charge a high price and receive a payoff of $10 billion, or it could charge a low price and receive a payoff of $4 billion. Microsoft would be better off charging a high price if it knew Apple was going to charge a low price. Because Microsoft’s best strategy depends upon the strategy Apple chooses, Microsoft doesn’t have a dominant strategy. To analyze Apple’s strategy: Suppose Apple knew that Microsoft was going to charge a high price. In that case, Apple could also charge a high price and receive a payoff of $6 billion, or it could charge a low price and also receive a payoff of $6 billion. Apple is indifferent between charging a high price and charging a low price if it knew Microsoft was going to charge a high price. Now suppose Apple knew that Microsoft was going to charge a low price. In that case, Apple could charge a high price and receive a payoff of $2 billion, or it could charge a low price and receive a payoff of $3 billion. Apple is better off charging a low price if it knew Microsoft was going to charge a low price. Because Apple is indifferent between strategies if Microsoft charges a high price and better off charging a low price if Microsoft charges a low price, a dominant strategy for Apple is to charge a low price. b. A Nash equilibrium occurs when neither player has an incentive to change strategies given the strategy the other player is using. In this game, Apple always chooses to charge a low price because that is its dominant strategy. If Apple chooses to charge a low price, then Microsoft is better off charging a high price, so the Nash equilibrium for this game is the outcome in the northeast quadrant. Apple has no incentive to change its behavior given Microsoft is charging a high price. If Apple switched to charging a high price, then its outcome would not improve. Microsoft has no incentive to change its behavior given that Apple is charging a low price. If Microsoft switched to charging a low price, then its payoff would fall from $10 billion to $4 billion, which makes it worse off. 2.18

14.3

No, this decision by one manufacturer of toilet tissue to raise prices and for its three large competitors to match the increase three days later is not evidence of explicit collusion because the four firms may not actually be colluding among themselves to raise their prices. This outcome is more likely to be an example of price leadership, a form of implicit collusion in which one toilet tissue manufacturer announces a price increase and the other firms in the industry match the increase sometime later.

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

xxxvi CHAPTER 15 | Monopoly and Antitrust Policy

Review Questions 3.1

In a sequential game one player (or firm) acts first, and then other players respond.

3.2

A decision tree allows players to map out how the other player(s) will respond to their actions, thereby identifying the action that yields the highest payoff.

Problems and Applications 3.3

Your answer does depend on the minimum rate of return owners of fast-food restaurants require on their investment. For example, suppose the minimum required return is 15 percent. Then Burger King will enter whether McDonald’s builds a large store or a small store. Therefore, McDonald’s should build a small store because it will receive a return of 20 percent rather than 16 percent. But suppose the minimum required return is 20 percent. Then Burger King will not enter if McDonald’s builds a large store. McDonald’s should build the large store, in which case it will earn a return of 25 percent. (Note that this answer depends critically on the assumption that McDonald’s moves first. If Burger King’s management is aware of this situation, they may want to try to make a preemptive first move themselves.)

3.4

a. Because the cost of the PlayStation 5 was greater than $499, Sony could not make a profit by selling the product at that price. If the PlayStation 5 sold for more than $499, Sony would have to convince consumers that its console was superior to the Xbox Series X and, therefore, worth paying more than $499 for it. Knowing the cost of the PlayStation 5 was important information for Microsoft. b. A game of chicken is a contest between two players where neither one wants to "back down" or let the other win, even though not backing down can be risky. When Microsoft announced the $499 price of its Xbox Series X, it gambled that Sony would not announce that it would sell its PlayStation 5 at a lower price. By setting the price of the PlayStation 5 at $499, Sony gambled that consumers would consider the PlayStation 5 to be superior to the Xbox Series X.

3.5

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

3.6

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

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

The Five Competitive Forces Model 14.4

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

Review Questions 4.1

The first of the competitive forces, competition from existing firms, involves differences in the prices of a firm’s product based on the extent of competition in the market for that product. The Copyright © 2023 Pearson Education, Inc.

xxxviii CHAPTER 15 | Monopoly and Antitrust Policy second of the competitive forces, the threat from potential entrants, may involve a firm pricing its product low (and earning lower profits) as a way to deter entry from additional competition. The third of the competitive forces, competition from substitute goods or services, suggests that the introduction of a new product at a lower price may serve as a good substitute for an existing product, thus reducing demand for the existing product. The fourth of the competitive forces, the bargaining power of buyers, may involve a firm insisting on lower prices because of the large amount it purchases. The fifth of the competitive forces, the bargaining power of a supplier, may involve a limited number of suppliers of a product having a greater ability to charge higher prices for their products. 4.2

The strength of these forces changes over time. For example, a small supplier, with no bargaining power, might grow into a virtual monopolist—as happened to IBM in its dealings with Microsoft.

Problems and Applications 4.3

a. Competition from existing firms: Although CLT is a relatively new test, some college admission offices are beginning to accept it. b. Threat from potential entrants: White Castle and Taco Bell are existing firms in a different market (hamburgers and tacos), but both restaurant chains are potential entrants in the fast-food breakfast market. c. Competition from substitute goods or services: Consumers ordering Harry’s Razors by mail is a substitute for buying Gillette’s razors in Target stores. d. Bargaining power of buyers: Amazon is using its large size as a retailer to bargain for paying lower prices for the Hachette books Amazon sells on its website. e. Bargaining power of a supplier: Because IMAX is the only provider of a specific type of technology, the company can use its monopoly position to bargain for a higher price from theater owners for using its technology.

4.4

Motion picture studios, such as Disney and Warner Brothers, produce films that are shown in theaters. When they release films on their own streaming services, studios—the suppliers of films to theaters—limit the bargaining power of theaters. Movie theaters have also suffered from competition from streaming services, which represents competition from a substitute service. Many consumers would rather stay at home than travel a nearby theater to watch the same movies.

4.5

Firms in these industries will not earn an economic profit. To earn an economic profit, firms need to offer products or services that competitors have difficulty copying, or they need one of the barriers to entry discussed in this chapter: economies of scale, ownership of a key input, or a government-imposed barrier, such as a patent.

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Most singers have little or no bargaining power with Apple and other streaming services. Taylor Swift is an exception. Her refusal to make her album available to Apple would have had a significant negative effect on the demand for Apple’s streaming service, given Swift’s popularity and the number of fans who would not use a service that failed to include her songs.

4.7

a. New technology most likely takes the form of competitive force (3)—competition from substitute goods or services. A firm is always vulnerable to a competitor introducing a new product that fills a consumer need better than the current product does. The new product takes some of the users away from the current product, decreasing its demand. b. We cannot conclude that the economy is better off with less technological change. Even though employees and investors lose when a firm fails, for the economy as a whole, in the long run the benefits of having new technologies greatly outweigh the costs associated with the disruption new technologies cause. Once a popular new product is developed, such as a solar-powered car, there are benefits not only to the owners and employees of the new firm, but to everyone who uses the new product.

4.8

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

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Suggestions for Critical Thinking Exercises CT14.1 a. Clearly, the results will vary by the source that each student finds. Examples of oligopolies include cigarettes, beer, aircraft manufacturers, airlines, automobiles, and cellular service. Examples of monopolistic competition include pizza restaurants, movie theaters, supermarkets, and furniture stores. b. Answer will vary by student depending on the industry chosen and the sources used. A student should classify the firms they identify in part (a) as monopolistically competitive if they: (1) are in an industry with many sellers and buyers; (2) have a differentiated product; and (3) have few or no barriers to entering the industry. Oligopolies have only a few sellers and have significant barriers to entry. c. Students should be judged on the quality of the answers they provide. CT14.2 The car industry would move from an oligopoly-like structure to one more akin to monopolistic competition. The market structure would unlikely be perfect competition as product differentiation would still exist. CT14.3 Demand has varied more in the examples discussed in Chapters 11 to 14. This exercise encourages students to think about the cost and demand side of firms and the focus of the past few chapters.

CHAPTER 15 | Monopoly and Antitrust Policy Brief Chapter Summary and Learning Objectives 15.1 Is Any Firm Ever Really a Monopoly? Define monopoly. ▪

A monopoly is a firm that is the only seller of a good or service that does not have a close substitute.

15.2 Where Do Monopolies Come From? Explain the four main reasons monopolies arise. ▪

Barriers high enough to create a monopoly include: (1) government blocking the entry of more than one firm into a market; (2) one firm having control over a necessary resource; (3) the existence of network externalities in supplying the good or service; and (4) economies of scale so large that one firm has a natural monopoly. Copyright © 2023 Pearson Education, Inc.

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15.3 How Does a Monopoly Choose Price and Output? Explain how a monopoly chooses price and output. ▪

A monopoly maximizes profit by producing where marginal revenue equals marginal cost. A monopoly’s demand curve is the demand curve for the product.

15.4 Does Monopoly Reduce Economic Efficiency? Use a graph to illustrate how a monopoly affects economic efficiency. ▪

Compared to a hypothetical industry that begins as perfectly competitive and then becomes a monopoly, the monopoly would charge a higher price and produce less.

15.5 Price Discrimination: Charging Different Prices for the Same Product Explain how a firm can increase its profits through price discrimination. ▪

Firms sometimes charge customers different prices based on differences in the willingness of customers to pay for the product.

15.6 Government Policy toward Monopoly Explain how the government regulates monopoly. ▪

In the United States, antitrust laws are designed to prevent monopolies and deter collusion among firms in all market structures.

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Key Terms Antitrust laws Laws aimed at eliminating collusion and promoting competition among firms.

Vertical merger A merger between firms at different stages in the production of a good.

Collusion An agreement among firms to charge the same price or otherwise not to compete. Copyright A government-granted exclusive right to produce and sell a creation. Horizontal merger A merger between firms in the same industry. Market power The ability of a firm to charge a price greater than marginal cost. Monopoly A firm that is the only seller of a good or service for which there is not a close substitute. Natural monopoly A situation in which economies of scale are so large that one firm can supply the entire market at a lower average total cost than can two or more firms. Network externality A situation in which the usefulness of a product increases with the number of consumers who use it. Patent The exclusive legal right to produce a product for a period of 20 years from the date the patent application is filed with the government. Price Discrimination The practice of charging different prices to different customers for the same good or service when the price differences are not due to differences in cost. Public franchise A government designation that a firm is the only legal provider of a good or service. Copyright © 2023 Pearson Education, Inc.

Chapter Outline The Monopoly in Your Mailbox In 1792, Congress established the General Post Office and made it illegal for anyone to set up a competing mail delivery system. During the Great Depression of the 1930s, the volume of letters and packages declined substantially, reducing the Post Office’s revenue. In response, in 1934, President Roosevelt and Congress made it illegal for anyone other than a postal employee to put anything in a residential mailbox. In 1970, Congress replaced the Post Office with the U.S. Postal Service. The management of the USPS has the authority to make decisions about how the system operates. The USPS has struggled with competition from FedEx, e-mail, text messaging and other modern services. In late 2020, the USPS had difficulty handling a sharp increase in mail, which resulted in packages and letters piling up in post offices and delays of up to several weeks in delivering some holiday packages. There were three main causes of the delivery problems: (1) An increase in packages due to a surge in online buying during the Covid-19 pandemic; (2) an increase in mail-in ballots during the 2020 presidential election; and (3) a shortage of workers as some USPS employees became ill with Covid-19. In response to the problems the USPS has been experiencing, some economists and policymakers have again advocated eliminating its monopoly over deliveries to residential mailboxes. Although monopolies are rare, they are worth studying because they provide a benchmark for how firms behave when they face little or no competition.

15.1 Is Any Firm Ever Really a Monopoly? Learning Objective: Define monopoly. A monopoly is a firm that is the only seller of a good or service for which there is not a close substitute. A narrow definition of monopoly is that a firm is a monopoly if it can ignore the actions of other firms. A broader definition of monopoly is that a firm is a monopoly if it can retain economic profits in the long run.

Extra Solved Problem 15.1 The Statute of Monopolies and the Patent and Copyright Clause In 1449, King Henry VI of England granted John of Utyman a twenty-year monopoly on the manufacture of stained glass for Eton College. This began a tradition whereby the English Crown granted “letters patent,” which are monopoly rights to certain favored individuals. (“Letters patent” means “open letter,” as compared to a sealed letter). Today, patents are granted to inventors of new products, but letters patent were increasingly used by English monarchs as a means to raise revenue by granting Copyright © 2023 Pearson Education, Inc.

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monopoly rights for the manufacture of known goods, such as salt. Public condemnation of the abuse of letters patent eventually forced King James I (1603–1625) to revoke all existing monopolies. In 1623, Parliament issued the “Statute of Monopolies” that limited the Crown’s power to issue letters patent to inventors for a fixed number of years. Following England’s tradition, legal protection for monopolies, such as patents, was incorporated into the U.S. Constitution by Article I, Section 8, Clause 8—the Patent and Copyright Clause—which granted to Congress the power: “To Promote the Progress of Science and useful Arts, by securing for limited Times to authors and Inventors the exclusive Right to their respective Writings and Discoveries.” The Patent Commission was created in 1790. The first three members of commission were Henry Knox, Thomas Jefferson, and Edmund Randolf—all members of President George Washington’s cabinet. Sources: “History of patent law,” Wikipedia. https://en.wikipedia.org/wiki/History_of_patent_law Statue of Monopolies 1623– Wikipedia. http://en.wikipedia.org/wiki/Statute_of_Monopolies_1623

a. What is the definition of monopoly? b. Why did critics consider the granting of a monopoly on the production of salt an abuse of the system of letters patent? c. How did the Statute of Monopolies and the Patent and Copyright Clause establish monopoly firms?

Solving the Problem Step 1:

Review the chapter material. This problem is about the definition of monopoly, so you may want to review the section “Is Any Firm Ever Really a Monopoly?” in the textbook.

Step 2:

Answer part (a) by defining monopoly. A monopoly is a firm that is the only seller of a good or service for which there is not a close substitute.

Step 3:

Answer part (b) by explaining why critics consider the granting of a monopoly on the production of salt an abuse of the system of letters patent. The purpose of the system was to grant a monopoly on the production of a new product, not a commodity, such as salt, that did not require any new knowledge to produce.

Step 4:

Answer part (c) by explaining how the Statute of Monopolies and the Patent and Copyright Clause establish monopoly firms.

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Both measures were designed to grant exclusive rights to the production of a new product— for copyrights this included books and other written works—for a limited time period.

Extra Apply the Is the NCAA a Monopoly? Concept

In 1905, President Theodore Roosevelt was disturbed by the 18 deaths and many injuries college football players had suffered during the previous season. A meeting took place in the White House between Roosevelt and several college presidents to discuss rule changes that would make the game safer. This meeting eventually led to the establishment of the National Collegiate Athletic Association (NCAA) in 1910. NCAA rules now govern men’s and women’s athletics at more than 1,200 institutions.

On its Web site, the NCAA states, “The National Collegiate Athletic Association is a membership-driven organization dedicated to safeguarding the well-being of student-athletes and equipping them with the skills to succeed on the playing field, in the classroom and throughout life.” Some economists wonder whether the NCAA’s rules might also have other goals.

Harvard University economist Robert Barro claims that the NCAA is effectively a monopoly. Nearly all colleges want their teams to participate in NCAA tournaments and other events. Those colleges have to agree to the NCAA’s rules. Included in those rules are limits on the number of scholarships that a college can award student athletes and a prohibition on paying salaries to athletes. These restrictions reduce the cost to colleges of running their athletic programs. Noting that very few college athletes go on to careers in professional sports, Barro argued that “many college basketball players come from poor families… Absent the NCAA, such a student would be able to amass significant cash during a college career. With the NCAA in charge, this student remains poor.” The NCAA defends its restrictions on scholarships and its prohibition on paying salaries to athletes as a way of preserving the amateur status of collegiate sports.

Because the NCAA does not directly control the operations of the athletic departments of the member colleges, some economists argue that it is more accurate to think of the organization as a cartel than as a monopoly. As we saw in Chapter 14, Section 14.2, when discussing the Organization of the Petroleum Exporting Countries (OPEC), a cartel is a group of firms that collude by agreeing to restrict output to Copyright © 2023 Pearson Education, Inc.

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increase prices and profits. The NCAA limits the number of games the member schools’ teams can play, effectively restricting output. For decades, the NCAA also restricted the number of college football and basketball games that could be televised. Some larger schools did not support these restrictions, however, and in 1982, the University of Georgia and the University of Oklahoma sued the NCAA under the federal antitrust laws. Antitrust laws are aimed at eliminating collusion and promoting competition among firms. In 1984, the Supreme Court decided the case against the NCAA, noting that “good motives alone will not validate an otherwise anticompetitive practice.” In the years since the decision, college football and basketball broadcasts have greatly increased.

The federal courts have ruled against some of the NCAA’s rules, such as the one restricting television broadcasts and the rule barring athletes from receiving compensation for commercial use of their names, images, and likenesses, but the courts have not made a final judgment on many of the group’s other rules. Nevertheless, the NCAA has agreed to loosen one of its key rules by allowing colleges the freedom to reimburse athletes for the full cost of attending college, as determined by federal government guidelines. This cost is typically several thousand dollars per year more than an athlete pays for tuition, books, and room and board because it includes food, clothing, and the cost of travel between the campus and the student’s home. The NCAA’s defenders argue that its rules and restrictions are necessary to preserve the ideal of amateurism in college sports and to make it possible for colleges to offer students the opportunity to participate in sports that do not generate much revenue from ticket sales and broadcasting rights, while preserving the ability of smaller schools to compete with larger schools. The organization’s critics believe that many of the NCAA’s regulations and restrictions are inconsistent with antitrust laws and argue that they should be removed.

Sources: Steve Berkowitz and A. J. Perez, “Supreme Court Will Not Consider the Ed O’Bannon Antitrust Case against NCAA,” usatoday.com, October 3, 2016; Sharon Terlep, “Colleges Don’t Need to Pay Athletes Beyond Attendance Costs,” Wall Street Journal, September 30, 2015; Gary Becker, “The NCAA as a Powerful Cartel,” becker-posnerblog.com, April 3, 2011; Robert L. Barro, “The Best Little Monopoly in America,” bloomberg.com, December 9, 2002; “Who We Are,” ncaa.org; and Michael A. Leeds and Peter von Allmen, The Economics of Sports, 5th ed., Boston: Pearson, 2014.

15.2

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

A monopoly requires that barriers to entering the market must be so high that no other firms can enter. There are four barriers high enough to keep out competing firms: (1) Government action blocks the entry of more than one firm into a market; (2) one firm has control over a key resource necessary to produce a good; (3) there are important network externalities in supplying the good or service; and (4) economies of scale are so large that one firm has a natural monopoly. Copyright © 2023 Pearson Education, Inc.

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A. Government Action Blocks Entry The U.S. government blocks entry by granting a patent, copyright, or trademark that gives an individual or firm the exclusive right to produce a product, and by granting a firm a public franchise, making it the exclusive legal provider of a good or service. A patent is the exclusive legal right to produce a product for a period of 20 years from the date the patent application is filed with the government. Patents encourage firms to spend money on research and development necessary to produce new products. A trademark grants a firm legal protection against other firms using its product’s name. Books, films, and pieces of music can receive copyright protection. A copyright is a government-granted exclusive right to produce and sell a creation. The right is granted for the creator’s lifetime, and his or her heirs retain this exclusive right for 70 years after the creator’s death. A public franchise is a government designation that a firm is the only legal provider of a good or service.

B. Control of a Key Resource Controlling a key resource happens infrequently. Examples include the Aluminum Company of America, which until the 1940s had long-term contracts to buy nearly all available bauxite, and the International Nickel Company of Canada.

C. Network Externalities A network externality refers to a situation in which the usefulness of a product increases with the number of consumers who use it. Some economists argue that network externalities can serve as barriers to entry, but there is debate about the extent to which network externalities serve as barriers.

D. Natural Monopoly A natural monopoly is a situation in which economies of scale are so large that one firm can supply the entire market at a lower average total cost than can two or more firms. In this case, there is room for only one firm. Natural monopolies are likely to occur in markets where fixed costs are very large relative to variable costs.

Extra Apply the

The End of the Christmas Plant Monopoly

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Concept

In December of each year, the poinsettia plant seems to be almost everywhere, decorating stores, restaurants, and houses. The poinsettia is a wildflower native to Mexico, and unlike almost every other flowering plant, the poinsettia blossoms in the winter. This timing, along with the plant’s striking red and green colors, makes the poinsettia ideal for Christmas decorating. The poinsettia was almost unknown in the United States before Albert Ecke, a German immigrant, began selling it in the early twentieth century at his flower stand in Hollywood, California. For many years, the Paul Ecke Ranch in Encinitas, California, had a monopoly on poinsettias. Albert Ecke’s son, Paul, discovered that by grafting together two varieties of poinsettias, it was possible to have multiple branches grow from one stem. The result was a plant that had more leaves and was much more colorful than conventional poinsettias. Paul Ecke did not attempt to patent his new technique for growing poinsettias. But because the Ecke family kept the technique secret for decades, it was able to maintain a monopoly on the commercial production of the plants. Unfortunately for the Ecke family—but fortunately for consumers—a university researcher discovered the technique and published it in an academic journal. New firms quickly entered the industry, and the price of poinsettias plummeted. Soon consumers could purchase them for as little as three for $10. At those prices, the Ecke family’s firm was unable to earn economic profits. Eventually, Paul Ecke III, the owner of the firm, decided to give up commercial production of poinsettias on his family’s ranch. He sold off more than half the firm’s land to fund new state-of-the-art greenhouses and research into new varieties of plants. Sources: Adam Kaye, “Ecke Farming Out His Poinsettia Crop,” North County Times, November 18, 2007; Cynthia Crossen,“Holiday’s Ubiquitous Houseplant,” Wall Street Journal, December 19, 2000; and Mike Freeman and David E. Graham, “Ecke Ranch Plans to Sell Most of Its Remaining Land,” San Diego Union-Tribune, December 11, 2003.

Question Would the Ecke family have been better off if it had patented its process for growing poinsettias? Briefly explain.

Answer If the process of grafting poinsettias were patented, the Ecke family might have continued their monopoly of the market, earned higher profits, and perhaps been better off. But they were afraid that the information they would have had to divulge to obtain a patent might have given competitors enough information to discover ways of grafting poinsettias that were similar to the Ecke method but

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that did not violate the patent. This approach might have resulted in the Ecke family losing its monopoly even earlier than it did.

15.3

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

Like other firms, a monopoly maximizes profit by producing where marginal revenue equals marginal cost but, unlike other firms, the monopoly’s demand curve is the same as the demand curve for the product.

A. Marginal Revenue Once Again A monopolist is a price maker, rather than a price taker. Its demand and marginal revenue curves are downward sloping.

B. Profit Maximization for a Monopolist Though a monopolist can earn economic profits, new firms will not enter the monopolist’s market. The firm can earn economic profits even in the long run.

15.4

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

A. Comparing Monopoly and Perfect Competition A monopoly will produce a smaller quantity and charge a higher price than would a perfectly competitive industry producing the same good.

B. Measuring the Efficiency Losses from Monopoly Because a monopoly raises the market price, it reduces consumer surplus. The increase in price due to monopoly increases producer surplus compared with perfect competition. By increasing price and reducing the quantity produced, the monopolist reduces economic surplus. The reduction in economic surplus is a deadweight loss and represents a loss of economic efficiency due to monopoly. In contrast to perfect competition, the monopolist charges a price that is greater than its marginal cost.

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Since there are few monopolies, the loss of economic efficiency from monopoly is small. But many firms have market power, which means they can charge a price greater than marginal cost. The only firms that have no market power are firms in perfectly competitive markets. Because few markets are perfectly competitive, some loss of economic efficiency occurs in the market for nearly every good or service. Arnold Harberger and other economists have confirmed that the total loss of economic efficiency in the U.S. economy from market power is relatively small. According to Harberger, if every industry in the United States were perfectly competitive, the gain in economic efficiency would equal less than 1 percent of the value of total production.

D. Market Power and Technological Change The late Joseph Schumpeter, who spent many years teaching economics at Harvard University, is closely associated with the argument that the economy may benefit from firms that have market power. Schumpeter argued that economic progress is dependent on technological change in the form of new products. Those who support Schumpeter’s view argue that the introduction of new products requires expenditures on research and development, and firms with market power that can fund research are more likely to earn economic profits than perfectly competitive firms. Others disagree with Schumpeter’s views and point out that small firms develop many new products.

Teaching Tips Product development involves taking a new product or process and making it commercially successful. Although small firms are often the source of invention and innovation, firms with market power are better able to afford product development. The failure rate for product development can be very high, over 50 percent in some industries, and it may take several years for new products to become profitable.

Extra Solved Problem 15.4 Computing the Difference in Economic Surplus between Perfect Competition and Monopoly The following graph illustrates a monopoly market where the firm maximizes profit by setting a price of $25 at the quantity where marginal revenue (MR) equals marginal cost (MC). The profit-maximizing quantity is 10,000. If this market were perfectly competitive, the price would equal marginal cost; therefore, the equilibrium price and quantity would be $20 and 14,000, respectively. a. Compute the difference between consumer surplus under monopoly and under perfect competition. b. Compute the difference between producer surplus under monopoly and under perfect competition. Copyright © 2023 Pearson Education, Inc.

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c. Compute the difference between economic surplus under monopoly and under perfect competition.

Solving the Problem Step 1:

Review the chapter material. This problem is about monopoly and economic efficiency, so you may want to review the section “Does Monopoly Reduce Economic Efficiency?” in the textbook.

Step 2:

Answer part (a) by computing the difference between consumer surplus under monopoly and under perfect competition. Monopoly results in a loss of consumer surplus equal to the sum of areas A and B in the graph. Area A equals $50,000 [($25 – $20) × 10,000]. Area B equals $10,000 [1/2 × ($25 – $20) × (14,000 – 10,000)]. There is a loss of consumer surplus equal to $60,000 from monopoly as compared to the perfectly competitive equilibrium.

Step 3:

Answer part (b) by computing the difference between producer surplus under monopoly and under perfect competition. Area A minus area C is the gain in producer surplus that results from the monopoly price of $25 rather than the perfectly competitive price $20. Area A equals $50,000. Area C equals $10,000 [1/2 × ($20 – $15) × (14,000 – 10,000)]. Area A minus area C equals $40,000.

Step 4:

Answer part (c) by computing the difference in economic surplus under monopoly and under perfect competition. Economic surplus is equal to consumer surplus plus producer surplus. Since area A is a transfer of surplus from consumers to producers there is a net loss of economic surplus (a deadweight loss) equal to area B ($10,000) plus area C ($10,000) or $20,000.

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15.5

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

Price discrimination is the practice of charging different prices to different customers for the same good or service when the price differences are not due to differences in costs.

A. The Requirements for Successful Price Discrimination To successfully practice price discrimination a firm must: (1) possess market power; (2) have some consumers with a greater willingness to pay for a product than other consumers and identify which consumers have greater willingness to pay; and (3) be able to segment the market. Buying a product at a low price and reselling it at a high price is called arbitrage. Firms can’t successfully practice price discrimination if buyers can engage in arbitrage with the good the firms are selling.

B. An Example of Price Discrimination Movie theaters know that many people are willing to pay more to see a movie in the evening than in the afternoon. Theaters typically charge higher prices for evening showings and make the tickets for afternoon showings a different color to make it difficult for someone to buy a lower-priced ticket and use it to gain admission to an evening showing.

C. Airlines: The Kings of Price Discrimination Since the late 1980s, airlines have used computers to construct models of the market for airline tickets. These models take into account several factors that affect the demand for tickets. Yield management is the practice of continually adjusting prices to take into account fluctuations in demand.

D. Big Data and Dynamic Pricing Firms use big data to determine consumers’ preferences. Using big data to determine how responsive different groups are to changes in price is a form of price discrimination, but many firms prefer to call their pricing strategies yield management, price optimization, or dynamic pricing. When firms adopt these pricing strategies, typically some consumers gain by paying lower prices while others lose by paying higher prices. As a group, consumers lose because, if successful, dynamic pricing strategies increase firms’ revenues.

E. Perfect Price Discrimination Perfect discrimination, or first-degree price discrimination, would occur if a firm could charge each consumer a price equal to the consumer’s willingness to pay and, therefore, consumers would receive no consumer surplus.

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F. Price Discrimination across Time Firms sometimes charge a higher price for a product when it is first introduced and a lower price later. Some consumers are early adopters who will pay a high price to be among the first to own certain new products.

G. Can Price Discrimination Be Illegal? Price discrimination may be illegal if its effect is to reduce competition in an industry.

Extra Apply the Have Generic Drug Firms Been Colluding to Raise Prices? Concept

Patents provide pharmaceutical firms with an economic incentive to undertake costly research necessary to develop new drugs. After 20 years, a patent on a drug expires, and other firms can legally produce the same drug. Drugs without patent protection are called generic drugs. About 88 percent of all prescriptions doctors write in the United States are for generic drugs. It’s common for the price of a drug to drop by 50 percent or more when it loses patent protection and several firms begin selling generic versions. Because competition can be intense in the market for generic drugs, firms have a strong incentive to break the antitrust laws and collude to raise prices.

In early 2017, two executives at Heritage Pharmaceuticals Inc., a small pharmaceutical firm, pleaded guilty to colluding with other firms to fix the prices of two drugs: doxycycline hyclate (an antibiotic) and glyburide (a drug used to treat diabetes). The names of the other firms involved were not made public at that time, but the Department of Justice (DOJ) conducted a wide-ranging probe into the pricing of more than 20 generic drugs.

Mylan Pharmaceuticals has been subjected to substantial criticism for the price it charges for its EpiPen, which is used to counteract the effects of severe allergies. Mylan holds a patent on the EpiPen, which helps shield it from competition from other firms. But Mylan also sells a number of generic drugs, Copyright © 2023 Pearson Education, Inc.

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including doxycycline hyclate, for which it has the largest market share. While Mylan denied colluding with other firms to fix the prices of generic drugs in 2017, the DOJ subpoenaed the firm’s records, along with the records of a dozen other firms. Federal investigators also searched the offices of another pharmaceutical firm, Perrigo.

In 2016, a report to Congress by the U.S. General Accountability Office (GAO) indicated that between 2010 and 2015, more than 300 of the 1,441 generic drugs studied had “had at least one extraordinary price increase of 100 percent or more.” The report also noted that “the extraordinary price increases generally persisted for at least 1 year and most had no downward movement after the extraordinary price increase.”

Were these price increases the result of collusion? The GAO report drew no conclusions but noted, “Manufacturers reported that competition, determined by the price and availability of the same drug from other manufacturers, is the primary driver of generic drug prices, as less competition could drive prices higher.”

The DOJ appeared skeptical of the manufacturers’ explanation for high prices, particularly in light of the Heritage executives having pleaded guilty to price fixing. A DOJ press release included the following statement from an FBI agent participating in the investigation: “Conspiring to fix prices on widely-used generic medications skews the market, flouts common decency—and very clearly breaks the law…. The FBI stands ready to investigate and hold accountable those who willfully violate federal antitrust law.”

Such cases can be hard for the government to prove in court because, as an article in the Wall Street Journal noted, “Courts have set a high bar for price-collusion cases, requiring a written document or other evidence of an agreement among companies to follow each other on prices.” By 2020, the DOJ had reached settlement agreements with several pharmaceutical firms in which the firms admitted having colluded to fix the prices of generic drugs. The firms were required to pay substantial fines. The DOJ was continuing to pursue cases against other firms.

Sources: Brent Kendall and Jared S. Hopkins, “Teva Pharmaceutical’s U.S. Unit Indicted on Price-Fixing Charges,” Wall Street Journal, August 25, 2020; Jeremy Roebuck, “Ex-N.J. Pharma Execs Admit to Fixing Generic Drug Prices,” philly.com, January 10, 2017; Tom Schoenberg, David McLaughlin, and Sophia Pearson, “U.S. Generic Drug Probe Seen Expanding After Guilty Pleas,” bloomberg.com, December 14, 2016; Jonathan D. Rockoff, “Perrigo Says Investigators Searched Its Offices in Generic-Drug Probe,” Wall Street Journal, May 4, 2017; U.S. General Accountability Office, “Generic Drugs Under Medicare,” August 2016; and U.S. Department of Justice, “Former Top Generic Pharmaceutical Executives Charged with Price-Fixing, Bid-Rigging, and Customer Allocation Conspiracies,” justice.gov, December 14, 2016.

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15.6

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Government Policy toward Monopoly Learning Objective: Explain how the government regulates monopoly.

Most governments have policies that regulate the behavior of monopolies. Collusion is an agreement among firms to charge the same price or otherwise not to compete. In the United States, antitrust laws are designed to prevent monopolies or collusion. Governments also regulate firms that are natural monopolies.

A. Antitrust Laws and Antitrust Enforcement The first important law regulating monopolies in the United States was the Sherman Act (1890), which was designed to promote competition and prevent the formation of monopolies. The Sherman Act targeted firms that had combined to form trusts. Trusts enabled firms to collude. Trusts disappeared after the Sherman Act was passed, but economists continue to use the term antitrust laws to refer to laws aimed at eliminating collusion and promoting competition among firms. To address loopholes in the Sherman Act, Congress passed the Clayton Act (1914) and the Federal Trade Commission Act (1914). Under the Clayton Act, a merger was illegal if its effect was “substantially to lessen competition, or to tend to create a monopoly.” The Federal Trade Commission Act established the Federal Trade Commission (FTC), which was given power to police unfair business practices. Congress divided the authority to police mergers between the FTC and the Antitrust Division of the U.S. Department of Justice.

B. Mergers: The Trade-off between Market Power and Efficiency The federal government regulates mergers because if firms gain market power by merging they may use this power to raise prices and reduce output. The government is most concerned with horizontal mergers. A horizontal merger is a merger between firms in the same industry. A vertical merger is a merger between firms at different stages of production of a good. Two factors complicate regulating horizontal mergers. First, the market that firms are in is not always clear. Second, there is a possibility that the newly merged firm might be more efficient than the merging firms were individually.

C. The Department of Justice and FTC Merger Guidelines and the HerfindahlHirschman Index of Concentration In 1973, the Antitrust Division of the Department of Justice established an Economics Section and staffed it with economists charged with evaluating the economic consequences of proposed mergers. In 1982, the Department of Justice and the FTC developed merger guidelines. The guidelines have three main parts:

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(1) Market definition. A market consists of all firms making products that consumers view as close substitutes. (2) The measure of market concentration. A merger between firms in a market that is already highly concentrated is likely to increase market power. The guidelines use the Herfindahl-Hirschman Index (HHI) of concentration, which squares the market shares of each firm in the industry and adds up the values of the squares. (3) Merger standards. The Department of Justice and the FTC use the HHI calculations to evaluate proposed horizontal mergers.

D. Regulating Natural Monopolies If a firm is a natural monopoly, competition will not play its role of forcing prices down to the level where the company earns zero economic profit. Local and state regulatory commissions usually set prices for natural monopolies. To achieve economic efficiency, regulators should require the monopoly to charge a price equal to marginal cost. But this strategy has a drawback when the firm’s average total cost curve is still falling when it crosses the demand curve. If the firm charges a price equal to marginal cost, price will be less than average total cost and the firm will suffer an economic loss. Most regulators will set the price equal to the level of average total cost so that the firm can break even.

Teaching Tips Regulatory commissions often recruit their members from the companies they regulate. Although these individuals are knowledgeable about the regulated firm, they may be biased toward the firm’s positions rather than the consumers whose interests they are supposed to represent. Other regulators may be biased against the firms they regulate. It is difficult to select commission members who are both knowledgeable and unbiased. Another problem is that allowing a firm to only break even rather than earn an economic profit may give it less incentive to reduce its costs than if it were unregulated. The firm would not earn higher profits from any cost-cutting actions, and the commission would be willing to allow a price increase if higher average total costs could be documented.

Extra Solved Problem 15.6 The Art of Collusion Sotheby’s and Christie’s account for about 90 percent of the international art auction market. Auction houses charge commissions to the owners of paintings they auction. By the early 1990s, Sotheby’s and Christie’s were in fierce competition for the best Old Master, Impressionist, and modern paintings. They offered sellers guaranteed prices, reduced commissions, free shipping, insurance, and even donations to their favorite charities. These aggressive tactics lowered the firms’ profits. For example, as a result of a guarantee given to the owner of one painting, Sotheby’s lost $9.5 million when the painting failed to sell at auction. Copyright © 2023 Pearson Education, Inc.

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In 1993, Sir Anthony Tenant, the British chairman of Christie’s, and A. Alfred Taubman, the American chairman of Sotheby’s, decided to collude by agreeing to charge similar commissions, not hire each other’s employees, and not speak badly of each other to clients. In 1999, an employee Christie’s had fired turned over records implicating the two auction house chairmen to the U.S. Justice Department. The Justice Department indicted Taubman and Tenant and fined both firms. The firms also paid $256 million to settle private lawsuits filed by their clients. Sources: Carol Vogel and Ralph Blumenthal, “Memos Point to Ties Between Auction Houses,” New York Times, May 25, 2001; Carol Vogel and Ralph Blumenthal, “At Auction Trial, a Cameo for a Johns Painting,” New York Times , November 21, 2001; and Carol Vogel and Ralph Blumenthal, “Ex-Chief of Sotheby’s is Convicted of Price Fixing,” New York Times, December 6, 2001.

Which antitrust laws did the chairmen of Sotheby’s and Christie’s violate when they agreed to collude?

Solving the Problem Step 1:

Review the chapter material. This problem is about government policy toward monopoly, so you may want to review the section “Government Policy toward Monopoly” in the textbook.

Step 2:

Explain which antitrust laws the chairmen of Sotheby’s and Christie’s violated when they agreed to collude. The Sherman Act of 1890 prohibits price fixing and collusion. These are the actions for which the Justice Department prosecuted the chairmen of Sotheby’s and Christie’s. Taubman was convicted and sentenced to one year and a day in prison and fined $7.5 million. Because Tenant was a British citizen, he refused to travel to New York to stand trial. Under British law, he could not be extradited to stand trial in the United States.

Extra Solved Problem 15.6 What Should Your College Charge For a MOOC? The following graph illustrates a monopoly market where the firm maximizes its profit by setting a price of $25 at the quantity where marginal revenue (MR) equals marginal cost (MC). The profit-maximizing quantity is 10,000. If this market were perfectly competitive, the price would equal marginal cost; therefore, the equilibrium price and quantity would be $20.

The fixed cost to a university of offering an online course is relatively high because instructors must develop new syllabi, exams, and teaching notes, as well as determine when and how to interact with their students. But after the course is placed online, the marginal cost of providing instruction to an additional student is low and will be constant rather than U shaped. Suppose that your college decides Copyright © 2023 Pearson Education, Inc.

CHAPTER 17 | The Markets for Labor and Other Factors of Production

to offer a calculus course as a MOOC (massive open online courses) that students anywhere in the world can take, whether they are enrolled in your college or not. The figure shows the demand and cost situation for the MOOC.

a. The faculty member who designed the course argues: “I think the course should be priced so that the maximum number of students enroll.” Which price should this faculty member favor? Briefly explain. b. An economics professor argues: “I think the course should be priced so as to achieve economic efficiency.” Which price should this faculty member favor? Briefly explain. c. The dean of the college argues: “I think the course should be priced to maximize the profit the college earns, so these funds can be used to pay some other expenses.” Which price should the dean favor? Briefly explain. d. You are a member of a student committee that is asked to recommend a price for the course, and you argue: “I think the college should charge a price so that it just breaks even on the course.” What price should you recommend? Briefly explain. e. How much profit (or loss) will the college make on the course if it charges each of the prices you found in your answers to parts (a), (b), (c), and (d)?

Solving the Problem

Step 1:

Review the chapter material. This problem is related to the discussion of price in a situation of natural monopoly, so you may want to review the section “Regulating Natural Monopolies” in the textbook.

Step 2:

Begin your answer by noting that the situation in the figure is similar to the situation of a natural monopoly, as show in Figure 15.8, which is reproduced below.

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Because the graph shows the average total cost curve for the MOOC as still falling when it crosses the demand curve, the MOOC is effectively a natural monopoly and we can employ the analysis of Figure 15.8 to answer the questions.

Step 3:

Answer part (a) by explaining which price will maximize the number of students enrolling in the course. The graph shows that the maximum number of students to take the course will occur when the price equals 0 and the demand curve intersects the quantity axis.

Step 4:

Answer part (b) by explaining which price will result in economic efficiency. Economic efficiency occurs where price equals marginal cost. In the graph, the price should be set at $20 to achieve economic efficiency.

Step 5:

Answer part (c) by explaining which price will maximize the profit the college will earn from the course. To maximize profit, the college should charge a price that results in a quantity demanded at which marginal revenue equals marginal cost. In the graph, the price that maximizes profit is $75.

Step 6:

Answer part (d) by explaining which price will result in the college just breaking even on the course. To break even, the college should charge a price equal to average total cost. In the graph, at a price of $44 price is equal to average total cost and the college breaks even on the course. Copyright © 2023 Pearson Education, Inc.

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Step 7:

Answer part (e) by calculating the profit (or loss) the college will make if it charges each of the prices you found in the earlier parts of the problem. The following table shows the calculation of profit (or loss) for each price.

Extra Economics in Your Life & Career: The Unintended Consequences of Government Regulation Question: An article in the Wall Street Journal referred to the market for salt as China’s oldest monopoly. The Chinese government limits the number of firms that can legally sell table salt and requires the firms to add iodine to their products. Adding iodine to salt can reduce the occurrence of health problems, including those related to brain development. Critics claim that the Chinese government’s regulation of the salt market has resulted in an unintended result: health problems from salt consumption, including problems the addition of iodine was designed to prevent. Suppose you are working as a consultant to the Chinese government on this issue and a Chinese official asks you the following question: “Why would the Chinese government’s regulation of the market for salt result in health problems that the regulation was designed to address?” How would you respond? Source: Dinny McMahon and Grace Zhu, “Salt Crimes and Misdemeanors: The Problem with China’s Oldest Monopoly,” Wall Street Journal, June 11, 2015.

Answer: You should make the following points to the Chinese official: By limiting the number of legal sellers of salt, the Chinese government caused prices to rise well above the cost of production. This led some companies to illegally produce and sell salt without iodine at prices lower than state-sanctioned salt, often without consumers being aware of the difference. Economists often warn policymakers that regulation of private markets often validates the “law of unintended consequences.” The French economist Frédèric Bastiat referred to this result of regulation as the difference between “what is seen and what is not seen.” In an 1848 essay Bastiat wrote: Copyright © 2023 Pearson Education, Inc.

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There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen. Source: Frédèric Bastiat, “What Is Seen and What Is Not Seen,” Library of Economics and Liberty, http://www.econlib.org/library/Bastiat/basEss1.html

Solutions to End-of-Chapter Exercises 15.1

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

Review Questions 1.1

A monopoly is a firm that is the only seller of a good or service that does not have a close substitute. A firm can’t have a monopoly if a close substitute for its product exists.

1.2

You would not have a monopoly under the narrow definition of the term because consumers in your town could buy hardware supplies on the Internet or drive to another town that has a hardware store. However, if competition from online sellers and stores in other towns was insufficient to eliminate your economic profit in the long run, you may have a monopoly in the broader sense of the term.

Problems and Applications 1.3

A monopoly is defined as a firm that is the only seller of a good or service that does not have a close substitute. Baseball great Ty Cobb considered candlelight a substitute for electric lights, so from his point of view the local electric company was not a monopoly.

1.4

Although it’s the sole bookstore in the Bronx, The Lit. Bar bookstore would be considered a monopoly only if it had no close substitutes. For consumers who are just interested in buying a copy of a particular book, Lit. Bar does have close substitutes because customers can buy books from Amazon and other online booksellers. Therefore, The Lit. Bar is not a monopoly, in the narrow definition of the term. But for consumers who are interested in browsing through shelves of physical books or attending book signings by authors, as the only bookstore in the Bronx, The Lit. Bar does not have any close competitors. That conclusion is particularly true of consumers who might have difficulty traveling long distances by bus or subway to find another bookstore. Because many consumers see bookstores as primarily places to buy a copy of a particular book, it is likely that competition from online sellers is a significant reason no other bookstores opened in the Bronx before owner Santos opened hers. Copyright © 2023 Pearson Education, Inc.

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1.5

A monopoly is a firm that is the only seller of a good or service that does not have close substitutes. Although Harvard Business Publishing (HBP) is the only seller of Harvard Business School’s case studies, HBP would have a monopoly in its market only if there were no other firms that sold case studies. In fact, there are other sellers of case studies, so HBP doesn’t have a monopoly in the narrow sense of being the only seller of case studies. Because, in recent years, Harvard Business School’s case studies has had about an 80 percent share of the total market for case studies, the market for case studies is better described as an oligopoly—a market structure in which a small number of interdependent firms compete. Barriers to entry keep firms from entering a market to compete away any economic profit earned by an existing firm. There are no barriers—such as government regulations that would block entry or HBP controlling a key resource—that would block entry into the case study market by a new firm. However, given the popularity of HBP’s case studies and given the ability of HBP to still earn a profit selling them after more than 100 years, it is apparently difficult for other firms to compete away HBP’s profit. So, using the broader definition of monopoly, we could say that HBP has a monopoly.

1.6

a. If Congress allowed the United States Postal Service (USPS) to operate as a private business, it would be likely to change some of its operating procedures. Because it would retain its monopoly on deliveries to residential mailboxes, it would be likely to raise the price of mail delivered in this way. In addition, the USPS would attempt to reduce its costs by eliminating services, such as operating post offices in thinly populated rural areas and delivering mail by air to remote areas of Alaska, that it is currently obliged to offer under the universal service requirement. The USPS would also be likely to: (1) increase the rates it charges for mailing newspapers and magazines; (2) stop delivering mail six days per week; and (3) charge rates for letters that differ depending on the costs of delivery. b. It’s impossible to know with certainty whether the USPS would gain or lose from Congress making it a private firm without a monopoly on deliveries to residential mailboxes. Competition from private firms would reduce the USPS’s share of these deliveries, likely resulting in a significant loss in revenue. But the USPS would have lower costs because it would no longer have to meet the universal service requirement. It would also be free to increase charges on services, such as delivering newspapers and magazines, on which it currently suffers losses. Losers from privatizing the USPS include those who benefit from the current universal service requirement—such as people living in remote rural areas— publishers of newspapers and magazines—who would likely experience higher delivery charges—and customers who rely on six-day delivery service.

15.2

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

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2.1

The most important ways a firm becomes a monopoly are through the following barriers to entry: (1) Government blocks the entry of other firms into the market; (2) the firm has control of a key resource; (3) there are important network externalities in supplying the product; and (4) economies of scale are so large that one firm has a natural monopoly.

2.2

The government grants patents, copyrights, and trademarks because it expects that in the long run society will benefit from them. The profits firms hope to earn from a temporary monopoly will encourage more rapid technological progress and will encourage firms to take risks that they otherwise wouldn’t. For example, in the pharmaceutical industry companies invest millions of dollars for research and development to create medications and vaccines because those products receive patent protection. Competition still exists, but it focuses more on firms developing new products and processes.

2.3

A public franchise is a firm that the government designates as the only legal provider of a good or service. It is doubtful that all or even most public franchises are natural monopolies. If they were, they wouldn’t need the government to restrict entry into their markets by other firms.

2.4

A natural monopoly arises when one firm can supply an entire market at a lower average total cost than can two or more firms. In these cases, a firm doesn’t need the government to enact a law to bar the entry of other firms, nor does it need to control a key resource. The monopoly occurs automatically, or naturally.

Problems and Applications 2.5

A natural monopoly is defined as a situation in which economies of scale are so large that one firm can supply the entire market at a lower average total cost than can two or more firms. Most of the costs incurred by firms that operate natural gas pipelines are the fixed costs of building the pipelines. The marginal cost of transporting an additional unit of gas is quite small. As a result, it is likely that the average total cost curve for transporting natural gas through a pipeline is still declining at the point where it crosses the demand curve. When this situation occurs, the firm is a natural monopoly.

2.6

If there are no network externalities in using product A while large network externalities exist in the use of product B, we would expect that the growth in using product A will initially be faster than the growth in using product B because product B’s usefulness to consumers depends on the number of people currently using it, as with a social media app. But as the number of users of product B increases, it will attract more users at an accelerating rate because the existence of network externalities increases the usefulness of the product the more people who use it. We would expect that, in equilibrium, market forces would make the market for product A more competitive than the market for product B. This outcome results because when network externalities are important, entry of new firms into a market can be difficult, as in the case of other social media apps attempting to compete with Facebook or other search engines attempting to compete with Google. Copyright © 2023 Pearson Education, Inc.

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2.7

Although copyright laws directly benefit the authors of novels and non-fiction books, without these laws it is likely that fewer books would be written. Without copyright protection, it would have been difficult for successful authors such as Charles Dickens, F. Scott Fitzgerald, J. K. Rowling, and Stephen King to make a living from their writings because once one publisher printed their books, other publishers would have brought out competing editions that would not have earned these writers any royalties. Readers benefit from copyright laws because the laws result in authors writing many more books. The framers of the U.S. Constitution understood this benefit to society and gave Congress the authority to enact copyright laws.

2.8

Apple is not the only producer of smartphones in the market, so the company does not have a monopoly in the smartphone industry. However, Apple is the only company that sells smartphones that use the iOS operating system. Because a consumer may have difficulty learning a new operating system when switching to a different smartphone, such as a Samsung, analysts do not consider Apple smartphones close substitutes for other smartphones. In this sense, Apple might not have a monopoly on smartphones, but the company does have monopoly power over smartphone consumers who currently use the Apple iOS operating system. In other words, the iOS operating system is a significant barrier to other firms competing with Apple in the smartphone industry.

2.9

Legally, if someone else had developed a game similar to Hasbro’s Monopoly game before Charles Darrow, the name Monopoly could not be trademarked. Without the trademark, Hasbro would lose millions of dollars annually as other firms marketed similar games using the same title. Allowing firms to trademark games that already exist would be economically inefficient because trademarks provide an incentive for firms to develop new games (or other products eligible to receive trademarks).

2.10

De Beers was concerned that used diamonds would be a close substitute for newly mined diamonds. The existence of a close substitute would reduce De Beers’s monopoly power. De Beers used advertising to convince people not to sell their diamonds. In particular, the advertising slogan, “A diamond is forever,” emphasized the sentimental value of diamonds, so people and their heirs would not sell their diamonds. Because the advertising campaign was successful, it greatly reduced the number of used diamonds that were substitutes for new diamonds. The reduction in the availability of a substitute: (1) increased the demand for new diamonds (shifting the demand curve for new diamonds to the right); (2) increased prices; (3) and increased De Beers’s profits.

2.11

A monopoly is the only seller of a good or service that has no close substitutes. The National Football League (NFL) can be considered a monopoly because, although some other football leagues, such as the Alliance of American Football (AAF), have attempted to compete with the NFL by offering professional games most football fans haven’t found these games to be close substitutes to those offered by the NFL. The NFL has control over two key resources that make it difficult for new entrants to compete with it: Ownership or long-term leases on large, modern football stadiums and contracts with television and cable networks to televise the team’s games Copyright © 2023 Pearson Education, Inc.

CHAPTER 16 | The Markets for Labor and Other Factors of Production xxvii (or to stream the games on apps). New entrants typically have to play their games in college (or even high school) stadiums and are unable to make their games widely available on television and cable networks or on widely used streaming apps. 2.12

We can calculate average total cost at each quantity.

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

15.3

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

Review Questions 3.1

The monopolist’s demand curve is the market demand curve. The marginal revenue curve is derived from the demand curve. For a linear demand curve, the marginal revenue curve will be below the demand curve. The marginal revenue curve is twice as steep as the demand curve because, in absolute value, the slope of the marginal revenue curve will be twice the slope of the demand curve.

3.2

A monopolist is a price maker in the sense that if a monopolist raises its price, it will lose some, but not all, of its customers. Charging the highest possible price will not maximize a monopolist’s profit. The monopolist would only sell one unit to the consumer willing to pay the highest possible price. To maximize profit, the monopolist charges a lower price—a price that results in selling the quantity at which marginal revenue equals marginal cost.

3.3

xxviii CHAPTER 17 | The Markets for Labor and Other Factors of Production

Problems and Applications 3.4

Price

Quantity (per week)

Total Revenue

Marginal Revenue

Total Cost

Marginal Cost

$20

15,000

$300,000

—

$330,000

—

20,000

380,000

$16

365,000

25,000

450,000

405,000

30,000

510,000

450,000

35,000

560,000

500,000

40,000

600,000

555,000

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b. To maximize profit, Ed should produce where marginal revenue equals marginal cost. So, he should charge $16 per baseball and produce 35,000 baseballs per week. Ed’s weekly profit will be $560,000 – $500,000 = $60,000. (Note: In the following graph, we have rounded the average total cost to $14.29. So, the calculation of total profit would be ($16.00 − $14.29) × 35,000 = $59,850.)

c. Because the tax does not affect Ed’s marginal revenue or marginal cost, he should not change the price he charges or the quantity he produces. Ed’s profit will fall by the amount of the tax, from a profit of $60,000 to a profit of only $10,000. d. Because the tax does not affect Ed’s marginal revenue or marginal cost, he should not change the price he charges or the quantity he produces. Ed’s profit will fall by the amount of the tax, from a profit of $10,000 (when the tax is $50,000) to a loss of $10,000 (when the tax is $70,000). If these losses continue, however, Ed will exit the market in the long run because he would be unwilling to suffer an economic loss in the long run. 3.5

a. In the short run, Comcast will continue to sell 6 subscriptions at $24 each. The company’s total revenue = $144, but its total cost is now $110 + $36, so its loss is $2. If this loss continues, in the long run Comcast will exit the market. See the following table. b. The new tax increases the marginal cost by $25 per subscriber and increases the total cost at each price level by ($25 × quantity). With the tax on each subscriber, marginal revenue is never greater than marginal cost, so Comcast would shut down and sell no subscriptions. Marginal Revenue (MR)

Total Cost (TC)

Marginal Cost (MC)

Profit

Profit with $25 Tax

Profit with $36 Tax

TC with $25 per Subscriber Tax

Profit with $25 per Subscriber Tax

Total Revenue (TR)

$27

$81

—

$56

—

$25

−$11

$131

−$50

104

$23

−5

173

−69

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CHAPTER 17 | The Markets for Labor and Other Factors of Production

125

−2

216

−91

144

110

−2

260

−116

161

130

−5

305

−144

176

151

−11

351

−175

3.6

Refer to the following figure. Your VCR firm is likely to suffer a loss because demand for VCRs is so low that it is below the average total cost (ATC) at the profit maximizing quantity Q1. The loss results from a decline in demand as consumers switched to better technologies, such as DVD players, Blu-ray players, and video streaming. Losses forced all VCR manufacturers to exit the industry by 2016. If earning a profit was still likely in this market, then some firm would probably have already entered it.

3.7

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

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3.8

The student’s argument is incorrect. As the following graph shows, a reduction in marginal cost will cause a monopolist to reduce his price, produce more, and increase his profit. If he kept his price unchanged at P1, he would not be maximizing profit because he would not be producing the units between Q1 and Q2 for which marginal revenue is greater than marginal cost.

3.9

a. A price maker is a firm that has some control over its price. If the firm raises its price, it will lose some, but not all, of its customers. Therefore, a price maker faces both a downwardsloping demand curve and a downward-sloping marginal revenue curve. A firm in a perfectly competitive industry is a price taker because it has no control over its price and must accept the market price if it wishes to sell any units of its product. A price taker faces perfectly elastic demand and marginal revenue curves. b. A monopolist cannot charge an infinite price because it faces a downward-sloping demand curve. There is some price at which consumers will no longer be willing to buy any of the product. At the price at which the demand curve intersects the vertical axis, the quantity of the product consumers demand will be zero. A monopolist will charge a profit-maximizing price, which will be well below the price at which the quantity demanded is zero.

3.10

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

15.4 Does Monopoly Reduce Economic Efficiency?

xxxii CHAPTER 17 | The Markets for Labor and Other Factors of Production Learning Objective: Use a graph to illustrate how a monopoly affects economic efficiency.

Review Questions 4.1

a. The following graph illustrates a monopoly firm that maximizes its profit by charging a price (PM) and selling a quantity (QM) where marginal revenue (MR) equals marginal cost (MC). Because the profit-maximizing price is greater than the firm’s average total cost (ATC), the monopolist earns a profit, indicated by the gray-shaded area in the graph. If the industry were perfectly competitive, the monopolist’s marginal cost curve would be the industry’s supply curve. In the graph, the equilibrium price would equal PC and the equilibrium quantity would be QC.

4.2

Society is worse off when a monopolist charges a price that earns monopoly profits rather than a price that is at the competitive level because: (1) the monopolist sets a price greater than marginal cost and, therefore, does not achieve allocative efficiency, and (2) the monopolist produces an output for which average total cost is not minimized and, therefore, does not achieve productive efficiency. In contrast, perfectly competitive firms achieve both allocative efficiency and productive efficiency. We can also conclude that a monopoly charges a higher price and produces a smaller quantity than would be produced if the industry were perfectly competitive. Market power allows a firm to set its price above marginal cost, which creates a deadweight loss because not every unit is produced for which the marginal benefit to consumers is greater than the marginal cost of production. Research suggests that in the United States, total deadweight loss from market power is fairly small, perhaps less than 1 percent of GDP or the value of total production in the U.S. economy.

CHAPTER 16 | The Markets for Labor and Other Factors of Production xxxiii 4.3

Entry of new firms delivering to residential mailboxes would lower prices of residential mail delivery and increase output, thereby increasing both consumer surplus and economic efficiency. That Congress has felt the need to maintain the USPS’s monopoly on delivery to mailboxes indicates that there are firms that would enter the market for residential mail deliveries if they were allowed to do so. That the USPS had been vigilant in taking legal action against anyone using residential mailboxes is another indication that the USPS values its monopoly. Only if residential mail delivery were a natural monopoly, would eliminating the USPS’s monopoly be unlikely to increase consumer surplus and economic efficiency. We would be better able to answer this question if we knew the demand and cost conditions in the market for residential mail delivery.

4.4

If the monopoly were more efficient, its marginal costs would decrease—from MC1 to MC2 in the following figure. As the figure shows, if a monopoly has higher costs (MC1) because it does not face competition, then the true deadweight loss is increased. The darker shaded area shows the original deadweight loss as it was in Figure 15.5 of the text. The lighter shaded area shows the additional deadweight loss from taking into account x-inefficiency—that is, from the firm producing the level of output, QM, rather than the efficient level of output, QCX.

4.5

The city charging users by the gallon is more likely to achieve allocative efficiency—as long as the price equals marginal cost. To charge by the gallon, the city has to install a water meter in each home, apartment complex, and firm and employ meter readers to gather information on how many gallons have been used. Some cities charge flat monthly fees to avoid this expense.

4.6

If a market is a monopoly, a negative externality in production will not always lead to production beyond the level of economic efficiency. In the following graph, the competitive output is at Q1, where price, P1, equals marginal private cost, MC1. If this market is a monopoly, the profitmaximizing output is at Q2, where marginal revenue is equal to marginal private cost. With a

xxxiv CHAPTER 17 | The Markets for Labor and Other Factors of Production negative externality in production, the marginal social cost curve is MC2. The point where price, P2, is equal to marginal social cost is economically efficient. In this example, the economically efficient quantity, Q2, is the same as the profit-maximizing quantity. Although the economically efficient quantity and the profit-maximizing quantity are the same on this graph, generally this will not be the case.

4.7

a. Fernando will produce at the level of output at which MR = MC, which is 15 baseball caps. At 15 caps, Fernando would charge a price of $20 per cap. b. Profit is TR – TC. Because TR (= P × Q) is $300 and TC (= ATC × Q) is $240, Fernando would earn a profit of $60. Or, (P – ATC) × Q = ($20 – $16) × 15 = $60. c. Allocative efficiency occurs at the level of output at which MB (or P) = MC. If Fernando produced at the allocatively efficient level of output, he would produce 20 baseball caps. d. The deadweight loss = ½ ($20 − $10) × (20 − 15) = $25.

15.5

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

Review Questions 5.1

Price discrimination occurs if a firm charges different prices to different customers for the same product when the price differences are not due to differences in cost. A firm can successfully practice price discrimination: (1) if it possesses market power; (2) if some consumers have a greater willingness to pay than others and the firm knows what prices customers are willing to pay; and (3) if the firm can divide up (or segment) the market so that consumers who buy the product at a low price cannot resell it at a high price (in other words, consumers cannot practice arbitrage). Copyright © 2023 Pearson Education, Inc.

CHAPTER 16 | The Markets for Labor and Other Factors of Production xxxv 5.2 a. The managers of the de Young Museum must believe that the price elasticity of demand for tickets is lower—in other words, the demand is more inelastic—on Saturdays, Sundays, and holidays than on Tuesdays through Fridays. Adults who don’t work and students who don’t attend classes on weekends and holidays have more free time to visit museums than they do on weekdays. b. The de Young Museum charges the highest ticket prices to groups it believes have the lowest price elasticities of demand and the lowest prices to the groups with the highest price elasticities of demand. So, given the information in the table, the ranking from highest price elasticity of demand to lowest is: children; college students; seniors; and (non-senior) adults. 5.3

Perfect price discrimination, also called first-degree price discrimination, is the practice of a firm charging each consumer a price equal to his or her willingness to pay. This type of discrimination is not likely to occur in practice because firms cannot know the exact amount most consumers are willing to pay. Perfect price discrimination is economically efficient because output is increased to the point where marginal cost equals marginal benefit. However, all consumer surplus is converted into producer surplus.

Problems and Applications 5.4

Explanation 4 is correct. As we saw in this chapter, firms can usually increase their profits if they can sell their products for different prices to different buyers. Firms can only use this strategy, though, if they can prevent people buying the product at a low price from reselling it (in other words, consumers cannot practice arbitrage). The person who originally purchased an airline ticket is the only one who can legally use it—a requirement that the airlines strictly enforce— but hamburgers can be resold. If McDonald’s tried to charge a Big Mac lover $20, this person could have someone else buy the hamburger at the original price and resell it to him.

5.5

a. It does appear the street vendors are practicing price discrimination because they are charging different prices to different people for the same (or roughly the same) product. The street vendors know that buyers in SoHo have higher incomes and are therefore likely to have more price inelastic demands for Christmas trees, so the vendors are charging these buyers a higher price. The street vendors also know that buyers in Harlem have lower incomes and are therefore likely to have more price elastic demands for the Christmas trees, so the vendors are charging these buyers a lower price. Note, though, that we are assuming the vendors do not face a higher cost of selling trees in SoHo in comparison with selling trees in Harlem. b. Yes, this information does affect the answer to part (a) because it indicates that the higher price of Christmas trees in SoHo and the lower price of Christmas trees in Harlem may be due to differences in the costs of selling trees in the two neighborhoods, rather than to price discrimination. We can’t be sure, though, whether the difference in price is caused entirely Copyright © 2023 Pearson Education, Inc.

xxxvi CHAPTER 17 | The Markets for Labor and Other Factors of Production by the difference in costs or whether the difference in price is partly due to the difference in cost and partly due to price discrimination. 5.6

a. Yes. Successful price discrimination has three requirements: 1. A firm must possess market power. In the Shanghai market, vendors have market power because they are able to charge consumers prices that are different from sticker prices. In other words, sellers are not price takers. 2. Some consumers must have a greater willingness to pay than other consumers, and the firm must be able to know which consumers have a greater willingness to pay. Sellers in the Shanghai market determine different consumers’ willingness to pay through haggling. 3. The firm must be able to segment the market in order to prevent arbitrage, where those who buy at low prices resell items to other consumers at higher prices. Buyers and sellers bargain for both price and quantity. Shanghai merchants can prevent arbitrage by not selling multiple items at low prices. b. Those consumers with the highest willingness to pay—and those most reluctant to bargain with sellers aggressively—tend to pay the highest prices. Many foreign visitors to markets similar to the Shanghai market where haggling is common are unfamiliar and uncomfortable with this practice. These foreign visitors may prefer to pay high prices in exchange for not having to haggle.

5.7

Selling basic economy tickets is a way for airlines to price discriminate because the airline can charge lower prices to leisure travelers or other passengers who have very elastic demand for airline travel. Business travelers who need more flexibility in scheduling their travel and individuals who want to reserve seats would avoid basic economy tickets and would be charged a higher price for airline travel. The fact that many corporate travel offices block employees from buying these tickets reinforces this conclusion.

5.8

a. Disney must believe that the price elasticity of demand is less during the summer and during the winter holiday season (these are the periods when demand is typically highest) than during other times of the year. They also must believe that people who attend Disney World for longer than a single day have a price elasticity of demand that is the same in the summer as during other times of the year. b. The complexity of ticket options could be considered a form of price discrimination whereby consumers who are unwilling to spend the time required to determine the pricing option that is “best” for them have a more inelastic demand (and are willing to pay higher prices) than those consumers who spend the time needed to determine their best pricing options. This strategy is similar to that used by firms that offer consumers coupons that can be used

CHAPTER 16 | The Markets for Labor and Other Factors of Production xxxvii to receive price discounts. “Coupon clippers” have a more price elastic demand than consumers who choose not to use coupons. 5.9

Firms that produce and sell virtual-reality headsets may be better off charging high prices initially, even though they sell smaller numbers of headsets, in order to take advantage of the demands of early adopters. Early adopters are willing to pay high prices in order to obtain new products. This situation can be described as price discrimination across time, which also explains the demand by some consumers for hardcover editions of new novels because consumers who are willing to wait to buy paperback editions of the same novels pay substantially lower prices.

5.10

Table 15.2 describes some of the provisions of the most important U.S. antitrust laws, including the Robinson-Patman Act (1936), which prohibits firms from charging buyers different prices if the result of doing so reduces competition. Offering different prices to different customers is legally acceptable if the differences in prices reflect differences in costs, and if the price differences do not reduce competition (which can be difficult to prove). A legally unacceptable reason for price differences would be if the price difference did reduce competition. In addition, federal law ordinarily prohibits firms from charging customers different prices on the basis of irrelevant characteristics, such as the customers’ race or gender. Firms can legally charge different prices on the basis of those characteristics in certain cases, as when insurance companies charge young women lower automobile insurance premiums than they charge young men. Whether legal price discrimination is ethically unacceptable is a normative issue.

5.11

a. The graph shows that in Market 1, marginal revenue equals marginal cost at a quantity of 25. Therefore, a price of $7 should be charged to maximize profit. b. The graph shows that in Market 2, marginal revenue equals marginal cost at a quantity of 45. Therefore, a price of $11 should be charged to maximize profit.

5.12

a. In referring to “underlying principles,” Furman and Simcoe mean that willingness to pay and consumer surplus vary among consumers who purchase the same items. Furman and Simcoe explain that differential pricing benefits those consumers who would otherwise be priced out of a market if they had to pay the (higher) single price a firm that was unable to price discriminate would charge. Differential pricing enables firms to convert consumer surplus into increased profits. b. Need-based financial aid is an example of price discrimination because students who receive this financial aid are paying a lower out-of-pocket price for tuition than are students who do not receive financial aid. So, different consumers (in this case students) are paying different prices for the same product (education), and these price differences are not due to differences in cost. c. Financial aid is good for both colleges and students because it allows colleges to increase enrollment by admitting qualified students who would not otherwise be able to afford to attend, and it allows students who are not financially able to pay for college to obtain a Copyright © 2023 Pearson Education, Inc.

xxxviii CHAPTER 17 | The Markets for Labor and Other Factors of Production college education. It also sends a signal to students and families that the college cares about all students regardless of their ability to pay and is willing to help those who can’t afford to pay the tuition. 5.13

If prices are largely computer-controlled, we would expect more different ticket prices because computer analysis can analyze sales more completely and adjust prices in response to the analysis more frequently than could the airline pricing executives who were setting prices without the help of software programs. Moreover, with the availability of big data, the computer programs can more accurately estimate consumer demand, which will aid an airline in price discriminating more effectively.

5.14

a. To maximize profit, Fernando should produce where MR = MC. Because MC = $5, we need to find the level of output in which MR = $5. Because MR = the change in TR divided by the change in Q, we can calculate that MR = $5 for the third unit of output. So, Fernando should produce 3 pizzas and charge a price of $15 per pizza. Profit = TR – TC. Because TR for 3 pizzas is $45 and the TC of 3 pizzas is $15, Fernando would earn a profit of $30. b. If Fernando can engage in perfect price discrimination, his TR for 3 units would be $15 + $20 + $25 = $60. The marginal revenue of the third unit would be $60 − $45 = $15. c. Profits are maximized where MR = MC. With perfect price discrimination, Fernando’s marginal revenue is equal to the price of the last unit sold, so MR = MC = $5 at the fifth unit of output, so he should produce 5 pizzas. If 5 pizzas are produced, his total revenue is equal to the highest price he can charge for each unit: $25 + $20 + $15 + $10 + $5 = $75. Fernando is producing the pizzas at a constant cost of $5 per pizza, so his total cost is $5 × 5 = $25. Therefore, his profit would be $75 − $25 = $50. d. The following graph on the left shows the areas of producer surplus, consumer surplus, and deadweight loss. In the graph on the right, in which Fernando practices perfect price discrimination, the consumer surplus and deadweight loss are converted into producer surplus (profit).

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15.6

Government Policy toward Monopoly Learning Objective: Explain how the government regulates monopoly.

Review Questions 6.1

The stated purpose of the antitrust laws is to eliminate collusion and promote competition among firms. The Department of Justice’s (DOJ) Antitrust Division and the Federal Trade Commission (FTC) enforce these laws.

6.2

A horizontal merger is a merger between firms in the same industry, such as Coca-Cola merging with PepsiCo, while a vertical merger combines firms at different stages in the production of a good, such as Coca-Cola merging with a firm that makes aluminum cans. Horizontal mergers are more likely to increase the market power of the newly merged firm because these mergers reduce the number of firms competing in the market for a particular good or service.

6.3

Charging a price equal to marginal cost means that output will be at the level at which marginal cost equals marginal benefit (represented by price), which is the efficient level of output. However, charging this price would mean that the typical regulated natural monopoly would suffer an economic loss because this price would be below average cost. If the regulator sets price to equal average cost instead, some efficiency will be lost but the natural monopoly will stay in business and its owners will earn a normal return on their investment.

CHAPTER 17 | The Markets for Labor and Other Factors of Production

Problems and Applications 6.4

a. A vertical merger is a merger between firms at different stages in the production of a good. The merger of AT&T and Time Warner is considered a vertical merger because Time Warner owned companies that produced television programs. AT&T owns DirecTV, which broadcasts television programs on its satellite network. AT&T and Time Warner were operating at different stages in producing and delivering television programs. b. It is more difficult to persuade courts to stop vertical mergers because when compared with horizontal mergers, vertical mergers do not as clearly reduce competition in a way that is likely to increase market power, leading to higher prices and a reduction of consumer surplus. It is possible, however, that a vertical merger, by giving a firm control of an important supplier—as, arguably, this merger did by giving AT&T control of Time Warner— may, in fact, also reduce competition in a way that harms consumers.

6.5

a. The Federal Trade Commission (FTC) and the Department of Justice (DOJ) usually identify the industry that the firm is in by looking for other firms that sell goods or services that are close substitutes for the good or service the firm is selling. b. No. Calculating Google’s market share is difficult because it is difficult to determine which other firms are selling close substitutes for Google’s service. As the columnist notes, Google has a large share of the market for search engine advertising. But search engine advertising is only part of online advertising. And online advertising is only part of the total market for advertising. Economists at the FTC and the DOJ would need to gather data on whether search advertising is a close substitute for these other types of advertising. One way of determining how close substitutes two services involves calculating the cross-price elasticity of demand. In other words, if Google raises the prices it charges for search advertising does it lose a substantial quantity of its sales? If it does, then other types of advertising are close substitutes for search advertising. If not, then Google may lack close competitors to the search advertising it offers. c. The DOJ and the FTC can attempt to determine whether Google is suppressing competition in search advertising by, for instance, buying other potential competitors. They can also study whether the advertising market is evolving in a way that makes it likely that firms looking for advertising venues will be able to find more alternatives to Google in the future.

6.6

a. Google and Facebook are like public utilities because they have grown large enough to have economies of scale that allow them to monopolize the industry they are in. The companies are unlike public utilities because they do not charge consumers a fee to use their services. b. Examples of services that Google and Facebook provide for free that were not free before are: messaging, video chat, navigation and telephone service (over the internet). Google has

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Google Voice (telephone service), Google Hangout (messaging), and Google maps (navigation). Facebook has Facebook Messenger for chats, video, and audio calls. c. To determine if consumers would be better off breaking up Google or Facebook, we would need to look at the services that each offers and the price that consumers pay for these services. Breaking up Google or Facebook would be detrimental to consumers if, after breaking them up, the services that consumers received for free or inexpensively would require higher payment. The break up would also hurt consumers if regulating these companies caused them to reduce the number of services they offered consumers. 6.7

a. Refer to the following figure. The merger causes the marginal costs to drop enough that the profit-maximizing price the monopoly charges after the merger (PMerge) is lower than the price if the market were at a competitive equilibrium (PC). If the merger did not decrease the marginal costs, the monopoly would charge PM, and the market experiences no efficiency gains with the merger. b. Before the merger, the price was Pc and the quantity was Qc, so consumer surplus equaled the areas A + B + C + D + E and producer surplus equaled the areas F + G + H + K + L + M. After the merger, price fell to PMerge and quantity rose to QMerge, so consumer surplus equaled the areas A + B + C + D + E + F + G + H + I + J and producer surplus equaled the areas K + L + M + N + O + P + Q + R.

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6.8

a. We need to calculate the Herfindahl-Hirschman Index (HHI). Before the merger the HHI is 20 × 52 = 500. After the merger the HHI is (16 × 52) + 202 = 400 + 400 = 800. Because the postmerger HHI is less than 1,500, the merger will not be opposed. b. The HHI before the merger is 5 × 202 = 2,000. After the merger the HHI is (3 × 202) + 402 = 1,200 + 1,600 = 2,800. After the merger the HHI is above 2,500 and the merger will increase the HHI by more than 200 points, so the DOJ would likely oppose the merger.

6.9

Assuming five firms in the “others” category, the HHI before any merger of two firms that each has a 3 percent share of the market is the following: 272 + 202 + 172 + 92 + 62 + 62 + 5(32) =1,616. The HHI after the merger would be 272 + 202 + 262 + 62 + 62 + 5(32) = 1,922. Because the HHI after the merger would be between 1,500 and 2,500 and would increase by more than 100 points, the DOJ could challenge the merger between Apple and Dell.

6.10

If the price is set equal to average total cost, the natural monopoly will earn a normal return on its investment. If a natural monopoly knows that it will always be able to charge a price equal to average total cost, it will have no incentive to reduce average costs because it will not be able to earn more than a normal return. In fact, a natural monopoly might try to inflate its costs in its reports to the regulatory agency.

6.11

a. To maximize profit, the monopoly will produce the quantity where marginal revenue equals marginal cost. So, the monopoly will produce 50 units and charge a price of $10. b. To achieve economic efficiency, the regulatory agency should require the monopoly to charge a price equal to marginal cost, which in this case would be a price of $7. The regulated monopoly will produce 90 units. It will make a profit because price is above average total cost.

6.12

a. To maximize profit, the monopoly will produce the quantity where marginal revenue equals marginal cost. So, the monopoly will produce 20 units and charge a price of $30. b. The monopoly’s marginal revenue curve is now a flat line at $18, running from the vertical axis to the demand curve, so the monopoly will produce 33 units and charge a price of $18. The quantity demanded at a price of $18 is 40, but the quantity supplied is only 33, so there will be a shortage of 7 units and some consumers will not be able to buy the product.

Suggestions for Critical Thinking Exercises CT15.1

Monopolists can certainly operate at a loss if their ATC is above the demand curve at the profit-maximizing level of output. Many students believe that monopolists always earn a profit. While a monopolist will generally earn a profit due to lack of competition, it is still possible for a monopolist to operate at a loss in the short run. For example, during an economic downturn, even a monopolist may find that demand for its good or service has Copyright © 2023 Pearson Education, Inc.

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declined to a point where ATC is greater than price at the profit-maximizing level of output. A monopolist may also be producing a good or service for which consumer demand has declined sharply, resulting in losses. If these losses persist, in the long run the monopolist would shut down. This question asks students to apply economic analysis to a topic in which many students have an incorrect preconception.

CT15.2

Marginal revenue equals marginal cost (MR = MC). Some students will realize that firms in all of these market structures maximize profit by producing the quantity at which MR = MC, but students often do not see common themes across the topics dealing with different market structures. When the students draw the graphs for each type of firm (as per the question), instructors can focus on comparing each graph and highlighting the points where MR = MC and showing that this point is where the profit-maximizing quantity is found in each market type.

CT15.3

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

CHAPTER 16 | The Markets for Labor and Other Factors of Production Brief Chapter Summary and Learning Objectives 16.1 The Demand for Labor Explain how firms choose the profit-maximizing quantity of labor to employ. ▪

The demand curve for labor is derived from the demand for the good or service it produces.

16.2 The Supply of Labor Explain how people choose the quantity of labor to supply. ▪

The labor supply curve for most people is upward sloping.

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CHAPTER 17 | The Markets for Labor and Other Factors of Production ▪

If the labor supply is unchanged, an increase in the demand for labor will increase the equilibrium wage and the number of workers employed. If labor demand is unchanged, an increase in the supply of labor will decrease the equilibrium wage but increase the number of workers employed.

16.4 Explaining Differences in Wages Use demand and supply analysis to explain how compensating differentials, discrimination, and labor unions cause wages to differ. ▪

The more productive workers are and the higher the price workers’ output can be sold for, the higher wages will be.

16.5 Personnel Economics Discuss the role personnel economics can play in helping firms deal with human resources issues. ▪

Personnel economics applies economic analysis to human resources issues, including how firms hire, train, and promote workers and set their wages and benefits.

16.6 The Markets for Capital and Natural Resources Show how equilibrium prices are determined in the markets for capital and natural resources. ▪

The approach used to analyze the market for labor can be used to analyze the markets for capital and natural resources.

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Key Terms Compensating differential A difference in wages that compensates workers for unpleasant aspects of a job. Derived demand The demand for a factor of production; it depends on the demand for the good the factor produces.

Monopsony. The situation in which a firm is sole buyer of a factor of production. Personnel economics The application of economic analysis to human resources issues.

Economic discrimination The practice of paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic such as race or gender. Economic rent (or pure rent) The price of a factor of production that is in fixed supply. Factors of production Labor, capital, natural resources, and other inputs used to make goods and services. Human capital The accumulated knowledge and skills that workers acquire from formal training and education or from life experiences. Labor union An organization of employees that has a legal right to bargain with employers about wages and working conditions. Marginal product of labor The additional output a firm produces as a result of hiring one more worker. Marginal productivity theory of income distribution The theory that the distribution of income is determined by the marginal productivity of the factors of production that individuals own. Marginal revenue product of labor (MRP) The change in a firm’s revenue as a result of hiring one more worker.

Chapter Outline Great Hamburger? Thank a Robot

Creator is a restaurant in San Francisco restaurant that uses a robot to create hamburgers. The robot grinds and cooks meat, cuts and toasts buns, adds seasonings, cuts pickles, tomatoes and onions and places them on a beef patty—all in five minutes. Many companies have begun to use robotic technology with sophisticated software to substitute for capital and labor. Some people see the spread of robotic technology and artificial intelligence software as a boon to the economy that will lead to higher living standards. Other people fear that robots will reduce the demand for labor enough to leave some workers permanently unemployed.

The Demand for Labor 16.1

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

Factors of production include labor, capital, natural resources, and other inputs used to make goods and services. The demand for labor is a derived demand. A derived demand is the demand for a factor of production; it depends on the demand for the good the factor produces.

A. The Marginal Revenue Product of Labor The marginal product of labor is the additional output a firm produces as a result of hiring one more worker. Because of the law of diminishing returns, the marginal product of labor declines as a firm hires more workers. The change in a firm’s revenue as a result of hiring one more worker is called the marginal revenue product of labor (MRP). As long as the marginal revenue product of labor is greater than the wage rate, a firm should hire more workers. The marginal revenue product of labor curve is the demand curve for labor.

B. The Market Demand Curve for Labor The market demand curve for labor is determined by adding up the quantity of labor demanded by each firm at each wage, holding constant all other variables that might affect the willingness of firms to hire workers.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income

C. Factors That Shift the Market Demand Curve for Labor An increase or decrease in the wage causes a change in the quantity of labor demanded, which we show by a movement along the demand curve. If any variable other than the wage changes, the result is an increase or a decrease in the demand for labor, which is shown by a shift of the demand curve. The five most important variables that cause the labor demand curve to shift are: (1) Increases in human capital, which is the accumulated knowledge and skills that workers acquire from formal training and education or from life experiences. (2) Changes in technology. (3) Changes in the price of the product. (4) Changes in the quantity of other inputs. (5) Changes in the number of firms in the market.

Extra Apply the

Demand for “Aerial Application” Pilots Soars during the 2007– 2009 Recession

Concept The 2007–2009 recession caused consumer demand to plummet in many industries, which led to thousands of workers losing their jobs. There was a decline in the number of people flying for business trips or to vacation destinations. Yet the demand for the services of one group of pilots increased. A surge in the demand for commodities like corn and wheat translated into an increase in the demand for “aerial application”—a more sophisticated term than “crop-dusting” and a term preferred by pilots who spread fertilizer, insecticides, and weed killers on farmland from the air. Though pilots employed by large commercial airlines were earning six-figure salaries, newly hired pilots employed by small regional airlines were earning as little as $22,000. Skilled agricultural (“ag”) pilots earned between $60,000 and $100,000 annually. While many experienced ag pilots retired between 2003 and 2007, hours flown by the remaining pilots rose by almost 30 percent, leading the National Agricultural Aviation Association, an industry trade group, to recruit new pilots. In addition to relatively attractive salaries, pilots working as crop dusters can be their own bosses and do low-altitude flying and stunt flying that are impossible with a large passenger jet. But crop-dusting requires special skills that call for special training. One pilot trainer, John (“Dusty”) Dowd, is a tough taskmaster who typically trains prospects for months before they are allowed to spray crops on their own. Mr. Dowd is the owner of Syracuse Flying Service and began dusting crops when he was 16 years old. Even experienced pilots find they must spend months learning from old hands like Dusty Dowd the special skills required for low-level flying and maneuvering.

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Source: Jonathan Welsh, “Flying Low Is Flying High As Demand for Crop-Dusters Soars,” Wall Street Journal, August 14, 2009.

16.2

The Supply of Labor Learning Objective: Explain how people choose the quantity of labor to supply.

The opportunity cost of leisure is the wage. As the wage rate increases, we tend to take less leisure and work more, which explains why the labor supply curve for most people slopes upward. At high wage levels the supply curve of an individual could be backward bending, so that higher wages result in a smaller quantity of labor supplied. When there is a wage change, there is a substitution effect: An increase in the wage rate raises the opportunity cost of leisure and causes the worker to devote more time to working and less to leisure. There is also an income effect: An increase in the wage rate will increase a consumer’s purchasing power for any given number of hours worked. Because leisure is a normal good, the income effect of a wage change causes a worker to devote less time to working and more time to leisure. Whether a worker supplies more or less labor following a wage increase depends on whether the substitution effect is larger than the income effect.

A. The Market Supply Curve of Labor The market supply curve of labor is determined by adding up the quantity of labor supplied by each worker at each wage, holding constant all other variables that might affect the willingness of workers to supply labor.

B. Factors That Shift the Market Supply Curve of Labor In constructing the market supply curve of labor, we hold constant all other variables that would affect the willingness of workers to supply labor, except the wage. The three most important variables that cause the market supply curve of labor to shift are: (1) Increasing population. (2) Changing demographics. (3) Changing alternatives (opportunities available in other labor markets).

Teaching Tips Some students may confuse the market for labor with the market for jobs and the demand for jobs with the demand for labor. It’s worth noting to your students that when workers “demand jobs,” economists refer to workers as supplying labor and to firms as demanding labor

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16.3

Equilibrium in the Labor Market Learning Objective: Explain how equilibrium wages are determined in labor markets.

A. The Effect on Equilibrium Wages of a Shift in Labor Demand In many labor markets, increases over time in labor productivity will cause the demand for labor to increase. If the labor supply is unchanged, an increase in labor demand will increase both the equilibrium wage and the number of workers employed.

B. The Effect of Immigration on the U.S. Labor Market Donald Trump has argued that immigration has had a net negative effect on the U.S. economy and proposed policies to reduce immigration; in particular, illegal or undocumented immigration. Although the Biden administration has proposed significant changes to U.S. immigration law, as of mid-2021 it was unclear whether Congress would enact the changes. Policymakers and economists continue to debate the effects of immigration on the U.S. economy. The direct effect of immigration is an increase in the labor supply. If the labor demand unchanged, an increase in the supply of labor due to immigration will decrease the equilibrium wage while increasing the number of employed workers. Immigration can also affect the demand for labor. Immigrants are responsible for innovations that raise productivity, which will increase the demand for labor. Estimates of the impact of immigration on wages vary, but there is some consensus that immigration is likely to have reduced the wages of low-skilled native-born workers.

Extra Apply the Immigration and Wages—in 1914 and 2007 Concept Between 1900 and the outbreak of World War I in 1914, about 13.4 million immigrants arrived in the United States. Relative to the U.S. population—which was about 76 million in 1900—this was the largest wave of immigration in the history of the world. Many commentators at the time predicted that this great increase in the U.S. labor supply would cause a sharp fall in wages. This is a reasonable prediction of the effect of an increase in labor supply on the equilibrium wage, only if the demand for labor remains unchanged. In fact, the demand for labor increased rapidly during these years as technological progress, Copyright © 2021 Pearson Education, Inc.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income

such as electrification and the development of mass-production techniques, increased the productivity of labor. As a result, the demand for labor shifted to the right faster than the supply of labor, and wages rose. The following figure shows the situation in manufacturing. Both demand and supply increased, but because the shift in demand was greater than the shift in supply, average hourly earnings rose from less than $0.18 in 1900 to $0.22 in 1914, or by almost 25 percent. (The data for both years use 1914 prices to correct for the effects of inflation.) During the same years, employment in manufacturing rose from about 5.5 million workers to almost 9 million.

In 2007, the economics of immigration was in the forefront during the debate over a proposal by President George W. Bush to revise the immigration laws. President Bush proposed allowing approximately 12 million illegal immigrants in the United States to enter a process that would allow them to become permanent legal residents. He also proposed strengthening security at the country’s borders to reduce future illegal immigration. The following figure shows estimates by the Pew Hispanic Center indicating that illegal immigrants had become a substantial part of the labor supply in a number of industries.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income

Economists have debated the impact of illegal immigrants on the wages of unskilled workers. As the figure indicates, illegal immigrants have substantially increased the supply of labor in some occupations. Some economists argue that illegal immigration may have significantly contributed to the distribution of income becoming more unequal in recent years. Illegal immigration increases income inequality if the supply of illegal workers reduces the wages of low-income workers relative to high-income workers. Claudia Goldin and Lawrence Katz, economists at Harvard University, have estimated that immigration— both legal and illegal—can explain only about 10 percent of the increase in the gap between the wages of college-educated workers and the wages of high school–educated workers during the years between 1980 and 2005. George Borjas of Harvard, Jeffrey Grogger of the University of Chicago, and Gordon Hanson of the University of California, San Diego, found a significant impact of immigration on the employment opportunities of African Americans: If as a result of immigration there is a 10 percent increase in the supply of labor with a particular skill, the wages of African Americans with that skill fall by 4 percent, the employment rate of African Americans falls by 3.5 percentage points, and the fraction of African Americans in jail increases by 1 percentage point. Sources: U.S. Department of Commerce, Historical Statistics of the United States, Washington, D.C.: USGPO, 1976; Jeffrey S. Passel, “The Size and Characteristics of the Unauthorized Migrant Population in the U.S.,” Pew Hispanic Center Research Report, March 7, 2006; Claudia Goldin and Lawrence F. Katz, “The Race Between Education and Technology,” NBER Working Paper, No. 12984, March 2007; and George J. Borjas, Jeffrey Grogger, and Gordon H. Hanson, “Immigration and AfricanAmerican Employment Opportunities,” NBER Working Paper No. 12518, May 2007.

Question Francis Walker served as commissioner general of the U.S. Immigration Service and was the first president of the American Economic Association. In 1896, he wrote the following: The question today is protecting the American rate of wages, the American standard of living, and the quality of American citizenship from degradation through the tumultuous access of vast throngs of ignorant and brutalized peasantry from the countries of Eastern and Southern Europe.

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Why would Walker have feared that immigration to the United States would drive down wages in the late 1800s? Did wages, in fact, fall as he predicted? Briefly explain. Source: Quoted in Julian L. Simon and Rita James Simon, “Do We Really Need All These Immigrants?” in D. N. McCloskey, Second Thoughts: Myths and Morals of U.S. Economic History, New York: Oxford University Press, 1993, p. 20.

Answer Walker feared that an increase in the supply of labor would lower the equilibrium wage. In fact, labor demand increased more than labor supply, and the equilibrium wage rose. Question Suppose the United States had not allowed any immigration between 1900 and 1914. Which groups would have benefited from prohibiting immigration and which groups would have lost? Answer In 1914, the market for manufacturing was at point A in the following figure. If the government had banned immigration, then the market for manufacturing would have been at a point like B with reduced employment but higher wages. The immediate effect of this ban would have been to make those individuals who would have immigrated worse off. People already working in manufacturing may have been better off because the new wage w is higher than the actual wage in 1914. (The graph represents the situation in which there is no change in the demand for labor.) However, immigrants do not just take jobs away from current workers. Immigrants are also consumers, so the demand curve for labor would not have shifted out as far as it actually did. The result would have been downward pressure on wages and reduced employment in manufacturing. We can also say that social welfare would have declined by the amount equal to area (C + D). That means that on net, society was better off with the immigrants than it would have been without the immigrants.

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Extra Apply the

Veterinarians Fall Victim to Demand and Supply During the 2007 – 2009 Recession

Concept Veterinarians have been hurt by changes in demand and supply in recent years. Schools of veterinary medicine in the United States have continued to turn out about 2,500 new veterinarians each year, while demand for the most important veterinary specialty—small animal medicine—has been declining. Over the long run, as more women have entered the workforce, some families have had greater difficulty caring for pets that may have to be left home alone during the day. The decline in incomes and employment during the 2007–2009 recession and the slow recovery that followed left many families looking for ways to cut back spending. As a result, the number of dogs and cats in the United States declined, thereby reducing the demand for small animal vets. The following figure shows that increases in the supply of small animal vets combined with a decrease in the demand for their services caused the equilibrium annual income of these vets to decline from $139,000 in 2003 to $121,000 in 2013 (both values are measured in dollars of 2013 purchasing power) at the same time that the number of small animal vets increased from 42,000 to 47,000.

The situation for new vets is worse than the figure indicates. Although an annual income of $121,000 may sound comfortable, the average annual income of new vets in 2013 was only about $46,000. Many new vets graduate from schools of veterinary medicine with large student loan balances as average outof-state tuition had risen to $63,000 per year. In fact, the ratio of debt to income for new vets was double the ratio for new medical doctors. Basic demand and supply analysis indicates that as long as the supply of vets continues to increase while the population of dogs and cats continues to fall, the incomes of vets will decline. Copyright © 2021 Pearson Education, Inc.

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Sources: David Segal, “High Debt and Falling Demand Trap New Vets,” New York Times, February 23, 2013; American Veterinary Medical Association, Veterinary Market Statistics, various issues; and Committee to Assess the Current and Future Workforce Needs in Veterinary Medicine, Workforce Needs in Veterinary Medicine, Washington, D.C.: The National Academies Press, 2013.

Question If the incomes of veterinarians were falling in 2013, why did the number of students enrolling in schools of veterinary medicine in the United States not decline? Answer Despite the declining incomes of veterinarians in 2013, there were still many students who had a sincere desire to become veterinarians. The incomes veterinarians earned, although declining, were still relatively high compared to earnings in other occupations. However, mounting debt from attending veterinary school, the increasing supply of veterinarians, and decreasing demand for the services of veterinarians likely slowed entry into the profession.

Explaining Differences in Wages 16.4

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

Differences in marginal revenue product are the most important factor in explaining differences in wages, but we must also take into account other factors.

A. Compensating Differentials A compensating differential is a difference in wages that compensates workers for unpleasant aspects of a job. One implication of this principle is that laws protecting the health and safety of workers may not make workers better off. If such laws make workers safer, then the compensating differential for assuming extra risk disappears. But this conclusion is true only if the compensating differential actually does compensate workers for additional risk. Some economists have argued that cognitive dissonance might cause workers to underestimate the true risks of their jobs. Workers in hazardous jobs may refuse to believe that their jobs really are hazardous. If true, the wages of these workers will not be high enough to compensate them fully for the risk they have assumed, and safety legislation may make workers better off.

B. Discrimination Economic discrimination is the practice of paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic such as race or gender. Most economists believe that only a part of the gap between the wages of white males and the wages of other groups is due to discrimination. Some of the gap in wages is due to differences in education, experience, and job preferences. Copyright © 2021 Pearson Education, Inc.

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Labor economists have attempted to measure the part of wage differences between Blacks and Whites and between men and women that is due to discrimination and the part that is due to other factors. But precise measurement of differences in productivity and preferences is difficult. There are three reasons why, in the past, non-discriminating competitors did not drive discriminating firms out of business: worker discrimination, customer discrimination, and negative feedback loops.

C. Labor Unions A labor union is an organization of employees that has a legal right to bargain with employers about wages and working conditions. If a union is unable to reach an agreement with a company, it has the legal right to call a strike, which means its members refuse to work until a satisfactory agreement is reached. In 2020, about 6 percent of private-sector and 35 percent of public-sector workers were members of unions. Economists have estimated that being in a union increases a worker’s wages about 10 percent, holding constant other factors.

Personnel Economics 16.5

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

Personnel economics is the application of economic analysis to human resources issues.

A. Should Workers’ Pay Depend on How Much They Work or on How Much They Produce? Personnel economics addresses when workers should receive straight-time pay—a certain wage or salary per week or month—and when they should receive commission or piece-rate pay—a wage based on how much output they produce.

B. Other Considerations in Setting Compensation Systems Many firms continue to pay their workers’ salaries, which means they are paying workers on the basis of how long they work rather than on how much they produce. Firms may choose a salary system for three key reasons: (1) when it is difficult to attribute output to any particular worker; (2) when there are concerns about the quality of the units produced and not just the quantity; and (3) when workers dislike the risk a piece-work system involves.

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Economist Edward Lazear examined the decision made by the clothing company Levi Strauss to change its compensation from a piece-rate system to a “team incentive” approach to compensate its workers. Levi Strauss abandoned a piece-rate pay system in 1992. Under this system, the firm paid workers based on their performance on specialized tasks. The new system required groups of 10 to 35 employees to work together on shared tasks, with their pay based on the work the groups completed. But this system failed. Rather than motivating workers, the quality of work fell as skilled workers feuded with less-skilled and slower colleagues. Threats and insults were common. Labor and overhead costs rose by 25 percent.

Lazear found that a “team incentive” approach worked very well for British Petrol and Exploration (BPE). This approach rewards workers based on the output produced by a group of workers. BPE had an oil field in Prudhoe Bay, Alaska, with about 300 workers. Six months after introducing its team bonus approach, productivity increased more than 12 percent. Source: Edward P. Lazear. “Personnel Economics and Economic Approaches to Incentives.” The Hong Kong Centre for Economic Research Letters, Vol. 61. September/October 2000.

a. Why was the team incentive approach at Levi Strauss a failure but a success at BPE? b. Under what circumstances are piecework systems and team incentive approaches likely to be successful?

Solving the Problem Step 1:

Review the chapter material. This problem is about personnel economics, so you may want to review the section “Personnel Economics” in the textbook.

Step 2:

Answer part (a) by explaining why the team incentive approach was a failure at Levi Strauss but a success at BPE. The team incentive approach failed at Levi Strauss because producing jeans does not require teamwork. When Levi Strauss used the team incentive approach, there was a tendency for some workers to be “free riders”—not working very hard and letting others do most of the work. The most skilled workers resented being paid the same wages as each of the other members of their group. At BPE’s Prudhoe Bay field, output could not be produced by one worker. Teamwork at BPE was necessary to produce oil, so team-based pay was effective.

Step 3:

Answer part (b) by describing the circumstances under which piecework systems and team incentive approaches are likely to be successful. In summarizing the lessons learned from the experience of Levi Strauss and BPE, Lazear wrote: “For production workers, pay *based+ on output is very effective. However, many Copyright © 2021 Pearson Education, Inc.

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CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income firms are reluctant to tie compensation to tangible measures of output…It is easier to simply pay everybody the same…Team-based pay is only effective when production is truly a team effort.”

Extra Apply the Raising Pay, Productivity and Profit at Safelite AutoGlass Concept Safelite Group, headquartered in Columbus, Ohio, is the parent company of Safelite AutoGlass, the nation’s largest installer of auto glass, with 600 repair shops. In the mid-1990s, Safelite shifted from paying its glass installers hourly wages to paying them on the basis of how many windows they installed. Safelite used a computer system to easily track how many windows each worker installed per day. To make sure quality did not suffer, Safelite added a rule that if a workmanship-related defect occurred with an installed windshield, the worker would have to install a new windshield and would not be paid for the additional work. Edward Lazear analyzed data provided by the firm and discovered that under the new piece-rate system, the number of windows installed per worker jumped 44 percent. Lazear estimated that half of this increase was due to increased productivity from workers who continued with the company and half was due to new hires being more productive than the workers they replaced who had left the company. Worker pay rose on average by 9.9 percent. Ninety-two percent of workers experienced a pay increase, and one-quarter received an increase of at least 28 percent. Safelite’s profit also increased as the cost to the company per window installed fell from $44.43 under the hourly wage system to $35.24 under the piece-rate system. Sociologists sometimes question whether worker productivity can be increased through the use of monetary incentives. The experience of Safelite AutoGlass provides a clear example of workers reacting favorably to the opportunity to increase output in exchange for higher compensation. Source: Edward P. Lazear, “Performance Pay and Productivity,” American Economic Review, Vol. 90, No. 5, December 2000, pp. 1346–1361.

Question What effect did the incentive pay system have on Safelite’s marginal cost of installing replacement car windows? If all firms that replace car windows adopted an incentive pay system, what would happen to the price of replacing automobile glass? Who would ultimately benefit? Answer

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The marginal cost to the company per window installed fell from $44.43 under the hourly wage system to $35.24 under the piece-rate system. If all firms adopted a system of incentive pay, the marginal cost of all window replacements would fall, and so would the price. Ultimately, it is the worker replacing the windows and the consumers who gain from this increased productivity: the workers would be paid more, and the consumers would pay less. This outcome is possible because the new pay scheme increased productivity.

The Markets for Capital and Natural Resources 16.6

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

A. The Market for Capital The demand for capital is a derived demand. When a firm considers increasing its capital by employing another machine, the value it receives equals the increase in the firm’s revenue from selling the additional output it can produce by employing the machine. The marginal revenue product of capital is the change in the firm’s revenue as a result of employing one more unit of capital. The marginal revenue product of the capital curve is the demand curve for capital. The supply curve for capital goods is upward sloping because the firms that produce capital goods face increasing marginal costs. In equilibrium, suppliers of capital receive a rental price equal to the marginal revenue product of capital.

B. The Market for Natural Resources The market for natural resources can be analyzed in the same way as the markets for labor and capital. The demand for natural resources is a derived demand. The marginal revenue product of natural resources is the change in the firm’s revenue as a result of employing one more unit of natural resources. The marginal revenue product of natural resources curve is also the demand curve for natural resources. The supply curve for natural resources is usually upward sloping. In some cases, the quantity of a natural resource is fixed and will not change as price changes. Economic rent (or pure rent) is the price of a factor of production that is in fixed supply.

C. Monopsony Monopsony is the situation in which a firm is sole buyer of a factor of production. A monopsony restricts the quantity of a factor demanded to force down the price of a factor and increase its profits. Monopoly and monopsony have similar effects on the economy. In both cases, a firm’s market power results in a lower equilibrium quantity, a deadweight loss, and a reduction in economic efficiency compared with a competitive market.

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D. The Marginal Productivity Theory of Income Distribution The marginal productivity theory of income distribution is the theory that the distribution of income is determined by the marginal productivity of the factors of production that individuals own. The more factors of production an individual owns and the more productive those factors are, the higher the individual’s income will be.

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Solutions to End-of-Chapter Exercises The Demand for Labor 16.1

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

Review Questions 1.1

The demand that firms have for labor is derived from the demand consumers have for the goods and services labor produces.

1.2

The marginal product of labor is the additional output a firm produces as a result of hiring one more worker. The marginal revenue product of labor is the change in the firm’s revenue as a result of hiring one more worker.

1.3

The demand curve for labor is the marginal revenue product of labor curve. The marginal revenue product of labor (MRP) equals the marginal product of labor multiplied by the marginal revenue from selling another unit of output. In the case of a firm that is a perfect competitor in the output market, the MRP equals the marginal product of labor multiplied by the price of the product because price equals marginal revenue. The MRPL, or demand curve for labor, slopes downward because the marginal product of labor decreases due to the law of diminishing returns.

1.4

The most important factors that cause the market demand curve for labor to shift are: (1) changes in human capital; (2) changes in technology; (3) changes in the quantity of other inputs; (4) changes in the price of the product; and (5) changes in the number of firms in the market. The first three factors cause changes in the marginal product of labor.

Problems and Applications 1.5

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

1.6

Number of Workers

Output of Televisions per Week

Marginal Product of Labor (television sets per week)

Product Price

Marginal Revenue Product of Labor (dollars per week)

Wage (dollars per week)

Additional Profit from Hiring One More Worker (dollars per week)

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income L

MRP = P × MP

MRP − W

—

$300

—

$1,800

—

300

$2,400

1,800

$600

300

2,100

1,800

300

1,800

300

1,500

1,800

−300

300

1,200

1,800

−600

300

900

1,800

−900

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

1.7

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

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

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

1.8 A basketball player with a large contract could have a negative value to the team if his marginal revenue product (MRP) or his contribution to the revenue of the team is less than his wage or salary. In this case, Kevin Love added less to his team’s revenue than his salary added to his team’s costs. 1.9

a. The restaurant owner meant that he would have difficulty selling hamburgers at a price of $20. b. The servers’ marginal revenue product (MRP) was less than the wage plus other compensation the city government required the restaurants to pay the servers. As a result, Copyright © 2021 Pearson Education, Inc.

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CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income the restaurants were attempting to get customers to do some jobs—such as bussing dirty dishes—that previously had been done by employees. c. The labor regulations are benefitting those restaurant workers who are still able to find jobs (or keep their existing jobs). These workers receive higher wages and more benefits than they would without the regulations. The groups that lose as a result of the labor regulations are: (1) the business owners, who are now required to pay their workers more; (2) workers who would otherwise have been hired to bus dirty dishes or perform other tasks that customers are now asked to perform; and (3) customers if restaurants raise their prices following the increase in their labor costs.

16.2

The Supply of Labor Learning Objective: Explain how people choose the quantity of labor to supply.

Review Questions 2.1

The opportunity cost of leisure is the wage that could have been earned by working. The supply curve of labor usually slopes upward because the substitution effect of a wage change is larger than the income effect. The substitution effect of a wage change refers to the fact that as the wage rate increases, the opportunity cost of leisure rises because time away from work becomes relatively more expensive, so people work more. The income effect of a wage change refers to the fact that as the wage rate increases, the individual’s purchasing power rises too, so he or she will want to buy more normal goods, including leisure. As the wage rate rises, the substitution effect leads individuals to want to work more, and the income effect leads them to want to work less, but the substitution effect is often larger than the income effect, causing the labor supply curve to slope upward.

2.2

The most important factors that cause the market supply curve of labor to shift are (1) changes in population; (2) changing demographics; and (3) changing alternatives to work in general or work within a particular sector of the economy.

Problems and Applications 2.3

We can conclude that Daniel’s income effect (higher wage  higher income  more leisure  less labor) is greater than his substitution effect (higher wage  higher opportunity cost of leisure  lower leisure  more labor). As a result, Daniel works fewer hours as his wage increases.

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2.4

When the CEO of Weifield Group Contracting was quoted as saying “There are some guys that will not work overtime. You can’t pay ’em enough to work overtime,” he meant that the workers declined to work more than 40 hours per week even though they would be paid higher wages for the extra hours. For these workers, the income effect resulting from the higher wage must have been greater than the substitution effect. They valued the leisure from not working more than 40 hours per week more than they valued the additional income they could have earned by working extra hours. These workers would have worked extra hours if the substitution effect of the higher wage had been greater than the income effect.

2.5

Most labor economists assume that many adult men will work the same number of hours despite changes in their current wage rates. If, for example, an adult man worked 40 hours per week, an increase in his wage would result in him working the same 40 hours: the substitution effect of the wage increase (which would lead him to substitute work for leisure and work more hours) is equal to the income effect (which would lead him to work fewer hours).

2.6

Eliminating the income tax on wages increases the opportunity cost of leisure because the aftertax wage (the wage after a worker has paid his or her taxes) would now be higher than it was. Workers will also earn more income for any given number of hours worked. Whether workers will end up supplying more hours at each wage rate depends on whether the substitution effect of this increase in the after-tax wage is greater than the income effect. If the substitution effect exceeds the income effect, then the workers will supply more hours of work and the labor supply curve will be positively sloped. If the income effect exceeds the substitution effect (and leisure is a normal good), then the workers will supply fewer hours of work and the labor supply curve will be backward-bending. Moreover, if the increase in the after-tax wage attracts more workers to Michigan from other states, the labor supply curve in Michigan will shift to the right.

2.7

a. Holding all else equal, the decrease in the number of people between the prime working ages of 25 and 64 will cause the labor supply curve in 2035 to be to the left of its position in 2015. b. Because the number of people in the United States between these ages who are children of U.S.-born parents will decline during this period, the source of the additional 13.6 million people between the prime working ages of 25 and 64 would have to be either immigrants or the children of immigrants.

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2.8

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

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

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16.3

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Equilibrium in the Labor Market Learning Objective: Explain how equilibrium wages are determined in labor markets.

Review Questions 3.1

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

3.2

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

Problems and Applications 3.3

a. If the gap between the wages of workers with college degrees and the wages of workers without college degrees has been increasing, then we know that either: (1) The wages of workers with college degrees have been falling more slowly than the wages of workers without college degrees, or (2) the wages of workers with college degrees have been Copyright © 2021 Pearson Education, Inc.

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CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income increasing more rapidly than the wages of workers without college degrees. The second possibility is the more likely and is illustrated in the following graph. The demand for the labor of workers with college degrees shifts to the right from Labor demand1 to Labor demand2, while the supply of workers with college degrees shifts to the right from Labor supply1 to Labor supply2. Because we are assuming that the wages of workers with a college degree increased, the demand for labor must have shifted more than the supply of labor, causing the equilibrium wage to increase from W1 to W2, while the equilibrium quantity of labor increases from L1 to L2.

b. The existence of the wage gap provides an incentive for more people to get college degrees. We might expect that over time the resulting increase in the supply of workers with college degrees would reduce the wage gap. 3.4

The columnist is arguing that attending an elite college doesn’t necessarily cause a student to be successful later in life. The student might have possessed the skills and attributes that lead to success in life at the time she enrolled in college. In that case, the student would have succeeded even if she had enrolled in a less selective college. As noted in the Apply the Concept, research by Stacy Dale and the late Alan Krueger of Princeton University found that once they held constant students’ characteristics, the earnings of people who graduate from highly selective colleges are no higher 30 years after graduation than are the earnings of people who graduated from less selective colleges. Students and their parents may make great efforts to obtain admission to an elite college if they are unaware of research such as that of Dale and Krueger or if they value the prestige of attending an elite college apart from the financial advantage such attendance might give graduates in later life.

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Salaries are not determined by the importance of the work being done. Salaries are determined by the intersection of the demand curve for labor and the supply curve for labor in a specific market. There are many more people with the skills to be a teacher than there are people with the skills to be a film star. In addition, the marginal revenue product of a film star is much greater than the marginal revenue product of a teacher.

3.6

a. The following graphs show the initial equilibrium in the market for computer science (CS) workers that existed prior to the immigration of the CS workers responsible for innovations, occurring at a wage of W1 and a quantity of workers L1. As a result of the H-1B visa program, the immigration of CS workers shifts the supply curve from S1 to S2. The increased demand for high technology products, such as applications related to the growth of the World Wide Web from 1994 to 2001, resulted in an increase in the derived demand for CS workers from D1 to D2. Graph (a) assumes that the increase in demand for CS workers was greater than the increase in supply of CS workers, resulting in an increase of the wage rate from W1 to W2. Graph (b) assumes that the increase in supply for CS workers exceeded the increase in demand for workers, resulting in a decrease in the equilibrium wage rate. b. Because the H1-B visa program is estimated to have reduced the wages received by U.S. CS workers, we can infer that the program had a greater effect on the labor supply than on demand. This outcome is consistent with graph (b).

3.7

a. Automation refers to using machines to carry out tasks that had previously been performed by human workers. b. While automation has resulted in the elimination of certain jobs, it has also created new jobs as, for instance, in writing software to control a robot that is doing tasks previously performed by an assembly line worker. Moreover, many people who lose their jobs due to automation receive training that allows them to gain the skills needed to succeed in other jobs.

3.8

a. Most of the workers who make shoes, clothing, and automobiles and those who have “offshore” jobs are middle-skill and low-skill workers. Middle-skill workers, including those Copyright © 2021 Pearson Education, Inc.

xxviii CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income who make shoes and automobiles, are likely to be affected by the increased use of robots, which would result in a decline in demand for labor and a decrease in wages. The demand for low-skill workers, including those who offer consumers assistance over the phone or online, is not likely to be affected by the use of robots. b. The increased use of robots, increases in manufactured goods imports, and offshoring all affect the U.S. labor market in a similar way. Namely, they result in a decrease in the demand for labor and a decline in the equilibrium wage. Therefore, it is not possible to distinguish these three separate influences. 3.9

a. The average wage of people who work at Creator is likely to be higher than the average wage of people who work at McDonald’s. Most people who work at the typical McDonald’s are unskilled. Therefore, we would expect that their marginal revenue products and their wages would be low. The people listed as working at Creator have skills that would result in their having high marginal revenue products and, therefore, high wages. b. If the owners of Creator expand their firm nationwide, the demand for the skilled workers the firm hires will increase. The increase in demand should raise the wages of these workers, so they will benefit from the firm’s expansion. Low-skilled workers, such as cooks, dishwashers, and cashiers, would experience a decrease in the demand for their labor. This decrease in demand should reduce their wages, so they may lose as a result of Creator’s expansion. These conclusions depend on Creator’s expansion being significant enough to have an effect on the markets for different types of labor. Or, in addition to Creator expanding, other restaurants would have to begin replacing unskilled workers with robots and skilled workers.

Explaining Differences in Wages 16.4

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

Review Questions 4.1

A compensating differential exists when a higher wage compensates workers for unpleasant aspects of a job. An example would be when workers need to be paid an extra $2 an hour to work in a job with a high risk of injury.

4.2

Economic discrimination refers to an employer paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic—such as race or gender. The fact that one group (men, for example) has higher average earnings than another group (women, for example) is not necessarily evidence of economic discrimination. Before concluding that economic discrimination is the reason for the pay gap, we must adjust for differences in the Copyright © 2021 Pearson Education, Inc.

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productivity of the two groups. Because it is difficult (especially for someone who doesn’t supervise the workers) to measure productivity precisely, it is hard to determine whether differences in pay are due to differences in productivity or to discrimination. 4.3

By discriminating, employers reduce the supply of workers who apply for jobs with them and increase the supply of workers who apply for jobs at competing firms that do not discriminate. As a result, employers who discriminate have to pay higher wages than do their competitors who do not discriminate. These higher wages are the economic penalty that the market imposes on employers who discriminate. Because employers who do not discriminate have lower costs, they can charge lower prices and, in principle, drive out of business employers who discriminate. The evidence suggests, however, that because of factors such as worker discrimination, customer discrimination, and feedback loops, the higher wages that employers who discriminate must pay are not sufficient to completely eliminate discrimination.

Problems and Applications 4.4

The closure of newspapers has decreased the demand for journalists. We would expect that both the number of journalists employed and their wages would fall. However, it’s possible, that if enough journalists left the market that the wages of journalists have actually increased since 2004. We illustrate the two possibilities in the following graph. We start in 2004 before the newspaper closures with Labor demand1 and Labor supply1. The equilibrium wage is W1 and the equilibrium number of journalists employed is L1. The closure of newspapers shifts the demand for journalists to the left from Labor demand1 to Labor demand2. If the labor supply curve doesn’t shift, then the new equilibrium wage is W2 and the new equilibrium number of journalists employed is L2. But if workers leave journalism for other occupations, the labor supply curve shifts from Labor supply1 to Labor supply2, and the new equilibrium wage is W3, which is higher than W1. In fact, the wages of journalists have fallen along with the number of journalists employed. We can conclude that since 2004 the shift in demand curve for journalists has been larger than the shift in the supply curve.

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4.5

Alex Rodriguez’s marginal revenue product—how much extra revenue he earned for his team— was obviously much higher than the marginal revenue product of this fan’s boss. Rodriguez’s high pay was justified in an economic sense by the willingness of fans to pay more to see a winning major league baseball team either in person or on television.

4.6

Even if Nick Saban’s marginal product as a coach—the number of games he is responsible for his team winning—is similar to that of other successful football coaches, you and many football fans could argue that Nick Saban is underpaid because the revenue his Alabama football program generates causes his marginal revenue product to be higher than the marginal revenue products of other coaches. Saban’s marginal revenue product is higher because attendance at University of Alabama football games is higher than for many other schools, television ratings for Alabama games are higher than games involving other schools, and he is responsible for greater alumni donations to his university. In that sense, Saban actually deserves a salary that is higher than the $9.5 million per year he earned in 2021.

4.7

Streaming has increased the revenue music companies can earn from signing popular recording artists. Sales of CDs or individual songs online had been continually declining, causing the revenue music companies earned from selling music to decline. Once Spotify, Apple Music, and other streaming services found they could sell monthly streaming subscriptions, they competed for the rights to stream the most successful performers, raising the amounts the performers received. In effect, streaming had increased the marginal revenue products of popular recording artists. Because less popular acts are unlikely to increase the chances that someone will sign up for a streaming service, the music companies are unwilling to sign these acts. As with other areas of the entertainment industry, technological progress has increased the incomes of the most popular performers while reducing the incomes of the less popular performers.

4.8

There is a great demand, domestic and worldwide, to watch superstar basketball players in person, on television, and streaming on the Internet. This demand results in a correspondingly Copyright © 2021 Pearson Education, Inc.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income

xxxi

high marginal revenue product for superstar basketball players. There is no demand to view the works of even the most skilled plumbers and, however skilled a plumber may be, he or she can fix only a limited number of clogged drains in a day. 4.9

Broadcast announcers and radio disc jockeys: The margin revenue products of announcers and disc jockeys vary by the size of the markets where they are employed and how much experience they have. Announcers and disc jockeys typically begin working in small local markets where they earn relatively modest starting salaries. If they are successful, they may move to larger markets; for example, in cities such as Chicago, Los Angeles, and Philadelphia, where they can earn higher salaries. The most successful announcers and disc jockeys work for employers that have large regional or national audiences.

b. Real estate brokers: The incomes earned by real estate brokers are primarily related to the commissions they receive when houses and buildings are bought and sold. Brokers who work hard to facilitate these transactions, especially in areas where real estate values are high, will earn more than other brokers. c. Lawyers: Oher factors being equal, more experienced lawyers will earn higher incomes than lawyers who are less experienced. Those who are partners in law firms will earn more than the firms’ associate lawyers. d. Veterinarians: Veterinarians who are recent graduates of schools of veterinary medicine earn much lower salaries than experienced veterinarians. As is the case with many occupations, salaries in large metropolitan areas are greater than salaries in areas with small populations of people and, therefore, pets. 4.10

a. Sam Goldwyn, who was famous for this and other (often unintentionally funny) sayings, probably meant that the movie star was getting paid more than other actors who could have played the same roles. b. The movie star was worth his high salary if he raised the probability that the movie would be popular with fans and bring in a great deal of revenue. In other words, as long as the movie star’s wage did not exceed his marginal revenue product, Goldwyn’s movie studio increased its profit by employing him.

4.11

Before the passage of workers’ compensation laws, the wages of workers in hazardous industries such as coal and lumber included compensating differentials. After the passage of the laws, these compensating differentials declined because workers now received payments from their employers for injuries suffered while on the job. The decline in the compensating differentials reduced workers’ wages.

4.12

If employers always discriminated against racial minorities, it would be unlikely that Asian males would earn more than white males. However, it is important not to use average wages to assess whether discrimination occurs. Differences in productivity are typically the main factor Copyright © 2021 Pearson Education, Inc.

xxxii CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income determining differences in wages. Economic discrimination occurs when someone is paid less due to an irrelevant characteristic that isn’t related to productivity. Comparing average wages across ethnic groups cannot definitively decide whether or to what extent economic discrimination occurs. 4.13

It is likely that these women ended up with less education than they would have had if they had known they would be in the labor force. For instance, more women would likely have gone to college. More women would also likely have obtained vocational training. Because they were less well prepared to enter the workforce, the earnings of these women were lower than they would have been if they had correctly predicted the probability of their being in the labor force later in life.

4.14

a. By “individual choices,” Katz probably referred to the decision that many women make to leave the labor force for a period when they have a child. As a result, many of these women have less workforce experience, so their lower incomes are the result of lower productivity. b. Because it is sometimes difficult to measure productivity, it is hard to estimate how much of the gap between what men and women earn is due to economic discrimination.

4.15

a. 7,000 trash collectors at a wage of $600 per week b. 9,000 receptionists at a wage of $400 per week c. The marginal revenue products of the two types of workers may differ. There may also be a compensating differential because the work of trash collectors is dirty and unpleasant. d. 6,000 trash collectors and 8,000 receptionists

4.16

A government requirement that universities pay economic professors and English professors the same salaries would be a version of comparable worth legislation. Assume, hypothetically, that before the legislation is passed, the equilibrium wage for economics professors is $70,000 per year, and the equilibrium number of economics professors hired is L1. Setting the wage at $60,000, which is below equilibrium, reduces the number of professors who are willing to work in this occupation from L1 to L2, but increases the number of professors colleges demand from L1 to L3. The result is a shortage of economics professors equal to L3 – L2, as shown in the following graph on the left. Without the legislation, the equilibrium wage for English professors is $50,000, and the equilibrium number hired is L1. Setting the wage for English professors at $60,000, which is above equilibrium, increases the number of professors who want to work in this occupation from L1 to L3, but reduces the number of professors colleges demand from L1 to L2. The result is a surplus of English professors equal to L3 – L2, as shown in the graph on the right.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income xxxiii

4.17

Employers might believe that applicants with white-sounding names are more productive, so they will be more inclined to interview those applicants. These employers, however, will likely incur an economic penalty. Employers who discriminate, by arbitrarily deciding not to consider some job applicants, will end up paying higher wages than will employers who do not discriminate. Because employers who do not discriminate will experience lower costs, they will be able to charge lower prices for their output and be more profitable than their discriminating competitors.

4.18

In a summary of their study, Doleac and Hansen wrote the following: “removing information about job applicants’ criminal histories could lead employers who don't want to hire exoffenders to try to guess who the ex-offenders are and avoid interviewing them .... This would worsen employment outcomes for these already-disadvantaged groups…We find that *ban the box+…policies decrease the probability of being employed by 3.4 percentage points (5.1%) for young, low-skilled black men, and by 2.3 percentage points (2.9%) for young, low-skilled Hispanic men. These findings support the hypothesis that when an applicant's criminal history is unavailable, employers statistically discriminate against demographic groups that are likely to have a criminal record.”

4.19

Economic discrimination is the practice of paying a person a lower wage or excluding a person from an occupation on the basis of a characteristic—such as race, gender, or even physical appearance—that is irrelevant to productivity on the job. Before concluding below-averagelooking men and women earn less than good-looking men and women because of their less appealing physical attributes, we must adjust for differences in the productivity of the two groups. And because of the difficulty involved with measuring productivity precisely, it is hard to determine whether differences in productivity, rather than economic discrimination, explain some of the gap in earnings that Daniel Hamermesh discovered. For example, for a salesperson, being better looking may make it easier to complete sales, and the higher sales will result in employees earning more revenue for the firm. In those cases, we might expect that the market will end up rewarding more attractive workers with higher earnings even if employers are not engaging in discrimination.

xxxiv CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income

Personnel Economics 16.5

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

Review Questions 5.1

Personnel economics is the application of economic analysis to human resources issues, such as compensation packages, promotions, training, and pensions.

5.2

As a firm moves from straight-time pay to commission pay, the productivity of the firm’s employees may increase because (1) the firm would attract and retain the most productive employees, and (2) commission pay provides employees with an incentive to sell more output. Some firms may prefer a salary compensation system when: (1) it is difficult to measure worker output; (2) there is concern that workers who would receive commission pay would be less concerned about the quality of the output they produce; or (3) workers fear that their output— and income—will decline for reasons unrelated to their work effort.

Problems and Applications 5.3

a. The compensation scheme at Frito-Lay may benefit delivery drivers because their pay will now be a straight salary and will not exhibit large variations, particularly if the demand for some Frito-Lay products is seasonal with consumers buying less during certain times of the year. The compensation may also be advantageous to drivers who are on less productive routes. Removing the commissions, however, results in a decrease in incentives for drivers to work harder by delivering more snacks. Workers who received large commissions prior to the compensation change will see a decline in their total earnings, which is why some of them quit. b. By moving away from compensation schemes that are dependent on commissions, Frito-Lay can control costs better, especially if the company thinks that the demand for its snacks and, therefore, its revenues will be increasing. The disadvantage to Frito-Lay is that in removing commissions it is also removing some of the incentive for its drivers to work harder; drivers expect similar pay regardless of whether they just meet their delivery quota or exceed the quota. Another disadvantage is that Frito-Lay may lose some of its better drivers to competing firms that still pay commissions.

5.4

a. A piece-rate system will motivate workers to be more productive because they will earn more income as they produce more output. Salespeople, in particular, will earn more as they sell more. However, manufacturing firms are likely to consider a salary system to be more profitable than a piece-rate system when: (1) output is difficult to measure and attribute to individual workers; (2) employers are especially concerned about the quality, Copyright © 2021 Pearson Education, Inc.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income xxxv rather than the quantity, of output that is produced; and (3) workers are reluctant to have their incomes determined by work effort. In other words, when workers are risk averse. b. Modern manufacturing systems that are designed to produce a variety of products to a demanding quality standard are not well suited to a compensation system that awards workers more income based on the quantity of output produced. When many different products are produced, it is difficult to attribute their production to individual workers, and the quality of output can suffer if workers are more concerned with the quantity of output they produce. For these reasons, firms would likely prefer a salary system of compensation. 5.5

a. Workers paid through piece-rate compensation schemes receive salaries based on their individual effort and ability. This type of compensation benefits both workers who prefer a slower work pace or who have less ability, as well as workers who prefer a faster work pace or who have greater ability b. Individuals who are on piece-rate schemes are not protected when the company suffers a decline in production (when business conditions are poor) because they will be producing less output and will be paid less. Workers on a salary, however, may receive more stable compensation when the company is experiencing a decline in production.

5.6

Previously, salespeople had an incentive to sell more inexpensive tires that were less profitable for Goodyear than more expensive tires. In addition, because they were compensated on the basis of the quantity of tires sold, they had an incentive to reduce the price to sell more tires, even if doing so reduced Goodyear’s profits.

5.7

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

The Markets for Capital and Natural Resources 16.6

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

Review Questions

xxxvi CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income 6.1

In equilibrium, the price of capital is determined by the intersection of the supply of capital curve and the demand for capital curve. Similarly, the equilibrium price of natural resources is determined by the intersection of the supply of natural resources curve and the demand for natural resources curve. Economic rent is the price paid for a factor of production (for example, land) that is in fixed supply.

6.2

A monopsony is a market with only one buyer of a factor of production.

6.3

The marginal productivity theory of income distribution states that each individual’s income is determined by the marginal productivity of the factors of production (such as labor, capital, and natural resources) that the individual owns.

Problems and Applications 6.4

Number of Machines

Output of Pins (boxes per week)

Marginal Product of Capital

Product Price (dollars per box)

Total Revenue

Marginal Revenue Product of Capital

Additional Profit from Renting One Additional Machine Rental Cost per Machine

MRP = P × MP

MRP − R

—

$100

—

$550

—

100

1,200

$1,200

550

$650

100

2,100

900

550

350

100

2,800

700

550

150

100

3,400

600

550

100

3,900

500

550

−50

100

4,300

400

550

−150

Adam should rent four machines for his pin factory to maximize his profit because at this quantity the additional profit from renting one additional machine is closest to zero without being negative. Copyright © 2021 Pearson Education, Inc.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income xxxvii b. The demand for capital curve equals the marginal revenue product of capital.

6.5

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

6.6

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

xxxviii CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income

6.7

a. By requiring their employees to sign an agreement barring them from working at the firm’s competitors, WeWork can avoid other firms hiring away some of their workers by offering them higher wages. b. There is no direct benefit to the WeWork employees from signing the agreement, other than it is a condition for employment. WeWork most likely didn’t hire applicants who refused to sign the agreement.

6.8

In the case of a monopsony, imposing a minimum wage removes market power from the single firm and encourages the firm to hire more workers than it would otherwise, assuming that the minimum wage is set at a level that is above the wage that the monopsony firm would otherwise have paid.

Suggestions for Critical Thinking Exercises

CT16.1 Demand and supply is the source of the disparity in the pay between college and professional players in basketball or football. In college football and basketball, the supply of athletes is much larger because many athletes have the skills to play at that level. By contrast, only a few players have the skills to play professional football and basketball. Moreover, the demand colleges have for basketball and football players is not as high as the demand professional sports teams have for players because the revenue that schools get from the National Collegiate Athletic Association (NCAA) is much less than what professional teams get from the National Basketball Association (NBA) or the National Football League (NFL). Professional teams receive much more revenue from television contracts than do colleges. The marginal revenue product of a professional superstar is much higher than is true of a college superstar. Copyright © 2021 Pearson Education, Inc.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income xxxix

CT16.2 Without salary caps, professional sports teams in big cities would likely dominate their sports because the larger populations in those cities would generate more revenue. In turn, this revenue would lead to the teams hiring more and better athletes because their marginal revenue product would be greater in these markets. Those teams could then dominate their sports year after year.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income Brief Chapter Summary and Learning Objectives 17.1 Public Choice Describe the public choice model and use it to analyze government decision making. ▪

The public choice model assumes that policymakers are likely to pursue their own selfinterest, even if it conflicts with the public interest.

17.2 The Tax System Explain the tax system in the United States, including the principles that governments use to create tax policy. ▪

The taxes most used to raise revenue are individual income taxes, social insurance taxes, sales taxes, property taxes, and excise taxes.

17.3 Tax Incidence Revisited: The Effect of Price Elasticity Explain the effect of price elasticity on tax incidence. ▪

When the demand for a product is less elastic than the supply, consumers pay the majority of the tax on a product. When demand for a product is more elastic than the supply, firms pay the majority of the tax on a product.

17.4 Income Distribution and Poverty Discuss income distribution and income mobility and the role of policy in addressing these issues.

CHAPTER 17 | Public Choice, Taxes, and the Distribution of Income ▪

Income in the United States was distributed more unequally in 2019 than in 1980, but rapid growth in income may increase income mobility.

Key Terms Arrow impossibility theorem A mathematical theorem that holds that no system of voting can be devised that will consistently represent the underlying preferences of voters. Average tax rate Total tax paid divided by total income. Excess burden A measure of the efficiency loss to the economy that results from a tax having reduced the quantity of a good produced; also known as the deadweight loss. Human capital The accumulated knowledge and skills that workers acquire from education and training or from their life experiences. Lorenz curve A curve that shows the distribution of income by arraying incomes from lowest to highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis. Marginal tax rate The fraction of each additional dollar of income that must be paid in taxes.

Poverty rate The percentage of the population that is poor according to the federal government’s definition. Progressive tax A tax for which people with lower incomes pay a lower percentage of their income in tax than do people with higher incomes. Public choice model A model that applies economic analysis to government decision making. Regressive tax A tax for which people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. Rent seeking Attempts by individuals and firms to use government action to make themselves better off at the expense of others. Tax incidence The actual division of the burden of a tax between buyers and sellers in a market. Voting paradox The failure of majority voting to always result in consistent choices.

Median voter theorem The proposition that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle. Poverty line A level of annual income equal to three times the amount of money necessary to purchase the minimum quantity of food required for adequate nutrition.

Chapter Outline Should Your Small Business Be Taxed Like Apple? When Congress and President Donald Trump enacted the Tax Cuts and Jobs Act of 2017, they cut the top corporate tax rate from 35 to 21 percent. They also lowered the tax rate for some “income passthrough businesses.” Sole proprietorships and most partnerships are pass-through businesses. The tax rate owners of some of these businesses was cut from the top personal income tax rate of 39.6 percent. The purpose of cutting tax rates is to increase economic growth. However, some economists disagreed with the tax cut proposals, arguing that many of the benefits would go to high-income individuals. Although the basic purpose of taxes is pay for government spending, Congress and the president often have used taxes to achieve other policy objectives. During the 2020 presidential election campaign, President Joe Biden pledged to reverse some, but not all, of the 2017 tax cuts. Among other changes, he proposed to raise the top corporate tax rate from 21 percent to 28 percent and to raise the top personal income tax rate from 37 percent to 39.6 percent, the rate that prevailed during the Obama administration. As of mid-2021, it was unclear if President Biden would be able to convince Congress to enact his tax proposals.

Public Choice 17.1

Learning Objective: Describe the public choice model and use it to analyze government decision making.

The public choice model applies economic analysis to government decision making. Because government policy plays an important role in the economy, it is important also to consider how government policymakers arrive at their decisions. Policymakers are likely to pursue their own selfinterest, even if it conflicts with the public interest.

A. How Do We Know the Public Interest? Models of Voting Elected officials do not simply represent the preferences of the voters who elect them. Policy decisions involve alternatives, and there are circumstances in which majority voting will fail to result in a consistent decision. The failure of majority voting to always result in consistent choices is called the voting paradox. The Arrow impossibility theorem is a mathematical theorem that holds that no system of voting can be devised that will consistently represent the underlying preferences of voters. The theorem suggests that there is no way through democratic voting to ensure that the preferences of voters are translated into policy choices.

In practice, many political issues are decided by a majority vote. The median voter theorem is the proposition that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle. There is a contrast between the political process, which results in collective actions in which everyone is obliged to participate, and the market process in which individuals are free to participate or not.

B. Government Failure? The public choice model questions whether the self-interest of policymakers is likely to cause them to take actions that are inconsistent with the preferences of voters, even when those preferences are clear. Economists usually analyze the actions of individuals and firms as they attempt to make themselves better off by interacting in markets. The public choice model shifts the focus to rent seeking, which refers to attempts by individuals and firms to use government action to make themselves better off at the expense of others. Policymakers may accept contributions from rent-seeking firms and be willing to introduce special interest legislation on their behalf. Logrolling is the situation in which a member of Congress votes to approve a bill in exchange for favorable votes from other members on other bills. Vote trading may result in a majority of Congress supporting legislation that benefits the economic interests of a few, while harming the economic interests of a much larger group. Even if a majority of voters is harmed by rent-seeking legislation, the loss is spread out widely so that most people do not take it into account when deciding how to vote in elections. Becoming informed on an issue may require time and effort and the economic payoff is often low, so many voters are rationally ignorant of the effect of rent-seeking legislation. One way in which the government intervenes in the economy is by establishing a regulatory agency or commission that is given authority over a particular industry or type of product. Ideally, regulatory agencies will make decisions in the public interest. However, because regulated firms are significantly affected by an agency’s actions, firms have an incentive to try to influence those actions. This influence could lead the agency to make decisions that are in the best interests of the regulated firms, even if these actions are not in the public interest. In such cases, the agency has been subject to regulatory capture by the regulated industry. Public choice analysis indicates that government failure can occur; it is possible that government intervention in the economy may reduce economic efficiency.

C. Is Government Regulation Necessary? The public choice model raises important questions about the effect of government regulation on economic efficiency. Despite their concerns, most economists agree that government agencies serve a useful purpose. Regulatory agencies can improve economic efficiency in markets where consumers have difficulty obtaining information needed to make informed purchases. Although government regulation can provide important benefits, we need to take into account the costs of regulation.

Preface

vii

Extra Solved Problem 17.1 Third Party Split Elects Woodrow Wilson President According to Kenneth Arrow’s impossibility theorem, no system of voting can be devised to consistently represent the preferences of voters. In a 2012 interview, Arrow commented on one of the consequences of a plurality voting system. In this system, the winner of an election is the candidate who receives more votes than any other candidate: …if you have a Plurality system, you’re…driven to a two-party system. If a party splits, both factions lose because they’re less likely to get a plurality. In the presidential election of 1912, former Republican president Theodore Roosevelt ran as the candidate of the Progressive Party against the incumbent President and Republican Party candidate William Howard Taft, and the Democratic Party candidate, Woodrow Wilson. a. How did “both factions lose” in the 1912 election? b. How can we show that the outcome of the 1912 election would have been different if only the candidates of the two major parties, and not Roosevelt, had run for president? Source: Aaron Hamlin, “Interview with Dr. Kenneth Arrow,” Center for Election Science, October 6, 2012. https://www.electionscience.org/commentary-analysis/voting-theory-interview-with-dr-kennetharrow/?highlight=kenneth%20arrow

Solving the Problem Step 1:

Review the chapter material. This problem is about public choice and voting models, so you may want to review the section “How Do We Know the Public Interest? Models of Voting” in the textbook.

Step 2:

Answer part (a) by explaining how “both factions” lost the 1912 presidential election. Historians generally agree that most people who voted for Theodore Roosevelt were either Republicans or former Republicans who would likely have voted for Taft if Roosevelt had not run as a third-party candidate. By splitting the Republican vote, neither Taft nor Roosevelt (“both factions”) was able to win enough electoral votes to defeat Wilson, who ultimately became president in 1913.

Step 3:

Answer part (b) by showing how the outcome of the 1912 presidential election would have been different if only the candidates of the two major parties, and not Roosevelt, had run for president. Here are the total number of votes and the percentage of the popular vote that each major candidate received (several minor candidates received far fewer votes):

Candidate

Total Number of Votes

Percentage of the Popular Vote

Wilson

6,294,284

41.83%

Roosevelt

4,120,609

27.39%

Taft

3,487,937

23.18%

If all of those who voted for either Roosevelt or Taft had voted for Taft, he would have received 50.57% of the total number of votes cast. Although the winning candidate receives the most electoral votes, rather than the most popular votes, it is likely that Taft would have been elected to a second term. Source: 1912 Presidential General Election Results, http://uselectionatlas.org/RESULTS/national.php?year=1912

Extra Apply the Explaining Support for Government Programs Concept With a population of only 50 people, Gravina Island, Alaska was an unlikely subject for national media attention. But in 2005, a proposal for Congress to spend $223 million to build a bridge between the island and nearby Ketchikan caused a storm of protest from critics who derided the project as a “bridge to nowhere.” Public criticism became so strong that Congress dropped the project. Public choice economists, who use economic principles to analyze political activity, viewed the bridge fiasco as an example of “diffused costs, concentrated benefits.” Special interests, in this case Alaskan construction workers hired to build the bridge, would benefit greatly from the project at the expense of U.S. taxpayers, each of whom would pay a tiny fraction of the total cost of the bridge. With the cost widely spread, rationally ignorant taxpayers typically have little incentive to inform themselves about, let alone protest, “pork barrel” projects. But economist Bryan Caplan has a different take on public choice theory. Doug Campbell explains Caplan’s argument: “…the public is getting precisely what it demands—policies that make voters feel good but don’t make any economic sense…Voters like protectionism and bridges to nowhere.” Although Caplan presents a new twist on one of the central tenets of the public choice model—voters are rationally ignorant—the “bridge to nowhere” furor highlights the relevance of another pillar of the model: the special interest effect. Gordon Tulluck and James Buchannan developed the public choice model. Tulluck explained the tendency for government to favor special interest projects: “Members of Congress wishing to get reelected will take careful account of issues…that strongly affect small minorities…less attention is given to issues affecting the general population…” Although private markets don’t always result in maximum efficiency and market failure provides a rationale for government regulation, public choice economists argue that government failure is also Copyright © 2023 Pearson Education, Inc.

Preface

possible. Therefore, these economists advocate limited government intervention. If government does intervene, public choice economists recommend letting multiple government entities provide the same service to promote competition in order to improve efficiency. Other policy recommendations include imposing term limits on politicians and allowing for a line-item veto. A line-item veto would allow a president to veto individual projects in a budget appropriations bill, rather than having to veto the entire bill. Source: Doug Campbell, “Democracy and Other Failures,” Region Focus, Federal Reserve Bank of Richmond. Summer 2007.

The Tax System 17.2

Learning Objective: Explain the tax system in the United States, including the principles that governments use to create tax policy.

The most widely used taxes are:     

Individual income taxes: The federal government, most state governments, and some local governments tax wages and other forms of income. Social insurance taxes: The federal government taxes wages and salaries to raise revenue for Social Security and Medicare. Federal and state governments also tax wages and salaries to raise revenue for unemployment insurance. Sales taxes: Most state and local governments tax retail sales of most products. Property taxes: Most local governments tax homes and other structures and the land on which they are built. In the United States, property taxes are the largest source of funds for public schools. Excise taxes: The federal government and some state governments levy taxes on specific goods.

A. An Overview of the U.S. Tax System In 2020, the federal government raised more than 80 percent of its revenue through individual income and social insurance taxes. Corporate income taxes and excise taxes accounted for much smaller fractions of federal revenue. In 2020, the largest source of revenue for state and local governments was grants from the federal government. Local governments raise substantial revenue from property taxes. Many school districts rely almost entirely on revenue from property taxes.

B. Progressive and Regressive Taxes A regressive tax is a tax for which people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. A progressive tax is a tax for which people with lower incomes pay a lower percentage of their income in tax than do people with higher incomes. The federal income tax is a progressive tax.

The marginal tax rate is the fraction of each additional dollar of income that must be paid in taxes. The average tax rate is the total tax paid divided by total income. The marginal tax rate is a better indicator than the average tax rate of how a change in a tax will affect people’s willingness to work, save, and invest.

D. The Corporate Income Tax The federal government taxes the profits earned by corporations under the corporate income tax. The corporate income tax is progressive. The corporate income tax “double taxes” earnings on shareholders’ investments in corporations since taxpayers already pay income taxes on dividends and capital gains they receive from owning stock.

E. International Comparison of Corporate Income Taxes Since 2000, governments of most high-income countries have cut their corporate income tax rates. Unlike many other countries, the United States imposes taxes on profits wherever they are earned but allows corporations to postpone paying taxes until the profits are brought back to the United States.

F. Evaluating Taxes In selecting which taxes to use, governments take into account the following goals and principles: 

   

The goal of economic efficiency: Whenever a government taxes an activity, it raises the cost of engaging in that activity, so less of the activity will occur. The tax will result in a deadweight loss. Excess burden is a measure of the efficiency loss to the economy that results from a tax having reduced the quantity of a good produced; also known as the deadweight loss. A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises. The ability-to-pay principle: This principle states that when the government raises revenue through taxes, it is fair to expect a greater share of the tax burden to be borne by people who have greater ability to pay. The horizontal-equity principle: This principle states that people in the same economic situation should be treated equally. The benefits-received principle—People who receive benefits from a government program should pay the taxes that support that program. The goal of attaining social objectives—taxes are sometimes used to attain social objectives such as discouraging smoking and drinking alcohol.

Extra Solved Problem 17.2 The Evolution of the Income Tax System The United States did not have an income tax prior to the Civil War. Government revenue had come from such sources as excise taxes, tariffs, and the sale of public lands. The demands placed on government because of the war forced Congress to pass a law in 1862 that raised excise taxes, imposed Copyright © 2023 Pearson Education, Inc.

Preface

a 3 percent tax on incomes up to $10,000, and taxed higher incomes at 5 percent. As the war ended, the government’s need for revenue declined. The income tax was abolished in 1872, and from 1868 to 1913 the federal government derived most of its revenue from excise taxes and tariffs. By the early 1900s, the U.S. policymakers were becoming increasingly aware that tariffs and excise taxes were neither efficient nor fair because they fell disproportionately on lower-income individuals. Members of Congress from agricultural states who feared the possibility of a tax on land championed proposals for a new income tax . By 1913, 36 states had ratified the 16th Amendment to the Constitution, which allowed Congress to institute an income tax. In October, Congress passed a law that levied a tax of 1 percent on those with low incomes. The tax rose to 7 percent for those with incomes exceeding $500,000. But less than 1 percent of the population paid the tax. The entry of the United States into World War I increased the revenue the federal government needed. The Revenue Act of 1916 raised the lowest tax rate to 2 percent and the top rate to 15 percent for incomes in excess of $1.5 million. Other revenue acts followed. Still, in 1918 only 5 percent of the population paid income taxes. As the economy boomed in the 1920s, Congress cut income tax rates five times. But after the economy plunged into the Great Depression and tax receipts fell, Congress passed the Tax Act of 1932, which raised tax rates. Another tax hike followed in 1936, after which the lowest tax rate was 4 percent and the top rate reached 79 percent. Individual and corporate taxes were raised once more in 1940 and 1941. Once again, wartime spending led to greater tax demands. By the end of World War II, taxpayers with taxable incomes of only $500 were subject to a tax rate of 23 percent, while taxpayers with incomes over $1 million faced a top rate of 94 percent. Federal taxes as a share of national income rose from 7.6 percent in 1941 to 20.4 percent in 1945. Source: Fact Sheets: Taxes. History of the U.S. Tax System. United States Treasury. https://www.treasury.gov/resourcecenter/faqs/Taxes/Pages/historyrooseveltmessage.aspx

a. Why did the United States first institute an income tax system? b. Select one goal or principle that policymakers considered in the decision to pass the 16th Amendment to the U.S. Constitution.

Solving the Problem Step 1:

Review the chapter material. This problem is about the tax system, so you may want to review the section “The Tax System” in the textbook.

Step 2:

Answer part (a) by explaining why the United States first instituted an income tax system. Prior to the Civil War, federal government spending was a relatively small percentage of national income. The government could meet its revenue needs through excise taxes, Copyright © 2023 Pearson Education, Inc.

tariffs, and sales of public land. But wartime spending required much more revenue. The government needed a broader tax base; that is, a tax or taxes that would affect many more people. Step 3:

Answer part (b) by selecting one goal or principle that policymakers considered in the decision to pass the 16th Amendment to the U.S. Constitution. Since the 16th Amendment was passed, progressive tax rates have been a characteristic of the income tax system. A progressive tax system follows the ability-to-pay principle. One could also argue that an income tax scores higher on the benefits-received principle than the alternatives of a land tax, excise tax, or tariff. As government spending grew, especially during times of war, the benefits of government programs and services were broadly spread across the population. Therefore, a tax with a broader base was justified.

Tax Incidence Revisited: The Effect of Price Elasticity 17.3 Learning Objective: Explain the effect of price elasticity on tax incidence. Tax incidence is the actual division of the burden of a tax between buyers and sellers in a market. When the demand for a product is less elastic than the supply, consumers pay the majority of the tax on the product. When demand for the product is more elastic than the supply, firms pay the majority of the tax on the product.

Income Distribution and Poverty 17.4

Learning Objective: Discuss income distribution and income mobility and the role of policy in addressing these issues.

A. Measuring the Income Distribution and Measuring Poverty In 2019, 17 percent of U.S. households had annual incomes less than $25,000 while 34 percent of households had incomes greater than $100,000. In 2019, the 20 percent of Americans with the lowest incomes received only 3.1 percent of all income, while the 20 percent with the highest incomes received 51.9 percent of all income. There was a moderate decline in income inequality between 1936 and 1980, followed by an increase in inequality after 1980. According to the federal government’s formal definition of poverty, the poverty line is a level of annual income equal to three times the amount of money necessary to purchase the minimum quantity of food required for adequate nutrition. The poverty rate is the percentage of the population that is poor Copyright © 2023 Pearson Education, Inc.

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according to the federal government’s definition. In the last forty years, there has been little decline in the poverty rate.

B. Showing the Income Distribution with a Lorenz Curve A Lorenz curve shows the distribution of income by arraying incomes from lowest to highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis. The Gini coefficient summarizes the information provided by the Lorenz curve. If the income distribution were completely equal, the Gini coefficient would equal 0. If the income distribution were completely unequal, the Gini coefficient would equal 1. In 1980, the Gini coefficient for the United States was 0.403. In 2019, it was 0.484, implying that income inequality increased between 1980 and 2019.

C. Problems in Measuring Poverty and the Distribution of Income Measures of poverty and the distribution of income are misleading. First, these measures do not take into account income mobility. Second, these measures ignore the effects of government programs meant to reduce poverty. A study by the U.S. Census Bureau examined incomes of the same households each year between 2004 and 2007. About 69 percent of the households that had incomes in the lowest quintile in 2004 were still in the lowest quintile in 2007. Of those households in the top income quintile in 2004, only two-thirds were still in the top quintile in 2007. This study indicates that there is significant income mobility in the United States. Because of government programs, there is a difference between the income people earn and the income they have available to spend. Since the income tax system is progressive, income remaining after taxes is more equally distributed than income before taxes. The Social Security system has been effective in reducing the poverty rate among people older than 65. Individuals with low incomes receive noncash benefits, such as food stamps, free school lunches, and rent subsidies. In 2019, about 38 million people participated in the food stamp program.

D. Explaining Income Inequality In equilibrium, each factor of production receives a payment equal to its marginal revenue product. Since the most important factor most people own is their labor, the income they earn depends on how productive they are and the prices of the goods and services their labor helps to produce. A person's productivity depends on his or her human capital. Human capital is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences. Technological change has led to the substitution of computers and other machines for unskilled labor. This has caused a decline in the wages of unskilled workers relative to other workers. Expanding trade has put U.S. workers in competition with foreign workers to a greater extent than in the past. This competition has caused the wages of unskilled workers to be depressed relative to other workers. Copyright © 2023 Pearson Education, Inc.

Some economists have argued that an increase in assortative mating—marriages between people with similar educations—may have increased inequality, since people with more years of education tend to earn higher incomes.

E. Policies to Reduce Income Inequality Some economists and policymakers argue that the after-tax distribution of income could be made more equal if the top marginal tax rate were raised. Higher-income people are more likely to own stocks and bonds and the returns people receive on their financial assets receive preferential tax treatment. Both dividends and capital gains are taxed at rates that are lower than the top marginal income tax rates. Other economists and policymakers are skeptical that raising taxes is an efficient way to reduce inequality. Higher marginal tax rates can discourage work, saving and investment, thereby slowing economic growth and reducing incomes for all groups. Economists also argue that high marginal tax rates encourage high-income people to engage in tax avoidance. Resources spent on tax avoidance add to the excess burden of the tax code. Economists and policymakers note that small business owners pay individual income taxes on their business earnings. Reducing tax rates as well as tax simplification may provide incentives to open new businesses and provide funds to expand existing businesses. Although the lower 40 percent of the income distribution pay no federal income tax, all workers pay payroll taxes that fund Social Security and Medicare programs. Some economists have advocated reducing payroll taxes or increasing the Earned Income Tax Credit to boost the incomes of lower-income workers. Many economists believe that workers who acquire skills that are complementary with new technologies will be able to find jobs that pay high wages.

F. Poverty around the World Although poverty remains a problem in high-income countries, it is a much larger problem in poor countries. Economists often use a much lower threshold income than used in the United States when calculating the rate of poverty in poor countries. Economic research demonstrates a positive relationship between economic growth and the incomes of lower-income people.

Extra Economics in Your Life & Career: Can Tax Reform Spur Economic Growth? Question: Every year, millions of U.S. taxpayers complete their income tax returns or hire an accountant to complete their returns for them. Some economists have advocated measures that would reduce the time and effort required to complete federal income tax forms. Proposals for tax simplification appeal to harried taxpayers but could these proposals also stimulate economic growth?

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Answer: Tax simplification measures could have a noticeable impact on growth. According to the American Action Forum (AAF), in 2016 U.S. taxpayers spent an average of 54 hours completing their income tax forms: “In other words, the average American spends more than a week sifting through paperwork and preparing to file” their income tax returns. An AAF report estimates that the annual dollar cost to taxpayers of this paperwork is about $170 billion “…which exceeds that gross domestic product of Kenya.” Reducing this paperwork burden could free up time that could be used to produce more output and income. (Or to give Americans an extra week of vacation.)

Source: Paul Bedard, “IRS Insanity: 54 Hours, More Than a Week, Spent on Tax Returns,” Washington Examiner, April 17, 2017.

Solutions to End-of-Chapter Exercises Public Choice 17.1

Learning Objective: Describe the public choice model and use it to analyze government decision making.

Review Questions 1.1

The public choice model applies economic analysis to government decision making.

1.2

The voting paradox is the failure of majority voting to always result in consistent choices. The Arrow impossibility theorem is a mathematical theorem that holds that no system of voting can be devised that will consistently represent the underlying preferences of voters.

1.3

Rent seeking is the attempt by individuals and firms to use government action to make themselves better off at the expense of others. Regulatory capture is one way of accomplishing rent seeking; it involves firms influencing the decisions made by a regulatory agency so that the decisions will be in the best interest of the firms, rather than in the best interest of the public.

1.4

Market failure is a situation in which the market fails to provide the economically efficient outcome. Government failure is a situation in which government intervention in a market causes an outcome that is not economically efficient. Although government intervention can sometimes increase economic efficiency, in some cases it reduces economic efficiency.

Problems and Applications 1.5

In the case shown in the table (reproduced below), there is no voting paradox because both David and Kathleen prefer mass transit as their first choice. As a result, in any two-way vote, David and Kathleen will vote for mass transit and that will be the outcome, so transitivity holds and there is no voting paradox. Copyright © 2023 Pearson Education, Inc.

1.6

a. The median voter theorem states that the outcome of a majority vote is likely to represent the preferences of the voter in the political middle. In the primaries, the only voters the politicians need to be concerned with are the ones in their own party and, therefore, politicians direct their attention to the median voter of this selected group. In the Republican Party, the median voter is likely to be more conservative than the median voter in the broader electorate; and in the Democratic Party, the median voter is likely to be more liberal than the median voter in the broader electorate. But once politicians have received their parties’ nominations, candidates will emphasize policies that are likely to appeal to the median voter in the electorate as a whole. Therefore, the median voter theory can explain the actions of both parties’ candidates. b. An ideologue is someone who holds extreme political views—views that are outside of the political mainstream. In the case of political parties, the ideologues are the “extreme conservatives” for Republicans and the “extreme liberals” for the Democrats. For the presidential election, the median voter theorem is unpopular with ideologues because both the Republican and the Democratic candidates will run on a platform that is appealing to voters whose views are in the middle rather than to those whose views are extreme.

1.7

An economist would disagree with this argument because the median voter theorem will hold in both cases. Majority rule will ensure that the politicians will aim for the median voter whether or not preferences among other voters are similar to or very different from those of the median voter.

1.8

a. Government failure means that sometimes government intervention will reduce, rather than increase, economic efficiency. Public choice theory suggests that government could fail systemically due to rent seeking, logrolling, and regulatory capture. b. The expression “rent seeking” describes the efforts by individuals and firms to use government action to make themselves better off at the expense of others. Rent seeking may be useful when thinking of policy because, as with the case of the quota Congress placed on sugar imports, rent seeking can result in a policy that benefits a few at the expense of others. For example, a sugar quote benefits U.S. sugar producers, but harms U.S. consumers and candy manufacturers that use sugar as an input.

1.9

a. A market failure is a situation in which the market does not supply the economically efficient quantity of a good or service. Government failure occurs when government intervention in the economy reduces rather than increases economic efficiency. Copyright © 2023 Pearson Education, Inc.

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b. Answers may vary. An example of market failure is air pollution. There is an economically efficient level of air pollution, which is the point where the marginal benefit from reducing the pollution equals the marginal cost of the reduction. Because firms are likely to emit more than the efficient level of pollution, the government can correct this market failure by imposing a tax on producers that is equal to the external cost of the pollution. It’s possible that the government would impose too large a tax or directly mandate that firms reduce the pollution they emit to below the efficient level. If either of these results occurs, then government policy would have failed to deal with the market failure by bringing about an economically efficient outcome. 1.10

a. Logrolling refers to the situation in which a member of Congress votes to approve a bill that benefits another member’s district in exchange for a favorable vote from that other member on a bill that would benefit the first member’s district. b. Tariffs typically benefit workers and firms in only a minority of Congressional districts (or states). Therefore, for a tariff bill to pass, members of Congress needed to engage in logrolling—convincing other members from districts with firms and workers that would not benefit from the tariff to vote for it anyway. Other members of Congress would trade their votes in favor of the tariff for votes on their own bills.

1.11

Logrolling refers to the situation where a member of Congress votes to approve a bill in exchange for favorable votes from other members of Congress on other bills. Including funding for the Supplemental Nutrition Assistance Program (SNAP) in the farm bill means that it receives support from members of Congress who have long voted for farm bills. The farm bill provides substantial benefits to relatively few people (farmers) by imposing a relatively small financial burden on a large number of taxpayers. This type of legislation has been proven difficult to change.

1.12

a. Rather than think of them as benevolent despots, public choice economists assume that government policymakers act in a manner similar to consumers and mangers of firms: They pursue their own self-interest even when it conflicts with the public interest. b. Rent seeking refers to attempts by individuals and firms to use government action to make themselves better off at the expense of others. These attempts interfere with programs that are intended to correct market failures.

The Tax System 17.2

Learning Objective: Explain the tax system in the United States, including the principles that governments use to create tax policy.

Review Questions 2.1

Panel (a) in Figure 17.2 shows that in 2020, individual income taxes raised the most revenue for the federal government. Panel (b) in Figure 17.2 shows that in 2020 grants from the federal government raised the most revenue for state and local governments.

2.2

A progressive tax (for example, the federal personal income tax) is a tax for which people with lower incomes pay a lower percentage of their income in taxes than do people with higher incomes. A regressive tax (for example, a state sales tax) is a tax for which people with lower incomes pay a higher percentage of their income in taxes than do people with higher incomes.

2.3

A marginal tax rate is the fraction of each additional dollar of income that is paid in taxes. An average tax rate is the fraction of all income that is paid in taxes. Because people make their decisions by comparing marginal costs to marginal benefits, the marginal tax rate plays a bigger role than the average tax rate in influencing economic behavior. For example, when contemplating whether to work an extra hour, a person will make the decision based on the after-tax wage earned from working that hour, which is found by multiplying the marginal tax rate by the wage rate and subtracting the result from the wage rate.

2.4

In deciding which taxes to use, a government will consider the effect of the tax in terms of these goals and principles: 1. Economic efficiency: Whether the tax inflicts a small or large deadweight loss 2. The ability-to-pay principle: Whether people who can afford to pay more do pay more 3. The horizontal equity principle: Whether people in the same economic situation are treated equally 4. The benefits-received principle: Whether people receiving benefits from a government project are the ones paying the taxes and fees to support it 5. Other social objectives: Whether the tax curtails some activities, such as cigarette smoking, that Congress wants to discourage or whether a tax deduction aids some activities, such as homeownership, that Congress wants to encourage.

Problems and Applications

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a. A market free of externalities and other sources of market failure will result in the economically efficient equilibrium quantity and price where the marginal benefit to consumers equals the marginal cost of production. If a tax is imposed in this market, the supply curve shifts to the left and the market produces less than the economically efficient level of output. This inefficiently low level of output results in a loss of economic surplus, which is a deadweight loss. b. More of the good or service does not get produced because the tax has effectively increased the cost of providing the good (or reduced the benefit from consuming the good), which means that the market equilibrium price and quantity are no longer the economically efficient price and quantity.

2.6

a. A state-run lottery is like a tax because it involves the payment of funds from individuals to the government. The lottery is similar to cigarette and alcohol taxes in that all three raise revenue for the government. b. A tax is regressive if people with lower incomes pay a higher percentage of their income in taxes than do people with higher incomes. A lottery can be thought of as a regressive tax because the lowest-income households spend approximately four times as much annually on lottery tickets than do the highest-income households.

2.7

A tax is regressive if people with lower incomes pay a higher percentage of their income in taxes than do people with higher incomes. A tax is progressive if people with lower incomes pay a smaller percentage of their income in taxes than do people with higher incomes. Based on the data in the table (reproduced below), the federal cigarette tax is regressive because the fraction of low-income people who smoke is higher than the fraction of high-income people who smoke.

2.8

a. The person earning $25,000 will have a total tax of $2,801: 0.10 × $9,950 = $995 plus 0.12 × $15,050 = $1,806

The marginal tax rate is 12 percent; the average tax rate is ($2,801/$25,000) × 100 = 11.204 percent. b. The person earning $125,000 will have a total tax of $24,021: 0.10 × $9,950 = $995 plus 0.12 × $30575 = $3,669 plus 0.22 × $45,850= $10,087 plus 0.24 × $38,625 = $9,270 The marginal tax rate is 24 percent, and the average tax rate is ($24,021/$125,000) × 100 = 19.21 percent. c. The person earning $300,000 will have a total tax of $79,544.25: 0.10 × $9,950 = $995 plus 0.12 × $30,575 = $3,669 plus 0.22 × $45,850 = $10,087 plus 0.24 × $78,550 = $18,852 plus 0.32 × $44,500 = $14,240 plus 0.35 × $90,575 = $31,701.25 The marginal tax rate is 35 percent, and the average tax rate is ($79,544.25/$300,000) × 100 = 26.51 percent. 2.9

a. At $15,000 income, the average tax rate ($0/$15,000 × 100) = 0% At $30,000 income, the average tax rate ($4,500/$30,000 × 100) = 15% At $45,000 income, the average tax rate ($11,250/$45,000 × 100) = 25% At $60,000 income, the average tax rate ($21,000/$60,000 × 100) = 35% At $75,000 income, the average tax rate ($30,000/$75,000 × 100) = 40% b. In this example, because the average tax rate increases as income increases, the tax is progressive.

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c. Because the average tax rate rises between incomes of $60,000 and $75,000, the marginal tax rate for income of $65,000 has to be higher than the average tax rate of 35 percent, but we cannot determine the exact marginal rate. 2.10

a. No. The highest 1 percent of U.S. income earners paid about 29.6 percent of their income in total federal taxes. Buffett’s secretary is likely to be in the third or fourth income quintile. These quintiles paid 13.2 percent and 16.9 percent of their income in total federal taxes. So, the typical person in the top 1 percent of incomes pays a larger fraction of his or her income in taxes than does the typical middle-income person. b. A capital gain represents the difference between the price at which a person purchases an asset, such as a stock or bond, and the price at which the person sells the asset. For example, if you purchased a share of stock for $40 and later sold it for $50, you would have received a $10 capital gain. Some goals and principles the federal government should consider with regard to taxing capital gains at a lower rate would include (1) the ability-topay principle; (2) the horizontal-equity principle; and (3) economic efficiency. In recent years, Congress has taxed capital gains at a lower rate than wage and salary income in order to provide a greater incentive for people to save and invest.

2.11

The proposal to eliminate the payroll tax and shift to funding Social Security and Medicare out of the federal personal income tax would make the federal income tax system more progressive. In 2021, income above $142,800 was not subject to the payroll tax for Social Security, but this income was subject to the federal personal income tax. So, if Social Security funding were to come from the federal personal income tax, any taxes paid on income above $142,800 would be available to fund Social Security. People earning these higher levels of income would likely be contributing more to Social Security than they currently do. Of course, Congress would have to decide how to adjust personal income tax rates in response to the loss of revenues from the payroll tax.

2.12

a. Pre-tax income is the income that a worker receives before federal and state income taxes are withheld. Pretax income is also known as “before tax” income. b. The tax break for employer-provided health insurance will likely make the overall tax system more regressive because the tax break that an individual with low income will receive is smaller than the tax break a high-income individual receives. For example, compared with the situation in which funds spent by a firm providing a health plan to an employee are fully taxable, a health plan that costs an employer $10,000 per employee will reduce the taxes of an employee who has a 10 percent marginal tax rate by $1,000, while reducing the taxes of an employee who has a 32 percent marginal tax rate by $3,200.

2.13

a. Your income is your earnings during the year, while your wealth is the difference between the value of your assets and the value of your liabilities.

b. 1. The goal of economic efficiency. Progressive income taxes and wealth taxes both can result in a deadweight loss because both taxes reduce the incentive to work (progressive income taxes) and the incentive to invest (wealth taxes). Progressive income taxes impose a significant administrative burden because preparing a tax return often requires people to hire an accountant or other professional. A wealth tax is likely to impose an even greater administrative burden because some forms of wealth would be difficult to value because they are not held in a form that is frequently bought and sold. For instance, a sole proprietorship such as a restaurant or a rare painting may be difficult to value. 2. The ability-to-pay principle. Someone who has substantial wealth may be better able to pay a tax than someone with the same income who has less wealth. Sometimes, however, someone’s wealth may be in a form, such as ownership of a business, a house or a rare painting, that makes it difficult for the person to easily obtain the money to pay the tax. With a wealth tax, a business owner who has a relatively low income might have to sell the business to obtain the funds to pay the tax. 3. The horizontal-equity principle. Some people with high incomes have little wealth and some people with substantial wealth have low incomes. People hold their wealth in various forms. Those who hold mainly financial assets can more easily pay a wealth tax than those whose wealth is primarily in the form of a business. As a result of these considerations, horizontal equity is difficult to achieve with either a progressive income tax or a wealth tax. 4. The benefits-received principle. Because neither a progressive income tax nor a wealth tax is targeted to funding a particular government program, the benefits-received principle is not strictly applicable. 5. The goal of attaining social objectives. Some policymakers support a progressive income tax or a wealth tax to reduce income inequality, as well as to help fund government programs. Because wealth is more unequally distributed than is income, a wealth tax may be better able to attain the goal of reduced income inequality than is a progressive income tax. This conclusion depends on the details of how the two taxes are implemented.

17.3

Tax Incidence Revisited: The Effect of Price Elasticity Learning Objective: Explain the effect of price elasticity on tax incidence.

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3.1

Tax incidence refers to the actual division of the burden of a tax between buyers and sellers in a market.

3.2

In general, if demand is less price elastic than supply, buyers pay the larger share of the tax. If supply is less price elastic than demand, sellers pay the larger share of the tax.

Problems and Applications 3.3

Although the seller of a house or apartment may be legally required to pay the tax, the burden of this tax is most likely borne partly by the seller and partly by the buyer. The seller of an existing house or apartment, knowing that he or she is responsible for paying the transfer tax, is likely to pass part of this tax along to the buyer in terms of a higher selling price. As with most other taxes, the burden of the transfer tax will be divided between the buyer and the seller, with the buyer paying more than he or she would in the absence of the tax and the seller receiving less than in the absence of the tax.

3.4

Most economists believe that some of the burden of the corporate income tax is borne by workers in the form of lower wages. Because the tax reduces the rates of return received by investors, the tax reduces corporations’ investments in physical capital. With less capital to work with, worker productivity and, therefore, workers’ wages are lower because of the corporate income tax. The Congressional Budget Office (CBO) has estimated that about 25 percent of the burden of the corporate income tax is in the form of lower wages. Other studies have estimated that lower wages may account for as much as 90 percent of the burden of the tax.

3.5

The corporate income tax is imposed on corporations, not on “the rich.” The burden of the tax is shared by corporate employees, customers, and shareholders, and not all of these people are wealthy. Corporate shareholders are taxed on dividends and capital gains, so the corporate income tax is an additional tax on corporate earnings. A more efficient means to “tax the rich” would be to eliminate the corporate income tax and require owners of corporate stock to include their shares of corporate profits with their taxable income when paying their federal individual income tax.

3.6

a. The type of business investment that the Wall Street Journal editorial is referring to is most likely physical capital (machinery, equipment, tools) and research and development. A cut in the corporate income tax allows corporations to keep more of the profits they earn from investing in physical capital, which increases their incentive to make these investments. b. Raising taxes is never popular among those who will pay them. Many wage earners believe that the burden the corporate income tax is borne solely by the owners of corporations (shareholders) even though the tax has been shown to lower wages and raise prices. The burden of some taxes is difficult for people to understand but politicians understand that an increase in the corporate income tax will be easier to sell to the general public than an increase in income taxes. Copyright © 2023 Pearson Education, Inc.

3.7

The more inelastic demand is relative to supply, the more the burden of a tax is borne by the buyer. Because the beer industry believes the French government’s new tax on beer would raise the price of beer by 25 cents per half pint, the beer industry must believe the demand for beer is relatively more price inelastic. The French government must believe the demand for beer is relatively more price elastic.

3.8

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

b. If the government is most interested in maximizing the revenue it receives from the tax, the taxes should be imposed on goods whose demand is inelastic. In the previous graph, the tax per unit is $1.00. If demand is elastic (D2), the tax revenue received by the government will be equal to the $1.00 tax times the quantity sold, which is 275 (the quantity at point C), or $275.00. If demand is inelastic (D1), the tax revenue received by the government will be equal to $1.00 × 400 (the quantity at point B), or $400.00. c. If the government wants to discourage the consumption of a product, the tax will have a greater effect if the demand for the product is elastic. In the previous graph, the $1.00 excise tax causes the quantity demanded to fall from 500 to 275 when demand is elastic (D2), but the quantity demanded only falls from 500 to 400 when demand is inelastic (D1).

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a. The price consumers pay for cigarettes will rise more if the demand curve is less elastic, which would be demand curve D2 in this case. In the following graph, the supply curve has shifted upward by 10 cents from S1 to S2. If the demand curve is D1, then the price paid by consumers rises to $4.53. If the demand curve is D2, then the price rises more—to $4.57. b. The revenue received by the government will be greater if the demand curve is D2 because the quantity of cigarettes sold is greater for D2 (Q2) than for D1 (Q1). c. The excess burden of the tax on cigarettes will be greater if the demand curve is D1, which is more elastic. With demand curve D1, the excess burden is the area = b + c + d + e. With demand curve D2, the excess burden is the area = a + b + c. The area of d + e is clearly greater than the area of a.

3.10

a. Most of the 1.75-cents-per-ounce tax on soda was paid by consumers (1.70 cents of the 1.75 cent tax), which indicates that the supply of soda is more price elastic than is the demand for soda. b. If the price of soda had increased by 0.20 cents per ounce rather than by 1.70 cents per ounce, then demand for soda would have been more price elastic than it is. The following graphs show the excess burden of a tax when demand is less elastic (the figure on the left) and when demand is more elastic (the figure on the right). In each graph, before the tax the equilibrium price is $0.03 or 3 cents per ounce and the equilibrium quantity is 100 units. In each graph, a $0.0175 or 1.75 cent tax per ounce of soda will shift the supply curve from S1 to S2. The excess burden in each graph is represented by the areas of the shaded triangles. Using the formula for the area of a triangle: ½ multiplied by length multiplied by height: 



The value of the area of the excess burden in figure on the right is ½ × ($0.0175 × 30) = $0.2625 or 26.25 cents.

The area representing the excess burden is greater in the figure on right.

3.11

a. The vertical distance between the supply curves indicates the amount of the per-unit tax, so in this case the tax is $4 per pizza. b. Before the tax, consumers pay $10 per pizza. After the tax, consumers pay $12 per pizza (found by locating where the new supply curve, S2, intersects the demand curve). c. Before the tax, sellers receive $10 per pizza. After the tax, sellers receive $8 per pizza (which is the difference between the $12 price consumers pay after the tax and the $4 tax per pizza the government receives). d. Of the $4-per-pizza tax, consumers pay $2.00 (the difference between the price consumers pay before the tax and after the tax). Because consumers pay $2.00 of the $4 tax, producers pay the other $2.00 of the tax, so consumers and producers bear an equal tax burden.

Income Distribution and Poverty 17.4

Learning Objective: Discuss income distribution and income mobility and the role of policy in addressing these issues.

Review Questions 4.1

Table 17.6 shows that in 2019 the 20 percent of Americans with the lowest incomes received only 3.1 percent of all income, while the 20 percent with the highest incomes received 51.9

Preface xxvii percent of all income. That table also shows that there was a decline in inequality from 1936 to 1980 but an increase in inequality after 1980. 4.2

The poverty line is the level of annual income equal to three times the amount necessary to purchase the minimum quantity of food required for adequate nutrition. The poverty rate is the percentage of the population that falls below the poverty line. The poverty rate fell from 22 percent to 11 percent between 1960 and 1973, but the poverty rate has not changed much over the past 40 years. The poverty rate was 11.4 percent in 2020.

4.3

The Lorenz curve is a curve that shows the distribution of income by arraying incomes from the lowest to the highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis. The Gini coefficient is equal to the area between the line representing perfect income equality and the Lorenz curve divided by the whole area below the line of perfect equality. A lower Gini coefficient shows a more equal income distribution. If the country had a Gini coefficient of 0.48 in 1960 and 0.44 in 2022, income inequality would have decreased during these years.

4.4

According to the marginal productivity theory of income distribution, the distribution of income is based mainly on the marginal revenue product of the factors owned by households. This theory suggests that income inequality is determined by the quantities of factors owned by households (including labor, capital, and natural resources) and the prices of these factors of production (which are determined by the interaction of demand and supply). Income inequality has risen over the past three decades. This increase is partly due to the income earned at the top end of the income distribution having risen in comparison to the income earned by those at the bottom end as a result of the effects of technological change and the globalization of markets. Government policies, especially those dealing with taxes and transfers, also have an effect on income inequality.

4.5

Using the World Bank’s estimates of changes in poverty with the poverty threshold set at $3.20 per day, between 1990 and 2015, the fraction of the world’s population living in poverty declined from more than half to about a quarter. The greatest reduction in poverty has taken place in East Asia, including China, where a large majority of people were poor in 1990, while many fewer are poor today.

Problems and Applications 4.6

a. Social mobility is the movement of an individual or a family within or between social groups (such as in income percentiles). Increasing social mobility is a less controversial policy goal than reducing income inequality because improving social mobility requires funding programs (such as education) that are typically supported by people at all income levels. Reducing income inequality is more controversial because it typically involves direct payments to the poor, as with the SNAP (food stamp program), funded through taxation on people with higher incomes. Copyright © 2023 Pearson Education, Inc.

b. In the quote, Lowenstein uses the phrase “to level” to mean decreasing income inequality. The implication is that higher income people have their incomes reduced, which they are likely to oppose, while lower income people have their incomes raised using funds taken from higher income people through increased taxes. The assumption is that income inequality is seen as an important issue in itself and should be reduced by taxing people earning higher incomes—leaving aside any benefits received by lower income people. 4.7

It is difficult to determine if changes in individual income tax rates are the best way of reducing inequality because “best” is a normative term. Changing individual income tax rates can reduce income inequality. However, as long as the source of inequality is the difference in productivity among firms, income inequality will persist. An alternative to using taxation to reduce income inequality from this cause would be to attempt to raise the productivity of lower income people through increased education and training.

4.8

a. Assortative mating refers to marriages between people with similar incomes or education levels. b. When high-income people marry other high-income people and low-income people marry other low-income people, then the incomes of the families that result are more unequal than if high-income people were to marry low-income people. c. There is not much that government policies can do to reduce income inequality that is due to assortative mating. Assortative mating results from changes in society that have caused people to become more likely to marry people of similar backgrounds, including similar levels of income and education, than was true decades ago. While government policies of progressive taxation and payments to lower income people can still reduce income inequality, these policies will be less effective in the presence of assortative mating.

4.9

a. The distribution of income became less equal in 2020. The Lorenz Curve for 2020 is farther away from the diagonal line of equality than is the Lorenz Curve for 2019. b. The Gini coefficient = (the area inside the Lorenz curve)/(the area beneath the diagonal line of equality). Therefore, for 2019, the Gini coefficient = A/(A + B + C) = 2,150/5,000 = 0.43. For 2020, the Gini coefficient = (A + B)/(A + B + C) = 2,400/5,000 = 0.48.

4.10

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The total income of this group is $250,000. Quintile

4.11

Share of Income

Cumulative Share of Income

Lowest 20% (Lori)

12%

Second lowest 20% (Jerome)

Middle 20% (Steve)

Second highest 20% (David)

Highest 20% (Lena)

100

a. A “rigid class structure…based upon income” implies that people who belong to a certain income percentile group are more likely to stay within that income percentile group for a long period. Someone in the bottom 20 percent in income rankings would most likely find it difficult to break into the top 20 percent in income rankings, while someone already in the top 20 percent would most likely stay in that income group. b. The income distribution in a particular year only provides information regarding what people earn at a given point in time and how their earnings compare to those of people in the same time period. The income distribution in a particular year does not provide information on how people’s incomes change over time. Longitudinal data follow people in the sample and records their income each year over a long period of time—44 years in this case. These data provide information on how people may have moved up and down the income distribution over time.

4.12

While policies to redistribute income may be needed in the United States—this is a normative issue—it doesn’t seem to be true that the more than 10.5 percent of the population that was poor in 2019 has no hope of ever climbing above the poverty line. The chapter cites a study by the U.S. Census Bureau that found that of people who were poor at some time during the years 2004 to 2006, about half were in poverty for four months or less. Of the people who were poor in January 2004, only about 23 percent remained in poverty every month through December 2006. Only 2.8 percent of the U.S. population was poor every month during those three years.

4.13

From the Forbes list of 400 wealthiest people, we can see that a greater percentage of those people created their fortunes (rather than inherited them) in 2020 than in 1984. This means that we can expect the composition of the people who are in the top 1 percent to be changing more today than in 1984. When more people outside of the top 1 percent of the income distribution create their own fortunes, their incomes may increase enough to put them into the top 1 percent in income. Doing so displaces some people who were in the top 1 percent and changes the group’s composition.

4.14

Economists like to examine both absolute poverty—measured in dollars or the amount of goods and services that a household can buy in comparison to an objective measure of the amount needed to survive or experience an adequate quality of life—and relative poverty—measured in comparison to the overall average of a society. The World Bank’s thresholds of $1.90, $3.20, or $5.50-per-day are useful ways to measure absolute poverty because it is very difficult for someone to survive or have an adequate quality of life with an income below $1.90 per day (although some people do). If this standard of poverty were used for rich countries, like the United States, virtually no one would be considered to be living in poverty. However, many people in the United States have a standard of living that is considered poor judged relative to the standard of living of the average person. To measure this kind of poverty, a higher standard is used, such as the 2021 U.S. poverty line of $26,500 per year for a family of four. Such families do not live in the absolute poverty of people trying to get by on $1.90 per day, but they are considered relatively impoverished by many people. Likewise, the U.S. poverty standard wouldn’t be very useful for people in sub-Saharan Africa. A family of four with two children living on $26,500 per year in a country like Nigeria would be considered very well off by its fellow citizens.

4.15

It is extremely unlikely that the incomes of the poor would rise by $6,000. Faced with the higher marginal tax rate, rich households are likely to work less, earn less, and therefore pay less than $6,000 each in taxes. Similarly, many poorer households will respond to the transfer by working less, so their pre-transfer labor market earnings will fall below $20,000.

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Suggestions for Critical Thinking Exercises

CT17.1 No, the theorem still applies as the median voter is roughly in the middle of the charts.

CT17.2 Answers will vary. This question comes from research that found that very few principles of economics students could name more than two different kinds of taxes. This result might not be surprising because students have little reason to pay attention to most taxes. Therefore, some parts of Section 17.2 and Section 17.3 are likely to surprise many students. By talking about these surprises, students are more likely to remember and understand this relatively dry topic.

CT17.3 Since 2008, the economies of a number of nations of the Middle East and North Africa have been devasted by civil disturbances and military conflicts. A civil war in Syria that started in 2011 led to over 400,000 deaths and millions of refugees, many of whom fled to other Middle Eastern and European countries. The United Nations described the Syrian conflict as the worst man-made disaster since World War II. Other civil wars have occurred in Iraq (2014-2017) and Yemen (beginning in 2015). Attempts to reduce poverty in the region would be difficult even without these conflicts. The quality of the school systems in many nations in the region is low. In 2019, the Carnegie Corporation of New York reported that international test scores show that around half of all mid-primary and mid-secondary school students in Middle Eastern public schools do not meet basic learning outcomes in reading, writing, and mathematics. And population growth has continued to increase faster than growth in income, which has led to high levels of unemployment.

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