PRINCIPLES OF ECONOMICS 10TH EDITION BY N. GREGORY MANKIW (CHAPTER 1_38) SOLUTIONS MANUAL by QuentinAxel

SOLUTIONS MANUAL

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter ....................................................................................................... 2 Chapter Objectives ................................................................................................................................................ 2 Complete List of Chapter Activities and Assessments .............................................................................. 3 Key Terms ................................................................................................................................................................ 3 What's New in This Chapter ............................................................................................................................... 4 Chapter Outline ...................................................................................................................................................... 4 Solutions to Text Problems ................................................................................................................................ 9 Questions for Review ........................................................................................................................................................ 9 Problems and Applications ........................................................................................................................................... 10 Additional Activities and Assignments ....................................................................................................... 13 Additional Resources ........................................................................................................................................ 14 Cengage Video Resources .............................................................................................................................................. 14

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 1 is the first chapter in a three-chapter section that serves as the introduction to the text. Chapter 1 introduces ten fundamental principles on which the study of economics is based. In a broad sense, the rest of the text is an elaboration on these ten principles. Chapter 2 will develop how economists approach problems while Chapter 3 will explain how individuals and countries gain from trade. The purpose of Chapter 1 is to lay out ten economic principles that will serve as building blocks for the rest of the text. The ten principles can be grouped into three categories: how people make decisions, how people interact, and how the economy works as a whole. Throughout the text, references will be made repeatedly to these ten principles. Key points addressed in this chapter: 

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The fundamental lessons about individual decision making are that people face trade-offs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behavior in response to the incentives they face. The fundamental lessons about economic interactions among people are that trade and interdependence can be mutually beneficial, that markets are usually a good way of coordinating economic activity, and that the government can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality. The fundamental lessons about the economy as a whole are that productivity is the ultimate source of improving living standards, that growth in the quantity of money is the ultimate source of inflation, and that society faces a short-run trade-off between inflation and unemployment.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain how scarcity influences decisions.

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Explain how individuals evaluate opportunity costs to make decisions.

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Explain how marginal analysis influences decision making.

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Apply basic, economic principles of individual decision making that determine how an economy generally works.

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Explain how the terms of trade can lead to gains.

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Given a scenario, identify the distribution system being used.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

Source (i.e., PPT slide, Workbook) PPT Slide 2 PPT Slide 14 PPT Slide 17 PPT Slide 28 PPT Slide 39 PPT Slide 40 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder

Duration

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30–45 mins. 20–30 mins.

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KEY TERMS Business Cycle: fluctuations in economic activity, such as employment and production Economics: the study of how society manages its scarce resources Efficiency: the property of society getting the most it can from its scarce resources Equality: the property of distributing economic prosperity uniformly among the members of society Externality: the uncompensated impact of one person’s actions on the well-being of a bystander Incentive: something that induces a person to act Inflation: an increase in the overall level of prices in the economy Marginal Change: an incremental adjustment to a plan of action

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics Market Economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services Market Failure: a situation in which a market left on its own does not allocate resources efficiently Market Power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices Opportunity Cost: whatever must be given up to obtain some item Productivity: the quantity of goods and services produced from each unit of labor Property Rights: the ability of an individual to own and exercise control over scarce resources Rational People: people who systematically and purposefully do the best they can to achieve their objectives Scarcity: the limited nature of society’s resources [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

An expanded discussion of inflation in the United States following the coronavirus recession of 2020.

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CHAPTER OUTLINE The following outline organizes activities (including any existing discussion questions in PowerPoints or other supplements) and assessments by chapter (and therefore by topic), so that you can see how all the content relates to the topics covered in the text. I.

Introduction A. The word “economy” comes from the Greek word oikonomos meaning “one who manages a household.” 1. Instruction Idea: Begin by pointing out that economics is a subject that students must confront in their daily lives. Point out that they already spend a great deal of their time thinking about economic issues: changes in prices, buying decisions, use of their time, concerns about employment, etc. B. Both households and economies face many decisions about how to allocate resources. C. Resources are scarce so they must be managed carefully.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

II.

1. Instruction Idea: You will want to start the semester by explaining to students that part of learning economics is understanding a new vocabulary. Economists generally use very precise (and sometimes different) definitions for words that are commonly used outside of the economics discipline. Therefore, it will be helpful to students if you follow the definitions provided in the text as much as possible. D. Definition of scarcity: the limited nature of society’s resources. E. Definition of economics: the study of how society manages its scarce resources. 1. Keep in Mind: Because most college freshmen and sophomores have limited experiences with viewing the world from a cause-and-effect perspective, do not underestimate how challenging these principles will be for the student. 2. Instruction Idea: As you discuss the ten principles, make sure that students realize that it is okay if they do not grasp each of the concepts completely or find each of the arguments fully convincing. These ideas will be explored more completely throughout the text. How People Make Decisions A. Principle #1: People Face Trade-offs 1. “There ain’t no such thing as a free lunch.” To get something that we like, we usually have to give up, or trade for, something else that we also like. 2. Examples include how students spend their time, how a family decides to spend its income, how the U.S. government spends tax dollars, and how regulations may protect the environment at a cost to firm owners. 3. An important trade-off that society faces is the trade-off between efficiency and equality. a. Definition of efficiency: the property of society getting the most it can from its scarce resources. b. Definition of equality: the property of distributing economic prosperity uniformly among the members of society. c. For example, tax dollars paid by wealthy Americans and then distributed to those less fortunate may improve equality but lower the return to hard work and therefore reduce the level of output produced by our resources. d. This implies that the cost of this increased equality is a reduction in the efficient use of our resources. 4. Recognizing that trade-offs exist does not indicate what decisions should or will be made. B. Principle #2: The Cost of Something Is What You Give Up to Get It 1. Making decisions requires individuals to consider the benefits and costs of some action. 2. What are the costs of going to college? a. We should not count room and board (unless they are more expensive at college than elsewhere) because the student would have to pay for food and shelter even if she were not in school. b. We should count the value of the student’s time because she could be working for pay instead of attending classes and studying.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics 3. Definition of opportunity cost: whatever must be given up in order to obtain some item. a. Keep in Mind: One of the hardest ideas for students to grasp is that “free” things are not truly free. Provide students with many examples of such “free” things with hidden costs, especially the value of time. Suggested examples include the time students spend waiting in line for “free” sporting event tickets at their universities, time spent relaxing in the sun outside their residence halls, or driving on a road with no tolls but lots of congestion. C. Principle #3: Rational People Think at the Margin 1. Economists generally assume that people are rational. a. Definition of rational people: people who systematically and purposefully do the best they can to achieve their objectives. b. Consumers want to purchase the goods and services that allow them the greatest level of satisfaction given their incomes and the prices they face. c. Firm managers want to produce the level of output that maximizes the profits the firms earn. 2. Many decisions in life involve incremental decisions: Should I remain in school this semester? Should I take another course this semester? Should I study another hour for tomorrow’s exam? a. Definition of marginal change: a small incremental adjustment to a plan of action. b. Example: Suppose that you are considering watching a movie tonight. You pay $40 a month for a streaming service that gives you unlimited access to its film library. If you typically watch 8 movies a month, the average cost of a movie is $5. The marginal cost, however, is zero because you pay the same $40 regardless how many movies you stream. At the margin, streaming is free. When deciding whether to watch a movie, a rational person would compare the marginal benefit of watching a movie to the marginal cost. In this case, the only cost is the value of your time. c. Suppose that flying a 200-seat plane across the country costs the airline $100,000, which means that the average cost of each seat is $500. Suppose that the plane is minutes from departure and a passenger is willing to pay $300 for a seat. Should the airline sell the seat for $300? In this case, the marginal cost of an additional passenger is very small. d. Another example: Why is water so cheap while diamonds are expensive? The marginal benefit of a good depends on how many units a person already has. Because water is plentiful, the marginal benefit of an additional cup is small. Because diamonds are rare, the marginal benefit of an extra diamond is high. 3. A rational decision maker takes an action if and only if the marginal benefit is at least as large as the marginal cost. D. Principle #4: People Respond to Incentives

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

III.

1. Definition of incentive: something that induces a person to act. 2. Because rational people make decisions by weighing costs and benefits, their decisions may change in response to incentives. a. When the price of a good rises, consumers will buy less of it because its cost has risen. b. When the price of a good rises, producers will allocate more resources to the production of the good because the benefit from producing the good has risen. 3. Many public policies change the costs and benefits that people face. Sometimes policymakers fail to understand how policies alter incentives and behavior and a policy may lead to unintended consequences. 4. Example: Seat belt laws increase the use of seat belts but lower the incentives of individuals to drive safely. This leads to an increase in the number of car accidents. This also leads to an increased risk for pedestrians. a. Instruction Idea: If you include any incentive-based criteria on your syllabus, discuss it now. For example, if you reward class attendance (or penalize students who do not attend class), explain to students how this change in the marginal benefit of attending class (or marginal cost of missing class) can be expected to alter their behavior. How People Interact A. Principle #5: Trade Can Make Everyone Better Off 1. Trade is not like a sports contest, where one side gains and the other side loses. 2. Consider trade that takes place inside your home. Your family is likely to be involved in trade with other families on a daily basis. Most families do not build their own homes, make their own clothes, or grow their own food. 3. Countries benefit from trading with one another as well. 4. Trade allows for specialization in products that countries (or families) can do best. B. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. C. Principle #6: Markets Are Usually a Good Way to Organize Economic Activity 1. Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. 2. Definition of market economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. 3. Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it. a. Instruction Idea: Explain to students that when households and firms do what is best for themselves, they often end up doing what is best for society, as if guided by market forces—or an invisible hand. Spend some time and emphasize the magic of the market. Use

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

IV.

numerous examples to show students that the market most often allocates resources to their highest valued use. 4. When a government interferes in a market and prevents price from adjusting, household and firm decisions become distorted. 5. Centrally planned economies failed because they did not allow the market to work. 6. FYI: Adam Smith and the Invisible Hand a. Adam Smith’s 1776 work suggested that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting society’s economic well-being. b. Smith’s insights are at the center of modern economics and will be analyzed more fully in the chapters to come. 7. Case Study: “Adam Smith Would Have Loved Uber” D. Principle #7: Governments Can Sometimes Improve Market Outcomes 1. The invisible hand will only work if the government enforces property rights. a. Definition of property rights: the ability of an individual to own and exercise control over scarce resources. 2. There are two broad reasons for the government to interfere with the economy: the promotion of efficiency and equality. 3. Government policy can improve efficiency when there is market failure. a. Definition of market failure: a situation in which a market left on its own does not allocate resources efficiently. 4. Examples of Market Failure a. Definition of externality: the impact of one person’s actions on the well-being of a bystander. b. Definition of market power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices. c. Because a market economy rewards people for their ability to produce things that other people are willing to pay for, there will be an unequal distribution of economic well-being. 5. Note that the principle states that the government can improve market outcomes. This is not saying that the government always does improve market outcomes. How the Economy as a Whole Works A. Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services 1. Differences in living standards from one country to another are quite large. 2. Changes in living standards over time are also great. 3. The explanation for differences in living standards lies in differences in productivity. 4. Definition of productivity: the quantity of goods and services produced by each unit of labor input. 5. High productivity implies a high standard of living.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics 6. Thus, policymakers must understand the impact of any policy on our ability to produce goods and services. B. Principle #9: Prices Rise When the Government Prints Too Much Money 1. Definition of inflation: an increase in the overall level of prices in the economy. 2. When the government creates a large amount of money, the value of money falls, leading to price increases. 3. Examples: Germany after World War I (in the early 1920s) and the United States in the 1970s. Inflation increased in the United States in 2021, in part due to the expansionary policies during the coronavirus recession of 2020. C. Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment 1. Most economists believe that the short-run effect of a monetary injection is lower unemployment and higher prices. a. An increase in the amount of money in the economy stimulates spending and increases the quantity of goods and services sold in the economy. The increase in the quantity of goods and services sold will cause firms to hire additional workers. b. An increase in the demand for goods and services leads to higher prices over time. 2. The short-run trade-off between inflation and unemployment plays a key role in the analysis of the business cycle. 3. Definition of business cycle: fluctuations in economic activity, such as employment and production. 4. Policymakers can exploit this trade-off by using various policy instruments, but the extent and desirability of these interventions is a subject of continuing debate. 5. This debate heated up during the early years of Obama’s presidency. The severe downturn in the economy led policymakers to try to stimulate demand, but some feared that the end result would be inflation. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 1. Examples of trade-offs include time trade-offs (such as studying one subject over another or studying at all compared to engaging in social activities) and spending trade-offs (such as whether to use your last 15 dollars to purchase a pizza or to buy a study guide for that tough economics course). 2. To figure out the opportunity cost of a vacation to an amusement park, you would include the monetary costs of: admission, travel, souvenirs. You would also include the cost of time spent on vacation. The time cost depends on your next best use of that time; if it is staying

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics home and watching TV, the time cost may be small, but if it is working extra hours at your job, the time cost is the money you could have earned. You would NOT include the costs of food and lodging unless they exceeded the costs you would have incurred had you not gone on vacation. In that case, you would only include the additional costs, not the total costs of food and lodging. 3. The marginal benefit of a glass of water depends on your circumstances. If you have just run a marathon or you have been walking in the desert sun for three hours, the marginal benefit is very high. But if you have been drinking a lot of liquids recently, the marginal benefit is quite low. The point is that even the necessities of life, like water, do not always have large marginal benefits. 4. Policymakers need to think about incentives so they can understand how people will respond to the policies they put in place. The text’s example of seat belt laws shows that policy actions can have unintended consequences. If incentives matter a lot, they may lead to a very different type of policy; for example, some economists have suggested putting knives in steering columns so that people will drive much more carefully! While this suggestion is silly, it highlights the importance of incentives. 5. Trade between two countries is not a game where one loses and one wins because trade can make both better off. By allowing specialization, trade between people and trade between countries can improve everyone’s welfare. 6. The “invisible hand” of the marketplace represents the idea that even though individuals and firms are all acting in their own self-interest, prices and the marketplace guide them to do what is good for society as a whole. 7. The two main causes of market failure are externalities and market power. An externality is the effect of one person’s actions on the well-being of a bystander, such as from pollution or the creation of knowledge. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices, such as in a town with only one well or only one cable television company. 8. Productivity is important because a country’s standard of living depends on its ability to produce goods and services. The greater a country’s productivity (the amount of goods and services produced from each hour of a worker’s time), the greater its standard of living will be. 9. Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases in the quantity of a nation’s money. 10. Inflation and unemployment are negatively related in the short run. Thus, reducing inflation entails costs to society in the form of higher unemployment in the short run.

PROBLEMS AND APPLICATIONS 1. a. A family deciding whether to buy a new car faces a trade-off between the cost of the car and other things they might want to buy. For example, buying the car might mean they must give up going on vacation for the next two years. Also, fuel efficient cars are more expensive but regular cars require spending more on gas. Smaller cars are less expensive, but bigger cars mean saving time by avoiding multiple trips. b. For a member of Congress deciding how much to spend on national parks, one trade-off is between parks and other spending items or tax cuts. If more money goes

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics

4. 5.

into the park system, that may mean less spending on national defense or on transportation. Or instead of spending more money on the park system, taxes could be reduced. Another tradeoff when deciding how much to spend on national parks is spending a small amount on a lot of parks or a larger amount on a single park. c. When a company president decides whether to open a new factory, the decision is based on whether the new factory will increase the firm’s profits compared to other alternatives. For example, the company could upgrade existing equipment or expand existing factories. The bottom line is: Which method of expanding production will increase profit the most? d. In deciding how much to prepare for class, a professor faces a trade-off between the value of improving the quality of the lecture compared to other things she could do with her time, such as working on additional research or enjoying some leisure time. e. In deciding whether to go to graduate school, the student faces a trade-off between his possible earnings with a bachelor’s degree and the benefits of an increased education (such as higher future earnings and greater knowledge). The student also faces the trade-off between spending time with family or on leisure and spending time studying. Also, the student may face the tradeoff between taking out student loans and buying a home or car with a loan. f. When choosing whether to take a job or stay home and take care of the children, a single parent would face the trade-off between the potential income earned from working (minus the cost of child care) and the value one places on being the caregiver and educator of the children (plus any public benefits that may be provided to low-income families). When the benefits of something are psychological, such as going on a vacation, it is not easy to compare benefits to costs to determine if it is worth doing. But there are two ways to think about the benefits. One is to compare the vacation with what you would do in its place. If you did not go on vacation, would you buy something like a new set of golf clubs? Then you can decide if you would rather have the new clubs or the vacation. A second way is to think about how hard you had to work to earn the money to pay for the vacation. You can then decide if the psychological benefits of the vacation were worth the psychological cost of working. If you are thinking of going skiing instead of working at your part-time job, the cost of skiing includes its monetary and time costs, which includes the opportunity cost of the wages you are giving up by not working. If the choice is between skiing and going to the library to study, then the cost of skiing is its monetary and time costs including the value of time spent studying. If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are giving up the opportunity to spend $105 one year from now. The fact that you have already sunk $5 million is not relevant to your decision anymore, because that money is gone. What matters now is the chance to earn profits at the margin. If you spend another $1 million and can generate sales of $3 million, you’ll earn $2 million in marginal profit, so you should do so. You are right to think that the project has lost a total of $3 million ($6 million in costs and only $3 million in revenue) and you should not have started it. However, if you do not spend the additional $1 million, you will not have any sales and your losses will be $5 million. What matters now is minimizing your loss. In fact,

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics you would pay up to $3 million to complete development; any more than that, and you will not be increasing profit at the margin. 6. a. When welfare recipients have their benefits cut off after two years, they have a greater incentive to find jobs than if their benefits were to last forever. b. The loss of benefits means that someone who cannot find a job will get no income at all, so the distribution of income will become less equal. But the economy will be more efficient, because welfare recipients have a greater incentive to find jobs. Thus, the change in the law is one that increases efficiency but reduces equality. 7. a. b. c. d. e. f.

Efficiency: The market failure comes from the market power of the cable TV firm. Equality Efficiency: An externality arises because secondhand smoke harms nonsmokers. Efficiency: The market failure occurs because of Standard Oil’s market power. Equality Efficiency: There is an externality because of accidents caused by drunk drivers.

8. a. If everyone were guaranteed the best healthcare possible, much more of our nation’s output would be devoted to medical care than is now the case. Would that be efficient? If you believe that doctors have market power and restrict health care to keep their incomes high, you might think efficiency would increase by providing more healthcare. But more likely, if the government mandated increased spending on healthcare, the economy would be less efficient because it would give people more healthcare than they would choose to pay for. From the point of view of equality, if poor people are less likely to have adequate healthcare, providing more health care would represent an improvement. Each person would have a more equal slice of the economic pie, though the pie would consist of more healthcare and less of other goods. b. When workers are laid off, equality considerations argue for the unemployment benefits system to provide them with some income until they can find new jobs. After all, no one plans to be laid off, so unemployment benefits are a form of insurance. But there is an efficiency problem—why work if you can get income for doing nothing? The economy is not operating efficiently if people remain unemployed for a long time, and unemployment benefits encourage unemployment. Thus, there is a trade-off between equality and efficiency. The more generous unemployment benefits are, the less income is lost by an unemployed person, but the more that person is encouraged to remain unemployed. So greater equality reduces efficiency. 9. Because average income in the United States has roughly doubled every 35 years, we are likely to have a better standard of living than our parents, and a much better standard of living than our grandparents. This is mainly the result of increased productivity; an hour of work produces more goods and services than it used to. Thus, incomes have continuously risen over time, as has the standard of living. 10. If Americans save more and it leads to more spending on factories, there will be an increase in production and productivity, because the same number of workers will have more equipment to work with. The benefits from higher productivity will go to both the workers,

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics who will get paid more because they are producing more, and the factory owners, who will get a return on their investments. There is no such thing as a free lunch, however, because when people save more, they are giving up spending. They get higher incomes at the cost of buying fewer goods. 11. When governments print money, they impose a “tax” on anyone who is holding money, because the value of money is decreased.

ADDITIONAL ACTIVITIES AND ASSIGNMENTS The following are activities and assignments developed by Cengage but not included in the text, PPTs, or courseware (if courseware exists) – they are for you to use if you wish. I.

[In-class assignment] Getting Dressed in the Global Economy: 20 minutes total. Works in any class size. Topics include specialization, interdependence, self-interest, consumer choice, and trade. A. Purpose: The advantages of specialization and division of labor are very clear in this example. The worldwide links of the modern economy are also illustrated. We depend on thousands of people we don’t know, won’t see, and don’t think about to get dressed each morning. Self-interest follows naturally from interdependence. Wages, profits, and rents give people the incentive to perform these varied tasks. We depend on them to clothe us and they depend on our purchases for their incomes. B. Instructions: Ask the class to answer the following questions. Give them time to write an answer to each question, then discuss their answers before moving on to the next question. The answer to the first question can be brief. The second question is the core of the assignment and takes several minutes. Ask them to list as many categories of workers as possible. The third question introduces demand concepts; you can introduce most of the determinants of demand during this discussion. For the fourth question, ask the class to look at the country-of-origin tags sewn in their garments. 1. Where did your clothes come from? 2. Who worked to produce your clothes? 3. What things do you consider when buying a garment? 4. In what countries were your clothes produced? C. Common Answers and Points for Discussion 1. Where did your clothes come from? a. There are many possible ways to answer, but many students will say “the mall” or another retail outlet. Some may say “a factory,” “a sweatshop,” or “a foreign country.” b. Mention the importance of markets. Ask “Is anyone wearing something made by themselves, a friend, or a relative?” and discuss distribution versus production. 2. Who worked to produce your clothes? a. There are many possible answers; garment and textile workers are obvious but most students will also list workers dealing with raw materials, transportation, management, design, or machinery. Some

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 1: Ten Principles of Economics may think more broadly to investors, road crews, bankers, engineers, or accountants. 3. What things do you consider when buying a garment? a. Most answers focus on preferences (fit, style, quality, color). Price is cited less frequently. Ask about the importance of price until someone volunteers that income is important. Prices of substitute goods and expectations of price changes may also be mentioned. 4. In what countries were your clothes produced? a. A large number of countries will be represented, even in small classes. Asia is always well represented. Latin American and European goods appear in smaller numbers. African products are conspicuously absent. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Efficiency o Concept Clip: Opportunity Cost o Concept Clip: Externality o Video Problem Walk-Through: The Basics of Calculating Opportunity Cost o Video Problem Walk-Through: Making a Decision Using Marginal Analysis

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................... 16 Chapter Objectives ............................................................................................................................................. 16 Complete List of Chapter Activities and Assessments ........................................................................... 17 Key Terms ............................................................................................................................................................. 17 What's New in This Chapter ............................................................................................................................ 18 Chapter Outline ................................................................................................................................................... 18 Solutions to Text Problems ............................................................................................................................. 27 Questions for Review ...................................................................................................................................................... 27 Problems and Applications ........................................................................................................................................... 29 Additional Resources ........................................................................................................................................ 31 Cengage Video Resources .............................................................................................................................................. 31

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 2 is the second chapter in a three-chapter section that serves as the introduction of the text. Chapter 1 introduced ten principles of economics that will be revisited throughout the text. Chapter 2 develops how economists approach problems while Chapter 3 will explain how individuals and countries gain from trade. The purpose of Chapter 2 is to familiarize students with how economists approach economic problems. With practice, they will learn how to approach similar problems in this dispassionate systematic way. They will see how economists employ the scientific method, the role of assumptions in model building, and the application of two specific economic models. Students will also learn the important distinction between two roles economists can play: as scientists when we try to explain the economic world and as policymakers when we try to improve it. Key points addressed in this chapter: 

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Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models to understand the world around them. Two simple economic models are the circular-flow diagram and the production possibilities frontier. The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists study decision making by households and firms and the interactions among households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole. A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisers than as scientists. Economists who advise policymakers sometimes offer conflicting advice either because of differences in scientific judgments or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore the advice because of the many forces and constraints imposed by the political process.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain how the circular flow diagram explains the economy.

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Describe how the production possibilities frontier explains aggregate production.

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Determine if an output level is exhibiting allocative or productive efficiency.

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Describe opportunity cost in the context of the production possibilities frontier.

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Describe the factors that cause the production possibilities frontier to shift.

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Contrast macroeconomic concepts versus microeconomic concepts.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist 

Contrast when an economist acts as a policy adviser and when an economist acts as a scientist.



Explain the difference between positive and normative economics.



Given a scenario, identify the source of disagreement between two economists.



Classify the different functions an economist may serve.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Ask the Experts Think-Pair-Share Activity Self-Assessment Section 02-1 QuickQuiz Section 02-2 QuickQuiz Section 02-3 QuickQuiz ConceptClip: Circular Flow Model ConceptClip: Production Possibilities Frontier ConceptClip: Micro vs. Macro ConceptClip: Positive and Normative Figure 2: The Production Possibilities Frontier Figure 3: A Shift in the Production Possibilities Frontier Figure A-4: Shifting Demand Curves Figure A-5: Calculating the Slope of a Line Chapter 02 Problems & Applications Chapter 02 A+ Test Prep Chapter 02 Homework Chapter 02 Quiz: Thinking Like an Economist

Source (i.e., PPT slide, Workbook) PPT Slide 18 PPT Slide 35 PPT Slide 38 PPT Slide 39 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

5 mins. 5 mins. 20–30 mins. N/A 25–35 mins. 20–30 mins.

5 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

[return to top]

KEY TERMS Circular-flow Diagram: a visual model of the economy that shows how dollars flow through markets among households and firms. Macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and economic growth.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist Microeconomics: the study of how households and firms make decisions and how they interact in markets. Normative Statements: claims that attempt to prescribe how the world should be. Positive Statements: claims that attempt to describe the world as it is. Production Possibilities Frontier: a graph that shows the combinations of output that the economy can possibly produce with the available factors of production and production technology. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

Table 1 has been deleted, but the general discussion associated with Table 1 remains.

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The Economist as Scientist F. Economists Follow the Scientific Method. 1. Observations help us to develop theory. 2. Data can be collected and analyzed to evaluate theories. 3. Using data to evaluate theories is more difficult in economics than in physical science because economists are unable to generate their own data and must make do with whatever data are available. 4. Thus, economists pay close attention to the natural experiments offered by history. G. Assumptions Make the World Easier to Understand. 1. Example: to understand international trade, it may be helpful to start out assuming that there are only two countries in the world producing only two goods. Once we understand how trade would work between these two countries, we can extend our analysis to a greater number of countries and goods. 2. One important role of a scientist is to understand which assumptions one should make. 3. Economists often use assumptions that are somewhat unrealistic but will have small effects on the actual outcome of the answer. H. Economists Use Economic Models to Explain the World around Us.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

1. Instruction Idea: To illustrate to the class how simple but unrealistic models can be useful, bring a road map to class. Point out how unrealistic it is. For example, it does not show where all of the stop signs, gas stations, or restaurants are located. It assumes that the earth is flat and twodimensional. But, despite these simplifications, a map usually helps travelers get from one place to another. Thus, it is a good model. 2. Most economic models are composed of diagrams and equations. 3. The goal of a model is to simplify reality to increase our understanding. Assumptions help to simplify reality. Our First Model: The Circular-Flow Diagram

Figure 1

6. Definition of circular-flow diagram: a visual model of the economy that shows how dollars flow through markets among households and firms. 7. This diagram is a very simple model of the economy. Note that it ignores the roles of government and international trade. a. There are two decision makers in the model: households and firms. b. There are two markets: the market for goods and services and the market for factors of production. c. Firms are sellers in the market for goods and services and buyers in the market for factors of production. d. Households are buyers in the market for goods and services and sellers in the market for factors of production. e. The inner loop represents the flows of inputs and outputs between households and firms. f. The outer loop represents the flows of dollars between households and firms. Our Second Model: The Production Possibilities Frontier

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist 1. Definition of production possibilities frontier: a graph that shows the combinations of output that the economy can possibly produce with the available factors of production and production technology. 2. Instruction Idea: Spend more time with this model than you think is necessary. Be aware that students need to feel confident with this first graphical and mathematical model. Be deliberate with every point. If you lose them with this model, they may be gone for the rest of the course. 3. Example: an economy that produces two goods, cars and computers. 1. If all resources are devoted to producing cars, the economy would produce 1,000 cars and zero computers. 2. If all resources are devoted to producing computers, the economy would produce 3,000 computers and zero cars. 3. More likely, the resources will be divided between the two industries, producing some cars and some computers. The feasible combinations of output are shown on the production possibilities frontier.

Figure 2

4. Instruction Idea: You may want to include time dimensions for variables. This will help students to realize that a new production possibilities frontier occurs for each period. The axes show the levels of output per period. Alternative Classroom Example: A small country produces two goods: mp3 players and music downloads. Points on a production possibilities frontier can be shown in a table or a graph:

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist mp3 Players Music Downloads

0 70,000

100 60,000

200 45,000

300 25,000

400 0

The production possibilities frontier should be drawn from the numbers above. Students should be asked to calculate the opportunity cost of increasing the number of mp3 players produced by 100: 1. between 0 and 100 2. between 100 and 200 3. between 200 and 300 4. between 300 and 400 5. Because resources are scarce, not every combination of computers and cars is possible. Production at a point outside of the curve (such as C) is not possible given the economy’s current level of resources and technology. 6. Instruction Idea: It is useful to point out that the production possibilities frontier depends on two things: the availability of resources and the level of technology. 7. Production is efficient at points on the curve (such as A and B). This implies that the economy is getting all it can from the scarce resources it has available. There is no way to produce more of one good without producing less of another. 8. Production at a point inside the curve (such as D) is inefficient. 1. This means that the economy is producing less than it can from the resources it has available. 2. If the source of the inefficiency is eliminated, the economy can increase its production of both goods. 9. The production possibilities frontier reveals Principle #1: People face trade-offs. 1. Suppose the economy is currently producing 600 cars and 2,200 computers. 2. To increase the production of cars to 700, the production of computers must fall to 2,000. 10. Principle #2 is also shown on the production possibilities frontier: The cost of something is what you give up to get it (opportunity cost). 1. The opportunity cost of increasing the production of cars from 600 to 700 is 200 computers. 2. Thus, the opportunity cost of each car is two computers. 11. The opportunity cost of a car depends on the number of cars and computers currently produced by the economy. 1. The opportunity cost of a car is high when the economy is producing many cars and few computers.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist 2. The opportunity cost of a car is low when the economy is producing few cars and many computers. 12. Economists generally believe that production possibilities frontiers often have this bowed-out shape because some resources are better suited to the production of cars than computers (and vice versa). 13. Keep in Mind: Be aware that students often have trouble understanding why opportunity costs rise as the production of a good increases. You may want to use several specific examples of resources that are more suited to producing cars than computers (e.g., an experienced mechanic) as well as examples of resources that are more suited to producing computers than cars (e.g., an experienced computer programmer). 14. The production possibilities frontier can shift if resource availability or technology changes. Economic growth can be illustrated by an outward shift of the production possibilities frontier. 15. Instruction Idea: You may also want to teach students about budget constraints at this time (call them “consumption possibilities frontiers”). This reinforces the idea of opportunity cost, and allows them to see how opportunity cost can be measured by the slope. Also, it will introduce students to the use of straight-line production possibilities frontiers (which appear in Chapter 3). However, be careful if you choose to do this as students often find the difference between straight-line and concave production possibilities frontiers challenging. Figure 3

Alternative Classroom Example: Ivan receives an allowance from his parents of $20 each week. He spends his entire allowance on two goods: ice cream cones (which cost $2 each) and tickets to the movies (which cost $10 each). Students should be asked to calculate the opportunity cost of one movie and the opportunity cost of one ice cream cone. Ivan’s consumption possibilities frontier (budget constraint) can be drawn. It should be noted that the slope is equal to the opportunity cost and is constant because the opportunity cost is constant. Ask students what would happen to the consumption possibilities frontier if Ivan’s allowance changes or if the price of ice cream cones or movies changes. K. Microeconomics and Macroeconomics 1. Economics is studied on various levels. 1. Definition of microeconomics: the study of how households and firms make decisions and how they interact in markets. 2. Definition of macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and economic growth.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

III.

2. Microeconomics and macroeconomics are closely intertwined because changes in the overall economy arise from the decisions of individual households and firms. 3. Because microeconomics and macroeconomics address different questions, each field has its own set of models which are often taught in separate courses. L. In the News: Why Tech Companies Hire Economists 1. High tech firms are hiring economists because economists have the analytical and technical tools to help design efficient markets. 2. Economists are willing to move from government and academic positions to high tech firms because of the promise of big data sets and big salaries. The Economist as Policy Adviser A. Positive versus Normative Analysis 1. Example of a discussion of minimum-wage laws: Portia says, “Minimumwage laws cause unemployment.” Noah says, “The government should raise the minimum wage.” 2. Definition of positive statements: claims that attempt to describe the world as it is. 3. Definition of normative statements: claims that attempt to prescribe how the world should be. 4. Positive statements can be evaluated by examining data, while normative statements involve personal viewpoints. 5. Positive views about how the world works affect normative views about which policies are desirable. 6. Instruction Idea: Use several examples to illustrate the differences between positive and normative statements and stimulate classroom discussion. Possible examples include the minimum wage, budget deficits, tobacco taxes, legalization of marijuana, and seat-belt laws. 7. Instruction Idea: Have students bring in newspaper articles and in groups, identify each statement in an editorial paragraph as being a positive or normative statement. Discuss the differences among news stories, editorials, and blogs and the analogy to economists as scientists and as policy advisers. 8. Much of economics is positive; it tries to explain how the economy works. But those who use economics often have goals that are normative. They want to understand how to improve the economy. B. Economists in Washington 1. Economists are aware that trade-offs are involved in most policy decisions. 2. The president receives advice from the Council of Economic Advisers (created in 1946). 3. Economists are also employed by administrative departments within the various federal agencies such as the Office of Management and Budget, the Department of Treasury, the Department of Labor, the Congressional Budget Office, and the Federal Reserve. 4. The research and writings of economists can also indirectly affect public policy.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

IV.

C. Why Economists’ Advice Is Not Always Followed 1. The process by which economic policy is made differs from the idealized policy process assumed in textbooks. 2. Economists offer crucial input into the policy process, but their advice is only part of the advice received by policymakers. Why Economists Disagree A. Differences in Scientific Judgments 1. Economists may disagree about the validity of alternative positive theories or about the size of the effects of changes in the economy on the behavior of households and firms. 2. Example: some economists feel that a change in the tax code that would eliminate a tax on income and create a tax on consumption would increase saving in this country. However, other economists feel that the change in the tax system would have little effect on saving behavior and therefore do not support the change. B. Differences in Values C. Perception versus Reality 1. While it seems as if economists do not agree on much, this is in fact not true. 2. Almost all economists believe that rent control adversely affects the availability and quality of housing. 3. Most economists also oppose barriers to trade. D. Ask the Experts: Ticket Resale 1. The first “Ask the Experts” box shows that 80% of economic experts agree that laws that limit resale of tickets make potential audience members worse off. 2. Instruction Idea: Use the “Ask the Expert” questions and responses from economists throughout the text to spark discussions. In this case, ask students their opinion on ticket scalping laws. Discuss the opportunity for potential audience members to pay a price higher than the stated ticket price to be able to attend the event rather than be excluded from the event because there are no more tickets available at the stated ticket price. Appendix—Graphing: A Brief Review a. Keep in Mind: Many instructors may be unaware of how much trouble beginning students have grasping the most basic graphs. It is important for instructors to make sure that students are comfortable with these techniques. b. Graphs of a Single Variable

Figure A-1

i. Pie Chart ii. Bar Graph iii. Time-Series Graph c. Graphs of Two Variables: The Coordinate System Figure A-2

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist i.

Economists are often concerned with relationships between two or more variables. ii. Ordered pairs of numbers can be graphed on a two-dimensional grid. 1. The first number in the ordered pair is the x-coordinate and tells us the horizontal location of the point. 2. The second number in the ordered pair is the y-coordinate and tells us the vertical location of the point. iii. The point with both an x-coordinate and y-coordinate of zero is called the origin. iv. Two variables that increase or decrease together have a positive correlation. v. Two variables that move in opposite directions (one increases when the other decreases) have a negative correlation. d. Curves in the Coordinate System i. Often, economists want to show how one variable affects another, holding all other variables constant. Table A-1 Figure A-3

1. An example of this is a demand curve. 2. The demand curve shows how the quantity of a good a consumer wants to purchase varies as its price varies, holding everything else (such as income) constant. 3. If income does change, this will alter the amount of a good that the consumer wants to purchase at any given price. Thus, the relationship between price and quantity desired has changed and must be represented as a new demand curve. Figure A-4

4. A simple way to tell if it is necessary to shift the curve is to look at the axes. When a variable that is not named on either axis changes, the curve shifts. e. Slope Figure A-5

We may want to ask how strongly a consumer reacts if the price of a product changes. 1. If the demand curve is very steep, the quantity desired does not change much in response to a change in price. 2. If the demand curve is very flat, the quantity desired changes a great deal when the price changes.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist ii.

The slope of a line is the ratio of the vertical distance covered to the horizontal distance covered as we move along the line (“rise over run”). slope

iii.

A small slope (in absolute value) means that the demand curve is relatively flat; a large slope (in absolute value) means that the demand curve is relatively steep. Cause and Effect i. Economists often make statements suggesting that a change in Variable A causes a change in Variable B. ii. Ideally, we would like to see how changes in Variable A affect Variable B, holding all other variables constant. iii. This is not always possible and could lead to a problem caused by omitted variables.

Figure A-6

iv.

1. If Variables A and B both change at the same time, we may conclude that the change in Variable A caused the change in Variable B. 2. But, if Variable C has also changed, it is entirely possible that Variable C is responsible for the change in Variable B. Another problem is reverse causality.

Figure A-7

1. If Variable A and Variable B both change at the same time, we may believe that the change in Variable A led to the change in Variable B. 2. However, it is entirely possible that the change in Variable B led to the change in Variable A. 3. It is not always as simple as determining which variable changed first because individuals often change their behavior in response to a change in their expectations about the future. This means that Variable A may change before Variable B but only because of the expected change in Variable B. Instruction Idea: There are two very good examples in the text that you should use in class. To discuss the omitted variable problem, point out to students that a rise in the sales of cigarette lighters is positively related to the number of individuals diagnosed with lung cancer. To discuss reverse causality, show that an increase in minivan sales is followed by an increase in birth rates.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 11. Economics is a science because economists use the scientific method. They devise theories, collect data, and then analyze these data in an attempt to verify or refute their theories about how the world works. Economists use theory and observation like other scientists, but they are limited in their ability to run controlled experiments. Instead, they must rely on natural experiments. 12. Economists make assumptions to simplify problems without substantially affecting the answer. Assumptions can make the world easier to understand. 13. An economic model cannot describe reality exactly because it would be too complicated to understand. A model is a simplification that allows the economist to see what is truly important. 14. There are many possible answers. 15. There are many possible answers, including interactions involving government or international trade. 16. Figure 3 shows a production possibilities frontier between milk and cookies (PPF1). If a disease kills half of the economy's cow population, less milk production is possible, so the PPF shifts inward (PPF2). Note that if the economy produces all cookies, it does not need any cows and production is unaffected. But if the economy produces any milk at all, then there will be less production possible after the disease hits.

Figure 3 17. An outcome is efficient if the economy is getting all it can from the scarce resources it has available. In terms of the production possibilities frontier, an efficient point is a point on the frontier, such as point A in Figure 4. When the economy is using its resources efficiently, it cannot increase the production of one good without reducing the production of the other. A point inside the frontier, such as point B, is inefficient since more of one good could be produced without reducing the production of another good.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

Figure 4 18. The two subfields in economics are microeconomics and macroeconomics. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets. Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth. 19. Positive statements are descriptive and make a claim about how the world is, while normative statements are prescriptive and make a claim about how the world ought to be. Here is an example. Positive: A rapid growth rate of money is the cause of inflation. Normative: The government should keep the growth rate of money low. 20. Economists sometimes offer conflicting advice to policymakers for two reasons: (1) economists may disagree about the validity of alternative positive theories about how the world works; and (2) economists may have different values and, therefore, different normative views about what public policy should try to accomplish.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist

PROBLEMS AND APPLICATIONS 1.

See Figure 5; the four transactions are shown. a. $1

a. $1

c. $40

c. $40 Markets for Goods and Services a. quart of milk

a. quart of milk

c. haircut

Firms

Households

b. one hour of work d. Acme's capital

b. one hour of work Markets for Factors of Production

b. $8.00 d. $20,000

d. Acme's capital b. $8.00

Figure 5

d. $20,000

2. a. Figure 6 shows a production possibilities frontier between guns and butter. It is bowed out because of the law of increasing opportunity costs. As the economy moves from producing many guns and a little butter (point H) to producing fewer guns and more butter (point D), the opportunity cost of each additional unit of butter increases because the resources best suited to producing guns are shifting toward the production of butter. Thus, the number of guns given up to produce one more unit of butter is increasing.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist Figure 6 b. Point A is impossible for the economy to achieve; it is outside the production possibilities frontier. Point B is feasible but inefficient because it is inside the production possibilities frontier. c. The Hawks might choose a point like H, with many guns and not much butter. The Doves might choose a point like D, with a lot of butter and few guns. d. If both Hawks and Doves reduced their desired quantity of guns by the same amount, the Hawks would get a bigger peace dividend because the production possibilities frontier is much flatter at point H than at point D. As a result, the reduction of a given number of guns, starting at point H, leads to a much larger increase in the quantity of butter produced than when starting at point D. 3. See Figure 7. The shape and position of the frontier depend on how costly it is to maintain a clean environmentthe productivity of the environmental industry. Gains in environmental productivity, such as the development of new way to produce electricity that emits fewer pollutants, lead to shifts of the production-possibilities frontier, like the shift from PPF1 to PPF2 shown in the figure.

Figure 7

Figure 8

4. e. A: 40 lawns mowed; 0 washed cars B: 0 lawns mowed, 40 washed cars C: 20 lawns mowed; 20 washed cars D: 25 lawns mowed; 25 washed cars f. The production possibilities frontier is shown in Figure 8. Points A, B, and D are on the frontier, while point C is inside the frontier. g. Larry is equally productive at both tasks. Moe is more productive at washing cars, while Curly is more productive at mowing lawns. h. Allocation C is inefficient. More washed cars and mowed lawns can be produced by simply reallocating the time of the three individuals.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 2: Thinking Like an Economist 5. i. j.

A family's decision about how much income to save is related to microeconomics. The effect of government regulations on auto emissions is related to microeconomics. k. The impact of higher saving on economic growth is related to macroeconomics. l. A firm's decision about how many workers to hire is related to microeconomics. m. The relationship between the inflation rate and changes in the quantity of money is related to macroeconomics. 6. n. The statement that society faces a short-run trade-off between inflation and unemployment is a positive statement. It deals with how the economy is, not how it should be. Since economists have examined data and found that there is a short-run negative relationship between inflation and unemployment, the statement is a fact. o. The statement that a reduction in the rate of money growth will reduce the rate of inflation is a positive statement. Economists have found that money growth and inflation are very closely related. The statement thus tells how the world is, and so it is a positive statement. p. The statement that the Federal Reserve should reduce the rate of money growth is a normative statement. It states an opinion about something that should be done, not how the world is. q. The statement that society ought to require welfare recipients to look for jobs is a normative statement. It does not state a fact about how the world is. Instead, it is a statement of how the world should be and is thus a normative statement. r. The statement that lower tax rates encourage more work and more saving is a positive statement. Economists have studied the relationship between tax rates and work, as well as the relationship between tax rates and saving. They have found a negative relationship in both cases. So, the statement reflects how the world is and is thus a positive statement.

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Circular Flow Model o Concept Clip: Production Possibilities Frontier o Concept Clip: Micro vs. Macro o Concept Clip: Positive and Normative o Video Problem Walk-Through: Calculating Opportunity Cost Using a Production Possibilities Frontier o Video Problem Walk-Through: Shifting the Production Possibilities Frontier o Video Problem Walk-Through: Identifying Efficient and Inefficient Outcomes Using a Production Possibilities Frontier o Graphing Basics

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade [return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

Complete List of Chapter Activities and Assessments Key Terms

What's New in This Chapter 35 Chapter Outline

Solutions to Text Problems 40 Questions for Review ...................................................................................................................................................... 41 Problems and Applications ........................................................................................................................................... 41 Additional Activities and Assignments

Additional Resources49 Cengage Video Resources .............................................................................................................................................. 49

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 3 is the third chapter in the three-chapter section that serves as the introduction of the text. Chapter 1 introduced ten fundamental principles of economics. Chapter 2 developed how economists approach problems. This chapter shows how people and countries gain from trade (which is one of the ten principles discussed in Chapter 1). The purpose of Chapter 3 is to demonstrate how everyone can gain from trade. Trade allows people to specialize in the production of goods for which they have a comparative advantage and then trade for goods that other people produce. Because of specialization, total output rises, and through trade we are all able to share in the bounty. This is as true for countries as it is for individuals. Because everyone can gain from trade, restrictions on trade tend to reduce welfare. Key points addressed in this chapter: 



 

Each person consumes goods and services produced by many other people both in the United States and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. There are two ways to compare the ability of two people to produce a good. The person who can produce the good with a smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. The principle of comparative advantage applies to countries as well as to people. Economists use the principle of comparative advantage to advocate free trade among countries.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain how the terms of trade can lead to gains.



Describe opportunity cost in the context of the production possibilities frontier.



Describe how the production possibilities frontier explains aggregate production.



Determine if an output level is exhibiting allocative or productive efficiency.



Explain how comparative advantage determines trade.



Describe absolute advantage in the context of trade.



Describe the factors that cause the production possibilities frontier to shift.



Determine whether a country will be an importer or exporter of a good if the country opens up to international trade.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Ask the Experts A Active Learning 1 Active Learning 2 Active Learning 3 Ask the Experts B Think-Pair-Share Activity Self-Assessment Section 03-1 QuickQuiz Section 03-2 QuickQuiz Section 03-3 QuickQuiz ConceptClip: Absolute and Comparative Advantage ConceptClip: Imports and Exports Figure 2: How Trade Expands the Set of Consumption Opportunities Chapter 03 Problems & Applications Chapter 03 A+ Test Prep Chapter 03 News Analysis: Dutch Disease Chapter 03 Homework Chapter 03 Quiz: Interdependence and the Gains from Trade

Source (i.e., PPT slide, Workbook) PPT Slide 5 PPT Slide 14 PPT Slide 19 PPT Slide 21 PPT Slide 39 PPT Slide 40 PPT Slide 41 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

45–60 mins. N/A 10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. 20–30 mins.

10–15 mins. 5 mins. 10–15 mins. 10–15 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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KEY TERMS Absolute Advantage: the ability to produce a good using fewer inputs than another producer does. Comparative Advantage: the ability to produce a good at a lower opportunity cost than another producer. Exports: goods produced domestically and sold abroad. Imports: goods produced abroad and sold domestically. Opportunity Cost: whatever must be given up to obtain some item.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade [return to top]

WHAT'S NEW IN THIS CHAPTER There are no major changes to this chapter. [return to top]

A Parable for the Modern Economy a. Instruction Idea: Begin by explaining that there are two basic ways that individuals can satisfy their wants. The first is to be economically self-sufficient. The second is to specialize in the production of one thing and then trade with others. With rare exceptions, individuals and nations tend to rely on specialization and trade. One way to demonstrate this is to survey the students on their future plans (doctors, lawyers, teachers, etc.). Point out that they plan to specialize and trade. Ask them why this is optimal. b. Example: two goods—meat and potatoes; and two people—a cattle rancher named Ruby and a potato farmer named Frank (each of whom likes to consume both potatoes and meat). i. The gains from trade are obvious if Frank can only grow potatoes and Ruby can only raise cattle. ii. The gains from trade are also obvious if, instead, Frank can raise cattle as well as grow potatoes, but he is not as good at it and Ruby can grow potatoes in addition to raising cattle, but her land is not well suited for it. iii. The gains from trade are not as clear if either Frank or Ruby is better at producing both potatoes and meat. iv. Keep in Mind: Make sure that you write out all of the algebra involved in this example. If you leave out steps, students will not understand how these calculations are made. c. Production Possibilities: i. Frank and Ruby both work eight hours per day and can use this time to grow potatoes, raise cattle, or both. ii. Figure 1 shows the amount of time each takes to produce one ounce of either good: Figure 1

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade Minutes Needed to Make One Ounce of:

Amount Produced in Eight Hours

Meat

Potatoes

Meat

Potatoes

Frank the farmer

60 min./oz.

15 min./oz.

8/1=8 oz.

8/0.25=32 oz.

Ruby the rancher

20 min./oz.

10 min./oz.

8/0.33=24 oz.

8/0.16=48 oz.

Alternative Classroom Example: Martha and Stewart each spend hours a day wallpapering and painting: Hours Needed to Do One Room Paint Wallpaper 2 hours/room 8 hours/room 4 hours/room 10 hours/room

Martha Stewart iii.

iv.

Rooms Finished in 40 Hours Paint Wallpaper 8/2=4 rooms 8/8=1 room 8/4=2 rooms 8/10=0.8 room

The production possibilities frontiers can also be drawn. 1. These production possibilities frontiers are drawn linearly instead of being bowed out. This assumes that Frank's and Ruby's technology for producing meat and potatoes allows them to switch between producing one good and the other at a constant rate. 2. As we saw in Chapter 2, these production possibilities frontiers represent the principles of trade-offs and opportunity costs. 3. Instruction Idea: It is important to take the time to explain how to calculate the x- and y-intercepts. Point out that Frank could produce 8 ounces of meat if all of his time is spent on meat or 32 ounces of potatoes if all of his time is spent on potatoes. We will assume that Frank and Ruby divide their time equally between raising cattle and growing potatoes.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade 1. Frank produces (and consumes) at point A—16 ounces of potatoes and 4 ounces of meat. 2. Ruby produces (and consumes) at point B—24 ounces of potatoes and 12 ounces of meat. 3. Instruction Idea: You should emphasize that these production possibilities frontiers represent the farmer’s and the rancher’s consumption possibilities because we are assuming that there is no trade. d. Specialization and Trade i. Suppose Ruby suggests that Frank specialize in the production of potatoes and then trade with her for meat. 1. Ruby will spend six hours a day producing meat (18 ounces) and two hours a week growing potatoes (12 ounces). 2. Frank will spend eight hours a day growing potatoes (32 ounces). 3. Ruby will trade 5 ounces of meat for 15 ounces of potatoes. 4. Keep in Mind: Students will ask how this “price” is determined. Explain the range of prices that each participant would be willing to accept. ii. End results: 1. Ruby produces 18 ounces of meat and trades 5 ounces, leaving her with 13 ounces of meat. She also grows 12 ounces of potatoes and receives 15 ounces in the trade, leaving her with 27 ounces of potatoes. 2. Frank produces 32 ounces of potatoes and trades 15 ounces, leaving him with 17 ounces. He also receives 5 ounces of meat in the trade with Ruby. iii. In both cases, they are able to consume quantities of potatoes and meat after the trade that they could not reach before the trade. 1. Instruction Idea: Prove to your students that it would take each of them more than eight hours to produce these quantities on their own. Figure 2

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade

VII.

Comparative Advantage: The Driving Force of Specialization a. Absolute Advantage i. Definition of absolute advantage: the ability to produce a good using fewer inputs than another producer does. ii. Ruby has an absolute advantage in the production of both potatoes and meat. b. Opportunity Cost and Comparative Advantage i. Definition of opportunity cost: whatever must be given up to obtain some item. Table 1

ii.

1. For Ruby, it takes ten minutes to produce one ounce of potatoes. Those same ten minutes could be used to produce one-half ounce of meat. Thus, the opportunity cost of producing an ounce of potatoes is one-half ounce of meat. 2. For Frank, it takes 15 minutes to produce one ounce of potatoes. Those same 15 minutes could be used to produce one-fourth ounce of meat. Therefore, the opportunity cost of producing one ounce of potatoes is one-fourth ounce of meat. 3. The opportunity cost of producing one ounce of meat is the inverse of the opportunity cost of producing one ounce of potatoes. 4. Keep in Mind: Your students may have a hard time comprehending this. Make sure that you go through these calculations several times and write out every step. Definition of comparative advantage: the ability to produce a good at a lower opportunity cost than another producer. 1. Frank has a lower opportunity cost of producing potatoes and therefore has a comparative advantage in the production of potatoes. 2. Ruby has a lower opportunity cost of producing meat and therefore has a comparative advantage in the production of meat.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade iii.

VIII.

Because the opportunity cost of producing one good is the inverse of the opportunity cost of producing the other, it is impossible for a person to have a comparative advantage in the production of both goods. c. Comparative Advantage and Trade i. When specialization in a good occurs (assuming there is a comparative advantage), total output will grow. ii. As long as the opportunity cost of producing the goods differs across the two individuals, both can gain from specialization and trade. 1. Frank buys 5 ounces of meat with 15 ounces of potatoes. This implies that the price of each ounce of meat is three ounces of potatoes, which is lower than Frank's opportunity cost of four ounces of potatoes. Trade is beneficial to Frank. 2. Ruby buys 15 ounces of potatoes for 5 ounces of meat. The price of each ounce of potatoes is one-third ounce of meat. This is lower than Ruby's opportunity cost of one-half ounce of meat. Trade also benefits Ruby. d. The Price of the Trade i. For both parties to gain from trade, the price at which they trade must lie between the opportunity costs. ii. In our example, Frank and Ruby must trade at the rate of between 2 and 4 ounces of potatoes for each ounce of meat. e. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. f. FYI: The Legacy of Adam Smith and David Ricardo i. In Adam Smith's 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, he writes of the ability of producers to benefit through specialization and trade. ii. In David Ricardo's 1817 book Principles of Political Economy and Taxation, Ricardo develops the theory of comparative advantage and argues against restrictions on free trade. iii. The benefits of free trade are an issue that is generally agreed upon by most economists, and the theories and arguments developed by these two individuals 200 years ago are still used today. Applications of Comparative Advantage a. Should Naomi Osaka Mow Her Own Lawn? i. Imagine that Naomi can mow her lawn faster than anyone else can. ii. This implies that she has an absolute advantage in lawn mowing. iii. Suppose that it takes her two hours to mow her lawn. In that same two hours, she could film a commercial for which she would earn $30,000. This means that the opportunity cost of mowing her lawn is $30,000. iv. It is likely that someone else would have a lower opportunity cost of mowing Naomi’s lawn; this individual would have a comparative advantage. v. Both she and the person hired will be better off as long as she pays the individual more than the individual's opportunity cost and less than her opportunity cost of $30,000.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade b. In the News: Economics within a Marriage i. The principles of comparative advantage and gains from specialization and trade even apply to housework. ii. This article from Slate describes the division of housework between the author and her husband, even though she has the absolute advantage in doing it all. c. Should the United States Trade with Other Countries? i. Just as individuals can benefit from specialization and trade, so can the populations of different countries. ii. Definition of imports: goods produced abroad and sold domestically. iii. Definition of exports: goods produced domestically and sold abroad. iv. The principle of comparative advantage suggests that each good should be produced by the country with a comparative advantage in producing that good (smaller opportunity cost). v. Through specialization and trade, countries can have more of all goods to consume. vi. Trade issues among nations are more complex. Some individuals can be made worse off even when the country as a whole is made better off. d. Ask the Experts: Trade Between China and the United States i. 100 percent of economic experts surveyed agreed that trade with China makes most Americans better off. ii. 96 percent of economic experts surveyed agreed that some Americans who work in the production of competing goods are made worse off by trade with China. iii. Instruction Idea: To help students reconcile these two survey results, point out that trade makes most Americans better off and only makes a small group of Americans worse off. iv. Instruction Idea: To help convince students that importing goods is not harmful to a country, ask the students to devise a way to produce coffee domestically. Point out that it is possible to grow coffee beans in the United States in enclosed nurseries, but the opportunity cost of the resources used would be significant. v. Instruction Idea: Discuss how differences in resource endowments can be significant factors in determining opportunity cost and comparative advantage. Such differences include climate, soil composition, education and training of the labor force, capital stock, and infrastructure. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade

QUESTIONS FOR REVIEW 21. The production possibilities frontier will be linear if the opportunity cost of producing a good is constant no matter how much of that good is produced. This will be most likely if the good is not produced using specialized inputs. 22. Absolute advantage reflects a comparison of the productivity of one person, firm, or nation to that of another, while comparative advantage is based on the relative opportunity costs of the persons, firms, or nations. While a person, firm, or nation may have an absolute advantage in the production of every good, they cannot have a comparative advantage in the production of every good. 23. Many examples are possible. Suppose, for example, that Roger can prepare a meal of hot dogs and macaroni in just 10 minutes, while it takes Anita 20 minutes. Also suppose that Roger can do all the laundry in 3 hours, while it takes Anita 4 hours. Roger has an absolute advantage in both cooking and doing the laundry, but Anita has a comparative advantage in doing the laundry. For Anita, the opportunity cost of doing the laundry is 12 meals; for Roger, it is 18 meals. 24. Comparative advantage is more important for trade than absolute advantage. In the example in Problem 3, Anita and Roger will complete their chores more quickly if Anita does at least some of the laundry and Roger cooks the meals for both, because Anita has a comparative advantage in doing the laundry, while Roger has a comparative advantage in cooking. 25. For trade to benefit both parties, the price for the trade must lie between the parties’ opportunity costs. 26. Economists oppose policies that restrict trade among nations because trade allows all countries to achieve greater prosperity by allowing them to receive the gains from comparative advantage. Restrictions on trade can hurt all countries.

PROBLEMS AND APPLICATIONS 12. a. See Figure 2. If Maria spends all 5 hours studying economics, she can read 100 pages, so that is the vertical intercept of the production possibilities frontier. If she spends all 5 hours studying sociology, she can read 250 pages, so that is the horizontal intercept. The opportunity costs are constant, so the production possibilities frontier is a straight line.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade

Figure 2 b. It takes Maria 2 hours to read 100 pages of sociology. In that time, she could read 40 pages of economics. So, the opportunity cost of 100 pages of sociology is 40 pages of economics. 13. a.

U.S. Japan

Workers needed to make: One Car One Ton of Grain 1/4 1/10 1/4 1/5

b. See Figure 3. With 100 million workers and 4 cars per worker, if either economy were devoted completely to cars, it could make 400 million cars. Because a U.S. worker can produce 10 tons of grain, if the United States produced only grain it would produce 1,000 million tons. Because a Japanese worker can produce 5 tons of grain, if Japan produced only grain it would produce 500 million tons. These are the intercepts of the production possibilities frontiers shown in the figure. Note that because the trade-off between cars and grain is constant for both countries, the production possibilities frontiers are straight lines.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade

Figure 3 c. Because a U.S. worker produces either 4 cars or 10 tons of grain, the opportunity cost of one car is 2 1/2 tons of grain, which is 10/4. Similarly, the U.S. opportunity cost of a ton of grain is 2/5 car (4 divided by 10). Because a Japanese worker produces either 4 cars or 5 tons of grain, the opportunity cost of one car is 1 1/4 tons of grain, which is 5/4 and the Japanese opportunity cost of a ton of grain is 4/5 car. This results in the following table:

U.S. Japan

Opportunity Cost of: One Car (in terms of tons One Ton of Grain (in of grain given up) terms of cars given up) 2 1/2 2/5 1 1/4 4/5

d. Neither country has an absolute advantage in producing cars, because they are equally productive (the same output per worker); the United States has an absolute advantage in producing grain, because it is more productive (greater output per worker). e. Japan has a comparative advantage in producing cars, because it has a lower opportunity cost in terms of grain given up. The United States has a comparative advantage in producing grain, because it has a lower opportunity cost in terms of cars given up. f. With half the workers in each country producing each of the goods, the United States would produce 200 million cars (50 million workers times 4 cars each) and 500 million tons of grain (50 million workers times 10 tons each). Japan would produce 200 million cars (50 million workers times 4 cars each) and 250 million tons of grain (50 million workers times 5 tons each). g. From any situation with no trade, in which each country is producing some cars and some grain, suppose the United States changed one worker from producing cars to

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade producing grain. That worker would produce 4 fewer cars and 10 additional tons of grain. Then suppose the United States offers to trade 7 tons of grain to Japan for 4 cars. The United States will do this because the cost of producing 4 cars in the United States is 10 tons of grain. By trading, the United States can gain 4 cars for a cost of only 7 tons of grain, so it is better off by 3 tons of grain. Suppose Japan changes one worker from producing grain to producing cars. That worker would produce 4 more cars and 5 fewer tons of grain. Japan will take the trade because it values 4 cars at 5 tons of grain, so it will be better off by 2 tons of grain. With the trade and the change of one worker in both the United States and Japan, each country gets the same amount of cars as before and both get additional tons of grain (3 for the United States and 2 for Japan). Thus, by trading and changing their production, both countries are better off. 14. a. Diego's opportunity cost of making a pizza is 1/2 gallon of root beer, because he could brew 1/2 gallon in the time (2 hours) it takes him to make a pizza. Darnell's opportunity cost of making a pizza is 2/3 gallon of root beer, because he could brew 2/3 of a gallon in the time (4 hours) it takes him to make a pizza. Diego has an absolute advantage in making pizza because he can make one in 2 hours, while it takes Darnell 4 hours. Because Diego's opportunity cost of making pizza is less than Darnell's, Diego has a comparative advantage in making pizza. b. Because Diego has a comparative advantage in making pizza, he will make pizza and exchange it for root beer that Darnell makes. c. The highest price of pizza in terms of root beer that will make both roommates better off is 2/3 of a gallon of root beer. If the price were higher than that, then Darnell would prefer making his own pizza (at an opportunity cost of 2/3 of a gallon of root beer) rather than trading for pizza that Diego makes. The lowest price of pizza in terms of root beer that will make both roommates better off is 1/2 gallon of root beer. If the price were lower than that, then Diego would prefer making his own root beer (he can make 1/2 gallon of root beer instead of making a pizza) rather than trading for root beer that Darnell makes. 15. a. Because a Canadian worker can make either 2 cars a year or 30 bushels of wheat, the opportunity cost of a car is 15 bushels of wheat. Similarly, the opportunity cost of a bushel of wheat is 1/15 of a car. The opportunity costs are the reciprocals of each other. b. See Figure 4. If all 10 million workers produce 2 cars each, they produce a total of 20 million cars, which is the vertical intercept of the production possibilities frontier. If all 10 million workers produce 30 bushels of wheat each, they produce a total of 300 million bushels, which is the horizontal intercept of the production possibilities frontier. Because the trade-off between cars and wheat is always the same, the production possibilities frontier is a straight line. If Canada chooses to consume 10 million cars, it will need 5 million workers devoted to car production. That leaves 5 million workers to produce wheat, who will produce a total of 150 million bushels (5 million workers times 30 bushels per worker). This is shown as point A on Figure 4.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade c. If the United States buys 10 million cars from Canada and Canada continues to consume 10 million cars, then Canada will need to produce a total of 20 million cars. So Canada will be producing at the vertical intercept of the production possibilities frontier. However, if Canada gets 20 bushels of wheat per car, it will be able to consume 200 million bushels of wheat, along with the 10 million cars. This is shown as point B in the figure. Canada should accept the deal because it gets the same number of cars and 50 million more bushels of wheat.

Figure 4 16. a. English workers have an absolute advantage over Scottish workers in producing scones, because English workers produce more scones per hour (50 vs. 40). Scottish workers have an absolute advantage over English workers in producing sweaters, because Scottish workers produce more sweaters per hour (2 vs. 1). Comparative advantage runs the same way. English workers, who have an opportunity cost of 1/50 sweater per scone (1 sweater per hour divided by 50 scones per hour), have a comparative advantage in scone production over Scottish workers, who have an opportunity cost of 1/20 sweater per scone (2 sweaters per hour divided by 40 scones per hour). Scottish workers, who have an opportunity cost of 20 scones per sweater (40 scones per hour divided by 2 sweaters per hour), have a comparative advantage in sweater production over English workers, who have an opportunity cost of 50 scones per sweater (50 scones per hour divided by 1 sweater per hour). b. If England and Scotland decide to trade, Scotland will produce sweaters and export them to England in exchange for scones. A trade with a price between 20 and 50 scones per sweater will benefit both countries, as they will be getting the traded good at a lower price than their opportunity cost of producing the good in their own countries. c. Even if a Scottish worker produced just one sweater per hour, the countries would still gain from trade, because Scotland would still have a comparative advantage in

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade producing sweaters. Its opportunity cost for sweaters would be higher than before (40 scones per sweater, instead of 20 scones per sweater before). But there are still gains from trade because England has a higher opportunity cost (50 scones per sweater). 17. a. With no trade, 1 pair of white socks trades for 1 pair of red socks in Boston, because productivity is the same for the two types of socks. The price in Chicago is 2 pairs of red socks per 1 pair of white socks. b. Boston has an absolute advantage in the production of both types of socks, because a worker in Boston produces more (3 pairs of socks per hour) than a worker in Chicago (2 pairs of red socks per hour or 1 pair of white socks per hour). Chicago has a comparative advantage in producing red socks, because the opportunity cost of producing a pair of red socks in Chicago is 1/2 pair of white socks, while the opportunity cost of producing a pair of red socks in Boston is 1 pair of white socks. Boston has a comparative advantage in producing white socks, because the opportunity cost of producing a pair of white socks in Boston is 1 pair of red socks, while the opportunity cost of producing a pair of white socks in Chicago is 2 pairs of red socks. c. If they trade socks, Boston will produce white socks for export, because it has the comparative advantage in white socks, while Chicago produces red socks for export, which is Chicago's comparative advantage. d. Trade can occur at any price between 1 and 2 pairs of red socks per pair of white socks. At a price lower than 1 pair of red socks per pair of white socks, Boston will choose to produce its own red socks (at a cost of 1 pair of red socks per pair of white socks) instead of buying them from Chicago. At a price higher than 2 pairs of red socks per pair of white socks, Chicago will choose to produce its own white socks (at a cost of 2 pairs of red socks per pair of white socks) instead of buying them from Boston. 18. a. Gains from trade will be possible when X does not equal 3. Gains from trade are possible when a comparative advantage exists. The opportunity cost of 1 car in Germany is 200 cases of wine (400 hours/2 hours per case of wine). Likewise, the opportunity cost of 1 case of wine in Germany is 1/200 car. When X=3, the opportunity cost of 1 car in France is 200 cases of wine (600 hours/3 hours per case of wine). In this instance, neither country has a comparative advantage. At all other values of X, a comparative advantage will exist. b. Germany will export cars and import wine for all values of X<3. For Germany to export cars, it must have the comparative advantage in producing cars and France must have the comparative advantage in producing wine. This occurs when Germany has a smaller opportunity cost of producing cars than France does. We know the opportunity cost of 1 car in Germany is 200 cases of wine. When X<3, the opportunity cost of 1 car in France is greater than 200 cases of wine. For example, when X=2, the opportunity cost of 1 car in France is 300 cases of wine (600 hours/2 hours per case = 300 cases). Therefore, Germany will have the comparative advantage in cars, export cars and import wine for all values of X<3.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade 19. a. The production possibilities frontiers for the two countries are shown in Figure 5. If, without trade, a U.S. worker spends half of his time producing each good, the United States will have 50 shirts and 10 computers. If, without trade, a worker in China spends half of his time producing each good, China will have 50 shirts and 5 computers.

Figure 5 b. China would export shirts because it has the lower opportunity cost of shirts. For China, the opportunity cost of 1 shirt is 1/10 computer. For the United States, the opportunity cost of a shirt is 1/5 computer. Therefore, China has a comparative advantage in the production of shirts and the United States has a comparative advantage in the production of computers. The price of a shirt will fall between 1/5 and 1/10 of a computer. An example would be a price of 1/7 computer. Suppose China produced only shirts (100 shirts) and exported 50 shirts in exchange for 7.14 computers (50/7 = 7.14). This trade makes China better off than it was before trade (50 shirts and 5 computers). The United States would also benefit from this trade. If the United States produced only computers (20 computers), and traded 7.14 of them to China for 50 shirts, the United States would have 12.86 (20-7.14) computers and 50 shirts and would be better off than before trade (10 computers and 50 shirts). c. The price of a computer would fall between 5 and 10 shirts. If the price were below 5, the United States would not be willing to export computers because the opportunity cost of a shirt for the United States is 1/5 computer. If the price were greater than 10 shirts, China would not be willing to import computers because (for China) the opportunity cost of a computer is 10 shirts. d. Once the productivity is the same in the two countries, the benefits of trade disappear. Trade is beneficial because it allows countries to exploit their comparative advantage. If China and the United States have exactly the same opportunity cost of producing shirts and computers, there will be no more gains from trade available.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 3: Interdependence and the Gains from Trade 20. a. True; two countries can achieve gains from trade even if one of the countries has an absolute advantage in the production of all goods. All that is necessary is that each country has a comparative advantage in some good. b. False; no one can have a comparative advantage in everything. Comparative advantage reflects the opportunity cost of one good or activity in terms of another. If you have a comparative advantage in one thing, you must have a comparative disadvantage in the other thing. c. False; trades can and do benefit both sides—especially trades based on comparative advantage. If both sides did not benefit, trades would never occur. d. False; to be good for both parties, the trade price must lie between the two opportunity costs. e. False; trade that makes the country better off can harm certain individuals in the country. For example, suppose a country has a comparative advantage in producing wheat and a comparative disadvantage in producing cars. Exporting wheat and importing cars will benefit the nation as a whole, as it will be able to consume more of both goods. However, the introduction of trade will likely be harmful to domestic auto workers and manufacturers.

[In-class assignment] Creating Comparative Advantage Examples: 15 minutes the first day, and then time will depend on the number of groups on the second day. Works in any class size. Topics include specialization, interdependence, self-interest, comparative advantage. 3-5 candy bars (or similar prize items) required. D. Purpose: This assignment allows students to further explore comparative advantage. E. Instructions: Divide the class into groups of three or four to write a comparative advantage problem of their own. Tell them to make creative, humorous, yet plausible examples. Give the students fifteen minutes to work on creating their examples at the end of class. Instruct them to bring a neatly written copy of their examples for the next class when each group will present its example to the rest of the class. Students should include tables and figures similar to those used in class. Let the students vote on which group has the best example and award a small prize to the group’s members. Make the examples available to all of the students in the class to use as practice problems for the exam.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Absolute and Comparative Advantage o Concept Clip: Imports and Exports o Video Problem Walk-Through: Using a Production Possibilities Frontier to Calculate Opportunity Cost and the Gains from Trade o Video Problem Walk-Through: Determining Absolute Advantage, Comparative Advantage, and a Beneficial Price of Trade o Video Problem Walk-Through: Determining Comparative Advantage and Whether Trade Is Beneficial at a Given Price o Graphing Basics o Slope of a Line o Slope of a Curve

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................... 51 Chapter Objectives ............................................................................................................................................. 52 Complete List of Chapter Activities and Assessments ........................................................................... 52 Key Terms ............................................................................................................................................................. 54 What's New in This Chapter ............................................................................................................................ 55 Chapter Outline ................................................................................................................................................... 55 Solutions to Text Problems ............................................................................................................................. 64 Questions for Review ...................................................................................................................................................... 64 Problems and Applications ........................................................................................................................................... 66 Additional Activities and Assignments ....................................................................................................... 78

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Additional Resources ........................................................................................................................................ 82 Cengage Video Resources .............................................................................................................................................. 82

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 4 is the first chapter in a three-chapter sequence that deals with supply and demand and how markets work. Chapter 4 shows how supply and demand for a good determines both the quantity produced and the price at which the good sells. Chapter 5 will add precision to the discussion of supply and demand by addressing the concept of elasticity—the sensitivity of the quantity supplied and quantity demanded to changes in economic variables. Chapter 6 will address the impact of government policies on prices and quantities in markets. The purpose of Chapter 4 is to establish the model of supply and demand. The model of supply and demand is the foundation for the discussion for the remainder of this text. For this reason, time spent studying the concepts in this chapter will return benefits to your students throughout their study of economics. Many instructors would argue that this chapter is the most important chapter in the text. Key points addressed in this chapter: 



 



Economists use the model of supply and demand to analyze competitive markets. In such markets, there are many buyers and sellers, each of whom has little or no influence on the market price. The demand curve for a good shows how the quantity demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. That’s why the demand curve slopes downward. In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, tastes, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts. The supply curve for a good shows how the quantity supplied depends on the price. According to the law of supply, as a good’s price rises, the quantity supplied rises. That’s why the supply curve slopes upward. In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts. The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied. The behavior of buyers and sellers naturally drives markets toward equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise. To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects equilibrium price and quantity. To do this we follow three steps. First, decide whether the event shifts the supply curve or the demand curve (or both). Second, decide which direction the curve shifts. Third, compare the new equilibrium with the initial equilibrium. In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand demand are in balance. The equilibrium price determines how much buyers choose to consume and how much sellers choose to produce.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Given a scenario, determine if a market is competitive.



Construct a demand curve using a given demand schedule.

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Describe the relationship between price and quantity demanded using the law of demand.

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Determine if a given scenario will cause a movement along or a shift of a good's demand curve.

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Explain how a change in a demand determinant impacts a good's demand curve.

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Determine market demand using information about individuals' demand.

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Determine if a given scenario will cause a movement along or a shift of a good's supply curve.

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Explain how the price of a good impacts the demand for its complements and substitutes.

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Construct a supply curve using a given supply schedule.

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Describe the relationship between price and quantity supplied using the law of supply.

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Explain how a change in a supply determinant impacts a good's supply curve.

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Determine market supply using information about individual firms' supply.

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Determine the equilibrium price and quantity using the supply and demand model.

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Explain how simultaneous changes in demand and supply impact market equilibrium.

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Explain how changes in demand impact market equilibrium.

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Explain how changes in supply impact market equilibrium.

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Explain how price changes eliminate a surplus or shortage.

Source (i.e., PPT slide, Workbook)

Duration

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Active Learning 1 Active Learning 2 Ask the Experts Active Learning 3 Think-Pair-Share Activity Self-Assessment Section 04-1 QuickQuiz Section 04-2 QuickQuiz Section 04-3 QuickQuiz Section 04-4 QuickQuiz ConceptClip: Law of Demand ConceptClip: Law of Supply ConceptClip: Equilibrium ConceptClip: Changes in Supply ConceptClip: Changes in Demand Figure 1: Catherine's Demand Schedule and Demand Curve Figure 2: Market Demand as the Sum of Individual Demands Figure 5: Ben's Supply Schedule and Supply Curve Figure 6: Market Supply as the Sum of Individual Supplies Figure 9: Markets Not in Equilibrium Figure 10: How an Increase in Demand Affects the Equilibrium Figure 11: How a Decrease in Supply Affects the Equilibrium Figure 12: A Shift in Both Supply and Demand Chapter 04 Problems & Applications Chapter 04 A+ Test Prep Video Quiz: The Law of Demand, Demand Schedules, and Demand Curves Video Quiz: Computing Market Demand from Individual Demand Video Quiz: Factors That Cause the Demand Curve to Shift Video Quiz: The Law of Supply, Supply Schedules, and Supply Curves Video Quiz: Computing Market Supply from Individual Supply Video Quiz: Factors That Cause the Supply Curve to Shift Video Quiz: Market Equilibrium Video Quiz: Changes in Equilibrium Chapter 04 News Analysis: When It Comes to Textbooks, Students and

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Publishers Do Their Homework Chapter 04 Homework Chapter 04 Quiz: The Market Forces of Supply and Demand

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KEY TERMS Competitive Market: a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. Complements: two goods for which an increase in the price of one good leads to a decrease in the demand for the other. Demand Curve: a graph of the relationship between the price of a good and the quantity demanded. Demand Schedule: a table that shows the relationship between the price of a good and the quantity demanded. Equilibrium: a situation in which the market price has reached the level at which quantity supplied equals quantity demanded. Equilibrium Price: the price that balances quantity supplied and quantity demanded. Equilibrium Quantity: the quantity supplied and the quantity demanded at the equilibrium price. Inferior Good: a good for which, other things equal, an increase in income leads to a decrease in demand. Law of Demand: the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises. Law of Supply: the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises. Law of Supply and Demand: the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded of that good into balance. Market: a group of buyers and sellers of a particular good or service. Normal Good: a good for which, other things equal, an increase in income leads to an increase in demand. Quantity Demanded: the amount of a good that buyers are willing and able to purchase. Quantity Supplied: the amount of a good that. Shortage: a situation in which quantity demanded is greater than quantity supplied.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Substitutes: two goods for which an increase in the price of one good leads to an increase in the demand for the other. Supply Curve: a graph of the relationship between the price of a good and the quantity supplied. Supply Schedule: a table that shows the relationship between the price of a good and the quantity supplied. Surplus: a situation in which quantity supplied is greater than quantity demanded. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new In the News feature on price increases after disasters: “The Law of Supply and Demand Isn’t Fair.” There is a new Ask the Experts feature on Price Gouging.

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Markets and Competition a. Instruction Idea: You may want to provide students with examples of markets other than the traditional retail store or the stock market. These include the online advertising sites such as eBay and Craigslist, the college “career services” department through which they can look for employment upon graduation, or the market for illegal drugs on a college campus. Be sure to list the good or service being sold, the buyers, and the sellers in each example. b. What Is a Market? i. Definition of market: a group of buyers and sellers of a particular good or service. ii. Markets can take many forms and may be organized (agricultural commodities) or less organized (ice cream). c. What Is Competition? i. Definition of competitive market: a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. ii. Each buyer knows that there are several sellers from which to choose. Sellers know that each buyer purchases only a small amount of the total amount sold.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand iii.

Keep in Mind: Students may find the name for this type of market misleading. You will have to point out that firms in a competitive market do not face head-to-head rivalry as in sports competitions. d. In this chapter, we will assume that markets are perfectly competitive. i. Characteristics of a perfectly competitive market: 1. The goods being offered for sale are exactly the same. 2. The buyers and sellers are so numerous that no single buyer or seller has any influence over the market price. ii. Because buyers and sellers must accept the market price as given, they are often called "price takers." iii. Not all goods are sold in a perfectly competitive market. 1. A market with only one seller is called a monopoly market. 2. Other markets fall between perfect competition and monopoly. e. We will start by studying perfect competition. i. Perfectly competitive markets are the easiest to analyze because buyers and sellers take the price as a given. ii. Because some degree of competition is present in most markets, many of the lessons that we learn by studying supply and demand under perfect competition apply in more complicated markets. Demand a. The Demand Curve: The Relationship between Price and Quantity Demanded i. Definition of quantity demanded: the amount of a good that buyers are willing and able to purchase. ii. One important determinant of quantity demanded is the price of the product. 1. Quantity demanded is negatively related to price. This implies that the demand curve is downward sloping. 2. Instruction Idea: Make sure that you explain that, when we discuss the relationship between quantity demanded and price, we hold all other variables constant. You will need to emphasize this more than once to ensure that students understand why a change in price leads to a movement along the demand curve. 3. Definition of law of demand: the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises. iii. Definition of demand schedule: a table that shows the relationship between the price of a good and the quantity demanded. Figure 1

Price of IceCream Cone

Quantity of Cones Demanded

$0.00 $0.50 $1.00

12 10 8

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand $1.50 $2.00 $2.50

6 4 2

$3.00

iv.

1. Instruction Idea: When you draw the demand curve for the first time, take the time to plot each of the points from the demand schedule. This way, students who have difficulty with graphs can see the relationship between the demand schedule and the demand curve. This is a good opportunity to see if students understand the (x, y) coordinate system. Definition of demand curve: a graph of the relationship between the price of a good and the quantity demanded. 1. Price is generally drawn on the vertical axis. 2. Quantity demanded is represented on the horizontal axis.

Alternative Classroom Example: Here is a demand schedule for ink pens: Price ($) .05 .10 .15 .20 .25

Quantity Demanded 1000 800 600 400 200

b. Market Demand versus Individual Demand i. The market demand is the sum of all of the individual demands for a particular good or service. ii. The demand curves are summed horizontally—meaning that the quantities demanded are added up at each price. Figure 2 iii.

The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding constant all other factors that affect how much consumers want to buy. c. Shifts in the Demand Curve

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand i.

ii.

Keep in Mind: Students have a difficult time understanding the difference between a change in price (which causes a movement along the demand curve) and a change in another determinant (which shifts the demand curve). You will have to emphasize what is meant by “change in quantity demanded” and “change in demand” several times using different examples. The Case Study on smoking will help to explain this difference as well. Because the market demand curve holds other things constant, it need not be stable over time.

Figure 3 iii.

iv.

vi. vii.

viii.

If any of these other factors change, the demand curve will shift. 1. An increase in demand is represented by a shift of the demand curve to the right. 2. A decrease in demand is represented by a shift of the demand curve to the left. Income 1. The relationship between income and quantity demanded depends on what type of good the product is. 2. Definition of normal good: a good for which, other things equal, an increase in income leads to an increase in demand. 3. Definition of inferior good: a good for which, other things equal, an increase in income leads to a decrease in demand. 4. Keep in Mind: Be careful! Students often confuse inferior goods with what economists call “bads.” One way to differentiate them is to ask students whether they would ever be willing to pay for such things as pollution or garbage. Prices of Related Goods 1. Definition of substitutes: two goods for which an increase in the price of one good leads to an increase in the demand for the other. 2. Definition of complements: two goods for which an increase in the price of one good leads to a decrease in the demand for the other. Tastes Expectations 1. Future income 2. Future prices Number of Buyers

Table 1 ix.

Instruction Idea: It would be a good idea to work through an example changing each of these variables individually. Students will benefit from the discussion and the practice drawing graphs. d. Case Study: Two Ways to Reduce Smoking Figure 4

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand i.

ii.

iii.

iv.

XI.

Public service announcements, mandatory health warnings on cigarette packages, and the prohibition of cigarette advertising on television are policies designed to reduce the demand for cigarettes (and shift the demand curve to the left). Raising the price of cigarettes (through tobacco taxes) lowers the quantity of cigarettes demanded. 1. The demand curve does not shift in this case, however. 2. An increase in the price of cigarettes can be shown by a movement along the original demand curve. Studies have shown that a 10% increase in the price of cigarettes causes a 4% reduction in the quantity of cigarettes demanded. For teens, a 10% increase in price leads to a 12% drop in quantity demanded. Studies have also shown that a decrease in the price of cigarettes is associated with greater use of marijuana. Thus, it appears that tobacco and marijuana are complements.

Supply a. Instruction Idea: If you have taken enough time teaching demand, students will catch on to supply more quickly. However, remember that as consumers, students can understand demand decisions more easily than supply decisions. You may want to point out to them that they are suppliers (of their time and effort) in the labor market. b. The Supply Curve: The Relationship between Price and Quantity Supplied i. Definition of quantity supplied: the amount of a good that 1. Quantity supplied is positively related to price. This implies that the supply curve will be upward sloping. 2. Definition of law of supply: the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises. 3. Instruction Idea: Again, you will want to point out that everything else is held constant when we discuss the relationship between price and quantity supplied. Students should understand that a change in price causes a movement along the supply curve. ii. Definition of supply schedule: a table that shows the relationship between the price of a good and the quantity supplied. iii. Definition of supply curve: a graph of the relationship between the price of a good and the quantity supplied.

Figure 5 Price of IceCream Cone

Quantity of Cones Supplied

$0.00 $0.50 $1.00

0 0 1

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand $1.50 $2.00 $2.50 $3.00

2 3 4 5 c. Market Supply versus Individual Supply

Figure 6 i.

The market supply curve can be found by summing individual supply curves. ii. Individual supply curves are summed horizontally at every price. iii. The market supply curve shows how the total quantity supplied varies as the price of the good varies. d. Shifts in the Supply Curve Figure 7 i.

ii. iii. iv. v.

Because the market supply curve holds other things constant, the supply curve will shift if any of these factors changes. 1. An increase in supply is represented by a shift of the supply curve to the right. 2. A decrease in supply is represented by a shift of the supply curve to the left. 3. Instruction Idea: You will want to take time to emphasize the difference between a “change in supply” and a “change in quantity supplied.” Input Prices Technology Expectations Number of Sellers

Table 2 XII.

Supply and Demand Together a. Equilibrium i. The point where the supply and demand curves intersect is called the market’s equilibrium. ii. Definition of equilibrium: a situation in which the market price has reached the level at which quantity supplied equals quantity demanded. iii. Definition of equilibrium price: the price that balances quantity supplied and quantity demanded. iv. Instruction Idea: Students will benefit from seeing equilibrium using both a graph and a supply-and-demand schedule. The schedule will also make it easier for students to understand concepts such as shortages and surpluses.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand v.

The equilibrium price is often called the "market-clearing" price because both buyers and sellers are satisfied at this price.

vi.

Definition of equilibrium quantity: the quantity supplied and the quantity demanded at the equilibrium price. Instruction Idea: There is a student activity (A Market Example) that applies to this topic in the "Additional Activities and Assignments” section. If the actual market price is higher than the equilibrium price, there will be a surplus of the good.

Figure 8

vii. viii.

Figure 9

1. Definition of surplus: a situation in which quantity supplied is greater than quantity demanded.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand 2. To eliminate the surplus, producers will lower the price until the market reaches equilibrium. ix. If the actual price is lower than the equilibrium price, there will be a shortage of the good. 1. Definition of shortage: a situation in which quantity demanded is greater than quantity supplied. 2. Sellers will respond to the shortage by raising the price of the good until the market reaches equilibrium. x. Definition of the law of supply and demand: the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded of that good into balance. xi. Instruction Idea: There is a student activity (Campus Parking) that applies to this topic in the "Additional Activities and Assignments” section. b. Three Steps to Analyzing Changes in Equilibrium Table 3 i.

Decide whether the event shifts the supply or demand curve (or perhaps both). ii. Determine the direction in which the curve shifts. iii. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity. iv. Instruction Idea: This three-step process is very important. Students often want to jump to the end without thinking the change through. They should be provided with numerous examples so that they can see the benefit of analyzing a change in equilibrium one step at a time. c. Example: A shift in demand changes the market equilibrium—the effect of hot weather on the market for ice cream. Figure 10 i.

Instruction Idea: Go through changes in supply and demand carefully. Show students why the equilibrium price must change after one of the curves shifts. For example, point out that if demand rises, a shortage will occur at the original equilibrium price. This leads to an increase in price, which causes quantity supplied to rise and quantity demanded to fall until equilibrium is achieved. The end result is an increase in both the equilibrium price and equilibrium quantity. Also point out that an increase in demand leads to an increase in quantity supplied, not supply.

Alternative Classroom Example: Go through these examples of events that would shift either the demand or supply of #2 pencils:    

an increase in the income of consumers an increase in the use of standardized exams (using opscan forms) a decrease in the price of graphite (used in the production of pencils) a decrease in the price of ink pens

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand  

the start of a school year new technology that lowers the cost of producing pencils d. Shifts in Curves Versus Movements Along Them i. A shift in the demand curve is called a "change in demand." A shift in the supply curve is called a "change in supply." 1. Keep in Mind: Emphasize that students should not think about the curves shifting “up” and “down” but rather think about the curves shifting “right” and “left” (or “out” and “in”). Point out that an increase in demand (or supply) is an increase in the quantity demanded (supplied) at every price. Thus, it is quantity that is getting larger. Review the same principle with a decrease in demand (or supply). ii. A movement along a fixed demand curve is called a "change in quantity demanded." A movement along a fixed supply curve is called a "change in quantity supplied." 1. Instruction Idea: It would helpful to students if you draw all four graphs (increase in demand, decrease in demand, increase in supply, and decrease in supply) on the board at the same time. Students will be able to see that the end result of each of these four shifts is unique. Point out to students that they can use these graphs to explain events going on in markets around them. For example, point out changes in gasoline prices seen during the past several years. Then ask students what could have led to these changes in price. Make sure that they realize that they would need to know the effect on equilibrium quantity to determine the ultimate cause. e. Example: A shift in supply changes the market equilibrium—the effect of a hurricane that destroys part of the sugar-cane crop and drives up the price of sugar.

Figure 11 f.

Example: Both supply and demand shift—the effect of hot weather and a hurricane that destroys part of the sugar cane crop.

Figure 12 i.

Instruction Idea: Make sure that you explain to students that two possible outcomes might result, depending on the relative sizes of the shifts in the demand and supply curves. Thus, if they do not know the relative sizes of these shifts, the end effect on either equilibrium price or equilibrium quantity will be ambiguous. Teach students to shift each curve using the three-step method and to draw them on separate graphs. g. Summary i. When an event shifts the supply or demand curve, we can examine the effects on the equilibrium price and quantity. ii. Table 4 reports the end results of these shifts in supply and demand.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Table 4

XIII.

h. In the News: Price Increases after Disasters. “The Law of Supply and Demand Isn’t Fair” i. When a disaster strikes a region, some economists argue that buyers are concerned with what is fair. As a result, sellers should not raise prices during emergencies because, after the crisis is over, buyers will respond with anger toward sellers that raised prices. ii. Other economists argue that higher prices encourage consumers to conserve important goods. It also provides incentives for producers to bring more goods to the disaster area. i. Ask the Experts: Price Gouging i. Economic experts were asked to evaluate the following statement: “Laws to prevent high prices for essential goods in short supply in a crisis would raise social welfare.” ii. 35 percent agreed, 36 percent disagreed, and 29 percent were uncertain. Conclusion: How Prices Allocate Resources a. The model of supply and demand is a powerful tool for analyzing markets. b. Supply and demand together determine the prices of the economy’s goods and services. i. These prices serve as signals that guide the allocation of scarce resources in the economy. ii. Prices determine who produces each good and how much of each good is produced. 1. Instruction Idea: Make a big deal about how well prices serve to allocate resources to their highest valued uses. For example, suppose that consumers develop an increased taste for corn and corn products. This leads to an increase in the demand for corn, pushing the price up. This increased price provides incentives to producers to produce more corn. Thus, price signals our wants and desires. This is one reason why markets generally serve as the best way to organize economic activity. 2. Instruction Idea: There is a student activity (Supply and Demand Article) that applies to this topic in the "Additional Activities and Assignments” section.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 27. A competitive market is a market in which there are many buyers and many sellers of an identical product so that each has a negligible impact on the market price. Another type of

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand market is a monopoly, in which there is only one seller. There are also other markets that fall between perfect competition and monopoly. 28. The demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. The demand curve is the downward-sloping line relating price and quantity demanded. The demand schedule and demand curve are related because the demand curve is simply a graph showing the points in the demand schedule. The demand curve slopes downward because of the law of demand—other things being equal, when the price of a good rises, the quantity demanded of the good falls. People buy less of a good when its price rises, both because they cannot afford to buy as much and because they switch to purchasing other goods. 29. A change in consumers' tastes leads to a shift of the demand curve. If the change in consumers' tastes leads to an increase in demand, consumers want to buy more of this good at every price level. A change in price leads to a movement along the demand curve. Because price is measured on the vertical axis, a change in the price represents a movement along the demand curve. 30. Because Harry buys more pumpkin juice when his income falls, pumpkin juice is an inferior good for him. His demand curve for pumpkin juice shifts out to the right as a result of the decrease in his income. 31. A supply schedule is a table showing the relationship between the price of a good and the quantity a producer is willing and able to supply. The supply curve is the upward-sloping line relating price and quantity supplied. The supply schedule and the supply curve are related because the supply curve is simply a graph showing the points in the supply schedule. The supply curve slopes upward because when the price is high, suppliers' profits increase, so they supply more output to the market. The result is the law of supply—other things being equal, when the price of a good rises, the quantity supplied of the good also rises. 32. A change in producers' technology leads to a shift in the supply curve. A change in price leads to a movement along the supply curve. 33. The equilibrium of a market is the point at which the quantity demanded is equal to quantity supplied. If the price is above the equilibrium price, sellers want to sell more than buyers want to buy, so there is a surplus. Sellers try to increase their sales by cutting prices. That continues until they reach the equilibrium price. If the price is below the equilibrium price, buyers want to buy more than sellers want to sell, so there is a shortage. Sellers can raise their price without losing customers. That continues until they reach the equilibrium price. 34. When the price of beer rises, the demand for pizza declines, because beer and pizza are complements and people want to buy less beer. When we say the demand for pizza declines, we mean that the demand curve for pizza shifts to the left as in Figure 5. The supply curve for pizza is not affected. With a shift to the left in the demand curve, the equilibrium price and quantity both decline, as the figure shows. Thus, the quantity of pizza supplied and demanded both fall. In sum, supply is unchanged, demand is decreased, quantity supplied declines, quantity demanded declines, and the price falls.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

Figure 5 35. Prices play a vital role in market economies because they bring markets into equilibrium. If the price is different from its equilibrium level, quantity supplied and quantity demanded are not equal. The resulting surplus or shortage leads suppliers to adjust the price until equilibrium is restored. Prices thus serve as signals that guide economic decisions and allocate scarce resources.

PROBLEMS AND APPLICATIONS 21. a. Cold weather damages the orange crop, reducing the supply of oranges and raising the price of oranges. This leads to a decline in the supply of orange juice because oranges are an important input in the production of orange juice. This can be seen in Figure 6 as a shift to the left in the supply curve for orange juice. The new equilibrium price is higher than the old equilibrium price.

Figure 6

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand b. People often travel to the Caribbean from New England to escape cold weather, so the demand for Caribbean hotel rooms is high in the winter. In the summer, fewer people travel to the Caribbean, because northern climates are more pleasant. The result, as shown in Figure 7, is a shift to the left in the demand curve. The equilibrium price of Caribbean hotel rooms is thus lower in the summer than in the winter, as the figure shows.

Figure 7 c. When a war breaks out in the Middle East, many markets are affected. Because a large proportion of oil production takes place there, the war disrupts oil supplies, shifting the supply curve for gasoline to the left, as shown in Figure 8. The result is a rise in the equilibrium price of gasoline. With a higher price for gasoline, the cost of operating a gas-guzzling automobile like an SUV will increase. As a result, the demand for used SUVs will decline, as people in the market for cars will not find SUVs as attractive. In addition, some people who already own SUVs will try to sell them. The result is that the demand curve for used SUVs shifts to the left, while the supply curve shifts to the right, as shown in Figure 9. The result is a decline in the equilibrium price of used SUVs.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

Figure 8

Figure 9

22. The statement is false. As Figure 10 shows, in equilibrium the increase in demand for notebooks results in an increased quantity demanded and the quantity supplied.

Figure 10 23. a. If people decide to have more children, they will want larger vehicles for hauling their kids around, so the demand for minivans will increase. Supply will not be affected. The result is a rise in both the price and the quantity sold, as Figure 12 shows.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

Figure 12

Figure 13

b. If a strike by steelworkers raises steel prices, the cost of producing a minivan rises and the supply of minivans decreases. Demand will not be affected. The result is a rise in the price of minivans and a decline in the quantity sold, as Figure 13 shows. c. The development of new automated machinery for the production of minivans is an improvement in technology. This reduction in firms' costs will result in an increase in supply. Demand is not affected. The result is a decline in the price of minivans and an increase in the quantity sold, as Figure 14 shows.

Figure 14 d. The rise in the price of sport utility vehicles affects minivan demand because sport utility vehicles are substitutes for minivans. The result is an increase in demand for minivans. Supply is not affected. The equilibrium price and quantity of minivans both rise, as Figure 12 shows. e. The reduction in peoples' wealth caused by a stock-market crash reduces their income, leading to a reduction in the demand for minivans, because minivans are

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand likely a normal good. Supply is not affected. As a result, both the equilibrium price and the equilibrium quantity decline, as Figure 15 shows.

Figure 15 24. a. Video streaming services and TV screens are likely to be complements because you cannot watch a video without a television. Video streaming services and movie tickets are likely to be substitutes because a movie can be watched at a theater or at home. TV screens and movie tickets are likely to be substitutes for the same reason. b. The technological improvement would reduce the cost of producing a TV screen, shifting the supply curve to the right. The demand curve would not be affected. The result is that the equilibrium price will fall, while the equilibrium quantity will rise. This is shown in Figure 16.

Figure 16 c. The reduction in the price of TV screens would lead to an increase in the demand for video streaming services because TV screens and video streaming are complements.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand The effect of this increase in the demand for video streaming is an increase in both the equilibrium price and quantity, as shown in Figure 17.

Figure 17 The reduction in the price of TV screens would cause a decline in the demand for movie tickets because TV screens and movie tickets are substitute goods. The decline in the demand for movie tickets would lead to a decline in the equilibrium price and quantity sold. This is shown in Figure 18.

Figure 18

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand 25. Technological advances that reduce the cost of producing computer chips represent a decline in an input price for producing a computer. The result is a shift to the right in the supply of computers, as shown in Figure 19. The equilibrium price falls and the equilibrium quantity rises, as the figure shows.

Figure 19 Because computer software is a complement to computers, the lower equilibrium price of computers increases the demand for software. As Figure 20 shows, the result is a rise in both the equilibrium price and quantity of software.

Figure 20

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand Because typewriters are substitutes for computers, the lower equilibrium price of computers reduces the demand for typewriters. As Figure 21 shows, the result is a decline in both the equilibrium price and quantity of typewriters.

Figure 21 26. a. When a hurricane in South Carolina damages the cotton crop, it raises input prices for producing sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in Figure 22. The new equilibrium price is higher and the new equilibrium quantity of sweatshirts is lower.

Figure 22

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand b. A decline in the price of leather jackets leads more people to buy leather jackets, reducing the demand for sweatshirts. The result, shown in Figure 23, is a decline in both the equilibrium price and quantity of sweatshirts.

Figure 23 c. The effects of colleges requiring students to engage in morning exercise in appropriate attire raises the demand for sweatshirts, as shown in Figure 24. The result is an increase in both the equilibrium price and quantity of sweatshirts.

Figure 24 d. The invention of new knitting machines increases the supply of sweatshirts. As Figure 25 shows, the result is a reduction in the equilibrium price and an increase in the equilibrium quantity of sweatshirts.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

Figure 25 27. Ketchup is a complement for hot dogs. Therefore, when the price of hot dogs rises, the quantity demanded of hot dogs falls and this lowers the demand for ketchup. The end result is that both the equilibrium price and quantity of ketchup fall. Because the quantity of ketchup falls, the demand for tomatoes by ketchup producers falls, so the equilibrium price and quantity of tomatoes fall. When the price of tomatoes falls, producers of tomato juice face lower input prices, so the supply curve for tomato juice shifts out, causing the price of tomato juice to fall and the quantity of tomato juice to rise. The fall in the price of tomato juice causes people to substitute tomato juice for orange juice, so the demand for orange juice declines, causing the price and quantity of orange juice to fall. Now you can see clearly why a rise in the price of hot dogs leads to a fall in the price of orange juice! 28. a. Quantity supplied equals quantity demanded at a price of $6 and quantity of 81 pizzas (Figure 30).

Figure 30

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand b. If the price were above $6, quantity supplied would exceed quantity demanded, so suppliers would reduce the price to gain sales. c. If the price were below $6, quantity demanded would exceed quantity supplied, so suppliers could raise the price without losing sales. In both cases, the price would continue to adjust until it reached $6, the only price at which there is neither a surplus nor a shortage. 29. The news of the increased health benefits from consuming oranges will increase the demand for oranges, increasing both the equilibrium price and quantity. If farmers use a new fertilizer that makes orange trees more productive, the supply of oranges will increase, leading to a fall in the equilibrium price but a rise in the equilibrium quantity. If both occur at the same time, the equilibrium quantity will definitely rise, but the effect on equilibrium price will be ambiguous. 30. a. Because flour is an ingredient in bagels, a decline in the price of flour would shift the supply curve for bagels to the right. The result, shown in Figure 31, would be a fall in the price of bagels and a rise in the equilibrium quantity of bagels.

Figure 31 Because cream cheese is a complement to bagels, the fall in the equilibrium price of bagels increases the demand for cream cheese, as shown in Figure 32. The result is a rise in both the equilibrium price and quantity of cream cheese. So, a fall in the price of flour indeed raises both the equilibrium price of cream cheese and the equilibrium quantity of bagels.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

Figure 32

Figure 33

What happens if the price of milk falls? Because milk is an ingredient in cream cheese, the fall in the price of milk leads to an increase in the supply of cream cheese. This leads to a decrease in the price of cream cheese (Figure 33), rather than a rise in the price of cream cheese. So a fall in the price of milk could not have been responsible for the pattern observed. b. In part (a), we found that a fall in the price of flour led to a rise in the price of cream cheese and a rise in the equilibrium quantity of bagels. If the price of flour rose, the opposite would be true; it would lead to a fall in the price of cream cheese and a fall in the equilibrium quantity of bagels. Because the question says the equilibrium price of cream cheese has risen, it could not have been caused by a rise in the price of flour. What happens if the price of milk rises? From part (a), we found that a fall in the price of milk caused a decline in the price of cream cheese, so a rise in the price of milk would cause a rise in the price of cream cheese. Because bagels and cream cheese are complements, the rise in the price of cream cheese would reduce the demand for bagels, as Figure 34 shows. The result is a decline in the equilibrium quantity of bagels. So a rise in the price of milk does cause both a rise in the price of cream cheese and a decline in the equilibrium quantity of bagels.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand

Figure 34

Figure 35

31. a. As Figure 35 shows, the supply curve is vertical. The constant quantity supplied makes sense because the basketball arena has a fixed number of seats at any price. b. Quantity supplied equals quantity demanded at a price of $8. The equilibrium quantity is 8,000 tickets. c. Price $4 $8 $12 $16 $20

Quantity Demanded 14,000 11,000 8,000 5,000 2,000

Quantity Supplied 8,000 8,000 8,000 8,000 8,000

The new equilibrium price will be $12, which equates quantity demanded to quantity supplied. The equilibrium quantity remains 8,000 tickets.

[In-class assignment] A Market Example: 35 minutes total. Works in large lectures or small classes with over 15 students. Topics include individual demand, market demand, equilibrium price, allocation. A bag of Pepperidge Farm cookies (15 cookies) and 5 volunteers needed. F. Purpose: This is an example of a real-world market, where real goods are exchanged for real money. It is a free market, so there will be no coercion, but participants should think carefully about their answers because actual trades will take place.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand G. Instructions: Ask five volunteers to participate in a market for Pepperidge Farm cookies. Read some of the package copy describing these “distinctively delicious” cookies. Write each volunteer’s name on the board. Ask the volunteers how many cookies they would be willing to buy at various prices. Record these prices and quantities. Give the volunteers the opportunity to revise their numbers if the figures do not accurately reflect their willingness to pay. Remind them this isn’t a hypothetical exercise and they will have to pay real money. At this point, there will be five individual demand curves, which can be graphed if desired. Add the individual quantities at each price to find the market demand at that price. This overall demand is used to find the market equilibrium. Sketch a graph of the market demand. Supply, in this case, is fixed at the number of cookies in the bag. There are 15 cookies. No more can be produced, and any leftovers will spoil. This gives a vertical supply curve in the very short run at Q = 15. (Sketch the supply curve.) Try various prices until the individual quantities sum to 15. This will give the equilibrium price and quantity. Distribute the cookies and collect money from each participant. H. Points for Discussion: The demand curves display the typical inverse relation between price and quantity. (Remark on any unusual patterns.) These tell us about each individual’s willingness to pay and reveal information about the marginal benefits of additional cookies to each consumer. Market demand is aggregated from individual demand curves. Notice the consumers do not get an equal number of cookies. This is typical of markets, because tastes and incomes vary across individuals. IV.

[In-class assignment] Campus Parking: 35 minutes total. Works in large lectures or small classes, if there is a campus parking problem. Topics include demand, supply, disequilibrium, shortage, and rationing. A. Purpose: Nothing seems to generate more heated discussion than campus parking. If your school has a parking shortage this assignment brings the ideas of price rationing and resource allocation to an issue close to the students’ hearts. K. Sen’s parable of the bamboo flute is a good introduction to this assignment: An artist makes a beautiful instrument that becomes famous throughout the country. A number of claimants arise, each of whom argues that they deserve the flute: the artist who created it, the most talented musician, the poorest musician, the neediest citizen, the hardest working musician, etc. Who deserves the flute? Students will have different opinions on who is most deserving but many will accept a market

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand solution—the person who is willing to pay the most (who has the highest marginal benefit, given the existing distribution of wealth and income). The allocation of campus parking spots makes a nice parallel. B. Instructions: Ask the class to answer the following questions. Give them time to write an answer to a question, then discuss their answers before moving to the next question. C. Common Answers and Points for Discussion: 1. Write down three things that are true about the parking situation on campus. 2. What two problems do you think are most important? The parking problem has two components in the eyes of most students. Parking permits are too expensive and there are too few spaces. 3. What policies could the administration make to resolve these problems? Students have many policies to alleviate the situation. The most common suggestion is to ban parking for freshmen. Freshmen respond with lists of other groups who should be banned. Another popular policy would be to open faculty lots to student parking. Parking fees should be lowered or better yet eliminated. Parking violations should have lower fines. More lots should be built. Shuttles, moving sidewalks, and monorails should be installed. Students never suggest raising prices to reach a market solution. 4. Who needs parking the most? 5. Who would pay the most for parking? Asking about need and willingness to pay moves the discussion away from group prohibitions; freshmen may be just as needy and equally able to pay. 6. Use a supply-and-demand graph to analyze this problem. Many students initially have difficulty graphing this problem. They want to illustrate that permit prices are too high, but then their graph will not show the shortage. Eventually they can be convinced that parking, while expensive, is actually priced too low. 7. How would your policy proposals affect the market for parking? Analysis of the various proposals in a supply-and-demand framework shows some popular policies, like free permits, would aggravate the parking shortage. Policies to restrict demand can reduce the shortage, although there will be inefficiencies in the resulting allocation. Make sure that students realize that building more parking lots is not a shift in the supply curve, but a movement along the existing supply curve. The additional costs of new parking need to be covered by some means: higher parking fees, tuition increases, or taxpayer subsidies.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 4: The Market Forces of Supply and Demand V.

[Take-home assignment] Supply and Demand Article. Works in any class. Topics include shifts in supply and demand as well as changing equilibrium. A. Purpose: This assignment is an excellent way to determine which students need extra help in understanding supply and demand. Students who have difficulty with it often need remedial help. Allowing students to correct errors and then resubmit the assignment can be worthwhile because it is fundamental to their understanding of how markets work. B. Instructions: Give the students the following assignment: Find an article in a recent newspaper or magazine illustrating a change in price or quantity in some market. Analyze the situation using economic reasoning. 1. Has there been an increase or decrease in demand? Factors that could shift the demand curve include changes in preferences, changes in income, changes in the price of substitutes or complements, or changes in the number of consumers in the market. 2. Has there been an increase or decrease in supply? Factors that could shift the supply curve include changes in costs of materials, wages, or other inputs; changes in technology; or changes in the number of firms in the market. 3. Draw a supply-and-demand graph to explain this change. Be sure to label your graph and clearly indicate which curve shifts. Ask students to turn in a copy of the article along with their explanation. Warn students to avoid advertisements because they contain little information. They should be wary of commodity and financial markets unless they have a good understanding of the particular market. Markets for ordinary goods and services are most easily analyzed. C. Points for Discussion: Most changes will only shift one curve—either supply or demand—not both. Remind students that price changes will not cause either curve to shift. (But shifting either curve will change price.) Equilibrium points are not fixed. They change when supply or demand changes. Prices will not necessarily return to previous levels nor will quantities. Remind the students of the four graphs showing the shifts in supply and demand.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Law of Demand o Concept Clip: Law of Supply o Concept Clip: Equilibrium o Concept Clip: Changes in Supply o Concept Clip: Changes in Demand o Video Problem Walk-Through: Determining Changes in Equilibrium Price and Quantity after a Demand or Supply Shift o Video Problem Walk-Through: Determining Changes in Equilibrium Price and Quantity after a Demand and Supply Shift o Video Problem Walk-Through: Calculating Equilibrium Price and Quantity from Supply and Demand Equations o Video Problem Walk-Through: Graphing Supply and Demand and Identifying a Shortage or Surplus o Equation Basics o Graphing Basics o Graphing Linear Equations o Video Quiz: The Law of Demand, Demand Schedules, and Demand Curves o Video Quiz: Computing Market Demand from Individual Demand o Video Quiz: Factors That Cause the Demand Curve to Shift o Video Quiz: The Law of Supply, Supply Schedules, and Supply Curves o Video Quiz: Computing Market Supply from Individual Supply o Video Quiz: Factors That Cause the Supply Curve to Shift o Video Quiz: Market Equilibrium o Video Quiz: Changes in Equilibrium

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

Complete List of Chapter Activities and Assessments Key Terms

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application What's New in This Chapter 87 Chapter Outline

Solutions to Text Problems 95 Questions for Review ...................................................................................................................................................... 95 Problems and Applications ........................................................................................................................................... 96 Additional Activities and Assignments

101

Additional Resources102 Cengage Video Resources ........................................................................................................................................... 102

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 5 is the second chapter of a three-chapter sequence that deals with supply and demand and how markets work. Chapter 4 introduced supply and demand. Chapter 5 shows how much buyers and sellers respond to changes in market conditions. Chapter 6 will address the impact of government policies on competitive markets. The purpose of Chapter 5 is to add precision to the supply-and-demand model. We introduce the concept of elasticity, which measures the responsiveness of buyers and sellers to changes in economic variables such as prices and income. The concept of elasticity allows us to make quantitative observations about the impact of changes in supply and demand on equilibrium prices and quantities. Key points addressed in this chapter: 



The price elasticity of demand measures how much quantity demanded responds to changes in price. Demand tends to be more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react to a price change. The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If quantity demanded moves proportionately less than price, then the elasticity is less than one, and demand is inelastic. If quantity demanded moves proportionately more than the price, then the elasticity is greater than one, and demand is elastic. Total revenue, the total amount paid for a good, equals the price times the quantity sold. For inelastic demand curves, total revenue moves in the same direction as price. For elastic demand curves, total revenue moves in the opposite direction. The income elasticity of demand measures how much quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another. The price elasticity of supply measures how much quantity supplied responds to changes in price. This elasticity often depends on the time horizon. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. If quantity supplied moves proportionately less than price, then the elasticity is less than one, and supply is inelastic. If quantity supplied moves proportionately more than price, then the elasticity is greater than one, and supply is elastic. The tools of supply and demand can be applied in many different markets. This chapter uses them to analyze the market for wheat, the market for oil, and the market for illegal drugs.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Calculate price elasticity of demand in a given scenario.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application 

Identify regions of the demand curve as elastic, inelastic, or unit elastic using price elasticity of demand.



List the factors that influence price elasticity of demand.



Describe the relationship between price elasticity of demand and the slope of a demand curve.



Explain how changes in supply impact market equilibrium.



Analyze the relationship between price elasticity of demand and total revenue.



Calculate income elasticity of demand in a given scenario.



Determine whether a good is inferior or normal using income elasticity of demand.



Calculate cross-price elasticity of demand in a given scenario.



Determine if two goods are complements or substitutes using cross-price elasticity of demand.



Calculate price elasticity of supply in a given scenario.



List the factors that influence price elasticity of supply.



Identify regions of the supply curve as elastic, inelastic, or unit elastic using price elasticity of supply.



Explain how changes in demand impact market equilibrium.

Source (i.e., PPT slide, Workbook) PPT Slide 12 PPT Slide 25 PPT Slide 49 PPT Slide 50 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

5 mins. 5 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application Figure 4: Elasticity of a Linear Demand Curve Figure 7: An Increase in Supply in the Market for Wheat Figure 8: A Reduction in Supply in the World Market for Oil Chapter 05 Problems & Applications Chapter 05 A+ Test Prep Video Quiz: Determinants of Price Elasticity of Demand Video Quiz: Calculation of the Price Elasticity of Demand Video Quiz: Interpretation of Elasticity Values and Demand Curves Video Quiz: Income Elasticity and Cross-Price Elasticity of Demand Video Quiz: Relationship between Total Revenue and the Price Elasticity of Demand Chapter 05 Homework Chapter 05 Quiz: Elasticity and Its Application

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

25–35 mins. N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

35–45 mins. 20–30 mins.

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KEY TERMS Cross-price Elasticity of Demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good, calculated as the percentage change in the quantity demanded of the first good divided by the percentage change in the price of the second good. Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. Income Elasticity of Demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, calculated as the percentage change in quantity demanded divided by the percentage change in income. Price Elasticity of Demand: a measure of how much the quantity demanded of a good responds to a change in price, calculated as the percentage change in quantity demanded divided by the percentage change in price. Price Elasticity of Supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, calculated as the percentage change in quantity supplied divided by the percentage change in price.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application Total Revenue: the amount paid by buyers and received by sellers of a good, calculated as the price of the good times the quantity sold. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

Expanded discussion of the future of oil prices. There is a new In the News feature on the elasticity of supply and demand in the ride-share market, “Passengers May Pay a Lot More. Drivers Won’t Accept Much Less.”

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The Elasticity of Demand a. Definition of elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. b. The Price Elasticity of Demand and Its Determinants i. Definition of price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in price, calculated as the percentage change in quantity demanded divided by the percentage change in price. ii. Determinants of the Price Elasticity of Demand 1. Availability of Close Substitutes: the more substitutes a good has, the more elastic its demand. 2. Necessities and Luxuries: necessities are more price inelastic. 3. Defining the Market Broadly or Narrowly: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food). 4. Time Horizon Matters: goods tend to have more elastic demand over longer time horizons. c. The Price Elasticity of Demand, with Numbers i. Formula % change in quantity demanded Price elasticity of demand % change in price

ii.

Instruction Idea: Work through a few elasticity calculations, starting with the example in the book. For principles of economics courses where there

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application

iii.

is no mathematical prerequisite, this may be difficult for some students. Working through a few simple examples will help to alleviate some of the students’ anxiety. Show every step of the algebra involved. Example: the price of ice cream rises by 10% and quantity demanded falls by 20%. Price elasticity of demand = (20%)/(10%) = 2

iv.

Because there is an inverse relationship between price and quantity demanded (the price of ice cream rose by 10% and the quantity demanded fell by 20%), the price elasticity of demand is sometimes reported as a negative number. We will ignore the minus sign and concentrate on the absolute value of the elasticity. v. Keep in Mind: Students hate this! Explain that it really makes things easier and makes more sense because larger elasticities (in absolute value) imply greater sensitivity and responsiveness. d. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities i. Because we use percentage changes in calculating the price elasticity of demand, the elasticity calculated by going from one point to another on a demand curve will be different from an elasticity calculated by going from the second point to the first. This difference arises because the percentage changes are calculated using a different base. 1. A way around this problem is to use the midpoint method. 2. Using the midpoint method involves calculating the percentage change in either price or quantity demanded by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial level itself. 3. Example: the price rises from $4 to $6 and quantity demanded falls from 120 to 80. % change in price (6 − 4)/5 × 100 40% % change in quantity demanded (120 − 80)/100 x 100 40% price elasticity of demand = 40/40 = 1 Price elasticity of demand e. The Variety of Demand Curves Figure 1 i.

Instruction Idea: To clearly show the differences between relatively elastic and relatively inelastic demand curves, draw a graph showing a relatively flat demand curve and one showing a relatively steep demand curve. Show that any given change in price will result in a larger change in

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application

quantity demanded if the demand curve is relatively flat. Use the same method when discussing the shape of the supply curve later in the chapter. ii. Classification of Elasticity 1. When the price elasticity of demand is greater than one, demand is defined to be elastic. 2. When the price elasticity of demand is less than one, the demand is defined to be inelastic. 3. When the price elasticity of demand is equal to one, the demand is said to have unit elasticity. 4. Instruction Idea: There is a student activity (How the Ball Bounces) that applies to this topic in the "Additional Activities and Assignments” section. iii. In general, the flatter the demand curve that passes through a given point, the more elastic the demand. iv. Extreme Cases 1. When the price elasticity of demand is equal to zero, the demand is perfectly inelastic and is a vertical line. 2. When the price elasticity of demand is infinite, the demand is perfectly elastic and is a horizontal line. 3. Instruction Idea: Make sure that you provide several examples of goods with these types of demand curves. You may want to point out that students will see the perfectly elastic demand curve again when competitive firms are discussed. v. FYI: A Few Elasticities from the Real World 1. Instruction Idea: There is a student activity (Ranking Elasticities) that applies to this topic in the "Additional Activities and Assignments” section. Total Revenue and the Price Elasticity of Demand

Figure 2 i.

ii.

iii.

iv.

Definition of total revenue: the amount paid by buyers and received by sellers of a good, calculated as the price of the good times the quantity sold. Instruction Idea: Another term for price times quantity is “total expenditure.” This term is sometimes used in questions found in the study guide and test bank. It is also important to point this out when discussing the market for illegal drugs at the end of the chapter. Keep in Mind: Students find the relationship between changes in total revenue and elasticity difficult to understand. It may take several thorough discussions of this material before students will be able to master it. If demand is inelastic, the percentage change in price will be greater than the percentage change in quantity demanded.

Figure 3

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application 1. If price rises, quantity demanded falls, and total revenue will rise (because the increase in price will be larger than the decrease in quantity demanded). 2. If price falls, quantity demanded rises, and total revenue will fall (because the fall in price will be larger than the increase in quantity demanded). v. If demand is elastic, the percentage change in quantity demanded will be greater than the percentage change in price. 1. If price rises, quantity demanded falls, and total revenue will fall (because the increase in price will be smaller than the decrease in quantity demanded). 2. If price falls, quantity demanded rises, and total revenue will rise (because the fall in price will be smaller than the increase in quantity demanded). vi. If demand is unit elastic, the percentage change in price will be equal to the percentage change in quantity demanded. 1. If price rises, quantity demanded falls, and total revenue will remain the same (because the increase in price will be equal to the decrease in quantity demanded). 2. If price falls, quantity demanded rises, and total revenue will remain the same (because the fall in price will be equal to the increase in quantity demanded). 3. Instruction Idea: Point out the usefulness of elasticity from a business owner’s point of view. Students should be able to see why a firm’s manager would want to know the elasticity of demand for the firm’s products. g. Elasticity and Total Revenue Along a Linear Demand Curve Figure 4

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application i.

The slope of a linear demand curve is constant, but the elasticity is not. 1. At points with a low price and a high quantity demanded, demand is inelastic. 2. At points with a high price and a low quantity demanded, demand is elastic. ii. Total revenue also varies at each point along the demand curve. 1. Instruction Idea: Note that when demand is elastic and price falls, total revenue rises. Also point out that once demand is inelastic, any further decrease in price results in a decrease in total revenue. h. Other Demand Elasticities i. Definition of income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, calculated as the percentage change in quantity demanded divided by the percentage change in income. 1. Formula Income elasticity of demand

ii.

% change in quantity demanded % change in income

2. Normal goods have positive income elasticities, while inferior goods have negative income elasticities. 3. Alternative Classroom Example: John’s income rises from $20,000 to $22,000 and the quantity of hamburger he buys each week falls from 2 pounds to 1 pound. a. % change in quantity demanded = (1−2)/1.5 x 100 66.67% b. % change in income (22,000 −20,000)/21,000 x 100 9.52% c. income elasticity = 66.67%/9.52% = -7.00 Point out that hamburger is an inferior good for John. 4. Necessities tend to have small income elasticities, while luxuries tend to have large income elasticities. An empirical regularity known as Engel’s Law establishes that as a family’s income rises, the percent of its income spent on food declines, indicating that food is a necessity. Definition of cross-price elasticity of demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good, calculated as the percentage change in the quantity demanded of the first good divided by the percentage change in the price of the second good. 1. Formula % change in quantity demanded of Cross price elasticity of demand % change in price of good 2

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application

XV.

2. Substitutes have positive cross-price elasticities, while complements have negative cross-price elasticities. 3. Alternative Classroom Example: The price of apples rises from $1.00 per pound to $1.50 per pound. As a result, the quantity of oranges demanded rises from 8,000 per week to 9,500. a. % change in quantity of oranges demanded (9,500 − 8,000)/8,750 x 100 = 17.14% b. % change in price of apples (1.50 − 1.00)/1.25 x 100 40% c. cross-price elasticity = 17.14%/40% = 0.43 Because the cross-price elasticity is positive, the two goods are substitutes. 4. Keep in Mind: Make sure that you explain to students why the signs of the income elasticity and the cross-price elasticity matter. This will undoubtedly lead to some confusion because we ignore the sign of the own-price elasticity of demand. You may want to put together a table to present this distinction to students. The Elasticity of Supply a. The Price Elasticity of Supply and Its Determinants i. Definition of price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, calculated as the percentage change in quantity supplied divided by the percentage change in price. ii. Flexibility of sellers: goods that are somewhat fixed in supply (beachfront property) have inelastic supplies. iii. Time horizon: supply is usually more inelastic in the short run than in the long run. b. The Price Elasticity of Supply, with Numbers i. Formula % change in quantity supplied Price elasticity of supply % change in price

ii.

Example: the price of milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month. 1. % change in price = (3.15 – 2.85)/3.00 × 100 = 10% 2. % change in quantity supplied = (11,000 – 9,000)/10,000 × 100 = 20% 3. Price elasticity of supply = (20%)/(10%) = 2 c. The Variety of Supply Curves Figure 5 i. ii.

In general, the flatter the supply curve that passes through a given point, the more elastic the supply. Extreme Cases

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application

iii.

1. When the elasticity is equal to zero, the supply is said to be perfectly inelastic and is a vertical line. 2. When the elasticity is infinite, the supply is said to be perfectly elastic and is a horizontal line. Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied.

Figure 6 iv.

XVI.

Instruction Idea: Again, you may want to present several examples of goods that may have supply curves like these. Three Applications of Supply, Demand, and Elasticity a. Can Good News for Farming Be Bad News for Farmers? Figure 7

i. ii. iii. iv. v.

A new hybrid of wheat is developed that is more productive than those used in the past. What happens? Supply increases, price falls, and quantity demanded rises. If demand is inelastic, the fall in price is greater than the increase in quantity demanded and total revenue falls. If demand is elastic, the fall in price is smaller than the rise in quantity demanded and total revenue rises. In practice, the demand for basic foodstuffs (like wheat) is usually inelastic. 1. This means less revenue for farmers. 2. Because farmers are price takers, they still have the incentive to adopt the new hybrid so that they can produce and sell more wheat. 3. This may help explain why the number of farms has declined so dramatically over the past two centuries. 4. This may also explain why some government policies encourage farmers to decrease the amount of crops planted.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application b. Why Has OPEC Failed to Keep the Price of Oil High? Figure 8

Short Run

Long Run

In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run. Why? ii. The demand and supply of oil are much more inelastic in the short run than the long run. The demand is more elastic in the long run because consumers can adjust to the higher price of oil by carpooling or buying an electric vehicle or a vehicle that gets better mileage. The supply is more elastic in the long run because non-OPEC producers will respond to the higher price of oil by producing more. iii. In the last two decades, fracking has increased supply. In the future, concerns about climate change is expected to reduce demand. c. Does Drug Interdiction Increase or Decrease Drug-Related Crime? i. The federal government increases the number of federal agents devoted to the war on drugs. What happens? 1. The supply of drugs decreases, which raises the price and leads to a reduction in quantity demanded. If demand is inelastic, total expenditure on drugs (equal to total revenue) will increase. If demand is elastic, total expenditure will fall. 2. Thus, because the demand for drugs is likely to be inelastic, drugrelated crime may rise. ii. What happens if the government instead pursued a policy of drug education? 1. The demand for drugs decreases, which lowers price and quantity supplied. Total expenditure must fall (because both price and quantity fall). 2. Thus, drug education should not increase drug-related crime.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application Figure 9 (a) Drug Interdiction

(b) Drug Education

d. In the News: Passengers May Pay a Lot More. Drivers Won’t Accept Less. i. Uber and Lyft passengers are much less price sensitive than Uber and Lyft drivers. ii. If Uber and Lyft are to become profitable, the price of a ride will have to rise rather than the wage of the driver falling. Any reduction in the wage will cause drivers to stop driving. iii. Even if the wage of drivers were to rise, the lack of entry barriers to driving will cause more drivers to enter the market and push the wage back down to the current market rate. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 36. The price elasticity of demand measures how much quantity demanded responds to a change in price. The income elasticity of demand measures how much quantity demanded responds to changes in consumers' income. 37. The determinants of the price elasticity of demand include the availability of close substitutes, whether the good is a necessity or a luxury, the breadth of the definition of the market, and the time horizon. Goods with close substitutes have greater elasticities, luxury goods have greater price elasticities than necessities, goods in more narrowly defined markets have greater elasticities, and the elasticity of demand is greater the longer the time horizon. 38. An elasticity greater than one means that demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application price. When the elasticity equals zero, demand is perfectly inelastic. There is no change in quantity demanded when there is a change in price. 39. Figure 1 presents a supply-and-demand diagram, showing the equilibrium price, P, the equilibrium quantity, Q, and the total revenue received by producers. Total revenue equals the equilibrium price times the equilibrium quantity, which is the area of the rectangle shown in the figure.

Figure 1 40. If demand is elastic, an increase in price reduces total revenue. With elastic demand, the quantity demanded falls by a greater percentage than the price rises. As a result, total revenue moves in the opposite direction as the price. Thus, if price rises, total revenue falls. 41. A good with income elasticity less than zero is called an inferior good because as income rises, the quantity demanded declines. 42. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. It measures how much quantity supplied responds to changes in price. 43. If a fixed quantity of a good is available and no more can be made, the price elasticity of supply is zero. Regardless of the percentage change in price, there will be no change in the quantity supplied. 44. Destruction of half of the fava bean crop is more likely to hurt fava bean farmers if the demand for fava beans is very elastic. Destruction of half of the crop causes the supply curve to shift to the left resulting in a higher price of fava beans. When demand is very elastic, an increase in price leads to a decrease in total revenue because the decrease in quantity demanded outweighs the increase in price.

PROBLEMS AND APPLICATIONS 32. a. Mystery novels have more elastic demand than required textbooks because mystery novels have close substitutes and are a luxury good, while required textbooks are a necessity with no close substitutes. If the price of mystery novels were to rise, readers could substitute other types of novels, or buy fewer novels altogether. But if

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application the price of required textbooks were to rise, students would have little choice but to pay the higher price. Thus, the quantity demanded of required textbooks is less responsive to price than the quantity demanded of mystery novels. b. Billie Eilish recordings have more elastic demand than pop music recordings in general. Billie Eilish recordings are a narrower market than pop music recordings, so it is easier to find close substitutes for them. If the price of Billie Eilish recordings were to rise, people could substitute other pop recordings, like Olivia Rodrigo. But if the price of all pop recordings were to rise, substitution would be more difficult. (A transition from pop music to classical is unlikely!) Thus, the quantity demanded of pop recordings is less responsive to price than the quantity demanded of Billie Eilish recordings. c. Subway rides during the next five years have more elastic demand than subway rides during the next six months. Goods have a more elastic demand over longer time horizons. If the fare for a subway ride was to rise temporarily, consumers could not switch to other forms of transportation without great expense or great inconvenience. But if the fare for a subway ride was to remain high for a long time, people would gradually switch to alternative forms of transportation. As a result, the quantity demanded of subway rides during the next six months will be less responsive to changes in the price than the quantity demanded of subway rides during the next five years. d. Root beer has more elastic demand than water. Root beer is a luxury with close substitutes, while water is a necessity with no close substitutes. If the price of water were to rise, consumers have little choice but to pay the higher price. But if the price of root beer were to rise, consumers could easily switch to other sodas or beverages. So the quantity demanded of root beer is more responsive to changes in price than the quantity demanded of water. 33. a. For business travelers, the price elasticity of demand when the price of tickets rises from $200 to $250 is [(2,000 – 1,900)/1,950]/[(250 – 200)/225] = 0.05/0.22 = 0.23. For vacationers, the price elasticity of demand when the price of tickets rises from $200 to $250 is [(800 – 600)/700] / [(250 – 200)/225] = 0.29/0.22 = 1.32. b. The price elasticity of demand for vacationers is higher than the elasticity for business travelers because vacationers can choose a substitute more easily than business travelers. For example, vacationers can choose a different mode of transportation (like driving or taking the train), a different destination, a different departure date, and a different return date. They may also choose to not travel at all. Business travelers are less likely to do so because their schedules are less adaptable. 34. a. The percentage change in price is equal to (2.20 – 1.80)/2.00) x 100 = 20%. If the price elasticity of demand is 0.2, quantity demanded will fall by 4% in the short run [0.20 x 0.20]. If the price elasticity of demand is 0.7, quantity demanded will fall by 14% in the long run [0.7 x 0.2]. b. Over time, consumers can make adjustments to their homes by purchasing alternative heat sources such as natural gas or electric furnaces. Thus, they can respond more easily to the change in the price of heating oil in the long run than in the short run.

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application 35. If quantity demanded fell, price must have increased according to the law of demand. For a price increase to increase total revenue, the percentage increase in the price must be greater than the percentage decline in quantity demanded. Therefore, demand is inelastic. 36. a. The effect on the market for coffee beans is shown in Figure 2. When a hurricane destroys half of the crop, the supply of coffee beans decreases, the price of coffee beans increases, and the quantity decreases.

Figure 2 b. The effect on the market for cups of coffee is shown in Figure 2. When the price of coffee beans, an important input into the production of a cup of coffee, increases, the supply of cups of coffee decreases, the price of a cup of coffee increases, and the quantity decreases. Because cups of coffee have an inelastic demand, when the price of a cup of coffee increases, the total expenditure on coffee increases. c. The effect on the market for donuts is shown in Figure 3. When the price of coffee increases and the quantity demanded of coffee decreases, consumers demand fewer donuts because coffee and donuts are complements. When demand decreases, the price of donuts decreases. Because donuts have an inelastic demand, when the price of donuts decreases, the total expenditure on donuts decreases.

Figure 3 37. If the price of Aspirin rose sharply while the quantity sold remained the same, the explanations offered by Meredith, Miranda, and Owen could be correct while the

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application explanations offered by Alex and Richard are incorrect. See Figures 4-8 below for illustrations of each explanation. Price of aspirin

Price of aspirin

D 2

D1 Quantity of aspirin

Quantity of aspirin

Figure 4: Meredith’s Explanation

Price of aspirin

Figure 5: Alex’s Explanation

Price of aspirin

D 2

Quantity of aspirin

Figure 6: Miranda’s Explanation

Price of aspirin

Quantity of aspirin

Figure 7: Richard’s Explanation

S2 S1

Quantity of aspirin

Figure 8: Owen’s Explanation In Figure 4, supply is perfectly inelastic and demand increased. As a result, the quantity remained the same but price increased so Meredith’s explanation could be correct. In Figure 5, demand is perfectly inelastic and it increased. As a result, both the price and quantity increased so Alex’s explanation cannot be correct. In Figure 6, demand increased and supply decreased. If demand increased and supply decreased by the same magnitude, price increased and quantity remained the same, as shown, so Miranda’s explanation could be correct. In Figure 7, demand is unit elastic and supply decreased. As a result, the quantity

Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application decreased and the price increased so Richard’s explanation cannot be correct. In Figure 8, demand is perfectly inelastic and supply decreased. As a result, price increased and quantity remained constant so Owen’s explanation could be correct. 38. a. If your income is $20,000, your price elasticity of demand as the price of pizzas rises from $8 to $10 is [(40 – 32)/36]/[(10 – 8)/9] =0.22/0.22 = 1. If your income is $24,000, the elasticity is [(50 – 45)/47.5]/[(10 – 8)/9] = 0.11/0.22 = 0.5. b. If the price is $12, your income elasticity of demand as your income increases from $20,000 to $24,000 is [(30 – 24)/27]/[(24,000 – 20,000)/22,000] = 0.22/0.18 = 1.22. If the price is $16, your income elasticity of demand as your income increases from $20,000 to $24,000 is [(12 – 8)/10]/[(24,000 – 20,000)/22,000] = 0.40/0.18 = 2.22. 39. a. The percentage change in price (using the midpoint formula) is (1.50 – 1.25)/(1.375) × 100% = 18.18%. Therefore, the price elasticity of demand is 4.3/18.18 = 0.24, which is very inelastic. b. Because the demand is inelastic, the Transit Authority's revenue rises when the fare rises. c. The elasticity estimate might be unreliable because it is only the first month after the fare increase. As time goes by, people may switch to other means of transportation in response to the price increase. So the elasticity may be larger in the long run than it is in the short run. 40. Thelma's price elasticity of demand is zero, because she wants the same quantity regardless of the price. Louise's price elasticity of demand is one, because she spends the same amount on gas, no matter what the price, which means her percentage change in quantity is equal to the percentage change in price. 41. a. With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20% requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes currently $5, this would require an increase in the price to $8.33 a pack using the midpoint method (note that ($8.33 – $5)/$6.67 = .50). b. The policy will have a larger effect five years from now than it does one year from now. The elasticity is larger in the long run, because it may take some time for people to reduce their cigarette usage. The habit of smoking is hard to break in the short run. c. Because teenagers do not have as much income as adults, they are likely to have a higher price elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult to reduce their quantity demanded in response to a higher price. 42. To determine whether you should increase or decrease the price of admission, you need to know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of admission will increase total revenue. If demand is inelastic, an increase in the price of admission will cause total revenue to rise. 43. A worldwide drought could increase the total revenue of farmers if the price elasticity of demand for grain is inelastic. The drought reduces the supply of grain, but if demand is inelastic, the reduction of supply causes a large increase in price. Total farm revenue would

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 5: Elasticity and Its Application rise as a result. If there is only a drought in Kansas, Kansas’ production is not a large enough proportion of the total farm product to have much impact on the price. As a result, price does not change (or changes by only a slight amount), while the output by Kansas farmers declines, thus reducing their income.

VII.

[In-class demonstration] How the Ball Bounces: 1 minute total. Works in any class size. Topics include elastic and inelastic. Materials needed are one rubber ball and one “dead ball” where the “dead” ball is made of shock-absorbing material and doesn’t bounce (museum stores and magic shops carry them). I. Purpose: This quick, but memorable, demonstration can be used to introduce the concepts of elastic and inelastic. J. Instructions: Bring two students to the front of the class. Give each of them a ball and ask them to bounce it off the floor and catch it. The student with the rubber ball can do this easily. The student with the “dead” ball will not be able to bounce it high enough to catch, no matter how hard they throw it. Explain that one ball is elastic; it is responsive to change. The other ball is inelastic; it responds very little to change. These physical properties of elastic and inelastic are analogous to the economic concepts of elastic and inelastic. [In-class assignment] Ranking Elasticities: 20 minutes total. Works in any class size. Topics include the determinants of price elasticity of demand. a. Purpose: The intent of this exercise is to get students to think about varying degrees of elasticity and the factors that determine demand elasticity. b. Instructions: Give the students the following list of goods. Ask them to rank them from most to least elastic. 1. beef 2. salt 3. European vacation 4. steak 5. new Honda Accord 6. Dijon mustard If they have difficulty, these hints can be helpful: 1. How narrowly defined is the market? 2. What substitutes are available for the good? 3. Do consumers think of this good as a necessity or a luxury? c. Common Answers and Points for Discussion: A typical ranking: i. European vacation (luxury, many other vacation destinations) ii. new Honda Accord (narrowly defined, many substitutes including used cars) iii. steak (perceived luxury, other cuts of beef are close substitutes)

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies iv. v. vi.

Dijon mustard (perceived luxury, many close substitutes) beef (pork and chicken are substitutes) salt (necessity, no close substitutes)

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Elasticity and Price Elasticity of Demand o Concept Clip: Cross Price Elasticity o Video Problem Walk-Through: Calculating Price Elasticity of Demand and Income Elasticity of Demand Using the Midpoint Method o Video Problem Walk-Through: Using Income Elasticity and Cross-Price Elasticity of Demand to Determine Changes in Demand o Video Problem Walk-Through: Calculating Price Elasticity of Demand and Income Elasticity of Demand When Spending Is a Constant Percentage of Income o Video Problem Walk-Through: Should a Firm Raise or Lower Its Price to Increase Total Revenue? o Areas o Equivalency of Fractions, Decimals, and Percentages o Graphing Basics o Graphing Linear Equations o Percentage Change o Slope of a Line o Video Quiz: Determinants of Price Elasticity of Demand o Video Quiz: Calculation of the Price Elasticity of Demand o Video Quiz: Interpretation of Elasticity Values and Demand Curves o Video Quiz: Income Elasticity and Cross-Price Elasticity of Demand o Video Quiz: Relationship between Total Revenue and the Price Elasticity of Demand

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 104

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies Chapter Objectives ........................................................................................................................................... 104 Complete List of Chapter Activities and Assessments ......................................................................... 105 Key Terms ........................................................................................................................................................... 106 What's New in This Chapter .......................................................................................................................... 106 Chapter Outline ................................................................................................................................................. 106 Solutions to Text Problems ........................................................................................................................... 113 Questions for Review ................................................................................................................................................... 113 Problems and Applications ........................................................................................................................................ 114 Additional Activities and Assignments ..................................................................................................... 118 Additional Resources ...................................................................................................................................... 119 Cengage Video Resources ........................................................................................................................................... 119

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 6 is the third chapter in a three-chapter sequence that deals with supply and demand and how markets work. Chapter 4 developed the model of supply and demand. Chapter 5 added precision to the model of supply and demand by developing the concept of elasticity—the sensitivity of the quantity supplied and quantity demanded to changes in economic conditions. Chapter 6 addresses the impact of government policies on competitive markets using the tools of supply and demand that you learned in Chapters 4 and 5. The purpose of Chapter 6 is to consider two types of government policies—price controls and taxes. Price controls set the maximum or minimum price at which a good can be sold while a tax creates a wedge between what the buyer pays and what the seller receives. These policies can be analyzed within the model of supply and demand. We will find that government policies sometimes produce unintended consequences. Key points addressed in this chapter: 



 



A price ceiling is a legal maximum on the price of a good or service. Rent control is an example. If the ceiling is below the equilibrium price, then it is binding, and the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must somehow ration the good or service among buyers. A price floor is a legal minimum on the price of a good or service. The minimum wage is an example. If the price floor is above the equilibrium price, then it is binding, and the quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers’ demands for the good or service must somehow be rationed among sellers. When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a market shrinks the market’s size. A tax on a good places a wedge between the price paid by buyers and the price received by sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers receive less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the division of the tax burden) does not depend on whether the tax is levied on buyers or sellers. The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden falls on the side of the market that is less elastic because that side of the market cannot respond as easily to the tax by changing the quantity bought or sold.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Determine the impact of price controls on economic welfare using the supply and demand model.



Determine if a price control is a price ceiling or a price floor using the supply and demand model.



Determine if a price control is binding using the supply and demand model.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies 

Determine the amount of shortage or surplus generated by a price control using the supply and demand model.



Describe the unintended consequences of rent control using the supply and demand model.

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Explain how a change in a labor supply determinant impacts labor supply.

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Identify the tax incidence on consumers and producers for a given market.

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Determine the impact of a tax on the equilibrium price and quantity in a market.

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Analyze the relationship between elasticity and tax burden.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Ask the Experts 1 Ask the Experts 2 Active Learning 2 Think-Pair-Share Activity Self-Assessment Section 06-1 QuickQuiz Section 06-2 QuickQuiz ConceptClip: Price Floor and Price Ceiling Figure 1: A Market with a Price Ceiling Figure 2: The Market for Gasoline with a Price Ceiling Figure 4: A Market with a Price Floor Figure 6: A Tax on Sellers Figure 7: A Tax on Buyers Figure 9: How the Burden of a Tax Is Divided Chapter 06 Problems & Applications Chapter 06 A+ Test Prep Chapter 06 News Analysis: Should the Minimum Wage Increase? Chapter 06 News Analysis: Rent Rates, Vacancies, and Rent Controls Chapter 06 Homework

PPT Slide 8 PPT Slide 14 PPT Slide 19 PPT Slide 21 PPT Slide 39 PPT Slide 40 MindTap eBook MindTap eBook MindTap Learn It Folder

5–10 mins. 10–15 mins. 10–15 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 5 mins. 5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

35–45 mins. N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

20–30 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies Chapter 06 Quiz: Supply, Demand, and Government Policies

MindTap Apply It Folder

20–30 mins.

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KEY TERMS Price Ceiling: a legal maximum on the price at which a good can be sold. Price Floor: a legal minimum on the price at which a good can be sold. Tax Incidence: the manner in which the burden of a tax is shared among participants in a market. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:   

The Case Study on “The Minimum Wage” is updated. There is a new Ask the Experts feature on the minimum wage. There is a new In the News feature addressing the question: Should the Minimum Wage Be $15 an hour? “Raising the Minimum Wage will Definitely Cost Jobs.”

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Controls on Prices a. Definition of price ceiling: a legal maximum on the price at which a good can be sold. b. Definition of price floor: a legal minimum on the price at which a good can be sold. c. How Price Ceilings Affect Market Outcomes i. There are two possible outcomes if a price ceiling is put into place in a market. 1. If the price ceiling is higher than or equal to the equilibrium price, it is not binding and has no effect on the price or quantity sold. 2. If the price ceiling is lower than the equilibrium price, the ceiling is a binding constraint and a shortage is created. Figure 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies

ii. iii. iv.

If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for rationing the good must develop. Not all buyers benefit from a price ceiling because some will be unable to purchase the product. Case Study: How to Create Long Lines at the Gas Pump

Figure 2

1. In 1973, OPEC raised the price of crude oil, which led to a reduction in the supply of gasoline. 2. The federal government put a price ceiling into place and this created large shortages. 3. Motorists were forced to spend large amounts of time in line at the gas pump (which is how the gas was rationed). 4. Eventually, the government realized its mistake and repealed the price ceiling. 5. Alternative Classroom Example: Ask students about the rental market in their town. Draw a supply-and-demand graph for twobedroom apartments asking students what they believe the equilibrium rental rate is. Then suggest that the city council is accusing landlords of taking advantage of students and thus places a price ceiling below the equilibrium price. Make sure that students can see that a shortage of apartments would result. Ask students to identify the winners and losers of this government policy. Case Study: Why Rent Control Causes Housing Shortages, Especially in the Long Run

Figure 3 1. The goal of rent control is to make housing more affordable for the poor.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies 2. Because the supply of apartments is fixed (perfectly inelastic) in the short run and upward sloping (elastic) in the long run, the shortage is much larger in the long run than in the short run. 3. Rent-controlled apartments are rationed in a number of ways including long waiting lists, discrimination against minorities and families with children, and even under-the-table payments to landlords. 4. The quality of apartments also suffers due to rent control. vi. Ask the Experts: Rent Control 1. 95 percent of economic experts disagreed that local ordinances imposing rent control have had a positive effect over the past three decades on the amount and quality of affordable rental housing. d. How Price Floors Affect Market Outcomes i. There are two possible outcomes if a price floor is put into place in a market. Figure 4

ii.

1. If the price floor is lower than or equal to the equilibrium price, it is not binding and has no effect on the price or quantity sold. 2. If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created. 3. Alternative Classroom Example: Go through an example with an agricultural price support. Show students that, even though a price support is not a legal minimum price, its result is exactly the same as a price floor. Make sure that students can see that a surplus will result. Ask students to identify the winners and losers of this government policy. Make sure that you also point out the costs of the program (purchasing the surplus and storing it). Case Study: Controversies Over the Minimum Wage

Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies 1. A competitive market for labor looks like any other competitive market: downward-sloping demand, upward-sloping supply, an equilibrium price (called a wage), and an equilibrium quantity of labor hired. 2. If the minimum wage is above the equilibrium wage in the labor market, a surplus of labor will develop (unemployment). 3. The minimum wage will be a binding constraint only in markets where equilibrium wages are low. 4. Thus, the minimum wage will have its greatest impact on the market for teenagers and other unskilled workers. 5. The long-run effect of a minimum wage on unemployment is likely to be larger than the short-run effect. 6. Some economists argue that the labor market is not a competitive market, so the predictions of unemployment from a minimum wage are exaggerated. However, the Congressional Budget Office forecasts an outcome of a $15 per hour minimum wage that aligns with the predictions of the competitive model. iii. Ask the Experts: The Minimum Wage 1. Economic experts’ opinions are somewhat divided on the effects of an increase in the minimum wage. 2. When asked if they thought that a federal minimum wage of $15 per hour would lower employment of low wage workers in some states, 50 percent of economists agreed, 16 percent disagreed, and 34 percent were uncertain. e. Evaluating Price Controls i. Because most economists feel that markets are usually a good way to organize economic activity, most oppose the use of price ceilings and floors. 1. Prices balance supply and demand and thus coordinate economic activity. 2. If prices are set by laws, they obscure the signals that efficiently allocate scarce resources. 3. Instruction Idea: This is a good chance to reinforce the principle “Markets are usually a good way to organize economic activity.” ii. Price ceilings and price floors often hurt the people they are intended to help. 1. Rent controls create a shortage of quality housing and provide disincentives for building maintenance. 2. Minimum wage laws create higher rates of unemployment for teenage and low skilled workers. 3. Instruction Idea: Be prepared to answer the question, “If price controls have such adverse consequences, why are they imposed?” You may want to point out that, sometimes, economic ignorance leads to unintended outcomes. You may also want to point out that economic analysis serves as only a guide to policymakers. They may choose to ignore it when forming policy. In addition, it is often

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XVIII.

interesting to encourage the students to think about the distributional effects of these government programs. iii. In the News: Should the Minimum Wage be $15 an Hour? “Raising the Minimum Wage will Definitely Cost Jobs.” 1. 79% of the reputable studies on the impact of minimum wages on employment find that minimum wages generate is a negative impact on employment. On average, the studies suggest that a $15 per hour minimum wage would reduce low-skilled employment by 16%. 2. Many economists argue that there are better ways to guarantee a minimally acceptable standard of living such as the Earned Income Tax Credit. 3. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. 4. Instruction Idea: Examples of unit taxes include most government excise taxes on products such as gasoline, alcohol, and tobacco. 5. Instruction Idea: Use this chance to reinforce the three steps learned in Chapter 4. Students should decide whether this tax law affects the demand curve or the supply curve, decide which way it shifts, and then examine how the shift affects equilibrium price and quantity. The Surprising Study of Tax Incidence a. Definition of tax incidence: the manner in which the burden of a tax is shared among participants in a market. b. How Taxes on Sellers Affect Market Outcomes i. If the government requires the seller to pay a certain dollar amount for each unit of a good sold, this will cause a decrease in supply. ii. The supply curve will shift upward by the exact amount of the tax. Figure 6

iii.

Keep in Mind: You will want to be very careful when discussing the “upward” shift of the supply curve given that we encourage students to

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies think of supply and demand curves shifting “right” and “left.” Make sure to emphasize the effects of the tax on sellers’ willingness to sell. iv. The quantity of the good sold will decline. v. Buyers and sellers will share the burden of the tax; buyers pay more for the good (including the tax) and sellers receive less. vi. Two lessons can be learned here. 1. Taxes discourage market activity. 2. Buyers and sellers share the burden of a tax. c. How Taxes on Buyers Affect Market Outcomes i. If the government requires the buyer to pay a certain dollar amount for each unit of a good purchased, this will cause a decrease in demand. ii. The demand curve will shift downward by the exact amount of the tax. iii. Keep in Mind: Again, be very careful when discussing the “downward” shift of the demand curve. Describe the effects of the tax on buyers’ willingness to buy. Figure 7

iv. v.

The quantity of the good sold will decline. Buyers and sellers will share the burden of the tax; buyers pay more for the good and sellers receive less (because of the tax). vi. Instruction Idea: Stress that the outcome of a tax levied on sellers is exactly the same as the outcome of a tax levied on buyers. When drawing this in class, make sure that the price that buyers end up paying and the price that sellers end up receiving is the same in both examples. d. Case Study: Can Congress Distribute the Burden of a Payroll Tax? Figure 8 i.

FICA (Social Security) taxes were designed so that firms and workers would equally share the burden of the tax.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies ii.

This type of payroll tax will simply put a wedge between the wage the firm pays and the wage the workers will receive. iii. It is true that firms and workers share the burden of this tax, but it is not necessarily 50-50. iv. Keep in Mind: Go through this material slowly. Make sure that students can see how to find the burden of the tax paid by consumers and the burden of the tax paid by producers before discussing the effects of elasticity on tax incidence. If you rush through this material, you will lose them. e. Elasticity and Tax Incidence i. When supply is elastic and demand is inelastic, the largest share of the tax burden falls on consumers. ii. When supply is inelastic and demand is elastic, the largest share of the tax burden falls on producers. iii. In general, a tax burden falls more heavily on the side of the market that is less elastic. 1. A small elasticity of demand means that buyers do not have good alternatives to consuming this product. 2. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. Figure 9

iv.

Case Study: Who Pays the Luxury Tax? 1. In 1990, Congress adopted a luxury tax. 2. The goal of the tax was to raise revenue from those who could most easily afford to pay. 3. Because the demand for luxuries is often relatively more elastic than supply, the burden of the tax fell on producers and their middle-class workers, not on rich consumers.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 45. An example of a price ceiling is the rent control system in New York City. An example of a price floor is the minimum wage. Many other examples are possible. 46. A shortage of a good arises when there is a binding price ceiling. A binding price ceiling is one that is placed below the market equilibrium price. This leads to a shortage because quantity demanded exceeds quantity supplied. See Figure 3.

Figure 3 47. When the price of a good is not allowed to bring supply and demand into equilibrium, some alternative mechanism must allocate resources. If quantity supplied exceeds quantity demanded, so that there is a surplus of a good as in the case of a binding price floor, sellers may try to appeal to the personal biases of the buyers. If quantity demanded exceeds quantity supplied, so that there is a shortage of a good as in the case of a binding price ceiling, sellers can ration the good according to their personal biases, or make buyers wait in line. 48. Economists frequently oppose controls on prices because prices have the crucial job of coordinating economic activity by balancing demand and supply. When policymakers set controls on prices, they obscure the signals that guide the allocation of society’s resources. Furthermore, price controls often hurt those they are trying to help. 49. Removing a tax paid by buyers and replacing it with a tax paid by sellers raises the price that buyers pay sellers by the amount of the tax, has no effect on the amount buyers are out of pocket, has no effect on the amount sellers receive net of any tax payments they make, increases the price received by sellers, and has no effect on the quantity of the good sold. 50. A tax on a good raises the price buyers pay, lowers the price sellers receive, and reduces the quantity sold.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies 51. The burden of a tax is divided between buyers and sellers depending on the elasticities of demand and supply. Elasticity represents the willingness of buyers or sellers to leave the market, which in turns depends on their alternatives. When a good is taxed, the side of the market with fewer alternatives cannot easily leave the market and thus bears more of the burden of the tax.

PROBLEMS AND APPLICATIONS 44. If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded exceeds quantity supplied, so there will be a shortage of tickets. The policy decreases the number of people who can attend, because the quantity supplied is lower because of the lower price. 45. a. The imposition of a binding price floor in the cheese market is shown in Figure 4. In the absence of the price floor, the price would be P1 and the quantity would be Q1. With the floor set at Pf, which is greater than P1, the quantity demanded is Q2, while quantity supplied is Q3, so there is a surplus of cheese in the amount Q3 – Q2.

Figure 4

46.

b. The producers’ complaint that their total revenue has declined is correct if demand is elastic. With elastic demand, the percentage decline in quantity would exceed the percentage rise in price, so total revenue would decline. c. If the government purchases all the surplus cheese at the price floor, producers benefit and taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue would increase substantially. However, consumers would buy only quantity Q2 of cheese, so they are in the same position as before. Taxpayers lose because they would be financing the purchase of the surplus cheese through higher taxes. a. The equilibrium price of Frisbees is $8 and the equilibrium quantity is six million Frisbees.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies

47.

b. With a price floor of $10, the new market price is $10 because the price floor is binding. At that price, only two million Frisbees are sold, because that is the quantity demanded. c. If there’s a price ceiling of $9, it has no effect, because the market equilibrium price is $8, which is below the ceiling. So the market price is $8 and the quantity sold is six million Frisbees. a. Figure 5 shows the market for beer without the tax. The equilibrium price is P1 and the equilibrium quantity is Q1. The price paid by consumers is the same as the price received by producers, P1.

Figure 5

Figure 6

b. When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown in Figure 6. The price paid by consumers is P2, while the price received by producers is P2 – $2. The difference between the price paid by consumers and the price received by producers is the $2 tax. The quantity of beer sold declines to Q2. 48. Raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by workers would not make workers better off, because the division of the burden of a tax depends on the elasticity of supply and demand and not on who must pay the tax. Because the tax wedge would be larger, it is likely that both firms and workers, who share the burden of any tax, would be worse off. 49. The price will rise by less than $500. The burden of any tax is shared by both producers and consumersthe price paid by consumers rises and the price received by producers falls, with the difference between the two equal to the amount of the tax. The only exceptions would be if the supply curve were perfectly elastic or the demand curve were perfectly inelastic, in which case consumers would bear the full burden of the tax and the price paid by consumers would rise by exactly $500. 50. a. It does not matter whether the tax is imposed on producers or consumersthe effect will be the same. With no tax, as shown in Figure 7, the demand curve is D1 and the supply curve is S1. If the tax is imposed on producers, the supply curve shifts

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies left by the amount of the tax (50 cents) to S2. Then the equilibrium quantity is Q2, the price paid by consumers is P2, and the price received (after taxes are paid) by producers is P2 – 50 cents. If the tax is instead imposed on consumers, the demand curve shifts left by the amount of the tax (50 cents) to D2. The leftward shift in the demand curve (when the tax is imposed on consumers) is exactly the same magnitude as the leftward shift in the supply curve when the tax is imposed on producers. So again, the equilibrium quantity is Q2, the price paid by consumers is P2 (including the tax paid to the government), and the price received by producers is P2 – 50 cents.

Figure 7

51.

Figure 8

b. The more elastic the demand curve is, the more effective this tax will be in reducing the quantity of gasoline consumed. Greater elasticity of demand means that quantity falls more in response to the rise in the price. Figure 8 illustrates this result. Demand curve D1 represents an elastic demand curve, while demand curve D2 is more inelastic. The tax will cause a greater decline in the quantity sold when demand is elastic. c. The consumers of gasoline are hurt by the tax because they get less gasoline at a higher price. d. Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline being produced, some workers may lose their jobs. With a lower price received by producers, wages of workers might decline.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies a. Figure 9 shows the effects of the minimum wage. In the absence of the minimum wage, the market wage would be w1 and Q1 workers would be employed. With the minimum wage (wm) imposed above w1, the market wage is wm, the number of employed workers is Q2, and the number of workers who are unemployed is Q3 − Q2. Total wage payments to workers are shown as the area of rectangle ABCD, which equals wm times Q2.

Figure 9 b. An increase in the minimum wage would decrease employment. The size of the effect on employment depends only on the elasticity of demand. The elasticity of supply does not matter, because there is a surplus of labor. c. The increase in the minimum wage would increase unemployment. The size of the rise in unemployment depends on both the elasticities of supply and demand. The elasticity of demand determines the change in the quantity of labor demanded, the elasticity of supply determines the change in the quantity of labor supplied, and the difference between the quantities supplied and demanded of labor is the amount of unemployment. d. If the demand for unskilled labor were inelastic, the rise in the minimum wage would increase total wage payments to unskilled labor. With inelastic demand, the percentage decline in employment would be lower than the percentage increase in the wage, so total wage payments increase. However, if the demand for unskilled labor were elastic, total wage payments would decline, because then the percentage decline in employment would exceed the percentage increase in the wage. 52. Since the supply of seats is perfectly inelastic, the entire burden of the tax will fall on the team’s owners. Figure 11 shows that the price the buyers pay for the tickets will fall by the exact amount of the tax.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies

Figure 11 53. a. Solve for the equilibrium price and quantity by setting the quantity supplied equal to the quantity demanded: 2P = 300 – P; 3P = 300; P = $100. When the equilibrium price is $100, the equilibrium quantity is 2(100) = 200. b. If the government imposes a price ceiling of $90, a shortage develops. The ceiling is below the equilibrium price so it is a binding price ceiling. At the ceiling price of $90, the quantity supplied is 2(90) = 180 units and the quantity demanded is 300 – 90 = 210 units. Consumers want to buy 30 more units than producers want to sell at the price ceiling. c. If the government imposes a price floor of $90, neither a shortage nor a surplus develops. The floor is lower than the equilibrium price so it is not a binding price floor. With a price floor of $90, the equilibrium price of $100 will prevail. The quantity supplied and demanded will be the equilibrium quantity of 200 units. d. If the government levies a $30 tax on producers, neither a shortage nor a surplus develops, but the quantity exchanged is smaller than without the tax. Using the new supply curve, 2(P-30) = 300 – P; 2P-60 = 300 – P; 3P = 360; P = $120 and Q= 300120=180. The price buyers pay is $120. Producers retain $90 per unit after submitting the $30 tax. The quantity demanded and supplied is 180 units.

[In-class demonstration] Ducks in a Row: 10 minutes total. Works in any class size. Topics include price ceilings, subsidies, and unintended consequences. Materials needed include 2 toy ducks, some play money, and 3 volunteers. K. Purpose: This demonstration illustrates some common problems of government intervention in markets. L. Instructions: One volunteer plays the role of the government in a poor country. Give the play money to the “government,” except for $1. The government uses this

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 6: Supply, Demand, and Government Policies money to buy ducks from the farmer and provides the ducks to the shopkeeper. The second volunteer is an urban shopkeeper. The shopkeeper asks the government for more ducks whenever they are sold out. Give the shopkeeper one duck. The third volunteer is a consumer. The consumer buys ducks. Give the consumer $1 in play money. The instructor is a duck farmer. The farmer keeps the second duck. Explain this background: “Ducks are a staple food in this country but they are expensive at $3 each. The government wants to make food cheap for the urban poor to alleviate hunger. They calculate people could afford ducks if they were priced at $1. The government decides to impose a price ceiling of $1; $1 is now the maximum retail price for ducks.” Start the game. The consumer buys one duck from the shopkeeper. The shopkeeper requests more ducks from the government. The government comes to the farmer. M. Points for Discussion: The instructor, as the duck farmer, controls the game. There are three points to make in this demonstration: 5. Shortage. The farmer refuses to sell ducks at $1 each. The shopkeeper has no ducks. 6. Subsidy. The farmer offers to sell the ducks for $3. The ducks can then be sold in the marketplace for $1. The government pays a $2 subsidy to keep food prices low. 7. Black markets. After the farmer sells the duck to the government for $3, the duck goes to the shopkeeper for $1. The farmer buys back the original duck for $1 and resells it to the government for $3. This can continue until the government runs out of money. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Price Floor and Price Ceiling o Video Problem Walk-Through: Analyzing the Impact of a Binding Price Floor on a Market o Video Problem Walk-Through: Determining Changes in Equilibrium Price and Quantity after a Price Ceiling Is Imposed o Video Problem Walk-Through: Using a Supply-and-Demand Diagram to Illustrate the Effect of a Tax o Video Problem Walk-Through: Using Elasticity to Determine the Burden of a Tax on Buyers and Sellers o Equation Basics o Graphing Basics o Graphing Linear Equations

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets [return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

121

Complete List of Chapter Activities and Assessments Key Terms

122

123

What's New in This Chapter 123 Chapter Outline

123

Solutions to Text Problems 131 Questions for Review ................................................................................................................................................... 131 Problems and Applications ........................................................................................................................................ 131 Additional Activities and Assignments

140

Additional Resources141 Cengage Video Resources ........................................................................................................................................... 141

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 7 is the first chapter in a three-chapter sequence on welfare economics and market efficiency. Chapter 7 employs the supply and demand model to develop consumer surplus and producer surplus as a measure of welfare and market efficiency. These concepts are used in Chapters 8 and 9 to determine the winners and losers from taxation and restrictions on international trade. The purpose of Chapter 7 is to develop welfare economics—the study of how the allocation of resources affects economic well-being. Chapters 4 through 6 employed supply and demand in a positive framework, which focused on the question, “What is the equilibrium price and quantity in a market?” This chapter now addresses the normative question, “Is the equilibrium price and quantity in a market the best possible solution to the resource allocation problem, or is it simply the price and quantity that balance supply and demand?” Students will discover that under most circumstances the equilibrium price and quantity is also the one that maximizes welfare. Key points addressed in this chapter: 



Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay, and it measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve and above the price. Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding the area below the price and above the supply curve. An allocation of resources that maximizes total surplus (the sum of consumer and producer surplus) is said to be efficient. Policymakers are often concerned with the efficiency, as well as the equality, of economic outcomes. The equilibrium of supply and demand in a competitive market maximizes total surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. Markets do not allocate resources efficiently in the presence of market failures such as market power or externalities.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Assess a market's efficiency.



Given a supply and demand graph, indicate the area that represents consumer surplus.



Given a scenario describing buyers' willingness to pay, compute consumer surplus in a market.



Derive the demand curve for a good from a group of buyers' willingness to pay for that good.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets 

Given a scenario describing sellers' costs, compute producer surplus in a market.



Determine the market supply curve for a good by summing two or more individual supply curves.



Given a supply and demand graph, indicate the area that represents producer surplus.



Explain why the equilibrium quantity in a competitive market maximizes total surplus in that market.



Explain the difference between efficiency and equality.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Active Learning 2 Ask the Experts Think-Pair-Share Activity Section 07-1 QuickQuiz Section 07-2 QuickQuiz Section 07-3 QuickQuiz ConceptClip: Consumer Surplus ConceptClip: Producer Surplus Figure 2: Measuring Consumer Surplus with the Demand Curve Figure 3: How Price Affects Consumer Surplus Figure 5: Measuring Producer Surplus with the Supply Curve Figure 6: How Price Affects Producer Surplus Figure 7: Consumer and Producer Surplus in the Market Equilibrium Chapter 07 Problems & Applications Chapter 07 A+ Test Prep Chapter 07 News Analysis: Do You "Appreciate" Wendy's Super Value Menu? Chapter 07 News Analysis: Go for

PPT Slide PPT Slide 26 PPT Slide PPT Slide 41 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

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MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder

55–65 mins.

MindTap Study It Folder MindTap Apply It Folder

N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets the Video Bonus Chapter 07 Homework Chapter 07 Quiz: Consumers, Producers, and the Efficiency of Markets

MindTap Apply It Folder MindTap Apply It Folder

30–40 mins. 20–30 mins.

[return to top]

KEY TERMS Consumer Surplus: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. Cost: the value of everything a seller must give up to produce a good. Efficiency: the property of a resource allocation of maximizing the total surplus received by all members of society. Equality: the property of distributing economic prosperity uniformly the members of society. Producer Surplus: the amount a seller is paid for a good minus the seller’s cost of providing it. Welfare Economics: the study of how the allocation of resources affects economic well-being. Willingness to Pay: the maximum amount that a buyer will pay for a good. [return to top]

WHAT'S NEW IN THIS CHAPTER There are no major changes to this chapter. [return to top]

XX.

Definition of welfare economics: the study of how the allocation of resources affects economic well-being. a. Keep in Mind: Students often are confused by the use of the word “welfare.” Remind them that we are talking about social well-being and not public assistance. Consumer Surplus

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets a. Willingness to Pay i. Definition of willingness to pay: the maximum amount that a buyer will pay for a good. ii. Example: You are auctioning a mint-condition recording of Elvis Presley’s first album. Four buyers show up. Their willingness to pay is as follows: Table 1 Buyer Taylor Carrie Rihanna Gaga

Willingness to Pay $100 $80 $70 $50

If the bidding goes to slightly higher than $80, all buyers drop out except for Taylor. Because Taylor is willing to pay more than she has to for the album, she derives some benefit from participating in the market. iii. Instruction Idea: Students will understand consumer surplus if you take the time to work through the Elvis Presley example. If you start with this simple example, students will have no trouble understanding how to find consumer surplus on a graph. iv. Definition of consumer surplus: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. v. Note that if you had more than one copy of the album, the price in the auction would end up being lower (a little over $70 in the case of two albums) and both Taylor and Carrie would gain consumer surplus. vi. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. b. Using the Demand Curve to Measure Consumer Surplus i. We can use the information on willingness to pay to derive a demand curve for the rare Elvis Presley album. Figure 1 Price More than $100 $80 to $100 $70 to $80 $50 to $70 $50 or less

Buyers None Taylor Taylor, Carrie Taylor, Carrie, Rihanna Taylor, Carrie, Rihanna, Gaga

Quantity Demanded 0 1 2 3 4

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

ii.

At any given quantity, the price given by the demand curve reflects the willingness to pay of the marginal buyer. Because the demand curve shows the buyers’ willingness to pay, we can use the demand curve to measure consumer surplus.

Figure 2 iii.

Consumer surplus can be measured as the area below the demand curve and above the price. c. How a Lower Price Raises Consumer Surplus Figure 3 i.

As price falls, consumer surplus increases for two reasons. 1. Those already buying the product will receive additional consumer surplus because they are paying less for the product than before (area A on the graph). 2. Because the price is now lower, some new buyers will enter the market and receive consumer surplus on these additional units of output purchased (area B on the graph).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

XXI.

d. What Does Consumer Surplus Measure? i. Instruction Idea: It is important to stress that consumer surplus is measured in monetary terms. Consumer surplus gives us a way to place a monetary cost from inefficient market outcomes (due to government involvement or market failure). ii. Remember that consumer surplus is the difference between the amount that buyers are willing to pay for a good and the price that they actually pay. iii. Thus, it measures the benefit that consumers receive from the good as the buyers themselves perceive it. iv. Alternative Classroom Example: Review the material on price ceilings from Chapter 6. Redraw the market for two-bedroom apartments in your town. Draw in a price ceiling below the equilibrium price. Then go through: 1. consumer surplus before the price ceiling is put into place. 2. consumer surplus after the price ceiling is put into place. Producer Surplus a. Cost and the Willingness to Sell i. Definition of cost: the value of everything a seller must give up to produce a good. ii. Instruction Idea: You will need to take some time to explain the relationship between the producers’ willingness to sell and the cost of producing the good. The relationship between cost and the supply curve is not as apparent as the relationship between the demand curve and willingness to pay. iii. Example: You want to hire someone to paint your house. You accept bids for the work from four sellers. Each painter is willing to work if the price you will pay exceeds her opportunity cost. (Note that this opportunity cost thus represents willingness to sell.) The costs are: Table 2 Seller Vincent Claude Pablo Andy iv.

Cost $900 $800 $600 $500

Bidding will stop when the price gets to be slightly below $600. All sellers will drop out except for Andy. Because Andy receives more than he would require to paint the house, he derives some benefit from producing in the market. Definition of producer surplus: the amount a seller is paid for a good minus the seller’s cost of providing it.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets vi.

Note that if you had more than one house to paint, the price in the auction would end up being higher (a little under $800 in the case of two houses) and both Andy and Pablo would gain producer surplus. b. Using the Supply Curve to Measure Producer Surplus i. We can use the information on cost (willingness to sell) to derive a supply curve for house painting services. Figure 4 Price $900 or more $800 to $900 $600 to $800 $500 to $600 less than $500

ii.

iii.

Sellers Vincent, Claude, Pablo, Andy Claude, Pablo, Andy Pablo, Andy Andy None

Quantity Supplied 4 3 2 1 0

At any given quantity, the price given by the supply curve represents the cost of the marginal seller. Because the supply curve shows the sellers’ cost (willingness to sell), we can use the supply curve to measure producer surplus. Producer surplus can be measured as the area above the supply curve and below the price.

Figure 5 c. How a Higher Price Raises Producer Surplus Figure 6 i.

As price rises, producer surplus increases for two reasons. 1. Those already selling the product will receive additional producer surplus because they are receiving more for the product than before (area C on the graph).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

XXII.

2. Because the price is now higher, some new sellers will enter the market and receive producer surplus on these additional units of output sold (area D on the graph). d. Producer surplus is used to measure the economic well-being of producers, much like consumer surplus is used to measure the economic well-being of consumers. i. Alternative Classroom Example: Review the material on price floors from Chapter 6. Redraw the market for an agricultural product such as corn. Draw in a price support above the equilibrium price. Then go through: 1. producer surplus before the price support is put in place. 2. producer surplus after the price support is put in place. Make sure that you discuss the cost of the price support to taxpayers. Market Efficiency a. Benevolent Social Planners i. The economic well-being of everyone in society can be measured by total surplus, which is the sum of consumer surplus and producer surplus: Total Surplus = Consumer Surplus + Producer Surplus Total Surplus = (Value to Buyers – Amount Paid by Buyers) + (Amount Received by Sellers – Cost to Sellers) Because the Amount Paid by Buyers = Amount Received by Sellers: Total Surplus Value to Buyers ii. iii. iv.

Cost to Sellers

Definition of efficiency: the property of a resource allocation of maximizing the total surplus received by all members of society. Definition of equality: the property of distributing economic prosperity uniformly the members of society. Instruction Idea: Now might be a good time to point out that many government policies involve a trade-off between efficiency and equality. When you evaluate government policies, like price ceilings or floors, you can explain them in terms of equality and efficiency.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets b. Evaluating the Market Equilibrium Figure 7

ii.

At the competitive market equilibrium price: 1. Buyers who value the product more than the equilibrium price will purchase the product; those who do not, will not purchase the product. In other words, the free market allocates the supply of a good to the buyers who value it most highly, as measured by their willingness to pay. 2. Sellers whose costs are lower than the equilibrium price will produce the product; those whose costs are higher, will not produce the product. In other words, the free market allocates the demand for goods to the sellers who can produce it at the lowest cost. Total surplus is maximized at the competitive market equilibrium.

Figure 8

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

XXIII.

1. At any quantity of output smaller than the equilibrium quantity, the value of the product to the marginal buyer is greater than the cost to the marginal seller so total surplus would rise if output increases. 2. At any quantity of output greater than the equilibrium quantity, the value of the product to the marginal buyer is less than the cost to the marginal seller so total surplus would rise if output decreases. iii. Note that this is one of the reasons that economists believe Principle #6: Markets are usually a good way to organize economic activity. 1. Instruction Idea: It would be a good idea to remind students that there are circumstances when the market process does not lead to the most efficient outcome. Examples include situations such as when a firm (or buyer) has market power over price or when there are externalities present. These situations will be discussed in later chapters. c. In the News: How Ticket Resellers Help Allocate Scarce Resources: Scalping Isn’t Scamming i. Scalpers buy a large share of tickets and sell them for higher prices. The higher prices from scalpers are due to a large demand and a limited supply – not the scalper. ii. Scalpers lower the risk of ticket producers and provide convenience to consumers. Laws preventing scalping eliminate a mutually beneficial transaction. d. Case Study: Should There Be a Market for Organs? i. As a matter of public policy, people are not allowed to sell their organs. 1. In essence, this means that there is a price ceiling on organs of $0. 2. This has led to a shortage of organs. ii. The creation of a market for organs would lead to a more efficient allocation of resources, but critics worry about the fairness of a market system for organs. e. Ask the Experts: Supplying Kidneys i. Economic experts were asked whether they agreed with the creation of a trial market that allows payment for human kidneys to extend the lives of those with kidney disease. ii. 57 percent of the experts agreed, while 16 percent disagreed and 27 percent were uncertain. Conclusion: Market Efficiency and Market Failure a. To conclude that markets are efficient, we made several assumptions about how markets worked. i. Perfectly competitive markets. ii. No externalities. b. When these assumptions do not hold, the market equilibrium may not be efficient. c. When markets fail, public policy can potentially remedy the situation.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 1. The price a buyer is willing to pay, consumer surplus, and the demand curve are all closely related. The height of the demand curve represents the willingness to pay of the buyers. Consumer surplus is the area below the demand curve and above the price, which equals the price that each buyer is willing to pay minus the price actually paid. 2. Sellers' costs, producer surplus, and the supply curve are all closely related. The height of the supply curve represents the costs of the sellers. Producer surplus is the area below the price and above the supply curve, which equals the price received minus each seller's costs of producing the good.

Figure 4 3. Figure 4 shows producer and consumer surplus in a supply-and-demand diagram. 4. An allocation of resources is efficient if it maximizes total surplus, the sum of consumer surplus and producer surplus. Efficiency may not be the only goal of economic policymakers; they may also be concerned about equality—the uniform distribution of economic prosperity among the members of society. 5. Two types of market failure are market power and externalities. Market power may cause market outcomes to be inefficient because firms may cause price and quantity to differ from the levels they would be under perfect competition, which keeps total surplus from being maximized. Externalities are side effects that are not taken into account by buyers and sellers. As a result, the free market does not maximize total surplus.

PROBLEMS AND APPLICATIONS 54. a. Willingness to pay is the sum of the price paid and consumer surplus. Therefore, Kyra’s willingness to pay is $600 = $360 + $240. b. Her consumer surplus at a price of $270 would be $600 − $270 $330.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets c. If the price of an iPhone was $750, Kyra would not have purchased one because the price is greater than her willingness to pay. Therefore, she would receive no consumer surplus. 55. If an early freeze in California sours the lemon crop, the supply curve for lemons shifts to the left, as shown in Figure 5. The result is a rise in the price of lemons and a decline in consumer surplus from A + B + C to just A. So, consumer surplus declines by the amount B + C.

Figure 5

Figure 6

In the market for lemonade, the higher cost of lemons reduces the supply of lemonade, as shown in Figure 6. The result is an increase in the price of lemonade and a decline in consumer surplus from D + E + F to just D, a loss of E + F. Note that an event that affects consumer surplus in one market often has effects on consumer surplus in related markets. 56. A rise in the demand for French bread leads to an increase in producer surplus in the market for French bread, as shown in Figure 7. The shift of the demand curve leads to an increased price, which increases producer surplus from area A to area A + B + C.

Figure 7

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets The increased quantity of French bread being sold increases the demand for flour, as shown in Figure 8. As a result, the price of flour rises, increasing producer surplus from area D to D + E + F. Note that an event that affects producer surplus in one market leads to effects on producer surplus in related markets.

Figure 8 57. a. Bert’s demand schedule is: Price More than $7 $5 to $7 $3 to $5 $1 to $3 $1 or less

Quantity Demanded 0 1 2 3 4

Bert’s demand curve is shown in Figure 9.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

Figure 9 b. When the price of each bottle of water is $4, Bert buys two bottles of water. His consumer surplus is shown as area A in the figure. He values his first bottle of water at $7, but pays only $4 for it, so has consumer surplus of $3. He values his second bottle of water at $5, but pays only $4 for it, so has consumer surplus of $1. Thus Bert’s total consumer surplus is $3 + $1 $4, which is the area of A in the figure. c. When the price of each bottle of water falls from $4 to $2, Bert buys three bottles of water, an increase of one. His consumer surplus consists of both areas A and B in the figure, an increase in the amount of area B. He gets consumer surplus of $5 from the first bottle ($7 value minus $2 price), $3 from the second bottle ($5 value minus $2 price), and $1 from the third bottle ($3 value minus $2 price), for a total consumer surplus of $9. Thus consumer surplus rises by $5 (which is the size of area B) when the price of each bottle of water falls from $4 to $2. 58. a. Ernie’s supply schedule for water is: Price More than $7 $5 to $7 $3 to $5 $1 to $3 Less than $1

Quantity Supplied 4 3 2 1 0

Ernie’s supply curve is shown in Figure 10.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

Figure 10 b. When the price of each bottle of water is $4, Ernie sells two bottles of water. His producer surplus is shown as area A in the figure. He receives $4 for his first bottle of water, but it costs only $1 to produce, so Ernie has producer surplus of $3. He also receives $4 for his second bottle of water, which costs $3 to produce, so he has producer surplus of $1. Thus Ernie’s total producer surplus is $3 + $1 $4, which is the area of A in the figure. c. When the price of each bottle of water rises from $4 to $6, Ernie sells three bottles of water, an increase of one. His producer surplus consists of both areas A and B in the figure, an increase by the amount of area B. He gets producer surplus of $5 from the first bottle ($6 price minus $1 cost), $3 from the second bottle ($6 price minus $3 cost), and $1 from the third bottle ($6 price minus $5 price), for a total producer surplus of $9. Thus producer surplus rises by $5 (which is the size of area B) when the price of each bottle of water rises from $4 to $6. 59. a. From Ernie’s supply schedule and Bert’s demand schedule, the quantity demanded and supplied are: Price Quantity Supplied Quantity Demanded $2 1 3 $4 2 2 $6 3 1 Only a price of $4 brings supply and demand into equilibrium, with an equilibrium quantity of two. b. At a price of $4, consumer surplus is $4 and producer surplus is $4, as shown in Problems 3 and 4 above. Total surplus is $4 + $4 = $8. c. If Ernie produced one less bottle, his producer surplus would decline to $3, as shown in Problem 4 above. If Bert consumed one less bottle, his consumer surplus would decline to $3, as shown in Problem 3 above. So total surplus would decline to $3 + $3 = $6.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets d. If Ernie produced one additional bottle of water, his cost would be $5, but the price is only $4, so his producer surplus would decline by $1. If Bert consumed one additional bottle of water, his value would be $3, but the price is $4, so his consumer surplus would decline by $1. So total surplus declines by $1 + $1 = $2. 60. a. The effect of falling production costs in the market for TVs results in a shift to the right in the supply curve, as shown in Figure 11. As a result, the equilibrium price of TVs declines and the equilibrium quantity increases.

Figure 11 b. The decline in the price of TVs increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G – B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Because consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D + F + G. c. If the supply of TVs is very elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were horizontal, as shown in Figure 12. Then there is no producer surplus at all. Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

Figure 12 61. Figure 13 shows supply and demand curves for haircuts. Supply equals demand at a quantity of three haircuts and a price between $20 and $25. Firms A, C, and D should cut the hair of Claire, Gloria, and Phil. Jay’s willingness to pay is too low and firm B’s costs are too high, so they do not participate. The maximum total surplus is the area between the demand and supply curves, which totals $55 ($40 value minus $10 cost for the first haircut, plus $35 value minus $15 cost for the second, plus $25 value minus $20 cost for the third).

Figure 13 62. a. The effect of falling production costs in the market for computers resulted in a shift to the right in the supply curve, as shown in Figure 14. As a result, the equilibrium price of computers declined and the equilibrium quantity increased. The decline in the price of computers increased consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

Figure 14

Figure 15

Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G – B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Because consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D + F + G. b. Typewriters and computers are substitutes. The decline in the price of computers means that people substituted computers for typewriters, shifting the demand for typewriters to the left, as shown in Figure 15. The result is a decline in both the equilibrium price and equilibrium quantity of typewriters. Consumer surplus in the typewriter market changes from area A + B to A + C, a net change of C – B. Producer surplus changes from area C + D + E to area E, a net loss of C + D. Typewriter producers are sad about technological advances in computers because their producer surplus declines. c. Software and computers are complements. When the price of computers decreases, the demand for software increases. The demand for software shifts to the right, as shown in Figure 16. The result is an increase in both the price and quantity of software. Consumer surplus in the software market changes from B + C to A + B, a net change of A – C. Producer surplus changes from E to C + D + E, an increase of C + D, so software producers should be happy about the technological progress in computers.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets

Figure 16 d. Yes, this analysis helps explain why Bill Gates is one the world’s richest people. His company produces a lot of software and the producer surplus in the software market increased with the technological advance in computers. 63. a. With Provider A, the cost of an extra movie is $0. With Provider B, the cost of an extra movie is $1. b. With Provider A, my friend will purchase 150 movies [= 150 – (50)(0)]. With Provider B, my friend would purchase 100 movies [= 150 – (50)(1)]. c. With Provider A, she would pay $120. With Provider B, she would pay $100.

Figure 17 d. Figure 17 shows the friend’s demand. With Provider A, she buys 150 movies and her consumer surplus is equal to (1/2)(3)(150) – 120 = 105. With Provider B, her consumer surplus is equal to (1/2)(2)(100) = 100.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 7: Consumers, Producers, and the Efficiency of Markets e. I would recommend Provider A because she receives greater consumer surplus when buying from that provider.

[In-class demonstration] Value of a Time Machine: 10 minutes total. Works in any class size. Topics include consumer surplus. N. Purpose: Consumer surplus can be a hard concept for students because it is based on avoided expense rather than on money that is actually exchanged. This example puts a specific dollar value on consumer surplus. O. Instructions: Tell the class, “A new technology has been developed that allows individuals to travel backward or forward in time. We want to identify the value this time machine provides to consumers. Let’s assume the four consumers who most desire this product are in this class.” Choose four student names and use them in the following example: “Scott is the consumer who most values this product. He wants to go back to the time of the dinosaurs. He is willing to pay $3,000.” “Carol is the consumer with the next highest willingness to pay. She would like to see 200 years in the future. She’d pay $2,500.” “Steve is the next highest bidder. He’d like to relive this entire semester. He’ll pay up to $800.” “Jeanne is our fourth consumer. She’d pay $200 to move the clock forward to the end of this class period.” On the board write: a. Scott b. Carol c. Steve d. Jeanne

$3,000 $2,500 $800 $200

“This represents the demand curve for the time machine. Consumer surplus is the difference between what consumers are willing to pay and the amount they actually have to pay. The market price will determine who uses the time machine and how much surplus they keep.” “If the price of a time machine were $500, three rides would be sold – one to Scott, one to Carol, and one to Steve. Jeanne is not willing to pay $500, so she wouldn’t time travel.” “We can calculate the consumer surplus of three trips. Scott would pay $3,000 but only pays $500, leaving $2,500 of net benefits.” (Put these numbers on the board.)

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation “Carol has net benefits of $2,000. Steve has $300 in net benefits. Adding up these net savings gives $4,800 in consumer surplus.” P. Points for Discussion: The consumer surplus depends on a good’s selling price and the number of consumers who are willing to purchase the good at that price. The lower the price, the greater the consumer surplus. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Consumer Surplus o Concept Clip: Producer Surplus o Video Problem Walk-Through: Calculating Consumer Surplus for a Purchase by an Individual Consumer o Video Problem Walk-Through: Calculating Consumer Surplus, Producer Surplus, and Total Surplus in a Market o Video Problem Walk-Through: Using Willingness to Pay and Willingness to Sell to Determine the Efficient Market Outcome o Video Problem Walk-Through: Calculating Consumer Surplus, Producer Surplus, and Total Surplus Using a Supply-and-Demand Diagram o Areas o Equation Basics o Graphing Basics o Graphing Linear Equations

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

143

Complete List of Chapter Activities and Assessments Key Terms

144

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation What's New in This Chapter 145 Chapter Outline

145

Solutions to Text Problems 150 Questions for Review ................................................................................................................................................... 150 Problems and Applications ........................................................................................................................................ 151 Additional Activities and Assignments

158

Additional Resources159 Cengage Video Resources ........................................................................................................................................... 159

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 8 is the second chapter in a three-chapter sequence dealing with welfare economics. In the previous section on supply and demand, Chapter 6 introduced taxes and demonstrated how a tax affects the price and quantity sold in a market. Chapter 6 also described the factors that determine how the burden of the tax is divided between the buyers and sellers in a market. Chapter 7 developed welfare economics—the study of how the allocation of resources affects economic wellbeing. Chapter 8 combines the lessons learned in Chapters 6 and 7 and addresses the effects of taxation on welfare. Chapter 9 will address the effects of trade restrictions on welfare. The purpose of Chapter 8 is to apply the lessons learned about welfare economics in Chapter 7 to the issue of taxation from Chapter 6. Students will learn that the cost of a tax to buyers and sellers in a market usually exceeds the revenue collected by the government. Students will also learn about the factors that determine the degree by which the cost of a tax exceeds the revenue collected by the government. Key points addressed in this chapter: 



A tax on a good reduces the welfare of buyers and sellers of that good, and the reduction in consumer and producer surplus usually exceeds the revenue raised by the government. The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue—is called the deadweight loss of the tax. Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and these changes in behavior shrink the market below the level that maximizes total surplus. Because the elasticities of supply and demand measure how much buyers and sellers respond to market conditions, larger elasticities imply larger deadweight losses. As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax reduces the size of a market, however, tax revenue does not continually increase. It first rises with the size of a tax, but if the tax gets large enough, tax revenue starts to fall.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Examine the effects of taxes on market outcomes.



Explain why the market outcome is the same regardless of whether a tax is collected from buyers or sellers.



Given a supply and demand graph, indicate the area representing the deadweight loss generated by a tax.



Given a supply and demand graph, determine the impact of a tax on the price and quantity in a market.



Given a supply and demand graph, determine the tax revenue generated by a tax.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation 

Given a supply and demand graph, indicate the change in consumer and producer surplus caused by a tax.



Determine the effect of elasticity on the size of the deadweight loss caused by a tax.



Graph deadweight loss as a function of the size of a tax in a market.



Analyze the relationship between deadweight loss and size of the tax.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Ask the Experts Think-Pair-Share Activity Self-Assessment Section 08-1 QuickQuiz Section 08-2 QuickQuiz Section 08-3 QuickQuiz Figure 3: How a Tax Affects Welfare Figure 5: Tax Distortions and Elasticities Figure 6: How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Chapter 08 Problems & Applications Chapter 08 A+ Test Prep Chapter 08 News Analysis: Airbnb Rentals: A New Source of Tax Revenue Chapter 08 Homework Chapter 08 Quiz: Application: The Costs of Taxation

PPT Slide 14 PPT Slide 25 PPT Slide 28 PPT Slide 29 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder

5 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

35–45 mins. N/A 10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. 20–30 mins.

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KEY TERMS Deadweight Loss: the fall in total surplus that results from a market distortion.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

The Case Study on “The Laffer Curve and Supply-Side Economics” is updated and includes additional information on the Trump tax cuts.

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The Deadweight Loss of Taxation M. Remember that it does not matter who a tax is levied on; buyers and sellers will likely share in the burden of the tax. N. If there is a tax on a product, the price that a buyer pays will be greater than the price the seller receives. Thus, there is a tax wedge between the two prices and the quantity sold will be smaller if there was no tax. Figure 1

O. How a Tax Affects Market Participants a. We can measure the effects of a tax on consumers by examining the change in consumer surplus. Similarly, we can measure the effects of the tax on producers by looking at the change in producer surplus.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation b. However, there is a third party that is affected by the tax—the government, which gets total tax revenue of T × Q. If the tax revenue is used to provide goods and services to the public, then the benefit from the tax revenue must not be ignored. c. Instruction Idea: If you spent enough time covering consumer and producer surplus in Chapter 7, students should have an easy time with this concept. Figure 2 d. Welfare without a Tax Figure 3

1. Consumer surplus is equal to: A + B + C. 2. Producer surplus is equal to: D + E + F. 3. Total surplus is equal to: A + B + C + D + E + F. e. Welfare with a Tax 1. Consumer surplus is equal to: A. 2. Producer surplus is equal to: F. 3. Tax revenue is equal to: B + D. 4. Total surplus is equal to: A + B + D + F. f. Changes in Welfare 1. Consumer surplus changes by: –(B + C). 2. Producer surplus changes by: –(D + E). 3. Tax revenue changes by: +(B + D). 4. Total surplus changes by: –(C + E).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation g. Definition of deadweight loss: the fall in total surplus that results from a market distortion. P. Deadweight Losses and the Gains from Trade Figure 4

XXV.

a. Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the benefits from trade. b. This occurs because the quantity of output declines; trades that would be beneficial to both the buyer and seller will not take place because of the tax. c. Instruction Idea: Show the students that the nature of this deadweight loss stems from the reduction in the quantity of the output exchanged. Stress the idea that goods that are not produced, consumed, or taxed do not generate benefits for anyone. d. The deadweight loss is equal to areas C and E (the drop in total surplus). e. Note that output levels between the equilibrium quantity without the tax and the quantity with the tax will not be produced, yet the value of these units to consumers (represented by the demand curve) is larger than the cost of these units to producers (represented by the supply curve). The Determinants of the Deadweight Loss Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

a. The price elasticities of supply and demand will determine the size of the deadweight loss that occurs from a tax. i. Given a stable demand curve, the deadweight loss is larger when supply is relatively elastic. ii. Given a stable supply curve, the deadweight loss is larger when demand is relatively elastic. b. Case Study: The Deadweight Loss Debate i. Social Security tax, Medicare tax, and federal income tax are taxes on labor earnings. A labor tax places a tax wedge between the wage the firm pays and the wage that workers receive. ii. There is considerable debate among economists concerning the size of the deadweight loss from this wage tax. iii. The size of the deadweight loss depends on the elasticity of labor supply and demand, and there is disagreement about the magnitude of the elasticity of supply. 1. Economists who argue that labor taxes do not greatly distort market outcomes believe that labor supply is fairly inelastic. 2. Economists who argue that labor taxes lead to large deadweight losses believe that labor supply is more elastic.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

XXVI.

3. Instruction Idea: There is a student activity (Labor Taxes) that applies to this topic in the "Additional Activities and Assignments” section. Deadweight Loss and Tax Revenue as Taxes Vary Figure 6 a. As taxes increase, the deadweight loss from the tax increases. b. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax. i. The deadweight loss is the area of a triangle and the area of a triangle depends on the square of its size. ii. If we double the size of a tax, the base and height of the triangle both double so the area of the triangle (the deadweight loss) rises by a factor of four. c. As the tax increases, the level of tax revenue first rises, but revenue will eventually fall as the size of the market shrinks. d. Case Study: The Laffer Curve and Supply-Side Economics i. The relationship between the size of a tax and the level of tax revenues is called a Laffer curve. ii. Supply-side economists in the 1980s used the Laffer curve to support their belief that a drop in tax rates could lead to an increase in tax revenue for the government. iii. Economists continue to debate Laffer’s argument. 1. Many believe that the 1980s refuted Laffer’s theory. 2. Others believe that the events of the 1980s tell a more favorable supply-side story. 3. Some economists believe that, while an overall cut in taxes normally decreases revenue, some taxpayers may find themselves on the wrong side of the Laffer curve, and a cut in their taxes increases the revenue collected from those taxpayers. 4. Laffer was an advisor to Donald Trump during the 2016 presidential race. Again, he argued that tax rates could be reduced without increasing the budget deficit because economic growth would increase. Most economists were skeptical. Recent data supports the skeptics. After the Trump tax cuts, fiscal deficits rose and economic growth remained relatively steady at a little over 2%. e. Ask the Experts: The Laffer Curve i. Economic experts were asked whether a cut in the federal income tax rates now in the U.S. would lead to higher national income in five years than without the tax cut. While 43 percent of the experts agreed, 9 percent disagreed and nearly half, 48 percent, were uncertain. ii. However, 96 percent of the same panel of experts disagreed that cutting the federal income tax rates now in the U.S. would result in greater tax revenue in five years.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation iii.

Alternative Classroom Example: Draw a graph showing the demand and supply of paper clips. (Draw each curve as a 45-degree line so that buyers and sellers will share any tax equally.) Mark the equilibrium price as $0.50 (per box) and the equilibrium quantity as 1,000 boxes. Show students the areas of producer and consumer surplus. Impose a $0.20 tax on each box. Assume that sellers are required to “pay” the tax to the government. Show students that: 1. 2. 3. 4.

the price buyers pay will rise to $0.60. the price sellers receive will fall to $0.40. the quantity of paper clips purchased will fall (assume to 800 units). tax revenue would be equal to $160 ($0.20 x 800)

Have students calculate the area of deadweight loss. (You may have to remind students how to calculate the area of a triangle.)

iv.

Show students that as the tax increases (to $0.40, $0.60, and $0.80), tax revenue rises and then falls, and the deadweight loss increases. Instruction Idea: There is a student activity (Tax Alternatives) that applies to this topic in the "Additional Activities and Assignments” section.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 1. When the sale of a good is taxed, both consumer surplus and producer surplus decline. The decline in consumer surplus and producer surplus exceeds the amount of government revenue that is raised, so society's total surplus declines. The tax distorts the incentives of both buyers and sellers, so resources are allocated inefficiently. 2. Figure 2 illustrates the deadweight loss and tax revenue from a tax on the sale of a good. Without a tax, the equilibrium quantity would be Q1, the equilibrium price would be P1, consumer surplus would be A + B + C, and producer surplus would be D + E + F. The imposition of a tax places a wedge between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS + tax. The quantity sold declines to Q2. Now consumer surplus is A, producer surplus is F, and government revenue is B + D. The deadweight loss of the tax is C+E, because that area is lost due to the decline in quantity from Q1 to Q2.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

Figure 2 3. The greater the elasticities of demand and supply, the greater the deadweight loss of a tax. Because elasticity measures the responsiveness of buyers and sellers to a change in price, higher elasticity means the tax induces a greater reduction in quantity, and therefore, a greater distortion to the market. 4. Experts disagree about whether labor taxes have small or large deadweight losses because they have different views about the elasticity of labor supply. Some believe that labor supply is inelastic, so a tax on labor has a small deadweight loss. But others think that workers can adjust their hours worked in various ways, so labor supply is elastic, and thus a tax on labor has a large deadweight loss. 5. The deadweight loss of a tax rises more than proportionally as the tax rises. Tax revenue, however, may increase initially as a tax rises, but as the tax rises further, revenue eventually declines.

PROBLEMS AND APPLICATIONS 64. a. Figure 3 illustrates the market for pizza. The equilibrium price is P1, the equilibrium quantity is Q1, consumer surplus is area A + B + C, and producer surplus is area D + E + F. There is no deadweight loss, as all the potential gains from trade are realized; total surplus is the entire area between the demand and supply curves: A + B + C + D + E + F.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

Figure 3

65.

b. With a $1 tax on each pizza sold, the price paid by buyers, PB, is now higher than the price received by sellers, PS, where PB = PS + $1. The quantity declines to Q2, consumer surplus is area A, producer surplus is area F, government revenue is area B + D, and deadweight loss is area C + E. Consumer surplus declines by B + C, producer surplus declines by D + E, government revenue increases by B + D, and deadweight loss increases by C + E. c. If the tax were removed and consumers and producers voluntarily transferred B + D to the government to make up for the lost tax revenue, then everyone would be better off than without the tax. The equilibrium quantity would be Q1, as in the case without the tax, and the equilibrium price would be P1. Consumer surplus would be A + C, because consumers get surplus of A + B + C, then voluntarily transfer B to the government. Producer surplus would be E + F, because producers get surplus of D + E + F, then voluntarily transfer D to the government. Both consumers and producers are better off than the case when the tax was imposed. If consumers and producers gave a little bit more than B + D to the government, then all three parties, including the government, would be better off. This illustrates the inefficiency of taxation. a. The statement, "A tax that has no deadweight loss cannot raise any revenue for the government," is incorrect. An example is the case of a tax when either supply or demand is perfectly inelastic. The tax has neither an effect on quantity nor any deadweight loss, but it does raise revenue. b. The statement, "A tax that raises no revenue for the government cannot have any deadweight loss," is incorrect. An example is the case of a 100% tax imposed on sellers. With a 100% tax on their sales of the good, sellers will not supply any of the good, so the tax will raise no revenue. Yet the tax has a large deadweight loss, because it reduces the quantity sold to zero.

66.

a. With very elastic supply and very inelastic demand, the burden of the tax on rubber bands will be borne largely by buyers. As Figure 4 shows, consumer surplus declines considerably, by area A + B, but producer surplus decreases only by area C+D.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

Figure 4

Figure 5

b. With very inelastic supply and very elastic demand, the burden of the tax on rubber bands will be borne largely by sellers. As Figure 5 shows, consumer surplus does not decline much, just by area A + B, while producer surplus falls substantially, by area C + D. Compared to part (a), producers bear much more of the burden of the tax, and consumers bear much less. 67. a. The deadweight loss from a tax on heating oil is likely to be greater in the fifth year after it is imposed rather than the first year. In the first year, the demand for heating oil is relatively inelastic, as people who own oil heaters are not likely to get rid of them right away. But over time they may switch to other energy sources and people buying new heaters for their homes will more likely choose gas or electric, so the tax will have a greater impact on quantity. Thus, the deadweight loss of the tax will get larger over time. b. The tax revenue is likely to be higher in the first year after it is imposed than in the fifth year. In the first year, demand is more inelastic, so the quantity does not decline as much and tax revenue is relatively high. As time passes and more people substitute away from oil, the quantity sold declines, as does tax revenue. 68. Because the demand for food is inelastic, a tax on food is a good way to raise revenue because it leads to a small deadweight loss; thus taxing food is less inefficient than taxing other things. But it is not a good way to raise revenue from an equity point of view, because poorer people spend a higher proportion of their income on food. The tax would affect them more than it would affect wealthier people. 69. a. This tax has such a high rate that it is not likely to raise much revenue. Because of the high tax rate, the equilibrium quantity in the market is likely to be at or near zero. b. Senator Moynihan's goal was probably to ban the use of hollow-tipped bullets. In this case, the tax could be as effective as an outright ban. 70.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation a. Figure 6 illustrates the market for socks and the effects of the tax. Without a tax, the equilibrium quantity would be Q1, the equilibrium price would be P1, total spending by consumers equals total revenue for producers, which is P1 x Q1, which equals area B + C + D + E + F, and government revenue is zero. The imposition of a tax places a wedge between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS + tax. The quantity sold declines to Q2. Now total spending by consumers is PB x Q2, which equals area A + B + C + D, total revenue for producers is PS x Q2, which is area C + D, and government tax revenue is Q2 x tax, which is area A + B. b. Unless supply is perfectly elastic or demand is perfectly inelastic, the price received by producers falls because of the tax. Total receipts for producers fall, because producers lose revenue equal to area B + E + F.

Figure 6

c. The price paid by consumers rises, unless demand is perfectly elastic or supply is perfectly inelastic. Whether total spending by consumers rises or falls depends on the price elasticity of demand. If demand is elastic, the percentage decline in quantity exceeds the percentage increase in price, so total spending declines. If demand is inelastic, the percentage decline in quantity is less than the percentage increase in price, so total spending rises. Whether total consumer spending falls or rises, consumer surplus declines because of the increase in price and reduction in quantity. 71. Figure 7 illustrates the effects of the $2 subsidy on a good. Without the subsidy, the equilibrium price is P1 and the equilibrium quantity is Q1. With the subsidy, buyers pay price PB, producers receive price PS (where PS = PB + $2), and the quantity sold is Q2. The following table illustrates the effect of the subsidy on consumer surplus, producer surplus, government revenue, and total surplus. Because total surplus declines by area D + H, the subsidy leads to a deadweight loss in that amount.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

Consumer Surplus Producer Surplus Government Revenue Total Surplus

Before Subsidy A+B

After Subsidy

Change

A+B+E+F+G

+(E + F + G)

E+I

B+C+E+I

+(B + C)

–(B + C + D + E + F + G + H)

A+B+E+I

A+B–D+E–H+I

–(D + H)

Figure 7 72. a. Figure 8 shows the effect of a $10 tax on hotel rooms. The tax revenue is represented by areas A + B, which are equal to ($10)(900) = $9,000. The deadweight loss from the tax is represented by areas C + D, which are equal to (0.5)($10)(100) = $500.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

Figure 8

Figure 9

b. Figure 9 shows the effect of a $20 tax on hotel rooms. The tax revenue is represented by areas A + B, which are equal to ($20)(800) = $16,000. The deadweight loss from the tax is represented by areas C + D, which are equal to (0.5)($20)(200) = $2,000. When the tax is doubled, the tax revenue rises by less than double, while the deadweight loss rises by more than double. The higher tax creates a greater distortion to the market. 73. a. Setting quantity supplied equal to quantity demanded gives 2P = 300 – P. Adding P to both sides of the equation gives 3P = 300. Dividing both sides by 3 gives P = 100. Substituting P = 100 back into either equation for quantity demanded or supplied gives Q = 200. b. Now P is the price received by sellers and P +T is the price paid by buyers. Equating quantity demanded to quantity supplied gives 2P 300 − (P+T). Adding P to both sides of the equation gives 3P = 300 – T. Dividing both sides by 3 gives P = 100 –T/3. This is the price received by sellers. The buyers pay a price equal to the price received by sellers plus the tax (P +T = 100 + 2T/3). The quantity sold is now Q = 2P = 200 – 2T/3. c. Because tax revenue is equal to T x Q and Q = 200 – 2T/3, tax revenue equals 200T − 2T 2 /3. Figure 10 shows a graph of this relationship. Tax revenue is zero at T = 0 and at T = 300.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

Figure 10

Figure 11

d. As Figure 11 shows, the area of the triangle (laid on its side) that represents the

deadweight loss is 1/2 × base × height, where the base is the change in the price, which is the size of the tax (T) and the height is the amount of the decline in quantity (2T/3). So the deadweight loss equals 1/2 × T × 2T/3 = T 2 /3. This rises exponentially from 0 (when T = 0) to 30,000 when T = 300, as shown in Figure 12.

Figure 12 e. A tax of $200 per unit is a bad policy, because tax revenue is declining at that tax level. The government could reduce the tax to $150 per unit, get more tax revenue ($15,000 when the tax is $150 versus $13,333 when the tax is $200), and reduce the deadweight loss (7,500 when the tax is $150 compared to 13,333 when the tax is $200).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation

[In-class discussion] Labor Taxes: 10 minutes total. Works in any class size. Topics include deadweight loss and taxation. Q. Purpose: Most students have not spent a great deal of time considering the effects of taxation on labor supply. This in-class exercise gives them the opportunity to consider the effects of proposed tax rates on their own willingness to supply labor. R. Instructions: Ask students to assume that they are full-time workers earning $10 per hour, $80 per day, $400 per week, $20,000 per year. Ask them if they would quit their jobs or keep working if the tax rate was 10%, 20%, 30%, … (up to 100%). Keep a tally as they show hands indicating that they are leaving the labor force. Ask students what they think the “best” tax rate is. S. Points for Discussion: Many students have no idea that current marginal tax rates are greater than 30% for many taxpayers.

XI.

Students will likely say that a tax rate of zero would be best, but remind them that there would be no roads, libraries, parks, or national defense without at least some revenue raised by the government. [In-class assignment] Tax Alternatives: 20 minutes total. Works in any class size. Topics include taxes and deadweight loss. A. Purpose: The market impact of taxes can be a new concept to many students. This exercise helps them think about the effects of taxes on different goods. Taxes that may be appealing for equity reasons can be distortionary from a market perspective. B. Instructions: Tell the class, “The state has decided to increase funding for public education. They are considering four alternative taxes to finance these expenditures. All four taxes would raise the same amount of revenue.” List these options on the board: 1. A sales tax on food. 2. A tax on families with school-age children. 3. A property tax on vacation homes. 4. A sales tax on jewelry. Ask the students to answer the following questions. Give them time to write an answer, and then discuss their answers before moving to the next question: 1. Taxes change incentives. How might individuals change their behavior because of each of these taxes? 2. Rank these taxes from smallest deadweight loss to largest deadweight loss. Explain. 3. Is deadweight loss the only thing to consider when designing a tax system?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 8: Application: The Costs of Taxation C. Points for Discussion: Many 1. Taxes change incentives. How might individuals change their behavior because of each of these taxes? a. A sales tax on food: At the margin, some consumers will purchase less food. Overall food purchases will not decrease substantially because the tax will be spread over a large number of consumers and demand is relatively inelastic. b. A tax on families with school-age children: No families would put their children up for adoption to avoid taxes. A large tax could have implications for family planning; couples may choose not to have children, or to have fewer children, over time. A more realistic concern would be relocation to other states by mobile families to avoid the tax. c. A property tax on vacation homes: This tax would be concentrated on fewer households. A large tax would discourage people from buying vacation homes. Developers would build fewer vacation homes in the long run. In many areas, people could choose an out-ofstate vacation home to avoid the tax. d. A sales tax on jewelry: This tax would also be relatively concentrated. People would buy less jewelry, or they would buy jewelry in other states with lower taxes. 2. Rank these taxes from smallest deadweight loss to largest deadweight loss. a. Lowest deadweight loss – tax on children, very inelastic b. Then – tax on food. Demand is inelastic; supply is elastic. c. Third – tax on vacation homes. Demand is elastic; short-run supply is inelastic. d. Most deadweight loss – tax on jewelry. Demand is elastic; supply is elastic. 3. Is deadweight loss the only thing to consider when designing a tax system? No. This can generate a lively discussion. There are a variety of equity or fairness concerns. The taxes on children and on food would be regressive. Each of the taxes would tax certain households at much higher rates than other households with similar incomes. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Video Problem Walk-Through: Calculating Welfare Before and after a Tax Is Imposed on a Market o Video Problem Walk-Through: Determining the Price, Tax Revenue, and Deadweight Loss in a Market after a Tax Is Imposed

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade o o o o o

Video Problem Walk-Through: Calculating Equilibrium Price and Quantity, Tax Revenue, and Deadweight Loss after a Tax Using Demand and Supply Equations Areas Equation Basics Graphing Basics Graphing Linear Equations

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 161 Chapter Objectives ........................................................................................................................................... 161 Complete List of Chapter Activities and Assessments ......................................................................... 162 Key Terms ........................................................................................................................................................... 163 What's New in This Chapter .......................................................................................................................... 163 Chapter Outline ................................................................................................................................................. 163 Solutions to Text Problems ........................................................................................................................... 171 Questions for Review ................................................................................................................................................... 171 Problems and Applications ........................................................................................................................................ 172 Additional Resources ...................................................................................................................................... 180 Cengage Video Resources ........................................................................................................................................... 180

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 9 is third in a three-chapter sequence dealing with welfare economics. Chapter 7 introduced welfare economics: the study of how the allocation of resources affects economic wellbeing. Chapter 8 applied the lessons of welfare economics to taxation. Chapter 9 applies the tools of welfare economics from Chapter 7 to the study of international trade, a topic that was first introduced in Chapter 3. The purpose of Chapter 9 is to use welfare economics to address the gains from trade more precisely than in Chapter 3, which discussed comparative advantage and the gains from trade. This chapter develops the conditions that determine whether a country imports or exports a good and discusses who wins and who loses when a country imports or exports a good. This chapter will show that when trade is allowed, the gains of the winners exceed the losses of the losers. Because there are gains from trade, restrictions on trade reduce the gains from trade and cause deadweight losses similar to those generated by a tax. Key points addressed in this chapter: 



The effects of international trade can be determined by comparing the domestic price before trade with the world price. A low domestic price indicates that the country has a comparative advantage in producing the good and that the country will become an exporter. A high domestic price indicates that the rest of the world has a comparative advantage in producing the good and that the country will become an importer. When a country allows trade and becomes an exporter of a good, producers of the good are better off, and consumers of the good are worse off. When a country allows trade and becomes an importer of a good, consumers are better off, and producers are worse off. In both cases, the gains from trade exceed the losses. A tariff—a tax on imports—moves a market closer to the equilibrium that would exist without trade and reduces the gains from trade. Although domestic producers are better off and the government raises revenue, the losses to consumers exceed these gains. There are various arguments for restricting trade: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions. Although some of these arguments have merit in some cases, most economists believe that free trade is usually the better policy.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Determine whether a country will be an importer or exporter of a good if the country opens up to international trade.



Determine the impact of a tariff on imports and government revenue, given a domestic supply and demand graph.



Determine the impact of the world price on domestic production and domestic consumption.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade 

Analyze the change in economic welfare when a previously closed economy begins exporting goods.



Analyze the change in economic welfare when a previously closed economy begins importing goods.



Indicate the area representing deadweight loss caused by a tariff, given a domestic supply and demand graph.



Compare the effect of a quota versus a tariff on an open economy.



Identify which argument for restricting trade is being applied, given a proposed trade restriction.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Ask the Experts 1 Ask the Experts 2 Ask the Experts 3 Ask the Experts 4 Think-Pair-Share Activity Self-Assessment Section 09-1 QuickQuiz Section 09-2 QuickQuiz Section 09-3 QuickQuiz Figure 2: International Trade in an Exporting Country Figure 3: International Trade in an Importing Country Figure 4: The Effects of a Tariff Chapter 09 Problems & Applications Chapter 09 A+ Test Prep Chapter 09 Homework Chapter 09 Quiz: Application: International Trade

Source (i.e., PPT slide, Workbook) PPT Slide 9 PPT Slide 22 PPT Slide 36 PPT Slide 37 PPT Slide 40 PPT Slide 41 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

5 mins. 35–45 mins. N/A 20–30 mins. 20–30 mins.

10–15 mins. 10–15 mins. 10–15 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

KEY TERMS Tariff: a tax on goods produced abroad and sold domestically. World Price: the price of a good that prevails in the world market for that good. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

The Case Study on Trade Agreements and the World Trade Organization has been updated. There is a new Ask the Experts box: “Tariffs and Trade Deals.”

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The Determinants of Trade a. Keep in Mind: This chapter may be difficult to teach and very difficult for students to understand and accept. Be prepared for a skeptical reaction from students who have been told that free international trade is detrimental to a country. For various historical, cultural, and political reasons, free trade has few defenders outside of the economics profession. b. Instruction Idea: Point out that international trade issues are no different from trading as it applies to individuals within a community or between states and regions within a country. The gains from trade between countries occur for the same reasons that we observe gains from trade between individuals. Pick a state adjacent to yours. Ask students why we do not seem to worry about “importing” goods from other states the same way in which we worry about importing goods from other countries. c. Example used throughout the chapter: The market for textiles in a country called Isoland. d. The Equilibrium without Trade f. If there is no trade, the domestic price in the textile market will balance supply and demand. Figure 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

XXVIII.

g. A new leader is elected who is interested in pursuing international trade. A committee of economists is organized to determine the following: 1. If the government allows trade, what will happen to the price of textiles and the quantity of textiles sold in the domestic market? 2. Who will gain from trade, who will lose, and will the gains exceed the losses? 3. Should a tariff (a tax on imported textiles) be part of the new trade policy? e. The World Price and Comparative Advantage i. The first issue is to decide whether Isoland should import or export textiles. a. The answer depends on the relative price of textiles in Isoland compared with the price of textiles in other countries. b. Definition of world price: the price of a good that prevails in the world market for that good. ii. If the world price is greater than the domestic price, Isoland should export textiles; if the world price is lower than the domestic price, Isoland should import textiles. 1. Note that the domestic price represents the opportunity cost of producing textiles in Isoland, while the world price represents the opportunity cost of producing textiles abroad. 2. Thus, if the domestic price is low, this implies that the opportunity cost of producing textiles in Isoland is low, suggesting that Isoland has a comparative advantage in the production of textiles. If the domestic price is high, the opposite is true. The Winners and Losers from Trade a. We can use welfare analysis to determine who will gain and who will lose if trade is allowed in Isoland. b. We will assume that, because Isoland would be such a small part of the market for textiles, they will be price takers in the world economy. This implies that they take the world price as given and must sell (or buy) at that price. c. The Gains and Losses of an Exporting Country

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade i.

ii.

iii.

If the world price is higher than the domestic price, Isoland will export textiles. Once trade is allowed, the domestic price will rise to the world price. As the price of textiles rises, the domestic quantity of textiles demanded will fall and the domestic quantity of textiles supplied will rise. Thus, with trade, the domestic quantity supplied will exceed the domestic quantity demanded and the difference will be exported. Instruction Idea: Have students come to the board and label the areas of consumer and producer surplus after you have drawn each of the figures. This should not be a problem as they are likely familiar enough with consumer and producer surplus after completing Chapters 7 and 8.

Figure 2

iv.

Welfare without Trade 1. Consumer surplus is equal to: A + B. 2. Producer surplus is equal to: C. 3. Total surplus is equal to: A + B + C. Welfare with Trade 1. Consumer surplus is equal to: A. 2. Producer Surplus is equal to: B + C + D. 3. Total surplus is equal to: A + B + C + D.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade vi.

Changes in Welfare a. Consumer surplus changes by: –B. b. Producer surplus changes by: +B + D. c. Total surplus changes by: +D. vii. When a country exports a good, domestic producers of the good are better off and domestic consumers of the good are worse off. viii. When a country exports a good, total surplus is increased and the economic well-being of the country rises. d. The Gains and Losses of an Importing Country i. If the world price is lower than the domestic price, Isoland will import textiles. Once trade is allowed, the domestic price will fall to the world price. ii. As the price of textiles falls, the domestic quantity of textiles demanded will rise and the domestic quantity of textiles supplied will fall. 1. Thus, with trade, the domestic quantity demanded will not be equal to the domestic quantity supplied. 2. Isoland will import the difference between the domestic quantity demanded and the domestic quantity supplied. 3. Instruction Idea: Note that there will be both imported and domestically produced textiles sold in this country. This is true for many imported goods. Figure 3

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

iii.

Welfare without Trade 1. Consumer surplus is equal to: A. 2. Producer surplus is equal to: B + C. 3. Total surplus is equal to: A + B + C. iv. Welfare with Trade 1. Consumer surplus is equal to: A + B + D. 2. Producer surplus is equal to: C. 3. Total surplus is equal to: A + B + C + D. v. Changes in Welfare 1. Consumer surplus changes by: +B + D. 2. Producer surplus changes by: –B. 3. Total surplus changes by: +D. vi. When a country imports a good, domestic consumers of the good are better off and domestic producers of the good are worse off. vii. When a country imports a good, total surplus is increased and the economic well-being of the country rises. viii. Keep in Mind: Be prepared for students to argue that trade cannot be good for everyone. More than likely at least one of your students will know an individual who lost their job when a factory closed and moved to another country. Take this opportunity to point out that this individual is one of the “losers,” but remind the class that the gains from trade exceed the losses, so the total well-being of society is increased. ix. Instruction Idea: Point out that during the 1990s with open trading (for example, the passage of NAFTA), the U.S. economy achieved and maintained full employment even as large quantities of imported goods entered the United States. Most of the jobs that “left the country” were low-skill, low-wage jobs. e. Trade policy is often contentious because the policy creates winners and losers. If the losers have political clout, the result is often trade restrictions such as tariffs and quotas. f. The Effects of a Tariff i. Definition of tariff: a tax on goods produced abroad and sold domestically. ii. A tariff raises the price above the world price. Thus, the domestic price of textiles will rise to the world price plus the tariff.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade iii.

iv.

As the price rises, the domestic quantity of textiles demanded will fall and the domestic quantity of textiles supplied will rise. The quantity of imports will fall and the market will move closer to the domestic market equilibrium that occurred before trade. Welfare before the Tariff (with trade) 1. Consumer surplus is equal to: A + B + C + D + E + F. 2. Producer surplus is equal to: G. 3. Government revenue is equal to: zero. 4. Total surplus is equal to: A + B + C + D + E + F + G.

Figure 4

Welfare after the Tariff 1. Consumer surplus is equal to: A + B. 2. Producer surplus is equal to: C + G. 3. Government revenue is equal to: E. 4. Total surplus is equal to: A + B + C + E + G. vi. Changes in Welfare 1. Consumer surplus changes by: –C - D - E - F). 2. Producer surplus changes by: +C. 3. Government revenue changes by: +E. 4. Total surplus changes by: –D - F. g. FYI: Import Quotas: Another Way to Restrict Trade i. An import quota is a limit on the quantity of a good that can be produced abroad and sold domestically. ii. Import quotas are much like tariffs. 1. Both tariffs and quotas raise the domestic price of the good, reduce the welfare of domestic consumers, increase the welfare of domestic producers, and cause deadweight losses. 2. However, a tariff raises revenue for the government, whereas a quota creates surplus for license holders unless the government charges a fee for the import permits. 3. A quota can potentially cause a larger deadweight loss than a tariff, depending on the mechanism used to allocate the import licenses. h. The Lessons for Trade Policy

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade i.

XXIX.

Instruction Idea: This section provides a good opportunity to review what the students have learned thus far about trade. You should reinforce the idea that total surplus rises when trade is introduced, but falls once trade restrictions are imposed. ii. If trade is allowed, the price of textiles will be driven to the world price. If the domestic price is higher than the world price, the country will become an importer and the domestic price will fall. If the domestic price is lower than the world price, the country will become an exporter and the domestic price will rise. iii. If a country imports a product, domestic producers are made worse off, domestic consumers are made better off, and the gains of consumers outweigh the losses of producers. If a country exports a product, domestic producers are made better off, domestic consumers are made worse off, and the gains of producers outweigh the losses of consumers. iv. A tariff would create a deadweight loss because total surplus would fall. v. Note that moving to free trade causes winners and losers. Even though the gains of the winners are larger than the losses of the losers, it might be necessary to have a social safety net to help those who are worse off when free trade is allowed. i. Other Benefits of International Trade i. In addition to increasing total surplus, there are several other benefits of free trade. ii. These include an increased variety of goods, lower costs through economies of scale, increased competition, increased productivity, and an enhanced flow of ideas. j. In the News: Trade as a Tool for Economic Development i. Free trade in poor countries is a simple, yet effective, solution to the poverty problem. ii. For more than two decades, the global poverty rate has been decreasing about 1 percent per year due to free trade. The Arguments for Restricting Trade a. The Jobs Argument i. If a country imports a product, domestic producers of the product will have to lay off workers because they will decrease domestic output when the price declines to the world price. ii. Free trade, however, will create job opportunities in other industries where the country enjoys a comparative advantage. b. The National-Security Argument i. Protecting certain industries may be appropriate if they produce products necessary for national security. ii. In many of the cases for which this argument is used, the role of the industry in providing national security is exaggerated. c. The Infant-Industry Argument i. New industries need time to establish themselves to be able to compete in world markets.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade ii.

Sometimes older industries argue that they need temporary protection to help them adjust to new conditions. iii. Even if this argument is legitimate, it is nearly impossible for the government to choose which industries will be profitable in the future and it is even more difficult to remove trade restrictions in an industry once they are in place. d. The Unfair-Competition Argument i. It is unfair if firms in one country are forced to comply with more regulations than firms in another country, or if another government subsidizes the production of a good. ii. Even if an exporting country subsidizes the production of the product so that it can be imported at a lower price, the domestic consumers who import the product gain more than the domestic producers lose. e. The Protection-as-a-Bargaining-Chip Argument i. Threats of protectionism can make other countries more willing to reduce the amounts of protectionism they use. ii. If the threat does not work, the country has to decide if it would rather reduce the economic well-being of its citizens (by carrying out the threat) or lose credibility in negotiations (by reneging on its threat). iii. In the News: Why Trump’s Protectionism Is Futile: The decline in employment in America’s heavy industries is due to increases in US productivity and not due to unfair foreign competition. Thus, protectionism will not improve employment in those industries. f. Case Study: Trade Agreements and the World Trade Organization i. Countries wanting to achieve freer trade can take two approaches to cutting trade restrictions: a unilateral approach or a multilateral approach. ii. A unilateral approach occurs when a country lowers its trade restrictions on its own. A multilateral approach occurs when a country reduces its trade restrictions while other countries do the same. iii. The 1993 North America Free Trade Agreement (NAFTA) and its 2020 update known as the United States-Mexico-Canada Agreement, and the General Agreement on Tariffs and Trade (GATT) are multilateral approaches to reducing trade barriers. iv. The rules established under GATT are enforced by the World Trade Organization (WTO). v. The functions of the WTO are to administer trade agreements, provide a forum for negotiation, and handle disputes that arise among member countries. vi. The Trump administration moved away from a multilateral approach and raised tariffs unilaterally on China, the European Union, and others. As one would expect, they raised their tariffs on US goods. g. Ask the Experts: Trade Deals i. 93 percent of economic experts agreed that past trade deals have benefited most Americans, while the remaining 7 percent are uncertain. ii. 49 percent of economic experts agreed that it is a bad policy to refuse to trade unless environmental and labor concerns are addressed because

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade trade restrictions cause large market distortions. 25 percent disagreed and 26 percent were uncertain. iii. 86 percent of economic experts agreed that the incidence (burden) of the 2019 US import tariffs is likely to fall primarily on American households, while 0 percent disagreed and 14 percent were uncertain. iv. 75 percent of economic experts agreed that the impact of US tariffs (and the Chinese response) on US prices and employment will be felt largely by lower income groups and regions. 0 percent disagreed and 25 percent were uncertain. h. In the News: Trade as a tool for Economic Development: Free trade can help the world’s poorest citizens. “Andy Warhol’s Guide to Public Policy.” i. Warhol declared, “I like boring things.” We naturally are drawn to exotic new high tech solutions to our problems, but simple solutions are often best. ii. Free international trade reduces poverty better than every fancy development program ever devised. iii. Free trade doesn’t solve every problem of a developing nation, but it is the best (and most boring) anti-poverty program available. iv. Instruction Idea: Make sure that you point out the conclusion in this chapter. The chapter ends with a very effective parable about the discovery of comparative advantage, its adoption, its beneficial consequences, and finally, its abandonment for political reasons. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 74. If the domestic price that prevails without international trade is above the world price, the country does not have a comparative advantage in producing the good. If the domestic price is below the world price, the country has a comparative advantage in producing the good. 75. A country will export a good for which its domestic price is lower than the prevailing world price. Thus, if a country has a comparative advantage in producing a good, it will become an exporter when trade is allowed. A country will import a product for which its domestic price is greater than the prevailing world price. Thus, if a country does not have a comparative advantage in producing a good, it will become an importer when trade is allowed. 76. Figure 2 illustrates supply and demand for an importing country. Before trade is allowed, consumer surplus is area A and producer surplus is area B + C. After trade is allowed, consumer surplus is area A + B + D and producer surplus is area C. The change in total surplus is an increase of area D.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

Figure 2 77. A tariff is a tax on goods produced abroad and sold domestically. If a country is an importer of a good, a tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade, increasing the price of the good, reducing consumer surplus and total surplus, while raising producer surplus and government revenue. 78. The arguments given to support trade restrictions are: (1) trade destroys jobs; (2) industries threatened with competition may be vital for national security; (3) new industries need trade restrictions to help them get started; (4) some countries unfairly subsidize their firms, so competition is not fair; and (5) trade restrictions can be useful bargaining chips. Economists disagree with these arguments: (1) trade may destroy some jobs, but it creates other jobs; (2) arguments about national security tend to be exaggerated; (3) the government cannot easily identify new industries that are worth protecting; (4) if countries subsidize their exports, doing so simply benefits consumers in importing countries; and (5) bargaining over trade is a risky business, because it may backfire, making the country worse off without trade. 79. A unilateral approach to achieving free trade occurs when a country removes trade restrictions on its own. Under a multilateral approach, a country reduces its trade restrictions while other countries do the same, based on an agreement reached through bargaining. The unilateral approach was taken by Great Britain in the 1800s and by Chile and South Korea in recent years. Examples of the multilateral approach include NAFTA in 1993 and the GATT negotiations since World War II.

PROBLEMS AND APPLICATIONS 1.

a. Figure 4 illustrates the Canadian market for wine, where the world price of wine is P1. The following table illustrates the results under the heading "P1."

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Figure 4 b. The shift in the Gulf Stream destroys some of the grape harvest in Europe and raises the world price of wine to P2. The table shows the new areas of consumer, producer, and total surplus, as well as the changes in these surplus measures. Consumers lose, producers win, and Canada as a whole is worse off.

Consumer Surplus Producer Surplus Total Surplus

P1 A+B+D+E C A+B+C+D+E

P2 A+D B+C A+B+C+D

Change –B - E +B –E

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade 2. The impact of a tariff on imported automobiles is shown in Figure 6. Without the tariff, the price of an auto is PW, the quantity produced in the United States is Q1S, and the quantity purchased in the United States is Q1D. The United States imports Q1D – Q1S autos. The imposition of the tariff raises the price of autos to PW + t, causing an increase in quantity supplied by U.S. producers to Q2S and a decline in the quantity demanded to Q2D. This reduces the number of imports to Q2D – Q2S. The table shows the areas of consumer surplus, producer surplus, government revenue, and total surplus both before and after the imposition of the tariff. Because consumer surplus declines by C + D + E + F while producer surplus rises by C and government revenue rises by E, the deadweight loss is D + F. The loss of consumer surplus in the amount C + D + E + F is split up as follows: C goes to producers, E goes to the government, and D + F is deadweight loss.

Figure 6 Consumer Surplus Producer Surplus Government Revenue Total Surplus

Before Tariff A+B+C+D+E+F G 0 A+B+C+D+E+F+G

After Tariff A+B C+G E A+B+C+E+G

Change –C - D - E - F +C +E –D - F

3. a. For a country that imports clothing, the effects of a decline in the world price are shown in Figure 7. The initial price is Pw1 and the initial level of imports is Qd1 – Qs1. The new world price is Pw2 and the new level of imports is Qd2 – Qs2. The table below shows the changes in consumer surplus, producer surplus, and total surplus. Domestic consumers are made better off, while domestic producers are made worse off. Total surplus rises by areas D + E + F.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

Figure 7

Figure 8 Pw1 A+B C+G A+C+G

Consumer Surplus Producer Surplus Total Surplus

Pw2 A+B+C+D+E+F G A+B+C+D+E+F+G

Change C+D+E+F –C D+E+F

b. For a country that exports clothing, the effects of a decline in the world price are shown in Figure 8. The initial price is Pw1 and the initial level of exports is Qs1 – Qd1. The new world price is Pw2 and the new level of exports is Qs2 – Qd2. The table below shows the changes in consumer surplus, producer surplus, and total surplus. Domestic consumers are made better off, while domestic producers are made worse off. Total surplus falls by area D. Pw1 Consumer Surplus Producer Surplus Total Surplus

Pw2

A+B+C

B+C+D+E+F+G+H

E+F+G+H

A+B+C+D+E+F+G+H

A+B+C+E+F+G+H

Change B+C –B – C – D –D

c. Overall, importing countries benefit from the fall in the world price of clothing, while exporting countries are harmed. 4. a. While there are many possible answers, one correct answer is: the jobs argument and the unfair-competition argument. There are many workers employed in the timber industry and they may not be well-trained for jobs in other industries if free trade prevails and they lose their jobs due to less expensive imports. Other countries may impose less stringent regulations on the timber industry making competitors' production cheaper. b. While there are many possible answers, one correct answer is: the national-security argument and the infant-industry argument. The economic rationale for the national-security argument is that if the product is necessary for national security,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade we should not rely on imports for the production of the good. The economic rationale against the national-security argument is that the proponents of trade restrictions may exaggerate the fact that the product is necessary for national security. The economic rationale for the infant-industry argument is that firms in industries just getting started need protection from foreign competition to become established in the industry. The economic rationale against the infant-industry argument is that it is very difficult for government to foresee which industries will be profitable and worth protecting. 5. a. Figure 9 shows the market for T-shirts in Textilia. The domestic price is $20 Once trade is allowed, the price drops to $16 and three million T-shirts are imported.

Figure 9 b. Consumer surplus increases by areas A + B + C. Area A is equal to ($4)(1 million) +(0.5)($4)(2 million) = $8 million. Area B is equal to (0.5)($4)(2 million) = $4 million. Area C is equal to (0.5)($4)(1 million) = $2 million. Thus, consumer surplus increases by $14 million. Producer surplus declines by area A. Thus, producer surplus falls by $8 million. Total surplus rises by areas B + C. Thus, total surplus rises by $6 million. 6. a. Figure 10 shows the market for grain in an exporting country. The world price is PW.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade

Figure 10 b. An export tax will reduce the effective world price received by the exporting nation. c. An export tax will increase domestic consumer surplus, decrease domestic producer surplus, and increase government revenue. d. Total surplus will fall because the decline in producer surplus is less than the sum of the changes in consumer surplus and government revenue. Thus, there is a deadweight loss as a result of the tax. 7. a. This statement is true. For a given world price that is lower than the domestic price, quantity demanded will rise more when demand is elastic. Therefore, the rise in consumer surplus will be greater when demand is elastic. b. This statement is false. Quantity demanded would remain unchanged, but buyers would pay a lower price. This would increase consumer surplus. Domestic producer surplus will fall, but by less than the rise in consumer surplus. Gains from trade will increase. c. This statement is false. Even though quantity demanded does not rise when trade is allowed, consumer surplus rises, because consumers are paying a lower price. 8. a. Using Figure 4 from the text, the quantity demanded will fall to Q2D, the same quantity demanded under the tariff. However, quantity supplied will not change because the price sellers receive will be the world price. Thus, quantity supplied will remain at Q1S. b. The effects of the consumption tax can be seen in the table below:

Consumer Surplus Producer Surplus Government Revenue Total Surplus

World Price A+B+C+D+E+F G None

World Price + Tax A+B G C+D+E

Change -C - D - E - F None C+D+E

A+B+C+D+E+F+G

A+B+C+D+E+G

-F

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade c. The consumption tax raises more government revenue because the tax is on all units (not just the imported units). Thus, the deadweight loss is smaller with the consumption tax than with a tariff. 9. a. When a technological advance lowers the world price of televisions, the effect on the United States, an importer of televisions, is shown in Figure 13. Initially the world price of televisions is P1, consumer surplus is A + B, producer surplus is C + G, total surplus is A + B + C + G, and the amount of imports is shown as “Import1”. After the improvement in technology, the world price of televisions declines to P2 (which is P1 – 100), consumer surplus increases by C + D + E + F, producer surplus declines by C, total surplus rises by D + E + F, and the amount of imports rises to “Import2”.

Figure 13 Consumer Surplus Producer Surplus Total Surplus

P1 A+B C+G A+B+C+G

P2 A+B+C+D+E+F G A+B+C+D+E+F+G

Change C+D+E+F –C D+E+F

b. The areas are calculated as follows: Area C = 200,000($100) + (0.5)(200,000)($100) = $30 million. Area D = (0.5)(200,000)($100) = $10 million. Area E = (600,000)($100) = $60 million. Area F = (0.5)(200,000)($100) = $10 million. Therefore, the change in consumer surplus is $110 million. The change in producer surplus is -$30 million. Total surplus rises by $80 million. c. If the government places a $100 tariff on imported televisions, consumer and producer surplus would return to their initial values. That is, consumer surplus would fall by areas C + D + E + F (a decline of $110 million). Producer surplus would rise by $30 million. The government would gain tariff revenue equal to ($100)(600,000) = $60 million. The deadweight loss from the tariff would be areas D and F (a value of $20 million). This is not a good policy from the standpoint of U.S.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 9: Application: International Trade welfare because total surplus is reduced after the tariff is introduced. However, domestic producers will be happier as they benefit from the tariff. d. It makes no difference why the world price dropped in terms of our analysis. The drop in the world price benefits domestic consumers more than it harms domestic producers and total welfare improves. 10. An export subsidy increases the price of steel exports received by producers by the amount of the subsidy, s, as shown in Figure 14. The figure shows the world price, PW, before the subsidy is put in place. At that price, domestic consumers buy quantity Q1D of steel, producers supply Q1S units, and the country exports the quantity Q1S – Q1D. With the subsidy put in place, suppliers get a total price per unit of PW + s, because they receive the world price for their exports PW, and the government pays them the subsidy of s. However, note that domestic consumers can still buy steel at the world price, PW, by importing it. Domestic firms do not want to sell steel to domestic customers, because they do not get the subsidy for doing so. So domestic companies will sell all the steel they produce abroad, in total quantity Q2S. Domestic consumers continue to buy quantity Q1D. The country imports steel in quantity Q1D and exports the quantity Q2S, so net exports of steel are the quantity Q2S – Q1D. The end result is that the domestic price of steel is unchanged, the quantity of steel produced increases, the quantity of steel consumed is unchanged, and the quantity of steel exported increases. As the following table shows, consumer surplus is unaffected, producer surplus rises, government revenue declines, and total surplus declines.

Figure 14 Thus, it is not a good policy from an economic standpoint because there is a decline in total surplus. Consumer Surplus Producer Surplus Government Revenue Total Surplus

Without Subsidy A+B E+F+G 0 A+B+E+F+G

With Subsidy

Change

A+B B+C+E+F+G –B - C - D A+B–D+E+F+G

0 +B + C –B - C - D –D

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Tariffs and Quotas o Concept Clip: Infant Industry Protection o Video Problem Walk-Through: Calculating the Welfare Effects of Allowing Trade for an Importing Country Using Demand and Supply Equations o Video Problem Walk-Through: Illustrating the Welfare Effects of a Drop in the World Price for an Importing Country o Video Problem Walk-Through: Determining the Welfare Effects of Allowing Trade for an Importing Country o Areas o Equation Basics o Graphing Basics o Graphing Linear Equations

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

181

Complete List of Chapter Activities and Assessments Key Terms

182

183

What's New in This Chapter 183 Chapter Outline

183

Solutions to Text Problems 189 Questions for Review ................................................................................................................................................... 190 Problems and Applications ........................................................................................................................................ 191 Additional Resources195 Cengage Video Resources ........................................................................................................................................... 195

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 10 is the first chapter in the microeconomic section of the text. It is the first chapter in a four-chapter sequence on the economics of the public sector. Chapter 10 addresses externalities— the uncompensated impact of one person’s actions on the well-being of a bystander. Chapter 11 will address public goods and common resources (goods that will be defined in Chapter 11), Chapter 12 will address the economics of healthcare, and Chapter 13 will address the tax system. In Chapter 10, different sources of externalities and a variety of potential cures for externalities are addressed. Markets maximize total surplus to buyers and sellers that participate in a market. However, if a market generates an externality (a cost or benefit to someone external to the market) the market equilibrium may not maximize the total benefit to society. Thus, in Chapter 10 we will see that while markets are usually a good way to organize economic activity, governments can sometimes improve market outcomes. Key points addressed in this chapter: 



When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. If an activity yields negative externalities, such as pollution, the socially optimal quantity in a market is less than the equilibrium quantity. If an activity yields positive externalities, such as technology spillovers, the socially optimal quantity is greater than the equilibrium quantity. Governments can remedy the inefficiencies caused by externalities. Sometimes it regulates behavior. Other times it internalizes an externality using corrective taxes. Another policy is to issue permits. For example, the government could protect the environment by issuing a limited number of pollution permits. The result of this policy is similar to imposing corrective taxes on polluters. Those affected by externalities can sometimes solve the problem privately. For instance, when one business imposes an externality on another business, the two businesses can internalize the externality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase theorem, if people can bargain without cost, then they can reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a bargain among the many interested parties is difficult, so the Coase theorem does not apply.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Describe the differences between positive and negative externalities.



Determine how negative externalities impact market efficiency.



Explain the impact of regulation on negative externalities.



Explain the impact of taxes on negative externalities.



Determine how positive externalities impact market efficiency.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities 

Explain the impact of subsidies on positive externalities.



Explain the impact of tradable permits on negative externalities.



Explain how private solutions can correct for negative externalities.



Explain the application of the Coase theorem, given a scenario.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments by objective, so that you can see how all this content relates to objectives and make decisions about which content you would like to emphasize in your class based on your objectives. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Ask the Experts 1 Ask the Experts 2 Active Learning 1 Ask the Experts 3 Think-Pair-Share Activity Self-Assessment Section 10-1 QuickQuiz Section 10-2 QuickQuiz Section 10-3 QuickQuiz ConceptClip: Internalizing Externalities ConceptClip: Coase Theorem Figure 2: Pollution and the Social Optimum Figure 3: Education and the Social Optimum Figure 4: The Equivalence of Corrective Taxes and Pollution Permits Chapter 10 Problems & Applications Chapter 10 A+ Test Prep Chapter 10 Homework Chapter 10 Quiz: Externalities

Source (i.e., PPT slide, Workbook) PPT Slide 17 PPT Slide 23 PPT Slide 24 PPT Slide 30 PPT Slide 37 PPT Slide 38 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

30–40 mins. N/A 30–40 mins. 20–30 mins.

10–15 mins. 10–15 mins. 5–10 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities

KEY TERMS Coase Theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Corrective Taxes: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality. Externality: the uncompensated impact of a person’s actions on the well-being of a bystander. Internalizing the Externality: altering incentives so that people take account the external effects of their actions. Transaction Costs: the costs that parties incur in the process of agreeing and following through on a bargain. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new Ask the Experts feature on Covid Vaccines. There is a new Case Study on Cimate Change and Carbon Taxes.

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II.

Definition of externality: the uncompensated impact of a person’s actions on the wellbeing of a bystander. A. If the impact on the bystander is adverse, we say that there is a negative externality. B. If the impact on the bystander is beneficial, we say that there is a positive externality. C. Instruction Idea: Give students several examples of both positive and negative externalities. Use current health debates or political topics to maintain interest. D. In either situation, decision makers fail to take account of the external effects of their behavior. Externalities and Market Inefficiency A. Welfare Economics: A Recap 1. The demand curve for a good reflects the value of that good to consumers, measured by the price that the marginal buyer is willing to pay. 2. The supply curve for a good reflects the cost of producing that good.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities 3. In a free market, the price of a good brings supply and demand into balance in a way that maximizes total surplus (the difference between the consumers’ valuation of the good and the sellers’ cost of producing it). Figure 1 B. Negative Externalities 1. Example: A steel firm emits pollution during production. 2. Alternative Classroom Example: A coal-fired power plant emits pollution during production. 3. Social cost is equal to the direct private cost to the firm of producing the steel plus the external costs to those bystanders affected by the pollution and climate effects. Thus, social cost exceeds the private cost paid by producers. 4. The optimal amount of steel in the market will occur where total surplus is maximized. a. Total surplus is equal to the value of steel to consumers minus the true cost (social cost) of producing it. b. This will occur where the social-cost curve intersects with demand curve. At this point, producing one more unit would lower total surplus because the value to consumers is less than the social cost to produce it. 5. Instruction Idea: Make sure that students understand how this pollution by the firm imposes costs on third parties. Point out that the firm is likely emitting pollution because this is the cheapest method of production. Stress that the firm is using a resource in production that it is not paying for. Figure 2

6. Because the supply curve does not reflect the true cost of producing steel, the market will produce more steel than is optimal.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities 7. This negative externality could be internalized by a tax on producers for each unit of steel sold, shifting the supply curve upward by the size of the tax. 8. Definition of internalizing an externality: altering incentives so that people take into account the external effects of their actions. 9. Instruction Idea: This is a good time to discuss why the government taxes goods like alcohol, tobacco, and gasoline. You will find that students have heard the phrase “sin tax,” but they often do not understand why economists might support such taxes (given the deadweight loss from taxes discussed in Chapter 8). C. Positive Externalities 1. Example: education. 2. Education yields positive externalities because better-educated voters lead to a better government. Crime rates also drop as the education level of the population rises. An educated population generates technological advances that can be used by all. 3. In this case, the demand curve does not reflect the true social value of a good. 4. Alternative Classroom Example: The purchase of a fire extinguisher when an individual lives in an apartment complex. 5. If there is a positive externality, the social value of the good is greater than the private value, and the optimal quantity will be greater than the quantity produced in the market. 6. To internalize a positive externality, the government could use a subsidy. Figure 3

7. Instruction Idea: Make sure that students realize how heavily subsidized education is in the United States – both primary education and secondary education. 8. Case Study: Technology Spillovers, Industrial Policy, and Patent Protection

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III.

a. A technology spillover occurs when one firm’s research and production efforts affect another firm’s access to technological advance. b. It is difficult to measure the amounts of technology spillover that occur and this leads to a debate over whether the government should pursue an industrial policy, for example subsidizing technology-enhancing industries, to encourage the production of technology. c. Patent protection is a type of technology policy of the government because it protects the rights of inventors who create new technologies. Without patents, there would be less incentive to develop new ideas and technologies. Public Policies toward Externalities A. When an externality causes a market to reach an inefficient allocation of resources, the government can respond in two ways. 1. Command-and-control policies regulate behavior directly. 2. Market-based policies provide incentives so that private decision makers will choose to solve the problem on their own. B. Command-and-Control Policies: Regulation 1. Externalities can be corrected by requiring or forbidding certain behaviors. 2. In the United States, the Environmental Protection Agency (EPA) develops and enforces regulations aimed at protecting the environment. 3. EPA regulations include maximum levels of pollution allowed or required adoption of a particular technology to reduce emissions. 4. Ask the Experts: Covid Vaccines: When asked whether the federal government should require and pay for an effective Covid-19 vaccine because of the positive externality associated with vaccination, 85% of economic experts agreed, 5 percent disagreed, and 10 percent were uncertain. C. Market-Based Policy 1: Corrective Taxes and Subsidies 1. Externalities can be internalized through the use of taxes and subsidies. 2. Definition of corrective tax: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality. a. These taxes are preferred by economists over regulation, because firms that can reduce pollution with the least cost are likely to do so (to avoid the tax) while firms that encounter high costs when reducing pollution will simply pay the tax. b. Thus, this tax allows firms that face the highest cost of reducing pollution to continue to pollute while encouraging less pollution over all. c. Unlike other taxes, corrective taxes do not cause a reduction in total surplus. In fact, they increase economic well-being by forcing decision makers to take into account the cost of all of the resources being used when making decisions.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities 3. Case Study: Why Is Gasoline Taxed So Heavily? a. In the United States, on average, drivers pay about 55 cents per gallon in gasoline taxes. This is much less than in many other countries. b. This is to correct for three negative externalities associated with driving: pollution, congestion, and accidents. D. Market-Based Policy 2: Tradable Pollution Permits 1. Example: EPA regulations restrict the amount of pollution that two firms can emit at 300 tons of glop per year. Firm A wants to increase its amount of pollution. Firm B agrees to decrease its pollution by the same amount if Firm A pays it $5 million. 2. Social welfare is increased if the EPA allows this situation. Total pollution remains the same so there are no external effects. If both firms are doing this willingly, it must make them better off. 3. If the EPA issued permits to pollute and then allowed firms to sell them, this would also increase social welfare. Firms that could control pollution most inexpensively would do so and sell their permits, while those who encounter high costs when reducing pollution would buy additional permits. 4. In the News: What Should We Do about Climate Change? “A Carbon Tax that Could Put Money in Your Pocket.” a. It is difficult to get people to agree on how to reduce global warming. b. To bring both sides together, many economists suggest the following: A carbon tax would reduce carbon emissions and reduce global warming. The tax revenue could be rebated back to citizens as a “carbon dividend.” Figure 4

5. Tradable pollution permits and corrective taxes are similar in effect. In both cases, firms must pay for the right to pollute.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities

IV.

a. In the case of the tax, the government basically sets the price of pollution and firms then choose the level of pollution (given the tax) that maximizes their profit. b. If tradable pollution permits are used, the government chooses the level of pollution (in total, for all firms) and firms then decide what they are willing to pay for these permit E. Objections to the Economic Analysis of Pollution 1. Instruction Idea: Stress to students that the socially optimal level of pollution is not “zero.” Make sure that they understand that society faces a trade-off because of the resources used to combat pollution. 2. Some individuals dislike the idea of allowing companies to purchase the right to pollute. 3. Economists point out that “people face trade-offs” (Principle #1) and we must decide how much we would be willing to give up in exchange for no pollution. It would likely not be enough. 4. A clean environment can be viewed as any other good that obeys the law of demand. The lower the price of environmental protection, the more the public will want. 5. Case Study: Climate Change and Carbon Taxes a. There are many ways to get people to make a smaller carbon footprint. Appeal to people’s social responsibility (but not all people are responsible) or regulate the size and type of cars people drive (but this doesn’t influence how much people drive). b. An alternative is to put a price on carbon emissions with a carbon tax or a cap-and-trade system of tradable pollution permits. The social cost of carbon emissions would be incorporated into the prices of the things people buy and people would consume less of the things that generate carbon emissions. Economists prefer this option. 6. Ask the Experts: Carbon Taxes a. 98 percent of expert economists on the panel agreed that a proposed carbon tax would distort the U.S. economy less than a tax increase on labor income that resulted in the same amount of revenue. The other 2 percent were uncertain. b. 95 percent of expert economists on the panel agreed that a tax on the carbon content of fuels would be a less expensive way to reduce carbon dioxide emissions than the command and control policies affecting fuel efficiency of automobiles. c. 79 percent of expert economists agreed that carbon taxes are a better way to implement climate policy than cap-and-trade. Private Solutions to Externalities A. We do not necessarily need government involvement to correct externalities. B. The Types of Private Solutions 1. Problems of externalities can sometimes be solved by moral codes and social sanctions. a. Do not litter.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities b. The Golden Rule 2. Many charities have been established that deal with externalities. The government encourages this private solution by allowing a deduction for charitable contributions in the determination of taxable income. a. Sierra Club (environment) b. University Alumni Association (scholarships) 3. A bee keeper and an apple orchard can merge in order to internalize the externality and increase the bees and trees to the optimal level. C. The Coase Theorem 1. Definition of Coase theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. 2. Example: Emily owns a dog Clifford who disturbs a neighbor (Horace) with its barking. a. One possible solution to this problem would be for Horace to pay Emily to get rid of the dog. The amount that he would be willing to pay would be equal to his valuation of the costs of the barking. Emily would only agree to this if Horace paid her an amount greater than the value she places on owning Clifford. b. Even if Horace could legally force Emily to get rid of Clifford, another solution could occur. Emily could pay Horace to let her keep the dog. 3. Whatever the initial distribution of rights, the parties involved in an externality can potentially solve the problem themselves and reach an efficient outcome where both parties are better off. 4. In the News: The Coase Theorem in Action a. This New York Times article illustrates how the Coase theorem can be applied to reclining seats on airlines. b. With low bargaining costs, passengers with the greatest value over the property right will end up with it, because the property right is clearly defined initially. D. Why Private Solutions Do Not Always Work 1. Definition of transaction costs: the costs that parties incur in the process of agreeing and following through on a bargain. 2. Coordination of all of the interested parties may be difficult so that bargaining breaks down. This is especially true when the number of interested parties is large. For example, the issue of climate change has an enormous number of interested parties and a private world-wide solution is impossible. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities

QUESTIONS FOR REVIEW 52. Examples of negative externalities include pollution, barking dogs, and consumption of alcoholic beverages. Examples of positive externalities include the restoration of historic buildings, research into new technologies, and education. (Many other examples of negative and positive externalities are possible.) 53. Figure 1 illustrates the effect of a negative externality. The equilibrium quantity provided by the market is Qmarket. Because of the externality, the social cost of production is greater than the private cost of production, so the social-cost curve is above the supply curve. The optimal quantity for society is Qoptimum. The private market produces too much of the good because Qmarket is greater than Qoptimum.

Figure 1 54. The patent system helps society solve the externality problem from technology spillovers. By giving inventors exclusive use of their inventions for a certain period, the inventor can capture much of the economic benefit of the invention. In doing so, the patent system encourages research and technological advance, which benefits society through spillover effects. 55. Corrective taxes are taxes enacted to correct the effects of a negative externality. Economists prefer corrective taxes over regulations as a way to protect the environment from pollution because they can reduce pollution at a lower cost to society. A tax can be set to reduce pollution to the same level as a regulation. The tax has the advantage of letting the market determine the least expensive way to reduce pollution. The tax gives firms incentives to develop cleaner technologies to reduce the taxes they have to pay. 56. Externalities can be solved without government intervention through moral codes and social sanctions, charities, merging firms whose externalities affect each other, or by contract. 57. According to the Coase theorem, you and your roommate will bargain over whether your roommate will smoke in the room. If you value clean air more than your roommate values smoking, the bargaining process will lead to your roommate not smoking. But if your roommate values smoking more than you value clean air, the bargaining process will lead to your roommate smoking. The outcome is efficient as long as transaction costs do not prevent an agreement from taking place. The solution may be reached by one of you paying off the other either not to smoke or for the right to smoke.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities

PROBLEMS AND APPLICATIONS 80. The Club conveys a negative externality on other car owners because car thieves will not attempt to steal a car with The Club visibly in place. This means that they will move on to another car. The Lojack system conveys a positive externality because thieves do not know which cars have this technology. Therefore, they are less likely to steal any car. Policy implications include a subsidy for car owners that use the Lojack technology or a tax on those who use The Club. 81. a. Fire extinguishers exhibit positive externalities because even though people buy them for their own use, they may prevent fire from damaging the property of others.

Figure 2

b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social-value curve is above the demand curve and the social-cost curve is the same as the supply curve. c. The market equilibrium level of output is denoted Qmarket and the efficient level of output is denoted Qoptimum. The quantities differ because in deciding to buy fire extinguishers, people don't account for the benefits they provide to others. d. A government policy that would result in the efficient outcome would be to subsidize people $10 for every fire extinguisher they buy. This would shift the demand curve up to the social-value curve, and the market quantity would increase to the optimum quantity. 82. a. The market for alcohol is shown in Figure 3. The social-value curve is the same as the demand curve in this case. The social-cost curve is above the supply curve because of the negative externality from increased motor vehicle accidents caused by those who drink and drive. The market equilibrium level of output is Qmarket and the efficient level of output is Qoptimum.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities b. The triangular area between points A, B, and C represents the deadweight loss of the market equilibrium. This area shows the amount by which social costs exceed social value for the quantity of alcohol consumption beyond the efficient level.

Figure 3 83.

84.

a. It is efficient to have different amounts of pollution reduction at different firms because the costs of reducing pollution differ across firms. If all firms were made to reduce pollution by the same amount, the costs would be low at some firms and prohibitively high at others, imposing a greater burden overall. b. Command-and-control approaches that rely on uniform pollution reduction among firms give the firms no incentive to reduce pollution beyond the mandated amount. Instead, every firm will reduce pollution by just the amount required and no more. c. Corrective taxes or tradable pollution rights give firms greater incentives to reduce pollution. Firms are rewarded by paying lower taxes or spending less on permits if they find methods to reduce pollution, so they have the incentive to engage in research on pollution control. The government does not have to figure out which firms can reduce pollution the mostit lets the market give firms the incentive to reduce pollution on their own. a. At a price of $1.50, each Whovillian will consume 4 bottles of Zlurp. Each consumer’s total willingness to pay is $14 (= $5 + $4 + $3 + $2). The total spent by each Whovillian on Zlurp is $6 (= $1.50  4). Therefore, each consumer receives $8 in consumer surplus ( $14 − $6). b. Total surplus would fall by $4 to $4. c. If Cindy Lou only consumes 3 bottles of Zlurp, her consumer surplus is $4.50. Her willingness to pay for 3 bottles is $5 + $4 + $3 = $12. She pays $1.50 x 3 = $4.50 and the externality is $1 x 3 = $3. Thus, Cindy Lou's consumer surplus is $12 - $4.50 $3.00 $4.50. Cindy’s decision increases consumer surplus in Whoville by $0.50 ($4.50-$4.00). d. The $1 tax raises the price of a bottle of Zlurp to $2.50. (The entire tax will be borne by consumers because supply is perfectly elastic.) Each resident will purchase only 3 bottles at the higher price and each consumer’s total willingness to pay is now $12

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities (= $5 + $4 + $3). Each resident pays $7.50 (= $2.50  3). Therefore, each resident receives $4.50 ($12-$7.50) in consumer surplus.

85.

86.

Because each bottle has an external cost of $1, the per-resident external cost is $3 ($1 per bottle x 3 bottles). The government collects $3 per resident in revenue. Total surplus with the tax is equal to $4.50 - $3.00 + $3.00 = $4.50. e. Yes, because total surplus is now higher than before the tax. a. The externality is noise pollution. Bruno’s consumption of rock and roll music affects Placido, but Bruno does not consider that in deciding how loudly he plays his music. b. The landlord could impose a rule that music could not be played above a certain decibel level. This could be inefficient because there would be no harm done by Bruno playing his music loud if Placido is not home. c. Bruno and Placido could negotiate an agreement that might, for example, allow Bruno to play his music loudly at certain times of the day. They might not be able to reach an agreement if the transaction costs are high or if bargaining fails because each holds out for a better deal. a. An improvement in the technology for controlling pollution would reduce the demand for pollution rights, shifting the demand curve to the left. Figure 4 illustrates what would happen if there were a corrective tax, while Figure 5 shows the impact if there were a fixed supply of pollution permits. In both figures, the curve labeled D1 is the original demand for pollution rights and the curve labeled D2 is the new demand for pollution rights after the improvement in technology.

Figure 4 b. With a corrective tax, the price of pollution remains unchanged and the quantity of pollution declines, as Figure 4 shows. With pollution permits, the price of pollution declines and the quantity of pollution is unchanged, as Figure 5 illustrates.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 10: Externalities

Figure 5 87.

88.

a. In terms of economic efficiency in the market for pollution, it does not matter if the government distributes the permits or auctions them off, as long as firms can sell the permits to each other. The only difference would be that the government could make money if it auctioned the permits off, thus allowing it to reduce taxes, which would help reduce the deadweight loss from taxation. There could also be some deadweight loss occurring if firms use resources to lobby for additional permits. b. If the government allocated the permits to firms who did not value them as highly as other firms, the firms could sell the permits to each other so they would end up in the hands of the firms who value them most highly. Thus, the allocation of permits among firms would not matter for efficiency. But it would affect the distribution of wealth, because those who got the permits and sold them would be better off. a. The firms with the highest cost of reducing pollution will buy permits rather than reduce their pollution. Firms that can sell their permits for more than it costs them to reduce their pollution will sell. Because firm B faces the highest costs of reducing pollution, $30 per unit, it will keep its own 20 permits and buy 20 permits from the other firms, so that it can still pollute 40 units. Thus, firm B does not reduce its pollution at all. Of the two remaining firms, firm A has the higher cost of reducing pollution so it will keep its own 20 permits and reduce its pollution by 10 units at a cost of $20 x 10 units = $200. Firm C sells all 20 of its permits to firm B and reduces its pollution by 20 units at a cost of $10 × 20 = $200. The total cost of pollution reduction is $400. b. If the permits could not be traded, then firm A would have to reduce its pollution by 10 units at a cost of $20 × 10 = $200, firm B would have to reduce its pollution by 20 units at a cost of $30 × 20 = $600, and firm C would not have to reduce its pollution

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources because its permits would cover the 20 units it emits. The total cost of pollution reduction would be $800, $400 higher than in the case in which the permits could be traded.

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Internalizing Externalities o Concept Clip: Coase Theorem o Video Problem Walk-Through: Analyzing the Use of Tradable Pollution Permits to Reduce Pollution o Video Problem Walk-Through: Determining Consumption and Consumer Surplus in a Market with a Negative Externality Before and After a Tax o Video Problem Walk-Through: Analyzing a Market with a Negative Externality and the Use of a Tax to Internalize the Externality o Areas o Equation Basics o Graphing Basics o Graphing Linear Equations

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 197 Chapter Objectives ........................................................................................................................................... 197 Complete List of Chapter Activities and Assessments ......................................................................... 198 Key Terms ........................................................................................................................................................... 198 What's New in This Chapter .......................................................................................................................... 199 Chapter Outline ................................................................................................................................................. 199 Solutions to Text Problems ........................................................................................................................... 203 Questions for Review ................................................................................................................................................... 203 Problems and Applications ........................................................................................................................................ 204

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources Additional Activities and Assignments ..................................................................................................... 206 Additional Resources ...................................................................................................................................... 207 Cengage Video Resources ........................................................................................................................................... 207

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 11 is the second chapter in a four-chapter sequence on the economics of the public sector. Chapter 10 addressed externalities. Chapter 11 addresses public goods and common resources— goods for which it is difficult to charge prices to users. Chapter 12 will address the economics of healthcare and chapter 13 will address the tax system. The purpose of Chapter 11 is to address a group of goods that are free to the consumer. When goods are free, market forces that normally allocate resources are absent. Therefore, free goods, such as playgrounds and public parks, may not be produced and consumed in the efficient amounts. Government can potentially remedy this market failure and improve economic well-being. Key points addressed in this chapter: 



Goods differ in whether they are excludable and whether they are rival in consumption. A good is excludable if it is possible to prevent someone from using it. It is rival in consumption if one person’s use of the good reduces other’s ability to use the same unit of the good. Markets work best for private goods, which are both excludable and rival in consumption. Markets do not work as well for other types of goods. Public goods are neither rival in consumption nor excludable. Examples of public goods include fireworks displays, national defense, and the discovery of fundamental knowledge. Because people are not charged for their use of the public good, they have an incentive to free ride, making private provision of the good untenable. Governments can improve the allocation of resources by providing public goods and determining the quantity of each good with cost–benefit analysis. Common resources are rival in consumption but not excludable. Examples include common grazing land, clean air, and congested roads. Because people are not charged for their use of common resources, they tend to use them excessively. Therefore, governments use various methods, such as regulations and corrective taxes, to limit the use of common resources.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Examine the implications of excludability and rivalry on the market for a good.



Identify a good as a public good, private good, common resource, or club good in a given scenario.



Determine whether a good is excludable in consumption.

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Determine whether a good is rival in consumption.

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Explain the presence of the free-rider problem, given an example of a public good.



Explain why private firms find it unprofitable to produce public goods.



Name a problem associated with using cost-benefit analysis to determine the optimal quantity of a public good.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources 

Explain why consumers tend to overuse common resources, resulting in the tragedy of the commons.



Explain the role of property rights on achieving market efficiency.

Source (i.e., PPT slide, Workbook) PPT Slide 10 PPT Slide 12 PPT Slide 20 PPT Slide 28 PPT Slide 31 PPT Slide 32 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

Duration

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

35–45 mins. N/A 20–30 mins. 20–30 mins.

5 mins. 10–15 mins. 5 mins. 10–15 mins. 10–15 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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KEY TERMS Club Goods: goods that are excludable but not rival in consumption. Common Resources: goods that are rival in consumption but not excludable. Cost-Benefit Analysis: a study that compares the costs and benefits to society of providing a public good. Excludability: the property of a good whereby a person can be prevented from using it. Free Rider: a person who receives the benefit of a good but avoids paying for it.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources Public Goods: goods that are neither excludable nor rival in consumption. Private Goods: goods that are both excludable and rival in consumption. Rivalry in Consumption: the property of a good whereby one person’s use diminishes other people’s use. Tragedy of the Commons: a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

There is a new In the News feature on Road Pricing: “How Federal Infrastructure Dollars Get Nickeled and Dimed.”

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The Different Kinds of Goods A. When classifying types of goods in the economy, two characteristics should be examined. 1. Definition of excludability: the property of a good whereby a person can be prevented from using it. 2. Definition of rivalry in consumption: the property of a good whereby one person’s use diminishes other people’s use. B. Using these two characteristics, goods can be divided into four categories. 1. Definition of private goods: goods that are both excludable and rival in consumption. 2. Definition of public goods: goods that are neither excludable nor rival in consumption. 3. Definition of common resources: goods that are rival in consumption but not excludable. 4. Definition of club goods: goods that are excludable but not rival in consumption. Figure 1 Rival in consumption?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources

Yes Excludable? No

VI.

Yes Private Goods  ice-cream cones  clothing  congested toll roads Common Resources  fish in the ocean  the environment  congested nontoll roads

No Club Goods  fire protection  satellite TV  uncongested toll roads Public Goods  national defense  knowledge  uncongested nontoll roads

C. The boundary between the categories is sometimes fuzzy. Whether goods are excludable or rival in consumption is often a matter of degree. D. Public goods and common resources each create externalities because they have value yet have no price because they are not sold in the marketplace. These external effects imply that market outcomes will be inefficient in the absence of government involvement or private resolutions to correct the externality. E. Instruction Idea: There is a student activity (Private Goods/Public Goods: A Demonstration) that applies to this topic in the "Additional Activities and Assignments” section. Public Goods A. Example: a fireworks display. It is not excludable because it would be nearly impossible to keep others from viewing it and it is not rival in consumption because one person’s enjoyment does not preclude others from enjoying the fireworks. 1. Instruction Idea: Other examples of public goods that may be of interest to students include highway snow removal, flood control, and mosquito control. In all of these instances, one can argue that government intervention is necessary in order to achieve economic efficiency. 2. It would be difficult to sell tickets to the fireworks show because it is not excludable. 3. Thus, some individuals would get a benefit from the show without paying for it. 4. Definition of free rider: a person who receives the benefit of a good but avoids paying for it. 5. More than likely, private individuals or firms will not produce the fireworks show because it would not be profitable. 6. If the social value of the fireworks show is greater than the cost of producing it, it would be efficient for the fireworks show to be produced. a. The local government can sponsor the show and charge each of its citizens part of the cost (in the form of a tax). b. If the tax is less than the value of the fireworks display to each individual, everyone is better off. 7. This is another demonstration of Principle #7: Governments can sometimes improve market outcomes. 8. Keep in Mind: Students often incorrectly believe that all goods and services provided by the government are public goods. An example of this

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources is education. This would be a good example to use to explain the meaning of excludability and rivalry in consumption. B. Some Important Public Goods 1. National defense 2. Basic research 3. Fighting poverty C. Case Study: Are Lighthouses Public Goods? 1. Lighthouses are used so that ships can mark specific locations and avoid treacherous waters. 2. Use of a lighthouse is not excludable, nor rival in consumption. 3. Thus, most lighthouses are provided by the government. 4. In 19th-century England, lighthouses were operated more like private goods. The owners of local ports were charged with the service and if they did not pay, the owner of the lighthouse simply turned off the light and ships avoided stopping in that port. D. The Difficult Job of Cost–Benefit Analysis 1. Instruction Idea: Point out the differences in the way in which a business provides and finances its products and the way in which governments do the same. This will help students see the difference between the market process and the political process as alternative ways of providing goods and services. 2. To decide whether it should fund a public good, the government often conducts a study of the total benefits and costs of the good. 3. Definition of cost-benefit analysis: a study that compares the costs and benefits to society of providing a public good. 4. This is very difficult to do because measuring how much individuals will value a specific good is problematic. a. Quantifying benefits is difficult using the results from a questionnaire. b. Respondents have little incentive to tell the truth. 5. This difficulty implies that the efficient supply of public goods is much more challenging than the efficient supply of private goods. In a market for private goods, the price allows buyers of the good to reveal its value to the sellers, and sellers of the good to reveal its cost to the buyers. 6. Case Study: How Much Is a Life Worth? a. Instruction Idea: Before talking about this section, ask students to write down the value of their lives. Ask them how they arrived at this answer. This is a nice way to lead into the difficulty of cost–benefit analysis. b. Example: the decision to place a stoplight at a busy intersection to reduce the risk of fatal accidents. c. The cost is known in dollar terms. But how can we put the value of a life in dollar terms? d. Some studies examine the value of the lifetime earnings the individual could have made, but this implies that the life of someone who is disabled or retired has no monetary value.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources

VII.

e. Economists instead may look at the risks that individuals voluntarily take and those for which they require compensation. Workers in risky occupations are paid a wage premium to take these risks. This approach gives us an idea of the value that an individual places on their life. Studies have shown this value to be approximately $10 million. Common Resources A. Common resources are not excludable, but they are rival in consumption. This implies that policymakers need to be concerned about how much is used. B. The Tragedy of the Commons 1. Definition of the Tragedy of the Commons: a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. 2. Example: small, medieval town where sheep graze on common land. a. Over time, as the population grows, so does the number of sheep. b. Given the fixed amount of land, the grass will begin to disappear because it is being overgrazed. c. The townspeople will no longer be able to raise sheep because the private incentives (using the land for free) outweigh the social incentives (using the land carefully). d. This problem could have been prevented if the town had regulated the number of sheep each farmer could have or auctioned off the right to use the common land for grazing. Alternatively, the town could have divided the common property between its citizens, thus turning the land into an excludable good. 3. Instruction Idea: A more modern example is the overfishing of oceans, bays, and rivers, leading to dangerously low seafood populations in some areas. Other examples include excessive extraction of oil from a large pool beneath several different property owners’ land, and congested highways. C. Some Important Common Resources 1. Clean air and water 2. Congested roads and polluted digital platforms a. Ask the Experts: Congestion Pricing – 98 percent of economic experts agreed that using more congestion charges in crowded transportation networks and reducing other taxes would make citizens better off. b. In the News: Road Pricing: “How Federal Infrastructure Dollars Get Nickeled and Dimed.” The author of this article argues that the proposed $2.25 trillion infrastructure of plan of 2021 will fail to significantly improve the nation’s roads and bridges. Unlike private investment, public investment in roads is not based on efficient pricing. Roads in the U.S. are not built in the most needed and valuable places, regulations inflate wages and materials costs, environmental regulations delay projects, infrastructure legislation is laden with unrelated earmarks for pet projects, and the production processes fail to use the most current technologies.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources

VIII.

3. Fish, Whales, and Other Wildlife a. Case Study: Why the Cow is Not Extinct — Elephants in Africa are common resources because no one owns them. This means that no one has an incentive to make sure that a sufficient number are preserved. This is different from a cow, which is usually owned by a rancher. The rancher has an incentive to ensure that the cattle population on his ranch is maintained so that he can continue to earn a profit. Thus, governments could actually be more successful in making sure that the elephant is not extinct by allowing people to kill the elephants on their own property (thus making the elephants a private good). The landowners would then have some incentive to preserve the stock of elephants on their land. 4. Instruction Idea: There is a student activity (Article on the Role of Government) that applies to this topic in the "Additional Activities and Assignments” section. Conclusion: Property Rights and Government Action A. With both public goods and common resources, the market outcome will be inefficient because of the lack of well-defined property rights. B. This absence of property rights can lead to a market failure, which implies that in these situations, governments can improve the allocation of resources and increase economic well-being.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 58. An excludable good is one that people can be prevented from using. A good that is rival in consumption is one for which one person's use diminishes other people's use of the same good. Pizza is excludable, because a pizza producer can prevent someone who does not pay for the pizza from eating it. Pizza is also rival in consumption, because when one person eats it, no one else can eat it. 59. A public good is a good that is neither excludable nor rival in consumption. An example is national defense, which protects the entire nation. No one can be prevented from enjoying the benefits of it, so it is not excludable. An additional person benefiting from it does not diminish the value of it to others, so it is not rival in consumption. The private market will not supply the good, because no one would pay for it because they cannot be excluded from enjoying it even if they don't pay for it. 60. Cost–benefit analysis is a study that compares the costs and benefits to society of providing a public good. It is important because the government needs to know which public goods people value most highly and which have benefits that exceed the costs of supplying them. It is hard to do because quantifying the benefits is difficult to do from a questionnaire and because respondents have little incentive to tell the truth.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources 61. A common resource is a good that is rival in consumption but not excludable. An example is fish in the ocean. If someone catches a fish, that leaves fewer fish for everyone else, so it is rival in consumption. But the ocean is so vast, you cannot charge people for the right to fish, or prevent them from fishing, so it is not excludable. Thus, without government intervention, people will use the good too much, because they do not account for the costs they impose on others when they use the good.

PROBLEMS AND APPLICATIONS 89. a. (1) Police protection is a club good because it is excludable (the police may ignore some neighborhoods) and not rival in consumption. You could make an argument that police protection is rival in consumption, if the police are too busy to respond to all crimes, so that one person's use of the police reduces the amount available for others. In that case, police protection is a private good. (2) Snow plowing is most likely a common resource. Once a street is plowed, it is not excludable. But it is rival in consumption, especially right after a big snowfall, because plowing one street means not plowing another street. (3) Education is a private good (with a positive externality). It is excludable, because someone who does not pay can be prevented from taking classes. It is rival in consumption, because the presence of an additional student in a class reduces the benefits to others. (4) Rural roads are public goods. They are not excludable and they are not rival in consumption because they are uncongested. (5) City streets are common resources when congested. They are not excludable, because anyone can drive on them. But they are rival in consumption, because congestion means that every additional driver slows down the progress of other drivers. When they are not congested, city streets are public goods, because they are no longer rival in consumption. b. The government may provide goods that are not public goods, such as education, because of the externalities associated with them. 90. a. The externalities associated with public goods are positive. Because the benefits from the public good received by one person do not reduce the benefits received by anyone else, the social value of public goods is substantially greater than the private value. Examples include national defense, knowledge, uncongested non-toll roads, and uncongested parks. Because public goods are not excludable, the free-market quantity is zero, so it is less than the efficient quantity. b. The externalities associated with common resources are generally negative. Because common resources are rival in consumption but not excludable, the use of the common resources by one person reduces the amount available for others. Because common resources of using the resources is less than the social cost. Examples include fish in the ocean,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources the environment, congested non-toll roads, the Town Commons, and congested parks. 91. a. Fredo is a free rider. b. The government could solve the problem by sponsoring the show and paying for it with tax revenue collected from everyone. c. The private market could also solve the problem by making people watch commercials that are incorporated into the program. The existence of cable TV makes the good excludable, so it would no longer be a public good. 92. a. If only a few people use the free wireless internet, it would not be excludable and not rival in consumption. Thus, it would be a public good. b. Once a large number of people begin using the free internet service, it is a common resource. It is still not excludable, but it is now rival in consumption. c. Overuse is likely to occur. One possible way to correct for this would be to make the good excludable by charging a fee for its use. 93. a. Within the dorm room, the showing of a movie is a public good. None of the roommates can be excluded from viewing the movie. Because one roommate’s viewing does not affect the ability of another roommate to view the movie, the good is also not rival in consumption. b. The roommates should stream three movies because the value of the fourth film ($6) would be less than the cost ($8). c. The total cost would be $8 x 3 = $24. If the cost were divided evenly among the roommates, each would pay $6. Dwayne values three movies at $18 so his surplus would be $12. Javier values three movies at $12 so his surplus would be $6. Salman values three movies at $6, so his surplus would be $0. Chris values three movies at $3 so his surplus is -$3. Total surplus among the three roommates would be $15. d. The costs could be divided up by the roommates based on the benefits they receive. Because Dwayne values the movies the most, he would pay the greatest share. The problem is that this gives each roommate an incentive to understate the value of the movies to him. e. Because they are going to pay equal shares, Dwayne has an incentive to tell the truth about the value he places on movies to ensure that the group rents three movies. He values each of the movies more than his cost per movie ($2). f. The optimal provision of public goods will occur if individuals do not have an incentive to hide their valuation of a good. This means that each individual’s cost cannot be related to his valuation. 94. a. Because knowledge is a public good, the benefits of basic scientific research are available to many people. The private firm doesn't take these external benefits into account when choosing how much research to undertake; it only takes into account what it will earn. b. The United States has tried to give private firms incentives to provide basic research by subsidizing it through organizations like the National Institute of Health and the National Science Foundation.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources c. If it is basic research that adds to knowledge, it is not excludable at all, unless people in other countries can be prevented somehow from sharing that knowledge. So perhaps U.S. firms get a slight advantage because they hear about technological advances first, but knowledge tends to diffuse rapidly. 95. a. In Bayport, the sum of the benefits ($50 + $100 + 300 = $450) is greater than the cost of the fireworks show ($360), so fireworks would pass a cost-benefit analysis. b. If the cost is split equally among all residents, the cost per resident would be ($360 / 3 =) $120. Frank would vote against because his value ($50) is less than the cost. Joe would vote against because his value ($100) is less than the cost. Callie would vote in favor because her value ($300) is greater than the cost. The result of the referendum vote would be against the fireworks, so the referendum would not yield the same answer as the cost-benefit analysis. c. In River Heights, the sum of the benefits ($20 + $140 + $160 = $320) is less than the cost of the fireworks show ($360), so fireworks would not pass a cost-benefit analysis. d. If the cost is split equally among all residents, the cost per resident would be ($360/3) $120. Nancy would vote against because her value ($20) is less than the cost. Bess would vote for because her value ($140) is greater than the cost. Ned would vote in favor because his value ($160) is greater than the cost. The result of the referendum vote would be for the fireworks, so the referendum would not yield the same answer as the cost-benefit analysis. e. The optimal provision of public goods is challenging because the total benefit may exceed the total cost when the average benefit is less than the average cost, or vice versa. 96. When a person litters along a highway, others bear the negative externality, so the private costs are low. Littering in your own yard (or perhaps your neighbors’ yards) imposes costs on you, so it has a higher private cost and is thus rare. In addition, the marginal benefit to the individual of picking up litter on the highway is small while the marginal benefit to the individual of picking up litter in one’s yard is large. 97. When the system is congested, each additional rider imposes costs on other riders. For example, when all seats are taken, some people must stand. Or if there isn't any room to stand, some people must wait for a train that isn't as crowded. Increasing the fare during rush hour internalizes this externality. 98. Recognizing that there are opportunity costs that are relevant for cost–benefit analysis is the key to answering this question. A richer community can afford to place a higher value on life and safety. So the richer community is willing to pay more for a traffic light, and that should be considered in cost–benefit analysis.

[In-class demonstration] Private Goods/Public Goods: 10 minutes total. Works in any class size. Topics include public and private goods. Materials needed include a candy bar.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 11: Public Goods and Common Resources T. Purpose: This example illustrates the difference between public and private goods. U. Instructions: Ask for a volunteer. Give the volunteer a candy bar and ask them to eat it. While the student eats the candy bar, explain that you do not want the student’s enjoyment of the candy to be marred by taking notes. Offer to draw some beautiful artwork on the board to increase the volunteer’s enjoyment.

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Draw a picture on the board. A large poster or a slide of real artwork could be substituted. Ask the volunteer if they are enjoying the candy and the art. Ask the class if they get any enjoyment from the candy. Ask the class if they get any enjoyment from the art. V. Points for Discussion: 8. The candy bar is a private good. It is rival in consumption and excludable. Only the volunteer gets to enjoy the candy. 9. The “artwork” is neither rival in consumption nor excludable. The volunteer’s enjoyment did not diminish the enjoyment of the rest of the class. The “artwork” is a public good. [Take-home assignment] Article on the Role of Government. Works in any class size. Topics include the role of the government and market failure. A. Purpose: This assignment gives students an opportunity to identify real-world market failures and consider how the government can address these issues. Categorizing a real problem will help students clearly distinguish the various types of market failure. B. Instructions: This assignment is difficult for many students, particularly if they are unclear on the concept of market failure. Not every example of government action will be appropriate for this assignment. Students may find it easier to make a list of possible areas of market failures before looking for an article. Ask the students to do the following: 1. Find an article in a recent newspaper or magazine that illustrates market failure. 2. Identify the type of market failure. Is it a problem of negative externalities, positive externalities, public goods, or common resources? 3. Explain how government action can improve economic efficiency. 4. Graph the market failure and explain the problem. Then show how the government action will change the situation.

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Rivalry and Exclusion

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare o o o o

Concept Clip: Free Rider Concept Clip: Tragedy of the Commons Video Problem Walk-Through: Determining the Efficient Allocation of a Public Good Video Problem Walk-Through: Identifying the Different Kinds of Goods Analysis

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 209 Chapter Objectives ........................................................................................................................................... 209 Complete List of Chapter Activities and Assessments ......................................................................... 210 Key Terms ........................................................................................................................................................... 210 What's New in This Chapter .......................................................................................................................... 211 Chapter Outline ................................................................................................................................................. 211 Solutions to Text Problems ........................................................................................................................... 216 Questions for Review ................................................................................................................................................... 217 Problems and Applications ........................................................................................................................................ 217 Additional Activities and Assignments ..................................................................................................... 219 Additional Resources ...................................................................................................................................... 219 Cengage Video Resources ........................................................................................................................................... 219

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 12 is the third chapter in a four-chapter sequence on the economics of the public sector. Chapter 10 addressed externalities. Chapter 11 addressed public goods and common resources. Chapter 12 addresses the economics of healthcare. Chapter 13 will address the tax system. The purpose of chapter 12 is to introduce students to the economics of the healthcare system and the sizable role that the government plays in the healthcare industry. The healthcare market is unusual in that it generates many externalities, it is difficult to measure the quality of the healthcare product, and most healthcare is paid by insurance companies rather than the consumer. The chapter also reports many key facts about the U.S. healthcare system. The chapter presents arguments in support and opposition to government involvement in the U.S. healthcare system. Key points addressed in this chapter: 

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The market for healthcare differs from most other markets in several ways. First, there are pervasive externalities, such as those associated with vaccination and medical research. Second, because consumers cannot easily gauge the quality of what they are buying, private and public institutions intervene to ensure that treatment is appropriate. Third, healthcare is often judged to be a right, leading to a government role to make sure that everyone has access to it. Spending on healthcare can be large and unpredictable, but health insurance reduces the financial risk that people face from a costly event. The problems of moral hazard and adverse selection, however, hinder the effectiveness of the market for health insurance. When people have insurance, either from a private company or a government program, the insurer establishes rules regarding financing, access, and payment. Since 1900, life expectancy in the United States has increased by about 30 years, largely because of advances in medical technology. Over the past 60 years, healthcare spending has grown substantially as a percentage of national income. Several forces are at work: Baumol’s cost disease, advances in medical technology, the aging of the population, and rising incomes. The United States spends a higher fraction of its national income on healthcare than other developed nations. This fact has no simple explanation. Critics and defenders of the U.S. healthcare system point to different possible reasons. The percentage of healthcare spending paid out of pocket, rather than by insurance, has declined substantially over time. Some economists say that reliance on insurance is excessive, exacerbating moral hazard and driving up healthcare costs.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain why the healthcare market generates so many externalities and provide some examples.

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Describe why risk aversion creates a market for health insurance.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare 

Explain why the problems of moral hazard and adverse selection may cause a death spiral in the market for health insurance.

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Identify the rules that are necessary for a successful healthcare market with payments made by an insurer.

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Explain why life expectancy has been rising in the United States.

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Provide reasons why healthcare spending as a percent of GDP has been rising in the United States.

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Explain why healthcare spending in the United States is higher than in other developed nations.

Source (i.e., PPT slide, Workbook) PPT Slide 11 PPT Slide 14 PPT Slide 24 PPT Slide 33 PPT Slide 34 PPT Slide 35 MindTap eBook MindTap eBook MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

Duration

MindTap Apply It Folder MindTap Apply It Folder

10–15 mins. 20–30 mins.

5 mins. 10–15 mins. 10–15 mins. 10–15 mins. 10–15 mins. 5 mins. 5 mins. 5 mins. 30–40 mins. N/A 10–15 mins.

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KEY TERMS Adverse Selection: the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare Moral Hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. Risk Aversion: a dislike of uncertainty. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

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In the previous edition, this chapter was an optional “module” in the digital version of the text. It is now included in both the digital and hard copy versions of the text in the section that addresses the economics of the public sector. The chapter now includes “Questions for Review” and “Problems and Applications.” The Case Study on “Vaccine Hesitancy” has been updated to include issues associated with the Covid-19 pandemic. There is a new In the News feature: Lessons from the Pandemic of 2020. “Why It’s So Hard to Cut Waste in Health Care.”

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In most nations, governments are deeply involved in the healthcare market because, in the healthcare market, the standard model of supply and demand often fails to allocate resources efficiently and equitably. The Special Characteristics of the Market for Healthcare A. Externalities Galore 1. Third parties – insurers, governments, and bystanders – often have an interest in healthcare outcomes. 2. Positive externalities are generated when people get a vaccine or when medical research creates new medical treatments. a. Governments can improve efficiency by requiring vaccination, giving vaccines for free, or paying people to get a vaccine. b. Governments can improve efficiency by providing patent protection for new drugs or by directly subsidizing medical research. 3. Case Study: Vaccine Hesitancy a. Measles was essentially eliminated due to an effective vaccine. However, once eliminated, many parents chose not to vaccinate their children and measles became more common again. To internalize the positive externality, some states are again requiring vaccination for measles.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare b. Some people have failed to get vaccinated for Covid-19, even though it is free. Some economists have proposed a Pigovian subsidy (paying people to get the vaccine). c. Instruction Idea: This is a good place to open up a discussion comparing the positive externalities associated with vaccines versus the general anti-vaccine movement. B. The Difficulty in Monitoring Quality 1. Consumers of healthcare cannot easily judge medical treatment. Some medical professionals may act out of self interest rather than the patient’s best interest. 2. Keep in Mind: Note the generational differences in the way patients judge medical treatments. Past generations often viewed the doctor’s choice of treatments as unquestionable. More recently, patients tend to question the doctor’s treatment suggestions and get second opinions. 3. In response, government requires healthcare professionals to be licensed. The FDA supervises and tests new drugs. Medical schools are accredited by medical professionals. 4. Some economists argue that there are too many hurdles to opening new medical schools and that the FDA is too slow in approving new drugs. C. The Insurance Market and Its Imperfections 1. The Value of Insurance a. Definition of risk aversion: a dislike of uncertainty. b. Due to risk aversion, people would rather pay a $600 per year premium for insurance rather than have a 2 percent chance of a $60,000 medical bill. c. There are two problems with the markets for insurance. 2. Moral Hazard a. Definition of moral hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. b. Patients and doctors have less incentive to avoid expensive treatments when they know that an insurance company will pay the bill. c. Keep in Mind: The moral hazard associated with medical services is unusual in that it has two sources. The patient has an incentive to overuse medical services and choose expensive treatments. The doctor has the same incentive. d. In response, insurance companies may require a co-pay or have strict rules regarding what medical services they will cover. 3. Adverse Selection a. Definition of adverse selection: the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. b. People with hidden health problems are more likely to buy health insurance. In response, insurance companies must raise the price. People with average health drop coverage because it is too

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare expensive. If this continues, the insurance market disappears, which is known as a death spiral. c. To avoid a death spiral, the Affordable Care Act of 2010 required all Americans to buy health insurance. This requirement has been removed, but there has been no death spiral yet. 4. Healthcare as a Right a. Because healthcare is considered as necessary as food, the government pays all healthcare bills in some countries. This is known as a single payer system. b. The United States has a mix of private and government-provided insurance. The government provides insurance for older Americans, those with low incomes, and former military personnel. 5. The Rules Governing the Healthcare Marketplace Figure 1 a. In the healthcare market, providers deliver healthcare to the patient but the providers are paid by insurers (government or insurance companies). The patient pays premiums or taxes to the insurer. This arrangement requires three sets of rules. b. First, there are rules regarding financing of healthcare services. Government determines taxes for government provided healthcare and limits the difference in premiums that private insurers can charge different people. c. Second, there are rules that determine patient access to healthcare. When insurance pays the bills, it creates moral hazard. Patients will overuse the healthcare system so services must be rationed based on costs and benefits. d. Third, there are rules that determine the payments from insurers to providers by limiting the treatments and prices the insurer will pay. e. Alternative Classroom Example: Because health insurance is such an emotional issue, it is sometimes easier to address the general problems associated with insurance using an unemotional product such as auto insurance. Then draw a comparison with the similar issues that arise with health insurance. i. People want auto collision insurance because they are risk averse. They would rather pay a small amount each month to avoid a large bill at a future date. The same is true for health insurance. ii. Auto insurance creates moral hazard. People tend to drive more carelessly when they have collision insurance. Health insurance creates moral hazard. People may be less likely to take care of their health when insured. They and their doctors may want expensive treatments when they know insurance will pay. iii. To avoid moral hazard, auto insurance companies require a deductible on collision insurance. As a result, the driver must

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare

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pay the first $500 or $1000 when a car is damaged. Health insurance companies require a co-pay for a doctor visit and limit the procedures they will cover. iv. Auto insurance suffers from adverse selection. People who drive recklessly have more to gain from insurance so they tend to buy insurance. People with hidden health problems are more likely to buy health insurance. v. To avoid adverse selection, auto insurance companies charge higher premiums to reckless drivers: those with many past accidents and speeding tickets. Health insurance companies charge more to those who use tobacco, but rules have eliminated much of the upcharge for preexisting conditions. Government health insurance also avoids adverse selection by requiring everyone to buy health insurance. vi. Students will have difficulty comparing past car accidents with preexisting health conditions. The comparison can be made by addressing the following questions. Would people want all collision insurance premiums to be the same for all drivers – safe and reckless? Would people want drivers to be able to buy insurance after they have wrecked the car? When it comes to auto insurance, the answer is “no.” But because healthcare is usually considered a right, most people believe that healthy people and those with preexisting conditions should both be able to buy health insurance and be charged a similar premium. The rules we impose on the health insurance market stem from this difference. Government limits the differences in premiums that insurers can charge different people. Key Facts about the U.S. Healthcare System A. People are Living Longer Figure 2 1. Life expectancy has increased from 47.3 years in 1900 to 78.8 years in 2019. 2. Pandemics and the opioid epidemic temporarily reduce life expectancy. 3. The large increase in life expectancy is from a decline in infant mortality, advances in medical technology, a reduction in smoking and car accidents, and improved sanitation. B. Healthcare Spending is a Growing Share of the Economy Figure 3

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare 1. Healthcare spending has increased from 5 percent of GDP in 1960 to 18 percent in 2019. 2. A doctor’s visit is a service and technological progress does not increase productivity in the service sector as much as it does in other sectors. If wages rise equally across all sectors, the cost of services will rise more than average. This is known as Baumol’s cost disease. 3. Keep in Mind: Baumol’s cost disease is a difficult concept for students. Question 3 in the Problems and Applications section of this chapter provides a step-by-step example of this theory. The education sector also suffers from Baumol’s cost disease. Therefore, the increase in the cost of attending college may provide an alternative example that is closer to a student’s experience. 4. Advances in medical technology tend to increase costs because new treatments are expensive. 5. Keep in Mind: The fact that advances in medical technology tend to increase costs is counterintuitive. Usually an increase in technology causes a decrease in costs. Compare the healthcare case to technological advances in manufacturing. 6. The U.S. population is aging and older people generally needs more healthcare. 7. The income elasticity of healthcare is about 1.3. When incomes increase, a larger share of income is spent on healthcare. C. Ask the Experts: Baumol’s Cost Disease. When economic experts were asked to evaluate the statement: “Because Labor markets across different sectors are connected, rising productivity in manufacturing leads the cost of labor-intensive services—such as education and healthcare—to rise,” 88 percent of economic experts agreed, 4 percent disagreed, and 8 percent were uncertain. D. Healthcare Spending is Especially High in the United States Figure 4 1. The United States spends about 17 percent of GDP on healthcare while most developed nations spend between 9 and 12 percent. 2. Critics of the U.S. system argue that private insurance is inefficient due to profit on premiums. They also argue that patients in the U.S. pay more for pharmaceutical drugs and that U.S. health outcomes are not better than other countries. 3. Defenders of the U.S. system argue that differences in outcomes reflect differences in exercise and diet, and price ceilings on drugs would reduce research into new drugs. E. Out-of-Pocket Spending Is a Declining Share of Health Expenditure Figure 5

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1. The percent of personal healthcare paid out-of-pocket has declined from 55 percent in 1960 to 13 percent in 2019. Third party payment has risen from 45 percent to 87 percent. 2. Many economists believe that the overreliance on health insurance for routine expenditures increases moral hazard and overuse of the system, causing healthcare costs to rise. 3. Employer provided health insurance receives favorable tax treatment, so workers bargain for more generous policies. The Affordable Care Act levied a “Cadillac tax” on expensive employer-provided policies. This tax has been repealed. F. Ask the Experts: Cadillac Tax. When asked if the Cadillac tax on expensive employerprovided health insurance plans would reduce costly distortions in U.S. healthcare market, 84 percent of economic experts agreed, 0 percent disagreed, and 16 percent were uncertain. G. In the News: Lessons from the Pandemic of 2020. “Why It’s So Hard to Cut Waste in Health Care” 1. During the pandemic, spending on healthcare fell by 10 percent. Some spending had been unnecessary but essential healthcare decreased at the same rate. 2. Attempts to reduce wasteful spending on healthcare has had the same result. Policies that reduce wasteful spending also reduce essential spending. High deductible plans reduce wasteful spending, but also reduce essential spending on managing diabetes and high cholesterol. 3. Paying a fixed fee for treatment has had the same effect. Encouraging costconsciousness can discourage optimal care. Conclusion: The Policy Debate over Healthcare A. People on the political left argue for a large government role in healthcare. 1. A “public option” would result in a government-run insurance program in addition to private insurance. 2. A “single payer system” would have the government pay for all healthcare out of tax revenue (like Medicare). 3. Instruction Idea: This is a good place to remind students that a “singlepayer system” does not mean “free health care.” Healthcare must still be paid for with tax revenue. B. People on the political right argue that the best healthcare will occur when insurers and providers compete for consumers. 1. Centralized systems limit individual freedom. 2. Single-payer systems excessively ration care and cause long waiting times for treatments.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare

QUESTIONS FOR REVIEW 62. Vaccines generate a positive externality because when people get vaccinated, they are less likely to transmit disease to others. Medical research generates a positive externality because new medical treatments enter society’s pool of medical knowledge which can be used by other physicians. 63. Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. Medical insurance creates moral hazard because when an insurance company pays the bill, patients may overuse the medical system and physicians may order tests of dubious value. Adverse selection is the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. Medical insurance creates adverse selection because people with hidden health problems are more likely to buy health insurance. This will raise the cost of insurance and cause people of average health to drop coverage, possibly causing a death spiral in the health insurance market. 64. The first set of rules determines who pays for the insurance and how much they pay. This includes taxes that pays for government provided insurance and limits on differences in premiums across individuals that private insurance companies can charge. The second set of rules determines patient’s access to healthcare. Due to the moral hazard problem with insurance, the insurer must limit access to medical services based on estimated costs and benefits. The third set of rules determines the payments from insurers to providers. These rules establish the treatments for which an insurer will pay, and how much it will pay. 65. Life expectancy has increased due to a decline in infant mortality. Advances in medical technology such as vaccines and improved sanitation have reduced disease. A reduction in smoking and improvements in automotive safety have also increased life expectancy. 66. Spending as a percent of GDP has more than tripled. First, a doctor’s visit is a service. Technological progress does not increase productivity in services as much as it does in manufacturing. If wages rise equally across sectors, the cost of services will rise relative to other goods. This is known as Baumol’s cost disease. Second, advances in medical technology may increase costs rather than reduce them because new treatments are often expensive. Third, the U.S. population is aging and older people generally need more healthcare than young people. Fourth, the income elasticity of healthcare is larger than one. As incomes grow over time, a larger share of income is spent on healthcare. 67. The U.S. spends a higher percent of GDP on healthcare than other developed nations. The U.S. spends about 17 percent of GDP on healthcare while most developed nations spend 9 to 12 percent. 68. Employer provided health insurance receives favorable tax treatment, so workers bargain for more generous policies. These Cadillac policies create moral hazard because it allows people to overuse the healthcare system. The Cadillac tax is a tax on these excessively generous policies. The tax removes the incentive to provide excessive insurance.

PROBLEMS AND APPLICATIONS 99. a. Figure 6 illustrates the demand for medical care. If each procedure has a price of $100, quantity demanded will be Q1 procedures.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 12: The Economics of Healthcare

Figure 6

b. If consumers pay only $20 per procedure, the quantity demanded will be Q2 procedures. Because the cost to society is $100, the number of procedures performed is too large to maximize total surplus. The quantity that maximizes total surplus is Q1 procedures, which is less than Q2. c. The use of medical care is excessive in the sense that consumers get procedures whose value is less than the cost of producing them. As a result, the economy’s total surplus is reduced. d. To prevent this excessive use, the consumer must bear the marginal cost of the procedure. But this would require eliminating insurance. Another possibility would be that the insurance company, which pays most of the marginal cost of the procedure ($80, in this case) could decide whether the procedure should be performed. But the insurance company does not get the benefits of the procedure, so its decisions may not reflect the value to the consumer. 100. Individuals who are relatively healthy may decide to forgo purchasing the policy if the premium rises. Thus, the insurance company is left with only those policyholders who are relatively unhealthy. This means that the firm’s revenues may in fact fall, but its costs could remain the same or even rise. Therefore, the firm’s profits could fall. 101. a. increases b. decreases c. increases d. increase e. increases f. rise 102. a. Total cost = $1,000 + $2,000 + $3,000 + $4,000 + $5,000 = $15,000 Average cost = $15,000/5 = $3,000 Share of profit paid by each person = $700/5 = $140 Price charged by insurance company = $3,000 + $140 = $3,140

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System b. Persons A and B value insurance at $2,000 and $3,000 respectively ($1,000 above their expected healthcare costs). At a price of $3,140, A and B will no longer buy insurance. Persons C, D, and E value insurance above $3,140. Persons C, D, and E will buy insurance. c. Total cost = $3,000 + $4,000 + $5,000 = $12,000 Average cost = $12,000/3 = $4,000 Share of profit paid by each person = $700/3 = $233.33 Price changed by insurance company = $4,000 + $233.33 = $4,233.33 d. Persons A, B, and C value insurance at $2,000, $3,000, and $4,000 respectively ($1,000 above their expected healthcare costs). Persons D and E value insurance at $5,000 and $6,000 ($1,000 above their expected healthcare costs). At a price of $4,233.33, only persons D and E will buy insurance. e. Total cost = $4,000 + $5,000 = $9,000 Average cost = $9,000/2 = $4,500 Share of profit paid by each person = $700/2 = $350 Price charged by insurance company = $4,500 + $350 = $4,850 f. At a price of $4,850, D and E will buy insurance. g. The pool of insured remains at D and E, so the price charged remains at $4,850 (as in part e). h. Because the price remains at $4,850, persons D and E will buy insurance. Yes, this outcome looks like an equilibrium because it is stable.

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Video Problem Walk-Through: Baumol's Cost Disease of the Service Sector o Video Problem Walk-Through: An Example of the Death Spiral

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System Prepared by David R. Hakes, University of Northern Iowa

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

221

Complete List of Chapter Activities and Assessments Key Terms

222

What's New in This Chapter 223 Chapter Outline

223

Solutions to Text Problems 227 Questions for Review ................................................................................................................................................... 228 Problems and Applications ........................................................................................................................................ 228 Additional Activities and Assignments

230

Additional Resources231 Cengage Video Resources ........................................................................................................................................... 231

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 13 is the fourth chapter in a four-chapter sequence on the economics of the public sector. Chapter 10 addressed externalities. Chapter 11 addressed public goods and common resources. Chapter 12 addressed the economics of healthcare, and Chapter 13 addresses the tax system. Taxes are inevitable because when the government remedies an externality, provides a public good, regulates the use of a common resource, or provides healthcare, it needs tax revenue to perform these functions. The purpose of Chapter 13 is to build on the lessons learned about taxes in previous chapters. We have seen that a tax reduces the quantity sold in a market, that the distribution of the burden of a tax depends on the relative elasticities of supply and demand, and that taxes cause deadweight losses. We expand the study of taxes in Chapter 13 by addressing how the U.S. government raises money. Finally, we address why designing a tax system that is both efficient and equitable is so difficult. Key points addressed in this chapter: 

The U.S. government raises revenue using various taxes. The most important taxes for the federal government are personal income taxes and payroll taxes for social insurance. The most important taxes for state and local governments are property taxes, personal income taxes, and sales taxes.



The efficiency of a tax system involves the costs it imposes on taxpayers. There are two costs of taxes beyond the transfer of resources from the taxpayer to the government. The first is the deadweight loss that arises as taxes alter incentives and distort the allocation of resources. The second is the administrative burden of complying with the tax laws.



The equity of a tax system concerns whether the tax burden is distributed fairly among the population. According to the benefits principle, it is fair for people to pay taxes based on the benefits they receive from the government. According to the ability-to-pay principle, it is fair for people to pay taxes based on their capability to handle the financial burden. When evaluating the equity of a tax system, it is important to remember a lesson from the study of tax incidence: The distribution of tax burdens is not the same as the distribution of tax bills.



When considering changes in the tax laws, policymakers often face a trade-off between efficiency and equity. Much of the debate over tax policy arises because people give different weights to these two goals.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Examine the design of the U.S. tax system.



Determine the effects of a negative tax on an individual's tax liability.



Classify a tax scheme as progressive, proportional, or regressive.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System

Source (i.e., PPT slide, Workbook) PPT Slide 8 PPT Slide 31 PPT Slide 33 PPT Slide 37 PPT Slide 38 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. N/A 20–30 mins. 20–30 mins.

10–15 mins. 5 mins. 5 mins. 10–15 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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KEY TERMS Ability-to-Pay Principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden. Average Tax Rate: total taxes paid divided by total income. Benefits Principle: the idea that people should pay taxes based on the benefits they receive from government services. Horizontal Equity: the idea that taxpayers with similar abilities to pay taxes should pay the same amount. Lump-Sum Tax: a tax that is the same amount for every person. Marginal Tax Rate: the increase in taxes from an additional dollar of income. Progressive Tax: a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System Proportional Tax: a tax for which high-income and low-income taxpayers pay the same fraction of income. Regressive Tax: a tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers. Vertical Equity: the idea that taxpayers with a greater ability to pay taxes should pay larger amounts. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 



There is a new In the News feature: The United States does not have a value-added tax, but the tax is common throughout the rest of the world. “How About This? A Tax That Discourages Tax Evasion.” There is a new question in the end of chapter “Problems and Applications” which addresses the deductibility of state and local taxes from taxable income when calculating one’s federal income tax.

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U.S. Taxation: The Big Picture A. Instruction Idea: For this material to be relevant, you will want to update it from time to time. Data on government receipts can be found easily on the Internet or through the most recent edition of the Economic Report of the President. B. Figure 1 shows the level of government revenue in the United States, including federal, state, and local governments, as a percentage of total income for the U.S. economy. Figure 1 1. The role of government has grown substantially over the past century. 2. The government’s revenue from taxation has grown at a faster rate than the economy’s level of income. C. Figure 2 compares the tax burden for several major countries, as measured by the government’s tax revenue as a percentage of the nation’s total income. Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System 1. The United States has a low tax burden compared to most other advanced economies. 2. Many European nations have much higher taxes, which finance a more generous social safety net. D. Taxes Collected by the Federal Government 1. Table 1 reports the receipts of the federal government in 2020. Table 1 a. Total receipts were $3.7 trillion or $11,069 per person. 2. Personal income taxes a. The largest source of revenue is the personal income tax. b. A family’s income tax liability is how much it owes in taxes based on income. This tax is not simply proportional to income. It is based on income minus deductions, and the tax rate rises as income rises. Table 2 presents federal tax rates for 2020. Table 2 3. Payroll taxes a. A payroll tax is a tax on the wages that a firm pays its workers. b. Payroll taxes are also known as social insurance taxes because the revenue from these taxes is mostly used for Social Security and Medicare. 4. Corporate income taxes a. A corporate income tax is a tax paid by a business set up to have its own legal existence based on its profit. Corporate profits are often taxed twice, once as corporate profits and again as personal income when profits are paid out as dividends. 5. Other taxes a. The other category includes excise taxes (taxes on specific goods), estate taxes, and customs duties. E. Taxes Collected by State and Local Governments Table 3

II.

1. Table 3 reports the receipts from state and local governments for 2020. a. Total receipts were $3 trillion or $9,157 per person. 2. The three most important taxes for state and local governments are property taxes, personal income taxes, and sales taxes. 3. Some state and local governments levy individual and corporate income taxes. Others do not. 4. State governments also receive funding from the federal government. Taxes and Efficiency A. Well-designed tax policies minimize the deadweight losses that occur when taxes distort incentives. They also minimize the administrative burdens that taxpayers face when complying with tax laws. B. Deadweight Losses

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System 1. Taxes lead to deadweight losses because they lower total surplus. 2. Instruction Idea: Provide students with several examples of how taxes lead to an inefficient outcome. Some examples to discuss include an inefficient shifting of productive activity from the market sector to the household sector, diminished saving, and increased leisure. 3. Case Study: Should Income or Consumption Be Taxed? a. Because income is taxed, some people don’t work as hard. Because interest income is taxed, the current income tax laws discourage saving. b. If consumption (instead of income) is taxed, this disincentive disappears. c. European nations tend to rely more on consumption taxes than does the United States. They often employ a value-added tax, known as a VAT, which is a consumption tax collected at various stages of production. C. Administrative Burden 1. The current tax system is quite burdensome because of the large amount of paperwork required both when filling out tax forms and keeping records throughout the year. The government also expends resources to enforce tax laws. 2. Keep in Mind: For most undergraduate students, this burden may seem somewhat trivial. Use some real-world examples of actual compliance costs to underscore this important aspect of taxation. Use some personal examples, if appropriate. 3. Many taxpayers spend resources hiring accountants and tax lawyers. a. People often need help filling out complex tax forms. b. Individuals may also want to learn how to arrange their affairs to reduce their tax burden. D. Marginal Tax Rates versus Average Tax Rates 1. Definition of average tax rate: total taxes paid divided by total income. 2. Definition of marginal tax rate: the increase in taxes from an additional dollar of income. 3. The average tax rate measures the sacrifice made by a taxpayer; the marginal tax rate measures how much the tax system distorts incentives. 4. Ask the Experts: Almost two-thirds of economists do not believe that raising the top federal marginal tax rate on personal income to 70% would raise more revenue without lowering economic activity. 5. Alternative Classroom Example: Income = $100,000 Tax Brackets $0–$20,000 $20,001–$50,000 $50,001 +

Tax Rate: 0% 15% 25%

Tax liability = (0.15)($30,000) + (0.25)($50,000) = $4,500 + $12,500 = $17,000

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System Average tax rate = $17,000/$100,000 = 17% Marginal tax rate = 25%

III.

E. Lump-Sum Taxes 1. Definition of lump-sum tax: a tax that is the same amount for every person. 2. For this type of tax, the marginal tax rate is equal to zero. 3. This is the most efficient type of tax because it does not distort incentives and thus has no effect on total surplus. There is also little administrative burden with this type of tax. 4. However, a lump-sum tax would take the same amount from the poor and the rich, which most people would view as unfair. Taxes and Equity A. The Benefits Principle 1. Definition of benefits principle: the idea that people should pay taxes based on the benefits they receive from government services. 2. This principle tries to make public goods similar to private goods. 3. An example of this would be the tax on gasoline, especially if revenues from the tax are used to build or maintain roads. B. The Ability-to-Pay Principle 1. Definition of ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden. 2. Definition of vertical equity: the idea that taxpayers with a greater ability to pay taxes should pay larger amounts. Table 4 a. Three tax systems: proportional, regressive, and progressive. b. Definition of proportional tax: a tax for which high-income and low-income taxpayers pay the same fraction of income. c. Definition of regressive tax: a tax for which high-income taxpayers pay a smaller fraction of their income than do lowincome taxpayers. d. Definition of progressive tax: a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers. e. Case Study: How the Tax Burden Is Distributed – Table 5 shows that the tax burden in the U.S. is progressive. In addition, studies have shown that, if transfer payments are also taken into account, the degree of progressivity is substantial. In 2021, President Biden proposed increasing taxes, especially for the top 1%, and increasing tax credits for lower-income people with children. Table 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System

IV.

3. Definition of horizontal equity: the idea that taxpayers with similar abilities to pay taxes should pay the same amount. C. Tax Incidence and Tax Equity 1. The burden of a tax is not always borne by who pays the tax bill. 2. Example: tax on fur coats. This will ultimately affect those who sell and produce the fur coats because the quantity of fur coats demanded will fall due to the increase in price. 3. Case Study: Who Pays the Corporate Income Tax? a. The corporate income tax is popular among voters because a corporation is nonhuman and faceless. b. However, the burden of the corporate tax falls on stockholders, customers, and workers. c. An increase in corporate taxes means an increase in the cost of producing the product. Firms will cut back production (which lowers supply and raises the price to the consumer) and possibly lay off workers (which causes unemployment, lower wages, or both). d. There are differing opinions about the impact of the 2017 Trump corporate-tax cuts on capital accumulation, productivity, and wages. 4. In the News: The United States does not have a value-added tax, but the tax is common throughout the rest of the world. “How About This? A Tax That Discourages Tax Evasion.” a. A VAT is a tax on the valued-added during each stage of production. The tax is applied to the difference between the cost of the inputs and the value of the firm’s sales. b. Compliance is self-enforcing because the sales of one firm becomes the cost to another, so the selling firm cannot underreport the value of their sales. c. As a result, the administrative burden declines and tax revenue rises. The problem is that the tax is regressive. Conclusion: The Trade-off between Equity and Efficiency A. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System

QUESTIONS FOR REVIEW 69. Over the past century, the government’s tax revenue has grown more rapidly than the rest of the economy. The ratio of government revenue to GDP has increased over time. 70. Corporate profits are taxed first when the corporate income tax is taken out of a corporation's income. When the profits are used to pay dividends to the corporation's shareholders, they are taxed again through personal income tax. 71. The burden of a tax to taxpayers is greater than the revenue received by the government because: (1) taxes impose deadweight losses by reducing the quantity of goods produced and purchased to below their efficient level; and (2) taxes entail a costly administrative burden on taxpayers. 72. Some economists advocate taxing consumption rather than income because taxing income discourages work and saving. A consumption tax would not distort individuals’ work and saving decisions. 73. The marginal tax rate on a lump-sum tax is zero. This type of tax has no deadweight loss, because it does not distort incentives. 74. People with high incomes should pay more taxes than people with low incomes because: (1) they benefit more from public services; and (2) they have a greater ability to pay. 75. Horizontal equity refers to the idea that families in the same economic situation should be taxed equally. The concept of horizontal equity is hard to apply because families differ in many ways, so it is not obvious how to tax them equitably. For example, two families with the same income may have different numbers of children and different levels of medical expenses.

PROBLEMS AND APPLICATIONS 103. a. The increase in revenue of the total government is attributable more to increases in state and local government revenue than to federal government revenue. b. Personal income taxes accounted for more of the total revenue of federal and state and local governments in 2017 than in 1950; social insurance taxes accounted for a substantially greater proportion in 2017 than in 1950; and corporate taxes accounted for a lower proportion in 2017 than in 1950. 104. If you earn $30,000 a year, then you pay federal income taxes in two parts: 10% on the first $9,325 of income and 15% on the amount above $9,325. Thus, your federal income taxes are ($9,325 x 0.10) + ($20,675 x 0.15) = $932.50 + $3,101.25 = $4,033.75. You also pay $30,000 x 0.153 = $4,590 in federal payroll taxes and $30,000 x 0.04 = $1,200 in state income taxes, for a total tax bill of $9,823.75. Your average tax rate is $9,823.75/$30,000 = 0.327 = 32.7%. Your marginal tax rate is 0.15 + 0.153 + 0.04 = 0.343 = 34.3%. If you earn $60,000 a year, then you pay federal income taxes in three parts: 10% on the first $9,325 of income, 15% for additional income up to $37,950, and 25% for the remaining $22,050 of income. Thus, your federal income taxes are ($9,325 x 0.10) + ($28,625 x 0.15) + ($22,050 x 0.25) = $932.50 + $4,293.75 + $5,512.50 = $10,738.75. You also pay $60,000 x 0.153 = $9,180 in federal payroll taxes, and $60,000 x 0.04 = $2,400 in state income taxes. Your total tax bill is $22,318.75. Your average tax rate is $22,318.75/$60,000 = 0.372 = 37.2%. Your marginal tax rate is 0.25 + 0.153 + 0.04 = 0.443 = 44.3%.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System 105. Excluding food and clothing from the sales tax is justified on equity grounds because poor people spend a greater proportion of their income on those items. By exempting them from taxation, the system makes the rich bear a greater burden of taxation than the poor. From the point of view of efficiency, however, excluding food and clothing from the sales tax is inefficient, because the incentives to purchase food and clothing rather than other items are likely affected by this tax exemption. This leads to an inefficient allocation of resources. In addition, because the demand for food and clothing is likely to be relatively inelastic, the deadweight loss from a tax on these goods would be relatively small (when compared with a tax on a good whose demand is relatively elastic). 106. a. Residents of high-income states like California and New York benefit more when SALT are deductible. High-income people pay higher state income taxes and higher property taxes resulting in larger deductions on their federal taxes and a lower federal tax bill. b. The 2018 limitation on the deductibility of SALT would cause people to migrate from states with high property values (causing high property taxes) and high state income taxes toward states with lower property values and lower state income taxes. This change in the tax law did cause people to move from California and New York to Florida and Texas. c. The fear of losing productive citizens and businesses should cause states to be less likely to raise taxes. 107. a. Serena must pay taxes on the asset only when she sells it. Thus, this tax law affects her decision of whether to keep or sell the asset. Tax revenues on accrued capital gains are only received by the government when an individual actually sells the asset. Lowering the tax rate on capital gains may induce individuals to sell assets that they have been holding to avoid paying the taxes on the accrued capital gains. b. Because capital gains are not realized and thus taxed until the investment is sold, investors can avoid the tax by not selling the investment. When capital gains taxes are lowered, even temporarily, the investor has an incentive to sell the investment while the tax is lower. Thus, sales to realize capital gains will increase at the lower rate and so will tax revenue on the increased volume of transactions. c. It is inefficient to tax only realized capital gains because it distorts the incentives an individual faces with regard to keeping or selling a particular asset. However, it may be difficult to estimate the rise in the value of an asset prior to its sale. 108. If the state raises its sales tax from 5% to 6%, it is not plausible that sales tax revenue will increase 20%. The increase in the tax rate is 20%, so the only way tax revenue could increase 20% would be if total spending didn't fall in response to the tax increase, which is unlikely. Instead, the higher tax would raise the price of goods, so people would spend less. Thus, tax revenue might go up, because the tax rate is higher, but by less than 20%. There is a possibility that tax revenues will fall. 109. The effect of the Tax Reform Act of 1986 on interest payments was to reduce consumer debt and increase home equity debt. People started financing general expenditures through home equity loans and paid down their mortgages less quickly. 110.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System a. The fact that visitors to many national parks pay an entrance fee is an example of the benefits principle, because people are paying for the benefits they receive. b. The fact that local property taxes support elementary and secondary schools is an example of the ability-to-pay principle, because if you own more expensive property, you must pay more tax. c. The setup of airport trust funds is an example of the benefits principle, because use of the airport generates tax revenue that pays for upkeep of the airport.

[In-class assignment] Tax Alternatives: 20 minutes total. Works in any class size. Topics include taxes and fairness. W. Purpose: The impact of taxes can be examined in a variety of ways. This exercise helps students think about the different effects of taxes on different goods. Taxes that may be appealing because they minimize deadweight loss may be undesirable for equity reasons. X. Instructions: Tell the class, “The state has decided to increase funding for public education. They are considering four alternative taxes to finance these expenditures. All four taxes would raise the same amount of revenue.” List these options: a. A sales tax on food b. A tax on families with school-age children c. A property tax on vacation homes d. A sales tax on jewelry Ask the students to answer the following questions. Give them time to write an answer, then discuss their answers before moving to the next question: 1. Analyze these taxes using the benefits principle. 2. Analyze these taxes using the principle of horizontal equity 3. Classify each tax as progressive, proportional, or regressive 4. Which tax would you choose to finance education? Explain. Y. Common Answers and Points for Discussion 10. Are the taxes related to the benefits received? a. A sales tax on food: This broad-based tax would be appropriate if citizens, as a whole receive benefits from education. To the extent that education provides positive externalities, this tax could be justified on the benefits principle. b. A tax on families with school-age children: This tax burden would be borne mainly by those who have the highest benefits. The exceptions would be families who choose private schools or home schooling; these households would pay the taxes but not receive the benefits.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 13: The Design of the Tax System c. A property tax on vacation homes: This tax is probably the worst from a benefits perspective. Many vacation homeowners may be from other states and receive minimal, if any, benefits from supporting education. d. A tax on jewelry: This tax is also weak from the benefits perspective. There is little reason to think jewelry buyers would disproportionately benefit from better public education. 11. Are taxes the same for households earning the same income? a. None of these taxes is horizontally equitable. They fall disproportionately on households who buy more food, have school-age children, own vacation homes, and buy jewelry. The food tax might be the best from this perspective. 12. Vertical equity a. A sales tax on food: Regressive—lower income households spend a larger portion of their income on food. b. A tax on families with school-age children: Regressive—lump-sum taxes have a bigger percentage impact on low incomes. c. A property tax on vacation homes: Progressive—higher income households are more likely to own vacation homes, and to own more expensive vacation properties. d. A sales tax on jewelry: Progressive—higher income households will typically buy more expensive jewelry. 13. Which Tax? a. No single tax satisfies all equity concerns. If market distortions are also considered, the decision becomes more complex. This question can generate good discussion about the trade-offs between different taxes. Many times students will volunteer additional tax options—income taxes are a common suggestion. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Marginal and Average Tax Rates o Concept Clip: Progressive and Regressive Taxes o Video Problem Walk-Through: Calculating the Tax Liability, Average Tax Rate, and Marginal Tax Rate for an Individual Tax Payer o Video Problem Walk-Through: Determining Whether a Tax System is Proportional, Regressive, or Progressive o Equivalency of Fractions, Decimals, and Percentages

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 233 Chapter Objectives ........................................................................................................................................... 233 Complete List of Chapter Activities and Assessments ......................................................................... 234 Key Terms ........................................................................................................................................................... 235 What's New in This Chapter .......................................................................................................................... 236 Chapter Outline ................................................................................................................................................. 236 Solutions to Text Problems ........................................................................................................................... 244 Questions for Review ................................................................................................................................................... 244 Problems and Applications ........................................................................................................................................ 246 Additional Activities and Assignments ..................................................................................................... 251 Additional Resources ...................................................................................................................................... 252 Cengage Video Resources ........................................................................................................................................... 252

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 14 is the first chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. It is important that students become comfortable with the material in Chapter 14 because Chapters 15 through 18 are based on the concepts developed in Chapter 14. To be more specific, Chapter 14 develops the cost curves on which firm behavior is based. The remaining chapters in this section (Chapters 15-18) use these cost curves to develop the behavior of firms in a variety of different market structures—competitive, monopolistic, monopolistically competitive, and oligopolistic. The purpose of Chapter 14 is to address the costs of production and develop the firm’s cost curves. These cost curves underlie the firm’s supply curve. In previous chapters, we summarized the firm’s production decisions by starting with the supply curve. While this is suitable for answering many questions, it is now necessary to address the costs that underlie the supply curve to address the part of economics known as industrial organization—the study of how firms’ decisions about prices and quantities depend on the market conditions they face. Key points addressed in this chapter:  



The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firm’s behavior, it is important to include all the opportunity costs of production. Some opportunity costs, such as the wages a firm pays its workers, are explicit. Other costs, like the wages the firm owner forgoes by not taking another job, are implicit. While accounting profit considers only explicit costs, economic profit accounts for both explicit and implicit costs. A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the quantity of an input increases, displaying the property of diminishing marginal product. As a result, the total-cost curve gets steeper as the quantity produced rises. A firm’s total costs can be separated into fixed costs and variable costs. Fixed costs remain constant when the firm alters the quantity of output produced. Variable costs change when the firm alters the quantity of output produced. From a firm’s total cost, two related measures of cost are derived. Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost rises if output increases by one unit. When analyzing firm behavior, it is often useful to graph average total cost and marginal cost. For a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output increases and then rises as output increases further. The marginal-cost curve always crosses the average-total-cost curve at the minimum of average total cost. A firm’s costs often depend on the time horizon considered. In particular, many costs are fixed in the short run but variable in the long run. As a result, when the firm changes its level of production, average total cost may rise more in the short run than in the long run.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production 

Calculate total revenue, given price and production data.



Calculate total cost, given input costs and production data.



Calculate profit, given price, input costs, and production data.



Compare economic profit and accounting profit, given data on total revenue, implicit costs, and explicit costs.



Categorize a cost as explicit or implicit, given a scenario.



Classify a firm's costs as fixed or variable.



Given a graph of the production function and input costs, derive the firm's total-cost curve.



Derive total product, average product, and marginal product, given data on a firm's production technology.



Explain the concept of diminishing marginal product using a production function.



Plot a production function for a firm, given its production data.



Calculate a firm's various average costs at different quantities, given data on that firm's cost structure.



Calculate a firm's marginal cost at different quantities, given data on that firm's cost structure.



Explain the shapes of the ATC, AVC, AFC, and MC curves.



Explain why a firm's marginal cost curve intersects the average-total-cost curve at its minimum.



Explain the relationship between short-run and long-run average total costs.



Given a graph of the average-total-cost curve in the long run, identify the regions that represent economies of scale, constant returns to scale, and diseconomies of scale.

Source (i.e., PPT slide, Workbook) PPT Slide 12 PPT Slide 21 PPT Slide 33 PPT Slide 42 PPT Slide 43

Duration 5 mins. 5 mins. 5 mins. 5–10 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production Section 14-1 QuickQuiz Section 14-2 QuickQuiz Section 14-3 QuickQuiz ConceptClip: Economic and Accounting Profit ConceptClip: Production Function ConceptClip: Fixed and Variable Costs ConceptClip: Marginal Cost and Marginal Revenue ConceptClip: Economies and Diseconomies of Scale Figure 4: Conrad’s Average-Cost and Marginal-Cost Curves Figure 6: Average Total Cost in the Short and Long Runs Chapter 14 Problems & Applications Chapter 14 A+ Test Prep Video Quiz: The Explicit and Implicit Costs of Production and Calculation of Economic and Accounting Profit Video Quiz: The Production Function, Marginal Product, and the Relationship between Production and Cost Video Quiz: Measures of Costs Video Quiz: Graphs of Cost Curves Video Quiz: Average Total Cost in the Short Run and the Long Run Chapter 14 News Analysis: Chapter 14 News Analysis: Should I Stay or Should I Go? Chapter 14 Homework Chapter 14 Quiz: The Costs of Production

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KEY TERMS Accounting Profit: total revenue minus total explicit cost. Average Fixed Cost: fixed cost divided by the quantity of output. Average Total Cost: total cost divided by the quantity of output. Average Variable Cost: variable cost divided by the quantity of output. Business Total Revenue: the amount a firm receives for the sale of its output.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production Constant Returns to Scale: the property whereby long-run average total cost stays the same as the quantity of output changes. Diminishing Marginal Product: the property whereby the marginal product of an input declines as the quantity of the input increases. Diseconomies of Scale: the property whereby long-run average total cost rises as the quantity of output increases. Economic Profit: total revenue minus total cost, including both explicit and implicit costs. Economies of Scale: the property whereby long-run average total cost falls as the quantity of output increases. Efficient Scale: the quantity of output that minimizes average total cost. Fixed Costs: costs that do not vary with the quantity of output produced. Implicit Costs: input costs that do not require an outlay of money by the firm. Marginal Cost: the increase in total cost that arises from an extra unit of production Marginal Product: the increase in output that arises from an additional unit of input. Production Function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good. Profit: total revenue minus total cost. Total Cost: the market value of the inputs a firm uses in production. Total Revenue: the amount a firm receives for the sale of its output. Variable Costs: costs that vary with the quantity of output produced. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

There are no major changes to this chapter.

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What Are Costs?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production A. Keep in Mind: This is an extremely important chapter, and it is critical that students have an understanding of the important principles developed here to follow the material presented in the next several chapters. Do not be surprised at the number of students who are unfamiliar with such seemingly simple concepts as revenue, costs, and profits. B. Instruction Idea: Point out to students that it is possible for firm owners to have different goals, but the one motive that makes the most accurate prediction about how firm managers behave is the assumption of profit maximization. To help illustrate this sometimes-controversial assumption, use the analogy of an automobile driver. Ask students to name an assumption about the goal of most drivers. Most would agree that drivers behave as if their goal is to get from one place to another in the least amount of time. This may not explain the behavior of every driver (i.e., “Sunday” drivers), but it works for most. C. Total Revenue, Total Cost, and Profit 1. The goal of a firm is to maximize profit. 2. Definition of total revenue: the amount a firm receives for the sale of its output. Total Revenue Price

Quantity

3. Definition of total cost: the market value of the inputs a firm uses in production. 4. Definition of profit: total revenue minus total cost. Profit Total Revenue

Total Cost

D. Why Opportunity Costs Matter 1. Keep in Mind: Students rarely have trouble understanding the concept of explicit costs. However, they do often have difficulty understanding the nature of implicit costs. Make sure that they grasp the concept here, because it is important in understanding why firms continue to operate even if they are earning zero economic profit in the long run. 2. Principle #2: The cost of something is what you give up to get it. 3. The costs of producing an item must include all of the opportunity costs of inputs used in production. 4. Total opportunity costs include both implicit and explicit costs. a. Definition of explicit costs: input costs that require an outlay of money by the firm. b. Definition of implicit costs: input costs that do not require an outlay of money by the firm. c. The total cost of a business is the sum of explicit costs and implicit costs. d. This is the major way in which accountants and economists differ in analyzing the performance of a business. e. Accountants focus on explicit costs, while economists examine both explicit and implicit costs.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production E. The Cost of Capital is an Opportunity Cost 1. The opportunity cost of financial capital is an important cost to include in any analysis of firm performance. 2. Example: Caroline uses $300,000 of her savings to start her firm. It was in a savings account paying 5% interest. 3. Because Caroline could have earned $15,000 per year on this savings, we must include this opportunity cost. (Note that an accountant would not count this $15,000 as part of the firm's costs.) 4. If Caroline had instead borrowed $200,000 from a bank and used $100,000 from her savings, the opportunity cost would not change if the interest rate stayed the same (according to the economist). But the accountant would now count the $10,000 in interest paid for the bank loan. F. Economists and Accountants Measure Profit Differently Figure 1

II.

1. Figure 1 highlights the differences in the ways in which economists and accountants calculate profit. 2. Definition of economic profit: total revenue minus total cost, including both explicit and implicit costs. a. Economic profit is what motivates firms to supply goods and services. b. To understand how industries evolve, we need to examine economic profit. 3. Definition of accounting profit: total revenue minus total explicit cost. 4. If implicit costs are greater than zero, accounting profit will always exceed economic profit. Production and Costs A. Instruction Idea: You may want to give students a handout that summarizes the definitions and provides them an opportunity to practice the calculations in this chapter. (See the alternative classroom examples.) B. The Production Function 1. Definition of production function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good. 2. Instructional Idea: It will be beneficial at this point to distinguish between the long run and the short run. This will help students understand the distinction between fixed inputs and variable inputs. 3. Example: Chloe's cookie factory. The size of the factory is assumed to be fixed; Chloe can vary her output (cookies) only by varying the labor used.

Table 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production (1) Number of Workers 0 1 2 3 4 5 6

(2) Output 0 50 90 120 140 150 155

(3) Marginal Product of Labor --50 40 30 20 10 5

(4) Cost of Factory $30 30 30 30 30 30 30

(5) Cost of Workers $0 10 20 30 40 50 60

(6) Total Cost of Inputs $30 40 50 60 70 80 90

4. Instruction Idea: Go through this table, column by column. Make sure that students understand the calculations involved. 5. Definition of marginal product: the increase in output that arises from an additional unit of input. Marginal Product of Labor

change in output change in labor

a. As the amount of labor used increases, the marginal product of labor falls. b. Definition of diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases. c. Instruction Idea: Point out that diminishing marginal returns is a result of fixed inputs and, therefore is a short-run phenomenon. d. Alternative Classroom Example: Consider the short-run production of a small firm that makes sweaters. These sweaters are made using a combination of labor and knitting machines. In the short run, the firm has signed a lease to rent one machine. Therefore, in the short run, the firm cannot vary the amount of knitting machines it uses. However, the firm can vary the amount of labor it employs. Columns (1) and (2) in the table below show the production level that the firm can achieve at various amounts of labor: (1) Labor (# workers) 0 1 2 3 4 5

(2) Total Output 0 4 10 13 15 16

(3) Marginal Product --4 6 3 2 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production 6. We can draw a graph of the firm's production function by plotting the level of labor (x-axis) against the level of output (y-axis). Figure 2

III.

a. The slope of the production function measures marginal product. b. Diminishing marginal product can be seen from the fact that the slope falls as the amount of labor used increases. C. From the Production Function to the Total-Cost Curve 1. We can draw a graph of the firm's total cost curve by plotting the level of output (x-axis) against the total cost of producing that output (y-axis). a. The total cost curve gets steeper and steeper as output rises. b. This increase in the slope of the total cost curve is also due to diminishing marginal product: As Chloe increases the production of cookies, her kitchen becomes overcrowded, and she needs a lot more labor. 2. Instruction Idea: There is a student activity (Growing Rice on a Chalkboard) that applies to this topic in the "Additional Activities and Assignments” section. The Many Measures of Cost A. Example: Caleb’s Coffee Shop

Table 2

(1) Output

(2) Total Cost

(3) Fixed Cost

(4) Variable Cost

(5) Average Fixed Cost

(6) Average Variable Cost

(7) Average Total Cost

(8) Marginal Cost

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production 0 1 2 3 4 5 6 7 8 9 10

$3.00 3.30 3.80 4.50 5.40 6.50 7.80 9.30 11.00 12.90 15.00

$3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00

$0 0.30 0.80 1.50 2.40 3.50 4.80 6.30 8.00 9.90 12.00

--$3.00 1.50 1.00 0.75 0.60 0.50 0.43 0.38 0.33 0.30

--$0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20

--$3.30 1.90 1.50 1.35 1.30 1.30 1.33 1.38 1.43 1.50

--$0.30 0.50 0.70 0.90 1.10 1.30 1.50 1.70 1.90 2.10

Figure 3 B. Alternative Classroom Example: Consider the sweater manufacturer (described earlier). The firm is currently renting one machine for $25 per day. Each worker is also paid $25 per day.

(1) Labor 0 1 2 3 4 5

(2) Output 0 4 10 13 15 16

(3) Fixed Cost $25 25 25 25 25 25

(4) Variable Cost $0 25 50 75 100 125

(5) Total Cost $25 50 75 100 125 150

(6) Average Fixed Cost ---$6.25 2.50 1.92 1.67 1.56

(7) Average Variable Cost ---$6.25 5.00 5.77 6.67 7.81

(8) Average Total Cost ---$12.50 7.50 7.69 8.33 9.38

(9) Marginal Cost ---$6.25 4.17 8.33 12.50 25.00

C. Fixed and Variable Costs 1. Definition of fixed costs: costs that do not vary with the quantity of output produced. 2. Definition of variable costs: costs that vary with the quantity of output produced. 3. Total cost is equal to fixed cost plus variable cost

D. Average and Marginal Cost 1. Definition of average total cost: total cost divided by the quantity of output. 2. Definition of average fixed cost: fixed cost divided by the quantity of output. 3. Definition of average variable cost: variable cost divided by the quantity of output.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

4. Definition of marginal cost: the increase in total cost that arises from an extra unit of production. change in total cost change in output

5. Average total cost tells us the cost of a typical unit of output and marginal cost tells us the cost of an additional unit of output. E. Cost Curves and Their Shapes Figure 4 1. Rising Marginal Cost a. This occurs because of diminishing marginal product. b. At a low level of output, there are few workers and a lot of idle equipment. As output increases, the coffee shop gets crowded and the cost of producing another unit of output increases. 2. U-Shaped Average Total Cost a. Average total cost is the sum of average fixed cost and average variable cost.

b. AFC declines as output expands and AVC typically increases as output expands. AFC is high when output levels are low. As output expands, AFC declines pulling ATC down. As fixed costs get spread over a larger number of units, the effect of AFC on ATC falls and ATC begins to rise because of diminishing marginal product. c. Definition of efficient scale: the quantity of output that minimizes average total cost. 3. The Relationship between Marginal Cost and Average Total Cost a. When marginal cost is less than average total cost, average total cost is falling. When marginal cost is greater than average total cost, average total cost is rising. b. The marginal-cost curve crosses the average-total-cost curve at minimum average total cost (the efficient scale). 4. Instruction Idea: There is a student activity (Average and Marginal Grades) that applies to this topic in the "Additional Activities and Assignments” section. 5. Typical Cost Curves Figure 5 © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

IV.

a. Marginal cost eventually rises with output. b. The average-total-cost curve is U-shaped. c. Marginal cost crosses average total cost at the minimum of average total cost. d. Instruction Idea: Emphasize that these cost curves include ALL costs for the resources needed to produce the good. Thus, both explicit and implicit costs are included. Costs in the Short Run and in the Long Run A. The division of total costs into fixed and variable costs will vary from firm to firm. B. Some costs are fixed in the short run, but all are variable in the long run. 1. For example, in the long run a firm could choose the size of its factory. 2. Once a factory is chosen, the firm must deal with the short-run costs associated with that plant size. C. The long-run average-total-cost curve lies along the lowest points of the short-run average-total-cost curves because the firm has more flexibility in the long run to deal with changes in production. Figure 6

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

D. The long-run average-total-cost curve is typically U-shaped, but is much flatter than a typical short-run average-total-cost curve. E. The length of time for a firm to get to the long run will depend on the firm involved. F. Economies and Diseconomies of Scale 1. Definition of economies of scale: the property whereby long-run average total cost falls as the quantity of output increases. 2. Definition of diseconomies of scale: the property whereby long-run average total cost rises as the quantity of output increases. 3. Definition of constant returns to scale: the property whereby long-run average total cost stays the same as the quantity of output changes. 4. FYI: Lessons from a Pin Factory a. In The Wealth of Nations, Adam Smith described how specialization in a pin factory allowed output to be greater than it would have been if each worker attempted to perform many different tasks. b. The use of specialization allows firms to achieve economies of scale. Table 3 provides a summary of all of the various cost definitions used throughout this chapter. Table 3

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 76. The relationship between a firm's total revenue, profit, and total cost is profit equals total revenue minus total costs. 77. An accountant would not count the owner’s opportunity cost of alternative employment as an accounting cost. An example is given in the text in which Chloe runs a cookie business, but she could instead work as a computer programmer. Because she's working in her cookie factory, she gives up the opportunity to earn $100 per hour as a computer programmer. The accountant ignores this opportunity cost because money does not flow into or out of the firm. But the cost is relevant to Chloe’s decision to run the cookie factory. 78. Marginal product is the increase in output that arises from an additional unit of input. Diminishing marginal product means that the marginal product of an input declines as the quantity of the input increases. 79. Figure 4 shows a production function that exhibits diminishing marginal product of labor. Figure 5 shows the associated total-cost curve. The production function is concave because of diminishing marginal product, while the total-cost curve is convex for the same reason.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

Figure 4

Figure 5

80. Total cost consists of the costs of all inputs needed to produce a given quantity of output. It includes fixed costs and variable costs. Average total cost is the cost of a typical unit of output and is equal to total cost divided by the quantity produced. Marginal cost is the cost of producing an additional unit of output and is equal to the change in total cost divided by the change in quantity. An additional relation between average total cost and marginal cost is that whenever marginal cost is less than average total cost, average total cost is declining; whenever marginal cost is greater than average total cost, average total cost is rising.

Figure 6 81. Figure 6 shows the marginal-cost curve and the average-total-cost curve for a typical firm. There are three main features of these curves: (1) marginal cost is U-shaped but rises sharply as output increases; (2) average total cost is U-shaped; and (3) whenever marginal cost is less than average total cost, average total cost is declining; whenever marginal cost is greater than average total cost, average total cost is rising. Marginal cost is increasing for output greater than a certain quantity because of diminishing returns. The average-totalcost curve is downward-sloping initially because the firm is able to spread out fixed costs over additional units. The average-total-cost curve is increasing beyond some output level because as quantity increases, the demand for important variable inputs increases; therefore, the cost of these inputs increases. The marginal-cost and average-total-cost curves intersect at the minimum of average total cost; that quantity is the efficient scale.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production 82. In the long run, a firm can adjust the factors of production that are fixed in the short run; for example, it can increase the size of its factory. As a result, the long-run average-total-cost curve has a much flatter U-shape than the short-run average-total-cost curve. In addition, the long-run curve lies along the lower envelope of the short-run curves. 83. Economies of scale exist when long-run average total cost decreases as the quantity of output increases, which occurs because of specialization among workers. Diseconomies of scale exist when long-run average total cost rises as the quantity of output increases, which occurs because of the coordination problems inherent in a large organization.

PROBLEMS AND APPLICATIONS 111. a. opportunity cost; b. average total cost; c. fixed cost; d. variable cost; e. total cost; f. marginal cost. 112. a. The opportunity cost of something is what must be given up to acquire it. b. The opportunity cost of running the amulet store is $430,000, consisting of $350,000 to rent the store and buy the stock and a $80,000 implicit cost, because Buffy would quit her job as a vampire hunter to run the store. c. $400,000 - $350,000 = $50,000 d. Because the total opportunity cost of $430,000 exceeds the projected revenue of $400,000, Buffy should not open the store, as her economic profit would be negative. e. Greater than $430,000. 113. a. The following table shows the marginal product of each hour spent fishing: Hours 0 1 2 3 4 5

Fish 0 10 18 24 28 30

Fixed Cost $10 10 10 10 10 10

Variable Cost $0 5 10 15 20 25

Total Cost $10 15 20 25 30 35

Marginal Product --10 8 6 4 2

b. Figure 7 graphs the fisherman's production function. The production function becomes flatter as the number of hours spent fishing increases, illustrating diminishing marginal product.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production

Figure 7 c. The table shows the fixed cost, variable cost, and total cost of fishing. Figure 8 shows the fisherman's total-cost curve. It has an upward slope because catching additional fish takes additional time. The curve is convex because there are diminishing returns to fishing time because each additional hour spent fishing yields fewer additional fish.

Figure 8 114.

Here is the completed table: Workers

Output

Marginal Product

Total Cost

0 1 2 3 4 5 6 7

0 20 50 90 120 140 150 155

--20 30 40 30 20 10 5

$200 300 400 500 600 700 800 900

Average Total Cost --$15.00 8.00 5.56 5.00 5.00 5.33 5.81

Marginal Cost --$5.00 3.33 2.50 3.33 5.00 10.00 20.00

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production a. See the table for marginal product. Marginal product rises at first, then declines because of diminishing marginal product. b. See the table for total cost. c. See the table for average total cost. Average total cost is U-shaped. When quantity is low, average total cost declines as quantity rises; when quantity is high, average total cost rises as quantity rises. d. See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply as output increases. This is due to diminishing marginal product. e. When marginal product is rising, marginal cost is falling, and vice versa. f. When marginal cost is less than average total cost, average total cost is falling; the cost of the last unit produced pulls the average down. When marginal cost is greater than average total cost, average total cost is rising; the cost of the last unit produced pushes the average up. 115. At an output level of 600 consoles, total cost is $180,000 (600 × $300). The total cost of producing 601 consoles is $180,901. Therefore, you should not accept the offer of $550, because the marginal cost of the 601st console is $901. 116. a. The fixed cost is $300, because fixed cost equals total cost minus variable cost. At an output of zero, the only costs are fixed cost. b. Quantity

Total Cost

Variable Cost

0 1 2 3 4 5 6

$300 350 390 420 450 490 540

$0 50 90 120 150 190 240

Marginal Cost (using total cost) --$50 40 30 30 40 50

Marginal Cost (using variable cost) --$50 40 30 30 40 50

Marginal cost equals the change in total cost for each additional unit of output. It is also equal to the change in variable cost for each additional unit of output. This relationship occurs because total cost equals the sum of variable cost and fixed cost and fixed cost does not change as the quantity changes. Thus, as quantity increases, the increase in total cost equals the increase in variable cost. 117. The following table illustrates average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) for each quantity. The efficient scale is 4 houses per month, because that minimizes average total cost.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production Quantity

Variable Cost

Fixed Cost

Total Cost

Average Fixed Cost

0 1 2 3 4 5 6 7

$0.00 10.00 20.00 40.00 80.00 160.00 320.00 640.00

$200.00 200.00 200.00 200.00 200.00 200.00 200.00 200.00

$200.00 210.00 220.00 240.00 280.00 360.00 520.00 840.00

--$200.00 100.00 66.67 50.00 40.00 33.33 28.57

Average Variable Cost --$10.00 10.00 13.33 20.00 32.00 53.33 91.43

Average Total Cost --$210.00 110.00 80.00 70.00 72.00 86.67 120.00

118. a. The lump-sum tax causes an increase in fixed cost. Therefore, as Figure 10 shows, only average fixed cost and average total cost will be affected.

Figure 10 b. Refer to Figure 11. Average variable cost, average total cost, and marginal cost will all be greater. Average fixed cost will be unaffected.

Figure 11

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production 119. a. The following table shows average variable cost (AVC), average total cost (ATC), and marginal cost (MC) for each quantity. Quantity

Variable Cost

Total Cost

0 1 2 3 4 5 6

$0.00 10.00 25.00 45.00 70.00 100.00 135.00

$30.00 40.00 55.00 75.00 100.00 130.00 165.00

Average Variable Cost --$10.00 12.50 15.00 17.50 20.00 22.50

Average Total Cost

Marginal Cost

--$40.00 27.50 25.00 25.00 26.00 27.50

--$10.00 15.00 20.00 25.00 30.00 35.00

b. Figure 12 shows the three curves. The marginal-cost curve is below the averagetotal-cost curve when output is less than four and average total cost is declining. The marginal-cost curve is above the average-total-cost curve when output is above four and average total cost is rising. The marginal-cost curve lies above the averagevariable-cost curve.

Figure 12 120. The following table shows quantity (Q), total cost (TC), and average total cost (ATC) for the three firms: Quantity 1 2 3 4 5 6 7

Firm A TC ATC $60.00 $60.00 70.00 35.00 80.00 26.67 90.00 22.50 100.00 20.00 110.00 18.33 120.00 17.14

Firm B TC ATC $11.00 $11.00 24.00 12.00 39.00 13.00 56.00 14.00 75.00 15.00 96.00 16.00 119.00 17.00

Firm C TC ATC $21.00 $21.00 34.00 17.00 49.00 16.33 66.00 16.50 85.00 17.00 106.00 17.67 129.00 18.43

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 14: The Costs of Production Firm A has economies of scale because average total cost declines as output increases. Firm B has diseconomies of scale because average total cost rises as output rises. Firm C has economies of scale from one to three units of output and diseconomies of scale for levels of output beyond three units.

[In-class demonstration] Growing Rice on a Chalkboard: 25 minutes total. Works in classes with more than 15 students. Topics include diminishing returns and increasing costs. Materials needed include chalkboard and chalk. Z. Purpose: Students often have difficulty understanding why diminishing returns exist in short-run production. This activity vividly demonstrates how fixed factors constrain the returns to variable inputs. Then the cause of increasing marginal cost is obvious. AA. Instructions: Prepare the game by selecting two volunteers and outlining two rectangular areas on the chalkboar label a column “Labor” and another “Total Output.” Give each volunteer one piece of chalk and hide any other pieces. The chalk is a fixed factor of production. The volunteers are farmers and the outlined areas are their farm fields. They produce rice by writing the word “RICE” in large letters inside their own field. The letters need to be at least three inches high. They want to produce as much rice as possible in each 15-second time period. The variable input in this example is labor. The game is played repeatedly, adding another student each period. Eventually five students will be crowded around each “field” trying to write with a tiny piece of chalk. The constraints from the fixed factors are physically demonstrated.

XVI.

Start the game with zeros in both the labor and total output columns; with no labor, no rice is produced. Then have the two volunteers race to see how much they can produce in 15 seconds. Record their production under “Total Output” with one “Labor.” [In-class demonstration] Average and Marginal Grades: 5 minutes total. Works in any size class. Topics include relationship between marginal and average cost. A. Purpose: This quick exercise uses an analogy to illustrate to students that they already know the relation between marginal values and averages. B. Instructions: Tell the class that twins (Miley and Hannah) are enrolled in Principles of Economics. They each had a “B” average (GPA 3.0) before taking the class. 1. Miley gets a “C” in the course. What happens to her GPA?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets 2. Hannah gets an “A” in the class. What happens to her GPA? C. Common Answers and Points for Discussion: 14. Students will likely know that Miley will have a lower GPA and Hannah a higher GPA. A “marginal” grade lower than the average will pull down the average. A “marginal” grade higher than the average will increase the average. 15. The same is true of marginal cost and average costs. If marginal cost is less than average cost, average cost will fall. If marginal cost is higher than average cost, average cost will rise. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Economic and Accounting Profit o Concept Clip: Production Function o Concept Clip: Fixed and Variable Costs o Concept Clip: Marginal Cost and Marginal Revenue o Concept Clip: Economies and Diseconomies of Scale o Video Problem Walk-Through: Calculating Marginal Product, Total Cost, Marginal Cost, Average Total Cost, and Efficient Scale for a Firm o Video Problem Walk-Through: Determining Whether Costs Are Short-Run or LongRun, Calculating Different Measures of Cost, and Identifying the Efficient Scale of a Firm o Video Problem Walk-Through: Determining Whether a Firm Is Experiencing Economies of Scale or Diseconomies of Scale o Video Problem Walk-Through: Using Average Total Cost to Calculate Marginal Cost and Using Marginal Cost to Analyze a Production Decision o Equivalency of Fractions, Decimals, and Percentages o Graphing Basics o Slope of a Curve

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets Prepared by David R. Hakes, University of Northern Iowa

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 254 Chapter Objectives ........................................................................................................................................... 254 Complete List of Chapter Activities and Assessments ......................................................................... 255 Key Terms ........................................................................................................................................................... 256 What's New in This Chapter .......................................................................................................................... 256 Chapter Outline ................................................................................................................................................. 256 Solutions to Text Problems ........................................................................................................................... 266 Questions for Review ................................................................................................................................................... 266 Problems and Applications ........................................................................................................................................ 267 Additional Activities and Assignments ..................................................................................................... 273 Additional Resources ...................................................................................................................................... 274 Cengage Video Resources ........................................................................................................................................... 274

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 15 is the second chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. Chapter 14 developed the cost curves on which firm behavior is based. These cost curves are employed in Chapter 15 to show how a competitive firm responds to changes in market conditions. Chapters 16 through 18 will employ these cost curves to see how firms with market power (monopolistic, monopolistically competitive, and oligopolistic firms) respond to changes in market conditions. The purpose of Chapter 15 is to examine the behavior of competitive firms—firms that do not have market power. The cost curves developed in the previous chapter shed light on the decisions that lie behind the supply curve in a competitive market. Key points addressed in this chapter: 



Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue. To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal-cost curve is its supply curve. In the short run when a firm cannot recover its fixed costs, the firm will shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will exit if the price is less than average total cost. In a market with free entry and exit, economic profit is driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter:     

Graph a firm's supply curve for a good, given a graph of a competitive firm's marginal cost curve. Describe the characteristics of a perfectly competitive market. Identify a market as perfectly competitive, monopolistically competitive, monopolistic, or oligopolistic. Given the market price of a good, compute a competitive firm's average revenue at various quantities. Compute a competitive firm's marginal revenue at various quantities using the market price of a good.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets     

Determine the profit-maximizing outcome of a competitive firm using the market price and the firm's production costs. Determine the shutdown price in the short run for a competitive firm, given a graph of the firm's production costs. Indicate the area on a graph that represents a competitive firm's profit or loss. Given a graph of a competitive firm’s marginal cost curve, derive the firm’s supply curve for that good. Explain why the long-run supply curve in a competitive market is more elastic than the short-run supply curve.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Think-Pair-Share Activity Self-Assessment Section 15-1 QuickQuiz Section 15-2 QuickQuiz Section 15-3 QuickQuiz ConceptClip: Average Revenue and Marginal Revenue ConceptClip: Profit Maximization PCF Figure 1: Profit Maximization for a Competitive Firm Figure 3: The Competitive Firm’s Short-Run Supply Curve Figure 4: The Competitive Firm’s Long-Run Supply Curve Figure 5: Profit as the Area between Price and Average Total Cost Chapter 15 Problems & Applications Chapter 15 A+ Test Prep Video Quiz: Introduction to Competitive Markets Video Quiz: Profit Maximization Video Quiz: Profit Maximization and the Competitive Firm’s Short-Run Decision-Making Video Quiz: Competitive Firm’s LongRun Decision-Making Video Quiz: Short Run and Long Run

Source (i.e., PPT slide, Workbook) PPT Slide 25 PPT Slide 45 PPT Slide 46 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

50–65 mins. N/A 10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

10–15 mins. 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

10–15 mins. 10–15 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets Supply in Competitive Markets Video Quiz: Effects of a Demand Shift in a Competitive Market Chapter 15 Homework Chapter 15 Quiz: Firms in Competitive Markets

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. 20–30 mins.

[return to top]

KEY TERMS Average Revenue: total revenue divided by the quantity sold. Competitive Market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker. Marginal Revenue: the change in total revenue from an additional unit sold. Sunk Cost: a cost that has already been committed and cannot be recovered. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

There are no major changes to this chapter.

[return to top]

What Is a Competitive Market? a. The Meaning of Competition i. Keep in Mind: Remember that students have a difficult time understanding what a competitive market is. The use of the word “competition” in economics is much different from that in sports. This will lead students to often forget that these firms are generally unconcerned with the actions of their rivals. ii. Definition of competitive market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets iii.

There are three characteristics of a competitive market (sometimes called a perfectly competitive market). a. There are many buyers and sellers. b. The goods offered by the sellers are largely the same. c. Firms can freely enter or exit the market. B. The Revenue of a Competitive Firm

Table 1 1. Total revenue from the sale of output is equal to price times quantity. Total Revenue Price

Quantity

2. Instruction Idea: Make sure that students realize that firms in perfect competition can only change their level of total revenue by varying their level of output because they have no ability to change the price. 3. Definition of average revenue: total revenue divided by the quantity sold. Average Revenue

Total Revenue Quantity

4. Definition of marginal revenue: the change in total revenue from an additional unit sold. Marginal Revenue

II.

Change in Total Revenue Change in Quantity

5. Instruction Idea: You may want to make it clear that, by definition, average revenue is equal to price for all firms. But marginal revenue is equal to price only for firms that operate in perfectly competitive markets. Profit Maximization and the Competitive Firm's Supply Curve A. A Simple Example of Profit Maximization: The Vaca Family Dairy Farm 1. Keep in Mind: To help students understand price-taking behavior, use the example of common stock. Have your students assume that they inherited 100 shares of stock in a well-known company. Point out that these 100 shares may seem like a lot, but it is a very small proportion of the total number of shares outstanding. If the student wanted to know the value of a share, it could be obtained from a broker. At this market-determined price, the student could sell as few or as many shares as they wishe. At a price above this, no one would be willing to buy any. There is also no reason to charge a price below the current market price, because the student can sell any number of shares that they wish at the current price. Table 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

(2) (3) (5) (6) (7) Total Total (4) Marginal Marginal Change in Revenue Cost Profit Revenue Cost Profit $0 $3 $-3 ---------6 5 1 $6 $2 $4 12 8 4 6 3 3 18 12 6 6 4 2 24 17 7 6 5 1 30 23 7 6 6 0 36 30 6 6 7 -1 42 38 4 6 8 -2 48 47 1 6 9 -3 2. In this example, profit is maximized if the farm produces four or five gallons of milk (refer to column 4). 3. The profit-maximizing quantity can also be found by comparing marginal revenue and marginal cost. a. As long as marginal revenue exceeds marginal cost, increasing output will raise profit. b. If marginal revenue is less than marginal cost, the firm can increase profit by decreasing output. c. Profit-maximization occurs where marginal revenue is equal to marginal cost. d. Alternative Classroom Example: Paulo’s Ping Pong Balls is a firm that operates in a competitive market. The ping pong balls sell for $3 per package. Fill in the following table with the class's help and discuss the profit-maximizing level of output:

(1) Q 0 1 2 3 4 5 6 7 8

Output

Price

0 1 2 3 4 5 6 7 8 9

$3 3 3 3 3 3 3 3 3 3

Total Revenue $0.00 3.00 6.00 9.00 12.00 15.00 18.00 21.00 24.00 27.00

Total Cost $1.50 2.00 3.00 4.50 6.50 9.00 12.00 15.50 19.50 24.00

Profit $-1.50 1.00 3.00 4.50 5.50 6.00 6.00 5.50 4.50 3.00

Marginal Revenue ---$3 3 3 3 3 3 3 3 3

Marginal Cost ---$0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets b. The Marginal-Cost Curve and the Firm's Supply Decision i. Cost curves have special features that are important for our analysis. 1. The marginal-cost curve is upward sloping. 2. The average-total-cost curve is U-shaped. 3. The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. ii. Marginal and average revenue can be shown by a horizontal line at the market price. iii. To find the profit-maximizing level of output, we can follow the same rules that we discussed above.

Figure 1

iv.

1. If marginal revenue is greater than the marginal cost, the firm should increase its output. 2. If marginal cost is greater than marginal revenue, the firm should decrease its output. 3. At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal. These rules apply not only to competitive firms, but to firms with market power as well. 1. Keep in Mind: The graphs in this chapter often confuse students because they contain many different curves at the same time. Thus, the first time you draw the profit-maximizing decision of the firm, use only the marginal cost curve and the marginal revenue line. Then, after students feel comfortable with this, add average total cost (to teach students how to measure profit or loss). Last, add average variable cost to teach students about the short-run shutdown decision of a firm earning an economic loss. Point out that each of the short-run cost curves tells a different part of the story. 2. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section.

Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

If the price in the market were to change to P2, the firm would set its new level of output by equating marginal revenue and marginal cost. vi. Because the firm's marginal-cost curve determines how much the firm is willing to supply at any price, it is the competitive firm's supply curve. c. The Firm's Short-Run Decision to Shut Down i. In certain circumstances, a firm will decide to shut down and produce zero output. ii. There is a difference between a temporary shutdown and an exit from the market. 1. A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. 2. Exit refers to a long-run decision to leave the market. 3. One important difference is that, when a firm shuts down temporarily, it still must pay fixed costs. If a firm exits the industry in the long run, it has no costs. iii. If a firm shuts down, it will earn no revenue and will have only fixed costs (no variable costs). iv. Therefore, a firm will shut down if the revenue that it would earn from producing is less than its variable costs of production: Shut down if TR < VC. v.

Because TR = P x Q and VC = AVC x Q, we can rewrite this condition as: Shut down if P < AVC.

vi.

We now can tell exactly what the firm will do to maximize profit (or minimize loss). 1. If the price is less than average variable cost, the firm will produce no output.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets 2. If the price is above average variable cost, the firm will produce the level of output where marginal revenue (price) is equal to marginal cost. If: P ≥ AVC P < AVC vii.

The Firm Will: Produce output level where MR = MC Shut down and produce zero output

Therefore, the competitive firm's short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.

Figure 3

viii.

Spilt Milk and Other Sunk Costs 1. Definition of sunk cost: a cost that has already been committed and cannot be recovered. 2. Once a cost is sunk, it is no longer an opportunity cost. 3. Because nothing can be done about sunk costs, you should ignore them when making decisions. ix. Case Study: Near-Empty Restaurants and Off-Season Miniature Golf 1. In making a decision of whether to open for lunch, a restaurant owner must weigh revenue with variable costs. (Much of the cost of running a restaurant is somewhat fixed.) 2. The same criteria would apply to a decision of whether a miniature golf course in a summer resort community should stay open during other seasons. The course should only be open if revenue exceeds variable costs. d. The Firm's Long-Run Decision to Exit or Enter a Market i. If a firm exits the market, it will earn no revenue, but it will have no costs as well. ii. Therefore, a firm will exit if the revenue that it would earn from producing is less than its total costs:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets Exit if TR < TC. iii.

Because TR = P x Q and TC = ATC x Q, we can rewrite this condition as: Exit if P < ATC.

iv.

A firm will enter an industry when there is profit potential, so this must mean that a firm will enter if revenues will exceed costs: Enter if P > ATC.

Figure 4

Because, in the long run, a firm will remain in a market only if P ≥ ATC, the firm's long-run supply curve will be its marginal cost curve above ATC.

If: P > ATC P = ATC P < ATC

The Firm Will: Enter because economic profits are earned Not enter or exit because economic profits are zero Exit because economic losses are incurred

e. Measuring Profit in Our Graph for the Competitive Firm i. Recall that Profit = TR – TC. ii. Because TR = P x Q and TC = ATC x Q, we can rewrite this equation: Profit = (P – ATC) x Q.

Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

iii.

III.

Using this equation, we can measure the amount of profit (or loss) at the firm's profit-maximizing level of output (or loss-minimizing level of output). f. Table 3 summarizes the profit maximizing rules for a competitive firm. i. Keep in Mind: Students tend to want to use the point of minimum average total cost when finding profit on the graph. Remind them to always find the average total cost of the profit-maximizing level of output. ii. Instruction Idea: Keep reminding students that economic profits and losses are different from accounting profits and losses. Point out that economic cost includes the cost of all resources, including a “normal return or profit” to compensate the firm’s owner for the risks and other efforts put into the business. The Supply Curve in a Competitive Market Figure 6 A. The Short Run: Market Supply with a Fixed Number of Firms

1. Example: a market with 1,000 identical firms. 2. Each firm's short-run supply curve is its marginal cost curve above average variable cost. 3. To get the market supply curve, we add the quantity supplied by each firm in the market at each price. B. The Long Run: Market Supply with Entry and Exit Figure 7 1. If firms in a market are earning profit, this will attract new firms. a. The supply of the product will increase (the supply curve will shift to the right). b. The price of the product will fall and profit will decline. 2. If firms in an industry are incurring losses, firms will exit.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets a. The supply of the product will decrease (the supply curve will shift to the left). b. The price of the product will rise and losses will decline. 3. At the end of this process of entry or exit, firms that remain in the market must be earning zero economic profit. 4. Because Profit = TR –TC, profit will only be zero when: TR = TC. 5. Because TR = P × Q and TC = ATC × Q, we can rewrite this as: P = ATC. 6. Therefore, the process of entry or exit ends only when price and average total cost become equal. 7. This implies that in long-run equilibrium in a competitive market, firms are operating at their efficient scale. C. Why Do Competitive Firms Stay in Business If They Make Zero Profit? 1. Profit is equal to total revenue minus total cost. 2. To an economist, total cost includes all of the opportunity costs of the firm. 3. When a firm is earning zero profit, this must mean that the firm's revenues are compensating the firm's owners for their opportunity costs. D. A Shift in Demand in the Short Run and Long Run 1. Assume that the market begins in long-run equilibrium. This means that firms are earning zero profit and price equals the minimum of average total cost. 2. If the demand for the product increases, this will lead to an increase in the price of the good. 3. Firms will respond to the increase in price by producing more in the short run. 4. Because price is now greater than average total cost, firms are earning

Figure 8 positive profit.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

5. The profit will attract new firms into the market, shifting the supply curve to the right. 6. This will lower price until it falls back to the minimum of average total cost and firms are once again earning zero economic profit. 7. Instruction Idea: After going through the effects of an increase in demand, ask students to work through the effects of a decrease in demand. Make sure that they can see that firms would exit the market because of economic losses. E. Why the Long-Run Supply Curve Might Slope Upward 1. Because we assumed that all potential entrants faced the same costs as existing firms, average total cost of each firm was unaffected by the entry of new firms into the market. 2. In this situation, the long-run supply of the market will be a horizontal line at minimum average total cost. 3. However, there are two possible reasons why this may not be the case. a. If a resource is limited in quantity, entry of firms will increase the price of this resource, raising the average total cost of production. b. If firms have different costs, then it is likely that those with the lowest costs will enter the market first. If the demand for the product then increases, the firms that would enter will likely have higher costs than those firms already in the market. 4. In this situation, the long-run supply curve of the market will be upward sloping. 5. Instruction Idea: No matter what the shape of the long-run supply curve, an increase in demand will always lead to a rise in the price in the short run and a decrease in demand will always lead to a drop in price in the short run. 6. In either case, the long-run supply curve of a market is generally more elastic than the short-run supply curve of the market (because firms can enter or exit in the long run). [return to top]

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 84. The main characteristics of a competitive firm are: (1) there are many buyers and many sellers in the market; (2) the goods offered by the various sellers are largely the same; and (3) usually firms can freely enter or exit the market. 85. A firm’s total revenue equals its price multiplied by the quantity of units it sells. Profit is the difference between total revenue and total cost. Firms are assumed to maximize profit. 86. Figure 2 shows the cost curves for a typical firm. A competitive firm chooses the level of output that maximizes profit where marginal cost equals price (Q*), as long as price exceeds average variable cost at that point (in the short run), or exceeds average total cost (in the long run). Total revenue can be measured by the rectangular area with a height of P* and a base of Q*. Total cost can be measured by the rectangular area with a height of ATC’ and a base of Q*.

Figure 2 87. A firm will shut down temporarily if the revenue it would get from producing is lower than the variable costs of production. This occurs if price is less than average variable cost. 88. A firm will exit a market if the revenue it would get from remaining in business is less than its total cost. This occurs if price is less than average total cost. 89. A competitive firm's price equals its marginal cost in both the short run and the long run. In both the short run and the long run, price equals marginal revenue. The firm should increase output as long as marginal revenue exceeds marginal cost, and reduce output if marginal revenue is less than marginal cost. Profits are always maximized when marginal revenue equals marginal cost. 90. The competitive firm's price must equal the minimum of its average total cost only in the long run. In the short run, price may be greater than average total cost (in which case the firm is earning a profit), price may be less than average total cost (in which case the firm is incurring a loss), or price may be equal to average total cost (in which case the firm is breaking even). In the long run, if firms are earning profits, other firms will enter the industry, which will lower the price of the good. In the long run, if firms are incurring losses, they will exit the industry, which will raise the price of the good. Entry or exit continues

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets until firms are making neither profits nor losses. At that point, price equals average total cost. 91. Market supply curves are typically more elastic in the long run than in the short run. In a competitive market, because entry or exit occurs until price equals average total cost, quantity supplied is more responsive to changes in price in the long run.

PROBLEMS AND APPLICATIONS 1.

a. As shown in Figure 3, the typical firm's initial marginal-cost curve is MC1 and its average-total-cost curve is ATC1. In the initial equilibrium, the market supply curve, S1, intersects the demand curve at price P1, which is equal to the minimum average total cost of the typical firm. Thus, the typical firm earns no economic profit. The rise in the price of crude oil increases production costs for individual firms (from MC1 to MC2 and from ATC1 to ATC2) and thus shifts the market supply curve to the left, to S2.

Figure 3 b. When the market supply curve shifts left to S2, the equilibrium price rises from P1 to P2, but the price does not increase by as much as the increase in marginal cost for the firm. As a result, price is less than average total cost for the firm, so profits are negative. In the long run, the negative profits lead some firms to exit the market. As they do so, the market supply curve shifts to the left. This continues until the price rises to equal the minimum point on the firm's average-total-cost curve. The long-run equilibrium occurs with supply curve S3, equilibrium price P3, total market output Q3, and firm's output q3. Thus, in the long run, profits are zero again and there are fewer firms in the market. 2. Leah’s total variable cost is her total cost each day less her fixed cost ($280 - $30 = $250). Her average variable cost is her total variable cost each day divided by the number of lawns she mows each day ($250/10 = $25). Because her average variable cost is less than her price, she will not shut down in the short run. Leah’s average total cost is her total cost each day divided by the number of lawns she mows each day ($280/10 = $28). Because her average total cost is greater than her price, she will exit the industry in the long run. 3. Here is the table showing costs, revenues, and profits:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets Quantity 0 1 2 3 4 5 6 7

Total Cost $8 9 10 11 13 19 27 37

Marginal Cost --$1 1 1 2 6 8 10

Total Revenue $0 8 16 24 32 40 48 56

Marginal Revenue --$8 8 8 8 8 8 8

Profit $-8 -1 6 13 19 21 21 19

a. The firm should produce five or six units to maximize profit. b. Marginal revenue and marginal cost are graphed in Figure 4. The curves cross at a quantity between five and six units, yielding the same answer as in Part (a).

Figure 4 c. This industry is competitive because marginal revenue is the same for each quantity. The industry is not in long-run equilibrium, because profit is not equal to zero. a. Costs are shown in the following table:

Q 0 1 2

TFC $100 100 100

TVC $0 50 70

AFC ---$100 50

AVC ---$50 35

ATC ---150 85

MC ---50 20

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets 3 4 5 6

100 100 100 100

90 140 200 360

33.3 25 20 16.7

30 35 40 60

63.3 60 60 76.7

20 50 60 160

b. If the price is $50, the firm will minimize its loss by producing 4 units, where price is equal to marginal cost. When the firm produces 4 units, its total revenue is $200 ($50 x 4 = $200) and its total cost is $240 ($100 + $140). This would give the firm a loss of $40. If the firm shuts down, it will earn a loss equal to its fixed cost ($100). Shutting down was not a wise decision. c. If the firm produces 1 unit, its total revenue is $50 and its total cost is $150 ($100 + $50), so its loss will still be $100. This was also not the best decision. The firm could have reduced its loss by producing more units because the marginal costs of the second and third unit are lower than the price. 5.

a. Figure 5 shows the curves of a typical firm in the industry, with average total cost ATC1, marginal cost MC1, and marginal revenue equal to price P1. The long-runsupply curve is the marginal cost curve above the minimum point of ATC1. b. The new process reduces Hi-Tech’s marginal cost to MC2 and its average total cost to ATC2, but the price remains at P1 because other firms cannot use the new process. Thus Hi-Tech produces Q2 units and earns positive profits. c. When the patent expires and other firms are free to use the technology, all firms’ average-total-cost curves decline to ATC2, so the market price falls to P3 and firms earn zero profit.

Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets 6. Since the firm operates in a perfectly competitive market, its price is equal to its marginal revenue of $10. This means that average revenue is also $10 and 50 units were sold. 7. a. Profit is equal to (P – ATC) × Q. Price is equal to AR. Therefore, profit is ($10 – $8) × 100 = $200. b. For firms in perfect competition, marginal revenue and average revenue are equal. Since profit maximization also implies that marginal revenue is equal to marginal cost, marginal cost must be $10. c. Average fixed cost is equal to AFC /Q which is $200/100 = $2. Since average variable cost is equal to average total cost minus average fixed cost, AVC $8 − $2 $6. d. Since average total cost is less than marginal cost, average total cost must be rising. Therefore, the efficient scale must occur at an output level less than 100. 8. a. If firms are currently incurring losses, price must be less than average total cost. However, because firms in the industry are currently producing output, price must be greater than average variable cost. If firms are maximizing profits, price must be equal to marginal cost. b. The present situation is depicted in Figure 6. The firm is currently producing q1 units of output at a price of P1.

Figure 6 c. Figure 6 also shows how the market will adjust in the long run. Because firms are incurring losses, there will be exit in this industry. This means that the market supply curve will shift to the left, increasing the price of the product. As the price rises, the remaining firms will increase quantity supplied; marginal cost will increase. Exit will continue until price is equal to minimum average total cost. Average total cost will be lower in the long run than in the short run. The total quantity supplied in the market will fall. 9.

a. The table below shows TC and ATC for a typical firm:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets Q 1 2 3 4 5 6

10.

TC 11 15 21 29 39 51

ATC 11 7.5 7 7.25 7.8 8.5

b. At a price of $11, quantity demanded is 200. With marginal revenue of $11, each firm will choose to produce 5 pies where their marginal cost is closest to the marginal revenue without exceeding marginal revenue. Therefore, there will be 40 firms (= 200/5). Each producer will earn total revenue of $55 ($11 x 5), total cost is $39, so profit is $16. c. The market is not in long-run equilibrium because firms are earning positive economic profit. Firms will want to enter the market. e. With free entry and exit, each producer will earn zero profit in the long run. Longrun equilibrium will occur when price is equal to minimum average total cost ($7). At that price, 600 pies are demanded. Each firm will only produce 3 pies (the quantity at which, MC is closest to MR without exceeding MR) meaning that there will be 200 pie producers in the market. a. The firms' variable cost (VC), total cost (TC), marginal cost (MC), and average total cost (ATC) are shown in the table below: Quantity 1 2 3 4 5 6

VC 1 4 9 16 25 36

TC 17 20 25 32 41 52

MC 1 3 5 7 9 11

ATC 17 10 8.33 8 8.20 8.67

b. If the price is $10, each firm will produce 5 units. There are 100 firms in the industry, so there will be 5 x 100 = 500 units supplied in the market. c. At a price of $10 and a quantity supplied of 5, each firm is earning a positive profit because price is greater than average total cost. Thus, entry will occur and the price will fall. As price falls, quantity demanded will rise in accordance with the law of demand. This entry will continue until price is equal to minimum average total cost, $8, and each firm is producing the quantity at which marginal revenue ($8) is equal to marginal cost (4 units if we assume units are not divisible). Therefore, the quantity supplied by each firm decreases. d. Figure 7 shows the long-run market supply curve, which will be horizontal at minimum average total cost, $8. Each firm produces 4 units.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets

Figure 7 11. a. Each firm’s fixed cost, the portion of total cost that does not vary with changes in q, is $50. Each firm’s variable cost, the portion of total cost that varies with changes in q, is . The equation for average total cost is: . b. See Figure 8 for the graph of the average-total-cost curve and the marginal-cost curve for q from 5 to 15. The average-total-cost curve is minimized when the quantity is 10. The average total cost and marginal cost are both $10 at that quantity.

Figure 8 c. The supply curve for each firm is the segment of the marginal-cost curve that lies above the intersection of the average-total-cost curve and the marginal-cost curve, so the supply curve for each firm is:

{

d. In the short run, the supply curve for each firm is the segment of the marginal-cost curve that lies above the intersection of the average-variable-cost curve ( ) and the marginal-cost curve. The average-variable-cost curve and the marginal-cost curve intersect where q=0, so the short-run supply curve for each firm is . Because the number of firms is fixed at 9 in the short run, the short-run market supply curve is . e. Setting the market demand and market supply curves equal to each other, , adding P to both sides of the equation, , and solving for P,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 15: Firms in Competitive Markets the equilibrium price is $12. Substituting the price into either the demand function or the supply function yields the equilibrium quantity, 108. f. In this equilibrium, each of the 9 firms produces (108/9 = 12) 12 units. Profit is total revenue minus total cost. Total revenue is and total cost is , so each firm’s profit is $144 - $122 = $22. Because the profit is greater than zero, there is an incentive for firms to enter the market. g. In the long run with free entry and exit, all firms will earn zero economic profit so the price will be equal to the minimum of the average-total-cost curve. The equilibrium price will be $10. When the price is $10, the equilibrium quantity is 110 units. h. In this long run equilibrium, , so each firm produces 10 units and there are 110/10 = 11 firms.

[In-class assignment] A Profitable Opportunity: 15 minutes total. Works in any class size. Topics include profit maximization. BB. Purpose: This exercise reinforces the importance of marginal cost in decisionmaking. It shows average costs can be misleading. CC. Instructions: Tell the class, “As a recent graduate of this college, you have landed a job in production management for Universal Clones, Inc. You are responsible for the entire company on weekends. Your costs are shown below.” Quantity 500 501

Average Total Cost 200 201

Your current level of production is 500 units. All 500 units have been ordered by your regular customers. “The phone rings. It’s a new customer who wants to buy one unit of your product. This means you would have to increase production to 501 units. Your new customer offers you $450 to produce the extra unit.” a. Should you accept this offer? b. What is the net change in the firm’s profit? DD. Common Answers and Points for Discussion: Most students will answer “yes.” Selling something for $450 when the average cost of production is $201 seems like good business. They are wrong. The relevant comparison is marginal cost to marginal revenue. Marginal cost can be easily calculated as the change in total costs.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly Quantity 500 501

Average Total Cost 200 201

Total Cost = Q x ATC 100,000 100,701

$100,701 – $100,000 = $701 Marginal cost in this example is $701. This is much higher than the marginal revenue of $450. The offer should not be accepted. It would result in a $251 loss. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Average Revenue and Marginal Revenue o Concept Clip: Profit Maximization PCF o Video Problem Walk-Through: Finding the Profit-Maximizing Quantity of Output and Making a Short-Run Shutdown Decision for a Competitive Firm o Video Problem Walk-Through: Determining a Competitive Firm's Short-Run Shutdown Rule and Long-Run Exit Rule o Video Problem Walk-Through: Profit Maximization and the Short-Run and Long-Run Equilibrium in a Competitive Market o Video Problem Walk-Through: Finding the Long-Run Equilibrium in a Competitive Market o Areas o Graphing Basics o Slope of a Curve o Video Quiz: Introduction to Competitive Markets o Video Quiz: Profit Maximization o Video Quiz: Profit Maximization and the Competitive Firm’s Short-Run DecisionMaking o Video Quiz: Competitive Firm’s Long-Run Decision-Making o Video Quiz: Short Run and Long Run Supply in Competitive Markets o Video Quiz: Effects of a Demand Shift in a Competitive Market

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly Prepared by David R. Hakes, University of Northern Iowa

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 276 Chapter Objectives ........................................................................................................................................... 277 Complete List of Chapter Activities and Assessments ......................................................................... 277 Key Terms ........................................................................................................................................................... 278 What's New in This Chapter .......................................................................................................................... 279 Chapter Outline ................................................................................................................................................. 279 Solutions to Text Problems ........................................................................................................................... 289 Questions for Review ................................................................................................................................................... 289 Problems and Applications ........................................................................................................................................ 290 Additional Activities and Assignments ..................................................................................................... 302 Additional Resources ...................................................................................................................................... 304 Cengage Video Resources ........................................................................................................................................... 304

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 16 is the third chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. Chapter 14 developed the cost curves on which firm behavior is based. These cost curves were employed in Chapter 15 to show how a competitive firm responds to changes in market conditions. In Chapter 16, these cost curves are again employed, this time to show how a monopolistic firm chooses the quantity to produce and the price to charge. Chapters 17 and 18 will address the decisions made by monopolistically competitive and oligopolistic firms. A monopolist is the sole seller of a product without close substitutes. As such, it has market power because it can influence the price of its output. That is, a monopolist is a price maker as opposed to a price taker. The purpose of Chapter 16 is to examine the production and pricing decisions of monopolists, the social implications of their market power, and the ways in which governments might respond to the problems caused by monopolists. Key points addressed in this chapter: 



A monopoly is the sole seller in its market. A monopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good, or when a single firm can supply the entire market at a lower cost than many firms could. Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for its product. When a monopoly increases production by one unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s marginal revenue is always below the price of its good. Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. The monopoly then sets the price at which that quantity is demanded. Unlike a competitive firm, a monopoly’s price exceeds its marginal revenue, so its price exceeds marginal cost. A monopolist’s profit-maximizing output is below the level that maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of production do not buy it. As a result, monopoly causes deadweight losses similar to those caused by taxes. A monopolist can often increase profit by charging different prices for the same good based on a buyer’s willingness to pay. This practice of price discrimination can raise economic welfare by getting the good to some consumers who would otherwise not buy it. In the extreme case of perfect price discrimination, the deadweight loss of monopoly is completely eliminated, and the entire surplus in the market goes to the monopoly producer. More generally, when price discrimination is imperfect, it can either raise or lower welfare compared with the outcome with a single monopoly price. Policymakers can respond to the inefficiency of monopoly behavior in several ways. They can use the antitrust laws to try to make the industry more competitive. They can regulate the prices that the monopoly charges. They can turn the monopolist into a government-run enterprise. Or, if the market failure is deemed small compared with the inevitable imperfections of policies, they can do nothing at all.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain the differences between a monopoly and a perfectly competitive firm.



Describe the characteristics of a monopoly.



Describe the barriers to entry that help create monopoly markets.



Describe the characteristics of a natural monopoly.



Explain why the monopolist's marginal revenue declines as the quantity produced increases.



Describe the slope of the demand curve for a monopoly.



Determine the monopolist's profit-maximizing price and quantity.



Identify the area on a graph that represents a monopoly's profit or loss.



Analyze the impact of regulation on monopolistic market structures.



Explain why deadweight loss occurs in a monopoly market structure.



Analyze the behavior and market effects of monopolies.



Compare total surplus in a market under monopolistic conditions versus competitive conditions.

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Determine if a price scheme scenario is an example of price discrimination.

Source (i.e., PPT slide, Workbook) PPT Slide 14 PPT Slide 41 PPT Slide 48 PPT Slides 49–50 PPT Slide 51 MindTap eBook MindTap eBook MindTap eBook MindTap eBook

Duration 10-15 mins. 10-15 mins. 10-15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly Section 16-5 QuickQuiz ConceptClip: Monopoly and Natural Monopoly ConceptClip: Profit Maximization Monopoly ConceptClip: Price Discrimination Figure 4: Profit Maximization for a Monopoly Figure 5: The Monopolist’s Profit Figure 8: The Inefficiency of Monopoly Chapter 16 Problems & Applications Chapter 16 A+ Test Prep Video Quiz: Barriers to Entry in Monopoly Markets Video Quiz: Monopoly Demand and Revenue Video Quiz: Profit Maximization for the Monopolist Video Quiz: Costs to Society from Monopolies Video Quiz: Example of Price Discrimination and the Lessons Learned Video Quiz: Perfect Price Discrimination and Other Forms of Price Discrimination Video Quiz: Policies Toward Monopolies Chapter 16 News Analysis: Market Power and the EpiPen Chapter 16 News Analysis: Coupon Clipping Craze Chapter 16 Homework Chapter 16 Quiz: Monopoly

MindTap eBook MindTap Learn It Folder

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MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

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KEY TERMS Monopoly: a firm that is the sole seller of a product without close substitutes. Natural Monopoly: a type of monopoly that arises because a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. Price Discrimination: the business practice of selling the same good at different prices to different customers.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new In the News feature addressing the Biden’s administration’s antitrust policies, “Antitrust’s New Mission: Preserving Democracy, Not Efficiency. There is a new Ask the Experts feature on the economic impact of mergers.

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A competitive firm is a price taker; a monopoly firm is a price maker. Why Monopolies Arise A. Definition of monopoly: a firm that is the sole seller of a product without close substitutes. B. The fundamental cause of monopoly is barriers to entry. 1. Monopoly Resources a. A monopoly could have sole ownership or control of a key resource that is used in the production of the good. b. A key example is DeBeers, which has at times controlled about 80% of the diamonds in the world. 2. Government-Created Monopolies a. Monopolies can arise because the government grants one person or one firm the exclusive right to sell some good or service. b. Patents are issued by the government to give firms the exclusive right to produce a product for 20 years. c. Patents involve trade-offs; they restrict competition but encourage research and development. 3. Natural Monopolies a. Definition of natural monopoly: a type of monopoly that arises because a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. b. A natural monopoly occurs when there are economies of scale, Figure 1 implying that average total cost falls as the firm's scale becomes larger. c. Other examples of natural monopolies are club goods – goods that are excludable but not rival in consumption.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly III.

How Monopolies Make Production and Pricing Decisions A. Monopoly versus Competition Figure 2 1. The key difference between a competitive firm and a monopoly is the monopoly's ability to influence the price of its output. 2. The demand curves that each of these types of firms faces is different as well. a. A competitive firm faces a perfectly elastic demand at the market price. The firm can sell all that it wants to at this price. b. A monopoly faces the market demand curve because it is the only seller in the market. If a monopoly wants to sell more output, it must lower the price of its product. B. A Monopoly's Revenue 1. Example: sole producer of water in a town. Table 1

(1) Quantity 0 1 2 3 4 5 6 7 8

(2) Price $11 10 9 8 7 6 5 4 3

(3) Total Revenue $0 10 18 24 28 30 30 28 24

(4) Average Revenue ---$10 9 8 7 6 5 4 3

(5) Marginal Revenue ---$10 8 6 4 2 0 -2 -4

2. A monopoly's marginal revenue is less than the price of the good (other than at the first unit sold). a. If the monopolist sells one more unit, its total revenue (P × Q) will rise because Q is getting larger. This is called the output effect. b. If the monopolist sells one more unit, it must lower price. This means that his total revenue (P × Q) will fall because P is getting smaller. This is called the price effect. a. Alternative Classroom Example: The Whatsa Widget Company has a monopoly in the sale of widgets. The demand the firm faces can be shown by the following schedule: Quantity

Price

Total Revenue

Marginal Revenue

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly 0 1 2 3 4 5

$15 14 13 12 11 10

$0 14 26 36 44 50

---$14 12 10 8 6

c. Note that, for a competitive firm, there is no price effect. d. Keep in Mind: Students often have trouble with this. Go through the table making sure that they understand the calculation of both total revenue and marginal revenue as output increases. Emphasize that the monopolist is selling all units at the same price.

Figure 3

3. When graphing the firm's demand and marginal revenue curve, they always start at the same point (because P = MR for the first unit sold); for every other level of output, marginal revenue lies below the demand curve (because MR < P). 4. Instruction Idea: At this point, you may want to discuss the price elasticity of demand again. Remind students that demand tends to be elastic along the upper left portion of the demand curve. Thus, a decrease in price causes total revenue to increase (so that marginal revenue is greater than zero). Further down the demand curve, the demand is inelastic. In this region, a decrease in price results in a drop in total revenue (implying that marginal revenue is now less than zero). Marginal revenue is equal to zero when demand is unit elastic. C. Profit Maximization 1. The monopolist's profit-maximizing quantity of output occurs where marginal revenue is equal to marginal cost.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly a. If marginal revenue is greater than marginal cost, profit can be increased by raising the firm’s level of output. b. If marginal revenue is less than marginal cost, profit can be increased by lowering the firm’s level of output. 2. Even though MR = MC is the profit-maximizing rule for both competitive firms and monopolies, there is one important difference. a. For competitive firms, P = MR; at the profit-maximizing level of output, P = MC. b. For a monopoly, P > MR; at the profit-maximizing level of output, P > MC. c. Alternative Classroom Example: The costs for the Whatsa Widget Company can be represented by the following schedule: Quantity 0 1 2 3 4 5

Total Cost $8 11 16 26 39 57

Marginal Cost ---$3 5 10 13 18

Using the earlier information regarding the demand for widgets, have the students find the profit-maximizing level of output (where marginal revenue is equal to marginal cost). Use the information on total revenue and total cost to calculate the level of maximum profit.

Figure 4

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly 3. The monopolist's price is determined by the demand curve (which shows us how much buyers are willing to pay for the product). 4. Keep in Mind: After having seen profit-maximization for a perfectly competitive firm, students generally do not have difficulty understanding that a monopolist will maximize profit where marginal revenue equals marginal cost. However, students do have trouble remembering to use the demand curve to find the monopolist’s price. Be careful to review this point several times. D. FYI: Why a Monopoly Does Not Have a Supply Curve 1. A supply curve tells us the quantity that a firm chooses to supply at any given price. 2. But a monopoly firm is a price maker; the firm sets the price at the same time it chooses the quantity to supply. 3. It is the market demand curve that tells us how much the monopolist will supply because the shape of the demand curve determines the shape of the marginal revenue curve (which in turn determines the profit-maximizing level of output). E. A Monopoly's Profit 1. We can find profit using the following equation: Profit = TR – TC. 2. Because TR = P × Q and TC = ATC × Q, we can rewrite this equation: Profit = (P – ATC) × Q.

Table 2 Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

F. Case Study: Monopoly Drugs versus Generic Drugs Figure 6

IV.

1. The market for pharmaceutical drugs takes on both monopoly characteristics and competitive characteristics. 2. When a firm discovers a drug, patent laws give the firm a monopoly on the sale of that drug. However, the patent eventually expires and any firm can make the drug, which causes the market to become competitive. 3. Analysis of the pharmaceutical industry has shown us that prices of drugs fall after patents expire and new firms begin production of that drug. The Welfare Cost of Monopolies A. The Deadweight Loss Figure 7 1. The demand curve represents the value that buyers place on each additional unit of a good or service. The marginal-cost curve represents the additional cost of producing each unit of a good or service. 2. The socially efficient quantity of output is found where the demand curve and the marginal cost curve intersect. This is where total surplus is maximized. 3. Instruction Idea: Remind students that total surplus is the area between the demand curve and the marginal cost curve. It should be clear that surplus is not realized for quantities of output between the monopoly output and the socially efficient output. 4. Because the monopolist sets marginal revenue equal to marginal cost to determine its output level, it will produce less than the socially efficient quantity of output. 5. The price that a monopolist charges is above marginal cost. Some potential customers value the good at more than its marginal cost but they do not

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly purchase the good because the price is above marginal cost. Therefore, total surplus is not maximized.

6. The deadweight loss can be seen on the graph as the area between the demand and marginal cost curves for the units between the monopoly quantity and the efficient quantity. 7. Instruction Idea: Point out to students that this is similar to the analysis of taxes in Chapter 8. Here, the monopolist places a wedge between price and marginal cost and the quantity sold ends up being short of the optimum level. B. The Monopoly's Profit: A Social Cost? 1. Welfare in a market includes the welfare of both consumers and producers. 2. The transfer of surplus from consumers to producers from monopoly profits is therefore not a social loss. 3. The deadweight loss from monopoly stems from the fact that monopolies produce less than the socially efficient level of output. 4. If the monopoly incurs costs to maintain (or create) its monopoly power, those costs would also be included in deadweight loss. 5. Deadweight loss is the social cost. Price Discrimination A. Definition of price discrimination: the business practice of selling the same good at different prices to different customers. B. A Parable about Pricing 1. Example: Readalot Publishing Company 2. The firm pays an author $2 million for the right to publish a book. (Assume that the cost of printing the book is zero.) 3. The firm knows that there are two types of readers. a. There are 100,000 die-hard fans (living in Australia) of the author willing to pay up to $30 for the book.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly b. There are 400,000 other readers (living in the United States) who are willing to pay up to $5 for the book. 4. How should the firm set its price? a. If the firm sets its price equal to $30, it will sell 100,000 copies of the book, receive total revenue of $3 million, and earn $1 million in profit. b. If the firm sets its price equal to $5, it will sell 500,000 copies, receive total revenue of $2.5 million, and earn only $500,000 in profit. c. It will choose to set its price at $30 and sell 100,000 books. Note that there is a deadweight loss from this decision because there are 400,000 other customers willing to pay $5, which is more than the marginal cost of producing the book ($0). 5. Since it would be difficult for Australian readers to buy a copy of the book in the United States, the company could make even more profit by selling 100,000 copies to the die-hard fans at $30 each, and then selling 400,000 copies to the other readers for $5 each. a. The total revenue from selling 100,000 copies at $30 each is $3 million. b. The total revenue from selling 400,000 copies at $5 each is $2 million. c. Because the firm's costs are $2 million, profit will be $3 million. d. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. C. The Moral of the Story 1. By charging different prices to different customers, a monopoly firm can increase its profit. 2. To price discriminate, a firm must be able to separate customers by their willingness to pay. 3. Arbitrage (the process of buying a good in one market at a low price and then selling it in another market at a higher price) will limit a monopolist's ability to price discriminate. 4. Price discrimination can increase economic welfare. Producer surplus rises (because price exceeds marginal cost for all of the units sold) while consumer surplus is unchanged (because price is equal to the consumers’ willingness to pay). D. The Analytics of Price Discrimination Figure 9 1. Perfect price discrimination describes a situation where a monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. 2. Without price discrimination, a firm produces an output level that is lower than the socially efficient level.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

VI.

3. If a firm perfectly price discriminates, each customer who values the good at more than its marginal cost will purchase the good and be charged their willingness to pay. a. There is no deadweight loss in this situation. b. Because consumers pay a price exactly equal to their willingness to pay, all surplus in this market will be producer surplus. E. Examples of Price Discrimination 1. Movie Tickets 2. Airline Prices 3. Discount Opportunities 4. Financial Aid 5. Quantity Discounts Public Policy toward Monopolies A. Increasing Competition with Antitrust Laws 1. Courts are more likely to block mergers between competitors (horizontal mergers) than mergers with suppliers (vertical mergers). 2. Antitrust laws are a collection of statutes that give the government the authority to control markets and promote competition. a. The Sherman Antitrust Act was passed in 1890 to lower the market power of the large and powerful "trusts” that were viewed as dominating the economy at that time. b. The Clayton Act was passed in 1914; it strengthened the government's ability to curb monopoly power and authorized private lawsuits. 3. Antitrust laws allow the government to prevent mergers and break up large, dominating companies. 4. Antitrust laws also impose costs on society. Some mergers may provide synergies, which occur when the costs of operations fall because of joint operations. B. Ask the Experts: Mergers 1. Economic experts are divided on whether air travelers would be better off today if regulators had not approved mergers in the past decade between major airlines, with 29 percent agreeing, 26 percent disagreeing, and 45 percent uncertain. 2. When asked to evaluate the statement, “Americans pay too much for broadband, cable television, and telecommunications services, in part because of a lack of adequate competition, 91 percent of economic experts agreed, 2% disagreed, and 7% were uncertain. C. Regulation 1. Regulation is often used when the government is dealing with a natural monopoly. 2. Instruction Idea: Local phone and electric companies are good examples of regulated monopoly firms. 3. Most often, regulation involves government limits on the price of the product.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly 4. While we might believe that the government can eliminate the deadweight loss from monopoly by setting the monopolist's price equal to its marginal cost, this is often difficult to do. Figure 10 a. If the firm is a natural monopoly, its average total cost curve will be declining because of its economies of scale. b. When average total cost is falling, marginal cost must be lower than average total cost. c. Therefore, if the government sets price equal to marginal cost, the price will be below average total cost and the firm will earn a loss, causing the firm to eventually leave the market. 5. Therefore, governments may choose to set the price of the monopolist's product equal to its average total cost. This gives the monopoly zero profit, but assures that it will remain in the market. a. There is still a deadweight loss in this situation because the level of output will be lower than the socially efficient level of output. b. Average-cost pricing also provides no incentive for the monopolist to reduce costs. D. Public Ownership 1. Rather than regulating a monopoly run by a private firm, the government can run the monopoly itself. 2. However, economists generally prefer private ownership of natural monopolies. a. Private owners have an incentive to keep costs down to earn higher profits. b. If government bureaucrats do a bad job running a monopoly, the political system is the taxpayers’ only recourse. E. Above All, Do No Harm 1. Sometimes the costs of government regulation outweigh the benefits. 2. Therefore, some economists believe that it is best for the government to leave monopolies alone. F. In the News: Will the Biden Administration Expand the Scope of Antitrust Policy? “Antitrust’s New Mission: Preserving Democracy, Not Efficiency.” 1. From the early 1900s until roughly 1970, antitrust efforts were guided by the view that big firms are inherently bad for democracy. This view was promoted by the Supreme Court justice Louis Brandeis. 2. From 1970 through the present, antitrust policy has been guided by the consumer welfare standard, promoted by legal scholar Robert Bork. If bigger companies can make goods more efficiently, then the merger should be allowed. This standard argues that interjecting politics into antitrust policy is arbitrary and dangerous. 3. Biden’s appointment to head the Federal Trade Commission (FTC) is considered a neo-Brandeisian because her writings are similar to Brandeis: The power of big companies is inherently bad for democracy.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly Table 3 VII.

Conclusion: The Prevalence of Monopolies

A. Monopoly firms behave very differently from competitive firms. B. Table 3 summarizes the key similarities and differences between monopoly and competitive markets. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 92. Government-created monopoly comes from the existence of patent and copyright laws. Both allow firms or individuals to be monopolies for extended periods of time—20 years for patents, the life of the author plus 70 years for copyrights. But this monopoly power is good, because without it, no one would write a book or a song and no firm would invest in research and development to invent new products or pharmaceuticals. 93. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. As a market grows, it may evolve from a natural monopoly to a competitive market. 94. A monopolist's marginal revenue is less than the price of its product because its demand curve is the market demand curve. Thus, to increase the amount sold, the monopolist must lower the price of its good for every unit it sells. This cut in price reduces the revenue on the units it was already selling. A monopolist's marginal revenue can be negative because to get purchasers to buy an additional unit of the good, the firm must reduce its price on all units of the good. The fact that it sells a greater quantity increases the firm’s revenue, but the decline in price decreases the firm’s revenue. The overall effect depends on the price elasticity of demand. If demand is inelastic, marginal revenue will be negative. 95. Figure 1 shows the demand, marginal-revenue, average-total-cost, and marginal-cost curves for a monopolist. The intersection of the marginal-revenue and marginal-cost curves determines the profit-maximizing level of output, Qm. The profit-maximizing price, Pm, can be found using the demand curve. Profit is shown as the rectangular area with a height of (PM – ATCM) and a base of QM.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

Figure 1 96. The level of output that maximizes total surplus in Figure 1 is where the demand curve intersects the marginal-cost curve, Qc. The deadweight loss from monopoly is the triangular area between Qc and Qm that is above the marginal-cost curve and below the demand curve. It represents deadweight loss, because society loses total surplus because of the monopoly. The deadweight loss is equal to the value of the good (measured by the height of the demand curve) less the cost of production (given by the height of the marginal-cost curve), for the quantities between Qm and Qc. 97. One example of price discrimination is in publishing books. Publishers charge a much higher price for hardback books than for paperback books—far higher than the difference in production costs. Publishers do this because die-hard fans will pay more for a hardback book when the book is first released. Those who don't value the book as highly will wait for the paperback version to come out. The publisher makes a greater profit this way than if it charged just one price. A second example is the pricing of movie tickets. Theaters give discounts to children and senior citizens because they have a lower willingness to pay for a ticket. Charging different prices helps the theater increase its profit above what it would be if it charged just one price. Many other examples are possible. 98. The government has the power to regulate mergers between firms because of antitrust laws. Firms might want to merge to increase operating efficiency and reduce costs, something that is good for society, or to gain market power, which is bad for society. 99. When regulators tell a natural monopoly that it must set price equal to marginal cost, two problems arise. The first is that, because a natural monopoly has a marginal cost that is always less than average total cost, setting price equal to marginal cost means that the firm will incur a loss. The firm would then exit the industry unless the government subsidized it. However, getting revenue for such a subsidy would cause the government to raise other taxes, increasing the deadweight loss. The second problem of using costs to set price is that it gives the monopoly no incentive to reduce costs.

PROBLEMS AND APPLICATIONS 121.

The following table shows revenue, costs, and profits:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly Price

Quantity

$100 90 80 70 60 50 40 30 20 10 0

0 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 900,000 1,000,000

Total Revenue $0 9,000,000 16,000,000 21,000,000 24,000,000 25,000,000 24,000,000 21,000,000 16,000,000 9,000,000 0

Marginal Revenue ---$90 70 50 30 10 -10 -30 -50 -70 -90

Total Cost

Profit

$2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 7,000,000 8,000,000 9,000,000 10,000,000 11,000,000 12,000,000

$-2,000,000 6,000,000 12,000,000 16,000,000 18,000,000 18,000,000 16,000,000 12,000,000 6,000,000 -2,000,000 -12,000,000

a. A family profit-maximizing publisher would choose a quantity of 400,000 at a price of $60 or a quantity of 500,000 at a price of $50; both combinations would lead to profits of $18 million. b. Marginal revenue is less than price. Price falls when quantity rises because the demand curve slopes downward, but marginal revenue falls even more than price because the firm loses revenue on all the units of the good sold when it lowers the price. c. Figure 2 shows the marginal-revenue, marginal-cost, and demand curves. The marginal-revenue and marginal-cost curves cross between quantities of 400,000 and 500,000. This signifies that the firm maximizes profits in that region.

Figure 2 d. The area of deadweight loss is marked “DWL” in the figure. Deadweight loss means that the total surplus in the economy is less than it would be if the market were competitive, because the monopolist produces less than the socially efficient level of output.

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122.

e. If the author were paid $3 million instead of $2 million, the publisher would not change the price, because there would be no change in marginal cost or marginal revenue. The only thing that would be affected would be the firm’s profit, which would fall. f. To maximize economic efficiency, the publisher would set the price at $10 per book, because that is the marginal cost of the book. At that price, the publisher would have negative profits equal to the amount paid to the author. a. Figure 3 illustrates the market for groceries when there are many competing supermarkets with constant marginal cost. Output is QC, price is PC, consumer surplus is area A, producer surplus is zero, and total surplus is area A.

Figure 3

Figure 4

b. Figure 4 illustrates the new situation when the supermarkets merge. Quantity declines from QC to QM and price rises to PM. Consumer surplus falls by areas D + E + F to areas B + C. Producer surplus becomes areas D + E, and total surplus is areas B + C + D + E. Consumers transfer the amount of areas D + E to producers and the deadweight loss is area F. 123.

a. The following table shows total revenue and marginal revenue for each price and quantity sold: Price

Quantity

24 22 20 18 16 14

10,000 20,000 30,000 40,000 50,000 60,000

Total Revenue $240,000 440,000 600,000 720,000 800,000 840,000

Marginal Revenue ---$20 16 12 8 4

Total Cost

Profit

$50,000 100,000 150,000 200,000 250,000 300,000

$190,000 340,000 450,000 520,000 550,000 540,000

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124.

b. Profits are maximized at a quantity where MR=MC. The quantity at which MC is closest to MR without exceeding it is 50,000 albums at a price of $16. At that point, profit is $550,000. c. As Swift’s agent, you should recommend that she demand $550,000 from them, so she receives all of the profit (rather than the record company). The firm would still choose to produce 50,000 albums because their marginal cost would not change. a. The table below shows total revenue and marginal revenue for the bridge. The profit-maximizing price will occur at the quantity at which marginal revenue equals marginal cost. In this case, marginal cost equals zero, so the profit-maximizing quantity occurs where marginal revenue equals 0. This occurs at a price of $4 and quantity of 400,000 crossings. The efficient level of output is 800,000 crossings, because that is where price is equal to marginal cost. The profit-maximizing quantity is lower than the efficient quantity because the firm is a monopolist. Price $8 7 6 5 4 3 2 1 0

Quantity (in Thousands) 0 100 200 300 400 500 600 700 800

Total Revenue (in Thousands) $0 700 1,200 1,500 1,600 1,500 1,200 700 0

Marginal Revenue ---$7 5 3 1 -1 -3 -5 -7

b. The company should not build the bridge because its profits are negative. The most revenue it can earn is $1,600,000 and the cost is $2,000,000, so it would lose $400,000. c. If the government were to build the bridge, it should set price equal to marginal cost to be efficient. Since marginal cost is zero, the government should not charge people to use the bridge.

Figure 5

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125.

d. Yes, the government should build the bridge, because it would increase society's total surplus. As shown in Figure 5, total surplus has area ½ × 8 × 800,000 = $3,200,000, which exceeds the cost of building the bridge. a. A monopolist always produces a quantity at which demand is elastic. If the firm produced a quantity for which demand was inelastic and the firm raised its price, quantity would fall by a smaller percentage than the rise in price, so revenue would increase. Because costs would decrease at a lower quantity, the firm would have higher revenue and lower costs, so profit would be higher. Thus the firm should keep raising its price until profits are maximized, which must happen on an elastic portion of the demand curve. b. As Figure 6 shows, another way to see this is to note that on an inelastic portion of the demand curve, marginal revenue is negative. Increasing quantity requires a greater percentage reduction in price, so revenue declines. Because a firm maximizes profit where marginal cost equals marginal revenue, and marginal cost is never negative, the profit-maximizing quantity can never occur where marginal revenue is negative. Thus, it can never be on the inelastic portion of the demand curve. Total revenue is maximized where marginal revenue is equal to zero (QTR on Figure 6).

Figure 6 126.

a. The profit-maximizing outcome is the same as maximizing total revenue in this case because there are no variable costs. The total revenue from selling to each type of consumer is shown in the following tables: Price 10 9 8 7 6 5

Quantity of Adult Tickets 0 100 200 300 300 300

Total Revenue from Sale of Adult Tickets 0 900 1,600 2,100 1,800 1,500

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly 4 3 2 1 0

300 300 300 300 300

1,200 900 600 300 0

Price

Quantity of Child Tickets 0 0 0 0 0 100 200 200 200 200 200

Total Revenue from Sale of Child Tickets 0 0 0 0 0 500 800 600 400 200 0

10 9 8 7 6 5 4 3 2 1 0

To maximize profit, you should charge adults $7 and sell 300 tickets. You should charge children $4 and sell 200 tickets. Total revenue will be $2,100 + $800 = $2,900. Because total cost is $2,000, profit will be $900. b. If price discrimination were not allowed, you would want to set a price of $7 for the tickets. You would sell 300 tickets and profit would be $100. c. The children who were willing to pay $4 but will not see the show now that the price is $7 will be worse off. The producer is worse off because profit is lower. Total surplus is lower. There is no one that is better off. d. In (a) total profit would be $400. In (b), there would be a $400 loss. There would be no change in (c). 127.

a. The museum’s average-total-cost curve and marginal-cost curve are shown in Figure 7 below. Because all of the cost is fixed, the average-total-cost curve is downward-sloping like an average-fixed-cost curve and the marginal cost is zero. The museum is a natural monopoly.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

Figure 7

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly b. With a lump sum tax of $24, the price of admission is $0 so each person would visit the museum ( 10 times. The benefit each person would get from the museum would be consumer surplus of (

) $50 less the $24 tax, or $26.

c. If the museum finances itself by charging an admission fee, the lowest price the museum can charge without incurring a loss is $4, as shown in the following table. Price

Number of Visits per Person

Museum Profit

($2 x 800,000) – $2,400,000 = -$800,000

($3 x 700,000) - $2,400,000 = -$300,000

($4 x 600,000) - $2,400,000 =

($5 x 500,000) - $2,400,000 = $100,000

d. When the price is $4 and each person visits the museum 6 times, each person’s consumer surplus is (

) $18, which is $8 less than each person’s

benefit under the tax plan. Because each person has the same demand curve, all are better off under the mayor’s plan. e. The real world considerations that might favor an admission fee include the administrative cost to collect the lump sum tax from all 100,000 residents compared to the relatively simple collection of an admission fee and the unpopular nature of taxes. 128. a. Figure 8 below illustrates the demand, marginal revenue, and marginal cost curves.

Figure 8 Assuming Mr. Potter profit-maximizes, he sets MR=MC and solves for the profit maximizing quantity. Then he substitutes the profit-maximizing quantity into the

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly demand curve: 70 – 2Q = 10 + Q 60 = 3Q Q = 20 P = 70 – Q = $50 b. If the mayor sets a price ceiling 10% lower than the profit-maximizing price, the price would be $45 and the quantity demanded would be 25 units of water. The marginal cost of producing 25 units of water is (10 +25) $35. While Mr. Potter would prefer to sell 20 units at a price of $50 per unit, he is willing to sell 25 units at the ceiling price of $45 because the price still exceeds his marginal cost of production. c. Uncle Billy is incorrect. Price ceilings cause shortages when the ceiling price is lower than the competitive price, at which price equals marginal cost. Because the ceiling still exceeds the competitive price and marginal cost, there is no shortage in this case. d. If the ceiling is set 50% below the profit-maximizing price, at $25, the quantity demanded would be 45 units of water and Mr. Potter would produce 15 units of water, where the price equals his marginal cost. In this case, Uncle Billy is correct. The price ceiling creates a shortage of 30 units of water. 129. a. The monopolist would set marginal revenue equal to marginal cost and then substitute the profit-maximizing quantity into the demand curve to find the price: 10 – 2Q = 1 + Q 9 = 3Q Q=3 P = 10 – Q = $7 Total revenue = P  Q = ($7)(3) = $21 Total cost = 3 + 3 + 0.5(9) = $10.5 Profit = $21 – $10.5 = $10.5 b. The firm becomes a price taker at a price of $6 and no longer has monopoly power. In a competitive equilibrium, the price equals marginal cost so, 10 - Q = 1 + Q 10 = 1 + 2Q 9 = 2Q Q = 4.5 P = 5.5 The firm will export soccer balls because the world price is greater than the domestic price (in the absence of monopoly power). As Figure 9 shows, domestic

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly production will rise to 5 soccer balls, domestic consumption will rise to 4, and exports will be 1.

Figure 9 c. The price actually falls even though Wiknam will now export soccer balls. Once trade begins, the firm no longer has monopoly power and must become a price taker. However, the world price of $6 is greater than the competitive equilibrium price ($5.50) so the country exports soccer balls. d. Yes. The country would still export balls at a world price of $7. The firm is a price taker and no longer is facing a downward-sloping demand curve. Thus, it is now possible to sell more without reducing price. 130. a. Figure 10 shows the firm’s demand, marginal revenue, and marginal cost curves. The firm’s profit is maximized at the output where marginal revenue is equal to marginal cost. Therefore, setting the two equations equal, we get: 1,000 – 20Q = 100 + 10Q domestic consumption will rise to 4, and exports will be 1. 900 = 30Q Q = 30 The monopoly price is P = 1,000 – 10Q = 700 dollars.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

Figure 10 b. Social welfare is maximized where price is equal to marginal cost: 1,000 – 10Q = 100 + 10Q 900 = 20Q Q = 45 At an output level of 45, the price would be 550 dollars. c. The deadweight loss would be equal to (0.5)(15)(300) = 2,250 dollars. d. i. A flat fee of 2000 dollars would not alter the profit-maximizing price or quantity. The deadweight loss would be unaffected. ii. A fee of 50 percent of the profits would not alter the profit-maximizing price or quantity. The deadweight loss would be unaffected. iii. The marginal cost of production would rise by 150 dollars if the director was paid that amount for every unit sold. The new marginal cost would be 100 + 10Q + 150. The new profit-maximizing output would be 25, the marginal cost at that level would be 500, and the price would rise to 750. The deadweight loss would be smaller. With the new marginal cost function, the quantity at which social welfare is maximized changes. Now, price is equal to marginal cost when Q = 37.5: 1,000 - 10Q = 250 + 10Q 750 20Q Q = 37.5 As a result, the deadweight loss would be equal to (0.5)(37.5-25)(750-500) = 1,562.50 dollars rather than 2,250 dollars.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly iv. If the director is paid 50 percent of the revenue, then total revenue is 500Q – 5Q2. Marginal revenue becomes 500 – 10Q. The profit-maximizing output level will be 20 and the price will be 800 dollars. The deadweight loss will be greater. 131. Larry wants to sell as many drinks as possible without losing money, so he wants to set quantity where price (demand) equals average total cost, which occurs at quantity QL and price PL in Figure 11. Curly wants to bring in as much revenue as possible, which occurs where marginal revenue equals zero, at quantity QC and price PC. Moe wants to maximize profits, which occurs where marginal cost equals marginal revenue, at quantity QM and price PM.

Figure 11 132. a. Figure 12 shows the cost, demand, and marginal-revenue curves for the monopolist. Without price discrimination, the monopolist would charge price PM and produce quantity QM.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly

Figure 12 b. The monopolist's profit consists of the two areas labeled X, consumer surplus is the two areas labeled Y, and the deadweight loss is the area labeled Z. c. If the monopolist can perfectly price discriminate, it produces quantity QC, and has profit equal to X + Y + Z. d. The monopolist's profit increases from X to X + Y + Z, an increase in the amount Y + Z. The change in total surplus is area Z. The rise in the monopolist's profit is greater than the change in total surplus, because the monopolist's profit increases both by the amount of deadweight loss (Z) and by the transfer from consumers to the monopolist (Y). e. A monopolist would pay the fixed cost that allows it to discriminate as long as Y + Z (the increase in profits) exceeds C (the fixed cost). f. A social planner who cared about maximizing total surplus would want the monopolist to price discriminate only if Z (the deadweight loss from monopoly) exceeded C (the fixed cost) because total surplus rises by Z – C. g. The monopolist has a greater incentive to price discriminate (it will do so if Y + Z > C) than the social planner (they would allow it only if Z > C). Thus if Z < C but Y + Z > C, the monopolist will price discriminate even though it is not in society's best interest.

[In-class assignment] Price Discrimination and Time Travel: 10 minutes total. Works in any class size. Topics include price discrimination and consumer surplus. EE. Purpose: This example illustrates how a price-discriminating monopolist can earn even higher profits than a monopolist charging a single price. The example uses an imaginary time machine to look at monopoly profits. The cases of competition, monopoly, and price discriminating monopoly are examined. FF. Instructions: Use student names in the demand for travel time below.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 16: Monopoly a. “Steve” wants to travel back in time to see the dinosaurs; he is willing to pay as much as $200 to use the time machine. b. “Joyce” wants to relive this semester; she is willing to pay up to $150 for time travel. c. “Chip” can’t wait for the semester to end; he is willing to pay up to $125 to use the time machine. d. “Dawn” just wants to get through this class period; she is willing to pay up to $100 to use the time machine. The demand curve for time travel is: Price $200 150 125 100

Quantity 1 2 3 4

For simplicity, let the marginal cost of time travel be constant at $100. (Remind students that when marginal cost is constant, marginal cost equals average total cost.) If time travel were a competitive industry, price would equal marginal cost ($100) and 4 trips would be sold. Total revenue would be (TR = P x Q = $100 x 4) $400 and total cost would be (TC = ATC x Q = $100 x 4) $400, so profit would be zero. If time travel were a monopoly, the quantity of trips would be determined where marginal revenue equals marginal cost, so 2 trips would be sold. Total revenue would be $300 and total cost would be $200, so profit would be $100.

Price $200 150 125 100

Quantity 1 2 3 4

Total Revenue $200 300 375 400

Marginal Revenue $200 100 75 25

If perfect price discrimination were used and each buyer paid a price equal to his/her willingness to pay, up to the marginal cost of a trip, 4 trips would be sold. Total revenue would be ($200 + $150 + $125 +100) $525 and total cost would be $400, so profit would be $125. Both profit and quantity are highest with price discrimination. [return to top]

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Concept Clip: Monopoly and Natural Monopoly o Concept Clip: Profit Maximization Monopoly o Concept Clip: Price Discrimination o Video Problem Walk-Through: Finding the Profit-Maximizing Price and Calculating Profit for a Monopoly o Video Problem Walk-Through: Profit Maximization and Welfare Analysis with a Monopoly Using Equations for Market Demand and the Firm's Costs o Video Problem Walk-Through: Price Discrimination and Profit Maximization for a Monopoly o Areas o Graphing Basics o Graphing Linear Equations o Slope of a Line o Video Quiz: Barriers to Entry in Monopoly Markets o Video Quiz: Monopoly Demand and Revenue o Video Quiz: Profit Maximization for the Monopolist o Video Quiz: Costs to Society from Monopolies o Video Quiz: Example of Price Discrimination and the Lessons Learned o Video Quiz: Perfect Price Discrimination and Other Forms of Price Discrimination o Video Quiz: Policies Toward Monopolies

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 306 Chapter Objectives ........................................................................................................................................... 306 Complete List of Chapter Activities and Assessments ......................................................................... 307 Key Terms ........................................................................................................................................................... 308 What's New in This Chapter .......................................................................................................................... 308 Chapter Outline ................................................................................................................................................. 308 Solutions to Text Problems ........................................................................................................................... 312

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition Questions for Review ................................................................................................................................................... 313 Problems and Applications ........................................................................................................................................ 314 Additional Activities and Assignments ..................................................................................................... 318 Additional Resources ...................................................................................................................................... 319 Cengage Video Resources ........................................................................................................................................... 319

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 17 is the fourth chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. The previous two chapters developed the two extreme forms of market structure—competition and monopoly. The market structure that lies between competition and monopoly is known as imperfect competition. There are two types of imperfect competition— monopolistic competition and oligopoly. This chapter addresses monopolistic competition while the final chapter in the sequence addresses oligopoly. The analysis in this chapter is based on the cost curves developed in Chapter 14. The purpose of Chapter 17 is to address monopolistic competition—a market structure in which many firms sell products that are similar but not identical. Monopolistic competition differs from perfect competition because each of the many sellers offers a somewhat different product. As a result, monopolistically competitive firms face a downward-sloping demand curve while competitive firms face a horizontal demand curve at the market price. Monopolistic competition is extremely common. Key points addressed in this chapter:  



A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry and exit. The long-run equilibrium in a monopolistically competitive market differs from that in a perfectly competitive market in two ways. First, in a monopolistically competitive market, each firm has excess capacity. That is, it chooses a quantity that puts it on the downwardsloping portion of the average-total-cost curve. Second, each firm charges a price above marginal cost. Monopolistic competition does not have all of the desirable properties of perfect competition. There is the standard deadweight loss of monopoly caused by the markup of price over marginal cost. In addition, the number of firms (and thus the number of product varieties) can be too large or too small. In practice, the ability of policymakers to correct these inefficiencies is limited. The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to manipulate consumers’ tastes and to reduce competition. Defenders of advertising and brand names argue that firms use them to inform consumers and to compete more vigorously on price and product quality.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Describe the characteristics of a monopolistically competitive market.



Explain the impact of product differentiation on monopolistically competitive markets.



Determine the profit-maximizing quantity and price for a monopolistically competitive firm.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition 

Compare the demand and marginal revenue curves of monopolistically competitive firms in the short run versus the long run.



Explain the differences between a monopolistically competitive firm and a perfectly competitive firm.



Identify the area on a graph that represents a monopolistically competitive firm's profit or loss.



Explain the adjustment process in a monopolistically competitive market if a firm in that market is not making zero profit.



Given a scenario about goods operating in a monopolistically competitive market, determine if it is a critique of advertising or a defense of advertising.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Think-Pair-Share Activity Self-Assessment Section 17-1 QuickQuiz Section 17-2 QuickQuiz Section 17-3 QuickQuiz ConceptClip: Oligopoly ConceptClip: Monopolistic Competitive Market Structure Figure 2: Monopolistic Competitors in the Short Run Figure 4: Monopolistic versus Perfect Competition Chapter 17 Problems & Applications Chapter 17 A+ Test Prep Video Quiz: Imperfectly Competitive Markets Video Quiz: Monopolistic Competition in the Short Run and the Long Run Video Quiz: The Economics of Advertising Chapter 17 Homework Chapter 17 Quiz: Monopolistic Competition

Source (i.e., PPT slide, Workbook) PPT Slide 12 PPT Slides 31–32 PPT Slide 33 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder

Duration

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

30–40 mins. N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

10–15 mins. 20–30 mins.

5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition [return to top]

KEY TERMS Monopolistic Competition: a market structure in which many firms sell products that are similar but not identical. Oligopoly: a market structure in which only a few sellers offer similar or identical products. [return to top]

WHAT'S NEW IN THIS CHAPTER There are no major changes to this chapter. [return to top]

Between Monopoly and Perfect Competition A. The typical firm has some market power, but its market power is not as great as that described by monopoly. B. Firms in imperfect competition lie somewhere between the competitive model and the monopoly model. C. Definition of oligopoly: a market structure in which only a few sellers offer similar or identical products. 1. Economists measure a market’s domination by a small number of firms with a statistic called a concentration ratio. 2. The concentration ratio is the percentage of total output in the market supplied by the four largest firms. 3. In the U.S. economy, most industries have a four-firm concentration ratio under 50%. D. Definition of monopolistic competition: a market structure in which many firms sell products that are similar but not identical. 1. Characteristics of Monopolistic Competition a. Many Sellers b. Product Differentiation c. Free Entry Figure 1

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II.

E. Figure 1 summarizes the four types of market structure. Note that it is the number of firms and the type of product sold that distinguishes one market structure from another. 1. Instruction Idea: Draw a table with the four types of markets across the top. Create rows for various market characteristics such as type of product sold, number of firms, control over price, freedom of entry and exit, and ability to earn profit in the long run. Students will then be able to see how these characteristics relate to one another. 2. Instruction Idea: There is a student activity (Think of a Firm) that applies to this topic in the "Additional Activities and Assignments” section. Competition with Differentiated Products A. The Monopolistically Competitive Firm in the Short Run 1. Each firm in monopolistic competition faces a downward-sloping demand curve because its product is different from those offered by other firms. 2. The monopolistically competitive firm follows a monopolist's rule for maximizing profit. a. Instruction Idea: Explain to students that product differentiation gives the seller in a monopolistically competitive market some ability to control the price of its product. In a sense, each firm is a monopoly in the production of its particular version of the product. This is reflected by the fact that these firms face a downward-sloping demand curve. Point out that the graph looks something like a monopoly, but that the demand the firm faces will likely be much flatter (because it will be more elastic). b. It chooses the output level where marginal revenue is equal to marginal cost. c. It sets the price using the demand curve to ensure that consumers will demand exactly the amount produced. Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition 3. We can determine whether the monopolistically competitive firm is earning a profit or loss by comparing price and average total cost. a. If P > ATC, the firm is earning a profit. b. If P < ATC, the firm is earning a loss. c. If P = ATC, the firm is earning zero economic profit. B. The Long-Run Equilibrium 1. When firms in monopolistic competition are making profit, new firms have an incentive to enter the market. a. This increases the number of products from which consumers can choose. b. Thus, the demand curve faced by each firm shifts to the left. c. As the demand falls, these firms experience declining profit. 2. When firms in monopolistic competition are incurring losses, firms in the market will have an incentive to exit. a. Consumers will have fewer products from which to choose. b. Thus, the demand curve for each firm shifts to the right. c. The losses of the remaining firms will decline. 3. The process of exit and entry continues until the firms in the market are earning zero profit. a. This means that the demand curve and the average-total-cost curve are tangent to each other. b. At this point, price is equal to average total cost and the firm is earning zero economic profit.

c. Keep in Mind: Remember that students have a hard time understanding why a firm will continue to operate if it is earning “only” zero economic profit. Remind them that zero economic profit means that firms are earning an accounting profit equal to their implicit costs. d. Instruction Idea: Point out to students that, just like firms in perfect competition, firms in monopolistic competition also earn zero economic profit in the long run. Show them that this result occurs because firms can freely enter the market when profits occur, driving the level of profits to zero. Any market with no barriers to entry will see zero economic profit in the long run. 4. There are two characteristics that describe the long-run equilibrium in a monopolistically competitive market.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition a. Price exceeds marginal cost as in monopoly (because each firm faces a downward-sloping demand curve). b. Price equals average total cost as in competition (due to the freedom of entry and exit) resulting is zero economic profits. C. Monopolistic versus Perfect Competition Figure 4

III.

1. Excess Capacity a. The quantity of output produced by a monopolistically competitive firm is smaller than the quantity that minimizes average total cost (the efficient scale). b. This implies that firms in monopolistic competition have excess capacity, because the firm could increase its output and lower its average total cost of production. c. Because firms in perfect competition produce where price is equal to the minimum average total cost, firms in perfect competition produce at their efficient scale. 2. Markup over Marginal Cost a. In monopolistic competition, price is greater than marginal cost because the firm has some market power. b. In perfect competition, price is equal to marginal cost. D. Monopolistic Competition and the Welfare of Society 1. One source of inefficiency is the markup over marginal cost. This implies a deadweight loss (similar to that caused by monopolies). 2. Because there are so many firms in this type of market structure, regulating these firms would be difficult and it is not clear that regulating them would be an improvement. 3. Also, forcing these firms to set price equal to marginal cost would force them out of business (because they are already earning zero economic profit). 4. There are also externalities associated with entry. a. The product-variety externality occurs because as new firms enter, consumers get some consumer surplus from the introduction of a new product. Note that this is a positive externality. b. The business-stealing externality occurs because as new firms enter, other firms lose customers and profit. Note that this is a negative externality. c. Depending on which externality is larger, a monopolistically competitive market could have too few or too many products. Advertising A. The Debate over Advertising 1. The Critique of Advertising a. Firms advertise to manipulate people's tastes. b. Advertising impedes competition because it increases the perception of product differentiation and fosters brand loyalty. This means that consumers will be less concerned with price differences among similar goods. 2. The Defense of Advertising a. Firms use advertising to provide information to consumers. b. Advertising fosters competition because it allows consumers to be better informed about all of the firms in the market. 3. Case Study: How Advertising Affects Prices

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition a. In the United States during the 1960s, states differed on whether or not they allowed advertising for optometrists. b. In the states that prohibited advertising, the average price paid for a pair of eyeglasses in 1963 was $33; in states that allowed advertising, the average price was $26 (a difference of more than 20%). c. When Rhode Island began to allow stores to advertise liquor prices, liquor prices on advertised items often fell by 20% or more when compared to Massachusetts where advertising laws didn’t change. B. Advertising as a Signal of Quality 1. The willingness of a firm to spend a large amount of money on advertising may be a signal to consumers about the quality of the product being offered. 2. Example: Kellogg and General Mills have each developed a new cereal that would sell for $5 per box. (Assume that the marginal cost of producing the cereal is zero.) Each company knows that if it spends $20 million on advertising, it will get one million new consumers to try the product. If consumers like the product, they will buy it again. a. General Mills has discovered through market research that its new cereal is not very good. After buying it once, consumers would not likely buy it again. Thus, it will only earn $5 million in revenue, which would not be enough to pay for the advertising. Therefore, it does not advertise. b. Kellogg knows that its cereal is great. Each person that buys it will likely buy one box per month for the next year. Therefore, its sales would be $60 million, which is more than enough to justify the advertisement. c. By its willingness to spend money on advertising, Kellogg signals to consumers the quality of its cereal. 3. Note that the content of the advertisement is unimportant; what IS important is that consumers know that the advertisements are expensive. C. Brand Names 1. In many markets there are two types of firms; some firms sell products with widely recognized brand names while others sell generic substitutes. 2. Critics of brand names argue that they cause consumers to perceive differences that do not really exist. 3. Economists have defended brand names as a useful way to ensure that goods are of high quality. a. Brand names provide consumers with information about quality when quality cannot be judged easily in advance of purchase. b. Brand names give firms an incentive to maintain high quality, because firms have a financial stake in maintaining the reputation of their brand names. Table 1 c. Instruction Idea: There is a student activity (Equilibrium Price for Jeans) that applies to this topic in the "Additional Activities and Assignments” section. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition

QUESTIONS FOR REVIEW 100. The three attributes of monopolistic competition are: (1) there are many sellers; (2) each seller produces a slightly different product; and (3) firms can enter or exit the market without restriction. Monopolistic competition is like monopoly because firms face a downward-sloping demand curve, so price exceeds marginal cost. Monopolistic competition is like perfect competition because, in the long run, price equals average total cost, as free entry and exit drive economic profit to zero. 101. In Figure 2, a firm has demand curve D1 and marginal-revenue curve MR1. The firm is making profits because at quantity Q1, price (P1) is above average total cost (ATC). Those profits induce other firms to enter the industry, causing the demand curve to shift to D2 and the marginal-revenue curve to shift to MR2. The result is a decline in quantity to Q2, at which point the price (P2) equals average total cost (ATC), so profits are now zero.

Figure 2 102. Figure 3 shows the long-run equilibrium in a monopolistically competitive market. Price equals average total cost. Price is above marginal cost.

Figure 3

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition 103. Because, in equilibrium, price is above marginal cost, a monopolistic competitor produces too little output. This is a hard problem to solve because: (1) the administrative burden of regulating the large number of monopolistically competitive firms would be high; and (2) the firms are earning zero economic profits, so forcing them to price at marginal cost means that firms would lose money unless the government subsidized them. 104. Advertising might reduce economic well-being because it manipulates people's tastes and impedes competition by making products appear more different than they really are. Advertising might increase economic well-being by providing useful information to consumers and fostering competition. 105. Advertising with no apparent informational content might convey information to consumers if it provides a signal of quality. A firm will not be willing to spend much money advertising a low-quality good, but may be willing to spend significantly more to advertise a high-quality good. 106. The two benefits that might arise from the existence of brand names are: (1) brand names provide consumers information about quality when quality cannot be easily judged in advance; and (2) brand names give firms an incentive to maintain high quality to maintain the reputation of their brand names.

PROBLEMS AND APPLICATIONS 1. a. Tap water is a monopoly because there is a single seller of tap water to a household. b. Bottled water is a monopolistically competitive market. There are many sellers of bottled water, but each firm tries to differentiate its own brand from the rest. c. The cola market is an oligopoly. There are only a few firms that control a large portion of the market. d. The beer market is an oligopoly. There are only a few firms that control a large portion of the market. 2. a. The market for wooden #2 pencils is perfectly competitive because pencils by any manufacturer are identical and there are a large number of manufacturers. b. The market for copper is perfectly competitive, because all copper is identical and there are a large number of producers. c. The market for local electricity service is monopolistic because it is a natural monopoly—it is cheaper for one firm to supply all the output. d. The market for peanut butter is monopolistically competitive because different brand names exist with different quality characteristics. e. The market for lipstick is monopolistically competitive because lipstick from different firms differs slightly, but there are a large number of firms that can enter or exit without restriction. 3. a. A firm in monopolistic competition sells a differentiated product from its competitors. b. A firm in monopolistic competition has marginal revenue less than price. c. Neither a firm in monopolistic competition nor in perfect competition earns economic profit in the long run. d. A firm in perfect competition produces at the minimum average total cost in the long run. e. Both a firm in monopolistic competition and a firm in perfect competition equate marginal revenue and marginal cost. f. A firm in monopolistic competition charges a price above marginal cost. 4. a. Both a firm in monopolistic competition and a monopoly firm face a downwardsloping demand curve.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition b. Both a firm in monopolistic competition and a monopoly firm have marginal revenue that is less than price. c. A firm in monopolistic competition faces the entry of new firms selling similar products. d. A monopoly firm earns economic profit in the long run. e. Both a firm in monopolistic competition and a monopoly firm equate marginal revenue and marginal cost. f. Neither a firm in monopolistic competition nor a monopoly firm produces the socially efficient quantity of output. 5. a. The firm is not maximizing profit. For a firm in monopolistic competition, price is greater than marginal revenue. If price is below marginal cost, marginal revenue must be less than marginal cost. Thus, the firm should reduce its output to increase its profit. b. The firm may be maximizing profit if marginal revenue is equal to marginal cost. However, the market is not in long-run equilibrium because price is less than average total cost. In this case, firms will exit the industry and the demand facing the remaining firms will rise until economic profit is zero. c. The firm is not maximizing profit. For a firm in monopolistic competition, price is greater than marginal revenue. If price is equal to marginal cost, marginal revenue must be less than marginal cost. Thus, the firm should reduce its output to increase its profit. d. The firm could be maximizing profit if marginal revenue is equal to marginal cost. The market is in long-run equilibrium because price is equal to average total cost. Therefore, the firm is earning zero economic profit. 6. a. Figure 4 illustrates the market for Sparkle toothpaste in long-run equilibrium. The profit-maximizing level of output is QM and the price is PM.

Figure 4 b. Sparkle's profit is zero, because at quantity QM, price equals average total cost. c. The consumer surplus from the purchase of Sparkle toothpaste is areas A + B. The efficient level of output occurs where the demand curve intersects the marginal-cost curve, at QC. The deadweight loss is area C, the area above marginal cost and below demand, from QM to QC. d. If the government forced Sparkle to produce the efficient level of output, the firm would lose money because average total cost would exceed price, so the firm would shut down. If that happened, Sparkle's customers would earn no consumer surplus. 7. a. As N rises, the demand for each firm’s product falls. As a result, each firm’s demand curve will shift left.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition b. The firm will produce where MR = MC: 100/N – 2Q = 2Q Q = 25/N c. 25/N = 100/N – P P = 75/N d. Total revenue = P  Q = 75/N  25/N = 1875/N2 Total cost = 50 + Q2 = 50 + (25/N)2 = 50 + 625/N2 Profit = 1875/N2 – 625/N2 – 50 = 1250/N2 – 50 e. In the long run, profit will be zero. Thus: 1250/N2 – 50 = 0 1250/N2 = 50 N=5 8. Figure 5 shows the cost, marginal revenue and demand curves for the firm under both conditions.

Figure 5 a. The price will fall from PMC to the minimum average total cost (PC) when the market becomes perfectly competitive. b. The quantity produced by a typical firm will rise to QC, which is at the efficient scale of output. c. Average total cost will fall as the firm increases its output to the efficient scale. d. Marginal cost will rise as output rises. Marginal cost is now equal to price. e. Profit will not change. In either case, the market will move to long-run equilibrium where all firms will earn zero economic profit. 9. a. A family-owned restaurant would be more likely to advertise than a family-owned farm because the output of the farm is sold in a perfectly competitive market, in which there is no reason to advertise, while the output of the restaurant is sold in a monopolistically competitive market. b. A manufacturer of cars is more likely to advertise than a manufacturer of forklifts because there is little difference between different brands of industrial products like forklifts, while there are greater perceived differences between consumer products like cars. The possible return to advertising is greater in the case of cars than in the case of forklifts.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition c. A company that invented a very comfortable razor is likely to advertise more than a company that invented a less comfortable razor that costs the same amount to make because the company with the very comfortable razor will get many repeat sales over time to cover the cost of the advertising, while the company with the less comfortable razor will not. 10. a. Figure 6 shows Sleek’s demand, marginal-revenue, marginal-cost, and average-totalcost curves. The firm will maximize profit at an output level of Q * and a price of P *. The shaded are shows the firm’s profits.

Figure 6 b. In the long run, firms will enter, shifting the demand for Sleek’s product to the left. Its price and output will fall. Firms will enter until profits are equal to zero (as shown in Figure 7).

Figure 7 c. As consumers become more focused on the stylistic differences in brands, they will be less focused on price. This will make the demand for each firm’s products more price inelastic. The demand curves may become relatively steeper, allowing Sleek to charge a higher price. If these stylistic features cannot be copied, they may serve as a barrier to entry and allow Sleek to earn profit in the long run. d. A firm in monopolistic competition produces where marginal revenue is greater than zero. This means that firm must be operating on the elastic portion of its demand curve.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition [return to top]

[In-class assignment] Think of a Firm: 15 minutes total. Works in any class size. Topics include market structure. GG. Purpose: This assignment helps students relate the concept of market structure to the real world. HH. Instructions: Ask the class to answer the following questions. After they have answered all of them, ask the students to share their answers with a neighbor. Ask the neighboring student to evaluate the answer to the last question. List the four market structures on the board and ask for examples that fit each category. a. Write the name of a specific firm. It should be a real company, not hypothetical. b. What products or services does this firm sell? If the firm sells a wide variety of goods, choose a single item to answer the following questions. c. What other firms compete with this company? Are there many competitors, only a few, or none? d. Do the competing firms sell exactly the same product or does each company produce goods with special characteristics? e. Categorize the industry as one of the following market structures: i. Perfect competition 1. many firms 2. identical products ii. Monopoly 1. one firm 2. unique product iii. Oligopoly 1. a few firms 2. standard or differentiated product iv. Monopolistic competition 1. many firms 2. differentiated products II. Common Answers and Points for Discussion: Many students will choose companies that produce consumer goods, where product differentiation is the most important characteristic. Most of these industries are either oligopolies or monopolistically competitive. A few students may have examples of monopoly, particularly utilities or patented medicines. Almost no one will give an example of perfect competition. Perfect competition, while an economic ideal, does not accurately describe all sectors of the economy. Explaining that perfect competition is a special case (and adding some examples of competitive industries) will help students understand why

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 17: Monopolistic Competition competitive firms face a horizontal demand curve and have no control over the prices of their products.

XX.

Some students may have questions about the differences between oligopoly and monopolistic competition. Differentiating between a “few” and “many” is not always easy. Measures of market concentration can be used to explain the difference between these two imperfectly competitive market structures. [In-class demonstration] Equilibrium Price for Jeans: 5 minutes total. Works in any class size. Topics include product differentiation. A. Purpose: This assignment shows that market supply and demand graphs give an oversimplified picture of price when products are diversified. B. Instructions: Ask the students to draw a supply and demand graph illustrating the market for jeans. After they have drawn the graph, have them label the equilibrium price with a real dollar figure. This dollar amount should reflect the price of jeans as accurately as possible. Draw a standard supply and demand graph on the board. Ask a student for the equilibrium price. Ask several more students for their prices. C. Common Answers and Points for Discussion: The class will have a whole range of prices for jeans, reflecting the range of jeans in the real world. Recent prices at one shopping mall varied from $14 to more than $100 for a pair. The price differences reflect product differentiation. Quality, style, and reputation all affect the price of jeans. The simple supply and demand diagram can be useful for broad analysis of the market, but individual prices and quantities are determined by the demand and cost curves of the individual products.

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Oligopoly o ConceptClip: Monopolistic Competitive Market Structure o Video Problem Walk-Through: Profit Maximization and Long-Run Equilibrium in a Monopolistically Competitive Market Using Equations for Demand and Costs o Video Problem Walk-Through: A Graphical Analysis of Profit Maximization and Long-Run Equilibrium for a Monopolistically Competitive Firm o Areas o Graphing Basics o Graphing Linear Equations o Slope of a Curve o Slope of a Line o Video Quiz: Imperfectly Competitive Markets o Video Quiz: Monopolistic Competition in the Short Run and the Long Run

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly o

Video Quiz: The Economics of Advertising

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

321

Complete List of Chapter Activities and Assessments Key Terms

322

323

What's New in This Chapter 323 Chapter Outline

323

Solutions to Text Problems 332 Questions for Review ................................................................................................................................................... 332 Problems and Applications ........................................................................................................................................ 332 Additional Activities and Assignments

336

Additional Resources338 Cengage Video Resources ........................................................................................................................................... 338

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 18 is the final chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. Chapters 15 and 16 discussed the two extreme forms of market structure—competition and monopoly. The market structure that lies between competition and monopoly is known as imperfect competition. There are two types of imperfect competition— monopolistic competition, which we addressed in the previous chapter, and oligopoly, which is the topic of the current chapter. The purpose of Chapter 18 is to address oligopoly—a market structure in which only a few sellers offer similar or identical products. Because there are only a few sellers in an oligopolistic market, oligopolistic firms are interdependent whereas competitive firms are not. That is, in a competitive market, the decisions of one firm have no effect on the other firms in the market while in an oligopolistic market, the decisions of any one firm may affect the pricing and production decisions of the other firms in the market. Key points addressed in this chapter: 



Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. Yet, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the closer the quantity and price will be to the levels that would prevail under perfect competition. The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many situations including arms races, advertising, common-resource problems, and oligopolies. Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition. The application of these laws can be controversial, because some behavior that can appear to reduce competition may have legitimate business purposes.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain how production decisions are made in a duopoly market.



Explain how collusion impacts production decisions in an oligopolistic market.



Identify the Nash equilibrium, given a payoff matrix.



Determine if a game represented by a payoff matrix is an example of the prisoners' dilemma.



Identify the dominant strategy, if present, for each player, given a payoff matrix.



Given a scenario, determine which antitrust law is violated.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly 

Given an example of a business practice, identify it as resale price maintenance, predatory pricing, or bundling.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1

PPT Slide 11

5–10 mins.

Active Learning 2

PPT Slide 15

5–10 mins.

Ask the Experts 1

PPT Slide 20

10–15 mins.

Ask the Experts 2

PPT Slide 32

10–15 mins.

Active Learning 3

PPT Slide 34

5–10 mins.

Think-Pair-Share Activity

PPT Slide 42

5–10 mins.

Self-Assessment

PPT Slide 43

5 mins.

Section 18-1 QuickQuiz

MindTap eBook

5 mins.

Section 18-2 QuickQuiz

MindTap eBook

5 mins.

Section 18-3 QuickQuiz

MindTap eBook

5 mins.

ConceptClip: Nash Equilibrium

MindTap Learn It Folder

5 mins.

ConceptClip: Game Theory and Dominant Strategy ConceptClip: Prisoner's Dilemma

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

Chapter 18 Problems & Applications

MindTap Study It Folder

35–45 mins.

Chapter 18 A+ Test Prep

MindTap Study It Folder

N/A

Video Quiz: Cooperation vs. SelfInterest in Oligopoly Markets Video Quiz: Oligopoly Markets as Prisoner’s Dilemma Video Quiz: Public Policies to Encourage Competition Rather Than Cooperation in Oligopolies Chapter 18 Homework

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

30–40 mins.

Chapter 18 Quiz: Oligopoly

MindTap Apply It Folder

20–30 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly

KEY TERMS Cartel: a group of firms acting in unison. Collusion: an agreement among firms in a market about quantities to produce or prices to charge. Dominant Strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players. Game Theory: the study of how people behave in strategic situations. Nash Equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. Oligopoly: a market structure in which only a few sellers offer similar or identical products. Prisoners’ Dilemma: a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:   

There are four new Ask the Experts features on “Antitrust in the Digital Economy.” There is a new In the News feature on Amazon in the Crosshairs: “A New Antitrust Case Cuts to the Core of Amazon’s Identity.” The act of “tying” two products together is now referred to as “bundling.”

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XXXIII.

Definition of oligopoly: a market structure in which only a few sellers offer similar or identical products. Definition of game theory: the study of how people behave in strategic situations. a. By strategic, we mean a situation in which each person, in deciding what actions to take, must consider how others might respond to that action. b. Each firm in an oligopoly must act strategically, because its profit not only depends on how much output it produces, but also on how much other firms produce as well. Markets with Only a Few Sellers a. A key feature of oligopoly is the tension between cooperation and self-interest.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly i.

The group of oligopolists is better off cooperating and acting like a monopolist, producing a small quantity of output and charging a price above marginal cost. ii. Yet, because the oligopolist cares about his own profit, there is an incentive to act on his own. This will limit the ability of the group to act as a monopoly. b. A Duopoly Example i. A duopoly is an oligopoly with only two members. ii. Example: Jack and Jill own the only water wells in town. They have to decide how much water to bring to town to sell. (Assume that the marginal cost of pumping each gallon of water is zero.) iii. Instruction Idea: Use this example and show the competitive equilibrium first. Then, show the monopoly price and output. Finally, explain how the two suppliers would end up producing a quantity between the competitive and monopoly output and charging a price between the competitive price and the monopoly price. iv. The demand for the water is as follows: Table 1 Quantity (gallons)

Price

0 10 20 30 40 50 60 70 80 90 100 110 120

$120 110 100 90 80 70 60 50 40 30 20 10 0

Total Revenue (and Total Profit) $0 1,100 2,000 2,700 3,200 3,500 3,600 3,500 3,200 2,700 2,000 1,100 0

c. Competition, Monopolies, and Cartels i. If the market for water were perfectly competitive, price would equal marginal cost ($0). This means that 120 gallons of water would be sold. ii. If a monopoly controlled the supply of water, profit would be maximized at a price of $60 and an output of 60 gallons. 1. Note that in this case, price ($60) exceeds marginal cost ($0).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly 2. This level of output is lower than the socially efficient level of output (120 gallons). iii. The duopolists may agree to act together to set the price and quantity of water. 1. Definition of collusion: an agreement among firms in a market about quantities to produce or prices to charge. 2. Definition of cartel: a group of firms acting in unison. 3. If Jill and Jack did collude, they would agree on the monopoly outcome of 60 gallons and a price of $60. 4. The cartel must also decide how to split the production of water. Each member will want a larger share because that means more profit. If they split it equally, each produces 30 gallons and earns a profit of $1800. d. The Equilibrium for an Oligopoly i. It is often difficult for oligopolies to form cartels. 1. Antitrust laws prohibit agreements among firms. 2. Squabbling among cartel members over their shares is also likely to occur. ii. In the absence of a binding agreement, the monopoly outcome is unlikely. iii. Assume that Jack expects Jill to produce 30 gallons of water (half of the monopoly outcome). 1. Jack could also produce 30 gallons and earn a profit of $1,800. 2. However, he could produce 40 gallons and earn a profit of $2,000. 3. Jack will want to produce 40 gallons. iv. Jill might reason the same way. If she expects Jack to produce 30 gallons, she could increase her profits by raising her output to 40 gallons. v. If duopolists pursue their own self-interest when deciding how much to produce, they produce a quantity greater than the monopoly quantity, charge a price lower than the monopoly price, and earn total profit less than the monopoly profit. vi. Definition of Nash equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. vii. In this example, the Nash equilibrium occurs when both Jack and Jill are producing 40 gallons. 1. Given that Jack expects Jill to produce 40 gallons, he will not be better off at any other output level than 40 gallons. 2. Given that Jill expects Jack to produce 40 gallons, she will not be better off at any other output level than 40 gallons. viii. Note that the oligopolists could earn a higher total profit if they cooperated with one another, but instead they often pursue their own selfinterest and earn a lower level of profit. ix. When firms in an oligopoly individually choose production to maximize profit, they end up somewhere between perfect competition and monopoly.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly

XXXIV.

1. The quantity of output produced by the oligopoly is greater than the level produced by a monopoly but less than the level produced by a competitive market. 2. The oligopoly price is less than the monopoly price but greater than the competitive price (which implies that it is greater than marginal cost). e. How the Size of an Oligopoly Affects the Market Outcome i. Instruction Idea: You might want to point out that the Nash equilibrium will be n / (n + 1) of the competitive output. Therefore, with two suppliers, the joint output (80 units) will be two-thirds of the competitive equilibrium (120 units). This will help to explain that as the number of firms in an oligopoly market increases, the market output quickly approaches the competitive outcome. ii. When an oligopolist decides to increase output, two things occur. 1. Because price is greater than marginal cost, increasing output will increase profit. This is the output effect. 2. Because increasing output will raise the total quantity sold, the price will fall and will therefore lower profit. This is the price effect. iii. The larger the number of sellers in the industry, the less concerned each seller is about its own effect on market price. iv. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. 1. Price will approach marginal cost. 2. The quantity of output produced will approach the socially efficient level. v. Ask the Experts: “Market Share and Market Power.” If a small number of firms have a large combined market share, then this is evidence that those firms have market power. 54% of economists agree with this statement, 25% disagree, and 21% are uncertain. vi. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. The Economics of Cooperation a. Definition of prisoners’ dilemma: a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. b. The Prisoners’ Dilemma i. Example: Bonnie and Clyde have been captured. The police have enough evidence to convict them on a weapons charge (sentence = one year) but suspect that they have been involved in a bank robbery. Because they lack hard evidence in the crime, they need at least one of them to confess. ii. The police lock the two in separate rooms and offer each of them a deal: "We can lock you up for one year. However, if you confess to the bank robbery and implicate your partner, we will give you immunity. You will go free and your partner will get 20 years in jail. If you both

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly confess, we won’t need your testimony and avoid the cost of a trial so you will both get an intermediate sentence of eight years." iii.

The decision for both Bonnie and Clyde can be described using a payoff matrix:

Figure 1

Bonnie’s Decision

Clyde’s Decision

Confess Confess Bonnie gets 8 years Clyde gets 8 years Remain Bonnie goes free Silent Clyde gets 20 years

Remain Silent Bonnie gets 20 years Clyde goes free Bonnie gets 1 year Clyde gets 1 year

iv.

Definition of dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players. v. Bonnie’s dominant strategy is to confess. 1. If Clyde remains silent, Bonnie can go free by confessing. 2. If Clyde confesses, Bonnie can lower her sentence by confessing. vi. Clyde’s dominant strategy is to confess. 1. If Bonnie remains silent, Clyde can go free by confessing. 2. If Bonnie confesses, Clyde can lower his sentence by confessing. vii. If they had both remained silent, they would have been better off collectively (with a sentence of only one year instead of eight). But, by each pursuing their own self-interests, the two prisoners together reach an outcome that is worse for both of them. viii. Cooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational. c. Oligopolies as a Prisoners’ Dilemma i. Example: Jack and Jill are trying to keep the sale of water low to keep the price high. After reaching an agreement, each person must decide whether to follow the agreement. ii. Suppose that they are faced with the following decision: Figure 2

Jack’s Decision

Jill’s Decision

High Production

Low Production

High $1,600 profit for Jack $1,600 profit for Jill

$1,500 profit for Jack

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly Production

$2,000 profit for Jill

Low $2,000 profit for Jack Production $1,500 profit for Jill

$1,800 profit for Jack $1,800 profit for Jill

iii.

The dominant strategy for Jack is to produce at a high rate. 1. If Jill produces at a high rate, Jack will earn a higher amount of profit if he, too, produces at a high rate. 2. If Jill produces at a low rate, Jack will earn a higher profit if he produces at a high rate as well. iv. For the same reasons, the dominant strategy for Jill is to produce at a high rate. v. Even though total profit would be highest if both individuals produced at a low rate, self-interest will encourage them to produce at a high rate. vi. Case Study: OPEC and the World Oil Market 1. Much of the world’s oil is produced by a few countries. These countries have formed a cartel called the Organization of Petroleum Exporting Countries (OPEC). (The recently expanded organization is now known as OPEC Plus.) 2. OPEC tries to raise the price of its product through a coordinated reduction in the quantity of oil produced. 3. Like any oligopoly, the member nations face the dilemma between cooperation and self-interest. 4. OPEC was fairly successful in maintaining cooperation and high prices from 1973 to 1985. 5. In the early 1980s, member countries began arguing over production levels. 6. In recent years, the cartel has been largely unsuccessful at reaching and enforcing agreements. (The rise in oil prices has been largely because of an increase in the demand.) Fracking has increased world oil supplies and reduced OPEC’s market power. d. Other Examples of the Prisoners’ Dilemma i. Arms Races 1. The decision matrix could look like this: Figure 3

Decision of United States (U.S.) Decision of Soviet Union (USSR)

Arm Arm U.S. at risk USSR at risk Disarm U.S. safe and powerful USSR at risk and weak

Disarm U.S. at risk and weak USSR safe and powerful U.S. safe USSR safe

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly ii.

2. The dominant strategy for each country in this example is to arm. Common Resources 1. The decision matrix could look like this:

Figure 4

ExxonMobil’s Decision Drill two wells Chevron’s Decision

XXXV.

Drill one well

Drill two $40 million profit for Exxon wells $40 million profit for Texaco

$30 million profit for Exxon $60 million profit for Texaco

Drill one $60 million profit for Exxon well $30 million profit for Texaco

$50 million profit for Exxon $50 million profit for Texaco

2. The dominant strategy for both firms will be to drill two wells. e. The Prisoners’ Dilemma and the Welfare of Society i. In some cases, the non-cooperative equilibrium is bad from society’s standpoint. 1. In the arms race example, both countries end up at risk. 2. In the common resources game, the extra wells dug are wasteful. ii. However, in the case of a cartel trying to maintain monopoly profits, the non-cooperative solution is an improvement from the standpoint of society. f. Why People Sometimes Cooperate i. While cooperation is difficult to maintain, it is not impossible. ii. Cooperation is easier to enforce if the game is repeated. iii. Case Study: The Prisoners’ Dilemma Tournament 1. Political scientist Robert Axelrod held a tournament in which people entered by sending computer programs designed to play repeated prisoners’ dilemma games. 2. The winner was the program that received the fewest total years in jail. 3. The simple winning strategy, called “tit-for-tat,” occurred where a player would start out cooperating and then do whatever the other player did during the previous time period. In other words, the strategy starts out friendly, penalizes unfriendly players, and then forgives them if warranted. Public Policy toward Oligopolies a. Restraint of Trade and the Antitrust Laws i. The Sherman Act of 1890 elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly ii.

The Clayton Act of 1914 strengthened the Sherman Act and allowed individuals the right to sue to recover three times the damages sustained from an illegal agreement to restrain trade. iii. Case Study: An Illegal Phone Call 1. In the early 1980s, Howard Putnam, the president of Braniff Airways, taped a telephone call from Robert Crandall, the president of American Airlines. 2. In the phone conversation, Crandall suggested to Putnam that they each raise their fares. 3. Putnam turned the tape over to the Justice Department, which filed suit against Crandall. b. Controversies over Antitrust Policy i. Business practices that appear to reduce competition may have legitimate purposes. ii. Resale Price Maintenance 1. Resale price maintenance is a restriction by a manufacturer on the price that sellers can charge for a product, usually used to keep the price from being lower at one retailer than another. 2. Economists have argued that this policy has a legitimate goal. Customers often go to one store with good service, knowledgeable sales people, and higher prices for information on a product and then buy the product at a discount superstore. Resale price maintenance limits the superstore’s ability to "free ride" on the service provided by other retailers. iii. Predatory Pricing 1. When firms with monopoly power are faced with new competition, they may cut prices drastically to drive the new competition out of business and restore their monopoly power. 2. This behavior is called predatory pricing. 3. Economists doubt whether this strategy is used often, because it would mean that the monopoly would have to sustain large losses. It is also difficult to expect that courts are able to determine which price cuts are competitive and which are predatory. iv. Bundling 1. Bundling occurs when two products are sold together. 2. Economists do not believe this to be a problem because people will not be willing to pay more for two products sold together than they would be willing to pay for the goods separately. Thus, this practice cannot change market power. 3. Instead, bundling may simply be a form of price discrimination. Profits may rise if a firm charges a combined price closer to the buyers’ total willingness to pay. v. Ask the Experts: Antitrust in the Digital Economy. 1. When asked to evaluate the statement, “Google’s dominance of the market for internet search arose mainly from a combination of

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly

vi.

vii.

economies of scale and a quality algorithm,” 95 percent of economic experts agreed, none disagreed, and 5 percent were uncertain. 2. When asked to evaluate the statement, “In light of Google’s dominance, its current operating practices could have a substantial negative effect on social welfare in the long run,” 52 percent agreed, 7 percent disagreed, and 41 percent were uncertain. 3. When asked to evaluate the statement, “The nature of the market dominance of technology giants warrants either the imposition of some kind of regulation or a fundamental change in antitrust policy,” 51 percent agreed, 21 percent disagreed, and 26 percent were uncertain. 4. When asked to evaluate the statement, “Requiring Facebook to divest What’sApp and Instagram is likely to make society better off,” 59 percent agreed, 16 percent disagreed, and 25 percent were uncertain. Case Study: The Microsoft Case 1. In 1998, the U.S. Justice Department filed suit against Microsoft Corporation. 2. A central issue in the case involved the tying of Microsoft’s Internet browser to its Windows operating system. 3. In November 1999, a judge issued a ruling that Microsoft had a great amount of monopoly power and had illegally abused this power. 4. In June 2000, the judge ordered that Microsoft be broken up into two companies, one that sold the operating system and one that sold applications software. An appeals court overturned the verdict and handed the case to a new judge. 5. In September 2001, the Justice Department announced that it no longer sought a breakup of the company and wanted to settle the case quickly. A settlement was reached in November 2002. 6. In recent years, Microsoft has contended with several private antitrust lawsuits as well as lawsuits brought by the European Union. 7. Technological development has reduced the importance of this issue. In 2021, Microsoft announced the retirement of Internet Explorer due to its reduced market share, possibly due to increased competition that stemmed from the Justice Department’s settlement. In the News: “Amazon in the Crosshairs.” A New Antitrust Case Cuts to the Core of Amazon’s Identity. 1. An antitrust case has been filed against Amazon for its ”Marketplace Fair Pricing Policy,” which prohibits 3rd party sellers on its platform from pricing their products below what they posts on Amazon. 2. Antitrust authorities argue that this policy requires retailers to charge higher prices than they would otherwise. Amazon argues that their policy causes retailers to offer lower prices to the consumer through Amazon’s platform.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 107. If a group of sellers could form a cartel, they would try to set quantity and price like a monopolist. They would set quantity at the point where marginal revenue equals marginal cost, and set price at the corresponding point on the demand curve. 108. Firms in an oligopoly produce a quantity of output that is greater than the level produced by a monopoly. They sell the product at a price that is lower than the monopoly price. 109. Firms in an oligopoly produce a quantity of output that is less than the level produced by a competitive market. They sell the product at a price that is greater than the competitive price. 110. As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. 111. The prisoners’ dilemma is a game between two people or firms that illustrates why it is difficult for opponents to cooperate even when cooperation would make them both better off. Each player has a great incentive to cheat on any cooperative agreement to make herself or itself better off. Thus, firms in an oligopoly have a difficult time maintaining a cooperative agreement. 112. The arms race and common resources are some examples of how the prisoners’ dilemma helps to explain behavior. In the arms race during the Cold War, the United States and the Soviet Union could not agree on arms reductions because each was fearful that after cooperating for a while, the other country would cheat. When two companies share a common resource, they would be better off sharing it. But, fearful that the other company will use more of the common resource, each company ends up overusing it. 113. Antitrust laws prohibit firms from trying to monopolize a market. They are used to prevent mergers that would lead to excessive market power in any firm and to keep oligopolists from acting together in ways that would make the market less competitive.

PROBLEMS AND APPLICATIONS 1.

a. If there were many suppliers of diamonds, price would equal marginal cost ($1,000), so the quantity would be 12,000. b. With only one supplier of diamonds, quantity would be set where marginal cost equals marginal revenue. The following table derives marginal revenue:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly Price $8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

Quantity 5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,000

Total Revenue $40,000,000 42,000,000 42,000,000 40,000,000 36,000,000 30,000,000 22,000,000 12,000,000

Marginal Revenue ---2,000,000 0 –2,000,000 –4,000,000 –6,000,000 –8,000,000 –10,000,000

With marginal cost of $1,000 per diamond, or $1 million per thousand diamonds, the monopoly will maximize profits at a price of $7,000 and a quantity of 6,000. Additional production beyond this point would lead to a situation where marginal revenue is lower than marginal cost. c. If Russia and South Africa formed a cartel, they would set price and quantity like a monopolist, so the price would be $7,000 and the quantity would be 6,000. If they split the market evenly, they would share total revenue of $42 million and costs of $6 million, for a total profit of $36 million. So each would produce 3,000 diamonds and get a profit of $18 million. If Russia produced 3,000 diamonds and South Africa produced 4,000, the price would decline to $6,000. South Africa’s revenue would rise to $24 million, costs would be $4 million, so profits would be $20 million, which is an increase of $2 million. d. Cartel agreements are often not successful because each party has a strong incentive to cheat to make more profit. In this case, each could increase profit by $2 million by producing an extra 1,000 diamonds. However, if both countries did this, profits would decline for both of them. a. OPEC members were trying to reach an agreement to cut production so they could raise the price. b. They were unable to agree on cutting production because each country has an incentive to cheat on any agreement. The “turmoil” is a decline in the price of oil because of increased production. c. OPEC would like Norway and Britain to join their cartel so that they could act as a monopoly. a. Buyers who are oligopolists try to decrease the prices of goods they buy. b. The owners of baseball teams would like to keep players’ salaries low. This goal is difficult to achieve because each team has an incentive to cheat on any agreement, because they will be able to attract better players by offering higher salaries. c. The salary cap would have formalized the collusion on salaries and helped to prevent any team from cheating. a. If Mexico imposes low tariffs, then the United States is better off with high tariffs, because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico imposes high tariffs, then the United States is better off with high tariffs,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly because it gets $20 billion with high tariffs and only $10 billion with low tariffs. The United States has a dominant strategy of high tariffs.

If the United States imposes low tariffs, then Mexico is better off with high tariffs, because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If the United States imposes high tariffs, then Mexico is better off with high tariffs, because it gets $20 billion with high tariffs and only $10 billion with low tariffs. Mexico has a dominant strategy of high tariffs. b. A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies others have chosen. The Nash equilibrium in this case is for each country to have high tariffs. c. The trade agreement represents cooperation between the two countries. Each country reduces tariffs and both are better off as a result. d. The payoffs in the upper left and lower right parts of the box do reflect a nation’s welfare. Trade is beneficial and tariffs are a barrier to trade. However, the payoffs in the upper right and lower left parts of the box are not valid. A tariff hurts domestic consumers and helps domestic producers, but total surplus declines, as we saw in Chapter 9. It would be more accurate for these two areas of the box to show that both countries’ welfare will decline if they imposed high tariffs, whether or not the other country had high or low tariffs. a. Synergy does not have a dominant strategy. If Synergy believes that Dynaco will go with a large budget, it will also choose a large budget. However, if Synergy believes that Dynaco will go with a small budget, it will want a small budget as well. b. Yes, Dynaco has a dominant strategy of going with a large budget. It is the best strategy for Dynaco to follow no matter what Synergy chooses. c. The Nash equilibrium is that both firms will choose a large budget. Dynaco will follow its dominant strategy so Synergy will choose a large budget as well.

a. The payoffs are:

Your Decision Classmate’s Decision

Work Work You get 15 units of happiness Classmate gets 15 units of happiness Shirk You get 5 units of happiness Classmate gets 30 units of happiness

Shirk You get 30 units of happiness Classmate gets 5 units of happiness You get 10 units of happiness Classmate gets 10 units of happiness

b. The likely outcome is that both of you will shirk. If your classmate works, you’re better off shirking, because you would rather have 30 units of happiness than 15. If your classmate shirks, you are better off shirking because you would rather have 10

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly units of happiness than 5. Your dominant strategy is to shirk. Your classmate faces the same payoffs, so they will also shirk. c. If you are likely to work with the same person again, you have a greater incentive to work, so that your classmate will work, and you will both be better off. In repeated games, cooperation is more likely. d. The payoff matrix would become:

Your Decision Classmate’s Decision

Work Work You get 15 units of happiness Classmate gets 55 units of happiness Shirk You get 5 units of happiness Classmate gets 50 units of happiness

Shirk You get 30 units of happiness Classmate gets 25 units of happiness You get 10 units of happiness Classmate gets 10 units of happiness

Work is a dominant strategy for this new classmate. Therefore, the Nash equilibrium will be for you to shirk and your classmate to work. You would get a B and thus would prefer this classmate to the first. However, they would prefer someone with a dominant strategy of working as well so that they could get an A. 7.

a. The decision box for this game is:

Braniff’s Decision American’s Decision

Low Price High Price

Low Price Low profit for Braniff Low profit for American High profit for Braniff Very low profit for American

High Price Very low profit for Braniff High profit for American Medium profit for Braniff Medium profit for American

b. If Braniff sets a low price, American will set a low price. If Braniff sets a high price, American will set a low price. American has a dominant strategy to set a low price.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly If American sets a low price, Braniff will set a low price. If American sets a high price, Braniff will set a low price. Braniff has a dominant strategy to set a low price.

Because both have a dominant strategy to set a low price, the Nash equilibrium is for both to set a low price. c. A better outcome would be for both airlines to set a high price; they would both get higher profits. That outcome could only be achieved by cooperation (collusion). If that happened, consumers would lose because prices would be higher and quantity would be lower. a. The playoff matrix for this game is:

Player Two’s Decision

Take Drug Don’t Take Drug

Player One’s Decision Take Drug Don’t Take Drug Player 1 gets 5,000 – X Player 1 gets 0 Player 2 gets 5,000 – X Player 2 gets 10,000 – X Player 1 gets 10,000 – X Player 1 gets 5,000 Player 2 gets 0 Player 1 gets 5,000

b. Taking the drug will be a dominant strategy for each player as long as X is less than 5,000. c. Making the drug safer (lowering X) raises the likelihood of taking the drug because it increases the payoff. a. If Kona enters, Big Brew would want to maintain a high price. If Kona does not enter, Big Brew would want to maintain a high price. Thus, Big Brew has a dominant strategy of maintaining a high price. If Big Brew maintains a high price, Kona would enter. If Big Brew maintains a low price, Kona would not enter. Kona does not have a dominant strategy. b. Because Big Brew has a dominant strategy of maintaining a high price, Kona should enter. This is the only Nash equilibrium. c. Big Brew makes more setting a high price regardless of whether Little Kona enters the market. Therefore, Little Kona should not believe the threat of Big Brew setting a low price. d. If the two firms could successfully collude, they would agree that Big Brew would maintain a high price and Kona would remain out of the market. They could then split a profit of $7 million.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 18: Oligopoly XXI.

[In-class demonstration] Four Markets for Widgets: 15 minutes duration. Works in any class size with more than 15 students. Topics market structure and price. Seven volunteers and money ($2.50 to $4.00) required. JJ. Purpose: This illustrates how different market structures can result in wide differences in price for the consumer. It also shows how communication can increase oligopoly profits. The opportunity to win real money creates great student interest. KK. Instructions: Divide the class into four groups. Group A consists of one student (the first volunteer). Group B consists of the next three volunteers. Group C consists of the other three volunteers. Group D is the rest of the class. Each group manufactures a unique type of widget. The firms within a group compete, but there is no competition across groups. Widgets are produced by writing the word “widget” on a sheet of paper. Group A represents a monopoly. The monopolist does not need to consider the actions of any other firms. The professor will buy one widget from Group A. The professor is willing to pay up to $1 for this widget. Group B represents an oligopoly. This group can communicate with each other and can examine each other’s bids. (Have these students sit together.) They are allowed to make their decisions jointly, and may make agreements to share profits. The professor will buy one widget from Group B. The professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder. Group C also represents an oligopoly. This group cannot communicate with each other. (Move these students away from each other.) The professor will buy one widget from Group C. The professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder. Group D represents competition. The professor will buy one widget from Group D. The professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder. Ask the students in each group to make a bid by writing their name and offer on a sheet of paper. Remind them they will need to consider the possible bids by rivals within their own group, because only the winning bid will be paid. Collect the bids from each group in turn. Pay the low bid in each group. LL. Common Answers and Points for Discussion: The monopolist will bid $1, the maximum willingness to pay. The colluding oligopolists usually each bid $1. They often will reach a profit-sharing agreement.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production The oligopolists who do not communicate will have a lower winning bid. They also display large variation in the individual bids. Typically, the bids range from a low of $0.25 to nearly a dollar. The competitive group will also have a range of bids, but the lowest bid will be even lower than Group C’s low bid. Typically, this widget will sell for $0.01. Communication among oligopolists allows price fixing. Collusion can lead to the joint profit-maximizing, or monopoly, price. Restricting communication greatly reduces the ability of oligopolists to coordinate pricing. Large numbers of competitors lead to prices at the cost of production, because higher prices will be underbid. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Nash Equilibrium o ConceptClip: Game Theory and Dominant Strategy o ConceptClip: Prisoner's Dilemma o Video Problem Walk-Through: Finding the Competitive, Monopoly, and Duopoly Outcomes in a Market o Video Problem Walk-Through: Identifying Dominant Strategies and the Nash Equilibrium in the Prisoners' Dilemma o Video Problem Walk-Through: Using Game Theory to Find Dominant Strategies and the Nash Equilibrium o Video Quiz: Cooperation vs. Self-Interest in Oligopoly Markets o Video Quiz: Oligopoly Markets as Prisoner’s Dilemma o Video Quiz: Public Policies to Encourage Competition Rather Than Cooperation in Oligopolies

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production Prepared by David R. Hakes, University of Northern Iowa

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 340 Chapter Objectives ........................................................................................................................................... 340 Complete List of Chapter Activities and Assessments ......................................................................... 341 Key Terms ........................................................................................................................................................... 342 What's New in This Chapter .......................................................................................................................... 342 Chapter Outline ................................................................................................................................................. 342 Solutions to Text Problems ........................................................................................................................... 350 Questions for Review ................................................................................................................................................... 351 Problems and Applications ........................................................................................................................................ 351 Additional Resources ...................................................................................................................................... 359 Cengage Video Resources ........................................................................................................................................... 359

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 19 is the first chapter in a three-chapter sequence that addresses the economics of labor markets. Chapter 19 develops and analyzes the markets for the factors of production—labor, land, and capital. Chapter 20 builds on Chapter 19 and explains in more detail why some workers earn more than others do. Chapter 21 addresses the distribution of income and the role the government can play in altering the distribution of income. The purpose of Chapter 19 is to provide the basic theory for the analysis of factor markets—the markets for labor, land, and capital. As you might expect, we find that the wages earned by the factors of production depend on the supply and demand for the factor. What is new in the analysis is that the demand for a factor is a derived demand. That is, a firm’s demand for a factor is determined by its decision to supply a good in another market. Key points addressed in this chapter:  



The economy’s income is distributed in the markets for the factors of production. The three most important factors are labor, land, and capital. The demand for factors, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services. Competitive, profit-maximizing firms hire each factor up to the point at which the value of the factor's marginal product equals its price. The supply of labor arises from individuals’ trade-offs between work and leisure. An upward-sloping labor supply curve means that people respond to an increase in the wage by working more hours and enjoying less leisure. In competitive factor markets, the price paid to each factor adjusts to balance supply and demand. Because factor demand reflects the value of the marginal product, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services. Because factors of production are used together, the marginal product of any one factor depends on the available quantities of all factors. A change in the supply of one factor alters the equilibrium earnings of all of them.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Analyze the markets for the factors of production.



Explain the concept of diminishing marginal product of labor.



Analyze the role that the value of the marginal product and wage play in input decisions.



Calculate a firm's value of the marginal product for an input.



Calculate the marginal product of labor, given data on a firm's production technology.



Determine if a change in the marginal product of labor or the output price causes a movement along or shift of the firm's labor-demand curve.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production 

Explain how changes in labor demand impact market equilibrium.



Explain the relationship between markets for different factors of production.



Explain how a change in a labor supply determinant impacts labor supply.



Explain how changes in labor supply impact market equilibrium.



Determine the equilibrium price and quantity for a factor of production using the supply and demand model.



Determine the equilibrium wage and quantity of labor in the market for labor.



Explain how a change in a labor demand determinant impacts labor demand.



Derive the impact of a change in the quantity of a factor of production on the market for a different factor of production.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments by objective, so that you can see how all this content relates to objectives and make decisions about which content you would like to emphasize in your class based on your objectives. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Ask the Experts 1 Active Learning Ask the Experts 2 Ask the Experts 3 Think-Pair-Share Activity Self-Assessment Section 19-1 QuickQuiz Section 19-2 QuickQuiz Section 19-3 QuickQuiz Section 19-4 QuickQuiz ConceptClip: Marginal Product of Labor and Diminishing MPL Figure 5: Monopolistic Competitors in the Short Run Figure 6: A Shift in Labor Demand Chapter 19 Problems & Applications Chapter 19 A+ Test Prep Chapter 19 News Analysis: Germany's Unemployment Solution: Understanding Worker Incentives Chapter 19 News Analysis: Exchange Rates Hold the Key to Trade between

Source (i.e., PPT slide, Workbook) PPT Slide 6 PPT Slide 18 PPT Slide 26 PPT Slide 40 PPT Slides 43–44 PPT Slide 45 MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

35–45 mins. N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

10–15 mins. 10–15 mins. 10–15 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production Japan and the U.S. Chapter 19 Homework Chapter 19 Quiz: The Markets for the Factors of Production

MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. 20–30 mins.

[return to top]

KEY TERMS Capital: the equipment and structures used to produce goods and services. Diminishing Marginal Product: the property whereby the marginal product of an input declines as the quantity of the input increases. Factors of Production: the inputs used to produce goods and services. Marginal Product of Labor: the increase in the amount of output from an additional unit of labor. Production Function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good. Value of the Marginal Product: the marginal product of an input times the price of the output. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:   

There is a new Case Study: “The Immigration Debate.” The Case Study on Productivity and Wages has been updated. The discussion of monopsony has been expanded and moved to Chapter 20: Earnings and Discrimination.

[return to top]

Instruction Idea: Begin this chapter by reviewing how demand and supply determine product prices. Start by asking, “Why is chicken cheaper than steak?” and “Why are apples cheaper (per pound) than grapes?” Review the explanations using supply and demand analysis. Now ask, “Why do airline pilots earn more than school bus drivers?” and “Why is oceanfront land more expensive than land 5 miles from the shore”

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production II.

III.

Definition of factors of production: the inputs used to produce goods and services. A. The markets for these factors of production are similar to the markets for goods and services discussed earlier, but they are different in one important way. B. The demand for a factor of production is a derived demand, meaning that the firm's demand for a factor of production is derived from its decision to supply a good in another market. The Demand for Labor A. Instruction Idea: In the market for labor, households are the suppliers while firms are the demanders. You will need to remind students of this because they are used to seeing markets in which this is reversed. Figure 1 B. The wage earned by workers is determined by the suppy and demand for workers. C. The Competitive Profit-Maximizing Firm 1. Example: A firm that owns an orchard must decide how many apple pickers to hire. 2. Assume that the firm operates in both a competitive output market and a competitive labor market. a. This implies that the firm is a price taker in the apple market, meaning that it has no control over the price at which it can sell its apples. b. The firm is also a price taker in the labor market, meaning that it has no control over the wage that it must pay its apple pickers. 3. Assume also that the firm's goal is to maximize profit (total revenue – total cost). D. The Production Function and the Marginal Product of Labor 1. The firm must consider how the quantity of apples it can harvest and sell is affected by the number of apple pickers hired. 2. Definition of production function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good. 3. Definition of marginal product of labor: the increase in the amount of output from an additional unit of labor. Table 1

(1)

(2)

(3)

L 0 1 2 3 4

Q 0 100 180 240 280

MPL ---100 80 60 40

(4) VMPL (= P x MPL) ---$1,000 800 600 400

(5) W ---$500 500 500 500

(6) Marginal Profit ---$500 300 100 –100

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production 5

300

200

500

–300

4. Definition of diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases. Figure 2 E. The Value of the Marginal Product and the Demand for Labor 1. When deciding how many workers to hire, the firm considers how much profit each worker would bring in. 2. Because profit equals total revenue minus total cost, the profit from an additional worker is the worker's contribution to revenue minus the worker's wage. 3. Definition of value of the marginal product: the marginal product of an input times the price of the output.

a. Economists sometimes refer to the value of the marginal product as the firm’s marginal revenue product. b. The value of the marginal product is the extra revenue a firm gets from hiring an additional unit of a factor of production. 4. Alternative Classroom Example: Binkle, Inc. produces and sells plastic bottles in a perfectly competitive market at a price of $0.25. Binkle hires its labor in a perfectly competitive labor market at an hourly wage of $10. The relationship between the quantity of labor hired and the amount of output produced per hour is presented in the following table:

MPL

0 1 2

0 90 170

---90 80

VMPL (= P x MPL) ---$22.5 20

Marginal Profit

---$10 10

---$12.5 10

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production 3 4 5 6 7 8

240 300 350 390 420 440

70 60 50 40 30 20

17.5 15 12.5 10 7.5 5

10 10 10 10 10 10

7.5 5 2.5 0 –2.5 –5

5. If the wage for workers is $500 per week, the firm will only hire three workers. a. For the first three workers, the value of the marginal product is greater than the wage, so the marginal profit from hiring these workers is positive. b. For the fourth worker, the value of the marginal product is lower than the wage, so the marginal profit from hiring this worker would be negative. 6. We can show the firm's decision graphically. a. The value of the marginal product curve will slope downward because of the diminishing marginal product of labor. b. The wage is depicted by a horizontal line because the firm is a price taker in the labor market. 7. A competitive, profit-maximizing firm hires workers up to the point at which the value of the marginal product of labor equals the wage. Figure 3

8. Because the firm chooses the quantity of labor at which the value of the marginal product equals the wage, the value-of-the-marginal-product curve is the firm's labor demand curve. 9. Instruction Idea: Emphasize that because the value of the marginal product involves both the marginal product and the price of the good, any

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production change in either of these two determinants will lead to a change in the demand for labor. F. FYI: Input Demand and Output Supply: Two Sides of the Same Coin 1. If W is the wage and an extra unit of labor produces MPL units of output, then the marginal cost of a unit of output is MC = W/MPL. 2. A profit-maximizing firm chooses the quantity of labor so that the value of the marginal product (P x MPL) is equal to the wage (W): P x MPL = W. Divide both sides by MPL to get: P = W/MPL. Because W/MPL = MC, we have: P = MC.

IV.

3. Keep in Mind: Students will probably not appreciate how important this is. For that reason, make sure that you go through it slowly. 4. When a competitive firm hires labor up to the point at which the value of the marginal product is equal to the wage, it also produces a level of output at which price equals marginal cost. G. What Causes the Labor Demand Curve to Shift? 1. The Output Price a. An increase in the price of the product raises the value of the marginal product of labor and therefore increases the demand for labor. b. A decrease in the price of the product lowers the value of the marginal product of labor and therefore decreases the demand for labor. 2. Technological Change a. Technological advance raises the marginal product of labor, which in turn raises the value of the marginal product of labor. b. It is also possible for technological change to reduce labor demand. A labor-saving technological change (such as an industrial robot) could reduce the marginal product of labor and thus the value of the marginal product of labor. c. History suggests that most technological progress has been laboraugmenting. 3. The Supply of Other Factors a. The quantity available of one factor can affect the marginal product of another. b. Therefore, any change in the availability of another factor will likely affect the demand for labor. The Supply of Labor

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

A. The Trade-off between Work and Leisure 1. Any hours spent working are hours that could be devoted to something else like studying or watching television. Economists refer to all time not spent working for pay as “leisure.” 2. The opportunity cost of an hour of leisure is the amount of money that would have been earned if that hour were spent at work. 3. Therefore, as the wage increases, so does the opportunity cost of leisure. 4. The labor supply curve shows how individuals respond to changes in the wage in terms of the labor–leisure trade-off. a. An upward-sloping labor supply curve means that an increase in the wage induces workers to increase the quantity of labor they supply. b. Note that, for some individuals, the labor supply curve may in fact be backward bending. This possibility is discussed in more detail in Chapter 22. B. What Causes the Labor Supply Curve to Shift? 1. Changes in Preferences (for leisure vs. working) 2. Changes in Alternative Opportunities (other occupations) 3. Immigration Equilibrium in the Labor Market Figure 4 A. Marginal Product in Equilibrium 1. The wage adjusts to balance the quantity of labor supplied and the quantity of labor demanded. 2. The wage equals the value of the marginal product of labor. 3. At the labor market equilibrium, each firm has bought as much labor as it finds profitable at the equilibrium wage. 4. Thus, any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by the same amount, because these must always be equal. 5. Instruction Idea: Go through each of these shifts carefully with the class. Make sure that they see the relationship between the change in the equilibrium wage and the change in the value of the marginal product of labor. B. Shifts in Labor Supply Figure 5 1. An increase in the supply of labor would shift the supply curve to the right, creating a surplus of workers at the original wage. This will put downward pressure on the equilibrium wage, causing the quantity of labor demanded to rise. a. As the number of workers employed rises, the marginal product of labor falls due to the diminishing marginal product of labor.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production b. Thus, both the wage and the value of the marginal product of labor are now lower. 2. A decrease in the supply of labor would shift the supply curve to the left, creating a shortage of workers at the original wage. This will put upward pressure on the equilibrium wage, causing the quantity of labor demanded to fall. a. As the number of workers employed falls, the marginal product of labor rises due to the diminishing marginal product of labor. b. Thus, both the wage and the value of the marginal product of labor are now higher. 3. The economy has a variety of labor markets for different kinds of labor. a. Immigration in one labor market increases the supply of labor and reduces the wage in that market, but may lead to higher wages in other labor markets because of greater demand for those outputs. b. The full effect of immigration is complex to analyze due to the linkages between markets. 4. Ask the Experts: Immigration a. Economic experts were asked their opinion on three immigration topics. b. 95 percent agreed that the average US citizen would be better off if a larger number of highly-educated workers were allowed to legally immigrate to the US each year. c. 63 percent agreed that the average US citizen would be better off if a larger number of low-skilled workers were allowed to legally enter the US each year. d. 60 percent agreed that, unless they were compensated by others, many low-skilled US workers would be worse off if a larger number of low-skilled workers were allowed to legally enter the US each year. 5. Case Study: The Immigration Debate a. Immigration benefits the firms that hire the immigrants and those that consume the products of those firms. b. The domestic workers that must compete with the immigrants lose because their wages are reduced due to the increase in labor supply. c. While overall welfare in a country is increased from immigration, there might be less political opposition to immigration if the benefits were more evenly distributed across domestic residents. Different schemes to redistribute the benefits have been proposed. C. Shifts in Labor Demand Figure 6 1. An increase in the demand for labor will shift the labor demand curve to the right, creating a shortage at the original wage. This will put upward pressure on the equilibrium wage causing the quantity of labor supplied to increase.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production a. The value of the marginal product rises because VMPL = P × MPL (and either P or MPL have risen to cause the demand for labor to rise). b. This implies that both the wage and the value of the marginal product are now higher. 2. A decrease in the demand for labor will shift the labor demand curve to the left, creating a surplus at the original wage. This will put downward pressure on the equilibrium wage causing the quantity of labor supplied to decrease. a. The value of the marginal product falls because VMPL = P × MPL (and either P or MPL have fallen to cause the demand for labor to decline). b. This implies that both the wage and the value of the marginal product are now lower. D. Case Study: Productivity and Wages 1. Principle #7: Our standard of living depends on our ability to produce goods and services. 2. This means that highly productive workers are highly paid, and less productive workers are less highly paid. 3. Figure 7 shows data on the growth rates of both productivity and wages in the United States from 1960 to 2020. Figure 7

VI.

a. From 1960 to 2020, productivity grew by about 2.0% per year and real wages grew at 1.9%. b. From 1973 to 1995, the growth in productivity was slow compared to the period before 1973 or the period from 1995 to 2010. The Other Factors of Production: Land and Capital A. Definition of capital: the equipment and structures used to produce goods and services. B. Equilibrium in the Markets for Land and Capital Figure 8 1. The purchase price of land or capital is the price paid to own that factor of production indefinitely. 2. The rental price of land or capital is the price paid to use that factor for a limited amount of time. 3. Because the wage is simply the rental price of labor, what we know about wage determination also applies to the rental prices of land and capital. a. The rental price of land is determined by the supply and demand for land; the rental price of capital is determined by the supply and demand for capital.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production b. For both land and capital, the firm increases the quantity hired until the value of the factor's marginal product equals the factor's rental price. 4. As long as the firms using the factors of production are competitive and profit maximizing, land, labor, and capital each earn the value of their marginal contribution to the production process. 5. The purchase price of land and capital depend on the current value of the marginal product and the expected future value of the marginal product. C. FYI: What Is Capital Income? 1. The measurement of capital income is less obvious than the measurement of labor income. 2. Capital income is the rent that households receive for the use of their capital. 3. Some of the earnings from capital are paid to households in the form of interest or dividends. 4. Also, some of the earnings from capital may be retained by the firm for future purchases of capital. D. Linkages among the Factors of Production 1. In most situations, factors of production are used together in a way that makes the productivity of each factor dependent on the quantities of the other factors available to be used in the production process. 2. This means that a change in the supply of any one factor can change the earnings of all of the factors. 3. The change in the earnings of any factor can be found by measuring the impact of the event on the value of the marginal product of that factor. 4. Case Study: The Economics of the Black Death a. In 14th-century Europe, the bubonic plague killed about one-third of the population within a few years. b. With a smaller supply of workers, we would expect that the wages paid to workers would rise. This occurs because of diminishing marginal returns: As the number of workers employed falls, the marginal product of labor rises. Thus, the value of the marginal product of labor rises. c. With fewer workers available to work the land, each additional unit of land was able to produce less additional output. Thus, the marginal product of land fell. Because this would lead to a decrease in the value of the marginal product of land as well, we would expect the rental price on land to fall. d. History shows that our predictions are correct: Wages doubled during the period and rents declined by 50%. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

QUESTIONS FOR REVIEW 114. A firm's production function describes the relationship between the quantity of labor used in production and the quantity of output from production. The marginal product of labor is the increase in the amount of output from an additional unit of labor. Thus, the marginal product of labor depends directly on the production function. The value of the marginal product of labor is the marginal product of labor multiplied by the market price of the output. A competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage. As a result, the value-of-marginal-product curve is the firm’s labor-demand curve. 115. Events that could shift the demand for labor include changes in the output price, technological change, and changes in the supply of other factors. If the output price increases, the firm's labor-demand curve will shift to the right because the value of the marginal product of labor increases. Technological advances typically raise the marginal product of labor, which in turn increases the demand for labor and shifts the labor-demand curve to the right. If the supply of capital increases, the marginal product of labor increases and the labor-demand curve shifts to the right. 116. Events that could shift the supply of labor include changes in tastes, changes in alternative opportunities, and immigration. If more people choose to work, the supply of labor will increase. If the wage earned in one labor market rises relative to the wage earned in another labor market, the supply of labor in the higher-wage market will increase. When immigrants enter a country, the supply of labor in that country increases. 117. The wage can adjust to balance the supply and demand for labor while simultaneously equaling the value of the marginal product of labor. Supply and demand for labor determine the equilibrium wage. Firms maximize profits by choosing the amount of labor where the wage is equal to the value of the marginal product of labor. 118. A large wave of immigration would increase the supply of labor, thus reducing the wage. With more labor working with capital and land, the marginal product of capital and land is higher, so rents earned by owners of land and capital would increase.

PROBLEMS AND APPLICATIONS 133. a. The law requiring people to eat one apple a day increases the demand for apples. As shown in Figure 2, demand shifts from D1 to D2, increasing the price from P1 to P2, and increasing quantity from Q1 to Q2.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

Figure 2 b. Because the price of apples increases, the value of the marginal product increases for any given quantity of labor. There is no change in the marginal product of labor for any given quantity of labor. However, firms will choose to hire more workers and thus the marginal product of labor at the profit-maximizing level of labor will be lower. c. As Figure 3 shows, the increase in the value of the marginal product of labor shifts the demand curve of labor from D1 to D2. The equilibrium quantity of labor rises from L1 to L2, and the wage rises from w1 to w2.

Figure 3 134. a. If Congress were to buy personal computers for all U.S. college students, the demand for computers would increase, raising the price of computers and thus increasing the value of the marginal product of workers who produce computers. This is shown in Figure 4 as a shift in the demand curve for labor from D1 to D2. The result is an increase in the wage from w1 to w2 and an increase in the quantity of labor from L1 to L2.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

Figure 4 b. If more college students major in engineering and computer science and assuming this trend does not affect the demand for computers, the supply of labor in the computer industry rises. This is shown in Figure 5 as a shift in the supply curve from S1 to S2. The result is a decrease in the wage from w1 to w2 and an increase in the quantity of labor from L1 to L2.

Figure 5

Figure 6

c. If computer firms build new manufacturing plants, this increases the marginal product of labor and the value of the marginal product of labor for any given quantity of labor. This is shown in Figure 6 as a shift in the demand curve for labor from D1 to D2. The result is an increase in the wage from w1 to w2 and an increase in the quantity of labor from L1 to L2. 135. a. The marginal product of labor is equal to the additional output produced by an additional unit of labor. The table below shows the marginal product of labor (MPL) for this firm:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production Days of Labor 0 1 2 3 4 5 6 7

Units of Output 0 7 13 19 25 28 29 29

MPL -7 6 6 6 3 1 0

VMPL -70 60 60 60 30 10 0

b. The value of the marginal product of labor (VMPL) is equal to the price of the output ($10) multiplied by the marginal product of labor (MPL). It is also reported in the table. c. The labor demand schedule for the firm is: Wage $0 10 30 60 60 60 70

Quantity of Labor Demanded 7 6 5 4 3 2 1

d. The labor demand curve is the same as the value-of-the-marginal-product curve. It is shown in Figure 7.

Figure 7 e. If the price of the output rises to $12, the demand for labor will shift to the right because the value of the marginal product will be higher at each level of labor hired. 136.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production a. Because the firm can sell all of the milk it wants to at the market price of $4 per gallon, Smiling Cow Dairy operates in a perfectly competitive output market. b. Because the firm can rent all the robots it wants to at the market price of $100 per day, Smiling Cow Dairy rents robots in a perfectly competitive market. c. The table below shows the MP and VMP for robots: # Robots 0 1 2 3 4 5 6

Total Output 0 gallons 50 85 115 140 150 155

MP ---50 gallons 35 30 25 10 5

VMP ---$200 140 120 100 40 20

d. The firm should rent robots up to the point where VMP is equal to the wage. Therefore, it should rent 4 robots. 137. a. The firm’s demand for labor is the same as its value of the marginal product. The firm will set wage equal to VMP: w = VMP = P  MPL = 2(100 – 2L) = 200 – 4L The market demand curve for labor will be the horizontal summation of the 20 firm demand curves (summed across L). Rearranging the firm’s demand, we get L = 50 – 0.25w. Thus, the market demand curve must be L = 20(50 – 0.25w) = 1,000 – 5w. b. If labor supply is inelastic at 200, then we can solve for wage by determining the market equilibrium: 200 = 1,000 – 5w w = 160. Each firm will hire 10 workers (200 workers/20 orchards) and produce Q = 100(10) – (10)2 = 900 apples. Total revenue for each firm will be (2)(900) = 1,800. Assuming that wages are the firm’s only costs, total costs will be (160)(10) 1,600, leaving each firm with profit = 200. Total income for the country will be (200)(160) + (20)(200) = 36,000. c. If the world price of apples rises to $4, the value of the marginal product (and thus each firm’s demand for labor) rises. w = VMP = P  MPL = 4(100 – 2L) = 400 – 8L Rearranging for L, we get L = 50 – 0.125w. Thus, the market demand for labor becomes:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production L = 20(50 – 0.125w) = 1,000 – 2.5w. Finding the new equilibrium wage, we get: 200 = 1,000 – 2.5w w = 320 Each firm will still hire 10 workers and produce 900 apples. Thus total revenue will be (4)(900) = 3,600. Total cost will be (320)(10) = 3,200. Profit will be 400. Total income will be (320)(200) + (400)(20) = 72,000. d. Now there are 10 orchards, so the market demand is 10 times the individual firm demand curves: L = 10(50 – 0.25w) = 500 – 2.5w. Solving for the equilibrium wage, we get: 200 = 500 – 2.5w w = 120 Each firm will now hire 20 workers and produce Q = 100(20) – (20)2 = 1,600. Total revenue = (2)(1,600) = 3,200 Total cost = (120)(20) = 2,400. So profit = 800. Total income in the country equals (120)(200) + (800)(10) = 32,000. Thus, income has fallen in the country. 138. Because your uncle is maximizing his profit, he must be hiring workers such that their wage equals the value of their marginal product. Because the wage is $12 per hour, their value of the marginal product must be $12 per hour. Because the value of the marginal product equals the marginal product times the price of the good and because the price of a sandwich is $6, the marginal product of a worker must be two sandwiches per hour. 139. a. Leadbelly should hire workers up to the point where VMP is equal to the wage of $150 per day. b. Since VMP is equal to $150 at the profit-maximizing level of output, and VMP = MP × P, the price of pencils must be $5 per box. c. As Figure 8 shows, the market wage is determined in the labor market ($150 per day). The firm takes this wage as given and chooses its level of labor where VMP is equal to $150 per day.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

Figure 8 d. The decrease in the supply of labor will raise the equilibrium wage (see Figure 9). The increase in wage will reduce the profit-maximizing level of labor hired in both the pencil market and by Leadbelly. The value of the marginal product of workers will rise to the level of the new wage. Because the price of pencils has not changed and the value of the marginal product increases, the marginal product of labor must increase. This change in the marginal product of labor is consistent with diminishing marginal product and a lower level of labor.

Figure 9 140. a. If a firm already gives workers fringe benefits valued at more than $3, the new law would have no effect. But a firm that currently has fringe benefits less than $3 would be affected by the law. Imagine a firm that currently pays no fringe benefits at all. The requirement that it pay fringe benefits of $3 reduces the value of the marginal product of labor effectively by $3 in terms of the cash wage the firm is willing to pay. This is shown in Figure 10 as a leftward shift in the firm's demand for labor from D1 to D2, a shift of exactly $3.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production

Figure 10 b. Because the supply curve has a positive but finite slope, the new equilibrium will be one in which the new wage, w2, is less than the old wage, w1, but w2 > w1  $3. The quantity of labor also declines. c. The preceding analysis is incomplete, of course, because it ignores the fact that the fringe benefits are valuable to workers. As a result, the supply curve of labor might increase, shown as a shift to the right in the supply of labor in Figure 11. In general, workers would prefer cash to specific benefits, so the mandated fringe benefits are not worth as much as cash would be. But in the case of fringe benefits there are two offsetting advantages: (1) fringe benefits are not taxed; and (2) firms offer cheaper provision of health care than workers could purchase on their own. Thus, whether the fringe benefits are worth more or less than $3 depends on which of these effects dominates.

Figure 11 Figure 11 is drawn under the assumption that the fringe benefits are worth more than $3 to the workers. In this case, the new wage, w2, is less than w1 – $3 and the quantity of labor increases from L1 to L2. If the shift in the supply curve were the same as the shift in the demand curve, then w2 = w1 – $3 and the quantity of labor remains unchanged.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 19: The Markets for the Factors of Production If the shift in the supply curve were less than the shift in the demand curve, then w2 > w1 – $3 and the quantity of labor decreases. In all three cases, there is a lower wage and higher quantity of labor than if the supply curve were unchanged. d. Because a minimum-wage law would not allow the wage to decline when greater fringe benefits are mandated, it would lead to increased unemployment, because firms would refuse to pay workers more than the value of their marginal product. 141. a. Substituting the values given, output dollar value of the output, PY, is $60,000.

and the

b. The wage is equal to the value of the marginal product, which is equal to the marginal product of labor multiplied by the price: and the real wage W/P is $40/$2 = $20. c. The labor share (WL)/(PY) is

[

(

)]

d. i. When inflation increases P from 2 to 3, output Y remains constant at 30,000, wage W increases from $40 to $60, the real wage W/P remains constant at $20, and the labor share (WL)/(PY) remains constant at 2/3. ii. When technological progress increases from 3 to 9, output Y increases from 30,000 to 90,000, wage W increases from $40 to $120, the real wage W/P increases from $20 to $60, and the labor share (WL)/(PY) remains constant at 2/3. iii. When capital accumulation increases from 1,000,000 to 8,000,000, output Y increases from 30,000 to 60,000, wage W increases from $40 to $80, the real wage W/P increases from $20 to $40, and the labor share (WL)/(PY) remains constant at 2/3. iv. When a plague decreases L from 1,000 to 125, output Y decreases from 30,000 to 7,500, wage W increases from $40 to $80, the real wage W/P increases from $20 to $40, and the labor share (WL)/(PY) remains constant at 2/3. e. The observation that the labor share is relatively stable over time in spite of changes in the U.S. economy is consistent with this Cobb-Douglas production function. With all of the changes, the labor share remained constant at 2/3.

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Marginal Product of Labor and Diminishing MPL o Video Problem Walk-Through: Computing and Using the Value of the Marginal Product

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination o o o o

Video Problem Walk-Through: Deriving the Demand for Labor and Finding the Equilibrium in the Labor Market Equation Basics Graphing Basics Graphing Linear Equations

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 361 Chapter Objectives ........................................................................................................................................... 362 Complete List of Chapter Activities and Assessments ......................................................................... 362 Key Terms ........................................................................................................................................................... 363 What's New in This Chapter .......................................................................................................................... 363 Chapter Outline ................................................................................................................................................. 363 Solutions to Text Problems ........................................................................................................................... 368 Questions for Review ................................................................................................................................................... 368 Problems and Applications ........................................................................................................................................ 369 Additional Activities and Assignments ..................................................................................................... 370 Additional Resources ...................................................................................................................................... 372 Cengage Video Resources ........................................................................................................................................... 372

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 20 is the second chapter in a three-chapter sequence that addresses the economics of labor markets. Chapter 19 developed the markets for the factors of production. Chapter 20 goes beyond the supply-and-demand models developed in Chapter 19 to help explain the wide variation in wages we find in the economy. Chapter 21 addresses the distribution of income and the role the government can play in altering the distribution of income. The purpose of Chapter 20 is to extend the basic neoclassical theory of the labor market that was developed in Chapter 19. Neoclassical theory argues that wages depend on the supply and demand for labor and that labor demand depends on the value of the marginal productivity of labor. To address the wide variation in the wages that occurs in the real world, it is important to examine more precisely what determines the supply and demand for various types of labor. Key points addressed in this chapter: 

 



Workers earn different wages for many reasons. One is that wage differentials play a role in compensating workers for job attributes. Other things equal, workers in hard, unpleasant jobs are paid more than workers in easy, pleasant jobs. Workers with more human capital get paid more than workers with less. The return to accumulating human capital is high and has increased over the past several decades. As theory predicts, years of education, experience, and job characteristics affect earnings, but much variation in earnings cannot be explained by things that economists can easily measure. The unexplained variation in earnings is largely attributable to ability, effort, and chance. Some economists have suggested that more educated workers earn higher wages not because education raises productivity but because it signals to employers that these workers have high levels of ability. If this signaling theory were correct, then increasing the educational attainment of all workers would not raise the overall level of wages. Wages are sometimes pushed above the level that brings supply and demand into balance. Three explanations of above-equilibrium wages are minimum-wage laws, unions, and efficiency wages. Some differences in earnings are attributable to discrimination on the basis of race, gender, or other factors. Measuring the amount of discrimination is difficult because one must correct for differences in human capital and job characteristics. Competitive markets tend to limit discriminatory wage differences. If one group of workers earns less than another for reasons unrelated to productivity, then nondiscriminatory firms will be more profitable than discriminatory ones. Profit-seeking behavior can therefore reduce discriminatory wage gaps. Discrimination persists in competitive markets if customers are willing to pay more to discriminatory firms or if the government enacts laws that require firms to discriminate. Discrimination can also occur for statistical reasons. If employers have imperfect information about employees, they may discriminate against all members of a group whose average characteristics the employers find undesirable.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Given a scenario describing workers' wages, identify the economic justification for this differential.



Compare the signaling and human-capital theory of education.



Explain how discrimination by employers, customers, and governments affects market outcomes.



Analyze the impact of efficiency wages on the labor market.



Analyze the effect of unions and collective bargaining on the labor market.



Recognize various wage determinants.

Source (i.e., PPT slide, Workbook) PPT Slide 10 PPT Slide 14 PPT Slide 17 PPT Slides 28–29 PPT Slide 30 MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

Duration 5–10 mins. 10–15 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 15–25 mins. N/A 10–15 mins. 20–30 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination

KEY TERMS Compensating Differential: a difference in wages that arises to offset the nonmonetary characteristics of different jobs. Discrimination: the offering of different opportunities to similar individuals who differ only by race, ethnicity, gender, sexual preference, age, religion, or other personal characteristics. Efficiency Wages: above-equilibrium wages paid by firms to increase worker productivity. Human Capital: the accumulation of investments in people, such as education and on-the-job training. Statistical Discrimination: discrimination that arises because an irrelevant but observable personal characteristic is correlated with a relevant but unobservable attribute. Strike: a collective refusal to work organized as a form of protest Union: a worker association that bargains with employers over wages and working conditions. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new section on Below-equilibrium wages: Monopsony. There is a new Ask the Experts feature on Competition in Labor Markets: The impact of noncompete clauses in labor contracts.

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Some Determinants of Equilibrium Wages A. Instruction Idea: Most people (especially college students) have little idea about the level of earnings in the labor force and about the extent of income differences. The general impression is that earnings are higher than they actually are. Thus, the actual differences in earnings among the population are a topic that most students will find interesting. B. Compensating Differentials 1. Definition of compensating differential: a difference in wages that arises to offset the nonmonetary characteristics of different jobs.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination 2. Jobs that are easy, fun, or safe will pay lower wages than jobs that are difficult, boring, or dangerous. 3. Instruction Idea: An obvious example of a compensating wage differential is work that entails danger and potential personal injury. A wage premium is paid to compensate workers for exposing themselves to risk. Examples include workers in high-rise construction or electrical linemen. C. Human Capital 1. Definition of human capital: the accumulation of investments in people, such as education and on-the-job training. 2. Workers with more human capital earn more on average than those with less human capital. 3. Firms are willing to pay more for highly educated workers because highly educated workers have higher marginal products. 4. Case Study: The Increasing Value of Skills a. Table 1 compares the average earnings of college graduates with the average earnings of high school graduates with no additional education. Table 1 b. We can see that there has been an increase in this difference over time. c. One possible reason that this has occurred is that international trade has decreased the demand for unskilled labor. d. Another possible reason is that changes in technology have increased the demand for skilled workers. 5. Ask the Experts: Inequality and Skills a. 88 percent of economic experts agree that one of the primary causes of rising income inequality in the US is the effect of technological change on workers with different skill sets. D. Ability, Effort, and Chance 1. Because of heredity and upbringing, people differ in their physical and mental attributes. This will affect their productivity level and therefore their wage. 2. People also differ in their level of effort. Those who work hard are more productive and earn a higher wage. 3. Chance also plays a role in determining wages. A worker’s training could become obsolete, or a person could be born into poverty. 4. Case Study: The Benefits of Beauty a. Daniel Hamermesh and Jeff Biddle used data from surveys conducted in the United States and Canada to try to determine how wages are affected by physical appearance. b. They found that people who are considered to be more attractive than average earned 5% more than people of average looks. People of average looks earn 5% to 10% more than people considered to be less attractive than average.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination

c. One possible reason for this is that good looks are important for workers who have close dealings with the public. d. Another possible reason is that a person who is successful in making themselves attractive may be equally successful in other tasks. e. A third possible reason for this difference in the wages is discrimination. An Alternative View of Education: Signaling 1. Some economists have suggested that firms may use education as a way to sort high-ability workers from low-ability workers. 2. This implies that when people earn a college degree, they do not become more productive, but instead signal their already high productivity to prospective employers. 3. This occurs because it is easier for high-ability people to get college degrees; therefore, more high-ability people get college degrees. The Superstar Phenomenon 1. Superstars arise in markets that have two characteristics. a. Every customer in the market wants to enjoy the services supplied by the best producer. b. The service is produced with a technology that makes it possible for the best producers to supply every customer at a low cost. 2. This is why we see superstars in some markets (entertainment, professional sports) and not in others (plumbing, carpentry). Below-Equilibrium Wages: Monoposony 1. A market in which there is a single buyer is called a monopsony. 2. In a town with only one large employer, the employer can act as a monopsonist in the labor market, reducing the number of workers it hires, and reducing the wages it pays. This causes a deadweight loss similar to a monopoly. 3. While true monopsonies are rare, many firms use employment contracts containing non-compete clauses that bar employees from leaving to work for a competitor, generating a result similar to monopsony. Ask the Experts: Competition in Labor Markets 1. When economic experts were asked to evaluate the following statement, “The use of non-compete clauses in employment contracts reduces workers’ wages by more than is justified by the protection of employers’ trade secrets,” 86 percent agreed, 3 percent disagree, and 11 percent were uncertain. Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages 1. For some workers, wages are set above the level that brings supply and demand into balance. 2. There are three reasons why this may be the case. a. Minimum-wage laws that generally apply to the least skilled and least experienced workers. b. Definition of union: a worker association that bargains with employers over wages and working conditions.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination

II.

c. Definition of strike: a collective refusal to work organized as a form of protest. d. Definition of efficiency wages: above-equilibrium wages paid by firms to increase worker productivity. e. Efficiency wages often reduce worker turnover, increase worker effort, and raise the quality of workers who apply for jobs at the firm. 3. Above-equilibrium wages raise the quantity of labor supplied and lower the quantity demanded, creating a surplus of labor. The Economics of Discrimination A. Definition of discrimination: the offering of different opportunities to similar individuals who differ only by race, ethnicity, gender, sexual preference, age, religion, or other personal characteristics. B. Measuring Labor-Market Discrimination

Table 2

1. Table 2 reports median annual earnings by race and gender for 2019. a. The median black man was paid 24% less than the median white man. b. The median black woman was paid 16% less than the median white woman. c. The median white woman was paid 19% less than the median white man. d. The median black woman was paid 10% less than the median black man. 2. However, it is difficult to determine how much of the differential in wages across different groups can be attributed to discrimination. a. For example, the quantity of education often differs between blacks and whites. b. It is also likely that the quality of education may differ as well. c. Women generally have less labor market experience than men. d. It may also be true that women take more pleasant jobs than men, leading to a compensating wage differential. 3. Because the differences in median earnings among groups in part reflect differences in human capital and job characteristics, they do not by themselves say anything about how much discrimination there is in the labor market. 4. Case Study: Is Emily More Employable than Lakisha? a. Economists Marianne Bertrand and Sendhil Mullainatham answered more than 1,300 help-wanted ads run in Boston and Chicago newspapers by sending in nearly 5,000 fake resumes. b. Half of the resumes had names that were common in the AfricanAmerican community, while the other half had names that were more common among the white population. Otherwise, the resumes were similar.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination c. Job applicants with “white” names received about 50% more calls from interested employers than applicants with “African-American” names. d. In Canada, economist Philip Oreopoulos sent out fake resumes with English names and with Indian, Pakistani, Chinese, and Greek names. The English sounding names got 39% more callbacks than the others. C. Discrimination by Employers 1. It may be incorrect to blame employers for discrimination because each firm has a profit motive. 2. Example: Two types of people, blondes and brunettes. Both groups have the same skills, experience, and work ethic. But employers prefer to hire brunettes. a. This implies that the demand for blondes is lower than it otherwise would be. b. This also means that blondes will earn a lower wage than brunettes. 3. In this economy, there is an easy way for a firm to beat out its competitors: hire all blondes. a. This firm would pay lower wages and therefore have lower costs. b. Over time, we would expect more firms to follow this example. c. The existing firms still hiring brunettes would be forced out of business due to their higher labor costs. d. The demand for blondes increases (increasing the wage that blondes earn), while the demand for brunettes falls (decreasing the wage that brunettes earn). This will continue until the wages of the two groups are equal. 4. Businesses that care about earning a profit are at an advantage when competing against those that also care about discriminating. 5. Case Study: Segregated Streetcars and the Profit Motive a. Studies of the streetcar industry suggest that streetcars were rarely segregated until the firms were required to do so by law. b. In fact, many firms that ran the streetcars protested these laws because of the increase in the firms' costs from the law (which meant lower profits). D. Discrimination by Customers and Governments 1. Customer preferences may limit the ability of the profit motive to eliminate discriminatory wage differentials. a. If customers do not care whether they are being waited on by a blonde or a brunette, the profit motive will work and both groups will eventually be earning the same wage. b. If customers prefer brunettes, the entry of firms that hire blondes will not succeed in eliminating the wage differential between blondes and brunettes. 2. Also, if the government mandates discriminatory practices, then the wage differentials between the groups will continue to exist. 3. Case Study: Discrimination in Sports

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination a. Studies of sports teams suggest that racial discrimination is common and that much of the blame lies with the customers. b. One study found that black basketball players earned 20% less than white players of comparable ability did. Attendance at basketball games was also higher for teams with a larger proportion of white players. Even if the team owners cared only about profit, the customer discrimination makes hiring black players less profitable than white players. c. The same situation was found in baseball in the 1960s, but more recent studies suggest that the wage differential in baseball no longer exists. d. Even the value of baseball cards has been affected by discrimination. A 1990 study found that the cards of black hitters sold for 10% less than the cards of comparable white hitters. The cards of black pitchers sold for 13% less than the cards of comparable white pitchers. E. Statistical Discrimination 1. Statistical discrimination occurs when an irrelevant but observable characteristic is correlated with a relevant but unobservable attribute. 2. As a result, if employers have imperfect information about employee characteristics, they may discriminate against member of a group that have an undesirable characteristic on average. 3. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 119. Roofers are paid more than other workers with similar amounts of education because the higher wage compensates them for the dirty and dangerous nature of roofing. As a result, they earn a sizable compensating differential. 120. Education is a type of capital because it represents an expenditure of resources at one point in time to raise productivity in the future. 121. Education might raise a worker's wage without raising the worker's productivity if education works as a signal that the worker has high ability. 122. The conditions that lead to highly-compensated superstars are: (1) every customer wants to enjoy the good supplied by the best producer; and (2) the good is produced with a technology that makes it possible for the best producer to supply every customer at a low cost. Because one dentist could not supply every customer, you would not expect to see superstars in dentistry. But because copies of music can be made at low cost, you would expect to see superstars in music.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination 123. A worker’s wage might be above the level that balances supply and demand because: (1) minimum-wage laws raise wages above the levels that some workers would earn in an unregulated labor market; (2) unions may have market power to raise wages above their equilibrium levels; and (3) a firm may find it profitable to pay an efficiency wage, which exceeds the equilibrium wage, because doing so raises productivity. 124. Deciding whether a group of workers has a lower wage because of discrimination is difficult because people differ in other attributes, such as the amount of education they have, the amount of experience they have, and the possibility of compensating differentials. 125. The forces of economic competition tend to ameliorate discrimination on the basis of race, because business owners who care only about making profit are at an advantage when competing against those who also care about discriminating. 126. Discrimination can persist in a competitive market if customers have a preference for discrimination. For example, if customers prefer blonde waiters to brunettes, restaurants will prefer to hire blonde waiters and they will discriminate against brunettes.

PROBLEMS AND APPLICATIONS 142. a. The opportunity cost of taking a job as a summer intern that pays little or nothing is the wage that the student could earn at an alternative job. b. Despite the low wages, students are willing to take internships because an internship might help them land a permanent job with the firm or the government later. Also, the internship enhances the student's resume. Finally, the student may gain valuable on-the-job training. c. You would expect that students who were interns earn higher incomes later in life. 143. The single minimum wage might distort the labor market for teenage workers more than for adult workers because: (1) teenagers have a lower value of marginal product, so it is more likely that the minimum wage will be above their value of marginal product; and (2) the demand for teenage labor is more elastic than for adult labor, so the minimum-wage law distorts the market more. The minimum wage affects those individuals who are least skilled and least experienced and these characteristics generally apply to teenagers. 144. People with more experience usually have had more on-the-job training than others with the same formal education but less experience. Such training increases the value of the marginal product of their labor. Job tenure is also valuable, because people gain job-specific knowledge or a specialization in knowledge that is useful to the firm. 145. a. Economics professors may receive higher salaries than professors in some other fields because they have better opportunities outside academia. For example, they could find jobs in the private sector or the government. b. Differences in teaching loads can make up for lower pay. If professors in all fields are paid the same, the pay level is probably below what economics professors could earn elsewhere. To attract economics professors, the university would have to offer them some other compensation, such as a lower teaching load. 146. Under the signaling theory, you would rather have the degree and not attend the university. But under the human-capital theory, you would rather attend, even though doing so would be a secret.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination 147. The development of recording devices led to a superstar phenomenon in which the best musicians were paid significantly more than average musicians because they could supply every customer at low cost. So the incomes of the best musicians rose and the income of the average musician fell. 148. a. People respond to incentives. Merit pay provides an incentive for teachers to work harder. b. Teachers whose classes do not perform well may be opposed to a system of merit pay. Also, some teachers may not want to work harder to receive higher pay. c. A large challenge would be to accurately measure the teachers’ performance. d. Because incentives matter, it should be able to secure better teachers by offering higher wages. 149. Yes, his behavior is profit maximizing. He is hiring labor at a lower cost. You might claim that Alan is despicable because he is discriminating against men. Some might claim that Alan was admirable, though, because he is maximizing profit and giving women a better opportunity to find a job. If more employers were like Alan, the wage differential between men and women would shrink, as employers would be competing for female workers, so women would have as many job options as men. Ultimately, the wage differential could disappear. Other firms at the time may not have followed his strategy because their customers may have preferred male consultants.

[In-class assignment] Even Money: 20 minute total. Works in any class size. Topics include incentives and distribution of income. MM. Purpose: This assignment explores labor market issues by looking at an artificial situation of complete equality. Notions of incentives and job differences are explored. This usually provokes lively discussion, particularly if the proposal is presented as a realistic alternative. NN. Instructions: Have the class answer the following questions. Give them time to write an answer to a question, then discuss their answers before moving to the next question. Ask the students to consider replacing the current U.S. economic system with a system where everyone is paid exactly the same salary. Assume that each family would receive an equal share of GDP. a. Would you personally favor this system? Explain. b. What problems would exist? c. What mechanisms could be enacted to overcome these problems? d. Who would benefit from this system? e. What jobs would be hard to fill? OO.Common Answers and Points for Discussion: a. Would you personally favor this system? Explain.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 20: Earnings and Discrimination Most students oppose a completely egalitarian distribution of income. Some expect to earn more under the existing system. Others see a variety of problems that make equality unworkable. Others simply see it as “unAmerican.” b. What problems would exist? Numerous problems exist. National income may fall if the incentives to work are changed drastically. People may not work at all. Others may put forth less work effort. Unpleasant jobs are unlikely to be completed. Everyone would want a fun job. New inventions and technological advance could be hindered. Saving and investment and investment rates would be low. Education would become unimportant. Immigration rates could increase. c. What mechanisms could be enacted to overcome these problems? Income could still be denied to people who did not work, and workers could still be fired for inadequate effort. Households could be required to participate in the labor force. Unpleasant jobs could be modified to improve safety, sanitation, or difficulty. Shorter hours could be assigned to those performing the least desirable work. In short, a complete set of alternative incentives would have to be developed. These incentives become increasingly complex as more and more aspects of the price system are replaced. d. Who would benefit from equalizing the distribution of income? A vast majority of households would gain (in the short run, if the system worked) because the median household income is so much lower than an equal share of GDP. e. What jobs would be hard to fill? Students break into two groups on this question. Many see the undesirable jobs as menial, rote, unsafe, or unclean. Slaughterhouses, garbage disposal, and assembly-line work are frequent examples. A relevant follow-up question is: “Why would these jobs be hard to fill at $90,000 a year, when people currently work these jobs for much lower wages?” Another group of students think professional jobs would be undesirable. Doctors, lawyers, and executives are their examples. Ask them, “Are these jobs worse than sucking the guts out of a dead chicken? These jobs seem to have better working conditions, high levels of personal autonomy, and some interesting challenges. Are people in these jobs motivated by more than money?”

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty Looking at the best jobs, many students seem to feel the ultimate “fun job” would be in professional sports. Ask them why these workers need to receive millions of dollars in compensation. This assignment can be used to introduce a number of topics such as market allocation of resources, distribution of income, risk premiums, compensating differentials, and returns to human capital. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Human Capital o ConceptClip: Unions o ConceptClip: Efficiency Wages o Video Problem Walk-Through: Calculating Compensating Differentials

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 374 Chapter Objectives ........................................................................................................................................... 374 Complete List of Chapter Activities and Assessments ......................................................................... 375 Key Terms ........................................................................................................................................................... 375 What's New in This Chapter .......................................................................................................................... 376 Chapter Outline ................................................................................................................................................. 376 Solutions to Text Problems ........................................................................................................................... 382 Questions for Review ................................................................................................................................................... 382 Problems and Applications ........................................................................................................................................ 383 Additional Resources ...................................................................................................................................... 384 Cengage Video Resources ........................................................................................................................................... 384

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 21 is the third chapter in a three-chapter sequence that addresses the economics of labor markets. Chapter 19 developed the markets for the factors of production. Chapter 20 extended the basic supply-and-demand model to help explain the wide variation in wages we find in the economy. Chapter 21 addresses the measurement of the distribution of income and looks at the role the government plays in altering the distribution of income. The purpose of Chapter 21 is to address income distribution. The discussion proceeds by answering three questions. First, how much economic inequality is there? Second, what do different political philosophies have to say about the proper role of government in altering the distribution of income? And third, what are the various government policies that are used to help those most in need? Key points addressed in this chapter: 



Data on the distribution of income show wide disparity in our society. The wealthiest fifth of families earns more than twelve times as much as a person in the lowest income bracketest fifth. Because in-kind transfers, the economic life cycle, transitory income, and economic mobility are so important for understanding variation in income, it is difficult to gauge the degree of inequality in society using data on the distribution of income in a single year. When these factors are considered, they tend to suggest that economic well-being is more equally distributed than is annual income. Political philosophers differ in their views about the role of government in altering the distribution of income. Utilitarians (such as John Stuart Mill) would choose the distribution of income that maximizes the sum of utility of everyone in society. Liberal contractarians (such as John Rawls) would determine the distribution of income as if we were behind a “veil of ignorance” that prevented us from knowing our stations in life. Libertarians (such as Robert Nozick) would have the government enforce individual rights to ensure a fair process but then would not be concerned about inequality in the resulting distribution of income. Various policies aim to help people with low incomes—minimum-wage laws, welfare, negative income taxes, and in-kind transfers. While these policies help alleviate poverty, they can have unintended side effects. Because financial assistance declines as income rises, a person in the lowest income bracket often face very high effective marginal tax rates, which discourage them from escaping poverty on their own.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain how the government's role in redistributing income differs based on whether it applies a utilitarian, liberal, or libertarian philosophy.



Compare the degree of income inequality among different economies, given the income distribution in each economy.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty 

Given a household's size and income, determine if a household is living in poverty according to the country of origin's poverty line.



Analyze the factors contributing to income inequality.

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Explain why critics of antipoverty programs such as the minimum wage and welfare argue that these programs are ineffective at reducing poverty.

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Determine the effect of in-kind transfers on a household's poverty status.

Source (i.e., PPT slide, Workbook) PPT Slide 43 PPT Slide 44 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. N/A 20–30 mins. 20–30 mins.

5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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KEY TERMS In-kind Transfers: transfers given in the form of goods and services rather than cash. The earnedincome tax credit gives cash payments to low income workers. Liberal Contractarianism: the political philosophy according to which the government should choose policies deemed to be just, as evaluated by impartial observers behind a “veil of ignorance.” Libertarianism: the political philosophy according to which the government should punish crimes and enforce voluntary agreements but not redistribute income. Life Cycle: the regular pattern of income variation over a person's life.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty Maximin Criterion: the claim that the government should aim to maximize the well-being of the worst-off person in society. Negative Income Tax: a tax system that collects revenue from high-income households and gives subsidies to low-income households. Permanent income: a person's normal income. Poverty Line: an absolute level of income set by the federal government for each family size below which a family is deemed to be in poverty. Poverty Rate: the percentage of the population whose family income falls below an absolute level called the poverty line. Social Insurance: government policy aimed at protecting people against the risk of adverse events. Utilitarianism: the political philosophy according to which the government should choose policies to maximize the total utility of everyone in society. Utility: a measure of satisfaction. Welfare: government programs that supplement the incomes of the needy. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:    

There is a new Case Study: A Lifetime Perspective on Income Inequality. There is a new In the News feature: Poverty During the Pandemic. “Temporary Pandemic Safety Net Drives Poverty to a Record Low.” The text addresses the impact of temporary welfare policies associated with the pandemic. Tables and values have been updated. Liberalism is now referred to as Liberal Contractarianism.

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Measuring Inequality A. To understand the distribution of income, we want to address four questions. 1. How much economic inequality is there in U.S. society? 2. How many people live in poverty? 3. What problems arise in measuring inequality and poverty?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty 4. How often do people move among income classes? B. U.S. Income Inequality 1. Instruction Idea: Encourage students to bring their textbooks to class on the day that you cover this chapter so they can see these tables and charts up close while you are discussing them. An alternative would be to provide handouts or use overheads or PowerPoint slides of the tables and charts. You may also want to check current events for any new legislation that modifies the rules under which government assistance programs operate. 2. Table 1 shows the distribution of income in the United States by quintile. Table 1 3. Table 2 shows the distribution of income in the U.S. over time. Table 2 a. Throughout the past several decades, the bottom quintile received about 4 to 5 percent of income, while the top fifth has received 40 to 50 percent of income. b. From 1935 to 1970, the distribution gradually became more equal. Since 1970, this trend has reversed itself. C. Inequality around the World 1. Figure 1 compares the income distribution in twenty four major countries. Figure 1 2. The U.S. has substantially greater income disparity than most other economically advanced countries (such as Japan, France, and Germany), but a more equal income distribution than some developing countries (such as South Africa, Venezuela, and Brazil). 3. In the News: Incomes of the Super-Rich a. The best data on the income of the super-rich is tax return data. b. This data suggests that the increase in inequality over the past half century is concentrated among the super-rich: those in the top 1% or even the top .01% of the income distribution. D. The Poverty Rate 1. Definition of poverty rate: the percentage of the population whose family income falls below an absolute level called the poverty line. 2. Definition of poverty line: an absolute level of income set by the federal government for each family size below which a family is deemed to be in poverty. a. In 2019, the poverty line for a family of four was $25,926. b. In 2019, the poverty rate was 10.5 percent in the U.S. 3. Figure 2 shows the poverty rate in the United States since 1959. Figure 2 a. The poverty rate fell from 22.4 percent in 1959 to 11.1 percent in 1973.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty b. Since 1973, income inequality in the United States has been somewhat stable. 4. Table 3 lists the poverty rates from 2019 for different groups of people in the United States. Table 3 a. Poverty is correlated with race. Black people and Hispanic people are more than twice as likely to live in poverty than White people. b. Poverty is correlated with age. Children are more likely to live in poverty and older adults are less likely to live in poverty. c. Poverty is correlated with family composition. Families headed by single mothers are five times as likely to live in poverty as families headed by married couples. E. Problems in Measuring Inequality 1. Taxes and In-Kind Transfers a. Definition of in-kind transfers: transfers given in the form of goods and services rather than cash. The earned-income tax credit gives cash payments to low income workers. b. Because standard measurements of income inequality are based on a family's pre-tax money income, they do not take into account these in-kind transfers or tax credits. c. If in-kind transfers and tax credits were included in money income at their market value, the number of families living in poverty would decline. d. In addition, stimulus checks received during the pandemic were not counted as income. 2. The Economic Life Cycle a. Definition of life cycle: the regular pattern of income variation over a person's life. b. Young workers typically have low incomes. Income rises as the worker matures and gains experience, peaks around age 50, and then declines until the worker retires at age 65. c. People borrow and save to smooth out life-cycle changes in income. Borrowing often occurs when the individual is young and most individuals save during middle age. As a result, standard of living in any one year is not dependent solely on that year’s income. 3. Transitory versus Permanent Income a. Definition of permanent income: a person's normal income. b. To gauge inequality of living standards, the distribution of permanent income is more relevant than the distribution of annual income. c. Because permanent income excludes transitory changes in income, permanent income is more equally distributed than is current income. F. Economic Mobility

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty

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1. Economic mobility is the movement of people between income classes and occurs often in the U.S. economy. 2. Because economic mobility is great, many of those below the poverty line are there only temporarily. 3. Economists have found substantial mobility in terms of economic success from generation to generation. 4. The U.S. economy is filled with self-made millionaires. Approximately 80 percent of the millionaires in the United States made their money on their own as opposed to inheriting it. 5. Studies show that countries with greater income inequality tend to have less intergenerational income mobility. G. Case Study: A Lifetime Perspective on Income Inequality 1. When accounting for inequality within specific cohorts, and looking not at a single year’s income but instead at the total resources people have available (including wealth, current income, expected future income, taxes, transfer payments) the United States has less inequality than conventional measures indicate. 2. The lowest quintile receives 6.6 percent of lifetime resources but only 4 percent of income. 3. The top 1 percent receives 11.8 percent of lifetime resources but 18.3 percent income. The Political Philosophy of Redistributing Income A. The Utilitarian Tradition 1. Definition of utilitarianism: the political philosophy according to which the government should choose policies to maximize the total utility of everyone in society. 2. Definition of utility: a measure of satisfaction. 3. The founders of utilitarianism are Jeremy Bentham and John Stuart Mill. 4. The utilitarian case for redistributing income is based on the assumption of diminishing marginal utility. a. An extra dollar of income provides a person with low income with more additional utility than an extra dollar would provide to a person with high income. b. As a person's income rises, the extra satisfaction from an additional dollar of income declines. 5. However, utilitarians do not believe that all incomes should be equal. a. Principle #3: People respond to incentives. b. If all incomes were to be equalized, this would reduce the incentive to work hard. If individuals do not work as hard, total income falls, which lowers total utility. c. Thus, in a utilitarian's opinion, the government must balance the gains from greater equality against the losses caused by the distorted incentives from the redistribution of income. B. The Liberal Contractarian Tradition

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty

III.

1. Definition of liberal contractarianism: the political philosophy according to which the government should choose policies deemed to be just, as evaluated by impartial observers behind a “veil of ignorance.” 2. This is a political philosophy developed by John Rawls. 3. Rawls considered what income distribution a person would consider just if that person did not know whether they would end up at the top, bottom, or in between. a. Rawls believed that a person would be most concerned about being at the bottom of the income distribution. b. Thus, the public policy social contract should aim to raise the welfare of the worst-off person in society. c. Definition of the maximin criterion: the claim that the government should aim to maximize the well-being of the worst-off person in society. d. This idea suggests that we should consider income redistribution as a form of social insurance. e. Definition of social insurance: government policy aimed at protecting people against the risk of adverse events. f. It is not clear that rational people would be so truly risk averse as to follow the maximin criterion. If a person were to treat all outcomes as equally likely, the best policy would be to maximize the average utility of the members of society (as suggested by utilitarianism). C. The Libertarian Tradition 1. Definition of libertarianism: the political philosophy according to which the government should punish crimes and enforce voluntary agreements but not redistribute income. 2. Libertarians believe that society itself earns no income; only individual members of society earn income. 3. Libertarians also believe that the government should not take income from some individuals and give it to others to achieve any particular distribution of income. 4. Libertarians conclude that equality of opportunities is more important than equality of incomes. Thus, they believe that the government should enforce individual rights to ensure that everyone has an equal opportunity to make the most of their talents and achieve success. Policies to Reduce Poverty A. Minimum-Wage Laws 1. For workers with low levels of skill and experience, a high minimum wage forces the wage above equilibrium. a. This leads to higher unemployment among those groups of workers affected by the minimum wage. b. Although those workers who remain employed benefit from a higher wage, those who might have been employed at a lower wage are worse off. 2. The magnitude of the effect depends on the elasticity of labor demand.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty

a. If the demand for labor is elastic, firms will lower employment more than if the demand is inelastic. b. This is especially true in the long run, when firms can adjust to the higher wage more fully. 3. Critics of the minimum wage also point out that many teenagers earning the minimum wage are from middle-class families, so that a high minimum wage does a bad job of targeting those with low incomes. Welfare 1. Definition of welfare: government programs that supplement the incomes of the needy. 2. Temporary Assistance for Needy Families (TANF) and Supplemental Security Income (SSI) are two welfare programs. 3. A common criticism of these programs is that they create incentives for people to become needy. a. These programs may encourage families to break up, because many families qualify only if the father is absent. b. These programs may also encourage illegitimate births, because many single women with lower income qualify only if they have children. 4. Proponents argue that being single mother with low income on welfare is not a life that someone would choose. Trends also indicate that, while the amount of welfare benefits (adjusted for inflation) has fallen since the 1970s, the percentage of children living with a single parent has risen. Negative Income Tax 1. Definition of negative income tax: a tax system that collects revenue from high-income households and gives subsidies to low-income households. 2. The only qualification required to receive assistance would be a low income. a. A negative income tax does not encourage illegitimate births and the breakup of families. b. A negative income tax would subsidize not only the unfortunate but also those who are simply lazy. 3. The Earned Income Tax Credit (EITC) works much like a negative income tax, but it applies only to the working poor. 4. A negative income tax provides what is sometimes called a “universal basic income.” In-Kind Transfers 1. The federal government provides low-income households with food through Supplemental Nutrition Assistance Program (SNAP) and healthcare through Medicaid. 2. Advocates of in-kind transfers argue that these make sure that a person in the lowest income bracket receive what they need most. 3. Advocates of cash payments argue that the government cannot know what goods and services a person in the lowest income bracket need the most. Anti-Poverty Programs and Work Incentives

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty 1. Many policies to help low-income households have the unintended effect of discouraging work. a. A person discouraged from working loses the on-the-job training that a job might offer. b. Children will not get to see their parents with a full-time job and this may impair their own ability to find and hold a job when they get older. 2. Welfare, Medicaid, SNAP, and the EITC all have eligibility requirements that are tied to income level. a. As a family's income rises, it becomes ineligible for these programs. b. When all programs are taken into account, these families face marginal tax rates that are very high. 3. One possible solution would be to gradually phase out the benefits as the family's income level rises. However, this would raise the costs of these programs substantially. 4. In 1996, the government passed a welfare-reform law that limits the amount of time that any person can collect welfare. F. In the News: Poverty During the Pandemic. “Temporary Pandemic Safety Net Drives Poverty to a Record Low.” 1. Poverty was cut nearly in half during the pandemic due to a massive temporary expansion of the social safety net. 2. Three programs cut poverty the most: stimulus checks, increased food stamps, and expanded unemployment insurance. 3. Liberals want to make the programs permanent. Conservatives argue that the programs are unsustainable due to their costs, they are wasteful, and they provide a disincentive to work. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 127. The richest fifth of the U.S. population earns about twelve times as much income as a person in the lowest income bracketest fifth. 128. Over the past forty years, the income share of the richest fifth of the U.S. population has increased from 40.9 to 49.5 percent. 129. In the U.S. population, the groups most likely to live in poverty are Black people and Hispanic people, children, and families headed by a single mother. 130. Because people may have temporarily high or low income and because income varies over the life cycle (people's incomes are lower when young and higher when older), annual income does not represent true inequality in living standards. 131. A utilitarian would like everyone to have equal incomes, but would recognize that redistributing income distorts incentives, so would proceed only part way to that goal. A

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty liberal contractarian would go further than a utilitarian in equalizing incomes, because a liberal contractarian would focus on the well-being of the worst-off person in society. A libertarian would not care about equalizing incomes at all as long as the process of getting income is fair. 132. In-kind transfers are beneficial because they ensure that low-income people get what they need most. In particular, they get food and shelter instead of alcohol and drugs. But in-kind transfers are not as beneficial to the recipients as cash because they provide no opportunity for substitution into more highly valued goods. Advocates of cash argue that a person in the lowest income bracket are in the best position to know what they need. 133. Antipoverty programs can discourage people from working because they effectively tax away earnings by significantly reducing benefits when a person earns income. This disincentive could be reduced by reducing the benefits more gradually, but the program would be much more expensive.

PROBLEMS AND APPLICATIONS 150. The factors contributing to the increase in income inequality in the United States during the past 40 years are the breakup of families making low-income families even less wealthy, the increase in the number of two-career families making high-income families even richer, and the effects of technological advances on workers with different skills. 151. The percentage of children in families with income below the poverty line is almost twice the percentage of the senior citizens in such families because the Social Security system supports the senior citizens quite well, but the TANF (Temporary Assistance for Needy Families) program has incentive effects that tend to keep families from working their way out of poverty. 152. a. To increase economic mobility within a generation, the government could support training programs (to provide skills to unskilled workers) and workfare instead of welfare (to help low-income people increase their incomes). b. To increase economic mobility across generations, the government might increase its support for education. c. The advantage of reducing spending on welfare to increase spending on programs that enhance economic mobility is that it gives people greater incentive to work hard to get ahead. The disadvantages are that such programs are expensive and are hard on those who do not make it. 153. Community 1 has ten families with income of $100,000 each and ten families with income of $20,000 each. Community 2 has ten families with income of $200,000 each and ten families with income of $22,000 each. a. Community 2 has more unequal income than Community 1. In Community 2 the people with higher incomes have nearly ten times the income of a person in the lowest income bracket, while in Community 1 the people with higher incomes have only five times the income of a person in the lowest income bracket. However, the problem of poverty is likely to be slightly worse in Community 1, since a person in the lowest income bracket have lower income and the people with higher incomes are likely to pay less in taxes than the people with higher incomes in Community 2. b. Rawls would prefer the distribution of income in Community 2, since the worst-off family has more income than in Community 1.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 21: Income Inequality and Poverty

154.

155.

c. Most people will prefer the income distribution of Community 2, since both wealthy and less wealthy families are better off than their counterparts in Community 1, even though inequality is greater. d. A utilitarian may prefer the income distribution of Community 1 because income is more equal across its citizens. a. Leaks in the bucket are caused by the administrative costs of redistributing income, people who lie about their income to cheat the system, and the fact that labor supply is elastic, so that redistributive taxes reduce labor supply. b. Generally, Republicans believe the redistributive bucket is leakier than do Democrats. As a result, they think the government should do less redistribution of income than do Democrats. a. A utilitarian would argue that the marginal utility of income for the person with an income of $20,000 is higher than the marginal utility of income for someone with an income of $60,000, so some income should be redistributed. b. Rawls would prefer the second distribution since the worst-off person is better off than in the first distribution. c. Nozick would not find either more equitable. He would think the most equitable distribution is the one in which people got what they deserved. If the rules of the game are fair, either distribution is quite acceptable.

156.

157.

a. If people received cash instead of Medicaid benefits, it is unlikely that they would spend as much on health care. Instead, they would purchase other things they want or need. b. This suggests that we probably should not value in-kind transfers at the price the government pays for them. They may not be worth as much as their cost. c. Since low-income people might prefer other things to Medicaid, it might be better to give them cash transfers instead. a. Since the woman receives a smaller TANF benefit when she earns a dollar more, she will be less likely to work. Thus, the labor supply of low-income women will be lower as a result of the TANF program. b. If an individual would receive a greater benefit when they earn more income, they will be more likely to work. Thus, the EITC has a positive effect on the labor supply of low-income workers. c. TANF provides a safety net for those who are less likely to be successful in the labor market.

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Poverty Rate and Poverty Line o Video Problem Walk-Through: Analyzing a Negative Income Tax as a Strategy to Reduce Poverty o Equivalency of Fractions, Decimals, and Percentages

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice [return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 386 Chapter Objectives ........................................................................................................................................... 386 Complete List of Chapter Activities and Assessments ......................................................................... 387 Key Terms ........................................................................................................................................................... 388 What's New in This Chapter .......................................................................................................................... 389 Chapter Outline ................................................................................................................................................. 389 Solutions to Text Problems ........................................................................................................................... 400 Questions for Review ................................................................................................................................................... 400 Problems and Applications ........................................................................................................................................ 403 Additional Activities and Assignments ..................................................................................................... 410 Additional Resources ...................................................................................................................................... 411 Cengage Video Resources ........................................................................................................................................... 411

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 22 is the first of two unrelated chapters that introduce students to advanced topics in microeconomics. These two chapters are intended to whet their appetites for further study in economics. Chapter 22 is devoted to an advanced topic known as the theory of consumer choice. The purpose of Chapter 22 is to develop the theory that describes how consumers make decisions about what to buy. So far, these decisions have been summarized with the demand curve. The theory of consumer choice underlies the demand curve. After developing the theory, the theory is applied to a number of questions about how the economy works. Key points addressed in this chapter: 



A consumer’s budget constraint shows the possible bundles of different goods they can buy given their income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. The consumer’s indifference curves represent their preferences. An indifference curve shows the various bundles of goods that make the consumer equally happy. Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer's marginal rate of substitution—the rate at which the consumer is willing to trade one good for the other. The consumer optimizes by choosing the point on their budget constraint that lies on the highest indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals the slope of the budget constraint (the relative price of the goods), and the consumer's valuation of the two goods (measured by the marginal rate of substitution) equals the market's valuation (measured by the relative price). When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The income effect is reflected in the movement from a lower to a higher indifference curve, while the substitution effect is reflected by a movement along an indifference curve to a point with a different slope. The theory of consumer choice can be applied in many situations. It explains why demand curves sometimes slope upward, why higher wages could either increase or decrease the quantity of labor supplied, and why higher interest rates could either increase or decrease saving.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Construct a consumer's budget constraint, given information on income and prices.



Determine how changes in income or price impact the budget constraint.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 

Explain the relationship between the slope of the budget constraint and opportunity cost.



Determine the preference relationship between two consumption bundles using indifference curves.



List the four properties of indifference curves.



Calculate the marginal rate of substitution from a given set of preferences.

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Describe the relationship between utility and preferences.

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Determine if two goods are complements or substitutes using the shape of indifference curves.

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Determine the optimal consumption bundle using a consumer's budget constraints and indifference curves.

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Explain how a consumer optimizes consumption, given that consumer's income and preferences.



Determine if a consumer is utility-maximizing, given prices and the marginal utility from consuming different goods.

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Determine if a good is normal or inferior by interpreting a graph representing consumer's preferences and affordability.

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Given a graph of a consumer's budget constraint and indifference curves, identify the income and substitution effects caused by a price change in one of the goods.

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Describe what the direction and magnitude of income and substitution effects must be in order for a good to be classified as a Giffen good.



Explain how the demand curve is derived graphically from the optimal consumption decisions.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Active Learning 2 Think-Pair-Share Activity Self-Assessment Section 22-1 QuickQuiz Section 22-2 QuickQuiz

PPT Slide 13 PPT Slide 34 PPT Slide 53 PPT Slide 54 MindTap eBook MindTap eBook

10–15 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Section 22-3 QuickQuiz Section 22-4 QuickQuiz ConceptClip: Budget Constraint ConceptClip: Indifference Curve and MRS ConceptClip: Marginal Utility Analysis Figure 1: The Consumer’s Budget Constraint Figure 5: Bowed Indifference Curves Figure 7: The Consumer’s Optimum Figure 8: An Increase in Income Figure 9: An Inferior Good Figure 10: A Change in Price Figure 11: Income and Substitution Effects Figure 12: Deriving the Demand Curve Figure 15: An Increase in the Wage Figure 18: An Increase in the Interest Rate Chapter 22 Problems & Applications Chapter 22 A+ Test Prep Chapter 22 Homework Chapter 22 Quiz: The Theory of Consumer Choice

MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

30–40 mins. N/A 30–40 mins. 20–30 mins.

[return to top]

KEY TERMS Budget Constraint: the limit on the consumption bundles that a consumer can afford. Income Effect: the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. Indifference Curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction. Inferior Good: a good for which an increase in income reduces the quantity demanded. Giffen Good: a good for which an increase in the price raises the quantity demanded. Marginal Rate of Substitution: the rate at which a consumer is willing to trade one good for another. Normal Good: a good for which an increase in income raises the quantity demanded.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Perfect Complements: two goods with right-angle indifference curves. Perfect Substitutes: two goods with straight-line indifference curves. Substitution Effect: the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

The Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the Carnegie Conjecture, has been updated to include a recent study of lottery winners.

[return to top]

II.

Keep in Mind: This chapter is an advanced treatment of consumer choice using indifference curve analysis. This chapter is much more difficult than the other chapters in the text. Most undergraduate principles students will find this material challenging. The Budget Constraint: What a Consumer Can Afford A. Instruction Idea: The best way to develop this model is to use specific examples with definite quantities, prices, and levels of income. Figure 1 B. Example: A consumer has an income of $1,000 per month to spend on pizza and Pepsi. The price of a pizza is $10 and the price of a liter of Pepsi is $2. C. If the consumer spends all of their income on pizza, they can buy 100 pizzas per month. If the consumer spends all of their income on Pepsi, they can buy 500 liters per month. D. Definition of budget constraint: the limit on the consumption bundles that a consumer can afford. E. Using this information, we can draw the consumer's budget constraint. 1. The slope of the budget constraint measures the rate at which the consumer can trade one good for another. 2. The slope of the budget constraint equals the relative price of the two goods (1 pizza can be traded for 5 liters of Pepsi).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

3. Instruction Idea: Although the book does it later, now might be a good time to show the effects of price and income changes. Show mathematically and graphically how a doubling (or halving) of the price of one good will cause its intercept to change. Also show what happens to the vertical and horizontal intercepts when income changes. Emphasize that the budget depicts the consumption possibilities available to the individual. The consumer can be on or within the budget constraint, but not beyond it. F. Shifts in the budget constraint 1. An increase in a consumer’s income leads to an outward parallel shift in the budget constraint. 2. A decrease in the price of a good leads to an outward rotation of the budget constraint because the intercept moves outward only for the good whose price has fallen. Figure 2

III.

3. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. Preferences: What a Consumer Wants A. Representing Preferences with Indifference Curves 1. A consumer is indifferent between two bundles of goods and services if the two bundles suit their tastes equally well. 2. Definition of indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction. 3. The consumer is indifferent among points A, B, and C. 4. Definition of marginal rate of substitution: the rate at which a consumer is willing to trade one good for another. 5. The marginal rate of substitution is equal to the slope of the indifference curve at any point.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice a. Because these indifference curves are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve. b. The rate at which a consumer is willing to trade one good for the other depends on how much of each good they are already consuming. Figure 3

6. A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences. 7. Any point on indifference curve I2 will be preferred to any point on indifference curve I1. a. It is obvious that point D would be preferred to point A because point D contains more pizza and more Pepsi. b. We can tell, though, that point D is also preferred to point C because point D is on a higher indifference curve. B. Four Properties of Indifference Curves 1. Higher indifference curves are preferred to lower ones. 2. Indifference curves slope downward. a. In most cases, the consumer would like more of both goods. b. If the quantity of one good increases, the quantity of the other good must fall in order for the consumer to remain equally satisfied. 3. Indifference curves do not cross. a. The easiest way to prove this is by showing what would happen if they did cross. b. Because point A is on the same indifference curve as point B, the two bundles make the consumer equally happy. Figure 4

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

c. Because point C is on the same indifference curve as point B, the two bundles make the consumer equally happy. d. But this should imply that points A and C make the consumer equally happy, even though point C represents a bundle with more of both goods (which makes it preferred to point A). 4. Indifference curves are bowed inward. Figure 5 a. The slope of the indifference curve is the rate at which the consumer is willing to trade one good for another. b. Because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the marginal rate of substitution falls as the consumer gains pizza and loses Pepsi. C. Two Extreme Examples of Indifference Curves Figure 6 1. Perfect Substitutes a. Examples: bundles of nickels and dimes. b. Most likely, a consumer would always be willing to trade one dime for two nickels, regardless of how many dimes or nickels they have. c. Definition of perfect substitutes: two goods with straight-line indifference curves. d. Because the marginal rate of substitution is the same no matter how many dimes and nickels the consumer has, the slope of the indifference curve is constant. Thus, the indifference curve is a straight line. 2. Perfect Complements a. Example: right shoes and left shoes. b. Most likely, the consumer would only care about the number of pairs of shoes.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

IV.

c. Thus, a bundle with five right shoes and five left shoes makes a consumer equally as happy as a bundle with seven right shoes and five left shoes. d. Definition of perfect complements: two goods with right-angle indifference curves. Optimization: What a Consumer Chooses A. The Consumer's Optimal Choices 1. The consumer would like to end up on the highest possible indifference curve, but they must also stay within their budget. 2. The highest indifference curve the consumer can reach is the one that just barely touches the budget constraint. The point where they touch is called the optimum. 3. The optimum point represents the best combination of Pepsi and pizza available to the consumer. a. The consumer would prefer point A, but they cannot afford that bundle because it lies outside of their budget constraint. b. The consumer could afford bundle B, but it lies on a lower indifference curve and therefore provides less satisfaction. Figure 7

4. At the optimum, the slope of the budget constraint is equal to the slope of the indifference curve. a. The indifference curve is tangent to the budget constraint at this point. b. At this point, the marginal rate of substitution is equal to the relative price of the two goods. c. The relative price is the rate at which the market is willing to trade one good for the other, while the marginal rate of substitution is the rate at which the consumer is willing to trade one good for the other.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice B. FYI: Utility: An Alternative Way to Describe Preferences and Optimization 1. Utility is an abstract measure of the satisfaction that a consumer receives from a bundle of goods and services. 2. A consumer will prefer bundle A to bundle B if bundle A provides more utility. 3. Indifference curves and utility are related. a. Bundles of goods in higher indifference curves provide a higher level of utility. b. Bundles of goods on the same indifference curve all provide the same level of utility. c. The slope of the indifference curve reflects the marginal utility of one good compared to the marginal utility of the other good. 4. A consumer can maximize their utility if they end up on the highest indifference curve possible. a. This occurs when MRS = PX /PY. b. Because MRS = MUX /MUY, optimization occurs where MUX /MUY = PX /PY. c. This can be rewritten as MUX /PX = MUY /PY. d. This implies that, at the consumer’s optimum, the marginal utility per dollar spent on good X equals the marginal utility per dollar spent on good Y. C. How Changes in Income Affect the Consumer's Choices

Figure 8 1. A change in income shifts the budget constraint. a. An increase in income can be shown by an outward shift of the budget constraint; a decrease in income means that the budget constraint shifts inward. b. Because the relative price of the two goods has not changed, the slope of the budget constraint remains the same. 2. An increase in income means that the consumer can now reach a higher indifference curve. 3. Because the consumer increased their consumption of both goods when their income increased, both Pepsi and pizza must be normal goods. a. Definition of normal good: a good for which an increase in income raises the quantity demanded. b. Definition of inferior good: a good for which an increase in income reduces the quantity demanded. Figure 9 D. How Changes in Prices Affect the Consumer's Choices 1. If the price of only one good changes, the budget constraint will have a different slope. Figure 10

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

2. Suppose that the price of Pepsi falls from $2 per liter to $1. a. If the consumer spends their entire income on pizza, the change in the price of Pepsi will not affect their ability to buy pizza, so point A on the budget constraint remains the same. b. If the consumer spends their entire income on Pepsi, they will now be able to buy 1,000 liters instead of only 500. Thus, the end point of their budget constraint moves from point B to point D. c. The slope of the budget constraint changes as well. Because the price of Pepsi has fallen, the relative price of the two goods has changed. The consumer can now trade a pizza for 10 liters of Pepsi instead of 5. Therefore, the budget constraint has become steeper. 3. How such a change in the price of one good alters the consumption of both goods depends on the consumer's preferences. E. Income and Substitution Effects 1. Definition of income effect: the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. 2. Definition of substitution effect: the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution. 3. Suppose that the price of Pepsi falls. Table 1 a. The decrease in the price of Pepsi will make the consumer better off. Thus, if pizza and Pepsi are both normal goods, the consumer will want to spread this improvement in their purchasing power over both goods. This is the income effect and will make the consumer want to buy more of both goods. b. At the same time, the consumption of Pepsi has become less expensive relative to the consumption of pizza. This is the

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice substitution effect and it will tend to make the consumer want to purchase more Pepsi and less pizza. c. The end result must mean that the consumer purchases more Pepsi because both effects move the consumer in that direction. But whether the consumer buys more or less pizza is not clear. The outcome depends on the sizes of the income and substitution effects. Figure 11

4. We can graphically decompose the change in the consumer's decision into the income effect and the substitution effect. a. Instruction Idea: Students can learn to separate the substitution effects easily if they follow a simple rule: Have them draw a line tangent to the original indifference curve but parallel to the new budget constraint. Make sure that they realize that the substitution effect is seen as the movement along one indifference curve (due to changes in relative prices), and the income effect is seen as the movement from one budget constraint to a parallel budget constraint (because the individual’s purchasing power has changed). b. First, the consumer moves from the initial optimum (point A) to point B. The consumer is equally happy at either of these points, but the marginal rate of substitution at point B reflects the new relative prices of the two goods. c. Second, the consumer shifts to higher indifference curve I2 by moving from point B to C. At these two points, the marginal rate of substitution is the same because the slope of indifference curve I1 at point B is equal to the slope of indifference curve I2 at point C. d. The movement from point A to point B is the substitution effect; the movement from point B to point C is the income effect. F. Deriving the Demand Curve

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Figure 12

1. A demand curve shows how the price of a good affects the quantity demanded. 2. We can view a consumer's demand curve as a summary of the optimal decisions that arise from their budget constraint and indifference curves. 3. When the price of Pepsi falls from $2 per liter to $1, the consumer's budget constraint shifts outward, leading to both an income effect and a substitution effect. The consumer moves from point A to point B, increasing their consumption of Pepsi from 50 liters to 150. 4. Note that at a price of $2, the consumer's quantity of Pepsi demanded is 50. At a price of $1, quantity demanded is 150. These are two of the points on their demand curve for Pepsi. Three Applications A. Do All Demand Curves Slope Downward?

Figure 13 1. The law of demand states that when the price of a good rises, people buy less of it. 2. However, it is possible that when the price of a good rises, people actually buy more of it. 3. Example: A consumer spends his entire budget on meat and potatoes. The price of potatoes rises. a. The budget constraint will shift in. b. The substitution effect suggests that the consumer will choose more meat and fewer potatoes. c. The income effect suggests that the individual has suffered a decline in purchasing power and therefore will choose to decrease their consumption of normal goods and increase their consumption of inferior goods. d. Suppose that potatoes are a strongly inferior good. When the price of potatoes rises, the substitution effect says that the consumer should consume fewer potatoes, while the income effect suggests that they will consume more potatoes. If the income effect dominates, the consumer will consume more potatoes even though the price of potatoes rose. 4. Definition of Giffen good: a good for which an increase in the price raises the quantity demanded. 5. Case Study: The Search for Giffen Goods a. A 2008 study by two economists has produced evidence of Giffen goods. b. Poor households exhibited Giffen behavior by purchasing less rice (a staple) when its price fell and more when its price rose. B. How Do Wages Affect Labor Supply? Figure 14

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 1. Example: Jasmine has 100 hours per week that she can devote to working or enjoying leisure. Her hourly wage is $50, which she spends on consumption goods. 2. We can show Jasmine's budget constraint graphically. a. On the horizontal axis, we have hours of leisure. On the vertical axis, we have consumption goods. b. If Jasmine spends all of her time in leisure (100 hours), she will have no consumption. If she spends all of her time working, she will have no leisure but will have consumption of $5,000. 3. Jasmine's optimum will occur where the highest possible indifference curve is tangent to the budget constraint. 4. If Jasmine's wage increases, her budget constraint will shift outward. Figure 15 a. The budget constraint will become steeper, because Jasmine can get more consumption for every hour of leisure that she gives up. b. We would expect that consumption would rise, because both the income and substitution effects move in that direction. When the wage rises, leisure becomes relatively more expensive. Thus, Jasmine will increase consumption and decrease leisure. Also when Jasmine's wage rises, her purchasing power is increased. Because consumption is a normal good, Jasmine will want more consumption. c. The response of leisure to the change in Jasmine's wage is not as straightforward. This occurs because the income and substitution effects with regard to leisure move in opposite directions. When the wage rises, leisure becomes relatively more expensive. Therefore, Jasmine will want to consume less leisure. However, when Jasmine's wage rises, her purchasing power is increased, causing her to increase her desire for more leisure (because it is a normal good). The end result depends on which effect is dominant. d. If the substitution effect is greater than the income effect, Jasmine will decrease leisure and work more hours if her wage rises. This results in an upward-sloping labor supply curve. e. If the income effect is greater than the substitution effect, Jasmine will increase leisure and work fewer hours if her wage rises. This results in a backward-bending labor supply curve. At first, as the wage increases, the labor supply curve may be positively sloped. As the wage increases further, the income effect outweighs the substitution effect and the labor supply curve becomes backwardbending. Figure 16 5. Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the Carnegie Conjecture

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice a. One hundred years ago, workers worked six days a week. As wages (adjusted for inflation) have risen, the length of the workweek has fallen. This suggests that a backward-bending labor supply curve is not unrealistic. b. The income effect can be isolated by examining the effects of winning the lottery on an individual's labor supply. Studies have shown that lottery prizes lead to significant decreases in labor supply. This is why Andrew Carnegie gave away much of his wealth before he died rather than leaving it for his children. He worried that such wealth would lead his children to become unproductive. C. How Do Interest Rates Affect Household Saving? Figure 17 1. Example: Ryder is planning ahead for retirement. There are two time periods. Currently, Ryder is young and working and able to earn a total income of $100,000. In the next period, Ryder is old and retired. He will have to consume using funds he saved while young. Assume that the interest rate is 10 percent. 2. We can view "consumption while young" and "consumption while old" as the two goods that Ryder must choose between. 3. The interest rate determines the relative price of these two goods. For every dollar that Ryder saves while he is young, he can consume $1.10 when he is old. 4. We can draw Ryder's budget constraint. a. On the horizontal axis, we have "consumption when young" and on the vertical axis, we have "consumption while old." b. If Ryder saves nothing, he will consume $100,000 when he is young and zero when he is old. Likewise, if he consumes nothing when he is young, he will be able to consume $110,000 when he is old. 5. Ryder's optimum occurs where his highest possible indifference curve is tangent to his budget constraint. 6. If the interest rate rises to 20 percent, two possible outcomes could occur. Figure 18 a. The increase in the interest rate raises the price of "consumption when young." The substitution effect suggests that Ryder would lower the amount of consumption when young and save more for the future. b. Because the increase in the interest rate means an increase in purchasing power, the income effect suggests that Ryder increase his consumption of normal goods. Because "consumption when young" is a normal good, Ryder will want to save less. c. Thus, the end result will depend on whether the income effect or the substitution effect dominates. If the substitution effect is larger than the income effect, Ryder will save more for the future and decrease

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice consumption when young. If the income effect is greater than the substitution effect, Ryder will save less for the future and increase consumption when young. 7. Because of this ambiguity, it is not clear how changing the way interest income is taxed will affect overall savings rates. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 6. Figure 4 shows the consumer's budget constraint. The intercept on the horizontal axis shows how much cheese the consumer could buy if they bought only cheese; with income of $3,000 and the price of cheese $6 a pound, they could buy 500 pounds of cheese. The intercept on the vertical axis shows how much wine the consumer could buy if they bought only wine; with income of $3,000 and the price of wine $3 a glass, they could buy 1,000 glasses of wine. With cheese on the horizontal axis and wine on the vertical axis, the budget constraint has a slope of -1,000/500 = -2.

Figure 4

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 7. Figure 5 shows a consumer's indifference curves for wine and cheese. Four properties of these indifference curves are: (1) higher indifference curves are preferred to lower ones because more is preferred to less; (2) indifference curves are downward sloping because if the quantity of wine is reduced, the quantity of cheese must increase for the consumer to be equally happy; (3) indifference curves do not cross because a consumer prefers more to less; and (4) indifference curves are bowed inward because a consumer is more willing to trade away wine if they have a lot of it and less willing to trade away wine if they have little of it.

Figure 5 8. In Figure 5, the marginal rate of substitution (MRS) of one point on an indifference curve is shown. The marginal rate of substitution shows the amount of wine the consumer would be willing to give up to get one more pound of cheese.

Figure 6 9. Figure 6 shows the consumer's budget constraint and indifference curves for wine and cheese. The consumer's optimum consumption choice is shown as w* and c*. Because the

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice marginal rate of substitution equals the relative price of the two goods at the optimum, the marginal rate of substitution is $6/$3 = 2

Figure 7 10. Figure 7 shows the effect of an increase in income. The rise in income shifts the budget constraint out from BC1 to BC2. If both wine and cheese are normal goods, consumption of both increases. If cheese is an inferior good, the increase in income causes the consumption of cheese to decline, as shown in Figure 8.

Figure 8

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

Figure 9 11. A rise in the price of cheese from $6 to $10 a pound makes the horizontal intercept of the budget line decline from 500 to 300, as shown in Figure 9. The consumer's budget constraint shifts from BC1 to BC2 and their optimal choice changes from point A (c1 cheese, w1 wine) to point B (c2 cheese, w2 wine). To decompose this change into income and substitution effects, we draw in budget constraint BC3, which is parallel to BC2 but tangent to the consumer's initial indifference curve at point C. The movement from point A to C represents the substitution effect. Because cheese became more expensive, the consumer substitutes wine for cheese as they move from point A to C. The movement from point C to B represents an income effect. The rise in the price of cheese results in an effective decline in income. 12. An increase in the price of cheese could induce a consumer to buy more cheese if cheese is a Giffen good. In that case, the income effect of the rise in the price of cheese outweighs the substitution effect and induces the consumer to buy more cheese because cheese is an inferior good.

PROBLEMS AND APPLICATIONS 158. a. Figure 10 shows the effect of the frost on Maya's budget constraint. Because the price of coffee rises, her budget constraint rotates from BC1 to BC2 b. If the substitution effect outweighs the income effect for croissants, Maya buys more croissants and less coffee, as shown in Figure 10. They moves from point A to point B.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

Figure 10 c. If the income effect outweighs the substitution effect for croissants, Maya buys fewer croissants and less coffee, moving from point A to point B in Figure 11.

Figure 11 159. a. Skis and ski bindings are complements. Coke and Pepsi are substitutes. b. Indifference curves between Coke and Pepsi are fairly straight, because there is little to distinguish them, so they are nearly perfect substitutes. Indifference curves between skis and ski bindings are very bowed, because they are complements. c. A consumer will respond more to a change in the relative price of Coke and Pepsi, possibly switching completely from one to the other if the price changes.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

Figure 12

160. a. Figure 12 shows the effects of these price changes. If you are equally happy, you will remain on the same indifference curve. However, both the increase in the price of soda and the decline in the price of pizza make the budget constraint steeper. b. You will consume less soda and more pizza. Since you remain equally happy, there is only the substitution effect to consider. c. You can no longer afford your initial bundle. It lies outside of your new budget constraint. 161. a. Cheese and crackers cannot both be inferior goods, because if Raj's income rises he must consume more of something. b. If the price of cheese falls, the substitution effect means Raj will consume more cheese and fewer crackers. The income effect means Raj will consume more cheese (because cheese is a normal good) and fewer crackers (because crackers are an inferior good). So, both effects lead Raj to consume more cheese and fewer crackers.

Figure 13

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 162. a. Figure 13 shows Darius's budget constraint. The vertical intercept is 50 quarts of milk, because if Darius spent all his money on milk he would buy $100/$2 = 50 quarts of it. The horizontal intercept is 25 dozen cookies, because if Darius spent all his money on cookies he would buy $100/$4 = 25 dozen cookies. b. If Darius's salary rises by 10 percent to $110 and the prices of milk and cookies rise by 10 percent to $2.20 and $4.40, Darius's budget constraint would be unchanged. Note that $110/$2.20 = 50 and $110/$4.40 = 25, so the intercepts of the new budget constraint would be the same as the old budget constraint. Because the budget constraint is unchanged, Darius's optimal consumption is unchanged. 163. a. This statement is true. All Giffen goods are inferior goods. It is impossible to have a Giffen good that is a normal good. b. This statement is false. A Giffen good is a special case of an inferior good for which the income effect outweighs the substitution effect. 164. a. Figure 14 shows the student’s budget constraint. If they spend equal amounts on both goods, they will purchase 5 meals in the dining hall and 20 packages of Cup O’ Soup represented by point A.

Figure 14 b. If the price of Cup O’ Soup rises to $2, the student’s budget constraint will get flatter (see Figure 15). They will now spend $18 on dining hall meals (purchasing 3) and $42 on Cup O’ Soup (purchasing 21 packages).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

Figure 15 c. As the price of Cup O’ Soup rises, the student purchased more. This means that Cup O’ Soup is an inferior good for which the income effect outweighs the substitution effect. d. Figure 16 shows the student’s demand for Cup O’ Soup. It is upward sloping, indicating that Cup O’ Soup is a Giffen good.

Figure 16 165. a. Budget constraint BC1 in Figure 17 shows the budget constraint if you pay no taxes. Budget constraint BC2 shows the budget constraint with a 15 percent income tax.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice

Figure 17

Figure 18

b. Figure 18 shows indifference curves for which a person will work more as a result of the tax because the income effect (less leisure) outweighs the substitution effect (more leisure), so there is less leisure overall. Figure 19 shows indifference curves for which a person will work fewer hours as a result of the tax because the income effect (less leisure) is smaller than the substitution effect (more leisure), so there is more leisure overall. Figure 20 shows indifference curves for which a person will work the same number of hours after the tax because the income effect (less leisure) equals the substitution effect (more leisure), so there is the same amount of leisure overall.

Figure 19

Figure 20

166. Figure 21 shows Anya's budget constraints and indifference curves if she earns $12 (BC1), $16 (BC2), and $20 (BC3) per hour. At a wage of $12 per hour, she works 100 – L12

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice hours; at a wage of $16 per hour, she works 100 – L16 hours; and at a wage of $20 per hour, she works 100 – L20 hours. Because the labor supply curve is upward sloping when the wage is between $12 and $16 per hour, L12 > L16; because the labor supply curve is backward sloping when the wage is between $16 and $20 per hour, L20 > L16.

Figure 21 167. Figure 22 shows the indifference curve between leisure and consumption that determines how much a person works. An increase in the wage leads to both an income effect and a substitution effect. The higher wage makes the budget constraint steeper, so the substitution effect increases consumption and reduces leisure. But the higher wage has an income effect that increases both consumption and leisure if both are normal goods. The only way that consumption could decrease when the wage increased would be if consumption is an inferior good and if the negative income effect outweighs the positive substitution effect. This could happen for a person who really placed an exceptionally high value on leisure.

Figure 22 168. If consumers do not buy less of a good when their incomes rise, the good in question must be a normal good. For a normal good, the income and substitution effects both imply that the consumer will buy less if the price rises.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 169. Utility is maximized when the marginal utility per dollar spent is equal across goods. Claire and Alex are both purchasing the utility-maximizing combination of apples and pears. Phil and Haley each get greater utility per dollar spent on apples than on pears. Therefore, they should purchase more apples and fewer pears. On the other hand, Luke gets higher utility per dollar spent on pears than on apples. He should reallocate his budget as well, increasing his purchases of pears and reducing his purchases of apples.

[In-class activity] You Can’t Always Get What You Want: 5 minutes total. Works in any class size. Topics include budget constraints. PP. Purpose: This activity shows consumers are restricted by their incomes and by the prices of goods. QQ. Instructions: Ask the students to think about maximizing their own utility. Specifically, ask them to assume that billionaire Bill Gates offers to buy them the one thing that would increase their happiness by the greatest amount. It cannot be money or a financial instrument, but he will buy them any single thing they feel would make them happy. Have them write down their requested item. Ask a few students what they chose. Then ask the class, “Why don’t you buy that item for yourself? Isn’t it the one thing that will increase your happiness by the largest amount? Why not buy it today?” The answer, of course, is they cannot afford it. Consumers’ purchases are constrained by their incomes. However, that is not the only constraint. Ask them to estimate the cost of their selected items and write it next to the items. Now, have them assume Bill Gates is too busy to go shopping, so he gives them the money instead. He does not put any restrictions on the use of the cash; all he wants is to see them maximize their happiness. This eliminates the income barrier. Ask the class how many of them would spend the entire amount of money buying that single good. Some students would buy that item, but most would buy a variety of things. Using the money for a single expensive item may not be the best way to allocate their newfound wealth. Buying several cheap things may give a higher level of happiness. RR. Points for Discussion: a. Consumers have limited income. b. Goods have prices. Together these things determine the consumer’s budget constraint.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Budget Constraint o ConceptClip: Indifference Curve and MRS o ConceptClip: Marginal Utility Analysis o Video Problem Walk-Through: Drawing a Consumer's Budget Constraint o Video Problem Walk-Through: Using the Budget Constraint and Indifference Curves to Determine a Consumer's Optimal Consumption o Video Problem Walk-Through: Deriving a Consumer's Demand Curve Using the Budget Constraint and Indifference Curves o Video Problem Walk-Through: Using Marginal Utilities and Prices to Determine Optimal Consumption o Equation Basics o Graphing Basics o Graphing Linear Equations o Slope of a Curve o Slope of a Line

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Instructor Manual

Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 23: Frontiers of Microeconomics Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

413

Complete List of Chapter Activities and Assessments Key Terms

414

What's New in This Chapter 415 Chapter Outline

415

Solutions to Text Problems 421 Questions for Review ................................................................................................................................................... 421 Problems and Applications ........................................................................................................................................ 421

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Additional Activities and Assignments

423

Additional Resources425 Cengage Video Resources ........................................................................................................................................... 425

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PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 23 is the last chapter in the microeconomics portion of the text. It is the second of two unrelated chapters that introduce students to advanced topics in microeconomics. These two chapters are intended to whet student’s appetites for further study in economics. The purpose of Chapter 23 is to give students a taste of three topics on the frontier of microeconomic research. The first topic addressed is asymmetric information, a situation when one person in an economic relationship has more relevant knowledge than the other person does. The second topic is political economy, the application of economic tools to the understanding of the functioning of government. The third topic is behavioral economics, the introduction of psychology into the study of economic issues. Key points addressed in this chapter: 



In many transactions, information is asymmetric. When there are hidden actions, principals may be concerned that agents suffer from the problem of moral hazard. When there are hidden characteristics, buyers may be concerned about the problem of adverse selection among the sellers. Private markets sometimes deal with asymmetric information with signaling and screening. Although government policy can sometimes improve market outcomes, governments are themselves imperfect institutions. The Condorcet paradox shows that the majority rule fails to produce transitive preferences for society, and Arrow's impossibility theorem shows that no voting system will be perfect. In many situations, democratic institutions will produce the outcome desired by the median voter, regardless of the preferences of the rest of the electorate. Moreover, the individuals who set government policy may be motivated by selfinterest rather than national interest. The study of psychology and economics reveals that human decision making is more complex than is assumed in conventional economic theory. People are not always rational, they care about the fairness of economic outcomes (even to their own detriment), and they can be inconsistent over time.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Analyze how asymmetric information distorts incentives.



Recognize the role psychology plays in behavioral economics.



Identify the presence of moral hazard or adverse selection in a given scenario.



Categorize an effort to reveal private information as screening or signaling.



Given a scenario, identify the presence of moral hazard or adverse selection.



Given a voting scheme scenario, identify which property from Arrow's impossibility theorem is violated.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 

Given a voting scheme scenario, determine if it suffers from the Condorcet paradox.



Explain why majority rule voting will always pick the choice most preferred by the median voter.

Source (i.e., PPT slide, Workbook) PPT Slide 14 PPT Slide 23 PPT Slide 34 PPT Slide 43 PPT Slide 44 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

Duration 5–10 mins. 5–10 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 30–40 mins. N/A 20–30 mins. 20–30 mins.

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KEY TERMS Adverse Selection: the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. Agent: a person who is performing an act for another person, called the principal. Arrow Impossibility Theorem: a mathematical result showing that, under certain assumed conditions, there is no method for aggregating individual preferences into a valid set of social preferences. Behavioral Economics: the subfield of economics that integrates the insights of psychology. Condorcet Paradox: the failure of majority rule to produce transitive preferences for society.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Median Voter Theorem: a mathematical result showing that if voters are choosing a point along a line and they all want the point closest to their own optimum, then majority rule will pick the optimum of the median voter. Moral Hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. Political Economy: the study of government using the analytic methods of economics. It is sometimes called political choice or social choice. Principal: a person for whom another person, called the agent, is performing some act. Screening: an action taken by an uninformed party to induce an informed party to reveal information. Signaling: an action taken by an informed party to reveal private information to an uninformed party. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new In the News feature on the Faults in Risk Assessment, “Irrational Covid Fears.” Ranked-Choice Voting is addressed in the section dealing with Arrow’s Impossibility Theorem.

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XXXVII.

Instruction Idea: This is a great chapter to get students interested in further study of economics. It is important for the students to learn that economics is a growing and developing science and that economists are always looking for new areas to study and new phenomena to explain. The Asymmetric Information a. Many times in life, one person holds more knowledge about what is going on than another. Such a difference in access to relevant information is known as an information asymmetry. b. Examples i. A worker knows more than his employer about the level of his work effort. This is an example of a hidden action.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice ii.

A seller of a used car knows more than the buyer does about the car's condition. This is an example of a hidden characteristic. c. When there is asymmetric information, the party without the relevant knowledge would like to have such knowledge, but the other party may have an incentive to conceal it. d. Hidden Actions: Principals, Agents, and Moral Hazard i. Important Definitions 1. Definition of moral hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. 2. Definition of agent: a person who is performing an act for another person, called the principal. 3. Definition of principal: a person for whom another person, called the agent, is performing some act. ii. The employment relationship is the classic example. 1. Workers (agents) may be tempted to shirk their work-related responsibilities because their employers (the principals) do not monitor their behavior closely. 2. Employers can respond by providing better monitoring, paying higher wages, or delaying part of the worker's pay until later in the worker's life. iii. FYI: Corporate Management 1. In addition to limited liability for the owners of the firm, an important feature of the corporate form of organization is the separation of ownership and control. 2. This creates a principal–agent problem where the shareholders are the principals and the managers are the agents. 3. Managers’ goals may not always coincide with shareholders' goal of profit maximization. 4. As a result, many managers are provided compensation packages that provide incentives to act in the best interest of the shareholders by maximizing corporate profits. e. Hidden Characteristics: Adverse Selection and the Lemons Problem i. Definition of adverse selection: the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. ii. Examples include the used car market, the labor market, and the market for insurance. iii. When markets suffer from adverse selection, the invisible hand does not necessarily work well. 1. In the used car market, owners of "cherry" or "plum" cars may choose to keep them rather than sell them at a low price. 2. In the labor market, wages may be stuck at a level above the equilibrium wage, resulting in unemployment. 3. In insurance markets, buyers with low risk may decline to purchase insurance because the price is too high.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice f.

XXXVIII.

Signaling to Convey Private Information i. Definition of signaling: an action taken by an informed party to reveal private information to an uninformed party. ii. Examples of Signaling 1. Firms may spend money on advertising to signal the high quality of their products. 2. Students may spend time in school to signal that they are high-ability individuals. iii. For a signal to be effective, it must be costly. However, it must be less costly (or more beneficial) to the person or firm with the higher-quality product. iv. Case Study: Gifts as Signals 1. Because people know their own preferences better than anyone else, we would expect that they would prefer cash gifts. 2. However, the ability to choose the right gift for someone may serve as a signal of an individual's love. 3. Note that choosing the right gift is costly and the cost depends on how well the giver knows the recipient (which may be determined as a measure of the giver's level of interest in the recipient). g. Screening to Uncover Private Information i. Definition of screening: an action taken by an uninformed party to induce an informed party to reveal information. ii. Examples of Screening 1. A buyer of a used car may ask to have the car examined by a mechanic prior to purchase. 2. An insurance company may offer different policies that would lead safe or risky drivers to reveal themselves. Safe drivers are likely to prefer policies with low premiums and high deductibles. Risky drivers are more likely to prefer policies with higher premiums and low deductibles. h. Asymmetric Information and Public Policy i. Market failures such as externalities, public goods, imperfect competition, and poverty show that governments can sometimes improve market outcomes. ii. Asymmetric information is another reason why market outcomes may be inefficient. iii. However, three factors make it difficult for the government to improve the outcome in some cases. 1. The private market can sometimes deal with information asymmetries on its own using a combination of signaling and screening. 2. The government rarely has more information than the private parties do. 3. The government is itself an imperfect institution. 4. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. Political Economy

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice a. Definition of political economy: the study of government using the analytic methods of economics. It is sometimes called political choice or social choice. b. The Condorcet Voting Paradox i. Most advanced societies rely on democratic principles, allowing the majority to set government policy. ii. For most policy issues, the number of possible outcomes exceeds two. iii. Example: Three possible outcomes (A, B, and C) and three voter types (Type 1, Type 2, and Type 3). The mayor of a town wishes to aggregate the individual preferences into preferences for society as a whole.

Table 1

Percent of Electorate First Choice Second Choice Third Choice

Type 1 35 A B C

Voter Type Type 2 45 B C A

Type 3 20 C A B

1. In pairwise majority voting, A would beat B, B would beat C, and C would beat A. 2. This violates transitivity. We generally expect that if A is preferred to B and B is preferred to C, then A would be preferred to C. 3. Definition of Condorcet paradox: the failure of majority rule to produce transitive preferences for society. 4. This implies that the order on which things are voted can determine the result. c. Arrow's Impossibility Theorem i. In a 1951 book, economist Kenneth Arrow examined if a perfect voting system exists. ii. He assumes that society wants a voting scheme that satisfies social properties. 1. Unanimity. 2. Transitivity. 3. Independence of irrelevant alternatives. 4. No dictators. iii. Arrow proved that no voting system could have all of these properties. iv. Definition of Arrow impossibility theorem: a mathematical result showing that, under certain assumed conditions, there is no method for aggregating individual preferences into a valid set of social preferences. v. Arrow’s impossibility theorem implies that no matter what voting scheme society adopts for aggregating the preferences of its members, in some way it will be flawed as a mechanism for social choice. Employing a Borda Count or

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice Ranked-Choice Voting may improve on the result of majority rule. But no voting system can satisfy all four requirements listed above. d. The Median Voter Is King i. Example: A society is deciding how much money to spend on a public good. Each voter has a most-preferred budget and prefers outcomes closer to his preferred budget. Figure 1

ii.

XXXIX.

Definition of median voter theorem: a mathematical result showing that if voters are choosing a point along a line and they all want the point closest to their own optimum, then majority rule will pick the optimum of the median voter. 1. The median voter is the voter exactly in the middle of the distribution. 2. In Figure 1, the median voter wants a budget of $10 billion. iii. One implication of the median voter theorem is that if two political candidates are each trying to maximize their chance of election, they will both move their positions toward the median voter. iv. Another implication of the median voter theorem is that minority views are not given much weight. e. Politicians Are People Too i. Politicians may be self-interested. ii. Some politicians may be motivated by desire for reelection and others may be motivated by greed. Behavioral Economics a. Definition of behavioral economics: the subfield of economics that integrates the insights of psychology. b. Behavioral economics is a relatively new field in economics where economists make use of basic psychological insights into human behavior. c. People Aren’t Always Rational i. Economists assume that human beings are always rational. 1. Firm owners maximize profit. 2. Consumers maximize utility. 3. Given constraints that they face, these individuals make decisions by rationally weighing all costs and benefits. ii. Real people are often more complex than economists assume. 1. They can be forgetful, impulsive, confused, emotional, and shortsighted.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice 2. These imperfections suggest that humans should not be viewed as rational maximizers but as “satisficers,” where they choose options that are simply “good enough.” iii. Studies of human decision-making have found several systematic mistakes that people make. 1. People are overconfident. 2. People give too much weight to a small number of vivid observations. 3. People are reluctant to change their minds, a behavior known as confirmation bias. d. People Care about Fairness i. Example: the ultimatum game. 1. Two volunteers are told they are going to play a game and could win a total of $100. 2. The game begins with a coin toss, which is used to assign the volunteers to the roles of the proposer and the responder. 3. The proposer’s job is to propose a division of the prize between himself and the other player. 4. After the proposer makes his proposal, the responder decides whether to accept or reject it. 5. If the responder accepts the proposal, both players are paid according to the proposal. If the responder rejects the proposal, both players receive nothing. ii. Conventional economic theory suggests that the proposer should know that if they offer $1 to the responder and keeps $99 for himself, the responder should accept it ($1 is greater than $0). iii. In reality, when the offer made to the responder is small, the responder often rejects it. iv. Knowing this, people in the role of the proposer often offer a more substantial portion of the money to the responder. v. This implies that people may be driven by a sense of fairness. e. People Are Inconsistent over Time i. Many times in life, people make plans for themselves but then fail to follow through. ii. The desire for instant gratification can induce a decision-maker to abandon his past plan. iii. An important implication is that people will try to find ways to commit their future selves to following through on their plans. f. In the News: Faults in Risk Assessment: “Irrational Covid Fears.” i. People often underestimate large chronic dangers and fixate on tiny salient risks, particularly if the risks are new. ii. If people are vaccinated, Covid presents a smaller risk than car travel. But because the dangers of car travel are old and well understood, we accept the risk. But Covid is new and salient, so vaccinated people still have an irrational fear of it. g. Ask the Experts: Behavioral Economics.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice i.

100% of economic experts agree that “insights from psychology about individual behavior predict several important types of observed market outcomes that full-rational economic models do not.”

[return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 6. Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. To reduce the severity of this problem, an employer may respond with (1) better monitoring, (2) paying efficiency wages, or (3) delaying part of a worker’s compensation to later in his work life. 7. Adverse selection is the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. Examples of markets in which adverse selection might be a problem include the market for used cars and the market for insurance. 8. Signaling is an action taken by an informed party to reveal private information to an uninformed party. Job applicants may use a college diploma as a signal of ability. Screening is an action taken by an uninformed party to induce an informed party to reveal information. A life insurance company may require applicants to submit to a health examination so that the company will have more information on the person’s risk of death. 9. Condorcet noticed that the majority rule will fail to produce transitive properties for society. 10. The median voter’s preferences will beat out any other proposal in a two-way race because the median voter will have more than half of the voters on his side. 11. Two volunteers are chosen and a coin toss determines which volunteer is the proposer and which is the responder. The proposer proposes a split of a sum of money and then the responder decides whether to accept or reject the proposal. If the responder accepts, the sum of money is divided as outlined in the proposal. If the responder rejects the proposal, each player gets nothing. 12. Conventional economic theory predicts that the proposer will offer only $1 to the responder and keep the remainder for himself. This is predicted to occur because the proposer knows that the responder will be better off with $1 than with $0. However, in reality, the responder generally rejects small proposals that they consider unfair. If the proposer considers this, they will likely offer the responder a more substantial amount.

PROBLEMS AND APPLICATIONS 170. a. The landlord is the principal and the tenant is the agent. There is asymmetric information because the landlord does not know how well the tenant will take care of the property. Having a tenant pay a security deposit increases the likelihood that the tenant will take care of the property in order to receive his deposit back when they vacate the property.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice b. The stockholders of the firm (the owners) are the principals and the top executives are the agents. The firm’s owners do not know in advance how well the top executives will perform their duties. Tying some of the executives’ compensation to the value of the firm provides incentive for the executives to work hard to increase the value of the firm. c. The insurance company is the principal and the customer is the agent. Insurance companies do not know whether the car owner is likely to leave the vehicle parked with the keys in it or park it in a high crime area. Individuals who will go to the trouble of installing anti-theft equipment are more likely to take good care of their vehicles. Offering a discount on insurance premiums will induce car owners to install such devices. 171. Saying "I love you" is likely not a good signal. To be an effective signal, the signal must be costly. In fact, the signal must be less costly, or more beneficial, to the person with the higher-quality product. Simply professing one's love does not meet this requirement. 172. a. Taken on its own, the policy that insurance companies must offer health insurance to everyone who applies and charge them the same price regardless of a person’s pre-existing health condition makes the problem of adverse selection worse. With this policy those who are ill would have a greater incentive to buy insurance. Covering these individuals would raise the cost of providing health insurance and the company would have to raise premiums for all buyers. Healthy individuals may decide that the benefits of having insurance do not exceed the higher premiums and may drop coverage. Insurance companies would be left insuring only those who are ill, increasing the adverse selection problem. b. The policy was included in the law to make the law equitable for all citizens. If insurance companies could exclude individuals with pre-existing conditions, they would be left with no insurance options and the insurance companies would have a pool of low risk individuals. However, those with no insurance would require social safety nets and government subsidies to cover the costs of their care. These costs can be borne more efficiently by society within the insurance market than outside of it through government programs. c. The requirement that everyone must buy health insurance or pay a penalty reduces the adverse selection problem. With everyone, healthy and ill, in the insurance pool the price of health insurance will reflect the costs of an average person, rather than a sicker-than-average person. 173. Ken is violating the property of independence of irrelevant alternatives. Adding a choice of strawberry after he chooses vanilla over chocolate should not induce him to change his mind and prefer chocolate. 174. a. If the three friends use a Borda count, the Chinese restaurant gets the most votes (10); the Italian restaurant gets 9 votes; the Mexican restaurant gets 7 votes; and the French restaurant gets 4 votes. b. In this scenario, the Italian restaurant gets 5 votes and the Chinese restaurant gets 4 votes. Thus, they will choose to eat at the Italian restaurant. c. This voting violates the assumption of independence of irrelevant alternatives. The presence of the Mexican and French restaurants should not alter the group’s preferences between the Italian and Chinese restaurants. 175. a. There would be a tie between the three television shows, with 6 votes each.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice b. In a vote between NCIS and Ted Lasso, NCIS would win. In a vote between NCIS and Survivor, Survivor would win. Thus, Monica’s first choice (Survivor) would win. c. No. He will want to vote between Ted Lasso and Survivor first, with the winner then competing in a second vote with NCIS. That way, his preferred choice (NCIS) would win. d. If Chandler says he prefers Ted Lasso over NCIS, Ted Lasso will then compete in a vote against Survivor (which it will win). This way, Chandler will not have to watch his least preferred show (Survivor). 176.

a. The efficient number of movies is three. Total surplus would be the sum of the roommates’ willingness to pay (38 + 26 + 18 82) minus the cost of the movies (15 + 15 + 15 = 45) which is 37. b. Ava would want 4 movies; Ridley would prefer 3; Spike wants 2; Chloe wants 1; and Quentin does not want to buy a movie. c. The preference of the median roommate (Spike) is 2 DVDs. d. Ava and Ridley would vote for 3 movies, but the other three roommates would vote for 2 movies. e. No. Any other option besides 2 movies would get fewer votes. f. No. The provision of the public good will likely be determined by the preferences of the median voter. This may or may not be the efficient outcome. 177. More than likely, the two stands will locate at the center of the beach. Thus, they will always be closest for at least half of the beach goers. This is related to the median voter theorem. 178. a. Assuming the low-income person is a rational consumer, they would use the cash to maximize his utility and purchase what they need most. b. The free meals at the soup kitchen may be better than the cash handout if the government does not have complete information about how the low-income person will spend the cash. That is, rather than the possibility of the low-income person spending the cash on drugs or alcohol, the government can be certain the lowincome person is getting food from the soup kitchen. c. The free meals at the soup kitchen may be better than the cash handout based on behavioral economics because people aren't always rational and the low-income person may spend the cash on something they don’t need as much as food.

[In-class demonstration] A Market for Lemons: 50-60 minutes total. Works in any class size (although using a larger number of groups will result in a larger amount of time necessary to complete each round). Topics include asymmetric information, signaling, and regulation. Prepared instruction sheets and record sheets required. D. Purpose: This classroom experiment demonstrates how a market for lemons can develop when buyers have no information on the quality of a product available for sale.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 22: The Theory of Consumer Choice E. Instructions: Divide the class into seven groups, three sellers and four buyers. Try to keep the groups separated and make sure that students know not to reveal their cost or value information to anyone. Pass out instruction sheets and record sheets for each group. Here are the rules for the first few rounds of the game 4. Sellers must decide their product quality and price simultaneously. Each seller can choose only one product quality but can sell up to two units each period. Sellers' decisions are recorded and given to the instructor. 5. Once all of the sellers have made their decisions, the instructor lists the sellers' product quality and the price on the board. 6. The instructor draws a number from a hat (1 through 4) and this will be the first buyer to make a purchase. Buyers decide which firm to buy from based on preferred quality and price. Buyers may purchase only one unit each period. Once a seller has sold two units, they can sell no more and should be eliminated from the list of choices. 7. Profit for sellers will be the difference between the price and the cost (given to them on their instruction sheets) for each unit sold. Due to rising marginal cost, the cost of the second unit is $1.00 more than the first. The cost information for each firm is: Quality 1 $1.75 $2.75

Cost of 1st unit Cost of 2nd unit

Quality 2 $4.95 $5.95

Quality 3 $11.35 $12.350

8. For the buyers, consumer surplus will be the difference between the value to the consumer (given on their instruction sheets) and the price paid. The value for each buyer is: Value to the buyer

Quality 1 $5.00

Quality 2 $9.80

Quality 3 $14.50

9. Once a few rounds have been played, the instructor should announce that they will only list the sellers' prices on the board. Buyers must base their decisions entirely on price information. F. Points for Discussion: Begin by discussing the results of the rounds where buyers and sellers had complete information. 1. Do sellers or buyers benefit from a higher quality of product? 2. What is the most efficient quality? (Which maximizes total surplus?) 3. Suppose the market ended up with only Quality 2 products? Would it be efficient for a regulator to force firms to manufacture Quality 3 products? Why or why not? Students will generally figure out that Quality 2 maximizes the sum of producer and consumer surplus in the market. To illustrate this point, the instructor can graph the supply and demand curves for each quality.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income Once you have discussed the market with full information, start a discussion on the results of the information asymmetry. 1. What happened in the market when buyers were unable to distinguish the product quality? 2. Why were firms driven to produce the lowest quality? 3. In reality, is there any way for a firm to reveal the quality of its product? Most students will reply that the producers were able to take advantage of buyers in this situation and thus cut product quality. Buyers quickly learned to protect themselves and only purchased lower priced goods. This led to a market where the only good available for sale is of the lowest quality. Students may discuss the ability of a firm to signal its quality through expensive advertisements or product guarantees and warranties. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Moral Hazard o ConceptClip: Principal Agent Problem o ConceptClip: Behavioral Economics o Video Problem Walk-Through: Analyzing Voting Outcomes Using Pairwise Majority Voting and Borda Count Voting Methods o Video Problem Walk-Through: Analyzing the Independence of Irrelevant Alternatives Using the Borda Count Voting Method o Video Problem Walk-Through: An Application of the Median Voter Theorem

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 427 Chapter Objectives ........................................................................................................................................... 427 Complete List of Chapter Activities and Assessments ......................................................................... 428 Key Terms ........................................................................................................................................................... 429

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income What's New in This Chapter .......................................................................................................................... 429 Chapter Outline ................................................................................................................................................. 429 Solutions to Text Problems ........................................................................................................................... 437 Questions for Review ................................................................................................................................................... 437 Problems and Applications ........................................................................................................................................ 438 Additional Activities and Assignments ..................................................................................................... 441 Additional Resources ...................................................................................................................................... 442 Cengage Video Resources ........................................................................................................................................... 442

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 24 is the first chapter in the macroeconomic section of the text. It is the first of a twochapter sequence that introduces students to two vital statistics that economists use to monitor the macroeconomy—GDP and the consumer price index. Chapter 24 develops how economists measure production and income in the macroeconomy. The following chapter develops how economists measure the level of prices in the macroeconomy. Taken together, Chapter 24 concentrates on the quantity of output in the macroeconomy while Chapter 25 concentrates on the price of output in the macroeconomy. The purpose of this chapter is to provide students with an understanding of the measurement and the use of gross domestic product (GDP). GDP is the single most important measure of the health of the macroeconomy. Indeed, it is the most widely reported statistic in every developed economy. Key points addressed in this chapter:  



Because every transaction has a buyer and a seller, the economy’s total expenditure must equal its income. Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on business capital, residential capital, and inventories. Government purchases include spending on goods and services by local, state, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports). Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value this production. The GDP deflator ―calculated from the ratio of nominal to real GDP―measures the level of prices in the economy. GDP is a good measure of economic well-being because people usually prefer higher incomes to lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Describe the income approach to calculating GDP.



Describe the expenditure approach to calculating GDP.



Calculate GDP, given data on a country's expenditures or income.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income 

Identify which component of GDP is affected in a given scenario.



Compare GDP and GNP for an economy.



Calculate GNP, given data on a country's income.



Explain the difference between real GDP versus nominal GDP.

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Calculate the GDP deflator, given data on a country's real and nominal GDP.



Identify limitations of using GDP as a measure of quality of living in a given scenario.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Active Learning 2 Active Learning 3 Active Learning 4 Think-Pair-Share Activity Self-Assessment Section 24-1 QuickQuiz Section 24-2 QuickQuiz Section 24-3 QuickQuiz Section 24-4 QuickQuiz Section 24-5 QuickQuiz ConceptClip: GDP ConceptClip: GDP Deflator Chapter 24 Problems & Applications Chapter 24 A+ Test Prep Video Quiz: What Is Gross Domestic Product? Video Quiz: Circular Flow: Income and Expenditures Video Quiz: Calculating Nominal GDP and Real GDP Video Quiz: How to Calculate Inflation Using the GDP Deflator Chapter 24 Homework Chapter 24 Quiz: Measuring a Nation’s Income

PPT Slide 7 PPT Slide 19 PPT Slide 28 PPT Slide 38 PPT Slide 47 PPT Slide 48 MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

5–10 mins. 5–10 mins. 5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 25–35 mins. N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

15–25 mins. 20–30 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income [return to top]

KEY TERMS Consumption: spending by households on goods and services, with the exception of purchases of new housing. GDP Deflator: a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. Government Purchases: spending on goods and services by local, state, and federal governments. Gross Domestic Product (GDP): the market value of all final goods and services produced within a country in a given period. Investment: spending on business capital, residential capital, and inventories. Macroeconomics: the study of economy-wide phenomena including inflation, unemployment, and economic growth. Microeconomics: the study of how households and firms make decisions and how they interact in markets. Net Exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports). Nominal GDP: the production of goods and services valued at current prices. Real GDP: the production of goods and services valued at constant prices. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

Data in the tables and figures have been updated.

[return to top]

Instruction Idea: Regardless of whether microeconomics is taught before macroeconomics or vice versa, students need to be reminded of the differences between the two areas of study. Begin by defining the two terms and contrasting and comparing their focus.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income XLI.

XLII.

Review of the Definitions of Microeconomics and Macroeconomics a. Definition of microeconomics: the study of how households and firms make decisions and how they interact in markets. b. Definition of macroeconomics: the study of economy-wide phenomena including inflation, unemployment, and economic growth. The Economy’s Income and Expenditure a. To judge whether an economy is doing well, it is useful to look at Gross Domestic Product (GDP). b. Instruction Idea: Students have heard of GDP and they are often interested in learning more about what it is. The basic point that you must get across is that GDP is a measure of both aggregate production and aggregate income in a nation over a period of one year. You can demonstrate this by using the circular-flow diagram and explaining that production generates income, which provides the purchasing power that generates the demand for the products. i. GDP measures the total income of everyone in the economy. ii. GDP measures total expenditure on an economy’s output of goods and services. c. For an economy as a whole, total income must equal total expenditure. i. If someone pays someone else $100 to mow a lawn, the expenditure on the lawn service ($100) is exactly equal to the income earned from the production of the lawn service ($100). ii. We can also use the circular-flow diagram from Chapter 2 to show why total income and total expenditure must be equal. Figure 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income

XLIII.

1. Households buy goods and services from firms; firms use this money to pay for resources purchased from households. 2. In the simple economy described by this circular-flow diagram, calculating GDP could be done by adding up the total purchases of households or summing total income paid by firms. 3. Note that this simple diagram is somewhat unrealistic as it omits saving, taxes, government purchases, and investment purchases by firms. However, because a transaction always has a buyer and a seller, total expenditure in the economy must be equal to total income. The Measurement of Gross Domestic Product a. Definition of gross domestic product (GDP): the market value of all final goods and services produced within a country in a given period. b. Instruction Idea: To put GDP in terms that students may understand better, explain to them that GDP represents the amount of money one would need to purchase one year’s worth of the economy’s production of all final goods and services. c. Instruction Idea: Have a contest and see which student can come closest in guessing the level of GDP for the United States last year. d. “GDP Is the Market Value . . .” i. To add together different items, market values are used. ii. Market values are calculated by using market prices. e. “. . . Of All . . .” i. GDP includes all items produced and sold legally in the economy. ii. The value of housing services is somewhat difficult to measure. 1. If housing is rented, the value of the rent is used to measure the value of the housing services. 2. For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services. iii. GDP does not include illegal goods or services or items that are not sold in markets. 1. When you hire someone to mow your lawn, that production is included in GDP. 2. If you mow your own lawn, that production is not included in GDP. f. “. . . Final . . .” i. Intermediate goods are not included in GDP. ii. Keep in Mind: Make sure that students realize that investment goods (such as structures and vehicles used in production) are not intermediate goods. Investment goods represent products purchased for final use by business firms. iii. The value of intermediate goods is already included as part of the value of the final good. iv. Goods that are placed into inventory are considered to be “final” and included in GDP as a firm’s inventory investment. 1. Goods that are sold out of inventory are counted as a decrease in inventory investment.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income 2. The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold. g. “. . . Goods and Services . . .” i. GDP includes both tangible goods and intangible services. h. “. . . Produced . . .” i. Only current production is counted. ii. Used goods that are sold do not count as part of GDP. i. “. . . Within a Country . . .” i. GDP measures the production that takes place within the geographical boundaries of a particular country. ii. If a Canadian citizen works temporarily in the United States, the value of her output is included in GDP for the United States. If an American owns a factory in Haiti, the value of the production of that factory is not included in U.S. GDP. iii. Keep in Mind: Students sometimes have trouble understanding that the production of a foreign firm operating in the United States is part of U.S. GDP. Help them make the connection by using the circular-flow diagram. Show them that, even if it is a foreign firm, the firm’s workers are living in the United States and buying clothes, groceries, and other goods in the United States. Thus, the workers in the foreign firm operating in the United States are fueling the domestic economy. j. “. . . in a Given Period.” i. The usual interval of time used to measure GDP is a year or a quarter (three months). ii. When the government reports GDP, the data are generally reported on an annual basis. iii. In addition, data are generally seasonally adjusted to eliminate systematic variations in the data for regular changes (such as Christmas and crop harvest). k. In addition to summing expenditure, the government also calculates GDP by adding up total income in the economy. i. The two ways of calculating GDP generate almost exactly the same answer. ii. The difference between the two calculations of GDP is called the statistical discrepancy. l. FYI: Other Measures of Income i. Gross National Product (GNP) is the total income earned by a nation’s permanent residents. 1. GNP includes income that permanent residents (called nationals) earn abroad. 2. GNP excludes income that foreigners earn in the United States. ii. Net National Product (NNP) is the total income of a nation’s residents (GNP) minus losses from depreciation (wear and tear on an economy’s stock of equipment and structures). iii. National income is the total income earned by a nation’s residents in the production of goods and services. It differs from NNP due to statistical discrepancy from data collection.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income iv.

XLIV.

Personal income is the income that households and noncorporate businesses receive. v. Disposable personal income is the income that households and noncorporate businesses have left after taxes and other obligations to the government. vi. Keep in Mind: It can be a challenge to teach all of these definitions without putting your students to sleep. Concentrate on the measures that will mean the most to students as the semester progresses. The Components of GDP a. GDP (Y) can be divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

b. Instruction Idea: Students will ask why GDP is called “Y.” Remind them that in equilibrium GDP expenditures must be equal to income. The “Y ” stands for income because the letter “I ” is used for investment c. Definition of consumption: spending by households on goods and services, with the exception of purchases of new housing. d. Definition of investment: spending on business capital, residential capital, and inventories. i. GDP accounting uses the word “investment” differently from how we use the term in everyday conversation. ii. When a student hears the word “investment,” they think of financial instruments such as stocks and bonds. iii. In GDP accounting, investment means purchases of goods used to produce other goods in the future such as business capital, residential structures, and inventories. e. Definition of government purchases: spending on goods and services by local, state, and federal governments. i. Salaries of government workers are counted as part of the government purchases component of GDP. ii. Transfer payments are not included as part of the government purchases component of GDP. iii. Instruction Idea: Spend some time in class distinguishing between government purchases and transfer payments. Point out that transfer payments are actually negative taxes representing payments from the government to individuals (with no good or service provided in return) rather than payments from individuals to the government. Define net taxes as the difference between taxes and transfers. f. Definition of net exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports). g. Case Study: The Components of U.S. GDP i. Table 1 shows these four components of GDP for 2021. Table 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income ii.

XLV.

The data for GDP come from the Bureau of Economic Analysis, which is part of the Department of Commerce. iii. Instruction Idea: Make sure that you point out Table 1. Call attention to the importance of consumption and the negative number in the net exports column. Real Versus Nominal GDP a. There are two possible reasons for total spending to rise from one year to the next. i. The economy may be producing a larger output of goods and services. ii. Goods and services could be selling at higher prices. b. When studying GDP over time, economists would like to know if output has changed (not prices). c. Thus, economists measure real GDP by valuing output using a fixed set of prices. d. A Numerical Example i. Instruction Idea: Make sure that you do this example or a similar numerical example in class. If you feel comfortable improvising, let the students pick two goods and then make up an example with them. ii. Two goods are being produced: hot dogs and hamburgers. Table 2

Year 2022 2023 2024 iii.

Price of Hot Dogs $1 $2 $3

Quantity of Hot Dogs 100 150 200

Price of Hamburgers $2 $3 $4

Quantity of Hamburgers 50 100 150

Definition of nominal GDP: the production of goods and services valued at current prices. Nominal GDP for 2022 = ($1 × 100) + ($2 × 50) = $200. Nominal GDP for 2023 = ($2 × 150) + ($3 × 100) = $600. Nominal GDP for 2024 = ($3 × 200) + ($4 × 150) = $1,200.

iv.

Definition of real GDP: the production of goods and services valued at constant prices. Let’s assume that the base year is 2022. Real GDP for 2022 = ($1 × 100) + ($2 × 50) = $200. Real GDP for 2023 = ($1 × 150) + ($2 × 100) = $350. Real GDP for 2024 = ($1 × 200) + ($2 × 150) = $500.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income v.

Instruction Idea: Make sure that it is clear to students how to calculate these numbers so that they can compute nominal GDP and real GDP on their own. e. Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect changes in the amount of goods and services produced. i. Instruction Idea: Emphasize that when there is inflation, nominal GDP can increase while real GDP actually declines. Make sure that students understand that real GDP will be used as a proxy for aggregate production throughout the course. ii. Alternative Classroom Example: The country of ____________ (insert name based on school mascot such as “Pantherville” or “Owlstown”) produces two goods: footballs and basketballs. Below is a table showing prices and quantities of output for three years:

Year Year 1 Year 2 Year 3

Price of Footballs $10 12 14

Quantity of Footballs 120 200 180

Price of Basketballs $12 15 18

Quantity of Basketballs 200 300 275

Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900 Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470 Using Year 1 as the Base Year: Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600 Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100 (Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.) GDP deflator for Year 1 = ($3,600/$3,600) × 100 = 1 × 100 = 100 GDP deflator for Year 2 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21 GDP deflator for Year 3 = ($7,470/$5,100) × 100 = 1.4647 × 100 = 146.47 f.

The GDP Deflator i. Definition of GDP deflator: a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. GDP deflator

ii.

Nominal GDP Real GDP

100

Example Calculations

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income GDP Deflator for 2022= ($200 / $200) × 100 = 100. GDP Deflator for 2023 = ($600 / $350) × 100 = 171. GDP Deflator for 2024 = ($1200 / $500) × 100 = 240. iii.

Instruction Idea: Make sure that you point out that nominal GDP and real GDP will be equal in the base year. This implies that the GDP deflator for the base year will always be equal to 100.

Figure 2 g. Case Study: A Half Century of Real GDP

i. ii. iii.

XLVI.

Figure 2 shows quarterly data on real GDP for the United States since 1970. We can see that real GDP has increased over time. We can also see that there are times when real GDP declines. These periods are called recessions. Is GDP a Good Measure of Economic Well-Being? a. Instruction Idea: Get students involved in a discussion of the merits and problems involved with using GDP as a measure of well-being. Students are often as interested in what is not included in GDP as they are in what is included. Have the students break into small groups and list the things that might be missing if we use GDP as a measure of well-being. Then, have each group report their results and summarize them on the board. b. GDP measures both an economy’s total income and its total expenditure on goods and services. c. GDP per person tells us the income and expenditure level of the average person in the economy. d. GDP, however, may not be a very good measure of the economic well-being of an individual. i. GDP omits important factors in the quality of life including leisure, the quality of the environment, and the value of goods produced but not sold in formal markets. ii. GDP also says nothing about the distribution of income. iii. However, a higher GDP does help us achieve a good life. Nations with larger GDP generally have better education and better health care. e. Case Study: International Differences in GDP and the Quality of Life

Table 3 i.

ii.

Table 3 shows real GDP per person, life expectancy at birth, the average years of schooling among adults, and an index of life satisfaction based on asking people to gauge how they feel about their lives. In rich countries, life expectancy is higher, adults have more years of schooling, and people rate their life satisfaction higher.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income iii.

In poor countries, people typically die about 10 years earlier, have less than half as much schooling, and rate their satisfaction about 2 points lower on the 10-point scale. iv. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. In the News: Sex, Drugs, and GDP i. Countries are reconsidering what goods and services to include in GDP. ii. The inclusion of typically excluded goods and services like illegal drugs and prostitution are considered in this Slate article.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 179. An economy's income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income to sellers. 180. The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value. 181. The contribution to GDP is $3, the market value of the loaf of bread, which is the final good that is purchased by a consumer. 182. The sale of used records does not affect GDP at all because it involves no current production. 183. The four components of GDP are consumption, such as the purchase of a DVD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of American wheat to Russia. (Many other examples are possible.) 184. Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. A rise in nominal GDP can be been caused by increased production, higher prices, or both. 185. Year Nominal Real GDP GDP Deflator GDP 2023 100 X $2 = 100 X $2 = ($200/$200) X 100 = 100 $200 $200 2024 200 X $3 = 200 X $2 = ($600/$400) X 100 = 150 $600 $400 The percentage change in nominal GDP is (600 – 200)/200 x 100 = 200%. The percentage change in real GDP is (400 – 200)/200 x 100 = 100%. The percentage change in the deflator is (150 – 100)/100 x 100 = 50%. 186. It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of well-being. For example,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

PROBLEMS AND APPLICATIONS 11. a. b. c. d. e.

Consumption increases because a refrigerator is a good purchased by a household. Investment increases because a house is an investment good. GDP is not affected because nothing new is produced. Consumption increases because a haircut is a service purchased by a household. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold. f. Investment increases because a car is an investment good to the car rental company. g. Government purchases increase because the government spent money to provide a good to the public. h. GDP is not affected because a Social Security check is a transfer payment, not a government purchase. i. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. j. Investment increases because new structures and equipment were built. 12. Refer to the completed table on the next page with answers in bold.

Year 1970 1980 1990 2000 2010 2020 2030

Real GDP (in 2000 dollars) 3,000 5,000 6,000 8,000 7,500 10,000 20,000

Nominal GDP (in current dollars) 1,200 3,000 6,000 8,000 15,000 30,000 50,000

GDP deflator base year 2000 40 60 100 100 200 300 250

13. With transfer payments, nothing is produced, so there is no contribution to GDP.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income 14. If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once. This double-counting would make GDP a less informative measure of economic well-being because it would overstate the value of production. 15. a. Calculating nominal GDP: 2023: ($1 per qt. of milk x 100 qts. milk) + ($2 per qt. of honey x 50 qts. honey) = $200 2024: ($1 per qt. of milk x 200 qts. milk) + ($2 per qt. of honey x 100 qts. honey) = $400 2025: ($2 per qt. of milk x 200 qts. milk) + ($4 per qt. of honey x 100 qts. honey) = $800 Calculating real GDP (base year 2023): 2023: ($1 per qt. of milk x 100 qts. milk) + ($2 per qt. of honey x 50 qts. honey) = $200 2024: ($1 per qt. of milk x 200 qts. milk) + ($2 per qt. of honey x 100 qts. honey) = $400 2025: ($1 per qt. of milk x 200 qts. milk) + ($2 per qt. of honey x 100 qts. honey) = $400 Calculating the GDP deflator: 2023: ($200/$200) x 100 = 100 2024: ($400/$400) x 100 = 100 2025: ($800/$400) x 100 = 200 b. Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2024 = [($400 – $200)/$200] x 100 = 100%. Percentage change in nominal GDP in 2025 = [($800 – $400)/$400] x 100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2024 = [($400 – $200)/$200] x 100 = 100%. Percentage change in real GDP in 2025 = [($400 – $400)/$400] x 100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2024 = [(100 – 100)/100] x 100 = 0%. Percentage change in the GDP deflator in 2025 = [(200 – 100)/100] x 100 = 100%.

16.

Prices did not change from 2023 to 2024. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2024 to 2025. This means that the percentage change in real GDP is zero. c. Economic well-being rose more in 2024 than in 2025, since real GDP rose in 2024 but not in 2025. In 2024, real GDP rose but prices did not. In 2025, real GDP did not rise but prices did. a. Calculating Nominal GDP: Year 1: (3 bars x $4) = $12 Year 2: (4 bars x $5) = $20

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income Year 3: (5 bars x $6) = $30 b. Calculating Real GDP: Year 1: (3 bars x $4) = $12 Year 2: (4 bars x $4) = $16 Year 3: (5 bars x $4) = $20 c. Calculating the GDP deflator: Year 1: $12/$12 x 100 = 100 Year 2: $20/$16 x 100 = 125 Year 3: $30/$20 x 100 = 150 d. The growth rate of real GDP from Year 2 to Year 3 = (20 – 16)/16 x 100 = 25% e. The inflation rate from Year 2 to Year 3 = (150 – 125)/125 x 100 = 20%. f. To calculate the growth rate of real GDP, we could simply calculate the percentage change in the quantity of bars. To calculate the inflation rate, we could measure the percentage change in the price of bars. 17. Year 2020 2000

Nominal GDP (billions) $21,141 $10,287

GDP Deflator (base year: 2012) 113.6 78.1

a. b. c. d. e. f.

The growth rate of nominal GDP = 100 x [($21,141/$10,287)0.05 – 1] = 3.7% The growth rate of the deflator = 100 x [(113.6/78.1)0.05 – 1] = 1.9% Real GDP in 2000 (in 2012 prices) is $10,287/(78.1/100) = $13,171.57. Real GDP in 2020 (in 2012 prices) is $21,141/(113.6/100) = $18,610.04. The growth rate of real GDP = 100 x [($18,610.04/$13,171.57)0.05 – 1] = 1.7% The growth rate of nominal GDP was higher than the growth rate of real GDP because of inflation. 18. Many answers are possible. 19. a. GDP is the market value of the final good sold, $180. b. Value added by the farmer: $100. Value added by the miller: $150 – $100 = $50. Value added by the baker: $180 – $150 = $30. c. Together, the value added for the three producers is $100 + $50 + $30 = $180. This is the value of GDP. This example suggests that GDP can be calculated as the sum of the value added by all producers. 20. In countries like India, people produce and consume more food at home that is not included in GDP than in the United States. So, GDP per person in India and the United States will differ by more than their comparative economic well-being. 21. a. The increased labor-force participation of women has increased GDP in the United States, because it means more people are working and production has increased. b. If our measure of well-being included time spent working in the home and taking leisure, it would not rise as much as GDP, because the rise in women's labor-force participation has reduced time spent working in the home and taking leisure.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 24: Measuring a Nation’s Income

22.

c. Other aspects of well-being that are associated with the rise in women's increased labor-force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure. a. b. c. d.

GDP equals the dollar amount Barry collects, which is $400. NNP = GDP – depreciation = $400 – $50 = $350. National income = NNP = $350. Personal income = national income – retained earnings – indirect business taxes = $350 – $100 – $30 = $220. e. Disposable personal income = personal income – personal income tax = $220 – $70 = $150.

[In-class demonstration] GDP and Well-Being: 15 minutes total. Works in any class size. Topics include per capita GDP. G. Purpose: This activity examines the usefulness and limits of measures of GDP. Students often have difficulty accepting the use of GDP as a proxy for well-being. Per capita GDP does not directly measure well-being but it is highly correlated with direct measures. Making this correlation explicit helps students understand the emphasis on GDP in macroeconomics. H. Instructions: Ask students the following questions. Discuss each before moving to the next question. 10. If GDP is a good measure of well-being, why is Switzerland’s GDP so much lower than India’s GDP or China’s GDP? 11. What measures would be better to compare the well-being of different countries? 12. How do you expect these direct measures to correlate with per capita GDP? I. Common Answers and Points for Discussion: 1. GDP itself tells very little; Switzerland’s GDP is much lower than that of India or China, yet Swiss citizens have one of the highest standards of living in the world. The difference, of course, is population. Switzerland is a small country, so its GDP is relatively small, despite its wealth. The appropriate comparison is per capita GDP. A more interesting question is “Is per capita GDP a good measure of well-being?” Or worded another way: “What constitutes well-being?” 2. Well-being can be measured directly in a variety of ways. Students often suggest these: a. Health care b. Food c. Education

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living These are certainly better measures than money income, but they can be difficult to collect and interpret. 3. Although per capita GDP is not a direct measure of well-being, it can be used as a proxy for direct measures. The wealthiest countries have per capita incomes over 10 times higher than the poorest. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: GDP o ConceptClip: GDP Deflator o Video Problem Walk-Through: Computing Nominal GDP, Real GDP, and the GDP Deflator for an Economy o Video Problem Walk-Through: Computing the Inflation Rate from Nominal GDP, Real GDP, and the GDP Deflator o Video Problem Walk-Through: Using the Components of GDP to Calculate GDP for an Economy o Equivalency of Fractions, Decimals, and Percentages o Video Quiz: What Is Gross Domestic Product? o Video Quiz: Circular Flow: Income and Expenditures o Video Quiz: Calculating Nominal GDP and Real GDP o Video Quiz: How to Calculate Inflation Using the GDP Deflator

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

444

Complete List of Chapter Activities and Assessments Key Terms

445

446

What's New in This Chapter 446 Chapter Outline

446

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living Solutions to Text Problems 452 Questions for Review ................................................................................................................................................... 452 Problems and Applications ........................................................................................................................................ 452 Additional Activities and Assignments

455

Additional Resources456 Cengage Video Resources ........................................................................................................................................... 456

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 25 is the second chapter of a two-chapter sequence that deals with how economists measure output and prices in the macroeconomy. Chapter 24 addressed how economists measure output. Chapter 25 develops how economists measure the overall price level in the macroeconomy. The purpose of Chapter 25 is twofold: first, to show students how to generate a price index and, second, to teach them how to employ a price index to compare dollar figures from different points in time and to adjust interest rates for inflation. In addition, students will learn some of the shortcomings of using the consumer price index as a measure of the cost of living. Key points addressed in this chapter: 



 

The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the CPI measures the inflation rate. The CPI is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute toward goods that become relatively cheaper over time. Second, it does not allow for increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation. Like the CPI, the GDP deflator measures the overall level of prices in the economy. The two price indexes usually move together, but there are important differences. Unlike the CPI, the GDP deflator reflects the prices of goods and services produced domestically rather than of those bought by consumers. As a result, imported goods affect the CPI but not the GDP deflator. In addition, while the CPI uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. Dollar figures from different times do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index. Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation. Correcting for inflation is especially important when looking at interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate is the rate at which the purchasing power of a savings account increases (or decreases) over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain the welfare effects of inflation in a given scenario.



Calculate the annual inflation rate for a specified year, given CPI data.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living 

Explain the differences between the GDP deflator and the CPI.



Calculate the CPI, given pricing and consumption data on a fixed basket of goods.



Explain why the producer price index is useful in predicting changes in the consumer price index.



Determine how a scenario will cause the CPI to bias the true cost of living.



Compare the value of a dollar in the past to the value of a dollar today.



Describe the relationship between the nominal interest rate, inflation, and the real interest rate.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Active Learning 2 Think-Pair-Share Activity Self-Assessment Section 25-1 QuickQuiz Section 25-2 QuickQuiz ConceptClip: Inflation and the CPI Chapter 25 Problems & Applications Chapter 25 A+ Test Prep Video Quiz: GDP Deflator and the Consumer Price Index Video Quiz: Consumer Price Index: Comparing Dollar Values Over Time Video Quiz: Shortcomings of the Consumer Price Index Chapter 25 Homework Chapter 25 Quiz: Measuring the Cost of Living

PPT Slide 12 PPT Slide 14 PPT Slide 31 PPT Slide 32 MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 25–35 mins. N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

10–15 mins. 20–30 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living

KEY TERMS Consumer Price Index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer. Core CPI: a measure of the overall cost of consumer goods and services excluding food and energy. Indexation: the automatic correction by law or contract of a dollar amount for the effects of inflation. Inflation Rate: the percentage change in the price index from the preceding period. Nominal Interest Rate: the interest rate as usually reported without a correction for the effects of inflation. Producer Price Index (PPI): a measure of the cost of a basket of goods and services sold by domestic firms. Real Interest Rate: the interest rate corrected for the effects of inflation. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

The numbers in the figures and tables have been updated. Some questions and answers in the Problems and Applications reflect the more recent data.

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The Consumer Price Index A. Definition of consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer. B. How the CPI Is Calculated Table 1 1. Fix the basket. a. The Bureau of Labor Statistics uses surveys to determine a representative bundle of goods and services purchased by a typical consumer. b. Example: 4 hot dogs and 2 hamburgers.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living 2. Find the prices. a. Prices for each of the goods and services in the basket must be determined for each time period. b. Example: Year

Price of Hot Dogs

Price of Hamburgers

2022 2023 2024

$1 $2 $3

$2 $3 $4

3. Compute the basket’s cost. a. By keeping the basket the same, only prices are being allowed to change. This allows us to isolate the effects of price changes over time. b. Example: Cost in 2022 = ($1 × 4) + ($2 × 2) = $8. Cost in 2023 = ($2 × 4) + ($3 × 2) = $14. Cost in 2024 = ($3 × 4) + ($4 × 2) = $20. 4. Keep in Mind: It is very important that students understand how to make these calculations. Students often have a difficult time recreating the steps taken in class without the instructor’s help. i. Alternative Classroom Example: 1) Fix the basket: 3 footballs and 4 basketballs. 2) Find the prices: Year Year 1 Year 2 Year 3

Price of Footballs $10 12 14

Price of Basketballs $12 15 18

3) Compute the Cost of the Basket: Cost in Year 1 = (3 × $10) + (4 × $12) = $78 Cost in Year 2 = (3 × $12) + (4 × $15) = $96 Cost in Year 3 = (3 × $14) + (4 × $18) = $114 4) Using Year 1 as the base year, compute the index: CPI in Year 1 = ($78/$78) × 100 = 100 CPI in Year 2 = ($96/$78) × 100 = 123.08 CPI in Year 3 = ($114/$78) × 100 = 146.15 5) Compute the inflation rate: Inflation rate for Year 2 = [(123.08 – 100)/100] × 100 = 23.08% Inflation rate for Year 3 =

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living [(146.15 – 123.08)/123.08] × 100 = 18.74% 5. Instruction Idea: There is a student activity (Create a Student Price Index) that applies to this topic in the "Additional Activities and Assignments” section. 6. Choose a base year and compute the index. a. The base year is the benchmark against which other years are compared. b. The formula for calculating the price index is: Pr ( Pr

)

c. Example (using 2022 as the base year): CPI for 2022 = ($8)/($8) × 100 = 100. CPI for 2023 = ($14)/($8) × 100 = 175. CPI for 2024 = ($20)/($8) × 100 = 250. 7. Instruction Idea: Point out that the CPI must be equal to 100 in the base year. 8. Compute the inflation rate. a. Definition of inflation rate: the percentage change in the price index from the preceding period. b. Instruction Idea: Make sure that you explain that inflation does not mean that the prices of all goods in the economy are rising. Inflation means that prices on average are rising. In fact, the prices of many electronic goods (such as computers and DVD players) have fallen over time. c. The formula used to calculate the inflation rate is:

d. Example: Inflation Rate for 2023 = [(175 – 100)/100] × 100 = 75% Inflation Rate for 2024 = [(250 – 175)/175] × 100 = 43% 9. Instruction Idea: Be sure to point out to students that it is possible for the CPI to fall if deflation is present. Point out to students that, even though they have not experienced deflation in their lifetimes, it has occurred during several periods of U.S. history (especially during the Great Depression). C. Core CPI 1. Definition of core CPI: a measure of the overall cost of consumer goods and services excluding food and energy. 2. Because the prices of food and energy are unstable, the core CPI better reflects ongoing inflation trends. D. The Producer Price Index

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living 1. Definition of producer price index (PPI): a measure of the cost of a basket of goods and services sold by domestic firms. 2. Because firms eventually pass on higher costs to consumers in the form of higher prices on products, the producer price index is believed to be useful in predicting changes in the CPI. E. FYI: What is in the CPI’s Basket? Figure 1 1. Figure 1 shows the makeup of the market basket used to compute the CPI. 2. The largest category is housing, which makes up 42% of a typical consumer’s budget. 3. Instruction Idea: One way to highlight this is to draw the pie chart on the board without the category names and let the students decide what goes where. Most likely, they will be surprised by the sizes of recreation and medical care. F. Problems in Measuring the Cost of Living 1. Substitution Bias a. When the price of one good changes, consumers often respond by substituting another good in its place. b. The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services. c. This implies that the CPI overstates the increase in the cost of living over time. 2. Introduction of New Goods a. When a new good is introduced, consumers have a wider variety of goods and services from which to choose. b. This makes every dollar more valuable, which lowers the cost of maintaining the same level of economic well-being. c. Because the market basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket. 3. Unmeasured Quality Change a. If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises. b. Attempts are made to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure. 4. The size of these problems is also difficult to measure. 5. Many economists believe that the CPI overstates the rate of inflation by between one-half and one percentage point per year. 6. The issue is important because many government transfer programs (such as Social Security) are tied to increases in the CPI. G. The GDP Deflator versus the Consumer Price Index 1. The GDP deflator reflects the prices of all goods produced domestically, while the CPI reflects the prices of all goods bought by consumers. 2. The CPI compares the prices of a fixed basket of goods over time, while the GDP deflator compares the prices of the goods currently produced to the

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living prices of the goods produced in the base year. This means that the group of goods and services used to compute the GDP deflator changes automatically over time as output changes.

II.

3. Figure 2 shows the inflation rate as measured by both the CPI and the GDP deflator. Correcting Economic Variables for the Effects of Inflation A. Dollar Figures from Different Times 1. To change dollar values from one year to the next, we can use this formula: Value in Year 2 dollars

Value in Year 1 dollars

Price level in Year 2 ( ) Price level in Year 1

2. Example: Babe Ruth’s 1931 salary in 2021 dollars: Salary in 2021 dollars = Salary in 1931 dollars × Salary in 2021 dollars = $80,000 × (271/15.2). Salary in 2021 dollars = $1,426,316.

Price level in 2021 Price level in 1931

a. Alternative Classroom Example: Your parent or guardian graduated from school and took their first job in 1982, which paid a salary of $15,000. What is this salary worth in 2021 dollars? CPI in 1982 = 96.5 CPI in 2021 = 271 Value in 2021 dollars = 1982 salary × (CPI in 2021/CPI in 1982) Value in 2021 dollars = $15,000 × (271/96.5) = $42,124 3. FYI: Mr. Index Goes to Hollywood a. Reports of box office success are often made in terms of the dollar values of ticket sales. b. These ticket sales are then compared with ticket sales of movies in the past. c. However, no corrections for changes in the value of a dollar are made. 4. Instruction Idea: There is a student activity (You Paid How Much?) that applies to this topic in the "Additional Activities and Assignments” section. 5. Case Study: Regional Differences in the Cost of Living a. The Bureau of Economic Analysis computes regional price parities, which measure variation in the cost of living from state to state. b. Regional differences in the prices of services, and particularly housing services, can be persistently large because services cannot be moved easily. Figure 3

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living B. Indexation 1. Definition of indexation: the automatic correction by law or contract of a dollar amount for the effects of inflation. 2. As mentioned above, many government transfer programs use indexation for the benefits. The government also indexes the tax brackets used for federal income tax. 3. There are uses of indexation in the private sector as well. Many labor contracts include cost-of-living allowances (COLAs). C. Real and Nominal Interest Rates 1. Instruction Idea: Use an example to make the importance of real interest rates clear. Suppose a student has $100 in their savings account earning 3% interest. Ask students what will happen to the purchasing power of that money if prices rise 3% during the year. Then, change the inflation rate to 5% and then 1% and go through the example again. 2. Example: Sara Saver deposits $1,000 into a bank account that pays an annual interest rate of 10%. A year later, she withdraws $1,100. 3. What matters to Sara is the purchasing power of her money. a. If there is zero inflation, her purchasing power has risen by 10%. b. If there is 6% inflation, her purchasing power has risen by about 4%. c. If there is 10% inflation, her purchasing power has remained the same. d. If there is 12% inflation, her purchasing power has declined by about 2%. e. If there is 2% deflation, her purchasing power has risen by about 12%. 4. Definition of nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation. 5. Definition of real interest rate: the interest rate corrected for the effects of inflation. real interest rate

nominal interest rate

inflation rate

6. Case Study: Interest Rates in the U.S. Economy Figure 4 a. Figure 4 shows real and nominal interest rates from 1965 to the present. b. The nominal interest rate is always greater than the real interest rate in this diagram because there was always inflation during this period. c. Note that in the late 1970s the real interest rate was negative because the inflation rate exceeded the nominal interest rate. During the coronavirus recession of 2020, real rates again turned negative. [return to top]

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 134. A 10% increase in the price of chicken has a greater effect on the CPI than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's market basket. 135. The three problems in the CPI as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change. 136. If the price of imported French wine rises, there is little effect on the CPI, because alcoholic beverages account for only 1 percent of the CPI's basket. But the GDP price index is not affected at all, because imported French wine is not produced domestically so it is not included in GDP. 137. Because the overall price level doubled, but the price of the candy bar rose sixfold, the real price (the price adjusted for inflation) of the candy bar tripled. 138. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation.

PROBLEMS AND APPLICATIONS 1. Answers will vary. Students should multiply $100 by the CPI for the year in which they were born and then divide by 100. 2. a. Find the price of one unit of each good in each year: Year 2023 2024

Cauliflower $2 $3

Broccoli $1.50 $1.50

Carrots $0.10 $0.20

b. If 2023 is the base year, the market basket used to compute the CPI is 100 heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now calculate the cost of the market basket in each year: 2023: (100 × $2) + (50 × $1.50) + (500 × $0.10) = $325 2024: (100 × $3) + (50 × $1.50) + (500 × $0.20) = $475 Then, using 2023 as the base year, we can compute the CPI in each year: 2023: $325/$325 × 100 = 100 2024: $475/$325 × 100 = 146 c. We can use the CPI to compute the inflation rate for 2024:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living (146 – 100)/100 × 100 = 46% 3. a. The percentage change in the price of tennis balls is [($2 – $2)/$2] × 100 = 0%. The percentage change in the price of golf balls is [($6 – $4)/$4] × 100 = 50%. The percentage change in the price of Gatorade is [($2 – $1)/$1] × 100 = 100%. b. The cost of the market basket in 2023 is (100 x $2) + (100 x $4) + (200 x $1) = $800. The cost of the market basket in 2024 is (100 x $2) + (100 x $6) + (200 x $2) = $1,200. Using 2023 as the base year, we can compute the CPI in each year: 2023 = ($800/$800) x 100 = 100 2024 = ($1,200/$800) x 100 = 150 We can use the CPI values to compute the percentage change in the overall price level: [(150-100)/100] x 100 = 50%. c. This would lower my estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before. The comparison should be made on a per-ounce basis. d. More flavors enhance consumers’ well-being. Thus, this would be considered a change in quality and would also lower my estimate of the inflation rate. 4. Answers will vary. 5. a. The cost of the market basket in 2023 is (5 × $40) + (3 × $50) = $350. The cost of the market basket in 2024 is (5 × $60) + (3 × $60) = $480.

Using 2023 as the base year, we can compute the CPI in each year: 2023: ($350/$350) × 100 = 100 2024: ($480/$350) × 100 = 137.14

We can use the CPI to compute the inflation rate for 2024: [(137.14 – 100)/100] × 100 = 37.14%

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living b. Nominal GDP for 2023 = (10 × $40) + (6 × $50) = $400 + $300 = $700. Nominal GDP for 2024 = (12 × $60) + (10 × $60) = $720 + $600 = $1,320. Real GDP for 2023 = (10 × $40) + (6 × $50) = $400 + $300 = $700. Real GDP for 2024 = (12 × $40) + (10 × $50) = $480 + $500 = $980. The GDP deflator for 2023 = ($700/$700) × 100 = 100. The GDP deflator for 2024 = ($1,320/$980) × 100 = 134.69. The rate of inflation for 2024 = [(134.69 – 100)/100] × 100 = 34.69%.

c. No, it is not the same. The rate of inflation calculated by the CPI holds the basket of goods and services constant, while the GDP deflator allows it to change and holds the prices constant. a. b. c. d. e.

introduction of new goods; unmeasured quality change; substitution bias; unmeasured quality change; substitution bias

a. [($1.47 – $0.88)/$0.88] × 100 = 67%. b. [($25.86 – $6.57)/$6.57] × 100 = 294%. c. In 1980: $0.88/($6.57/60) = 8.0 minutes. In 2021: $1.47/($25.86/60) = 3.4 minutes. d. Workers' purchasing power in terms of eggs rose. a. If older people consume the same market basket as other people, Social Security would provide senior citizens with an improvement in their standard of living each year because the CPI overstates inflation and Social Security payments are tied to the CPI. b. Because older people consume more health care than younger people do, and because health care costs have risen faster than overall inflation, it is possible that senior citizens are worse off. To investigate this, you would need to put together a market basket for older people, which would have a higher weight on health care. You would then compare the rise in the cost of the "elderly" basket with that of the general basket for CPI. a. When inflation is higher than was expected, the real interest rate is lower than expected. For example, suppose the market equilibrium has an expected real interest rate of 3% and people expect inflation to be 4%, so the nominal interest rate is 7%. If inflation turns out to be 5%, the real interest rate is 7% minus 5% equals 2%, which is less than the 3% that was expected.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 25: Measuring the Cost of Living b. Because the real interest rate is lower than was expected, the lender loses and the borrower gains. The borrower is repaying the loan with dollars that are worth less than was expected. c. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks that made the mortgage loans were harmed.

XXVII.

[Take-home assignment] Create a Student Price Index. Works in any class size. Topics consumer price index. SS. Purpose: This assignment gives students a practical look at how price indices are measured. It also establishes base prices for calculating inflation rates later in the term. TT. Instructions: The students should pick real transaction prices for goods they actually purchase. If the indices will be used to calculate inflation rate, they should save a copy of this assignment. They should not use prices from catalogs because such prices will not be subject to much change over the semester. UU. Common Answers and Points for Discussion: This assignment makes a good introduction to a discussion of market basket selection for price indices. The goods that students usually pick for their market basket account for a relatively small portion of consumer spending compared to housing, medical care, transportation, etc. Ask the students which goods are likely to change price frequently. This can be used to introduce problems with the measurement of the consumer price index. VV. Assignment: The consumer price index includes the prices of hundreds of goods purchased by consumers. It is possible to construct many other price indexes. Your mission: Create a personalized student price index. a. Choose five (or more) different products. i. Be specific e.g., unleaded gasoline, Pepsi b. Pick a quantity for each product. This will be your market basket. i. e.g., 15 gallons gasoline, 12 pack of Pepsi c. Find the actual price for each product. d. Calculate the total cost of buying these products. At the end of the semester, have students find the prices for these same five products and recalculate the cost of their market basket. Then, have the students calculate their SPI (Student Price Index) and the rate of inflation. [Take-home assignment] You Paid How Much? Works in any class size. Topics include consumer price index.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth A. Purpose: This assignment gives students a chance to see how dollar values have changed over time. It also provides them some practice at using the formula to calculate changes in dollar values over time. B. Instructions: Have students ask their parents (or grandparents) how much they paid for their first car and in what year they bought it. (If there are older students in the class, ask them to remember how much they paid for their first car.) Students can then determine how much they would have to pay in current dollars using the consumer price index. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Inflation and the CPI o Video Problem Walk-Through: Determining the Inflation Rate Using the Consumer Price Index and Comparing the Results with the GDP Deflator o Video Problem Walk-Through: Calculating the Consumer Price Index and the Inflation Rate for an Economy o Video Problem Walk-Through: Comparing Prices Across Time Using the Consumer Price Index o Video Problem Walk-Through: Comparing the Minimum Wage Across Time Using the Consumer Price Index o Equivalency of Fractions, Decimals, and Percentages o Percentage Change o Video Quiz: GDP Deflator and the Consumer Price Index o Video Quiz: Consumer Price Index: Comparing Dollar Values Over Time o Video Quiz: Shortcomings of the Consumer Price Index

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

458

Complete List of Chapter Activities and Assessments

459

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth Key Terms

460

What's New in This Chapter 460 Chapter Outline

460

Solutions to Text Problems 466 Questions for Review ................................................................................................................................................... 466 Problems and Applications ........................................................................................................................................ 467 Additional Resources468 Cengage Video Resources ........................................................................................................................................... 468

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 26 is the first chapter in a four-chapter sequence on the production of output in the long run. Chapter 26 addresses the determinants of the level and growth rate of output. We find that capital and labor are among the primary determinants of output. In Chapter 27, we address how saving and investment in capital goods affect the production of output, and in Chapter 28, we learn about some of the tools people and firms use when choosing capital projects in which to invest. In Chapter 29, we address the market for labor. The purpose of Chapter 26 is to examine the long-run determinants of both the level and the growth rate of real GDP per person. Along the way, we will discover the factors that determine the productivity of workers and address what governments might do to improve the productivity of their citizens. Key points addressed in this chapter: 



Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the world’s richest countries is more than ten times that in the poorest. Because growth rates of real GDP also vary substantially, the relative positions of countries can change dramatically over time. The standard of living depends on an economy’s ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources, and technological knowledge available to workers. Government policies can try to influence the economy’s growth rate in many ways: by encouraging saving and investment, encouraging investment from abroad, fostering education, promoting good health, maintaining property rights and political stability, allowing free trade, and promoting the research and development of new technologies. The accumulation of capital is subject to diminishing returns: The more capital an economy has, the less additional output it gets from an extra unit of capital. Although higher saving and investment leads to higher growth for a while, growth eventually slows down as capital, productivity, and income rise. Also because of diminishing returns, the return to capital is often high in poor countries. Other things equal, these countries can grow faster because of the catch-up effect. Population growth has various effects on economic growth. More rapid population growth may lower productivity by stretching the supply of natural resources and by reducing the amount of capital available for each worker. But a larger population may enhance the rate of technological progress because there are more scientists and engineers.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain how productivity influences economic growth.



Compare the future economic situation of two countries, given past data on income and growth rates.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth 

Identify which productivity determinant a given scenario represents.



Describe the catch-up effect.



Explain how a change in a productivity determinant impacts productivity.



Explain how investments in education and R&D impact growth.



Explain the impact of the enforcement of property rights on growth.



Explain how savings and investment impact growth.



Explain how government structure and stability impact growth rates.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments by objective, so that you can see how all this content relates to objectives and make decisions about which content you would like to emphasize in your class based on your objectives. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Ask the Experts Active Learning 2 Think-Pair-Share Activity Self-Assessment Section 26-1 QuickQuiz Section 26-2 QuickQuiz Section 26-3 QuickQuiz Figure 1: Illustrating the Production Function Chapter 26 Problems & Applications Chapter 26 A+ Test Prep Video Quiz: Productivity Video Quiz: Determinants of LongRun Economic Growth Chapter 26 Homework Chapter 26 Quiz: Production and Growth

Source (i.e., PPT slide, Workbook) PPT Slide 13 PPT Slide 31 PPT Slide 33 PPT Slide 37 PPT Slide 38 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

15–25 mins. N/A 10–15 mins. 10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

10–15 mins. 20–30 mins.

10 mins. 10–15 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth

KEY TERMS Catch-Up Effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. Diminishing Returns: the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. Human Capital: the knowledge and skills that workers acquire through education, training, and experience. Natural Resources: the inputs into production that are provided by nature, such as land, rivers, and mineral deposits. Physical Capital: the stock of equipment and structures used to produce goods and services. Productivity: the quantity of goods and services produced from each unit of labor. Technological Knowledge: society’s understanding of the best ways to produce goods and services. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

The Case Study on “Why Is So Much of Africa Poor?” now includes a discussion of the aftermath of the slave trade. Table 1 is updated.

[return to top]

Economic Growth around the World Table 1 A. Table 1 shows data on real income per person for 13 countries during different periods of time. 1. The data reveal the fact that living standards vary a great deal between these countries.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth

II.

2. Growth rates are also reported in the table. China has had the largest growth rate over time, 2.56% per year (on average). 3. Instruction Idea: Use Table 1 to make the point that a one-percentage point change in a country’s growth rate can make a significant difference over several generations. The powerful effects of compounding should be used to underscore the process of economic growth. 4. Because of different growth rates, the ranking of countries by income per person changes over time. a. In the late 19th century, the United Kingdom was the richest country in the world. b. Today, income per person is lower in the United Kingdom than in the United States. B. FYI: Are You Richer Than the Richest American? 1. According to the magazine American Heritage, the richest American of all time is John B. Rockefeller, whose wealth today would be the equivalent of approximately $250 billion, roughly equal to the wealth of Elon Musk. 2. Yet, because Rockefeller lived from 1839 to 1937, he did not get the chance to enjoy many of the conveniences we take for granted today such as television, air conditioning, and modern medicine. 3. Thus, because of technological advances, the average American today may enjoy a “richer” life than the richest American who lived a century ago. Productivity: Its Role and Determinants A. Why Productivity Is So Important 1. Example: Robinson Crusoe a. Because he is stranded alone, he must catch his own fish, grow his own vegetables, and make his own clothes. b. His standard of living depends on his ability to produce goods and services. 2. Definition of productivity: the quantity of goods and services produced from each unit of labor. 3. Review of Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services. B. How Productivity Is Determined 1. Physical Capital per Worker a. Definition of physical capital: the stock of equipment and structures used to produce goods and services. b. Example: Crusoe will catch more fish if he has more fishing poles. 2. Human Capital per Worker a. Definition of human capital: the knowledge and skills that workers acquire through education, training, and experience. b. Example: Crusoe will catch more fish if he has been trained in the best fishing techniques or as he gains experience fishing. 3. Natural Resources per Worker a. Definition of natural resources: the inputs into production that are provided by nature, such as land, rivers, and mineral deposits.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth b. Example: Crusoe will have better luck catching fish if there is a plentiful supply around his island. 4. Technological Knowledge a. Definition of technological knowledge: society’s understanding of the best ways to produce goods and services. b. Example: Crusoe will catch more fish if he has invented a better fishing lure. C. FYI: The Production Function 1. A production function describes the relationship between the quantity of inputs used in production and the quantity of output from production. 2. The production function generally is written like this:

where Y = output, L = quantity of labor, K = quantity of physical capital, H = quantity of human capital, N = quantity of natural resources, A reflects the available production technology, and F () is a function that shows how inputs are combined to produce output. 3. Many production functions have a property called constant returns to scale. a. This property implies that as all inputs are doubled, output will exactly double. b. This implies that the following must be true:

where x = 2 if inputs are doubled. c. This also means that if we want to examine output per worker we could set x = 1/L and we would get the following:

III.

This shows that output per worker depends on technology, the amount of physical capital per worker (K/L), the amount of human capital per worker (H/L), and the amount of natural resources per worker (N/L). 4. Case Study: Are Natural Resources a Limit to Growth? a. This section points out that as the population has grown over time, we have discovered ways to lower our use of natural resources. Thus, most economists are not worried about shortages of natural resources. Economic Growth and Public Policy A. Instruction Idea: Start out by asking students what factors they believe will lead to greater economic growth in the future. B. Saving and Investment 1. Because capital is a produced factor of production, a society can change the amount of capital that it has.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth 2. However, there is an opportunity cost of doing so; if resources are used to produce capital goods, fewer goods and services are produced for current consumption. C. Diminishing Returns and the Catch-Up Effect 1. Definition of diminishing returns: the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. Figure 1 a. As the capital stock rises, the extra output produced from an additional unit of capital will fall. This is known as the diminishing marginal product of capital. b. This can be seen in Figure 1, which shows how the amount of capital per worker determines the amount of output per worker, holding constant all other determinants of output. c. Thus, if workers already have a large amount of capital to work with, giving them an additional unit of capital will not increase their productivity by much. d. In the long run, a higher saving rate leads to a higher level of productivity and income, but not to permanently higher growth rates in these variables. 2. An important implication of diminishing returns is the catch-up effect. a. Definition of catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. b. When workers have very little capital to begin with, an additional unit of capital will increase their productivity a great deal. D. Investment from Abroad 1. Saving by domestic residents is not the only way for a country to invest in new capital. 2. Investment in the country by foreigners can also occur. a. Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity. b. Foreign portfolio investment occurs when a capital investment is financed with foreign money but operated by domestic residents. 3. Some of the benefits of foreign investment flow back to foreign owners. But the economy still experiences an increase in the capital stock, which leads to higher productivity and higher wages. 4. The World Bank is an organization that tries to encourage the flow of investment to less developed countries. a. The World Bank obtains funds from developed countries such as the United States and makes loans to less developed countries so that they can invest in roads, sewer systems, schools, and other types of capital. b. The World Bank also offers these countries advice on how best to use these funds.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth E. Education 1. Investment in human capital also has an opportunity cost. a. When students are in class, they cannot produce goods and services for consumption. b. In less developed countries, this opportunity cost is considered to be high; as a result, children often drop out of school at a young age. 2. Because there are positive externalities in education, the effect of lower education on the economic growth rate of a country can be large. 3. Many poor countries also face a “brain drain”—the best educated often leave to go to other countries where they can enjoy a higher standard of living. F. Health and Nutrition 1. Human capital can also be used to describe another type of investment in people: expenditures that lead to a healthier population. 2. Other things being equal, healthier workers are more productive. 3. Making the right investments in the health of the population is one way for a nation to increase productivity. G. Property Rights and Political Stability 1. Protection of property rights and promotion of political stability are two other important ways that policymakers can improve economic growth. 2. There is little incentive to produce products if there is no guarantee that they cannot be taken. Contracts must also be enforced. 3. Countries with questionable enforcement of property rights or an unstable political climate will also have difficulty in attracting foreign (or even domestic) investment. H. Free Trade 1. Some countries have tried to achieve faster economic growth by avoiding transacting with the rest of the world, often to protect infant industry. 2. However, trade allows a country to specialize in what it does best and thus consume beyond its production possibilities. 3. When a country trades wheat for steel, it is as well off as it would be if it had developed a new technology for turning wheat into steel. 4. The amount a nation trades is determined not only by government policy but also by geography. Countries with good, natural seaports find trade easier than countries without this resource. I. Research and Development 1. The primary reason why living standards have improved over time has been due to large increases in technological knowledge. 2. Knowledge can be considered a public good. 3. The U.S. government promotes the creation of new technological information by providing research grants and providing tax incentives for firms engaged in research. 4. The patent system also encourages research by granting an inventor the exclusive right to produce the product for a specified number of years. 5. Ask the Experts: Innovation and Growth

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth a. When asked whether future innovations worldwide would not be transformational enough to promote sustained per capita economic growth rates in the US and western Europe in the future as in the past, 59 percent of economic experts were uncertain, while 7 percent agreed and 34 percent disagreed. J. Population Growth 1. Stretching Natural Resources a. Thomas Malthus (an English minister and early economic thinker) argued that an ever-increasing population meant that the world was doomed to live in poverty forever. b. However, he failed to understand that new ideas would be developed to increase the production of food and other goods, including pesticides, fertilizers, mechanized equipment, and new crop varieties. 2. Diluting the Capital Stock a. High population growth reduces GDP per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly. b. Countries with a high population growth have large numbers of school-age children, placing a burden on the education system. c. Some countries have already instituted measures to reduce population growth rates. d. Policies that foster equal treatment for women should raise economic opportunities for women leading to lower rates of population. 3. Promoting Technological Progress a. Some economists have suggested that population growth has driven technological progress and economic prosperity. b. In a 1993 journal article, economist Michael Kremer provided evidence that increases in population lead to technological progress. 4. Case Study: “Why Is So Much of Africa Poor?” a. People in sub-Saharan Africa produce GDP per person that is just 22% of the world average. b. Factors that contribute to Africa’s poverty are low capital investment, low educational attainment, poor health, high population growth, geographic disadvantages, restricted freedom, corruption, a legacy of colonization, and the aftermath of the slave trade. 5. Instruction Idea: Start a class discussion of the trade-offs that are necessary to sustain economic growth. Point out that current consumption must be forgone for higher consumption in the future. Ask students to examine the trade-offs involved with each of the public policies discussed. K. In the News: The Secret Sauce of American Prosperity 1. Martin Feldstein argues that the U.S. produces more per person than other advanced economies in Europe for a number of reasons.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth 2. Schumpeter would argue that the lower production in Europe is due to the growth of the welfare state. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 139. The level of a nation’s GDP measures both the total income earned in the economy and the total expenditure on the economy’s output of goods and services. The level of real GDP is a good gauge of economic prosperity, and the growth rate of real GDP is a good gauge of economic progress. You would rather live in a nation with a high level of GDP, even though it had a low growth rate, than in a nation with a low level of GDP and a high growth rate, because the level of GDP is a measure of prosperity. 140. The four determinants of productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) human capital, which consists of the knowledge and skills that workers acquire through education, training, and experience; (3) natural resources, which are inputs into production that are provided by nature; and (4) technological knowledge, which is society’s understanding of the best ways to produce goods and services. 141. A college degree is a form of human capital. The skills learned in earning a college degree increase a worker's productivity. 142. Higher saving means fewer resources are devoted to consumption and more to producing capital goods. The rise in the capital stock leads to rising productivity and more rapid growth in GDP for a while. In the long run, the higher saving rate leads to a higher standard of living. A policymaker might be deterred from trying to raise the rate of saving because doing so requires that people reduce their consumption today and it can take a long time to get to a higher standard of living. 143. A higher rate of saving leads to a higher growth rate temporarily, not permanently. In the short run, increased saving leads to a larger capital stock and faster growth. But as growth continues, diminishing returns to capital mean growth slows down and eventually settles down to its initial rate, though this may take several decades. 144. Removing a trade restriction, such as a tariff, would lead to more rapid economic growth because the removal of the trade restriction acts like an improvement in technology. Free trade allows all countries to consume more goods and services. 145. Population growth may have both negative and positive effects. The higher the rate of population growth, the lower is the level of GDP per person because there's less capital per person, hence lower productivity. However, higher population growth tends to promote technological innovations, which would increase GDP per person. 146. The U.S. government tries to encourage advances in technological knowledge by providing research grants through the National Science Foundation and the National Institute of Health, with tax breaks for firms engaging in research and development, and through the patent system.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 26: Production and Growth

PROBLEMS AND APPLICATIONS 187. The facts that countries import many goods and services yet must produce a large quantity of goods and services themselves to enjoy a high standard of living are reconciled by noting that there are substantial gains from trade. To be able to afford to purchase goods from other countries, an economy must generate income. By producing many goods and services, then trading them for goods and services produced in other countries, a nation maximizes its standard of living. 188. a. More investment would lead to faster economic growth in the short run. b. The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption-good industries would get lower incomes, and workers and owners in investment-good industries would get higher incomes. In addition, some group would have to reduce their spending for some time so that investment could rise. 189. a. Private consumption spending includes buying food and buying clothes; private investment spending includes people buying houses and firms buying computers. Many other examples are possible. Education can be considered as both consumption and investment. b. Government consumption spending includes paying workers to administer government programs; government investment spending includes buying military equipment and building roads. Many other examples are possible. 190. The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources toward investment. Over-investment in capital is possible because of diminishing marginal returns. A country can over-invest in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could over-invest in human capital if people were too highly educated for the jobs they could getfor example, if the best job a Ph.D. in philosophy could find is managing a restaurant. 191. a. The United States benefited from the Chinese and Japanese investment because it made our capital stock larger, increasing our economic growth. b. It would have been better for Americans to make the investments because then they would have received all of the returns on the investments, instead of the returns going to China and Japan. 192. Greater educational opportunities for women could lead to faster economic growth in these developing countries because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child. 193. Answers will vary. For example, countries with high scores include (2014 GDP per capita in parenthesis) Finland ($35,900), New Zealand ($30,400), Luxembourg ($77,900), and Norway ($55,400) and countries with low scores include Venezuela ($13,600), Haiti ($1,300), Myanmar ($1,700), and Bangladesh ($2,100). The pattern is clear. Countries with high Property Right Index scores have high GDP per capita and countries with low Property Right Index scores have low GDP per capita. Property rights allow people to exercise authority over the resources they own. With well-defined and enforced property rights,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System markets coordinate efficiently with prices. Also, domestic saving and investment from abroad are lower with poorly-defined or enforced property rights. 194. a. Individuals with higher incomes have better access to clean water, medical care, and good nutrition. b. Healthier individuals are likely to be more productive. c. Understanding the direction of causation will help policymakers place proper emphasis on the programs that will achieve both greater health and higher incomes. 195. Peace would promote economic growth because it is an indication that property rights will be respected in the future. Armed conflict and the threat of a revolutionary government reduce domestic residents' incentive to save, invest, and start new businesses. Moreover, foreigners have less incentive to invest in the country. Easy taxes would promote economic growth because they result in citizens and businesses retaining a greater share of the income they earn and, thus, being able to save and invest a greater portion of that income. A tolerable administration of justice would promote economic growth because it would ensure the maintenance of property rights, which encourages domestic saving and investment from abroad. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Video Problem Walk-Through: Real GDP per Person, the Growth Rate, and the Catch-Up Effect o Video Problem Walk-Through: Identifying the Determinants of Productivity o Graphing Basics o Slope of a Curve o Video Quiz: Productivity o Video Quiz: Determinants of Long-Run Economic Growth

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 470

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System Chapter Objectives ........................................................................................................................................... 470 Complete List of Chapter Activities and Assessments ......................................................................... 471 Key Terms ........................................................................................................................................................... 472 What's New in This Chapter .......................................................................................................................... 473 Chapter Outline ................................................................................................................................................. 473 Solutions to Text Problems ........................................................................................................................... 480 Questions for Review ................................................................................................................................................... 481 Problems and Applications ........................................................................................................................................ 481 Additional Activities and Assignments ..................................................................................................... 485 Additional Resources ...................................................................................................................................... 486 Cengage Video Resources ........................................................................................................................................... 486

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 27 is the second chapter in a four-chapter sequence on the production of output in the long run. In Chapter 26, we found that capital and labor are among the primary determinants of output. For this reason, Chapter 27 addresses the market for saving and investment in capital, and Chapter 28 addresses the tools people and firms use when choosing capital projects in which to invest. Chapter 29 will address the market for labor. The purpose of Chapter 27 is to show how saving and investment are coordinated by the loanable funds market. Within the framework of the loanable funds market, we are able to see the effects of taxes and government deficits on saving, investment, the accumulation of capital, and ultimately, the growth rate of output. Key points addressed in this chapter: 



The U.S. financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks, and mutual funds. They all act to direct the resources of households that want to save some of their income into the hands of households and firms who want to borrow. National income accounting identities reveal important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy matches one person’s saving with another person’s investment. The interest rate is determined by the supply and demand for loanable funds. The supply comes from households who want to save some of their income and lend it out. The demand comes from households and firms who want to borrow for investment. To analyze how any policy or event affects the interest rate, consider how it affects the supply and demand for loanable funds. National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Categorize an event as either saving or investment.



Explain how financial intermediaries connect borrowers and savers.



Analyze the relationship between bond prices and the interest rate.



Explain how financial markets connect borrowers and savers.



Explain the difference between the bond market and the stock market.



Explain how government borrowing can lead to crowding out.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System 

Analyze how changes in demand impact equilibrium in the market for loanable funds.



Describe the loanable funds market.



Explain the relationship between national saving, public saving, and private saving.



Analyze how changes in the government budget impact equilibrium in the market for loanable funds.



Explain the saving and investment identity.

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Analyze how changes in supply impact equilibrium in the market for loanable funds.

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Analyze the relationship between interest rates and quantity demanded.



Analyze the relationship between interest rates and quantity supplied.



Identify market equilibrium in the loanable funds market.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning Ask the Experts Think-Pair-Share Activity Self-Assessment Section 27-1 QuickQuiz Section 27-2 QuickQuiz Section 27-3 QuickQuiz ConceptClip: Stocks and Bonds ConceptClip: Mutual Funds ConceptClip: Budget Deficits and Surplus ConceptClip: Loanable Funds Market ConceptClip: Crowding Out ConceptClip: Loanable Funds Equilibrium Figure 2: Saving Incentives Increase the Supply of Loanable Funds Figure 3: Investment Incentives Increase the Demand for Loanable Funds Figure 5: The Effect of a Government

Source (i.e., PPT slide, Workbook) PPT Slide 25 PPT Slide 36 PPT Slide 49 PPT Slide 50 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

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MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

5–10 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System Budget Deficit Chapter 27 Problems & Applications Chapter 27 A+ Test Prep Video Quiz: Financial Markets Video Quiz: The Market for Loanable Funds Video Quiz: The Effects of Budget Deficits and Surpluses on the Market for Loanable Funds Chapter 27 News Analysis: Financial Freeze Brings Below-Zero-T-Bill Yields Chapter 27 Homework Chapter 27 Quiz: Saving, Investment, and the Financial System

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. N/A 10–15 mins. 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

15–25 mins. 20–30 mins.

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KEY TERMS Bond: a certificate of indebtedness. Budget Deficit: a shortfall of tax revenue from government spending. Budget Surplus: an excess of tax revenue over government spending. Crowding Out: a decrease in investment that results from government borrowing. Financial Intermediaries: financial institutions through which savers can indirectly provide funds to borrowers. Financial Markets: financial institutions through which savers can directly provide funds to borrowers. Financial System: the group of institutions in the economy that help to match one person’s saving with another person’s investment. Market for Loanable Funds: the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Mutual Fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds. National Saving (Saving): the total income in the economy that remains after paying for consumption and government purchases. Private Saving: the income that households have left after paying for taxes and consumption. Public Saving: the tax revenue that the government has left after paying for its spending. Stock: a claim to partial ownership in a firm.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new Case Study: The Decline in Real Interest Rates from 1984 to 2020. The Case Study: The History of U.S. Government Debt, has been updated.

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Definition of financial system: the group of institutions in the economy that help to match one person’s saving with another person’s investment. Financial Institutions in the U.S. Economy a. Financial Markets i. Definition of financial markets: financial institutions through which savers can directly provide funds to borrowers. ii. The Bond Market 1. Definition of bond: a certificate of indebtedness. 2. A bond identifies the date of maturity and the rate of interest that will be paid periodically until the loan matures. 3. One important characteristic that determines a bond’s value is its term. The term is the length of time until the bond matures. All else being equal, long-term bonds pay higher rates of interest than shortterm bonds. 4. Another important characteristic of a bond is its credit risk, which is the probability that the borrower will fail to pay some of the interest or principal. All else being equal, the more risky a bond is, the higher its interest rate. Very risky bonds are known as junk bonds. 5. A third important characteristic of a bond is its tax treatment. For example, when state and local governments issue bonds (called municipal bonds), the interest income earned by the holders of these bonds is not taxed by the federal government. This makes the bonds more attractive, lowering the interest rate needed to entice people to buy them. 6. A fourth characteristic of a bond is whether it offers inflation protection. Some bonds (TIPS bonds from the U.S. government) index payments of interest and principal so the payments rise as the price level rises. iii. The Stock Market

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XLIX.

1. Definition of stock: a claim to partial ownership in a firm. 2. The sale of stock to raise money is called equity finance; the sale of bonds to raise money is called debt finance. 3. Stocks are sold on organized stock exchanges (such as the New York Stock Exchange or NASDAQ) and the prices of stocks are determined by supply and demand. 4. The price of a stock generally reflects the perception of a company’s future profitability. 5. A stock index is computed as an average of a group of stock prices. b. Financial Intermediaries i. Definition of financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers. ii. Banks 1. The primary role of banks is to take in deposits from people who want to save and then lend them out to others who want to borrow. 2. Banks pay depositors interest on their deposits and charge borrowers a slightly higher rate of interest to cover the costs of running the bank and provide the bank owners with some amount of profit. 3. Banks also play another important role in the economy by allowing individuals to use checking deposits, which can be accessed by the depositor in a number of ways, as a medium of exchange. iii. Mutual Funds 1. Definition of mutual fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds. 2. The primary advantage of a mutual fund is that it allows individuals with small amounts of money to diversify. They also provide access to professional money managers. 3. Mutual funds called “index funds” buy all of the stocks of a given stock index. These funds have generally performed better than funds with active fund managers. This may be true because they trade stocks less frequently and they do not have to pay the salaries of fund managers. iv. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. c. Summing Up i. There are many financial institutions in the U.S. economy. ii. These institutions all serve the same goal—moving funds from savers to borrowers. Saving and Investment in the National Income Accounts a. Keep in Mind: Make sure that you work through all of the algebraic steps here. Students will not understand this material if you skip steps. b. Some Important Identities i. Remember that GDP can be divided up into four components: consumption, investment, government purchases, and net exports.

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ii.

We will assume that we are dealing with a closed economy (an economy that does not engage in international trade or international borrowing and lending). This implies that GDP can now be divided into only three components:

iii.

To isolate investment, we can subtract C and G from both sides:

iv.

vi.

The left-hand side of this equation (Y – C – G) is the total income in the economy after paying for consumption and government purchases. This amount is called national saving. Definition of national saving (saving): the total income in the economy that remains after paying for consumption and government purchases. Substituting saving (S) into our identity gives us:

vii. viii.

This equation tells us that saving equals investment. Let’s go back to our definition of national saving once again:

ix.

We can add taxes (T) and subtract taxes (T):

The first part of this equation (Y – T – C) is called private saving; the second part (T – G) is called public saving. 1. Definition of private saving: the income that households have left after paying for taxes and consumption. 2. Definition of public saving: the tax revenue that the government has left after paying for its spending. 3. Definition of budget surplus: an excess of tax revenue over government spending. 4. Definition of budget deficit: a shortfall of tax revenue from government spending. 5. Instruction Idea: The important point to make here is that with a government budget deficit, public saving is negative and the public sector is thus “dissaving.” To make up for this shortfall, it must go to the loanable funds market and borrow the money. This will reduce the supply of loanable funds available for investment. The fact that S = I means that (for the economy as a whole) saving must be equal to investment.

xi.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System

1. The bond market, the stock market, banks, mutual funds, and other financial markets and institutions stand between the two sides of the S = I equation. 2. These markets and institutions take in the nation's saving and direct it to the nation's investment. c. The Meaning of Saving and Investment i. In macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings. ii. Keep in Mind: You will have to keep reminding students what the term “investment” means to economists. Outside of the economics profession, most people use the terms “saving” and “investing” interchangeably. iii. If an individual spends less than they earn and use the rest to buy stocks or mutual funds, economists call this saving. The Market for Loanable Funds a. Definition of market for loanable funds: the market in which those who want to save supply funds and those who want to borrow to invest demand funds. b. Supply and Demand for Loanable Funds i. The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary. ii. The demand for loanable funds comes from households and firms who wish to borrow funds to make investments. Families generally invest in new homes while firms may borrow to purchase new equipment or to build factories. iii. The price of a loan is the interest rate. Figure 1

iv.

1. All else equal, as the interest rate rises, the quantity of loanable funds supplied will increase. 2. All else equal, as the interest rate rises, the quantity of loanable funds demanded will fall. Instruction Idea: Students will wonder which interest rate is the price of a loan. Explain to them that interest rates in the economy do vary because of the things discussed earlier (term, risk, and tax treatment), but that

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System these interest rates tend to move together when changes in the loanable funds market occur. Thus, it is appropriate to talk of one interest rate. In addition, the loanable funds market determines the real interest rate. v. Instruction Idea: Make sure that you spend time discussing why the demand for loanable funds is downward sloping and why the supply of loanable funds is upward sloping. It is important for students to understand the relationships among the interest rate, saving, and investment. vi. At equilibrium, the quantity of funds demanded is equal to the quantity of funds supplied. 1. If the interest rate in the market is greater than the equilibrium rate, the quantity of funds demanded would be smaller than the quantity of funds supplied. Lenders would compete for borrowers, driving the interest rate down. 2. If the interest rate in the market is less than the equilibrium rate, the quantity of funds demanded would be greater than the quantity of funds supplied. The shortage of loanable funds would encourage lenders to raise the interest rate they charge. vii. Instruction Idea: It is a good idea to remind students that the supply of loanable funds comes from saving and the demand for loanable funds comes from investment by putting “(saving)” next to the supply curve and “(investment)” next to the demand curve as shown above. viii. The supply and demand for loanable funds depends on the real (rather than nominal) interest rate because the real rate reflects the true return to saving and the true cost of borrowing. c. Instruction Idea: When examining the next three sections on different policies, encourage students to follow the three-step process developed in Chapter 4. First, determine which curve is affected. Then, decide which way it shifts to determine the effects on the equilibrium interest rate and quantity of funds. d. Policy 1: Saving Incentives i. Many economists and policymakers have advocated increases in how much people save. Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System

ii.

Suppose that the government changes the tax code to encourage greater saving. 1. This will cause an increase in saving, shifting the supply of loanable funds to the right. 2. The equilibrium interest rate will fall and the equilibrium quantity of funds will rise. iii. Thus, the result of the new tax laws would be a decrease in the equilibrium interest rate and greater saving and investment. e. Instruction Idea: If you would like, now would be a good time to discuss the debate in Chapter 37 concerning whether the tax laws should be reformed to encourage saving. f. Policy 2: Investment Incentives Figure 3

Suppose instead that the government passed a new law lowering taxes for any firm building a new factory or buying a new piece of equipment (through the use of an investment tax credit).

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System 1. This will cause an increase in investment, causing the demand for loanable funds to shift to the right. 2. The equilibrium interest rate will rise, and the equilibrium quantity of funds will increase as well. ii. Thus, the result of the new tax laws would be an increase in the equilibrium interest rate and greater saving and investment. iii. Instruction Idea: Point out that both Policy 1 (a law to increase saving) and Policy 2 (a law to increase investment) each lead to an increase in both saving and investment. The difference between these two policies lies in their effects on the interest rate. g. Case Study: The Decline in Real Interest Rates from 1984 to 2020. i. Real interest rates have fallen from 1984 to 2020 due to an increase in the supply of loanable funds and a decrease in the demand for loanable funds. This can be seen in Figure 4. Figure 4 ii.

The lower real rate has benefited those who borrow (young home buyers) and harmed those who save (older people saving for retirement). h. Policy 3: Government Budget Deficits and Surpluses i. A budget deficit occurs if the government spends more than it receives in tax revenue. ii. This implies that public saving (T – G) falls, which will lower national saving. Figure 5

iii. iv.

1. The supply of loanable funds will shift to the left. 2. The equilibrium interest rate will rise, and the equilibrium quantity of funds will decrease. When the interest rate rises, the quantity of funds demanded for investment purposes falls. Definition of crowding out: a decrease in investment that results from government borrowing.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System v. vi.

vii.

viii.

ix.

When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. A budget deficit resulting from a tax cut has similar effects. A tax cut reduces public saving. Private saving rises by less than public saving declines. Once again, the budget deficit reduces the supply of loanable funds. Government budget surpluses work in the opposite way. The supply of loanable funds increases, the equilibrium interest rate falls, and investment rises. Instruction Idea: Now might be a good time to move to the section in Chapter 37 concerning the debate on whether or not the government should balance its budget. Ask the Experts: Fiscal Policy and Saving 1. 79 percent of economic experts agree that continuing to use tax and spending policies that increase consumption but decrease the saving rate are likely to lead to lower long-run living standards, while the remaining 21 percent are uncertain. Case Study: The History of U.S. Government Debt

Figure 6 1. Figure 6 shows the debt of the U.S. government expressed as a percentage of GDP. 2. Throughout history, the primary cause of fluctuations in government debt has been wars and deep economic downturns. 3. A very large increase in the debt-to-GDP ratio started occurring in 2008 because of the financial crisis and the deep economic contraction. It rose again in 2020 due to the Covid recession. 4. Due to the increase in government spending as baby boomers retire, the debt-to-GDP ratio is projected to rise substantially. i. FYI: Financial Crises i. What are the key elements of a financial crisis? 1. A large decline in asset prices. 2. Insolvencies at some financial institutions. 3. A decline in confidence in financial institutions. 4. A credit crunch. 5. An economic downturn. 6. A vicious circle. ii. Financial crises do have serious consequences but eventually end. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System

QUESTIONS FOR REVIEW 147. The financial system's role is to help match one person's saving with another person's investment. Two markets that are part of the financial system are the bond market, through which large corporations, the federal government, or state and local governments borrow, and the stock market, through which corporations sell ownership shares. Two financial intermediaries are banks, which take in deposits and use the deposits to make loans, and mutual funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets. 148. It is important for people who own stocks and bonds to diversify their holdings because then they will have only a small stake in each asset, which reduces risk. Mutual funds make such diversification easy by allowing a small investor to purchase parts of hundreds of different stocks and bonds. 149. National saving is the amount of a nation's income that is not spent on consumption or government purchases. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. The three variables are related because national saving equals private saving plus public saving. 150. Investment refers to the purchase of new capital, such as equipment or buildings. It is equal to national saving in a closed economy. 151. A change in the tax code that might increase private saving is the expansion of eligibility for special accounts that allow people to shelter some of their saving from taxation. This would increase the supply of loanable funds, lower interest rates, and increase investment. 152. A government budget deficit arises when the government spends more than it receives in tax revenue. Because a government budget deficit reduces national saving, it raises interest rates, reduces private investment, and thus reduces economic growth.

PROBLEMS AND APPLICATIONS 196. a. The bond of an eastern European government would pay a higher interest rate than the bond of the U.S. government because there would be a greater risk of default. b. A bond that repays the principal in 2050 would pay a higher interest rate than a bond that repays the principal in 2030 because it has a longer term to maturity, so there is more risk to the principal. c. A bond from a software company you run in your garage would pay a higher interest rate than a bond from Coca-Cola because your software company has more credit risk. d. A bond issued by the federal government would pay a higher interest rate than a bond issued by New York State because an investor does not have to pay federal income tax on the bond from New York State. 197. Companies encourage their employees to hold stock in the company because it gives the employees the incentive to care about the firm’s profits, not just their own salaries. Then, if employees see waste or see areas in which the firm can improve, they will take actions that benefit the company because they know the value of their stock will rise as a result. It also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System But from an employee’s point of view, owning stock in the company for which they work can be risky. The employee’s wages or salary is already tied to how well the firm performs. If the firm has trouble, the employee could be laid off or have their salary reduced. If the employee owns stock in the firm, then there is a double whammythe employee is unemployed or gets a lower salary and the value of the stock falls as well. So owning stock in your own company is a risky proposition. Most employees would be better off diversifyingowning stock or bonds in other companiesso their fortunes would not depend so much on the firm for which they work. 198. To a macroeconomist, saving occurs when a person’s income exceeds their consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment. a. When your family takes out a mortgage and buys a new house, that is investment because it is a purchase of new capital. b. When you use your $200 paycheck to buy stock in AT&T, that is saving because your income of $200 is not being spent on consumption goods. c. When your roommate earns $100 and deposits it in their account at a bank, that is saving because the money is not spent on consumption goods. d. When you borrow $1,000 from a bank to buy a car to use in your pizza-delivery business, that is investment because the car is a capital good. 199. Given that Y = 8, T = 1.5, Sprivate = 0.5 = Y –T – C, Spublic = 0.2 = T – G. Because Sprivate = Y – T – C, then rearranging gives C = Y – T – Sprivate = 8 – 1.5 – 0.5 = 6. Because Spublic = T – G, then rearranging gives G = T – Spublic = 1.5 – 0.2 = 1.3. Because S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7. Finally, because I = investment = S, I = 0.7. 200.

Private saving is equal to (Y – T – C) = 10,000 – 1,500 - 6,000 = 2,500.

Public saving is equal to (T – G) = 1,500 – 1,700 = -200. National saving is equal to (Y – C – G) = 10,000 – 6,000 – 1,700 = 2,300. Investment is equal to saving = 2,300. The equilibrium interest rate is found by setting investment equal to 2,300 and solving for r: 3,300 – 100r = 2,300. 100r = 1,000. r = 10%. 201. a. If interest rates increase, the costs of borrowing money to build the factory become higher, so the returns from building the new plant may not be sufficient to cover the costs. Thus, higher interest rates make it less likely that Intel will build the new factory. b. Even if Intel uses its own funds to finance the factory, the rise in interest rates still matters. There is an opportunity cost on the use of the funds. Instead of investing in

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System

202.

the factory, Intel could use the money to purchase bonds and earn the higher interest rate available there. Intel will compare its potential returns from building the factory to the potential returns from the bond market. If interest rates rise, so that bond market returns rise, Intel is again less likely to invest in the factory. a. Harry will have $1,000(1 + 0.05) = $1,050. Ron will have $1,000(1 + 0.08) = $1,080. Hermione will have $1,000(1 + 0.20) = $1,200. b. Each student would compare the expected rate of return on their own project with the market rate of interest (r). If the expected rate of return is greater than r, the student would borrow. If the expected rate of return is less than r, the student would lend. c. If r = 7%, Harry would want to lend while Ron and Hermione would want to borrow. The quantity of funds demanded would be $2,000, while the quantity supplied would be $1,000. If r = 10%, only Hermione would want to borrow. The quantity of funds demanded would be $1,000, while the quantity supplied would be $2,000. d. The loanable funds market would be in equilibrium at an interest rate of 8%. Harry would want to lend and Hermione would want to borrow. Ron would use his own savings for his project, but would want to neither borrow nor lend. Thus quantity demanded = quantity supplied = $1,000. e. Harry will have $1,000(1 + 0.08) = $1,080. Ron will have $1,000(1 + 0.08) = $1,080. Hermione will have $2,000(1 + 0.20) – $1,000(1 + 0.08) = $2,400 – $1,080 = $1,320. Both borrowers and lenders are better off. No one is worse off.

Figure 1 203. a. Figure 1 illustrates the effect of the $20 billion increase in government borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System by $20 billion reduces the supply of loanable funds at each interest rate by $20 billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly $20 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing. b. Because the interest rate has increased, investment and national saving decline and private saving increases. The increase in government borrowing reduces public saving. From the figure you can see that total loanable funds (and thus both investment and national saving) decline by less than $20 billion, while public saving declines by $20 billion and private saving rises by less than $20 billion. c. The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 2 shows.

Figure 2

Figure 3 d. The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 3 shows. e. If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher future taxes. Thus, private saving will increase, as will the supply of

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System

204.

loanable funds. This will offset the reduction in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving decline, and reducing the amount that the interest rate rises. a. Investment can be increased by reducing taxes on private saving or by reducing the government budget deficit. But reducing taxes on private saving has the effect of increasing the government budget deficit, unless some other taxes are increased or government spending is reduced. So it is difficult to engage in both policies at the same time. b. To know which of these policies would be a more effective way to raise investment, you would need to know: (1) what the elasticity of private saving is with respect to the after-tax real interest rate, because that would determine how much private saving would increase if you reduced taxes on saving; (2) how private saving responds to changes in the government budget deficit, because the decline in the government budget deficit could be matched by an equal decline in private saving, so national saving would not increase at all; and (3) how elastic investment is with respect to the interest rate, because if investment is quite inelastic, neither policy will have much of an impact on investment.

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[Take-home assignment] Create a Portfolio. Works in any class size. Topics include financial markets. WW. Purpose: This assignment requires students to use the financial pages of the newspaper to create their own portfolio. Many students are unfamiliar with the basic elements of stock and bond tables. This assignment then asks students to analyze elements that would affect their portfolio. XX. Instructions: Ask the students to do the following assignment. Many possible variations exist. It can be worthwhile to have students reevaluate their portfolio at the end of the semester. a. Assume you have $100,000 in savings. Create a portfolio of securities worth $100,000. Decide what financial instruments you would like to use, then find their current prices in the newspaper. Calculate your holdings of each security based on current prices. b. What objectives do you have for this portfolio? Was it chosen to maximize short-term gains, long-term stability, or some other objective? c. Explain how each of the following economic events would affect the value of your portfolio: i. An increase or decrease in interest rates ii. A recession iii. Rapid inflation

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 27: Saving, Investment, and the Financial System iv. A depreciation of the U.S. dollar YY. Common Answers and Points for Discussion: Most students pick a mix of common stocks, mutual funds, and bonds. Some choose familiar, low-risk, but lowyielding bank accounts and certificates of deposit. A few may choose more sophisticated financial instruments. This can be used to introduce the trade-off between risk and return and the concept of the risk premium. The impact of macroeconomic events on financial markets usually interests students. Portfolios heavily invested in cyclical stocks will give low returns in the event of recession. Bonds and cash perform poorly with unanticipated inflation. Foreign-denominated assets may give high returns if the dollar depreciates. Interest rate changes can cause large swings in the value of bond-heavy portfolios. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Stocks and Bonds o ConceptClip: Mutual Funds o ConceptClip: Budget Deficits and Surplus o ConceptClip: Loanable Funds Market o ConceptClip: Crowding Out o ConceptClip: Loanable Funds Equilibrium o Video Problem Walk-Through: Analyzing the Impact of a Reduction in Government Spending on the Market for Loanable Funds o Video Problem Walk-Through: Analyzing Changes in Saving and Investment on the Market for Loanable Funds o Video Problem Walk-Through: Calculating Private Saving, Public Saving, National Saving, Investment, and the Equilibrium Real Interest Rate o Video Problem Walk-Through: Calculating Taxes, Government Purchases, National Saving, and Investment from the GDP Accounting Identity o Equation Basics o Graphing Basics o Graphing Linear Equations o Video Quiz: Financial Markets o Video Quiz: The Market for Loanable Funds o Video Quiz: The Effects of Budget Deficits and Surpluses on the Market for Loanable Funds

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance [return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 488 Chapter Objectives ........................................................................................................................................... 488 Complete List of Chapter Activities and Assessments ......................................................................... 489 Key Terms ........................................................................................................................................................... 489 What's New in This Chapter .......................................................................................................................... 490 Chapter Outline ................................................................................................................................................. 490 Solutions to Text Problems ........................................................................................................................... 496 Questions for Review ................................................................................................................................................... 496 Problems and Applications ........................................................................................................................................ 496 Additional Resources ...................................................................................................................................... 499 Cengage Video Resources ........................................................................................................................................... 499

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 28 is the third chapter in a four-chapter sequence on the level and growth of output in the long run. In Chapter 26, we discussed how capital and labor are among the primary determinants of output and growth. In Chapter 27, we addressed how saving and investment in capital goods affect the production of output. In Chapter 28, we will show some of the tools people and firms use when choosing capital projects in which to invest. Because both capital and labor are among the primary determinants of output, Chapter 29 will address the market for labor. The purpose of Chapter 28 is to introduce the students to some tools that people use when they participate in financial markets. We will show how people compare different sums of money at different points in time, how they manage risk, and how these concepts combine to help determine the value of a financial asset, such as a share of stock. Key points addressed in this chapter: 



Because savings can earn interest, a sum of money today is more valuable than the same sum in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount of money today needed to produce a future amount of money, given prevailing interest rates. Because of diminishing marginal utility, most people are risk averse. Risk can be reduced by buying insurance, diversifying their holdings, and choosing a portfolio with lower risk and lower return. The value of an asset equals the present value of the cash flows the owner will receive. For a share of stock, these cash flows include the stream of dividends and the final share price. According to the efficient markets hypothesis, financial markets process available information rationally, so a stock price always equals the best estimate of the value of the underlying business. Some economists question the efficient markets hypothesis, however, and say that irrational psychological factors influence asset prices.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Apply the basic tools of finance.



Calculate the present value of a sum of money received in n years.



Determine how long it takes for an economy to double according to the rule of 70 and its current growth rate.

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Explain the implications of being risk averse.

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Explain the relationship between risk and return in the markets for financial assets.

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Compare the level of diversification across different stock portfolios.



Identify if a statement is consistent with the efficient markets hypothesis.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Active Learning 2 Active Learning 3 Ask the Experts Think-Pair-Share Activity Self-Assessment Section 28-1 QuickQuiz Section 28-2 QuickQuiz Section 28-3 QuickQuiz ConceptClip: Present Value and Time Value of Money ConceptClip: Future Value Figure 1: The Utility Function Figure 2: Diversification Reduces Risk Chapter 28 Problems & Applications Chapter 28 A+ Test Prep Video Quiz: Time Value of Money Video Quiz: Risk, Insurance, and Investing Chapter 28 News Analysis: Optimal Decision Making; A Parking Dilemma Chapter 28 News Analysis: Diapers Dilemma Chapter 28 Homework Chapter 28 Quiz: The Basic Tools of Finance

Source (i.e., PPT slide, Workbook) PPT Slide 11 PPT Slide 20 PPT Slide 29 PPT Slide 33 PPT Slide 39 PPT Slide 40 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

Duration

MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. N/A 10–15 mins. 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. 20–30 mins.

5–10 mins. 5–10 mins. 5–10 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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KEY TERMS Compounding: the accumulation of a sum of money in, say, a bank account where the interest earned remains in the account to earn additional interest in the future. Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance Efficient Markets Hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset. Firm-Specific Risk: risk that affects only a single company. Finance: the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk. Fundamental Analysis: the study of a company’s accounting statements and future prospects to determine its value. Future Value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates. Informational Efficiency: the description of asset prices that rationally reflect all available information. Market Risk: risk that affects all companies at once. Present Value: the amount of money today needed to produce a future amount of money, given prevailing interest rates. Random Walk: the path of a variable whose changes are impossible to predict. Risk Aversion: a dislike of uncertainty. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

There is a new In the News feature: The Perils of Investing with a Y Chromosome. “Women May Be Better Investors Than Men. Let Me Explain Why.”

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LII.

Definition of finance: the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk. a. Many of the basic insights of finance are central to understanding how the economy works. b. The tools of finance can help us think through some of the decisions that we must make in our lives. Present Value: Measuring the Time Value of Money

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance a. Money today is more valuable than the same amount of money in the future. b. Definition of present value: the amount of money today needed to produce a future amount of money, given prevailing interest rates. i. Example: you put $100 in a bank account today. How much will it be worth in N years? ii. Definition of future value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates. 1. Definition of compounding: the accumulation of a sum of money in, say, a bank account where the interest earned remains in the account to earn additional interest in the future. 2. If we invest $100 at an interest rate of 5% for 10 years, the future value will be (1.05)10 × $100 = $163. 3. Example: You expect to receive $200 in N years. What is the present value of $200 that will be paid in N years? a. To compute a present value from a future value, we divide by the factor (1 + r)N. b. If the interest rate is 5% and the $200 will be received 10 years from now, the present value is $200/(1.05)10 = $123. If is the interest rate, then an amount $ to be received in years has a present value of $ 1+ 4. The higher the interest rate, the more you can earn by depositing your money at the bank, so the more attractive having $100 today becomes. 5. The concept of present value also helps to explain why investment is inversely related to the interest rate. 6. If the future sum to be discounted is stated in nominal terms, use the nominal interest rate. If it is stated in real terms, use the real interest rate. c. FYI: The Magic of Compounding and the Rule of 70 i. Growth rates that seem small in percentage terms seem large after they are compounded for many years. ii. Example: William and Sarah both graduate from college at the age of 22 and take jobs earning $50,000 per year. 1. William lives in an economy where incomes grow at 1% per year. 2. Sarah lives in an economy where incomes grow at 3% per year. 3. Forty years later (when both are 62), William will be earning $74,000 and Sarah will be earning $163,000. iii. The Rule of 70 can help us understand the effects of compounding: Rule of 70: If a variable grows at % per year, then that variable will double in approximately 70/ years. d. Instruction Idea: This is a good time to explain to students how important saving can be while they are young. Show students how the magic of compounding can turn

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance a small amount of saving (say, $1,000 per year) into a large amount in 25 or 30 years. LIII.

Managing Risk a. Risk Aversion i. Most people are risk averse. 1. People dislike bad things happening to them. 2. In fact, they dislike bad things more than they like comparable good things. 3. For a risk-averse person, the pain from losing the $1,000 would exceed the pleasure from winning $1,000. 4. Definition of risk aversion: a dislike of uncertainty. Figure 1

ii.

Economists have developed models of risk aversion using the concept of utility, which is a person’s subjective measure of well-being or satisfaction. 1. A utility function exhibits the property of diminishing marginal utility: the more wealth a person has, the less utility they get from an additional dollar. 2. Because of diminishing marginal utility, the utility lost from losing $1,000 is greater than the utility of winning $1,000. b. The Markets for Insurance i. One way to deal with risk is to purchase insurance. ii. From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life but to spread them around more efficiently. 1. Owning insurance does not prevent bad things from happening to you.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance 2. However, the risk is shared among thousands of insurance-company shareholders rather than being borne by you alone. iii. The markets for insurance suffer from two types of problems that impede their ability to spread risk. 1. A high-risk person is more likely to apply for insurance than a lowrisk person because a high-risk person would benefit more from insurance protection. This is adverse selection. 2. After people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses. This is moral hazard. c. Diversification of Firm-Specific Risk i. Practical advice that finance offers to risk-averse people: “Don’t put all your eggs in one basket.” ii. Definition of diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks. 1. A person who buys stock in a company is placing a bet on the future profitability of that company. 2. Risk can be reduced by placing a large number of small bets rather than a small number of large ones. iii. Risk can be measured by the standard deviation of a portfolio’s return. 1. Standard deviation measures the volatility of a variable. 2. The higher the standard deviation of a portfolio’s return, the riskier it is. 3. The risk of a stock portfolio falls as the number of stocks increases. Figure 2

iv.

It is impossible to eliminate all risk by increasing the number of stocks in the portfolio. 1. Definition of firm-specific risk: risk that affects only a single company. 2. Definition of market risk: risk that affects all companies at once. 3. Diversification can eliminate firm-specific risk, but will not affect market risk. d. The Trade-off between Risk and Return i. Principle #1: People face trade-offs. ii. Risk-averse people are willing to accept the risk inherent in holding stock because they are compensated for doing so. iii. When deciding how to allocate their savings, people can accept more risk in order to earn a higher return.

Figure 3 iv. LIV.

The choice of a particular combination of risk and return depends on a person’s risk aversion, which reflects her own preferences.

Asset Valuation a. The price of a share of stock is determined by supply and demand.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance b. To understand stock prices, we need to understand what determines a person’s willingness to pay for a share of stock. c. Fundamental Analysis i. Definition of fundamental analysis: the study of a company’s accounting statements and future prospects to determine its value. ii. If the price of a share of stock is less than the value, the stock is said to be undervalued. iii. If the price of a share of stock is greater than its value, the stock is said to be overvalued. iv. If the price of a share of stock is equal to its value, the stock is said to be fairly valued. v. The value of a stock to a shareholder is what they receive from owning it, which includes the present value of dividend payments and the final sale price. 1. Both of these are highly related to the firm’s ability to earn profits. 2. The firm’s profitability depends on a large number of factors that affect the demand for its product and its costs of doing business. vi. There are three ways to rely on fundamental analysis to select a stock portfolio. 1. Do all of the necessary research yourself. 2. Rely on the advice of Wall Street analysts. 3. Buy shares in a mutual fund. vii. FYI: Key Numbers for Stock Watchers: Price, Dividend, Price-earnings ratio. d. The Efficient Markets Hypothesis i. Definition of the efficient markets hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset. ii. Each company listed on a major stock exchange is followed closely by money managers who monitor news stories and conduct fundamental analysis to determine a stock’s value. iii. At the equilibrium market price of a share of stock, the number of shares being offered for sale is exactly equal to the number of shares that people want to buy. 1. At the market price, the number of people who think that the stock is overvalued exactly balances the number of people who think it is undervalued. 2. As judged by the typical person in the market, all stocks are fairly valued all of the time. iv. Definition of informational efficiency: the description of asset prices that rationally reflect all available information. 1. Stock prices change when information changes. 2. When the good (bad) news about a company’s prospects becomes public, the value and the price of the stock will rise (fall). v. Definition of random walk: the path of a variable whose changes are impossible to predict. 1. Changes in stock prices are impossible to predict from available information.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance 2. The only thing that can move stock prices is news that changes the market’s perception of the company’s value. 3. Because news is unpredictable, changes in stock prices should be unpredictable. vi. Case Study: Random Walks and Index Funds 1. Some of the best evidence in favor of the efficient markets hypothesis comes from the performance of index funds. 2. In practice, funds that are actively managed by a professional usually fail to beat index funds. vii. Ask the Experts: Diversified Investing 1. 100 percent of economic experts agreed that an equity investor can expect to do better holding a well-diversified low-fee passive index fund than by holding a few stocks. e. Market Irrationality i. The efficient markets hypothesis assumes that people buying and selling stock rationally process all of the information they have about the stock’s underlying value. ii. There is a long tradition suggesting that fluctuations in stock prices are partly psychological. 1. In the 1930s, John Maynard Keynes suggested that asset markets are driven by the “animal spirits” of investors. 2. In the 1990s, Federal Reserve Chairman Alan Greenspan questioned whether the stock market boom was due to "irrational exuberance,” possibly creating a speculative bubble in stock prices. iii. The value of a stock depends on the final sale price expected in the future. 1. A person may be willing to pay more than a stock is worth today if they believe that another person will pay even more in the future. 2. Therefore, to evaluate a stock, you have to estimate not only the value of the business but also what other people may believe the business is worth in the future. iv. There is much debate among economists about whether departures from rational pricing are important or rare. 1. Believers in market irrationality point out that the stock market often moves in ways that are hard to explain on the basis of news that might alter a rational valuation. 2. Believers in the efficient markets hypothesis point out that it is difficult to know the correct, rational valuation of a company so it is hard to tell if any particular valuation is irrational. v. In the News: The Perils of Investing with a Y Chromosome. “Women May Be Better Investors Than Men. Let Me Explain Why.” 1. Overconfidence is bad when investing, and this problem is especially common among men. Testosterone tends to reduce fear and increase greed. 2. Evidence from Fidelity shows that, over a 10-year period, female customers earned an average of 0.4 percent more annually than

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance male customers. Women trade less often than men so they incur fewer trading fees. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 1. If the interest rate is 7%, the present value of $200 to be received in 10 years is $200/(1.07)10 = $101.67. If the interest rate is 7%, the present value of $300 to be received 20 years from now is $300/(1.07)20 = $77.53. Given the choice between the two options, $200 to be received in 10 years is preferred to $300 to be received in 20 years. 2. Purchasing insurance allows an individual to reduce the level of risk they face. Two problems that impede the insurance market from working correctly are adverse selection and moral hazard. Adverse selection occurs because a high-risk person is more likely to apply for insurance than a low-risk person is. Moral hazard occurs because people have less incentive to be careful about their risky behavior after they purchase insurance. 3. Diversification is the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks. A stockholder will get a greater benefit from diversification going from 1 to 10 stocks than from 100 to 120 stocks. 4. Stocks have more risk because their value depends on the future value of the firm. Because of its higher risk, shareholders will demand a higher return than bondholders. There is a positive relationship between risk and return. 5. A stock analyst will consider the future profitability of a firm when determining the value of the stock. 6. The efficient markets hypothesis suggests that stock prices reflect all available information. This means that we cannot use current information to predict future changes in stock prices. One piece of evidence that supports this theory is the fact that many index funds outperform mutual funds that are actively managed by a professional portfolio manager. 7. Economists who are skeptical of the efficient markets hypothesis believe that fluctuations in stock prices are partly psychological. People may in fact be willing to purchase a stock that is overvalued if they believe that someone will be willing to pay even more in the future. This means that the stock price may not be a rational valuation of the firm.

PROBLEMS AND APPLICATIONS 205. The future value of $24 invested for 400 years at an interest rate of 7% is (1.07)400  $24 = $13,600,000,000,000 = $13.6 trillion. 206. a. The present value of $15 million to be received in four years at an interest rate of 11% is $15 million/(1.11)4 = $9.88 million. Because the present value of the payoff is less than the cost, the project should not be undertaken. The present value of $15 million to be received in four years at an interest rate of 10% is $15 million/(1.10)4 = $10.25 million. Because the present value of the payoff is greater than the cost, the project should be undertaken.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance The present value of $15 million to be received in four years at an interest rate of 9% is $15 million/(1.09)4 = $10.63 million. Because the present value of the payoff is greater than the cost, the project should be undertaken. The present value of $15 million to be received in four years at an interest rate of 8% is $15 million/(1.08)4 = $11.03 million. Because the present value of the payoff is greater than the cost, the project should be undertaken. b. The interest rate that would make the firm indifferent between undertaking and foregoing the project is the interest rate that is the cut-off between profitability and nonprofitability (known as the internal rate of return). This is the interest rate that will equate the present value of receiving $15 million in four years with the current cost of the project ($10 million): $10 = 15/(1 + x)4 10(1 + x)4 = 15 (1 + x)4 = 1.5 1 + x = (1.5)0.25 1 + x = 1.10668 x = 0.10668 Therefore, an interest rate of 10.668% would make the firm indifferent between undertaking and foregoing the project. 207.

a. Using the rule of 70, when the interest rate is 3.5 percent, the value of the bond will double in approximately (70/3.5 =) 20 years. Therefore the value today of Bond A, which matures in 20 years, is approximately $4,000 because its value will double once in 20 years. The value today of Bond B, which matures in 40 years, is approximately $2,000 because its value will double twice in 40 years to $8,000. (More specifically, its value today is $2,000 and its value will double to $4,000 in 20 years and will double again to the $8,000 maturity value in 20 more years.) b. Using the rule of 70, when the interest rate is 7 percent the value of the bond will double in approximately (70/7 = ) 10 years. Therefore, the value today of Bond A, which matures in 20 years, is approximately $2,000 because its value will double twice in 20 years. Today's value of Bond B, which matures in 40 years, is approximately $500 because its value will double 4 times in 40 years. The percentage change in value for Bond A: (2000-4000)/4000 x 100 = -50%

The percentage change in value for Bond B: (500-2000)/2000 x 100 = -75%. c. The value of a bond falls when the interest rate increases, and bonds with a longer time to maturity are more sensitive to changes in the interest rate. 208. The value of the stock is equal to the present value of its dividends and its final sale price. This is equal to $5/1.08 + $5/(1.08)2 + ($5 + $120)/(1.08)3 = $4.63 + $4.29 + $99.23 =

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance $108.15. Since this is lower than the initial selling price of $110, XYZ stock is not a good investment. 209. a. A sick person is more likely to apply for health insurance than a well person is. This is adverse selection. Once a person has health insurance, they may be less likely to take good care of himself. This is moral hazard. b. A risky driver is more likely than a safe driver to apply for car insurance. This is adverse selection. Once a driver has insurance, they may drive more recklessly. This is adverse selection. c. An old or unhealthy person is more likely to apply for life insurance than a young or healthy person. This is adverse selection. Once a person has life insurance, they may engage in risky behavior or be less likely to take good care of himself. This is moral hazard. 210. A stock that is very sensitive to economic conditions will have more risk associated with it. Thus, we would expect that stock to pay a higher return. To get stockholders to be willing to accept the risk, the expected return must be larger than the return on a less-risky asset. 211. Shareholders will likely demand a higher return due to the stock’s firm-specific risk. Firm-specific risk is risk that affects only that particular stock. All stocks in the economy are subject to market risk. 212. a. Answers will vary, but may include things like information on new products under development or information concerning future government regulations that will affect the profitability of the firm. b. The fact that those who trade stocks based on inside information earn very high rates of return does not violate the efficient markets hypothesis. The efficient market hypothesis suggests that the price of a stock reflects all available information concerning the future profitability of the firm. Inside information is not readily available to the public and thus is not reflected in the stock’s price. c. Insider trading is illegal because it gives some buyers or sellers an unfair advantage in the stock market. 213.

a. Yes, Jamal is risk averse. The marginal utility of an additional dollar of wealth is diminishing. Figure 1 shows Jamal’s utility function.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 28: The Basic Tools of Finance

Figure 1 b. Expected value of A = $4 million Expected value of B = (0.6) ($1 million) + (0.4) ($9 million) = $4.2 million c. The expected utility of option A = U(W = $4 million) = 2,000. The expected utility of option B = (0.6)  U(W = $1 million) + 0.4  U(W = $9 million) = (0.6)  1,000 + (0.4)  3,000 = 600 + 1,200 = 1,800. d. Jamal should choose option A because it has the higher expected utility. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Present Value and Time Value of Money o ConceptClip: Future Value o Video Problem Walk-Through: Computing the Present Value of a Firm's Investment Project o Video Problem Walk-Through: Calculating the Present Value of a Financial Investment o Video Problem Walk-Through: Determining Whether to Take Your Lottery Winnings Over Time or in One Lump-Sum Payment o Video Problem Walk-Through: Using the Rule of 70 to Estimate the Value of a LongTerm Investment o Graphing Basics o Video Quiz: Time Value of Money o Video Quiz: Risk, Insurance, and Investing

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 501 Chapter Objectives ........................................................................................................................................... 501 Complete List of Chapter Activities and Assessments ......................................................................... 502 Key Terms ........................................................................................................................................................... 503 What's New in This Chapter .......................................................................................................................... 503 Chapter Outline ................................................................................................................................................. 504 Solutions to Text Problems ........................................................................................................................... 511 Questions for Review ................................................................................................................................................... 511 Problems and Applications ........................................................................................................................................ 512 Additional Activities and Assignments ..................................................................................................... 517 Additional Resources ...................................................................................................................................... 518 Cengage Video Resources ........................................................................................................................................... 518

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 29 is the fourth chapter in a four-chapter sequence on the level and growth of output in the long run. In Chapter 26, we learned that capital and labor are among the primary determinants of output and growth. In Chapter 27, we addressed how saving and investment in capital goods affect the production of output. In Chapter 28, we learned about some of the tools people and firms use when choosing capital projects in which to invest. In Chapter 29, we see how full utilization of our labor resources improves the level of production and our standard of living. The purpose of Chapter 29 is to introduce students to the labor market. We will see how economists measure the performance of the labor market using unemployment statistics. We will also address a number of sources of unemployment and some policies that the government might use to lower certain types of unemployment. Key points addressed in this chapter: 



 

The unemployment rate is the percentage of those who would like to work but don’t have jobs. The Bureau of Labor Statistics calculates this statistic monthly based on a survey of thousands of households. The unemployment rate is an imperfect measure of joblessness. Some people who call themselves unemployed may actually not want to work, and some who would like to work have left the labor force after an unsuccessful search and therefore are not counted as unemployed. In the U.S. economy, most people who become unemployed find work within a short period of time. Nonetheless, most unemployment observed at any given time is attributable to the few people who are unemployed for long periods. One reason for unemployment is the time it takes for workers to search for jobs that best suit their tastes and skills. Unemployment insurance, a government policy designed to protect workers’ incomes, increases frictional unemployment by reducing the search effort of the unemployed. A second reason the economy always has some unemployment is minimum-wage laws. By raising the wage of unskilled and inexperienced workers above the equilibrium level, these laws increase the quantity of labor supplied and reduce the quantity demanded. The resulting surplus of labor represents unemployment. A third reason for unemployment is the market power of unions. When unions push the wages in unionized industries above the equilibrium level, they create a surplus of labor. A fourth reason for unemployment is suggested by the theory of efficiency wages. According to this theory, firms find it profitable to pay wages above the equilibrium level. Higher wages can improve worker health, reduce worker turnover, raise worker quality, increase worker effort, and boost worker morale

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain why a natural rate of unemployment exists.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment 

Analyze the presence of unemployment in an economy.

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Categorize the type of unemployment in a given scenario as structural, frictional, or cyclical.

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Identify an individual's employment status in a given scenario.

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Calculate the labor force participation rate in a given scenario.

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Determine how discouraged workers impact the unemployment rate.

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Calculate the unemployment rate for an economy.

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Identify whether a given policy will reduce frictional unemployment.

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Analyze the effect of unions and collective bargaining on the labor market.

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Active Learning 2 Active Learning 3 Think-Pair-Share Activity Self-Assessment Section 29-1 QuickQuiz Section 29-2 QuickQuiz Section 29-3 QuickQuiz Section 29-4 QuickQuiz Section 29-5 QuickQuiz ConceptClip: Labor Force and Unemployment Rate ConceptClip: Cyclical Unemployment and the Discouraged Worker Figure 4: Unemployment from a Wage above the Equilibrium Level

PPT Slide 11 PPT Slide 19 PPT Slide 46 PPT Slide 50 PPT Slide 51 MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

5–10 mins. 5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

Chapter 29 Problems & Applications Chapter 29 A+ Test Prep Video Quiz: Unemployment: Part I Video Quiz: Unemployment: Part II Chapter 29 News Analysis: The Monthly Employment Situation

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. N/A 10–15 mins. 10–15 mins. 15–20 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment Chapter 29 Homework Chapter 29 Quiz: Unemployment

MindTap Apply It Folder MindTap Apply It Folder

20–30 mins. 20–30 mins.

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KEY TERMS Collective Bargaining: the process by which unions and firms agree on the terms of employment. Cyclical Unemployment: the deviation of unemployment from its natural rate. Discouraged Workers: individuals who would like to work but have given up looking for a job. Efficiency Wages: above-equilibrium wages paid by firms in order to increase worker productivity. Frictional Unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills. Job Search: the process by which workers find appropriate jobs given their tastes and skills. Labor Force: the total number of workers, including both the employed and the unemployed. Labor-Force Participation Rate: the percentage of the adult population that is in the labor force. Natural Rate of Unemployment: the normal rate of unemployment around which the unemployment rate fluctuates. Strike: the organized withdrawal of labor from a firm by a union. Structural Unemployment: unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. Unemployment Insurance: a government program that partially protects the incomes of workers who become unemployed. Unemployment Rate: the percentage of the labor force that is unemployed. Union: a worker association that bargains with employers over wages, benefits, and working conditions. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:   

There is a new FYI feature: “Mismatch as a Source of Structural Unemployment.” There is a new In the News feature: Efficiency Wages in Practice. “How Higher Wages Can Increase Profits.” Worker morale is addressed as an additional reason why firms may pay efficiency wages.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment 

The data in the figures and tables have been updated.

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LVI.

Unemployment can be divided into two categories. a. The economy’s natural rate of unemployment refers to the amount of unemployment that the economy normally experiences. b. Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. Identifying Unemployment a. How Is Unemployment Measured? i. The Bureau of Labor Statistics (BLS) surveys about 60,000 households every month. ii. The BLS places each adult (age 16 or older) into one of three categories: employed, unemployed, or not in the labor force. Figure 1 iii.

iv.

Instruction Idea: Ask students which category they are in. Remind them that to be considered to be unemployed, they must be without a job and looking for work. Many students are not in the labor force, but may consider themselves to be unemployed simply because they do not have a job. Explain to students that the unemployment rate is a useful statistic because it answers the following question: Of those in the economy who want to work, what percentage cannot find a job. Definition of labor force: the total number of workers, including both the employed and the unemployed. Labor force

Number of employed

Definition of unemployment rate: the percentage of the labor force that is unemployed. Unemployment rate

vi.

Number of unemployed

Number of unemployed × 100 Labor force

Definition of labor-force participation rate: the percentage of the adult population that is in the labor force. Labor force participation rate

Labor force × 100 Adult population

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment vii.

viii.

ix.

Example: Data from December 2021. In that month, there were 156.7 million employed people and 6.5 million unemployed people. 1. Labor Force = 156.0 + 6.3 = 162.3 million. 2. Unemployment Rate = (6.3/162.3) × 100 = 3.9%. 3. Because the adult population was 262.1 million, the labor-force participation rate was: Labor-Force Participation Rate = (162.3/262.1) × 100 = 61.9%. Instruction Idea: Make sure that students understand how to make these calculations. Make sure that the formula is written on the board and refer to it often. Alternative Classroom Example: The country of Bada has collected the following information. Population Employed Unemployed

xi.

240,000 180,000 30,000

Labor Force = 180,000 + 30,000 = 210,000 Unemployment rate = (30,000/210,000) × 100 = 14.3% Labor-force participation rate = (210,000/240,000) × 100 = 87.5% Unemployment and labor-force participation rates vary widely across demographic groups in the United States. Female labor-force participation is rising while male labor-force participation is falling. Figure 2 shows the unemployment rate in the United States since 1960.

Figure 2 b. Definition of the natural rate of unemployment: the normal rate of unemployment around which the unemployment rate fluctuates. c. Definition of cyclical unemployment: the deviation of unemployment from its natural rate. d. Instruction Idea: Discuss how the age composition of the labor force and other demographic and social factors can cause the natural rate of unemployment to vary over time. For 2021, economists at the Congressional Budget Office have estimated a natural rate of 4.5%. e. Case Study: Labor-Force Participation of Women and Men in the U.S. Economy i. There has been a dramatic rise in the labor-force participation rates of women since 1950. Figure 3

ii.

Figure 3 shows this rise in the labor-force participation rate of women. The figure also shows that the labor-force participation rates for men have actually fallen over the same time period. Does the Unemployment Rate Measure What We Want It to Measure?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment i. ii.

iii.

iv.

Measuring the unemployment rate is not as straightforward as it may seem. There is a tremendous amount of movement into and out of the labor force. 1. Many of the unemployed are new entrants or re-entrants looking for work. 2. Many unemployment spells end with a person leaving the labor force as opposed to actually finding a job. There may be individuals who are calling themselves unemployed to qualify for government assistance, yet they are not trying hard to find work. These individuals are more likely not a part of the true labor force, but they will be counted as unemployed. Definition of discouraged workers: individuals who would like to work but have given up looking for a job. 1. These individuals will not be counted as part of the labor force. 2. Thus, while they are likely a part of the unemployed, they will not

Table 1 show up in the unemployment statistics. Table 1 presents other measures of labor underutilization calculated by the Bureau of Labor Statistics. g. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. h. How Long Are the Unemployed without Work? i. Another important variable that policymakers may be concerned with is the duration of unemployment. ii. Most spells of unemployment are short, but most unemployment observed at any given time is long term. i. Why Are There Always Some People Unemployed? i. In an ideal labor market, wages would adjust so that the quantity of labor supplied and the quantity of labor demanded would be equal. ii. However, there is always unemployment even when the economy is doing well. The unemployment rate is never zero; it fluctuates around the natural rate. 1. Definition of frictional unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills. 2. Definition of structural unemployment: unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. 3. Three possible reasons for structural unemployment are minimumwage laws, unions, and efficiency wages. j. FYI: The Jobs Number v.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment i.

LVII.

When the Bureau of Labor Statistics announces the unemployment rate each month, it also announces the number of jobs the economy gained or lost. This information comes from a survey of 160,000 business establishments.

ii. Job Search a. Definition of job search: the process by which workers find appropriate jobs given their tastes and skills. b. Because workers differ from one another in terms of their skills and tastes and jobs differ in their attributes, it is often difficult for workers to match with the appropriate job. c. Why Some Frictional Unemployment Is Inevitable i. Frictional unemployment often occurs because of a change in the demand for labor among different firms. 1. When consumers decide to stop buying a good produced by Firm A and instead start buying a good produced by Firm B, some workers at Firm A will likely lose their jobs. 2. New jobs will be created at Firm B, but it will take some time to move the displaced workers from Firm A to Firm B. 3. The result of this transition is a period of unemployment. 4. The same situation can occur across industries and regions as well. This is known as sectoral shifts. 5. Another source of unemployment is changing patterns of international trade. ii. This implies that, because the economy is always changing, frictional unemployment is inevitable. Workers in declining industries will find themselves looking for new jobs, and firms in growing industries will be seeking new workers. d. Public Policy and Job Search i. The faster information spreads about job openings and worker availability, the more rapidly the economy can match workers and firms. ii. Government programs try to facilitate job search in various ways. 1. Government-run employment agencies give out information on job vacancies. 2. Public training programs can ease the transition of workers from declining to growing industries and help disadvantaged groups escape poverty. iii. Critics of these programs argue that the private labor market will do a better job of matching workers with employers and therefore the government should not be involved in the process of job search. e. Unemployment Insurance i. Definition of unemployment insurance: a government program that partially protects the incomes of workers who become unemployed. ii. Because unemployment insurance reduces the hardship of unemployment, it also increases the amount of unemployment that exists.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment iii.

LVIII.

Many studies have shown that more generous unemployment insurance benefits lead to reduced job search effort and, as a result, more unemployment. Minimum-Wage Laws Figure 4 a. Unemployment can also occur because of minimum-wage laws.

If the minimum wage is set above the equilibrium wage in the labor market, a surplus of labor will occur. ii. While minimum-wage laws are one reason unemployment exists in the U.S. economy, they affect only a small percent of the labor force. 1. The vast majority of workers in the economy have wages well above the legal minimum, so the law does not prevent most wages from adjusting to balance supply and demand. 2. Minimum-wage laws therefore have the largest effect on the least skilled and least experienced members of the labor force, such as teenagers. b. Anytime a wage is kept above the equilibrium level for any reason, the result is unemployment. i. Other causes of this situation include unions and efficiency wages. ii. This situation is different from frictional unemployment where the search for the right job is the reason for unemployment. c. Case Study: Who Earns the Federal Minimum Wage? i. In 2021, the Department of Labor released a study of which workers reported earnings at or below the minimum wage in 2020. 1. Of those workers paid an hourly rate, about 1.5% reported wages at or below the federal minimum, which is about 0.8% of all workers.

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LIX.

2. Minimum-wage workers tend to be young, with about 5% of 16 to 19-year-old hourly workers earning the minimum wage but only 1% of hourly workers aged 25 and over. 3. Minimum-wage workers tend to be less educated. Of those workers ages 16 and over, 2% with no bachelors degree earned the minimum wage or less, compared to 1% with a college degree. 4. Minimum-wage workers are more likely to be working part time. 5. The industry with the highest proportion of workers with reported hourly wages at or below the minimum wage was leisure and hospitality. 6. The proportion of workers earning the prevailing minimum wage has changed substantially over time, trending downward from 1979 to 2020. This is in part because the minimum wage has not kept up with inflation so it is a binding price floor for fewer workers. Unions and Collective Bargaining a. Definition of union: a worker association that bargains with employers over wages, benefits, and working conditions. b. Unions play a smaller role in the U.S. economy today than they did in the past. However, unions continue to be prevalent in many European countries. c. The Economics of Unions i. Definition of collective bargaining: the process by which unions and firms agree on the terms of employment. ii. Unions try to negotiate for higher wages, better benefits, and better working conditions than the firm would offer if there were no union. iii. Definition of strike: the organized withdrawal of labor from a firm by a union. iv. Economists have found that union workers typically earn 10% to 20% more than similar workers who do not belong to unions. v. This implies that unions raise the wage above the equilibrium wage, resulting in unemployment. 1. Unions are often believed to cause conflict between insiders (who benefit from high union wages) and outsiders (who do not get the union jobs). 2. Outsiders will either remain unemployed or find jobs in firms that are not unionized. 3. The supply of workers in nonunion firms will increase, pushing wages at those firms down. vi. Right-to-work laws bar a union and employer from requiring all workers (members and non-members of the union) to financially support the union, which weakens unions. Other proposed laws would prevent firms from hiring permanent replacements for striking workers, strengthening unions. d. Are Unions Good or Bad for the Economy? i. Critics of unions argue that unions are a cartel, which causes inefficiency because fewer workers end up being hired at the higher union wage.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment ii.

LX.

Advocates of unions argue that unions are an answer to the problems that occur when a firm has too much power in the labor market (for example, if it is the only major employer in town). In addition, by representing workers’ views, unions help firms provide the right mix of job attributes. e. FYI: Mismatch as a Source of Structural Unemployment i. Unemployment can result from a mismatch between the kinds of workers that are seeking jobs and the kinds that firms are looking for. This could be based on skills, education, or location. ii. If wages can’t fall in the areas of oversupply of workers, then unemployment will result in those areas. The Theory of Efficiency Wages a. Definition of efficiency wages: above-equilibrium wages paid by firms in order to increase worker productivity. b. Efficiency wages raise the wage above the market equilibrium wage, resulting in unemployment. c. There are several reasons why a firm may pay efficiency wages. i. Worker Health 1. Better-paid workers can afford to eat better and can afford good medical care. 2. This is more applicable in developing countries where inadequate nutrition can be a significant problem. ii. Worker Turnover 1. A firm can reduce turnover by paying a wage greater than its workers could receive elsewhere. 2. This is especially helpful for firms that face high hiring and training costs. iii. Worker Quality 1. Offering higher wages attracts a better pool of applicants. 2. This is especially helpful for firms that are not able to perfectly gauge the quality of job applicants. iv. Worker Effort 1. Again, if a firm pays a worker more than they can receive elsewhere, the worker will be more likely to try to protect their job by working harder. 2. This is especially helpful for firms that have difficulty monitoring their workers. v. Worker Morale 1. Workers are more productive when their morale is high. 2. Worker morale is higher when they feel as if they are being treated fairly by a profitable employer. vi. Case Study: Henry Ford and the Amazing $5-a-Day Wage 1. Henry Ford used a high wage (about twice the going rate) to attract better employees. 2. After instituting this higher wage policy, the company’s production costs actually fell due to reduced turnover, absenteeism, and shirking.

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vii.

viii.

3. At present, In-N-Out Burger pays its store managers three times the industry average because it feels that the high wage will promote worker efficiency. In the News: Efficiency Wages in Practice. “Higher Wages Can Increase Profits.” 1. Evidence suggests that some increases in wages pay for themselves by improving motivation and retention. An unexpected increase in wages seems to have a larger effect on productivity. 2. Pay cuts may lead employees to be deliberately unproductive, the most productive to leave the company, and some employees to sabotage the company. Keep in Mind: When discussing the material in this chapter, you may find that students want to begin discussing possible policies to deal with unemployment. Keep the focus on institutional responses such as unemployment insurance, job training, and government-sponsored employment agencies.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 153. The BLS categorizes each adult (16 years of age and older) as employed, unemployed, or not in the labor force. The labor force consists of the sum of the employed and the unemployed. The unemployment rate is the percentage of the labor force that is unemployed. The labor-force participation rate is the percentage of the total adult population that is in the labor force. 154. Unemployment is typically short term. Most people who become unemployed are able to find new jobs fairly quickly. But most unemployment observed at any given time is attributable to the relatively few workers who are jobless for long periods of time. 155. Frictional unemployment is inevitable because the economy is always changing. Some firms are shrinking while others are expanding. Some regions are experiencing faster growth than other regions. Transitions of workers between firms and between regions are accompanied by temporary unemployment. The government could help to reduce the amount of frictional unemployment through public policies that provide information about job vacancies in order to match workers and jobs more quickly, and through public training programs that help ease the transition of workers from declining to expanding industries and help disadvantaged groups escape poverty. 156. Minimum-wage laws are a better explanation for unemployment among teenagers than among college graduates. Teenagers have fewer job-related skills than college

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment graduates do, so their wages are low enough to be affected by the minimum wage. College graduates' wages generally exceed the minimum wage. 157. Unions affect the natural rate of unemployment via the effect on insiders and outsiders. Because unions raise the wage above the equilibrium level, the quantity of labor demanded declines while the quantity supplied of labor rises, so there is unemployment. Insiders are those who keep their jobs. Outsiders, workers who become unemployed, have two choices: either get a job in a firm that is not unionized, or remain unemployed and wait for a job to open up in the union sector. As a result, the natural rate of unemployment is higher than it would be without unions. 158. Advocates of unions claim that unions are good for the economy because they are an antidote to the market power of the firms that hire workers and they are important for helping firms respond efficiently to workers' concerns. 159. Four reasons why a firm's profits might increase when it raises wages are: (1) better paid workers are healthier and more productive; (2) worker turnover is reduced; (3) the firm can attract higher quality workers; and (4) worker effort is increased.

PROBLEMS AND APPLICATIONS 214. a. The adult population consisted of the number of employed (133,320,000) plus the number of unemployed (23,038,000) plus those not in the labor force (103,538,000), which equals 259,896,000. b. The labor force consisted of the number of employed (133,320,000) plus the number of unemployed (23,038,000), which equals 156,358,000. c. The labor-force participation rate was the labor force (156,358,000) divided by the adult population (259,896,000) times 100, which equals 60.2%. d. The unemployment rate was the number of unemployed (23,038,000) divided by the labor force (156,358,000) times 100, which equals 14.7%. 215.

a. When Jon finds a job after a long search, the unemployment rate decreases and there is no effect on the labor-force participation rate because Jon was and continues to be part of the labor force and the adult population. b. When Tyrion graduates and is immediately employed, the unemployment rate decreases because the labor force increases, and the labor-force participation rate increases because Tyrion was part of the adult population and is now part of the labor force. c. When Arya gives up looking for a job, the unemployment rate decreases because Arya is no longer considered unemployed and has left the labor force and the laborforce participation rate decreases. d. When Daenerys quits her job to be a stay-at-home mom, the unemployment rate increases because the labor force decreases, and the labor-force participation rate decreases because Daenerys is still part of the adult population but is no longer part of the labor force. e. When Sansa becomes an adult but does not look for work, there is no effect on the unemployment rate. The labor-force participation rate decreases because Sansa is now part of the adult population but is not part of the labor force.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment f.

When Jaime becomes an adult and begins looking for work, the unemployment rate increases and the labor-force participation rate increases because the labor force and the adult population both increased by one. g. When Cersei dies while enjoying retirement, there is no effect on the unemployment rate. The labor-force participation rate increases because the adult population decreases. h. When Jorah dies working long hours at the office, the unemployment rate increases because the labor force decreases, and the labor-force participation rate decreases because the labor force and the adult population both decreased by one. 216. Many answers are possible. 217. The fact that employment increased 17.3 million while the unemployed declined by only 6.3 million is consistent with growth in the labor force. The labor force constantly increases as the population grows, so the increase in the number of people employed may exceed the reduction in the number unemployed. 218. a. If an auto company goes bankrupt and its workers immediately begin looking for work, the unemployment rate will rise and the employment-population ratio will fall. b. If some of the unemployed auto workers give up looking for a job, the unemployment rate will fall and the employment-population ratio will remain the same. c. If numerous students graduate from college and cannot find work, the unemployment rate will rise and the employment-population ratio will remain unchanged. d. If numerous students graduate from college and immediately begin new jobs, the unemployment rate will fall and the employment-population ratio will rise. e. If a stock market boom induces earlier retirement, the unemployment rate will rise and the employment-population ratio will fall. f. Advances in health care that prolong the life of retirees will not affect the unemployment rate and will lower the employment-population ratio. 219. a. A construction worker who is laid off because of bad weather is likely to experience short-term unemployment, because the worker will be back to work as soon as the weather clears up. b. A manufacturing worker who loses a job at a plant in an isolated area is likely to experience long-term unemployment, because there are probably few other employment opportunities in the area. The worker may need to move somewhere else to find a suitable job, which means the worker will be unemployed for some time. c. A worker in the stagecoach industry who was laid off because of the growth of railroads is likely to be unemployed for a long time. The worker will have a lot of trouble finding another job because the entire stagecoach industry is shrinking. The worker will probably need to gain additional training or skills to get a job in a different industry. d. A short-order cook who loses a job when a new restaurant opens is likely to find another job fairly quickly, perhaps even at the new restaurant, and thus will probably have only a short spell of unemployment.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment e. An expert welder with little education who loses a job when the company installs automatic welding machinery is likely to be without a job for a long time, because the worker lacks the technological skills to keep up with the latest equipment. To remain in the welding industry, the worker may need to go back to school and learn the newest techniques.

Figure 2 220. Figure 2 shows a diagram of the labor market with a binding minimum wage. At the initial minimum wage (wM,1), the quantity of labor supplied LS,1 is greater than the quantity of labor demanded LD,1, and unemployment is equal to LS,1 – LD,1. An increase in the minimum wage to wM,2 leads to an increase in the quantity of labor supplied to LS,2 and a decrease in the quantity of labor demanded to LD,2. As a result, unemployment increases as the minimum wage rises. 221. a. Figure 3 illustrates the effects of a union being established in the manufacturing labor market. In the manufacturing labor market (figure on the left), the wage rises from the non-union wage, wNU, to the union wage, wU, and the quantity of labor demanded declines from the non-union quantity of labor, LNU, to the union quantity of labor demanded, LUD. Because the wage is higher, the quantity supplied of labor increases to the union quantity of labor supplied LUS, so there are LUS – LUD unemployed workers in the unionized manufacturing sector. b. When those workers who become unemployed in the manufacturing sector seek employment in the service labor market, shown in the figure on the right, the supply of labor shifts to the right from S1 to S2. The result is a decline in the wage in the nonunionized service sector from w1 to w2 and an increase in employment in the nonunionized service sector from L1 to L2.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment

Figure 3 222.

223.

a. Wages between the two industries would be equal. If not, new workers would choose the industry with the higher wage, pushing the wage in that industry down. b. If the country begins importing autos, the demand for domestic auto workers would fall. If the country begins to export aircraft, there would be an increase in the demand for workers in the aircraft industry. c. In the short run, wages in the auto industry would fall, while wages in the aircraft industry would rise. Over time, new workers would move into the aircraft industry bringing its wage down until wages were equal across the two industries. d. If the wage did not adjust to its equilibrium level, there would be a shortage of workers in the aircraft industry and a surplus of labor (unemployment) in the auto industry. a. If a firm was not providing such benefits prior to the legislation, the curve showing the demand for labor would shift to the left by exactly $4 at each quantity of labor, because the firm would not be willing to pay as high a wage given the increased cost of the benefits. b. If employees value the benefit by exactly $4 per hour, they would be willing to work the same amount for a wage that is $4 less per hour, so the supply curve of labor shifts to the right by exactly $4.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment

Figure 4 c. Figure 4 shows the equilibrium in the labor market. Because the demand and supply curves of labor both shift by $4, the equilibrium quantity of labor is unchanged and the wage declines by $4. Both employees and employers are just as well off as before. d. If the minimum wage prevents the wage from falling to the new equilibrium level, the result will be increased unemployment, as Figure 5 shows. Initially, the equilibrium quantity of labor is L1 and the equilibrium wage is w1, which is $3 higher than the minimum wage wm. After the law is passed, demand falls to D2 and supply rises to S2. Because of the minimum wage, the quantity of labor demanded (LD2) will be smaller than the quantity supplied (LS2). Thus, there will be unemployment equal to LS2 – LD2.

Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 29: Unemployment

Figure 6 e. If the workers do not value the mandated benefit at all, the supply curve of labor does not shift. As a result, the wage rate will decline by less than $4 and the equilibrium quantity of labor will decline, as shown in Figure 6. Employers are worse off, because they now pay a greater total wage plus benefits for fewer workers. Employees are worse off, because they get a lower wage and fewer are employed.

[In-class assignment] Who Is Unemployed?: 5 minutes total. Works in any class size. Topics include unemployment categories. ZZ. Purpose: This assignment helps familiarize students with labor-force statistics. AAA. Instructions: Ask the students to classify each of the following individuals in one of the following categories: employed, unemployed, or not in the labor force. a. Steve worked 40 hours last week in an office supply store. b. Last week, Elizabeth worked 10 hours as a computer programmer for the National Video Company and attended night classes at the local college. She would prefer a full-time job. c. Roger lost his job at the R-gone Manufacturing Company. Since then he has been trying to find a job at other local factories. d. Charles is a homemaker. Last week he was occupied with his normal household chores. He neither held a job nor looked for a job. e. Charles’ father is unable to work. f. Scott has a Ph.D. He worked full-time but does not like his job as a dishwasher. He has applied for jobs with three companies and five universities. As soon as he gets an offer, he will quit his current job.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System g. Mary-Helen has been out of work for a full year. She would take a job if it was offered, but no local companies are hiring. She is not actively searching for work. BBB. Common Answers and Points for Discussion: Steve, Elizabeth, and Scott are employed. Roger is unemployed. Charles, Charles’ father, and Mary-Helen are not in the labor force. This assignment can also be used to discuss measurement problems such as underemployment (Elizabeth and Scott are examples) and discouraged workers (Mary-Helen provides an example). [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Labor Force and Unemployment Rate o ConceptClip: Cyclical Unemployment and the Discouraged Worker o Video Problem Walk-Through: Calculating the Size of the Labor Force, the Unemployment Rate, and the Labor-Force Participation Rate o Video Problem Walk-Through: Analyzing an Increase in the Minimum Wage o Equivalency of Fractions, Decimals, and Percentages o Graphing Basics o Video Quiz: Unemployment: Part I o Video Quiz: Unemployment: Part II

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 520 Chapter Objectives ........................................................................................................................................... 521 Complete List of Chapter Activities and Assessments ......................................................................... 521 Key Terms ........................................................................................................................................................... 522 What's New in This Chapter .......................................................................................................................... 523 Chapter Outline ................................................................................................................................................. 524

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System Solutions to Text Problems ........................................................................................................................... 531 Questions for Review ................................................................................................................................................... 531 Problems and Applications ........................................................................................................................................ 532 Additional Activities and Assignments ..................................................................................................... 535 Additional Resources ...................................................................................................................................... 537 Cengage Video Resources ........................................................................................................................................... 537

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 30 is the first chapter in a two-chapter sequence dealing with money and prices in the long run. Chapter 30 describes what money is and develops how the Federal Reserve controls the quantity of money. Because the quantity of money influences the rate of inflation in the long run, the following chapter concentrates on the causes and costs of inflation. The purpose of Chapter 30 is to help students develop an understanding of what money is, what forms money takes, how the banking system helps create money, and how the Federal Reserve controls the quantity of money and interest rates. An understanding of money is important because the quantity of money affects inflation and interest rates in the long run, and production and employment in the short run. Key points addressed in this chapter:  



 



The term money refers to assets that people regularly use to buy goods and services. Money serves three functions. As a medium of exchange, it is the item used to make transactions. As a unit of account, it provides a measure with which to record prices and other economic values. As a store of value, it offers a way to transfer purchasing power from the present to the future. Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money. In the U.S. economy, money takes the form of currency and various types of bank deposits, such as checking accounts. The Federal Reserve, the central bank of the United States, is responsible for overseeing the U.S. monetary system. The Fed chair is appointed by the president and confirmed by the Senate. The chair is the lead member of the Federal Open Market Committee, which sets monetary policy. When people deposit money in banks and banks use a fraction of these deposits to make loans to the public, the quantity of money in the economy increases. Because the banking system affects the money supply in this way, the Fed’s control of the money supply is imperfect. Bank owners provide the resources necessary to start a bank, called bank capital. Because of leverage (the use of borrowed funds for investment), a small change in the value of a bank’s assets can lead to a large change in the value of its capital. To protect depositors, regulators require banks to hold a certain minimum amount of capital. The Fed has several tools it can use to influence the money supply. It can expand the money supply by buying bonds in open-market operations, reducing the discount rate, increasing its lending to banks, lowering reserve requirements, or decreasing the interest rate on reserves. It can contract the money supply by selling bonds in open-market operations, increasing the discount rate, reducing its lending to banks, raising reserve requirements or increasing the interest rate on reserves. Historically, open-market operations were the Fed’s primary too, but since 2008, it has relied more on the interest rate it pays on reserves. In recent years, the Federal Reserve has conducted monetary policy by setting a target for the federal funds rate, a short-term interest rate at which banks lend to one another. As the Fed pursues its target, it adjusts the money supply.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Define the three functions of money.



Given a list of assets, order the assets from most liquid to least liquid.



Identify an example of money as commodity money or fiat money.



Differentiate between various money aggregates.

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Identify the responsibilities of the Federal Reserve System.

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Describe the organizational structure of the Fed.

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Explain how open market operations impact the money supply.

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Examine the role of monetary policy in governing an economy.

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Calculate how much money fractional reserve banking creates, in a given scenario.

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Determine the impact of a change in reserve requirements on the money supply.

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Given data on a bank's balance sheets, evaluate the bank's reserve situation.

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Calculate the value of the money multiplier using the reserve ratio.

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Given a bank's balance sheet, calculate the leverage ratio.

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Explain how the discount rate impacts the money supply.

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Explain how the Fed uses the interest it pays on bank reserves to adjust short-term interest rates.

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Explain why the Federal Reserve does not have perfect control of the money supply.

Source (i.e., PPT slide, Workbook) PPT Slide 12 PPT Slide 29 PPT Slide 52 PPT Slide 53 MindTap eBook MindTap eBook

Duration 5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System Section 30-3 QuickQuiz Section 30-4 QuickQuiz ConceptClip: Medium of Exchange and Barter ConceptClip: Unit of Account ConceptClip: Store of Value and Inflation ConceptClip: Money and Demand Deposits ConceptClip: Central Banks and the Federal Reserve ConceptClip: Federal Reserve System ConceptClip: Fractional Reserve Banking ConceptClip: Money Multiplier ConceptClip: Open Market Operations ConceptClip: Discount Rate and Fed Funds Rate Chapter 30 Problems & Applications Chapter 30 A+ Test Prep Video Quiz: Money: Functions and Types Video Quiz: U.S. Money Stock Measures Video Quiz: Money and Banking Video Quiz: The Federal Reserve System Chapter 30 Homework Chapter 30 Quiz: The Monetary System

MindTap eBook MindTap eBook MindTap Learn It Folder

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MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

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KEY TERMS Bank Capital: the resources a bank’s owners have put into the institution. Capital Requirement: a government regulation specifying a minimum amount of bank capital. Central Bank: An institution designed to oversee the banking system and regulate the quantity of money in the economy. Commodity Money: money that takes the form of a commodity with intrinsic value. Currency: the paper bills and coins in the hands of the public. Demand Deposits: balances in bank accounts that depositors can access on demand by writing a check.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System Discount Rate: the interest rate on the loans that the Fed makes to banks. Federal Funds Rate: the short-term interest rate that banks charge one another for loans. Federal Reserve (Fed): the central bank of the United States. Fiat Money: money without intrinsic value that is used as money because of government decree. Fractional-Reserve Banking: a banking system in which banks hold only a fraction of deposits as reserves. Interest on Reserves: the interest rate paid to banks on the reserves held in deposit at the Fed. Leverage: the use of borrowed money to supplement existing funds for investment purposes. Leverage Ratio: the ratio of assets to bank capital. Liquidity: the ease with which an asset can be converted into the economy’s medium of exchange. Medium of Exchange: an item that buyers give to sellers when they want to purchase goods and services. Monetary Policy: the setting of the money supply by policymakers in the central bank. Note that the money supply is closely related to interest rates. Money: the set of assets in an economy that people regularly use to buy goods and services. Money Multiplier: the amount of money that results from each dollar of reserves. Money Supply: the quantity of money available in the economy. Open-Market Operations: the purchase and sale of U.S. government bonds by the Fed. Reserve Ratio: the fraction of deposits that banks hold as reserves. Reserve Requirements: regulations on the minimum amount of reserves that banks must hold against deposits. Reserves: deposits that banks have received but have not loaned out. Store of Value: an item that people can use to transfer purchasing power from the present to the future. Unit of Account: the yardstick people use to post prices and record debts. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

The section on the Fed’s tools of monetary control has been updated to focus on the interest that the Fed pays on bank reserves.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System [return to top]

LXII.

Instruction Idea: This is a good chapter to “win back” the students who were bored with national income accounting. Students are generally interested in learning more about the banking system and the Federal Reserve. The Federal Reserve offers a free, 13-minute video entitled “The Fed Today” that discusses the history and operations of the Fed. The Meaning of Money a. Instruction Idea: Begin the analysis by asking students, “What is money?” Students will likely want to start right in with a discussion of the functions that money serves. Stop them. Ask them instead to describe money. Hold up a dollar bill and a piece of paper cut to the same size. Ask the students which they would prefer and why. b. Definition of money: the set of assets in an economy that people regularly use to buy goods and services. c. The Functions of Money i. Money serves three functions in our economy. 1. Definition of medium of exchange: an item that buyers give to sellers when they want to purchase goods and services. 2. Definition of unit of account: the yardstick people use to post prices and record debts. 3. Definition of store of value: an item that people can use to transfer purchasing power from the present to the future. ii. Definition of liquidity: the ease with which an asset can be converted into the economy’s medium of exchange. 1. Money is the most liquid asset available. 2. Other assets (such as stocks, bonds, and real estate) vary in their liquidity. 3. When people decide how to allocate their wealth, they must balance the liquidity of each possible asset against the asset’s usefulness as a store of value. d. The Kinds of Money i. Definition of commodity money: money that takes the form of a commodity with intrinsic value. ii. Definition of fiat money: money without intrinsic value that is used as money because of government decree. iii. FYI: Cryptocurrencies: A Fad or the Future? 1. Cryptocurrency, such as bitcoin, is a new type of money that exists only in electronic form. 2. Because the value of bitcoin fluctuates wildly and because few retailers accept it in exchange, it is excluded from standard measures of money.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

LXIII.

e. Money in the U.S. Economy i. The quantity of money circulating in the United States is sometimes called the money stock. ii. Included in the measure of the money supply are currency, demand deposits, and other monetary assets. 1. Definition of currency: the paper bills and coins in the hands of the public. 2. Definition of demand deposits: balances in bank accounts that depositors can access on demand by writing a check. iii. There are two important measures of the U.S. money supply, M1 and M2. These two measures of money are now very similar. For our purposes, the money stock in the U.S. is composed of currency and spendable deposits. iv. Instruction Idea: Make sure that students realize that the assets included in M1 and M2 differ slightly in terms of their liquidity. v. FYI: Why Credit Cards Aren’t Money 1. Credit cards are not a form of money; when a person uses a credit card, they are simply deferring payment for the item. 2. Instruction Idea: Students are quite curious about whether credit cards are considered money. You can satisfy their curiosity in part by pointing out that credit cards actually lead to a drop in the quantity of money people need to carry because they allow households to consolidate bills for payment once a month. 3. Because using a debit card is like writing a check, the account balances that lie behind debit cards are included in the measures of money. vi. Case Study: Where Is All the Currency? 1. If we divide the amount of outstanding currency in the United States by the adult population, we find that the average adult holds over $8,000 in currency. 2. Of course, most adults carry a much smaller amount. 3. One explanation is that a great deal of U.S. currency may be held in other countries. 4. Another explanation is that large amounts of currency may be held by criminals because transactions that use currency leave no paper trail. The Federal Reserve System a. Definition of Federal Reserve (Fed): the central bank of the United States. b. Definition of central bank: An institution designed to oversee the banking system and regulate the quantity of money in the economy. i. Instruction Idea: There is a student activity (What Can Be Learned from a Dollar?) that applies to this topic in the "Additional Activities and Assignments” section. c. The Fed’s Organization i. Instruction Idea: Highlight the Federal Reserve’s independence from the federal government. Students are surprised to find that the Fed actually

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

LXIV.

earns more than enough to finance its operations without being funded by Congress. ii. The Fed was created in 1913 after a series of bank failures. iii. The Fed is run by a Board of Governors with up to 7 members who serve 14-year terms. 1. The Board of Governors has a chair who is appointed for a four-year term. 2. The current chair is Jerome Powell. iv. The Federal Reserve System is made up of 12 regional Federal Reserve Banks located in major cities around the country. v. Instruction Idea: Have students pull out dollar bills and read the name of the city of the district bank on the bill. However, make sure that they are actually reading off dollar bills and not just guessing the names of large cities. vi. One job performed by the Fed is the regulation of banks to ensure the health of the nation’s banking system. 1. The Fed monitors each bank's financial condition and facilitates bank transactions by clearing checks. 2. The Fed also makes loans to banks when they want to borrow. vii. The second job of the Fed is to control the quantity of money available in the economy. 1. Definition of money supply: the quantity of money available in the economy. 2. Definition of monetary policy: the setting of the money supply by policymakers in the central bank. Note that the money supply is closely related to interest rates. d. The Federal Open Market Committee i. The Federal Open Market Committee (FOMC) consists of the members of the Board of Governors and 5 of the 12 regional bank presidents. ii. Keep in Mind: Introduce students to the idea of open market operations here, but do not be surprised if they do not catch on quickly. You can return to this topic later in the chapter. iii. Historically, the primary tool the Fed uses to increase or decrease the number of dollars in the economy is open-market operations (which involve the purchase or sale of U.S. government bonds). 1. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public through the nation's bond markets. 2. If the Fed wants to reduce the supply of money, it sells government bonds from its portfolio to the public. Money is then taken out of the hands of the public and the supply of money falls. 3. More recently, the Fed relies less on open-market operations to manage monetary policy. Banks and the Money Supply a. Keep in Mind: The process of money creation in the banking system is one of the more difficult things to teach at the Principles level. Nearly every aspect of the

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System process will be new to students and nothing is obvious or intuitive. Therefore, it is extremely important that each step in the process is shown through T-accounts so that students can see how the banking system creates money as banks carry out their normal functions of accepting deposits and giving out loans. b. The Simple Case of 100-Percent-Reserve Banking i. Example: Suppose that currency is the only form of money and the total amount of currency is $100. ii. A bank is created as a safe place to store currency; all deposits are kept in the vault until the depositor withdraws them. 1. Definition of reserves: deposits that banks have received but have not loaned out. 2. Under the example described above, we have 100-percent-reserve banking. iii. Instruction Idea: Make sure that you explain why bank reserves are an asset from the bank’s perspective, but customer deposits are a liability. iv. The financial position of the bank can be described with a T-account: First National Bank Assets Reserves

Liabilities $100.00 Deposits

$100.00

Keep in Mind: Students will either catch on to T-accounts immediately or be completely confused. It is a good idea to explain them and then let students work together in small groups of two or three. You can check each group to identify the students who will require individualized attention. vi. The money supply in this economy is unaffected by the existence of a bank. 1. Before the bank existed, the money supply consisted of $100 worth of currency. 2. Now, with the bank, the money supply consists of $100 worth of deposits. vii. This means that, if banks hold all deposits in reserve, banks do not influence the supply of money. c. Money Creation with Fractional-Reserve Banking i. Definition of fractional-reserve banking: a banking system in which banks hold only a fraction of deposits as reserves. ii. Definition of reserve ratio: the fraction of deposits that banks hold as reserves. iii. Example: Same as before, but First National decides to set its reserve ratio equal to 10% and lend the remainder of the deposits. iv. The bank’s T-account would look like this: First National Bank Assets Reserves Loans

Liabilities $10.00 Deposits $90.00

$100.00

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System v.

When the bank makes these loans, the money supply changes. 1. Before the bank made any loans, the money supply was equal to the $100 worth of deposits. 2. Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans. 3. Therefore, when banks hold only a fraction of deposits in reserve, banks create money. vi. Note that, while new money has been created, so has debt. There is no new wealth created by this process. d. The Money Multiplier i. The creation of money does not stop at this point. ii. Borrowers usually borrow money to purchase something and then the money likely becomes redeposited at a bank. iii. Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second National Bank. Here is this bank’s Taccount (assuming that it also sets its reserve ratio to 10%): Second National Bank Assets Reserves Loans iv. v. vi.

Liabilities $9.00 Deposits $81.00

$90.00

If the $81 in loans becomes redeposited in another bank, this process will go on and on. Each time the money is deposited and a bank loan is created, more money is created. Definition of money multiplier: the amount of money that results from each dollar of reserves. money multiplier

1/reserve ratio

vii.

In our example, the money supply will ultimately increase from $100 to $1,000 due to fractional-reserve banking. 1. Alternative Classroom Example: Reserve ratio = 12.5% Money multiplier = 1/0.125 = 8 2. Instruction Idea: Spend some time showing students how the multiplier changes as the reserve ratio changes. Make sure that you explain why the multiplier changes when the reserve ratio changes. Students will catch on to the math fairly quickly; it is the intuition that is most difficult for them. e. Bank Capital, Leverage, and the Financial Crisis of 2008–2009 i. In reality, banks also get funds from issuing debt and equity.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System ii. iii.

Definition of bank capital: the resources a bank’s owners have put into the institution. A more realistic balance sheet for a bank: Assets

Reserves Loans Securities

More Realistic National Bank Liabilities and Owners' Equity $200.00 Deposits $800.00 $700.00 Debt $150.00 $100.00 Capital (owner’s equity) $50.00

iv.

LXV.

Definition of leverage: the use of borrowed money to supplement existing funds for investment purposes. v. Definition of leverage ratio: the ratio of assets to bank capital. 1. The leverage ratio is $1,000/$50 = 20. 2. A leverage ratio of 20 means that, for every dollar of capital that has been contributed by the owners, the bank has $20 of assets. 3. Because of leverage, a small change in assets can lead to a large change in owner’s equity. vi. Definition of capital requirement: a government regulation specifying a minimum amount of bank capital. vii. In 2008 and 2009, many banks realized they had incurred sizable losses on some of their assets. The Fed’s Tools of Monetary Control a. How the Fed Influences the Quantity of Reserves i. Open-Market Operations 1. Definition of open-market operations: the purchase and sale of U.S. government bonds by the Fed. 2. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public in the nation's bond markets. 3. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public in the nation's bond markets. Money is then taken out of the hands of the public and the supply of money falls. 4. The impact of the Fed’s sale or purchase of government bonds on the money supply will be made larger due to the money multiplier. 5. Open market operations are easy for the Fed to conduct. It is the tool that the Fed has historically used most often. ii. Instruction Idea: You may wish to use T-accounts to show the effects of an open market purchase or sale. This way, students can see that the effect of an open market operation can be quite large because of the money multiplier. iii. Fed Lending to Banks 1. The Fed can also lend reserves to banks. 2. Definition of discount rate: the interest rate on the loans that the Fed makes to banks.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System 3. A higher discount rate discourages banks from borrowing from the Fed, which, in turn, lowers the money supply. 4. A lower discount rate encourages banks to borrow from the Fed. This will increase the money supply. 5. In recent years, the Fed has set up new mechanisms for banks to borrow from the Fed such as the Term Auction Facility. b. How the Fed Influences the Reserve Ratio i. Reserve Requirements 1. Definition of reserve requirements: regulations on the minimum amount of reserves that banks must hold against deposits. 2. This can affect the size of the money supply through changes in the money multiplier. An increase in the reserve requirement decreases the money multiplier and the money supply. 3. This policy tool has become less relevant because after 2008, banks began holding reserves in excess of the requirement. In addition, in 2020, the Fed effectively eliminated the reserve requirement by setting it at zero. ii. Paying Interest on Reserves 1. Definition of interest on reserves: the interest rate paid to banks on the reserves held in deposit at the Fed. 2. In October of 2008, the Fed began paying banks interest on bank reserves. 3. The higher the interest rate, the more reserves a bank will want to hold. This increases the reserve ratio and decreases the money multiplier and the money supply. 4. Because recent Fed policy has emphasized a target for short-term interest rates rather than the money supply, this tool has become one of the most important tools of monetary policy. c. Problems in Controlling the Money Supply i. The Fed does not control the amount of money that consumers choose to deposit in banks. 1. The more money that households deposit, the more reserves the banks have, and the more money the banking system can create. 2. The less money that households deposit, the less reserves banks have, and the less money the banking system can create. ii. The Fed does not control the amount that bankers choose to lend. 1. The amount of money created by the banking system depends on loans being made. 2. If banks choose to hold onto a greater level of reserves than required by the Fed (called excess reserves), the money supply will fall. iii. Therefore, in a system of fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositors and bankers. iv. Because the Fed cannot control or perfectly predict this behavior, it cannot perfectly control the money supply.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System v.

The Fed’s precise control of the money supply has become less important in recent years because current monetary policy sets a target for interest rates rather than the money supply. d. Case Study: Bank Runs and the Money Supply i. Bank runs create a large problem under fractional-reserve banking. ii. Because the bank only holds a fraction of its deposits in reserve, it will not have the funds to satisfy withdrawal requests from all of its depositors at the same time. iii. Today, deposits are guaranteed through the Federal Depository Insurance Corporation (FDIC). In addition, the Fed stands ready to provide liquidity to the system during a run on the banks or mutual funds. iv. Instruction Idea: There is a student activity (Money Creation) that applies to this topic in the "Additional Activities and Assignments” section. e. The Federal Funds Rate i. Definition of federal funds rate: the short-term interest rate that banks charge one another for loans. ii. When the federal funds rate rises or falls, other interest rates often move in the same direction. iii. In recent years, the Fed has set a target for the federal funds rate. iv. The Fed adjusts monetary policy to hit the fed funds rate target by increasing or decreasing the rate it pays on bank reserves. If the Fed decreases the fed funds target, it decreases the interest it pays on reserves, banks lend more reserves, the fed funds rate decreases, and the money supply increases. f. In the News: A Trip to Jekyll Island i. In spite of many examples of its positive effects on the economy, the Fed still faces public scorn and mistrust. ii. This Los Angeles Times article describes the story of the creation of the Fed and the public’s paranoia associated with the central bank. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 160. Money is different from other assets in the economy because it is the most liquid asset available. Other assets vary widely in their liquidity. 161. Commodity money is money with intrinsic value, like gold, which can be used for purposes other than as a medium of exchange. Fiat money is money without intrinsic value; it has no value other than its use as a medium of exchange. Our economy uses fiat money. 162. Demand deposits are balances in bank accounts that depositors can access on demand simply by writing a check or using a debit card. They should be included in the supply of money because they can be used as a medium of exchange.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System 163. The Federal Open Market Committee (FOMC) is responsible for setting monetary policy in the United States. The FOMC consists of the 7 members of the Federal Reserve Board of Governors and 5 of the 12 presidents of Federal Reserve Banks. Members of the Board of Governors are appointed by the president of the United States and confirmed by the U.S. Senate. The presidents of the Federal Reserve Banks are chosen by each bank’s board of directors. 164. If the Fed wants to increase the supply of money with open-market operations, it purchases U.S. government bonds from the public on the open market. The purchase increases the number of dollars in the hands of the public, thus raising the money supply. 165. Banks do not hold 100% reserves because it is more profitable to use the reserves to make loans, which earn interest, instead of leaving the money as reserves. The amount of reserves banks hold is related to the amount of money the banking system creates through the money multiplier. The smaller the fraction of reserves banks hold, the larger the money multiplier, because each dollar of reserves is used to create more money. 166. Bank B will show a larger change in bank capital. The decrease in assets will render Bank B insolvent because its assets will fall below its liabilities, a decrease in bank capital of 140%. Bank A will suffer a large decline in bank capital (70%) but will remain solvent. 167. The discount rate is the interest rate on loans that the Federal Reserve makes to banks. If the Fed raises the discount rate, banks will borrow less from the Fed, so both banks' reserves and the money supply will be lower. 168. Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. 169. The Fed cannot control the money supply perfectly because: (1) the Fed does not control the amount of money that households choose to hold as deposits in banks; and (2) the Fed does not control the amount that bankers choose to lend. The actions of households and banks affect the money supply in ways the Fed cannot perfectly control or predict.

PROBLEMS AND APPLICATIONS 224. a. A U.S. penny is considered money in the U.S. economy because it is used as a medium of exchange to buy goods or services, it serves as a unit of account because prices in stores are listed in terms of dollars and cents, and it serves as a store of value for anyone who holds it over time. b. A Mexican peso is not considered money in the U.S. economy, because it is not used as a medium of exchange, and prices are not given in terms of pesos, so it is not a unit of account. It could serve as a store of value, though. c. A Picasso painting is not considered money, because you cannot exchange it for goods or services, and prices are not given in terms of Picasso paintings. It does, however, serve as a store of value. d. A plastic credit card is similar to money, but represents deferred payment rather than immediate payment. So credit cards do not fully represent the medium of exchange function of money, nor are they stores of value, because they represent short-term loans rather than being an asset like currency. 225.

a. When the Fed buys bonds in open market operations, the money supply increases.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System b. When the Fed reduces the reserve requirement, the money supply increases. c. When the Fed increases the interest rate it pays on reserves, the money supply decreases. d. When Citibank repays a loan from the Fed, the money supply decreases. e. When people decide to hold less currency, they likely deposit their currency in a bank and the bank will lend portion of that money, so the money supply increases. f. When bankers decide to hold more reserves, the money supply decreases. g. When the FOMC increases its target for the federal funds rate, the money supply decreases. 226. When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a check from his TNB checking account, the result is a change in the assets and liabilities of both your uncle and TNB, as shown in these T-accounts:

Your Uncle Assets

Liabilities

Before: Checking Account After: Checking Account

$100 Loans

$100

$0 Loans

Tenth National Bank Assets

Liabilities

Before: Loans After: Loans

$100 Deposits

$100

$0 Deposits

By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his checking account. Your uncle's wealth has not changed; they simply have fewer assets and fewer liabilities. 227.

a. Here is BSB's T-account: Beleaguered State Bank Liabilities $25 million Deposits $250 million $225 million

Assets Reserves Loans

b. When BSB's largest depositor withdraws $10 million in cash and BSB reduces its loans outstanding to maintain the same reserve ratio, its T-account is now:

Assets

Beleaguered State Bank Liabilities

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System Reserves Loans

$24 million Deposits $216 million

$240 million

c. Because BSB is cutting back on its loans, other banks will find themselves short of reserves and they may also cut back on their loans as well. d. BSB may find it difficult to cut back on its loans immediately, because it cannot force people to pay off loans. Instead, it can stop making new loans. But for a time, it might find itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the Fed. 228. If you take $100 that you held as currency and put it into the banking system, then the total amount of deposits in the banking system increases by $1,000, because a reserve ratio of 10% means the money multiplier is 1/0.10 = 10. Thus, the money supply increases by $900, because deposits increase by $1,000 but currency declines by $100. 229. a. Happy Bank Assets Liabilities Reserves $100 Deposits $800 Loans $900 Bank Capital $200 b. The leverage ratio = $1,000/$200 = 5. c. Happy Bank Assets Reserves Loans

Liabilities $100 Deposits $810 Bank Capital

$800 $110

d. Assets decline by 9%. The bank's capital declines by 45%. The reduction in bank capital is larger than the reduction in assets because all of the defaulted loans are covered by bank capital. 230. With a required reserve ratio of 10%, and if banks hold no excess reserves and people do not increase their currency holdings, the money multiplier could be as high as 1/0.10 = 10. Therefore, the maximum increase in the money supply from a $10 million open-market purchase is $100 million. Alternatively, if all of the new money is held as currency by the individual investors, the result would be the smallest possible increase of $10 million. 231. The money supply will expand more if the Fed buys $2,000 worth of bonds. Both deposits will lead to monetary expansion, but the Fed’s deposit is new money. With a 5% reserve requirement, the multiplier is 20 (1/0.05). The $2,000 from the Fed will increase the money supply by $40,000 ($2,000 x 20). The $2,000 from the cookie jar is already part of the money supply as currency. When it is deposited the money supply increases by $38,000. Deposits increase by $40,000 ($2,000 x 20) but currency decreases by $2,000. 232.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System a. With a required reserve ratio of 10% and no excess reserves, the money multiplier is 1/0.10 = 10. If the Fed sells $1 million of government bonds, reserves will decline by $1 million and the money supply will contract by 10 × $1 million = $10 million. b. Banks might wish to hold excess reserves if they need to hold the reserves for their day-to-day operations, such as paying other banks for customers' transactions, making change, cashing paychecks, and so on. If banks increase excess reserves such that there is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money supply. 233.

234.

235.

a. With banks holding only required reserves of 10%, the money multiplier is 1/0.10 = 10. Because reserves are $100 billion, the money supply is 10 × $100 billion = $1,000 billion or $1 trillion. b. If the required reserve ratio is raised to 20%, the money multiplier declines to 1/0.20 = 5. With reserves of $100 billion, the money supply would decline to $500 billion, a decline of $500 billion. Reserves would be unchanged. a. To expand the money supply, the Fed should buy bonds. b. With a reserve requirement of 20%, the money multiplier is 1/0.20 = 5. Therefore to expand the money supply by $40 million, the Fed should buy $40 million/5 = $8 million worth of bonds. a. If people hold all money as currency, the quantity of money is $2,000. b. If people hold all money as demand deposits at banks with 100% reserves, the quantity of money is $2,000. c. If people have $1,000 in currency and $1,000 in demand deposits, the quantity of money is $2,000. d. If banks have a reserve ratio of 10%, the money multiplier is 1/0.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 × $2,000 = $20,000. e. If people hold equal amounts of currency (C) and demand deposits (D) and the money multiplier for reserves is 10, then two equations must be satisfied: (1) C = D, so that people have equal amounts of currency and demand deposits; and (2) 10 × ($2,000 – C) = D, so that the money multiplier (10) times the number of dollar bills that are not being held by people ($2,000 – C) equals the amount of demand deposits (D). Using the first equation in the second gives 10 × ($2,000 – D) = D, or $20,000 – 10D = D, or $20,000 = 11 D, so D = $1,818.18. Then C = $1,818.18. The quantity of money is C + D = $3,636.36.

[In-class demonstration] What Can Be Learned from a Dollar?: 5 minutes total. Works in any class size. Topics include money and Federal Reserve. CCC. Purpose: This activity introduces the role of the Federal Reserve in controlling the money supply.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System DDD. Instructions: Ask the class to take a dollar bill from wallets (or a $5, $10, $20, or $100). Students without any currency can share with someone who does. Ask the class to read the bill. After a minute, ask them what they have learned. EEE. Common Answers and Points for Discussion: Most students focus on the statement “This note is legal tender for all debts, public and private.” This statement is the only “backing” U.S. currency has—the note is not convertible into gold or silver. This can be used to introduce the difference between fiat money and commodity money. Someone will usually point to the phrase printed at the top of the face of each bill: “Federal Reserve Note.” Explain the Fed functions as the United States' central bank—controlling the money supply and supplying currency to banks. Information about the structure of the Federal Reserve can be found in the seal to the left of the portrait. The writing around the seal says “Federal Reserve Bank of ___________.” If the class is big enough, all 12 Federal Reserve Banks will be represented: Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

XXXI.

This is a good place to introduce the Federal Reserve Districts, and the Banks’ roles in those regions. These include check clearing, holding commercial bank reserves, supplying currency, lending to commercial banks, and collecting and analyzing regional economic data. [In-class demonstration] Money Creation: 25 minutes total. Works in any class size. Topics include the banking system and deposit expansion. Two volunteers and a paper with “$1,000” written on it are required. a. Purpose: This activity demonstrates the role of the banking system in expanding the money supply. b. Instructions: The two volunteers are bankers. Have each of them draw a balance sheet on the board. BankTwo Assets Liabilities 0 0

AmerBankCorp Assets Liabilities 0 0

The rest of the class is the public. They are all eager borrowers and depositors. The instructor is the Federal Reserve. The Federal Reserve sets the reserve requirement at 20% of deposits. The Federal Reserve also conducts open-market operations. Use the $1,000 paper to buy a baseball cap from a student. (Explain that the Fed actually buys government bonds from the public because the market for used baseball caps is small.)

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System The capless student now has $1,000 to spend with any other member of the class. This student receives $1,000 and puts it in the bank of their choice. The bank now has $1,000 in deposits (a liability) and $1,000 in cash (an asset). The bank needs to keep $200 in reserve (20%) but can loan the other $800. Have the banker tear off 20% of the bill and give the rest to another student. Revise the banks' balance sheets. Now the borrower spends the $800 and the recipient deposits it in a bank. This bank now has $800 in deposits and $800 in cash. Of that, $160 needs to be kept in reserve and $640 can be lent. Have the banker save 20% of the paper and give the rest to another eager borrower. Revise the banks' balance sheets. Continue this process for a few more iterations. At the end, ask everyone who has money in the bank to stand. The total deposits in the bank will far exceed the initial $1,000 that the Fed put into the economy. Show the final balance sheet for each bank. c. Points for Discussion: i. Banks are important to the process of money creation. The banking system, as a whole, literally expands the money supply. ii. If the process is carried on far enough, you can derive the money multiplier. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Medium of Exchange and Barter o ConceptClip: Unit of Account o ConceptClip: Store of Value and Inflation o ConceptClip: Money and Demand Deposits o ConceptClip: Central Banks and the Federal Reserve o ConceptClip: Federal Reserve System o ConceptClip: Fractional Reserve Banking o ConceptClip: Money Multiplier o ConceptClip: Open Market Operations o ConceptClip: Discount Rate and Fed Funds Rate o Video Problem Walk-Through: Tracking Bank Assets, Liabilities, and Owners' Equity with T-Accounts

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation o o o o o o o o

Video Problem Walk-Through: The Money Multiplier and the Money Supply Video Problem Walk-Through: Calculating the Quantity of Money Equivalency of Fractions, Decimals, and Percentages Graphing Basics Video Quiz: Money: Functions and Types Video Quiz: U.S. Money Stock Measures Video Quiz: Money and Banking Video Quiz: The Federal Reserve System

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 539 Chapter Objectives ........................................................................................................................................... 539 Complete List of Chapter Activities and Assessments ......................................................................... 540 Key Terms ........................................................................................................................................................... 540 What's New in This Chapter .......................................................................................................................... 541 Chapter Outline ................................................................................................................................................. 541 Solutions to Text Problems ........................................................................................................................... 104 Questions for Review ................................................................................................................................................... 104 Problems and Applications ........................................................................................................................................ 105 Additional Activities and Assignments ..................................................................................................... 106 Additional Resources ...................................................................................................................................... 106 Cengage Video Resources ........................................................................................................................................... 106

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 31 is the second chapter in a two-chapter sequence dealing with money and prices in the long run. Chapter 30 explained what money is and how the Federal Reserve controls the quantity of money. Chapter 31 establishes the relationship between the rate of growth of money and the inflation rate. The purpose of this chapter is to acquaint students with the causes and costs of inflation. Students will find that, in the long run, there is a strong relationship between the growth rate of money and inflation. Students will also find that there are numerous costs to the economy from high inflation, but that there is not a consensus on the importance of these costs when inflation is moderate. Key points addressed in this chapter: 



 

The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money leads to continuing inflation. The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behavior of the economy in the long run. A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation. One application of the principle of monetary neutrality is the Fisher effect. When the expected inflation rate increases, the nominal interest rate increases by the same amount, so that the real interest rate remains the same. Many people think that inflation makes them poorer by raising the cost of what they buy. This view is a fallacy because inflation also raises nominal incomes. Economists have identified six costs of inflation: shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities because of nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Interpret the quantity theory of money.



Describe the relationship between the nominal interest rate, inflation, and the real interest rate.



Given a graph of the market for money, show the effect of a change in the money supply on the market equilibrium.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation 

Determine the effect of a change in the money supply on inflation using the quantity equation.



Explain how the classical dichotomy relates to money neutrality.



Calculate the impact of unexpected inflation using the Fisher effect.



Given a scenario, identify the cost of inflation being described.



Compare the results of a low-inflation scenario against a high-inflation scenario with regards to tax distortions.

Source (i.e., PPT slide, Workbook) PPT Slide 18 PPT Slide 23 PPT Slide 29 PPT Slide 49 PPT Slide 50 MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder MindTap Learn It Folder

Duration 5–10 mins. 5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder

20–30 mins. N/A 10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. 20–30 mins.

[return to top]

KEY TERMS Classical Dichotomy: the theoretical separation of nominal and real variables. Fisher Effect: the one-for-one adjustment of the nominal interest rate to the inflation rate. Inflation Tax: the revenue the government raises by creating money.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation Menu Costs: the costs of changing prices. Monetary Neutrality: the proposition that changes in the money supply do not affect real variables. Nominal Variables: variables measured in monetary units. Real Variables: variables measured in physical units. Shoeleather Costs: the resources wasted when inflation encourages people to reduce their money holdings. Quantity Equation: the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services. Quantity Theory of Money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. Velocity of Money: the rate at which money changes hands. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

The data in Figures 3 and 5 have been updated.

[return to top]

LXVII.

The inflation rate is measured as the percentage change in the Consumer Price Index, the GDP deflator, or some other index of the overall price level. a. Over the past 85 years, prices have risen on average 3.5% per year in the United States. i. There has been substantial variation in the rate of price changes over time. ii. From 2010 to 2020, prices rose at an average rate of 1.7% per year, while prices rose by 7.8% per year during the 1970s. b. International data shows an even broader range of inflation experiences. In 2020, inflation was zero in Japan, 3.4% in Mexico, 11% in Nigeria, and 12% in Turkey. In 2018, inflation reached 1 million% in Venezuela. The Classical Theory of Inflation a. Instruction Idea: Start off the chapter by differentiating between a “once-and-forall” increase in the average level of prices and a continuous increase in the price

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation level. Also make sure that students realize that inflation means that the average level of prices in the economy is rising rather than the prices of all goods. b. Instruction Idea: It is instructive to review the inflation history of the United States. While your students are likely fully aware of inflation, they may not realize that, prior to World War II, the United States experienced several periods of deflation. Also point out to the students that the rate of inflation has varied significantly since World War II. c. The Level of Prices and the Value of Money i. When the price level rises, people have to pay more for the goods and services they buy. ii. A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller quantity of goods and services. iii. If P is the price level, then the quantity of goods and services that can be purchased with $1 is equal to 1/P. iv. Suppose you live in a country with one good (ice cream cones). 1. When the price of an ice cream cone is $2, the value of a dollar is 1/2 cone. 2. When the price of an ice cream cone rises to $3, the value of a dollar is 1/3 cone. d. Money Supply, Money Demand, and Monetary Equilibrium i. The value of money is determined by the supply and demand for money. ii. For the most part, the supply of money is determined by the Fed. iii. The demand for money reflects how much wealth people want to hold in liquid form. 1. One variable that is very important in determining the demand for money is the price level. 2. The higher prices are, the more money that is needed to perform transactions. 3. Thus, a higher price level (and a lower value of money) leads to a higher quantity of money demanded. iv. In the long run, money supply and money demand are brought into equilibrium by the overall level of prices. 1. If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline. 2. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise. Figure 1

We can show the supply and demand for money using a graph. 1. The horizontal axis shows the quantity of money. 2. The left-hand vertical axis is the value of money, measured by 1/P. 3. The right-hand vertical axis is the price level (P). Note that it is inverted—a high value of money means a low price level and vice versa. 4. The supply curve is vertical because the Fed has fixed the quantity of money available.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation 5. The demand curve for money is downward sloping. When the value of money is low, people demand a larger quantity of it to buy goods and services. 6. At the equilibrium, the quantity of money demanded is equal to the quantity of money supplied. e. The Effects of a Monetary Injection i. Assume that the economy is currently in equilibrium and the Fed suddenly increases the supply of money. ii. The supply of money shifts to the right. Figure 2

iii. iv.

The equilibrium value of money falls and the price level rises. When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable. v. Definition of quantity theory of money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. f. A Brief Look at the Adjustment Process i. The immediate effect of an increase in the money supply is to create an excess supply of money. ii. People try to get rid of this excess supply in a variety of ways. 1. They may buy goods and services with the excess funds. 2. They may use these excess funds to make loans to others by buying bonds or depositing the money in a bank account. These loans will then be used by others to buy goods and services. 3. In either case, the increase in the money supply leads to an increase in the demand for goods and services. 4. Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices. g. The Classical Dichotomy and Monetary Neutrality i. The relationship between monetary changes and important macroeconomic variables such as production, employment, wages, and interest rates, has long been of interest to economists.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation ii.

Economists have found that economic variables can be divided into two groups: nominal variables and real variables. 1. Definition of nominal variables: variables measured in monetary units. 2. Definition of real variables: variables measured in physical units. iii. Definition of classical dichotomy: the theoretical separation of nominal and real variables. iv. Prices in the economy are nominal (because they are quoted in units of money), but relative prices are real (because they are not measured in money terms). v. Classical analysis suggested that different forces influence real and nominal variables. 1. Changes in the money supply affect nominal variables but not real variables. 2. Definition of monetary neutrality: the proposition that changes in the money supply do not affect real variables. h. Instruction Idea: Mankiw’s analogy of changing the size of a yard stick from 36 inches to 18 inches is a useful way to explain the confusion that a change in a unit of measurement (or a unit of account) can cause. i. Velocity and the Quantity Equation i. Definition of velocity of money: the rate at which money changes hands. ii. To calculate velocity, we divide nominal GDP by the quantity of money. velocity nominal GDP/money supply iii.

If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money: velocity

iv.

Rearranging, we get the quantity equation:

Alternative Classroom Example: Suppose that: Real GDP $5,000 Velocity 5 Money supply $2,000 Price level 2 We can show that: MxV PxY $2,000 x 5 2 x $5,000 $10,000 $10,00

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation vi.

Definition of quantity equation: the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services. 1. The quantity equation shows that an increase in the quantity of money must be reflected in one of the other three variables. 2. Specifically, the price level must rise, output must rise, or velocity must fall.

Figure 3

3. Figure 3 shows nominal GDP, the quantity of money (as measured by M2) and the velocity of money for the United States since 1960. It appears that velocity is fairly stable, while nominal GDP and the money supply have grown dramatically. vii. We can now explain how an increase in the quantity of money affects the price level using the quantity equation. 1. The velocity of money is relatively stable over time. 2. When the central bank changes the quantity of money (M), it will proportionately change the nominal value of output (P × Y). 3. The economy’s output of goods and services (Y) is determined primarily by available resources and technology. Because money is neutral, changes in the money supply do not affect output. 4. This must mean that P increases proportionately with the change in M. 5. Thus, when the central bank increases the money supply rapidly, the result is a high rate of inflation. Case Study: Money and Prices during Four Hyperinflations i. Hyperinflation is generally defined as inflation that exceeds 50% per month.

Figure 4 ii.

Figure 4 shows data from four classic periods of hyperinflation during the 1920s in Austria, Hungary, Germany, and Poland. iii. We can see that, in each graph, the quantity of money and the price level are almost parallel. iv. These episodes illustrate Principle #9: Prices rise when the government prints too much money. k. The Inflation Tax i. Some countries use money creation to pay for spending instead of using tax revenue. ii. Definition of inflation tax: the revenue the government raises by creating money. iii. The inflation tax is like a tax on everyone who holds money.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation iv.

Instruction Idea: Point out that an inflation tax is a more subtle form of taxation than the standard forms of taxation (income tax, sales tax, etc.). v. Almost all hyperinflations follow the same pattern. 1. The government has a high level of spending and inadequate tax revenue to pay for its spending. 2. The government’s ability to borrow funds is limited. 3. As a result, it turns to printing money to pay for its spending. 4. The large increases in the money supply lead to large amounts of inflation. 5. The hyperinflation ends when the government cuts its spending and eliminates the need to create new money. The Fisher Effect i. Recall that the real interest rate is equal to the nominal interest rate minus the inflation rate. ii. This, of course, means that: nominal interest rate real interest rate + inflation rate

iii.

1. The supply and demand for loanable funds determines the real interest rate. 2. Growth in the money supply determines the inflation rate. Alternative Classroom Example: Real interest rate = 5% Inflation rate = 2% This means that the nominal interest rate will be 5% + 2% = 7%

iv.

If the inflation rate rises to 3%, the nominal interest rate will rise to 5% + 3% = 8% When the Fed increases the rate of growth of the money supply, the inflation rate increases. This in turn will lead to an increase in the nominal interest rate. Definition of Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate. 1. The Fisher effect does not hold in the short run to the extent that inflation is unanticipated. 2. If inflation catches borrowers and lenders by surprise, the nominal interest rate will fail to reflect the rise in prices.

Figure 5 vi.

LXVIII.

Figure 5 shows the nominal interest rate and the inflation rate in the U.S. economy since 1960. The Costs of Inflation a. A Fall in Purchasing Power? The Inflation Fallacy i. Most individuals believe that the major problem caused by inflation is that inflation lowers the purchasing power of a person’s income.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation ii.

However, as prices rise, so do incomes. Thus, inflation does not in itself reduce the purchasing power of incomes. iii. Instruction Idea: Point out to students that prices involve both buyers and sellers. This implies that the higher prices paid by consumers are offset by the higher incomes received by the sellers. Also remind students that workers often get pay increases over time to compensate for increases in the cost of living. Shoeleather Costs i. Because inflation erodes the value of money that you carry in your pocket, you can avoid this drop in value by holding less money. ii. However, holding less money generally means more trips to the bank. iii. Definition of shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings. iv. This cost can be considerable in countries experiencing hyperinflation. Menu Costs i. Definition of menu costs: the costs of changing prices. ii. During periods of inflation, firms must change their prices more often. Relative-Price Variability and the Misallocation of Resources i. Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise. ii. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use. Inflation-Induced Tax Distortions i. Lawmakers fail to take inflation into account when they write tax laws. ii. The nominal values of interest income and capital gains are taxed (not the real values). iii. Instruction Idea: Students find this section intriguing. Most have not considered the fact that tax laws do not differentiate between nominal and real interest income and capital gains, and they soon realize that this can lead to effects on rates of saving. Work through an example of the after-tax real interest rate under different inflation scenarios as is done in the text.

Table 1 iv.

v. vi. vii. viii.

Table 1 shows a hypothetical example of two individuals, living in two countries earning the same real interest rate, and paying the same tax rate, but one individual lives in a country without inflation and the other lives in a country with 8% inflation. The person living in the country with inflation ends up with a smaller after-tax real interest rate. This implies that higher inflation will tend to discourage saving. A possible solution to this problem would be to index the tax system. Alternative Classroom Example: Hannah and Miley each earn a real interest rate on their savings account of 3%. However, Hannah lives in a country with a 1% inflation rate, while Miley lives in a country with a 10%

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation inflation rate. Both countries have a 20% tax on income.

Real interest rate Inflation rate Nominal interest rate Reduced interest due to 20% tax After-tax nominal interest rate After-tax real interest rate

Hannah 3% 1 4 0.8 3.2 2.2

Miley 3% 10 13 2.6 11.4 1.4

Note that the after-tax return on saving is lower in Miley’s country than in Hannah’s. This means that individuals in Miley’s country will be less likely to save. f.

Confusion and Inconvenience i. Money is the yardstick that we use to measure economic transactions. ii. When inflation occurs, the value of money falls. This alters the yardstick that we use to measure important variables like incomes and profit. g. A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth i. Example: Sophie Student takes out a $50,000 loan at 7% interest (nominal). In 10 years, the loan will come due. After her debt has compounded for 10 years at 7%, Sophie will owe the bank $100,000. ii. The real value of this debt will depend on inflation. 1. If the economy has a hyperinflation, wages and prices will rise so much that Sophie may be able to pay the $100,000 out of pocket change. 2. If the economy has deflation, Sophie will find the $100,000 a greater burden than she anticipated. iii. Because inflation is often hard to predict, it imposes risk on both Sophie and the bank that the real value of the debt will differ from that expected when the loan is made. iv. Inflation is especially volatile and uncertain when the average rate of inflation is high. h. Inflation Is Bad, but Deflation May Be Worse i. Although inflation has been the norm in recent U.S. history, from 1998 to 2012 Japan experienced a 4-percent decline in its overall price level. ii. Deflation leads to lower shoeleather costs, but still creates menu costs and relative-price variability. iii. Deflation also results in the redistribution of wealth toward creditors and away from debtors. It tends to occur when there is a significant reduction in aggregate demand, which causes reduced output and rising unemployment. i. Case Study: The Wizard of Oz and the Free Silver Debate i. Some scholars believe that the book The Wizard of Oz was written about U.S. monetary policy in the late 19th century.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation ii.

From 1880 to 1896, the United States experienced deflation, redistributing wealth from farmers (with outstanding loans) to banks. iii. Because the United States followed the gold standard at this time, one possible solution to the problem was to start to use silver as well. This would increase the supply of money, raising the price level, and reduce the real value of the farmers’ debts. iv. There has been some debate over the interpretation assigned to each character, but it is clear that the story revolves around the monetary policy debate at that time in history. v. Even though those who wanted to use silver were defeated, the money supply in the United States increased in 1898 when gold was discovered in Alaska and supplies of gold were shipped in from Canada and South Africa. vi. Within 15 years, prices were back up and the farmers were better able to handle their debts. j. In the News: Life During Hyperinflation: “What 52,000 Percent Inflation Can do to a Country.” i. Hyperinflation is sometimes defined as 50% per month for at least 30 days. ii. Hyperinflation occurs when a government spends (or prints) money that it doesn’t have, and the public loses confidence in the money. iii. A most recent hyperinflation is in Venezuela. With inflation at 52,000%, Venezuela’s economy shrank 35% in five years. Nine of ten people can’t buy sufficient food and have lost 24 pounds on average. More than 2.3 million have fled the country, including more than half the nation’s doctors. This in a country with more oil reserves than Saudi Arabia. iv. Venezuela’s government earns most of its revenue from oil and it refused to reduce its spending when oil prices went down. k. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 170. An increase in the price level reduces the real value of money because each dollar in your wallet now buys a smaller quantity of goods and services. 171. According to the quantity theory of money, an increase in the quantity of money causes a proportional increase in the price level. 172. Nominal variables are those measured in monetary units, while real variables are those measured in physical units. Examples of nominal variables include the prices of goods

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation and nominal GDP. Examples of real variables include relative prices (the price of one good in terms of another), and real wages. According to the principle of monetary neutrality, only nominal variables are affected by changes in the quantity of money. 173. Inflation is like a tax because everyone who holds money loses purchasing power. In a hyperinflation, the government increases the money supply rapidly, which leads to a high rate of inflation. Thus the government uses the inflation tax, instead of taxes, to finance its spending. 174. According to the Fisher effect, an increase in the inflation rate raises the nominal interest rate by the same amount that the inflation rate increases, with no effect on the real interest rate. 175. The costs of inflation include shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. With a low and stable rate of inflation like that in the United States, none of these costs are very high. Perhaps the most important one is the interaction between inflation and the tax code, which may reduce saving and investment even though the inflation rate is low. 176. If inflation is less than expected, creditors benefit and debtors lose. Creditors receive dollar payments from debtors that have a higher real value than was expected.

PROBLEMS AND APPLICATIONS 236.

237.

In this problem, all amounts are shown in billions. a. Nominal GDP = P × Y = $10,000 and Y = real GDP = $5,000, so P = (P × Y)/Y = $10,000/$5,000 = 2. Because M × V = P × Y, then V = (P × Y )/M = $10,000/$500 = 20. b. If M and V are unchanged and Y rises by 5%, then because M × V = P × Y, P must fall by 5%. As a result, nominal GDP is unchanged. c. To keep the price level stable, the Fed must increase the money supply by 5%, matching the increase in real GDP. Then, because velocity is unchanged, the price level will be stable. d. If the Fed wants inflation to be 10%, it will need to increase the money supply 15%. Thus M × V will rise 15%, causing P × Y to rise 15%, with a 10% increase in prices and a 5% rise in real GDP. a. If people need to hold less cash, the demand for money shifts to the left, because there will be less money demanded at any price level. b. If the Fed does not respond to this event, the shift to the left of the demand for money combined with no change in the supply of money leads to a decline in the value of money (1/P), which means the price level rises, as shown in Figure 1.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation

Figure 1 c. If the Fed wants to keep the price level stable, it should reduce the money supply from S1 to S2 in Figure 2. This would cause the supply of money to shift to the left by the same amount that the demand for money shifted, resulting in no change in the value of money and the price level.

Figure 2 238. With constant velocity, reducing the inflation rate to zero would require the money growth rate to equal the growth rate of output, according to the quantity theory of money (M × V = P × Y ). 239. If a country's inflation rate increases sharply, the inflation tax on holders of money increases significantly. Wealth in savings accounts is not subject to a change in the inflation tax because the nominal interest rate will increase with the rise in inflation. But holders of savings accounts are hurt by the increase in the inflation rate because they are taxed on their nominal interest income, so their real returns are lower. 240. a. When the price of both goods doubles in a year, inflation is 100%. Let’s set the market basket equal to one unit of each good. The cost of the market basket is initially $4 and becomes $8 in the second year. Thus, the rate of inflation is [($8 – $4)/$4] × 100 = 100%. Because the prices of all goods rise by 100%, the farmers get a 100% increase in their incomes to go along with the 100% increase in prices, so neither is affected by the change in prices.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation

241.

b. If the price of beans rises to $2 and the price of rice rises to $4, then the cost of the market basket in the second year is $6. This means that the inflation rate is [($6 – $4)/$4] × 100 = 50%. Bob is better off because his dollar revenues doubled (increased 100%) while inflation was only 50%. Rita is worse off because inflation was 50% percent, so the price of the good she buys rose faster than the price of the good (rice) she sells, which rose only 33%. c. If the price of beans rises to $2 and the price of rice falls to $1.50, then the cost of the market basket in the second year is $3.50. This means that the inflation rate is ($3.5 – $4)/$4 × 100 = -12.5%. Bob is better off because his dollar revenues doubled (increased 100%) while prices overall fell 12.5%. Rita is worse off because inflation was -12.5%, so the price of the good she buys didn't fall as fast as the price of the good (rice) she sells, which fell 50%. d. The relative price of rice and beans matters more to Bob and Rita than the overall inflation rate. If the price of the good that a person produces rises more than inflation, they will be better off. If the price of the good a person produces rises less than inflation, they will be worse off. The following table shows the relevant calculations:

(1) Nominal interest rate (2) Inflation rate (3) Before-tax real interest rate (4) Reduction in nominal interest rate due to 40% tax (5) After-tax nominal interest rate (6) After-tax real interest rate

(a) 10.0 5.0 5.0 4.0

(b) 6.0 2.0 4.0 2.4

6.0 1.0

3.6 1.6

2.4 1.4

Row (3) is row (1) minus row (2). Row (4) is 0.40 × row (1). Row (5) is (1 – .40) × row (1), which equals row (1) minus row (4). Row (6) is row (5) minus row (2). Note that even though part (a) has the highest before-tax real interest rate, it has the lowest after-tax real interest rate. Note also that the after-tax real interest rate is much lower than the before-tax real interest rate. 242. The functions of money are to serve as a medium of exchange, a unit of account, and a store of value. Inflation mainly affects the ability of money to serve as a store of value, because inflation erodes money's purchasing power, making it less attractive as a store of value. Money also is not as useful as a unit of account when there is inflation, because stores have to change prices more often and because people are confused and inconvenienced by the changes in the value of money. In some countries with hyperinflation, stores post prices in terms of a more stable currency, such as the U.S. dollar, even when the local currency is still used as the medium of exchange. Sometimes countries even stop using their local currency altogether and use a foreign currency as the medium of exchange as well. 243. a. Unexpectedly high inflation helps the government by providing higher tax revenue and reducing the real value of outstanding government debt. b. Unexpectedly high inflation helps a homeowner with a fixed-rate mortgage because they pay a fixed nominal interest rate that was based on expected inflation, and thus pays a lower real interest rate than was expected. c. Unexpectedly high inflation hurts a union worker in the second year of a labor contract because the contract probably based the worker's nominal wage on the

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation

244.

expected inflation rate. As a result, the worker receives a lower-than-expected real wage. d. Unexpectedly high inflation hurts a college that has invested some of its endowment in government bonds because the higher inflation rate means the college is receiving a lower real interest rate than it had planned. (This assumes that the college did not purchase indexed Treasury bonds.) a. The statement that "Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest," is false. Higher expected inflation means borrowers pay a higher nominal rate of interest, but it is the same real rate of interest, so borrowers are not worse off and lenders are not better off. Higher unexpected inflation, on the other hand, makes borrowers better off and lenders worse off. b. The statement, "If prices change in a way that leaves the overall price level unchanged, then no one is made better or worse off," is false. Changes in relative prices can make some people better off and others worse off, even though the overall price level does not change. See problem 6 for an illustration of this. c. The statement, "Inflation does not reduce the purchasing power of most workers," is true. Most workers' incomes keep up with inflation reasonably well.

[In-class demonstration] The Inflation Fairy: 10 minutes total. Works in any class size. Topics include price ceilings, subsidies, and unintended consequences. Materials needed include 2 toy ducks, some play money, and 3 volunteers. FFF. Purpose: This activity demonstrates the effects of inflation. GGG. Instructions: Ask the class to consider the effect of an overnight doubling of prices. Tell them everything doubled in price while they slept. A soft drink that sold for a dollar, now sells for two dollars; a car that sold for $20,000 now sells for $40,000. The price of labor doubled as well, so a job paying $6 an hour now pays $12; a $30,000 annual salary becomes a $60,000 annual salary. The value of all assets doubled as well. Stock prices are twice what they were at yesterday’s closing. A $1,000 bond becomes a $2,000 bond. A $35 balance in a checking account becomes $70, and so on. Debts have also doubled. The $5 borrowed from a roommate becomes $10. The $3,000 in student loans becomes $6,000. A $75,000 home mortgage becomes a $150,000 mortgage.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 31: Money Growth and Inflation And even cash balances double. The inflation fairy sneaks in at night and replaces the $10 bill in their wallet with a new $20 bill. The inflation fairy even doubles the coins in their piggy banks. If the prices of everything doubled overnight, what would happen? HHH. Points for Discussion: If the prices of everything doubled overnight, what would happen: NOTHING. If all prices adjusted perfectly there would be no real effect. Everyone would have exactly the same purchasing power. They have twice as much money but everything costs twice as much. There have been no relative changes in price. This is a fantastic rate of inflation: 100% daily. Prices would increase more than a billion-fold in a month at this rate of price change. Yet, if everything adjusts perfectly there will be no real effect on the economy. The problem, of course, is there is no inflation fairy ensuring that everything adjusts smoothly. Some prices adjust quickly and others do not. Cash balances would not double without the inflation fairy, so people would not be willing to hold cash or accept cash in payment. This would increase transaction costs considerably. If prices do not change at the same rate, there will be winners and losers from inflation. For example, if everything doubled in price overnight except debt, then borrowers would see the real value of their loan payments halved. Borrowers would win and lenders would lose. If the overnight inflation is an ongoing process, everyone would try to borrow, but no one would be willing to lend. Credit markets would collapse. More generally, anyone whose income does not keep up with inflation will lose. Anyone whose costs rise less than inflation will come out ahead. Other problems can be introduced here: bracket creep, increased uncertainty, weakening of price signals, shoeleather costs, menu costs, etc. Much of the problem with inflation is distributional, but there are real consequences as well. Time spent worrying about inflation, or profiting from inflation, is a diversion of resources away from productive activity. [return to top]

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Nominal vs. Real o ConceptClip: Fisher Effect o ConceptClip: Menu Costs o Video Problem Walk-Through: Using the Quantity Equation to Examine Monetary Policy o Video Problem Walk-Through: Examining the Impact of a Change in the Demand for Money o Video Problem Walk-Through: Calculating the Before-Tax and After-Tax Real Interest Rate

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 556 Chapter Objectives ........................................................................................................................................... 556 Complete List of Chapter Activities and Assessments ......................................................................... 557 Key Terms ........................................................................................................................................................... 557 What's New in This Chapter .......................................................................................................................... 558 Chapter Outline ................................................................................................................................................. 558 Solutions to Text Problems ........................................................................................................................... 568 Questions for Review ................................................................................................................................................... 568 Problems and Applications ........................................................................................................................................ 568 Additional Activities and Assignments ..................................................................................................... 570 Additional Resources ...................................................................................................................................... 571 Cengage Video Resources ........................................................................................................................................... 571

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 32 is the first chapter in a two-chapter sequence dealing with open-economy macroeconomics. Chapter 32 develops the basic concepts and vocabulary associated with macroeconomics in an international setting: net exports, net capital outflow, real and nominal exchange rates, and purchasing-power parity. The next chapter, Chapter 33, builds an openeconomy macroeconomic model that shows how these variables are determined simultaneously. The purpose of Chapter 32 is to develop the basic concepts macroeconomists use to study open economies. It addresses why a nation’s net exports must equal its net capital outflow. It also addresses the concepts of the real and nominal exchange rate and develops a theory of exchange rate determination known as purchasing-power parity. Key points addressed in this chapter: 

 



Net exports are the value of domestic goods and services sold abroad (exports) minus the value of foreign goods and services sold domestically (imports). Net capital outflow is the acquisition of foreign assets by domestic residents (capital outflow) minus the acquisition of domestic assets by foreigners (capital inflow). Because every export is balanced either with an import or with the acquisition of a capital asset, an economy’s net exports always equals its net capital outflow. An economy’s saving can be used to finance investment at home or buy assets abroad. Thus, national saving equals domestic investment plus net capital outflow. The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the relative price of the goods and services of two countries. When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken. According to the theory of purchasing-power parity, a dollar (or a unit of any other currency) should be able to buy the same quantity of goods in all countries. This theory implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those countries. As a result, countries with relatively high inflation should have depreciating currencies, and countries with relatively low inflation should have appreciating currencies.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain the relationship between net exports and net capital outflow.



Explain the relationship between saving, investment, and international flows.



Given data on prices in various countries, compute the exchange rate that is consistent with purchasing-power parity.



Describe the market for foreign-currency exchange.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts 

Contrast a country's nominal exchange rate with its real exchange rate.



Determine the implications of purchasing-power parity on exchange rates.

Source (i.e., PPT slide, Workbook) PPT Slide 6 PPT Slide 12 PPT Slide 23 PPT Slide 32 PPT Slide 44 PPT Slide 45 MindTap eBook MindTap eBook MindTap eBook MindTap Study It Folder

Duration

MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

N/A 20-30 mins. 20–30 mins.

10-15 mins. 5-10 mins. 10-15 mins. 5-10 mins. 5-10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 15-25 mins.

[return to top]

KEY TERMS Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy. Balanced Trade: a situation in which exports equal imports. Closed Economy: an economy that does not interact with other economies in the world. Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy. Exports: goods and services produced domestically and sold abroad. Imports: goods and services produced abroad and sold domestically. Nominal Exchange Rate: the rate at which a person can trade the currency of one country for the currency of another.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts Net Capital Outflow (NCO): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net Exports: the value of a nation’s exports minus the value of its imports, also called the trade balance. Purchasing-power Parity: a theory of exchange rates that says unit of any given currency should be able to buy the same quantity of goods in all countries. Real Exchange Rate: the rate at which a person can trade the goods and services of one country for the goods and services of another. Trade Balance: the value of a nation’s exports minus the value of its imports, also called net exports. Trade Deficit: an excess of imports over exports. Trade Surplus: an excess of exports over imports. Open Economy: an economy that interacts freely with other economies around the world. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

Data on the Hamburger Standard has been updated. Data in Figures 1 and 2 are updated.

[return to top]

LXX.

We will no longer be assuming that the economy is a closed economy. a. Definition of closed economy: an economy that does not interact with other economies in the world. b. Definition of open economy: an economy that interacts freely with other economies around the world. The International Flows of Goods and Capital a. The Flow of Goods: Exports, Imports, and Net Exports i. Definition of exports: goods and services produced domestically and sold abroad. ii. Definition of imports: goods and services produced abroad and sold domestically.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts

iii.

1. Instruction Idea: Point out foreign products that students are likely to buy. Definition of net exports: the value of a nation’s exports minus the value of its imports, also called the trade balance. 𝑁𝑋

iv. v. vi. vii.

viii.

ix.

Exports

Imports

Definition of trade balance: the value of a nation’s exports minus the value of its imports, also called net exports. Definition of trade surplus: an excess of exports over imports. Definition of trade deficit: an excess of imports over exports. Definition of balanced trade: a situation in which exports equal imports. 1. Instruction Idea: Point out to students that a trade surplus implies a positive level of net exports, a trade deficit means that net exports are negative, and balanced trade occurs when net exports are equal to zero. While this will likely be obvious to most students, some will benefit if you review this. There are several factors that influence a country’s exports, imports, and net exports: 1. The tastes of consumers for domestic and foreign goods. 2. The prices of goods at home and abroad. 3. The exchange rates at which people can use domestic currency to buy foreign currencies. 4. The incomes of consumers at home and abroad. 5. The cost of transporting goods from country to country. 6. Government policies toward international trade. Case Study: The Increasing Openness of the U.S. Economy

Figure 1 1. Figure 1 shows the total value of exports and imports (expressed as a percentage of GDP) for the United States since 1950. 2. Advances in transportation, telecommunications, and technological progress are some of the reasons why international trade has increased over time. 3. Policymakers around the world have also become more accepting of free trade over time. 4. President Trump is challenging these trends by imposing tariffs on many foreign goods hoping to use this pressure to negotiate more favorable trade agreements. The trade policies of the Biden administration are not yet clear, but it appears that he will move to reduce some tariffs. b. The Flow of Financial Resources: Net Capital Outflow i. Definition of net capital outflow (NCO): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. 𝑁𝐶𝑂

purchases of foreign assets by domestic residents

purchases of domestic assets by foreigners

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts 1. Instruction Idea: You will likely have to write this equation several times on the board for students when discussing this chapter and the next. Students can grasp the concept of net exports more easily than they can grasp the concept of net capital outflow. ii. The flow of capital abroad takes two forms. 1. Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity. 2. Foreign portfolio investment involves an investment that is financed with foreign money but operated by domestic residents. iii. Net capital outflow can be positive or negative. 1. When net capital outflow is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is flowing out of the country. 2. When net capital outflow is negative, domestic residents are buying fewer foreign assets than foreigners are buying domestic assets. The country is experiencing a capital inflow. iv. There are several factors that influence a country’s net capital outflow: 1. The real interest rates being paid on foreign assets. 2. The real interest rates being paid on domestic assets. 3. The perceived economic and political risks of holding assets abroad. 4. The government policies that affect foreign ownership of domestic assets. c. The Equality of Net Exports and Net Capital Outflow i. Net exports and net capital outflow each measure a type of imbalance in a world market. 1. Net exports measure the imbalance between a country’s exports and imports in world markets for goods and services. 2. Net capital outflow measures the imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners in world financial markets. ii. For an economy, net exports must be equal to net capital outflow. iii. Example: You are a computer programmer who sells some software to a Japanese consumer for 10,000 yen. 1. The sale is an export of the United States so U.S. net exports increase. 2. There are several things you could do with the 10,000 yen. 3. You could hold the yen (which is a Japanese asset) or use it to purchase another Japanese asset. Either way, U.S. net capital outflow rises. 4. Alternatively, you could use the yen to purchase a Japanese good. Thus, U.S. imports will rise so the net effect on net exports will be zero. 5. One final possibility is that you could exchange the yen for dollars at a bank. This does not change the situation though, because the bank then must use the yen for something.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts iv.

Alternative Classroom Example: Assume that U.S. residents do not want to buy any foreign assets, but foreign residents want to purchase some stock in a U.S. firm (such as Microsoft). How are the foreigners going to get the dollars to purchase the stock? They would do it the same way U.S. residents would purchase the stock— they would have to earn more than they spend. In other words, foreigners must sell the United States more goods and services than they purchase from the United States.

This leads to negative net exports for the United States. The extra dollars spent by U.S. residents on foreign-produced goods and services would be used to purchase the stock in Microsoft. v. This example can be generalized to the economy as a whole. 1. When a nation is running a trade surplus (NX > 0), it must be using the foreign currency to purchase foreign assets. Thus, capital is flowing out of the country (NCO > 0). 2. When a nation is running a trade deficit (NX < 0), it must be financing the net purchase of these goods by selling assets abroad. Thus, capital is flowing into the country (NCO < 0). vi. Every international transaction involves exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for the good or service. vii. Thus, the net value of the goods and services sold by a country (net exports) must equal the net value of the assets acquired (net capital outflow). d. Saving, Investment, and Their Relationship to the International Flows i. Recall that GDP (Y) is the sum of four components: consumption (C), investment (I), government purchases (G) and net exports (NX). 𝑌 ii.

𝐼

𝐺

𝑁𝑋

Recall that national saving is equal to the income of the nation after paying for current consumption and government purchases. 𝑆

iii.

𝐶

𝑌

𝐶

𝐺

We can rearrange the equation for GDP to get: 𝑌

𝐶

𝐺

𝐼

𝑁𝑋

Substituting for the left-hand side, we get: 𝑆 iv.

𝐼

𝑁𝑋

Because net exports and net capital outflow are equal, we can rewrite this as: 𝑆

𝐼

𝑁𝐶𝑂

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts v.

This implies that saving is equal to the sum of domestic investment (I) and net capital outflow (NCO). vi. When a U.S. citizen saves $1 of their income, that dollar can be used to finance the accumulation of domestic capital or it can be used to finance the purchase of foreign capital. vii. Note that, in a closed economy such as the one we assumed earlier, net capital outflow would equal zero and saving would simply be equal to domestic investment. e. Summing Up Table 1 i.

ii.

Table 1 describes three possible outcomes for an open economy: a country with a trade deficit, a country with balanced trade, or a country with a trade surplus. Case Study: Is the U.S. Trade Deficit a National Problem?

iii.

1. Panel (a) of Figure 2 shows national saving and domestic investment for the United States as a percentage of GDP since 1960. 2. Panel (b) of Figure 2 shows net capital outflow for the United States as a percentage of GDP for the same time period. 3. Before 1980, domestic investment and national saving tended to fluctuate together, so net capital outflow was typically small. 4. Trade deficits can arise under a variety of circumstances. 5. Unbalanced fiscal policy: From 1980 to 1987, national saving fell due to an increase in the government budget deficit. 6. Investment boom: From 1991 to 2000, the capital flow into the United States increased as the government's budget switched from deficit to surplus, but investment went from 15.3% to 19.8% of GDP. The economy enjoyed a boom in information technology and firms invested heavily. 7. Economic downturn and recovery: From 2000 to 2019, the capital flow into the United States remained large. From 2000 to 2009, both saving and investment fell by about 6%. Tough economic times made additional capital less profitable and national saving fell due to extraordinarily large budget deficits. From 2009 to 2019, as the economy recovered both saving and investment increased by about 4%. 8. When national saving falls, either investment will have to fall or net capital outflow will have to fall. 9. On the other hand, a trade deficit led by an increase in investment will not pose a large problem for the United States if the increased investment leads to a higher production of goods and services. Ask the Experts: Trade Balances

Table 2

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LXXI.

1. When asked if a typical country can increase its’ citizens welfare by enacting policies that would increase its trade surplus, 66 percent of economic experts disagreed, while 6 percent agreed and 28 percent were uncertain. 2. When asked if an important reason why many workers in Michigan and Ohio have lost jobs in recent years is because U.S. presidential administrations over the last 30 years have not been tough enough in trade negotiations, only 3% of economic experts agreed, while 87% disagreed and 10% were uncertain. The Prices for International Transactions: Real and Nominal Exchange Rates a. Instruction Idea: Students are curious about the currencies of other countries. Bring in a current list of nominal exchange rates between several currencies and the U.S. dollar. Quiz the students to see if they can match up the currencies with the countries where they are used. Encourage students to bring in foreign currencies if they have them. b. Nominal Exchange Rates i. Definition of nominal exchange rate: the rate at which a person can trade the currency of one country for the currency of another. ii. An exchange rate can be expressed in two ways. 1. Example: 80 yen per dollar. (The text always states nominal exchange rates in terms of foreign currency per dollar.) 2. This can also be written as 1/80 dollar (or 0.0125 dollar) per yen. 3. Alternative Classroom Example: $1 = 10 pesos 1 peso = $0.10 iii. Definition of appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy. iv. Definition of depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy. v. When a currency appreciates, it is said to strengthen; when a currency depreciates, it is said to weaken. vi. When economists study nominal exchange rates, they often use an exchange rate index, which converts the many nominal exchange rates into a single measure. vii. FYI: The Euro 1. During the 1990s, many European nations decided to give up their national currencies and use a new common currency called the euro. 2. The euro started circulating on January 1, 2002. 3. Monetary policy is now set by the European Central Bank (ECB), which controls the supply of euros in the economy. 4. Benefits of a common currency include easier trading ability and increased unity. 5. However, because there is only one currency, there can be only one monetary policy.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts 6. From 2010 to 2015, worries about having a common currency came to the forefront when Greece faced a possible default of its government debt. viii. Instruction Idea: Make sure that you emphasize that when the dollar appreciates against a particular currency that currency must depreciate against the dollar. Use an example to illustrate this point. c. Real Exchange Rates i. Definition of real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another. ii. Example: A bushel of American rice sells for $100 and a bushel of Japanese rice sells for 16,000 yen. The nominal exchange rate is 80 yen per dollar. iii. The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies. real exchange rate

iv.

Nominal exchange rate Domestic price Foreign price

In our example:

real exchange rate

80 yen per dollar $100 per bushel of American rice 16,000 yen per bushel of Japanese rice

8,000 yen per bushel of American rice 16,000 yen per bushel of Japanese rice

real exchange rate = 1/2 bushel of Japanese rice per bushel of American rice v.

Alternative Classroom Example: Price of Mexican corn = 50 pesos/bushel Price of American corn = $10/bushel Nominal exchange rate: $1 = 12 pesos

real exchange rate = (12 pesos per dollar)($10 per bushel of American corn) 50 pesos per bushel of Mexican corn real exchange rate = 120 pesos per bushel of American corn 50 pesos per bushel of Mexican corn real exchange rate = 2.4 bushels of Mexican corn per bushel of American corn vi. vii.

The real exchange rate is a key determinant of how much a country exports and imports. When studying an economy as a whole, macroeconomists focus on overall prices instead of the prices of individual goods and services.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts 1. Price indexes are used to measure the level of overall prices. 2. Assume that P is the price index for the United States, P* is a price index for prices abroad, and e is the nominal exchange rate between the U.S. dollar and foreign currencies. real exchange rate viii.

LXXII.

The real exchange rate measures the price of a basket of goods and services available domestically relative to the price of a basket of goods and services available abroad. ix. A depreciation in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. U.S. exports will rise, imports will fall, and net exports will increase. x. Likewise, an appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive relative to foreign goods. U.S. exports will fall, imports will rise, and net exports will decline. A First Theory of Exchange-Rate Determination: Purchasing-Power Parity a. Definition of purchasing-power parity: a theory of exchange rates that says unit of any given currency should be able to buy the same quantity of goods in all countries. b. The Basic Logic of Purchasing-Power Parity i. The law of one price suggests that a good must sell for the same price in all locations. 1. If a good sold for less in one location than another, a person could make a profit by buying the good in the location where it is cheaper and selling it in the location where it is more expensive. 2. The process of taking advantage of differences in prices for the same item in different markets is called arbitrage. 3. Note what will happen as people take advantage of the differences in prices. The price in the location where the good is cheaper will rise (because the demand is now higher) and the price in the location where the good was more expensive will fall (because the supply is greater). This will continue until the two prices are equal. ii. The same logic should apply to currency. 1. A U.S. dollar should buy the same quantity of goods and services in the United States and Japan; a Japanese yen should buy the same quantity of goods and services in the United States and Japan. 2. Purchasing-power parity suggests that a unit of all currencies must have the same purchasing power in every country. 3. If this was not the case, people would take advantage of the profitmaking opportunity and this arbitrage would then push the real values of the currencies to equality. 4. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. c. Implications of Purchasing-Power Parity

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts i.

ii.

iii.

Purchasing-power parity means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries. If a dollar buys the same amount of goods and services in the United States (where prices are measured in dollars) as it does in Japan (where prices are measured in yen), then the nominal exchange rate (the number of yen per dollar) must reflect the prices of goods and services in the two countries. Suppose that P is the price of a basket of goods in the United States (measured in dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate (the number of yen each dollar can buy). 1. In the United States, the purchasing power of $1 is 1/P. 2. In Japan, $1 can be exchanged for e units of yen, which in turn have the purchasing power of e/P*. 3. Purchasing-power parity implies that the two must be equal: 1/𝑃

𝑒 𝑃

4. Rearranging, we get: 1

𝑒𝑃 𝑃

Note that the left-hand side is a constant and the right-hand side is the real exchange rate. This implies that if the purchasing power of a dollar is always the same at home and abroad, then the real exchange rate cannot change. 5. We can rearrange again to see that: 𝑒

𝑃 𝑃

The nominal exchange rate is determined by the ratio of the foreign price level to the domestic price level. Nominal exchange rates will change when price levels change. iv.

Because the nominal exchange rate depends on the price levels, it must also depend on the money supply and money demand in each country. 1. If the central bank increases the supply of money in a country and raises the price level, it also causes the country’s currency to depreciate relative to other currencies in the world. 2. When a central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy. Case Study: The Nominal Exchange Rate during a Hyperinflation

Figure 3

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts 1. Figure 3 shows the German money supply, the German price level, and the nominal exchange rate (measured as U.S. cents per German mark) during Germany's hyperinflation in the early 1920s. 2. When the supply of money begins growing, the price level also increases and the German mark depreciates. d. Limitations of Purchasing-Power Parity i. Exchange rates do not always move to ensure that a dollar has the same real value in all countries all of the time. ii. There are two reasons why the theory of purchasing-power parity does not always hold in practice. 1. Many goods are not easily traded (haircuts in Paris versus haircuts in New York). Thus, arbitrage would be too limited to eliminate the difference in prices between the locations. 2. Tradable goods are not always perfect substitutes when they are produced in different countries (American cars versus German cars). There is no opportunity for arbitrage here, because the price difference reflects the different values the consumer places on the two products. iii. Case Study: The Hamburger Standard 1. The Economist, an international newsmagazine, occasionally compares the cost of a Big Mac in various countries all around the world. 2. Once we have the prices of Big Macs in two countries, we can compute the nominal exchange rate predicted by the theory of purchasing-power parity and compare it with the actual exchange rate. 3. In 2019, the exchange rates predicted by the theory were not exactly equal to the actual rates. However, the predicted rates were fairly close to the actual rates. iv. Instruction Idea: Students who have lived or traveled overseas will often point out that many American products (such as blue jeans) are much more expensive overseas than they are in the United States. Point out to students that this could be the result of trade restrictions or price discrimination. Examine the implications of each. v. Instruction Idea: Point out to students that, even with its flaws, purchasing-power parity does tell us about exchange rates. Large and persistent movements in nominal exchange rates typically reflect changes in price level at home and abroad. [return to top]

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 13. The net exports of a country are the value of its exports minus the value of its imports. Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports are equal to net capital outflow by an accounting identity, because exports from one country to another are matched by payments of some asset from the second country to the first. 14. Saving equals domestic investment plus net capital outflow, because any dollar saved can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad. 15. If a dollar can buy 100 yen, the nominal exchange rate is 100 yen per dollar. The real exchange rate equals the nominal exchange rate times the domestic price divided by the foreign price, which equals 100 yen per dollar times $30,000 per American car divided by 1,500,000 yen per Japanese car, which equals two Japanese cars per American car. 16. The economic logic behind the theory of purchasing-power parity is that a good must sell for the same price in all locations. Otherwise, people would profit by engaging in arbitrage. 17. If the Fed started printing large quantities of U.S. dollars, the U.S. price level would increase, and a dollar would buy fewer Japanese yen because the U.S. dollar loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

PROBLEMS AND APPLICATIONS 245. a. When an American art professor spends the summer touring museums in Europe, they spend money buying foreign goods and services, so U.S. exports are unchanged, imports increase, and net exports decrease. b. When students in Paris flock to see the latest movie from Hollywood, foreigners are buying a U.S. good, so U.S. exports rise, imports are unchanged, and net exports increase. c. When your uncle buys a new Fiat, an American is buying a foreign good, so U.S. exports are unchanged, imports rise, and net exports decline. d. When the student bookstore at Oxford University sells a copy of this textbook, foreigners are buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. e. When a Canadian citizen shops in northern Vermont to avoid Canadian sales taxes, a foreigner is buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. 246. a. When an American buys a Sony TV, there is a decrease in net exports. b. When an American buys a share of Sony stock, there is an increase in net capital outflow.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts c. When the Sony pension fund buys a U.S. Treasury bond, there is a decrease in net capital outflow. d. When a worker at Sony buys some Georgia peaches from an American farmer, there is an increase in net exports. 247. Foreign direct investment requires actively managing an investment, for example, by opening a retail store in a foreign country. Foreign portfolio investment is passive, for example, buying corporate stock in a retail chain in a foreign country. As a result, a corporation is more likely to engage in foreign direct investment, while an individual investor is more likely to engage in foreign portfolio investment. 248. a. When an American cellular phone company establishes an office in the Czech Republic, U.S. net capital outflow increases, because the U.S. company makes a direct investment in capital in the foreign country. b. When Harrod's of London sells stock to the General Motors pension fund, U.S. net capital outflow increases, because the U.S. company makes a portfolio investment in the foreign country. c. When Honda expands its factory in Marysville, Ohio, U.S. net capital outflow declines, because the foreign company makes a direct investment in capital in the United States. d. When a Fidelity mutual fund sells its Toyota stock to a French investor, U.S. net capital outflow declines (if the French investor pays in U.S. dollars), because the U.S. company is reducing its portfolio investment in a foreign country. 249. a. Dutch pension funds holding U.S. government bonds would be happy if the U.S. dollar appreciated. They would then get more Euros for each dollar they earned on their U.S. investment. In general, if you have an investment in a foreign country, you are better off if that country's currency appreciates. b. U.S. manufacturing industries would be unhappy if the U.S. dollar appreciated because their prices would be higher in terms of foreign currencies, which will reduce their sales. c. Australian tourists planning a trip to the United States would be unhappy if the U.S. dollar appreciated because they would get fewer U.S. dollars for each Australian dollar, so their vacation will be more expensive. d. An American firm trying to purchase property overseas would be happy if the U.S. dollar appreciated because it would get more units of the foreign currency and could thus buy more property. 250. All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level. a. If the U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad, the real exchange rate rises. b. If the U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States, the real exchange rate declines. c. If the U.S. nominal exchange rate declines and prices are unchanged in the United States and abroad, the real exchange rate declines.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 32: Open-Economy Macroeconomics: Basic Concepts d. If the U.S. nominal exchange rate declines and prices rise faster abroad than in the United States, the real exchange rate declines. 251. If purchasing-power parity holds, then 25 pesos per soda divided by $1.25 per soda equals the exchange rate of 20 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 40 pesos per dollar. 252. If you take X units of foreign currency per Big Mac divided by 5.58 dollars per Big Mac, you get X/5.58 units of the foreign currency per dollar; that is the predicted exchange rate. a. Chile: 2640 pesos/$5.58 = 473 pesos/$ Hungary: 850 forints/$5.58 = 152 forints/$ Czech Republic: 85 korunas/$5.58 = 15.2 korunas/$ Brazil: 16.9 reales/$5.58 = 3.01 reales/$ Canada: 6.77C$/$5.58 = 1.21C$/$ b. Under purchasing-power parity, the exchange rate of the Chilean pesos to the Canadian dollar is 2640 per Big Mac divided by 6.77 Canadian dollars per Big Mac equals 390 Chilean pesos per Canadian dollar. The actual exchange rate is 679 Chilean pesos per dollar divided by 1.33 Canadian dollars per dollar equals 510 Chilean pesos per Canadian dollar. c. The exchange rates predicted by the Big Mac index are somewhat close to the actual exchange rates. 253. a. The exchange rate is 1 Ecterian dollar is equal to 6 Wiknamian pesos. b. In Ecteria, the price of Spam would double. The price level will quadruple in Wiknam. The exchange rate between the two countries’ currencies would double because of the differences in inflation rates. c. Wiknam will have a higher nominal interest rate because of the Fisher effect. d. The get-rich scheme would only work if there were a difference in real interest rates, not nominal interest rates. The nominal exchange rate between the two countries will adjust for the effects of inflation.

[In-class assignment] A Profitable Opportunity: 20 minutes total. Works in any class size. Topics include exchange rates and arbitrage. III. Purpose: This assignment lets students practice calculating prices with exchange rates and looking for profit opportunities. JJJ. Instructions: Explain the following: Molson’s Beer is produced in Canada and sold in many countries. In the province of Ontario, a six-pack of Molson’s beer sells for $12.95 Canadian. Across the border in Michigan, a six pack of the same beer sells for $6.99 U.S. Suppose that the exchange rate is $0.90 U.S. = $1.00 Canadian. Ask the class to make the following calculations: a. How much would it cost in U.S. currency to buy the beer in Ontario?

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

KKK.

b. How much would it cost in Canadian currency to buy the beer in Michigan? c. Is there an arbitrage opportunity? d. If there is an arbitrage opportunity, where would you buy and where would you sell? How much profit could you expect on a six-pack? Common Answers and Points for Discussion: a. How much would it cost in U.S. currency to buy the beer in Ontario? $12.95 X 0.90 = $11.66 U.S. b. How much would it cost in Canadian currency to buy the beer in Michigan? $6.99/0.90 = $7.77 Canadian c. Is there an arbitrage opportunity? Yes. A price differential exists. The beer is more expensive in Canada, cheaper in the United States. d. If there is an arbitrage opportunity, where would you buy and where would you sell? How much profit could you expect on a six-pack? Buy in Michigan, sell in Ontario. The profit per six-pack would be the difference between the price in Ontario, $11.66 and the price in Michigan, $6.99, which equals $4.67 U.S. (Or, measured in Canadian currency, a profit of $5.19 Canadian.)

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o Video Problem Walk-Through: Determining the Impact of Various Transactions on Imports, Exports, and Net Exports o Video Problem Walk-Through: Determining the Impact of Various Transactions on Foreign Direct Investment, Foreign Portfolio Investment, and Net Capital Outflow o Video Problem Walk-Through: Purchasing Power Parity and the Nominal Exchange Rate o Video Problem Walk-Through: Calculating the Nominal Exchange Rate, Real Exchange Rate, and Prices with Purchasing-Power Parity o Equation Basics o Equivalency of Fractions, Decimals, and Percentages

[return to top]

Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy Prepared by David R. Hakes, University of Northern Iowa

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

573

Complete List of Chapter Activities and Assessments Key Terms

574

575

What's New in This Chapter 575 Chapter Outline

575

Solutions to Text Problems 585 Questions for Review ................................................................................................................................................... 585 Problems and Applications ........................................................................................................................................ 587 Additional Activities and Assignments

592

Additional Resources593 Cengage Video Resources ........................................................................................................................................... 593

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

PURPOSE AND PERSPECTIVE OF THE CHAPTER The purpose of Chapter 33 is to establish the interdependence of a number of economic variables in an open economy. In particular, Chapter 33 demonstrates the relationships between the prices and quantities in the market for loanable funds and the prices and quantities in the market for foreigncurrency exchange. Using these markets, we can analyze the impact of a variety of government policies on an economy’s exchange rate and trade balance. Key points addressed in this chapter: 



Two markets are central to the macroeconomics of open economies: the market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the real interest rate adjusts to balance the supply of loanable funds (from national saving) and the demand for loanable funds (for domestic investment and net capital outflow). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (from net capital outflow) and the demand for dollars (for net exports). Because net capital outflow is part of the demand for loanable funds and because it provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets. A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net capital outflow, which reduces the supply of dollars in the market for foreign-currency exchange. The dollar appreciates, and net exports fall. Although restrictive trade policies, such as tariffs or quotas on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the demand for dollars in the market for foreign-currency exchange. As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports. When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Apply basic principles about the international flow of goods and capital.



Explain the relationship between saving, investment, and international flows.



Explain the relationship between national saving, public saving, and private saving.



Describe the loanable funds market.



Analyze how changes in demand impact equilibrium in the market for loanable funds.



Analyze how changes in supply impact equilibrium in the market for loanable funds.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy 

Explain the saving and investment identity.



Identify market equilibrium in the loanable funds market.



Determine the implications of purchasing-power parity on exchange rates.



Describe the market for foreign-currency exchange.



Determine the effect of a budget deficit on the supply curve in the foreign-currency exchange market.



Compare the effect of a quota versus a tariff on an open economy.



Indicate the effects of capital flight on macroeconomic variables.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments so that you can make decisions about which content you would like to emphasize in your class. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Active Learning 2 Ask the Experts: Deficits Ask the Experts: Currency Manipulation Think-Pair-Share Activity Self-Assessment Section 33-1 QuickQuiz Section 33-2 QuickQuiz Section 33-3 QuickQuiz ConceptClip: Long-Run Equilibrium Figure 4: The Real Equilibrium in an Open Economy Figure 5: The Effects of a Government Budget Deficit Figure 6: The Effects of an Import Quota Figure 7: The Effects of Capital Flight Chapter 33 Problems & Applications Chapter 33 A+ Test Preop Video Quiz: The Open Economy: Part I Video Quiz: The Open Economy: Part II

Source (i.e., PPT slide, Workbook) PPT Slide 25 PPT Slide 31 PPT Slide 33 PPT Slide 44

Duration 5–10 mins. 5–10 mins. 10–15 mins. 10–15 mins.

PPT Slide 47 PPT Slide 48 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder

5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder

25–35 mins.

MindTap Study It Folder MindTap Apply It Folder

N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy Chapter 33 Homework Chapter 33 Quiz: A Macroeconomic Theory of the Open Economy

MindTap Apply It Folder MindTap Apply It Folder

15–25 mins. 20–30 mins.

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KEY TERMS Capital Flight: a large and sudden reduction in the demand for assets located in a country. Trade Policy: government policy that directly influences the quantity of goods and services that a country imports or exports. [return to top]

WHAT'S NEW IN THIS CHAPTER There are no major changes to this chapter. [return to top]

Supply and Demand for Loanable Funds and for Foreign-Currency Exchange a. The Market for Loanable Funds i. Whenever a nation saves a dollar of income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad. ii. The supply of loanable funds comes from national saving. iii. The demand for loanable funds comes from domestic investment and net capital outflow. 1. Because net capital outflow can be positive or negative, it can either add to or subtract from the demand for loanable funds that arises from domestic investment. 2. When NCO > 0, the country is experiencing a net outflow of capital. When NCO < 0, the country is experiencing a net inflow of capital. iv. The quantity of loanable funds demanded and the quantity of loanable funds supplied depend on the real interest rate. 1. A higher real interest rate encourages people to save and thus raises the quantity of loanable funds supplied.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

2. A higher real interest rate makes borrowing to finance capital projects more costly, discouraging investment and reducing the quantity of loanable funds demanded. 3. A higher real interest rate in a country will also lower net capital outflow. All else being equal, a higher domestic interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of domestic assets by foreigners will rise. 4. Instruction Idea: You may need to write the equation for net capital outflow on the board to explain its relationship with the real interest rate. Point out that when the U.S. real interest rate rises, purchases of foreign assets by domestic residents fall and purchases of U.S. assets by foreigners rise. Thus, net capital outflow is inversely related to the real interest rate. The supply and demand for loanable funds can be shown graphically. 1. The real interest rate is the price of borrowing funds and is therefore on the vertical axis; the quantity of loanable funds is on the horizontal axis. 2. The supply of loanable funds is upward sloping because of the positive relationship between the real interest rate and the quantity of loanable funds supplied. 3. The demand for loanable funds is downward sloping because of the inverse relationship between the real interest rate and the quantity of loanable funds demanded.

Figure 1

4. Instruction Idea: Put “saving” in parentheses next to the supply of loanable funds and “I + NCO” next to the demand for loanable funds. Encourage students to do the same. These will serve as reminders of the sources of the supply and demand for loanable funds.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy vi.

The interest rate adjusts to bring the supply and demand for loanable funds into balance. 1. If the interest rate were below r*, the quantity of loanable funds demanded would be greater than the quantity of loanable funds supplied. The shortage of loanable funds would lead to upward pressure on the interest rate. 2. If the interest rate were above r*, the quantity of loanable funds demanded would be less than the quantity of loanable funds supplied. The surplus of loanable funds would lead to downward pressure on the interest rate. vii. At the equilibrium interest rate, the amount that people want to save is equal to the desired quantities of domestic investment and net capital outflow. b. The Market for Foreign-Currency Exchange i. The imbalance between the purchase and sale of capital assets abroad must be equal to the imbalance between exports and imports of goods and services. ii. Net capital outflow represents the quantity of dollars supplied for the purpose of buying assets abroad. iii. Net exports represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services. iv. The real exchange rate is the price that balances the supply and demand in the market for foreign-currency exchange. 1. When the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods, lowering U.S. exports and raising imports. Thus, an increase in the real exchange rate will reduce the quantity of dollars demanded. 2. The key determinant of net capital outflow is the real interest rate. Thus, as the real exchange rate changes, there will be no change in net capital outflow. While an increase in the value of the dollar lowers the cost of foreign assets, it lowers the benefits of owning them because profits must be turned back into dollars. These two offset. 3. Instruction Idea: Go back to the list of factors that influence net capital outflow (from the previous chapter). Show students that the exchange rate is not there. v. We can show the market for foreign-currency exchange graphically. 1. The real exchange rate is on the vertical axis; the quantity of dollars exchanged is on the horizontal axis. 2. The demand for dollars will be downward sloping because of the inverse relationship between the real exchange rate and the quantity of dollars demanded. 3. The supply of dollars will be a vertical line because of the fact that changes in the real exchange rate have no influence on the quantity of dollars supplied. Figure 2 © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

4. Instruction Idea: Remind students that net exports determine the demand for dollars by placing “NX ” in parentheses next to the demand curve. Show that net capital outflow determines the supply of dollars by placing “NCO ” in parentheses next to the supply curve. vi. The real exchange rate adjusts to balance the supply and demand for dollars. 1. If the real exchange rate were lower than real e*, the quantity of dollars demanded would be greater than the quantity of dollars supplied and there would be upward pressure on the real exchange rate. 2. If the real exchange rate were higher than real e*, the quantity of dollars demanded would be less than the quantity of dollars supplied and there would be downward pressure on the real exchange rate. vii. At the equilibrium real exchange rate, the demand for dollars to buy net exports balances the supply of dollars to be exchanged into foreign currency to buy assets abroad. c. FYI: Purchasing-Power Parity as a Special Case i. Purchasing-power parity suggests that a dollar must buy the same quantity of goods and services in every country. As a result, the real exchange rate is fixed and the nominal exchange rate is determined by the price levels in the two countries. ii. Purchasing-power parity assumes that international trade responds quickly to international price differences. 1. If goods were cheaper in one country than another, they would be exported from the country where they are cheaper and imported into the second country where the prices are higher until the price differential disappears. 2. Because net exports are so responsive to small changes in the real exchange rate, purchasing-power parity implies that the demand for dollars would be horizontal. Thus, purchasing-power parity is simply a special case of the model of the foreign-currency exchange market.

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LXXIV.

3. However, in practice, foreign and domestic goods are not always perfect substitutes and there are costs that impede trade. Therefore, it is more realistic to draw the demand curve downward sloping. Equilibrium in the Open Economy a. Net Capital Outflow: The Link between the Two Markets i. In the market for loanable funds, net capital outflow is one of the sources of demand. Figure 3

ii.

In the foreign-currency exchange market, net capital outflow is the source of the supply of dollars. iii. This means that net capital outflow is the variable that links the two markets. iv. The key determinant of net capital outflow is the real interest rate. v. We can show the relationship between net capital outflow and the real interest rate graphically. 1. When the real interest rate is high, owning domestic assets is more attractive and thus, net capital outflow is low. 2. Instruction Idea: Again, you may need to write the equation for net capital outflow on the board to demonstrate the inverse relationship between the real interest rate and net capital outflow. 3. This inverse relationship implies that net capital outflow will be downward sloping. 4. Note that net capital outflow can be positive or negative. b. Simultaneous Equilibrium in Two Markets i. Keep in Mind: Students may be intimidated by the next diagram showing the market for loanable funds and the market for foreign-currency exchange, with the diagram of net capital outflow linking the two. Go through it very slowly. You will likely have to repeat the equilibrium process several times before students understand it. Figure 4 © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

ii. iii. iv.

The real interest rate is determined in the market for loanable funds. This real interest rate determines the level of net capital outflow. Because net capital outflow must be paid for with foreign currency, the quantity of net capital outflow determines the supply of dollars. v. The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars demanded. vi. Thus, the real interest rate and the real exchange rate adjust simultaneously to balance supply and demand in the two markets. As they do so, they determine the levels of national saving, domestic investment, net capital outflow, and net exports. c. FYI: Disentangling Supply and Demand i. Sometimes it is a bit arbitrary how we divide things between supply and demand. ii. In the market for loanable funds, our model treats net capital outflow as part of the demand for loanable funds. 1. Investment plus net capital outflow must equal saving (I + NCO = S). 2. Thus, we could say instead that investment is equal to saving minus net capital outflow (I = S – NCO). iii. In the market for foreign-currency exchange, net exports are the source of the demand for dollars and net capital outflow is the source of the supply of dollars. 1. When a U.S. citizen buys an imported good, we treat it as a decrease in the quantity of dollars demanded rather than an increase in the quantity of dollars supplied. 2. When a Japanese citizen buys a U.S. government bond, we treat the transaction as a decline in the quantity of dollars supplied rather than an increase in the quantity of dollars demanded.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy LXXV.

How Policies and Events Affect an Open Economy a. Instruction Idea: For the next three applications, use the three-step process developed in Chapter 4. First, determine which of the curves have been affected. Second, determine in which direction the curves shift, and finally, use the diagrams to examine how these shifts alter equilibrium in the two markets. b. Government Budget Deficits i. A government budget deficit occurs when the government spending exceeds government revenue. ii. Because a government deficit represents negative public saving, it reduces national saving. This leads to a decline in the supply of loanable funds. iii. The real interest rate rises, leading to a decline in both domestic investment and net capital outflow. iv. Because net capital outflow falls, people need less foreign currency to buy foreign assets, and therefore supply fewer dollars in the market for foreigncurrency exchange. v. The real exchange rate rises, making U.S. goods more expensive relative to foreign goods. Exports will fall, imports will rise, and net exports will fall. vi. In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the currency to appreciate, and push the trade balance toward deficit. vii. Because they are so closely related, the budget deficit and the trade deficit are often called the twin deficits. Note that because many other factors affect the trade deficit, these “twins” are not identical. Figure 5

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

viii.

Instruction Idea: Now would be a good time to discuss the debate in Chapter 37 concerning whether the federal government should balance the budget. c. Trade Policy i. Definition of trade policy: government policy that directly influences the quantity of goods and services that a country imports or exports. ii. Two common types of trade policies are tariffs (taxes on imported goods) and import quotas (limits on the quantity of goods produced abroad that can be sold domestically). iii. Example: The U.S. government imposes a quota on the amount of steel that can be imported from Europe. iv. Note that the quota will have no effect on the market for loanable funds. Thus, the real interest rate will be unaffected. v. The quota will lower imports and thus increase net exports. Because net exports are the source of demand for dollars in the market for foreigncurrency exchange, the demand for dollars will increase. vi. The real exchange rate will rise, making U.S. goods relatively more expensive than foreign goods. Exports will fall, imports will rise, and net exports will fall, offsetting the increase in net exports from the quota. vii. In the end, the quota reduces both imports and exports but net exports remain the same. Figure 6 © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

viii. ix.

Trade policies do not affect the trade balance. Recall that NX = NCO. Also remember that S = I + NCO. Rewriting, we get: NCO = S – I. Substituting for NCO, we get: NX = S – I. x. Because trade policies do not affect national saving or domestic investment, they cannot affect net exports. xi. Trade policies do have effects on specific firms, industries, and countries. But these effects are more microeconomic than macroeconomic. xii. Ask the Experts: Deficits: When asked, “If the United States reduced its fiscal deficit, then its trade deficit would also shrink,” 57% of economic experts agreed, while 6% disagreed and 37% were uncertain. d. Political Instability and Capital Flight i. Definition of capital flight: a large and sudden reduction in the demand for assets located in a country. ii. Capital flight often occurs because investors feel that the country is unstable, due to either economic or political problems. iii. Example: Investors around the world observe political problems in Mexico and begin selling Mexican assets and buying assets from other countries that are viewed as safe. iv. Mexican net capital outflow will rise because investors are selling Mexican assets and purchasing assets from other countries.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

v. vi. vii.

viii.

ix.

1. Because net capital outflow determines the supply of pesos, the supply of pesos increases. 2. Because net capital outflow is also a part of the demand for loanable funds, the demand for loanable funds rises. The increased demand for loanable funds causes the equilibrium real interest rate to rise. The increased supply of pesos lowers the equilibrium real exchange rate. Thus, capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign-currency exchange. The increase in interest rates reduces domestic investment and growth, and the reduction in the value of the peso moves the trade balance toward surplus. Capital flight in Mexico will also affect other countries. If the capital flows out of Mexico and into the United States, it has the opposite effect on the U.S. economy. In 1997, several Asian countries experienced capital flight. A similar experience occurred in Russia in 1998 and Argentina in 2002, and again in 2019 and 2020.

Figure 7

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy x.

xi.

xii. xiii.

xiv.

Alternative Classroom Example: Suppose that investors feel very confident about the prospects for investment in Brazilian assets. In this case (from the perspective of Brazil): 1. The demand for loanable funds will shift left because NCO decreases. 2. The NCO curve will also shift left. 3. The real interest rate in Brazil will fall. 4. The supply of reals (the “real” is the currency of Brazil) will shift left. 5. The real exchange rate will rise. 6. Brazilian net exports will fall. Case Study: Capital Flows from China 1. What happens if a country’s government encourages capital to flow to other countries? 2. It leads to a weaker currency and a trade surplus. 3. In recent years, this has been the case with China as its government has tried to depress its currency. Net capital outflow from China has slowed since 2014. Instruction Idea: There is a student activity that applies to this topic in the "Additional Activities and Assignments” section. In the News: Separating Fact from Fiction: “Five Big Truths about Trade.” 1. Most job losses are not due to international trade, trade is more about efficiency than about the number of jobs, bilateral trade imbalances are inevitable and uninteresting, running an overall trade deficit does not make us losers, and trade agreements barely affect a nation’s trade balance. 2. America’s trade deficits stem from the dollar’s international role and from American’s lack of saving, not from trade deals. Ask the Experts: Currency Manipulation: When asked to evaluate the following statement, “Economic analysis can identify whether countries are using their exchange rates to benefit their own people at the expense of their trading partners’ welfare,” 30% of economic experts agree, while 34% disagree and 36% are uncertain.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 1. The supply of loanable funds comes from national saving; the demand for loanable funds comes from domestic investment and net capital outflow. The supply of dollars in the market for foreign exchange comes from net capital outflow; the demand for dollars in the market for foreign exchange comes from net exports. The link between the two markets is net capital outflow.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy 2. Government budget deficits and trade deficits are sometimes called the twin deficits because a government budget deficit often leads to a trade deficit. The government budget deficit leads to reduced national saving, causing the interest rate to increase, and reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars, raising the real exchange rate. Thus, the trade balance will move toward deficit. 3. If a union of textile workers encourages people to buy only American-made clothes, imports would be reduced, so net exports would increase for any given real exchange rate. This would cause the demand curve in the market for foreign exchange to shift to the right, as shown in Figure 2. The result is a rise in the real exchange rate, but no effect on the trade balance. The textile industry would import less, but other industries, such as the auto industry, would import more because of the higher real exchange rate.

Figure 2 4. Capital flight is a large and sudden movement of funds out of a country. Capital flight

causes the interest rate to increase and the exchange rate to depreciate.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

PROBLEMS AND APPLICATIONS 254. Japan generally runs a trade surplus because the Japanese saving rate is high relative to Japanese domestic investment. The result is high net capital outflow, which is matched by high net exports, resulting in a trade surplus. The other possibilities (high foreign demand for Japanese goods, low Japanese demand for foreign goods, and structural barriers against imports into Japan) would affect the real exchange rate, but not the trade surplus.

Figure 3 255. a. If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as shown in Figure 3. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance moves toward deficit, because net capital outflow, hence net exports, is lower. The higher real interest rate also increases the quantity of national saving. In summary, saving increases, domestic investment increases, net capital

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance moves toward deficit. b. A rise in the real exchange rate reduces exports. 256. a. A decline in the quality of U.S. goods at a given real exchange rate would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange, as shown in Figure 4. b. The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. c. The claim in the popular press is incorrect. A change in the quality of U.S. goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that we get fewer foreign goods in exchange for our goods, so our standard of living may decline.

Figure 4 257. A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the demand curve for dollars to the left. The shift of the demand curve for dollars leads to a decline in the real exchange rate, which increases net exports. Because net capital outflow is unchanged and net exports equals net capital outflow, there is

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy no change in equilibrium in net exports or the trade balance. But both imports and exports rise, so export industries benefit. 258. a. When the French develop a strong taste for California wines, the demand for dollars in the foreign-currency market increases at any given real exchange rate, as shown in Figure 5. b. The result of the increased demand for dollars is a rise in the real exchange rate. c. The quantity of net exports is unchanged.

Figure 5 259. An export subsidy increases net exports at any given real exchange rate, causing the demand for dollars in the foreign exchange market to shift to the right as shown in Figure 6. The resulting increase in the real exchange rate increases imports to match the increase in exports generated by the export subsidy. Thus, net exports and the trade deficit are unchanged. The senator is incorrect.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

Figure 6 260. An export subsidy increases net exports at any given real exchange rate, causing the demand for dollars in the foreign exchange market to shift to the right as shown in Figure 7. The resulting increase in the real exchange rate increases imports to match the increase in exports generated by the export subsidy. Thus, net exports and the trade deficit are unchanged at this point. The expenditure on the export subsidy, however, increases the fiscal deficit, decreases public saving, causing the supply of loanable funds to shift left. The resulting increase in the real interest rate reduces domestic investment and net capital outflow, decreasing the supply of dollars on the foreign exchange market. The real exchange rate rises again, further increasing imports but decreasing exports. In the end, imports increase, exports could increase or decrease, net exports fall, and the trade balance moves toward deficit.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

Figure 7 261. Higher real interest rates in Europe lead to increased U.S. net capital outflow. Higher net capital outflow leads to higher net exports, because in equilibrium net exports equal net capital outflow (NX = NCO ). Figure 8 shows that the increase in net capital outflow leads to a lower real exchange rate, higher real interest rate, and increased net exports.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy

Figure 8 262. a. If the elasticity of U.S. net capital outflow with respect to the real interest rate is very high, the lower real interest rate that occurs because of the increase in private saving will increase net capital outflow a great deal, so U.S. domestic investment will not increase much. b. Because an increase in private saving reduces the real interest rate, inducing an increase in net capital outflow, the real exchange rate will decline. If the elasticity of U.S. exports with respect to the real exchange rate is very low, it will take a large decline in the real exchange rate to increase U.S. net exports by enough to match the increase in net capital outflow.

[Take-home assignment] Open Economy Article. Works in any class size. Topics include open-economy macroeconomics.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 33: A Macroeconomic Theory of the Open Economy LLL. Purpose: This assignment helps students apply the open-economy macro model to world events. MMM. Instructions: This model is often confusing to students. This assignment has them work through an example of real-world events that relate to international macroeconomics. Students may need some direction in finding appropriate topics such as interest rate changes, changes in net capital outflow, or changes in net exports. NNN. Assignment: a. Find an article in a recent newspaper or magazine illustrating a change that will affect net capital outflow or net exports. b. Explain how and why net capital outflow or net exports would shift. c. Use the three market open-economy model (the market for loanable funds, net capital outflow, and the market for foreign-currency exchange) to analyze this change. d. Graph the equilibrium real interest rate, level of net capital outflow, and real exchange rate before the change. Then show how the change will affect these variables. e. Turn in a copy of the article along with your explanation. [return to top]

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Long-Run Equilibrium o Video Problem Walk-Through: Determining the Impact of an Increase in Saving on Domestic Investment, the Real Interest Rate, the Real Exchange Rate, and the Trade Balance o Video Problem Walk-Through: Determining the Impact of an Investment Tax Credit on Domestic Saving, the Real Interest Rate, the Real Exchange Rate, and the Trade Balance o Video Problem Walk-Through: Examining the Impact of an Increase in Export Demand on the Market for Foreign-Currency Exchange o Equation Basics o Graphing Basics o Graphing Linear Equations o Video Quiz: The Open Economy: Part I o Video Quiz: The Open Economy: Part II

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 595 Chapter Objectives ........................................................................................................................................... 597 Complete List of Chapter Activities and Assessments ......................................................................... 597 Key Terms ........................................................................................................................................................... 598 What's New in This Chapter .......................................................................................................................... 598 Chapter Outline ................................................................................................................................................. 599 Solutions to Text Problems ........................................................................................................................... 612 Questions for Review ................................................................................................................................................... 612 Problems and Applications ........................................................................................................................................ 615 Additional Activities and Assignments ..................................................................................................... 623 Additional Resources ...................................................................................................................................... 624 Cengage Video Resources ........................................................................................................................................... 624

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply

PURPOSE AND PERSPECTIVE OF THE CHAPTER To this point, our study of macroeconomic theory has concentrated on the behavior of the economy in the long run. Chapters 34 through 36 now focus on short-run fluctuations in the economy around its long-term trend. Chapter 34 introduces aggregate demand and aggregate supply and shows how shifts in these curves can cause recessions. Chapter 35 focuses on how policymakers use the tools of monetary and fiscal policy to influence aggregate demand. Chapter 36 addresses the relationship between inflation and unemployment. The purpose of Chapter 34 is to develop the model economists use to analyze the economy’s shortrun fluctuations—the model of aggregate demand and aggregate supply. Students will learn about some of the sources for shifts in the aggregate-demand curve and the aggregate-supply curve and how these shifts can cause recessions. This chapter also introduces actions policymakers might undertake to offset recessions. Key points addressed in this chapter: 



All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, while unemployment rises. Classical economic theory is based on the assumption that nominal variables such as the money supply and the price level do not influence real variables such as output and employment. Most economists believe that this assumption is accurate in the long run but not in the short run. Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. The aggregate-demand curve slopes downward for three reasons. The first is the wealth effect: A lower price level raises the real value of households’ money holdings, which stimulates consumer spending. The second is the interest-rate effect: A lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. The third is the exchange-rate effect: As a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports. Any event or policy that raises consumption, investment, government purchases, or net exports at any price level increases aggregate demand. Any event or policy that reduces consumption, investment, government purchases, or net exports at a given price level decreases aggregate demand. The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labor, capital, natural resources, and technology, but not on the overall level of prices. Three theories have been proposed to explain the upward slope of the short-run aggregatesupply curve. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the sticky-price theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply



back production. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. All three theories imply that output deviates from its natural level when the actual price level deviates from the price level that people expected. Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural resources, or technology, shift the short-run aggregate-supply curve (and may shift the long-run aggregate-supply curve as well). In addition, the position of the short-run aggregate-supply curve depends on the expected price level. One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate-demand curve shifts to the left, output and prices fall in the short run. Over time, as a change in the expected price level causes perceptions, wages, and prices to adjust, the short-run aggregate-supply curve shifts to the right. This shift returns the economy to its natural level of output at a new, lower price level. A second possible cause of economic fluctuations is a shift in aggregate supply. When the short-run aggregate-supply curve shifts to the left, the effect is falling output and rising prices―a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the short-run aggregate-supply curve shifts back to the right, returning the price level and output back to their original levels.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain why the aggregate-demand curve is downward sloping.



Identify factors that cause the aggregate-demand curve to shift.



Derive the short-run and long-run effects on output and prices according to the AD-AS model, given a scenario about an economic shock.



Determine the effect of an economic event on the position of the long-run aggregate supply curve.



Contrast the slope of the long-run aggregate supply curve and the short-run aggregate supply curve.



Determine the effect of a change in one of the determinants of aggregate supply, given a graph of the short-run aggregate-supply curve.



Explain how the sticky-wage theory affects equilibrium.



Explain how the sticky-price theory affects equilibrium.



Identify the long-run equilibrium in the AD-AS model.

Source (i.e., PPT slide, Workbook) PPT Slide 20 PPT Slide 44 PPT Slide 48 PPT Slide 49 MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder

Duration

MindTap Learn It Folder

5 mins.

5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply Demand and Aggregate Supply Figure 8: A Contraction in Aggregate Demand Figure 10: An Adverse Shift in Aggregate Supply Figure 11: Accommodating an Adverse Shift in Aggregate Supply Chapter 34 Problems & Applications Chapter 34 A+ Test Prep Video Quiz: Introduction to the Aggregate Demand and Aggregate Supply Model Video Quiz: Long-Run Aggregate Supply Video Quiz: Short-Run Aggregate Supply Chapter 34 Homework Chapter 34 Quiz: Aggregate Demand and Aggregate Supply

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Study It Folder

25–35 mins.

MindTap Study It Folder MindTap Apply It Folder

N/A 10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder

10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. 20–30 mins.

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KEY TERMS Aggregate-Demand Curve: a curve that shows the quantity of goods and services that households, firms, the government, and consumers abroad want to buy at each price level. Aggregate-Supply Curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. Depression: a severe recession. Model of Aggregate Demand and Aggregate Supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend. Natural Level of Output: the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate. Recession: a period of declining real incomes and rising unemployment. Stagflation: a period of falling output and rising prices. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply    

The data in Figures 1 and 9 have been updated. There is a new Case Study: The Covid Recession of 2020. There is a new Ask the Experts feature on the economic impact of the Omicron variant. There is a new In the News feature on the strange downturn of 2020, “The Unusual Covid Recession.”

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LXXVII.

Economic activity fluctuates from year to year. a. Definition of recession: a period of declining real incomes and rising unemployment. b. Definition of depression: a severe recession. Three Key Facts about Economic Fluctuations a. Fact 1: Economic Fluctuations Are Irregular and Unpredictable i. Fluctuations in the economy are often called the business cycle. ii. Economic fluctuations correspond to changes in business conditions. iii. These fluctuations are not at all regular and are almost impossible to predict. Figure 1 iv.

LXXVIII.

Panel (a) of Figure 1 shows real GDP since 1972. The shaded areas represent recessions. b. Fact 2: Most Macroeconomic Quantities Fluctuate Together i. Real GDP is the variable that is most often used to examine short-run changes in the economy. ii. However, most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together. iii. Panel (b) of Figure 1 shows how investment spending changes over the business cycle. Note that investment spending falls during recessions just as real GDP does. c. Fact 3: As Output Falls, Unemployment Rises i. Changes in the economy’s output level will have an effect on the economy’s utilization of its labor force. ii. When firms choose to produce a smaller amount of goods and services, they lay off workers, which increases the unemployment rate. iii. Panel (c) of Figure 1 shows how the unemployment rate changes over the business cycle. Note that during recessions, unemployment generally rises. Note also that the unemployment rate never approaches zero but instead fluctuates around its natural rate of about 5%. Explaining Short-Run Economic Fluctuations

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply a. The Assumptions of Classical Economics i. The classical dichotomy is the separation of variables into real variables and nominal variables. ii. According to classical theory, changes in the money supply only affect nominal variables. This is known as money neutrality. b. The Reality of Short-Run Fluctuations i. Most economists believe that the classical theory describes the world in the long run but not in the short run. ii. Beyond a period of several years, changes in the money supply affects prices and other nominal variables, but does not affect real GDP, unemployment, or other real variables. iii. However, when studying year-to-year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined. c. The Model of Aggregate Demand and Aggregate Supply i. Instruction Idea: Begin by reviewing demand, supply, and equilibrium. Make it clear that the microeconomic variables of price and quantity can be aggregated into a price level (measured by either the GDP deflator or the Consumer Price Index) and total output (real GDP). ii. Definition of model of aggregate demand and aggregate supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend. iii. We can show this model using a graph. Figure 2

LXXIX.

1. The variable on the vertical axis is the average level of prices in the economy, as measured by the CPI or the GDP deflator. 2. The variable on the horizontal axis is the economy’s output of goods and services, as measured by real GDP. 3. Definition of aggregate-demand curve: a curve that shows the quantity of goods and services that households, firms, the government, and consumers abroad want to buy at each price level. 4. Definition of aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. iv. In this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance. The Aggregate-Demand Curve a. Why the Aggregate-Demand Curve Slopes Downward Figure 3

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Recall that GDP (Y) is made up of four components: consumption (C), investment (I), government purchases (G), and net exports (NX). 𝑌

ii.

iii.

iv.

𝐶

𝐼

𝐺

𝑁𝑋

Each of the four components is a part of aggregate demand. 1. Government purchases are assumed to be fixed by policy. 2. This means that to understand why the aggregate-demand curve slopes downward, we must understand how changes in the price level affect consumption, investment, and net exports. a. Keep in Mind: You will likely need to remind students of the difference between changes in quantity demanded (movements along the demand curve) and changes in demand (shifts in the demand curve). b. Instruction Idea: Highlight the fact that all three of these effects begin with a decrease (or increase) in the price level and end with an increase (decrease) in aggregate quantity demanded. The Price Level and Consumption: The Wealth Effect 1. A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. 2. The increase in consumer spending means a larger quantity of goods and services demanded. The Price Level and Investment: The Interest-Rate Effect 1. The lower the price level, the less money households need to buy goods and services. 2. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial markets or through financial intermediaries). 3. As households try to convert some of their money into interestbearing assets, the interest rate will drop.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply 4. Lower interest rates encourage borrowing firms to borrow more to invest in new plants and equipment, and it encourages households to borrow more to invest in new housing. 5. Thus, a lower price level reduces the interest rate, encourages spending on investment goods, and therefore increases the quantity of goods and services demanded. v. The Price Level and Net Exports: The Exchange-Rate Effect 1. A lower price level in the United States lowers the U.S. interest rate. 2. Some U.S. investors will seek higher returns by investing abroad. 3. The increase in the supply of dollars on foreign exchange markets lowers the real exchange rate for dollars (the dollar depreciates on foreign exchange markets). 4. U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase. 5. Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the dollar depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services demanded. vi. All three of these effects imply that, all else being equal, there is an inverse relationship between the price level and the quantity of goods and services demanded. 1. Instruction Idea: Remind students that the aggregate-demand curve (like all demand curves) is drawn assuming that everything else is held constant. b. Why the Aggregate-Demand Curve Might Shift i. Instruction Idea: Get the students involved in suggesting factors that might shift the aggregate- demand curve. Relate changes in aggregate demand to changes in consumption, investment, government purchases, and net exports. Show students that, if any of these four components of GDP change (for reasons other than a change in the price level), the aggregate-demand curve will shift. ii. Shifts Arising from Changes in Consumption 1. If Americans become more concerned with saving for retirement and reduce current consumption, aggregate demand will shift to the left. 2. If the government cuts taxes, it encourages people to spend more, resulting in a shift to the right in aggregate demand. iii. Shifts Arising from Changes in Investment 1. Suppose that the computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will cause aggregate demand to shift to the right. 2. If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left. 3. An investment tax credit increases the quantity of investment goods that firms demand, which shifts aggregate demand to the right.

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iv.

4. An increase in the supply of money lowers the interest rate in the short run. This leads to more investment spending, which causes aggregate demand to shift to the right. Shifts Arising from Changes in Government Purchases 1. If Congress decides to reduce purchases of new weapon systems, aggregate demand will shift to the left. 2. If state governments decide to build more highways, aggregate demand will shift to the right. Shifts Arising from Changes in Net Exports 1. When Europe experiences a recession, it buys fewer American goods, which lowers U.S. net exports at every price level. Aggregate demand for the U.S. economy will shift to the left. 2. If the exchange rate of the U.S. dollar increases, U.S. goods become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left.

Table 1

LXXX.

The Aggregate-Supply Curve a. The relationship between the price level and the quantity of goods and services supplied depends on the time horizon being examined. b. Why the Aggregate-Supply Curve Is Vertical in the Long Run i. In the long run, an economy’s production of goods and services depends on its supplies of resources along with the available production technology. ii. Because the price level does not affect these determinants of output in the long run, the long-run aggregate-supply curve is vertical at the natural level of output.

Figure 4

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The vertical long-run aggregate-supply curve is a graphical representation of the classical dichotomy and monetary neutrality. c. Why the Long-Run Aggregate-Supply Curve Might Shift i. The position of the aggregate-supply curve occurs at an output level sometimes referred to as potential output or full-employment output. ii. Definition of natural level of output: the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate. iii. Any change in the economy that alters the natural level of output shifts the long-run aggregate-supply curve. iv. Shifts Arising from Changes in Labor 1. Increases in immigration increase the number of workers available. The long-run aggregate-supply curve would shift to the right. 2. Any change in the natural rate of unemployment will alter long-run aggregate supply as well. v. Shifts Arising from Changes in Capital 1. An increase in the economy’s capital stock raises productivity and thus shifts long-run aggregate supply to the right. 2. This would also be true if the increase occurred in human capital rather than physical capital. vi. Shifts Arising from Changes in Natural Resources 1. A discovery of a new mineral deposit shifts the long-run aggregatesupply curve to the right. 2. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve to the left. 3. A change in the availability of imported resources (such as oil) can also affect long-run aggregate supply. vii. Shifts Arising from Changes in Technological Knowledge 1. The invention of the computer has allowed us to produce more goods and services from any given level of resources. As a result, it has shifted the long-run aggregate-supply curve to the right. 2. Opening up international trade has similar effects to inventing new production processes. Therefore, it also shifts the long-run aggregate-supply curve to the right. d. Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation Figure 5

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Two important forces that govern the economy in the long run are technological progress and monetary policy. 1. Technological progress shifts the long-run aggregate-supply curve to the right. 2. The Fed increases the money supply over time, which raises aggregate demand. ii. The result is growth in output and continuing inflation (increases in the price level). iii. Although the purpose of developing the model of aggregate demand and aggregate supply is to describe short-run fluctuations, these short-run fluctuations should be considered deviations from the long-run trends of output growth and inflation. e. Why the Aggregate-Supply Curve Slopes Upward in the Short Run i. In the short run, the price level does affect the economy's output. An increase in the overall level of prices tends to raise the quantity of goods and services supplied. Figure 6

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ii. iii.

iv.

The quantity of output supplied deviates from its natural level when the actual price level deviates from the expected price level. The Sticky-Wage Theory 1. Nominal wages are often slow to adjust to changing economic conditions due to long-term contracts between workers and firms along with social norms and notions of fairness that influence wage setting and are slow to change over time. 2. Example: Suppose a firm has agreed in advance to pay workers an hourly wage of $30 based on the expectation that the price level will be 100. If the price level is actually 95, the firm receives 5% less for its output than it expected and its labor costs are fixed at $30 per hour. 3. Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied. 4. Nominal wages are based on expected prices and do not adjust immediately when the actual price level differs from what is expected. Thus, an unexpected fall in the price level causes firms to reduce the quantity of output supplied causing the short-run aggregate-supply curve to be upward sloping. 5. This theory of short-run aggregate supply is emphasized in the text. The Sticky-Price Theory 1. The prices of some goods and services are also sometimes slow to respond to changing economic conditions. This is often blamed on menu costs. 2. If the price level falls unexpectedly, and a firm does not change the price of its product quickly, its relative price will rise and this will lead to a loss in sales. 3. Thus, when sales decline, firms will produce a lower quantity of goods and services. 4. Because not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply desired prices, which depress sales and cause firms to reduce the quantity of goods and services supplied. v. The Misperceptions Theory 1. Changes in the overall price level can temporarily mislead suppliers about what is happening in the markets in which they sell their output. 2. As a result of these misperceptions, suppliers respond to changes in the level of prices and thus, the short-run aggregate-supply curve is upward sloping. 3. Example: The price level falls unexpectedly. Suppliers mistakenly believe that as the price of their product falls, it is a drop in the relative price of their product. Suppliers may then believe that the reward of supplying their product has fallen, and thus they decrease the quantity that they supply. The same misperception may happen if workers see a decline in their nominal wage (caused by a fall in the price level). 4. Thus, a lower price level causes misperceptions about relative prices, and these misperceptions lead suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied. vi. Note that each of these theories suggests that output deviates from its natural level when the price level deviates from the price level that people expected. vii. Note also that the effects of the change in the price level will be temporary. Eventually people will adjust their price level expectations and output will return to its natural level; thus, the aggregate-supply curve will be vertical in the long run. viii. Because the sticky-wage theory is the simplest of the three theories, it is the one that is emphasized in the text. f. Summing Up i. Economists debate which of these theories is correct and it is possible that each contains an element of truth. ii. All three theories suggest that output deviates in the short run from its longrun level when the actual price level deviates from the expected price level. iii. Each of the three theories emphasizes a problem that is likely to be temporary. 1. Over time, nominal wages will become unstuck, prices will become unstuck, and misperceptions about relative prices will be corrected. 2. In the long run, it is reasonable to assume that wages and prices are flexible and that people are not confused about relative prices. g. Why the Short-Run Aggregate-Supply Curve Might Shift i. Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-supply curve as well. ii. However, expectations of the price level will affect the position of the shortrun aggregate-supply curve even though it has no effect on the long-run aggregate-supply curve.

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An increase in the expected price level decreases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price level increases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

Table 2 LXXXI.

Two Causes of Economic Fluctuations a. Long-Run Equilibrium Figure 7

Long-run equilibrium is found where the aggregate-demand curve intersects with the long-run aggregate-supply curve. ii. Output is at its natural level. iii. Also at this point, perceptions, wages, and prices have all adjusted to the actual price level so that the short-run aggregate-supply curve intersects at this point as well. b. The Effects of a Shift in Aggregate Demand Table 3 i.

ii. iii.

Keep in Mind: Students will be confused by the graphs showing the adjustment process that occurs when aggregate demand shifts. Take the time to walk them through step-by-step several times, summarizing what moves the economy from one point to the next. Example: Pessimism causes household spending and investment to decline. This will cause the aggregate-demand curve to shift to the left.

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In the short run, both output and the price level fall. This drop in output means that the economy is in a recession. In the long run, the economy will move back to the natural rate of output. 1. People will correct the misperceptions, sticky wages, and sticky prices that cause the aggregate-supply curve to be upward sloping in the short run. 2. The expected price level will fall, shifting the short-run aggregatesupply curve to the right.

Figure 8

Price Level

Long-Run Aggregate Supply AS1 AS2

AD1 AD2 Output vi.

vii.

viii.

In the long run, the decrease in aggregate demand can be seen solely by the drop in the equilibrium price level. Thus, the long-run effect of a change in aggregate demand is a nominal change (in the price level) but not a real change (output is the same). Instead of waiting for the economy to adjust on its own, policymakers may want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate demand curve back to the right. FYI: Monetary Neutrality Revisited 1. According to classical theory, changes in the quantity of money affect nominal variables such as the price level, but not real variables such as output. 2. If the Fed decreases the money supply, aggregate demand shifts to the left. In the short run, output and the price level decline. After expectations, prices, and wages have adjusted, the economy finds itself back on the long-run aggregate-supply curve at the natural level of output. 3. Thus, changes in the money supply have effects on real output in the short run only.

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Case Study: Two Big Shifts in Aggregate Demand: The Great Depression and World War II 1. Figure 9 shows real GDP for the United States since 1900.

Figure 9 2. Two time periods of economic fluctuations can be seen dramatically in the picture. These are the early 1930s (the Great Depression) and the early 1940s (World War II). 3. From 1929 to 1933, GDP fell by 27%. From 1939 to 1944, the economy’s production of goods and services almost doubled. x. Case Study: The Great Recession of 2008–2009 1. The United States experienced a financial crisis and severe economic downturn in 2008 and 2009. 2. The recession was preceded by a housing boom fueled by low interest rates and various developments in the mortgage market. 3. From 2006 to 2009, housing values in the U.S. fell by 30%. This led to substantial defaults, causing additional large losses in the values of mortgage-backed securities. Due to these losses, many financial institutions cut back on their lending causing a credit crunch. 4. The economy experienced a large drop in aggregate demand causing real GDP to fall and unemployment to rise. c. The Effects of a Shift in Aggregate Supply i. Example: Firms experience a sudden increase in their costs of production. ii. This will cause the short-run aggregate-supply curve to shift to the left. (Depending on the event, long-run aggregate supply may also shift. We will assume that it does not.) iii. In the short run, output will fall and the price level will rise. The economy is experiencing stagflation. iv. Definition of stagflation: a period of falling output and rising prices. Figure 10

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vii.

The result over time may be a wage-price spiral. Eventually, the low level of output will put downward pressure on wages. 1. Producing goods and services becomes more profitable. 2. Short-run aggregate supply shifts back to the right until the economy is again producing at the natural level of output. If policymakers want to end the stagflation, they can shift the aggregatedemand curve. Note that they cannot simultaneously offset the drop in output and the rise in the price level. If they increase aggregate demand, the recession will end, but the price level will be permanently higher. This increase in aggregate demand is referred to as accommodating an adverse supply shock.

Figure 11 viii.

ix.

x. xi. xii.

Case Study: Oil and the Economy 1. Crude oil is a key input in the production of many goods and services. 2. When some event (often political) leads to a rise in the price of crude oil, firms must endure higher costs of production and the short-run aggregate-supply curve shifts to the left. 3. In the mid-1970s, OPEC lowered production of oil and the price of crude oil rose substantially. The inflation rate in the United States was pushed to over 10%. Unemployment also grew from 4.9% in 1973 to 8.5% in 1975. 4. This occurred again in the late 1970s. Oil prices rose, output fell, and the rate of inflation increased. 5. In the late 1980s, OPEC began to lose control over the oil market as members began cheating on the agreement. Oil prices fell, which led to a rightward shift of the short-run aggregate-supply curve. This caused both unemployment and inflation to decline. FYI: The Origins of the Model of Aggregate Demand and Aggregate Supply 1. The AD/AS model is a by-product of the Great Depression. 2. In 1936, economist John Maynard Keynes published a book that attempted to explain short-run fluctuations. 3. Keynes believed that recessions occur because of inadequate demand for goods and services. 4. Therefore, Keynes advocated policies to increase aggregate demand. Instruction Idea: There is a student activity (National Output Article) that applies to this topic in the "Additional Activities and Assignments” section. Instruction Idea: There is a student activity (The Economics of War) that applies to this topic in the "Additional Activities and Assignments” section. Case Study: The Covid Recession of 2020 1. The economic downturn in 2020 had three unusual features. First, the cause was an infectious disease. Second, the downturn was exceptionally fast and deep. Third, the downturn was intentional

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xiii.

xiv.

because policymakers required changes in behavior that reduced output and employment. 2. Many businesses were closed by government decree, causing aggregate demand to shift left and aggregate supply to shift left. This led to a sharp reduction in production and employment. 3. Policymakers responded with a stimulus bill: The Coronavirus Aid, Relief, and Economic Security Act known as the CARES Act. It included government spending and additional loans from the Fed. 4. Some economists have argued that the March 2021 $1.9 trillion relief package was excessive and caused inflation. Ask the Experts: The Omicron Variant. 1. When asked whether uncertainty about the health threat from the Omicron variant is likely to reduce economic activity through the first half of 2022, 43 percent of economists agreed, 3 percent disagreed, and 54 percent were uncertain. 2. When asked whether imposing travel bans on countries where new Covid-19 variants are discovered will make it less likely that countries will reveal information about new variants, 76 percent of economists agreed, 6 percent disagreed, and 18 percent were uncertain. In the News: The Strange Downturn of 2020. “The Unusual Covid Recession.” 1. The 2020 recession lasted only two months, and it was like no other recession in recent times. 2. Because people stayed home, the demand for physical goods rose while the demand for services fell. This reversed a long-term trend. It also created a shortage of physical goods, raising their prices and contributing to inflation. 3. As a result, the industries that are usually hurt during recessions, such as construction materials and cars, did well. Normally recession proof industries, such as dentistry and education did poorly. 4. As a result, things we learned from prior recession may be of little help in dealing with this recession.

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SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 263. Two macroeconomic variables that decline when the economy goes into a recession are real GDP and investment spending (many other answers are possible). A macroeconomic variable that rises during a recession is the unemployment rate. 264. Figure 3 shows aggregate demand, short-run aggregate supply, and long-run aggregate supply.

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Figure 3 265. The aggregate-demand curve slopes downward because: (1) a decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more, so there is a larger quantity of goods and services demanded; (2) a lower price level reduces the interest rate, encouraging greater spending on investment, so there is a larger quantity of goods and services demanded; (3) a fall in the U.S. price level causes U.S. interest rates to fall, so the real exchange rate depreciates, stimulating U.S. net exports, so there is a larger quantity of goods and services demanded. 266. The long-run aggregate supply curve is vertical because in the long run, an economy's supply of goods and services depends on its supplies of capital, labor, and natural resources and on the available production technology used to turn these resources into goods and services. The price level does not affect these long-run determinants of real GDP. 267. Three theories explain why the short-run aggregate-supply curve slopes upward: (1) the sticky-wage theory, in which a lower price level makes employment and production less profitable because wages do not adjust immediately to the price level, so firms reduce the quantity of goods and services supplied; (2) the sticky-price theory, in which an unexpected fall in the price level leaves some firms with higher-than-desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce; and (3) the misperceptions theory, in which a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied. 268. The aggregate-demand curve might shift to the left when something (other than a rise in the price level) causes a reduction in consumption spending (such as a desire for increased saving), a reduction in investment spending (such as increased taxes on the returns to investment), decreased government spending (such as a cutback in defense spending), or reduced net exports (such as when foreign economies go into recession). Figure 4 traces through the steps of such a shift in aggregate demand. The economy begins in equilibrium, with short-run aggregate supply, AS1, intersecting aggregate demand, AD1, at point A. When the aggregate-demand curve shifts to the left to AD2, the economy moves from point A to point B, reducing the price level and the quantity of output. Over time,

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply people adjust their perceptions, wages, and prices, shifting the short-run aggregate-supply curve to the right to AS2, and moving the economy from point B to point C, which is back on the long-run aggregate-supply curve and has a lower price level.

Figure 4 269. The aggregate-supply curve might shift to the left because of a decline in the economy's capital stock, labor supply, or productivity, or an increase in the natural rate of unemployment, all of which shift both the long-run and short-run aggregate-supply curves to the left. An increase in the expected price level shifts just the short-run aggregate-supply curve (not the long-run aggregate-supply curve) to the left. Figure 5 traces through the effects of a shift in short-run aggregate supply. The economy starts in equilibrium at point A. The aggregate-supply curve shifts to the left from AS1 to AS2. The new equilibrium is at point B, the intersection of the aggregate-demand curve and AS2. As time goes on, perceptions and expectations adjust and the economy returns to long-run equilibrium at point A, because the short-run aggregate-supply curve shifts back to its original position.

Figure 5

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PROBLEMS AND APPLICATIONS

Figure 6 23. a. The current state of the economy is shown in Figure 6. The aggregate-demand curve (AD1) and short-run aggregate-supply curve (AS1) intersect at the same point on the long-run aggregate-supply curve. b. A stock market crash leads to a leftward shift of aggregate demand (to AD2). The equilibrium level of output and the price level will fall. Because the quantity of output is less than the natural level of output, the unemployment rate will rise above the natural rate of unemployment. c. If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time as expectations adjust, the shortrun aggregate-supply curve will shift to the right (to AS2), moving the economy back to the natural level of output. 24.

25.

a. When the United States experiences a wave of immigration, the labor force increases, so long-run aggregate supply shifts to the right. b. When Congress raises the minimum wage to $15 per hour, the natural rate of unemployment rises, so the long-run aggregate-supply curve shifts to the left. c. When Intel invents a new and more powerful computer chip, productivity increases, so long-run aggregate supply increases because more output can be produced with the same inputs. d. When a severe hurricane damages factories along the East Coast, the capital stock is smaller, so long-run aggregate supply declines. a. The current state of the economy is shown in Figure 7. The aggregate-demand curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate-supply curve.

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Figure 7 b. If the central bank increases the money supply, aggregate demand shifts to the right (to point B). In the short run, there is an increase in output and the price level. c. Over time, nominal wages, prices, and perceptions will adjust to this new price level. As a result, the short-run aggregate-supply curve will shift to the left. The economy will return to its natural level of output (point C). d. According to the sticky-wage theory, nominal wages at points A and B are equal. However, nominal wages at point C are higher than at point A. e. According to the sticky-wage theory, real wages at point B are lower than real wages at point A. However, real wages at points A and C are equal. f. Yes, this analysis is consistent with long-run monetary neutrality. In the long run, an increase in the money supply causes an increase in the nominal wage, but leaves the real wage unchanged. 26. During the Great Depression, equilibrium output (Y1) was lower than the natural level of output (Y2). The idea of lengthening the shopping period between Thanksgiving and Christmas was to increase aggregate demand. As Figure 8 shows, this could increase output back to its long-run equilibrium level (Y2).

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Figure 8 27.

28.

a. The statement that "the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods" is false. The aggregatedemand curve slopes downward because a fall in the price level raises the overall quantity of goods and services demanded through the wealth effect, the interestrate effect, and the exchange-rate effect. b. The statement that "the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" is false. Economic forces of various kinds (such as population and productivity) do affect long-run aggregate supply. The long-run aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply. c. The statement that "if firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal" is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the shortrun aggregate-supply curve, then the short-run aggregate-supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed. d. The statement that "whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" is false. An economy could enter a recession if either the aggregate-demand curve or the short-run aggregate-supply curve shifts to the left. a. According to the sticky-wage theory, the economy is in a recession because the price level has declined so that real wages are too high, thus labor demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment. According to the sticky-price theory, the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply the economy returns to the long-run aggregate-supply curve. According to the misperceptions theory, the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregatesupply curve. b. The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust. 29.

a. People will likely expect that the new chair will not actively fight inflation so they will expect the price level to rise. b. If people believe that the price level will be higher over the next year, workers will want higher nominal wages. c. At any given price level, higher labor costs lead to reduced profitability. d. The short-run aggregate-supply curve will shift to the left as shown in Figure 9.

Figure 9 e. A decline in short-run aggregate supply leads to reduced output and a higher price level. f. No, this choice was probably not wise. The end result is stagflation, which provides limited choices in terms of policies to remedy the situation.

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Figure 10 30. a. If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure 10. The equilibrium changes from point A to point B, so the price level declines and output declines. b. If Florida orange groves suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This decline in the natural level of output is represented in Figure 11 by a shift to the left in both the short-run and long-run aggregate-supply curves. The equilibrium changes from point A to point B, so the price level rises and output declines.

Figure 11

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply

Figure 12 c. If increased job opportunities cause people to leave the country, the long-run and short-run aggregate-supply curves will shift to the left because there are fewer people producing output. The aggregate-demand curve will also shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 12 shows. Whether the price level rises or declines depends on the relative sizes of the shifts in the aggregate-demand curve and the aggregate-supply curves. 31.

a. When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 13. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

Figure 13

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply

Figure 14 b. When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 14. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A.

Figure 15 c. When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 15. The economy moves from point A to point B, as output rises and the price level declines.

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Figure 16 d. When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 16. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. 32.

a. If firms become optimistic about future business conditions and increase investment, the result is shown in Figure 17. The economy begins at point A with aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The equilibrium has price level P1 and output level Y1. Increased optimism leads to greater investment, so the aggregate-demand curve shifts to AD2. Now the economy is at point B, with price level P2 and output level Y2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

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Figure 17 b. Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate-supply curve shifts to the left to AS2 and the economy gets to equilibrium at point C, with price level P3 and output level Y1. The quantity of output demanded declines as the price level rises. c. The investment boom might increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output.

[Take-home assignment] National Output Article. Works in any class size. Topics include fluctuations in output and the price level. OOO. Purpose: This assignment is a good way for students to connect economic theory to actual events. PPP. Assignment: a. Find an article in a recent newspaper or magazine illustrating a change that will affect national output. b. Analyze the situation using economic reasoning. c. Draw an aggregate demand and aggregate supply graph to explain this change. Be sure to label your graph and clearly indicate which curve shifts. Explain what happens to national income and to the price level in the short run. d. Turn in a copy of the article along with your explanation.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 34: Aggregate Demand and Aggregate Supply QQQ. Points for Discussion: This can be a nice way to review the elements of aggregate demand (consumption, investment, government spending, and net exports) and the elements of aggregate supply (productive resources, technology). Most changes will only shift one curve.

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Discussing the long-run impact of these changes can emphasize the differences between AS and AD shifts. [In-class assignment] The Economics of War: 20 minutes. Works in any class size. Topics include national income, price levels, total spending, and resources. A. Purpose: This assignment asks students to examine their beliefs about the effect of war on the economy. It can be used to examine aggregate demand shifts and aggregate supply shifts. This assignment can generate lively discussion. B. Assignment: Ask the class to answer the following questions. Give them time to write an answer to a question, then discuss their answers before moving to the next question. a. Is war good or bad for the economy? b. What are the opportunity costs of using resources in wars? c. How would a war affect aggregate supply? d. Graph the shift in aggregate supply. What happens to output and the price level? e. How would a war affect aggregate demand? f. Graph the shift in aggregate demand. What happens to output and the price level? g. Is peace good or bad for the economy?

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Aggregate Demand o ConceptClip: Long-Run Aggregate Supply o Video Problem Walk-Through: Analyzing the Impact of a Stock Market Boom on the Price Level and Output in the Short Run and the Long Run o Video Problem Walk-Through: Analyzing the Impact of a Drought on the Price Level and Output in the Short Run and the Long Run o Equation Basics o Graphing Basics o Graphing Linear Equations o Video Quiz: Introduction to the Aggregate Demand and Aggregate Supply Model o Video Quiz: Long-Run Aggregate Supply

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand o

Video Quiz: Short-Run Aggregate Supply

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

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627

Complete List of Chapter Activities and Assessments Key Terms

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628

What's New in This Chapter 628 Chapter Outline

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Solutions to Text Problems 639 Questions for Review ................................................................................................................................................... 639 Problems and Applications ........................................................................................................................................ 640 Additional Resources647 Cengage Video Resources ........................................................................................................................................... 647

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PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 35 is the second chapter in a three-chapter sequence that concentrates on short-run fluctuations in the economy around its long-term trend. In Chapter 34, the model of aggregate supply and aggregate demand is introduced. In Chapter 35, we see how the government’s monetary and fiscal policies affect aggregate demand. In Chapter 36, we will see some of the trade-offs between short-run and long-run objectives when we address the relationship between inflation and unemployment. The purpose of Chapter 35 is to address the short-run effects of monetary and fiscal policies. In Chapter 34, we found that when aggregate demand or short-run aggregate supply shifts, it causes fluctuations in output. As a result, policymakers sometimes try to offset these shifts by shifting aggregate demand with monetary and fiscal policy. Chapter 35 addresses the theory behind these policies and some of the shortcomings of stabilization policy. Key points addressed in this chapter: 



In his work on short-run economic fluctuations, Keynes proposed the theory of liquidity preference to explain the determinants of the interest rate. According to this theory, the interest rate adjusts to balance the supply and demand for money. An increase in the price level raises money demand and increases the interest rate that brings the money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and, thereby, the quantity of goods and services demanded. The downward-sloping aggregate-demand curve expresses this negative relationship between the price level and the quantity demanded. Policymakers can influence aggregate demand with monetary policy. An increase in the money supply reduces the equilibrium interest rate for any price level. Because a lower interest rate stimulates investment spending, the aggregate-demand curve shifts to the right. Conversely, a decrease in the money supply raises the equilibrium interest rate for any price level and shifts the aggregate-demand curve to the left. Policymakers can also influence aggregate demand with fiscal policy. An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left. When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. The crowding-out effect tends to dampen those effects. Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments to stabilize the economy. Economists disagree about how actively the government should do this. Advocates of active stabilization policy say that changes in attitudes by households and firms shift aggregate demand and that if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment. Advocates of more passive stabilization policy say that monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up being destabilizing.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Derive the short-run and long-run effects on output and prices according to the AD-AS model, given a scenario about an economic shock.

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Illustrate the short-run impact of a change in the price level under liquidity preference theory according to the model of aggregate demand and aggregate supply.

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Explain how open market operations impact the money supply.

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Explain the benefits and challenges of using monetary policy to address economic imbalances.

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Describe the concept of a liquidity trap.

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Explain the benefits and challenges of using fiscal policy to address economic imbalances.

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Given a graph of the aggregate-demand curve, determine the effect of a change in fiscal policy on that curve.

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Explain the multiplier effect of a change in fiscal policy.

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Explain how expansionary fiscal policy causes crowding out.

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Explain how government borrowing can lead to crowding out.

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Explain the effect of tax policy on aggregate demand.

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Given a scenario about an economy's current state, determine the appropriate stabilization policy to restore the natural rate of output.

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Discuss the pros and cons of employing stabilization policies.

Source (i.e., PPT slide, Workbook) PPT Slide 11 PPT Slide 23 PPT Slide 40 PPT Slide 45

Duration

PPT Slide 48

10–15 mins.

PPT Slide 53

5–10 mins.

5–10 mins. 5–10 mins. 5–10 mins. 10–15 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand Self-Assessment Section 35-1 QuickQuiz Section 35-2 QuickQuiz Section 35-3 QuickQuiz ConceptClip: Fiscal Multiplier Figure 1: Equilibrium in the Money Market Figure 2: The Money Market and the Slope of the Aggregate-Demand Curve Figure 3: A Monetary Injection Figure 5: The Crowding-Out Effect Chapter 35 Problems & Applications Chapter 35 A+ Test Prep Video Quiz: Monetary Policy Video Quiz: Fiscal Policy Video Quiz: Tax Policy Chapter 35 Homework Chapter 35 Quiz: The Influence of Monetary and Fiscal Policy on Aggregate Demand

PPT Slide 54 MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder

5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder MindTap Learn It Folder MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder MindTap Apply It Folder MindTap Apply It Folder MindTap Apply It Folder

5 mins. 5 mins. 30–40 mins. N/A 10–15 mins. 10–15 mins. 10–15 mins. 25–35 mins. 20–30 mins.

KEY TERMS Automatic Stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession but that occur without policymakers having to take any deliberate action. Crowding-Out Effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Fiscal Policy: the setting of the levels of government spending and taxation by government policymakers. Multiplier Effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. Theory of Liquidity Preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition: 

The text addresses the Fed’s recent use of the interest rate it pays on bank reserves and its targeting of the federal funds interest rate.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand 

Policymakers response to the Coronavirus Recession is addressed.

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How Monetary Policy Influences Aggregate Demand A. Instruction Idea: Students are very interested in the way in which the Fed changes interest rates. Review what they learned about the Fed and its tools to change the money supply. B. Instruction Idea: The effects of monetary policy are easy to show graphically. Begin with money supply, money demand, and an equilibrium interest rate. Show how both an increase and a decrease in the money supply affect interest rates. C. The aggregate-demand curve is downward sloping for three reasons. 1. The wealth effect. 2. The interest-rate effect. 3. The exchange-rate effect. D. All three effects occur simultaneously, but are not of equal importance. 1. Because a household’s money holdings are a small part of total wealth, the wealth effect is the least important of the three. 2. Because imports and exports are a small fraction of U.S. GDP, the exchangerate effect is also fairly small for the U.S. economy. 3. Thus, the most important reason for the downward-sloping aggregatedemand curve is the interest-rate effect. E. Definition of theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance. F. The Theory of Liquidity Preference 1. This theory is an explanation of the supply and demand for money and how they relate to the interest rate. a. Instruction Idea: Point out that when we discuss the "interest rate" we are discussing both the nominal interest rate and the real interest rate. Because we are assuming that expected inflation rate is constant, they will move together. Remind the students of the Fisher equation. 2. Money Supply a. The money supply in the economy is controlled by the Federal Reserve. b. The Fed can alter the supply of money using open market operations, changes in the discount rate, changes in reserve requirements and, more recently, changes in the interest it pays banks on their reserves.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand c. Because we assume that the Fed can control the size of the money supply directly, the quantity of money supplied does not depend on any other economic variables, including the interest rate. Thus, the supply of money is represented by a vertical supply curve. Figure 1

3. Money Demand a. Any asset’s liquidity refers to the ease with which that asset can be converted into a medium of exchange. Thus, money is the most liquid asset in the economy. b. The liquidity of money explains why people choose to hold it instead of other assets that could earn them a higher return. c. However, the return on other assets (the interest rate) is the opportunity cost of holding money. All else being equal, as the interest rate rises, the quantity of money demanded will fall. Therefore, the demand for money will be downward sloping. 4. Equilibrium in the Money Market a. The interest rate adjusts to bring money demand and money supply into balance. b. If the interest rate is higher than the equilibrium interest rate, the quantity of money that people want to hold is less than the quantity that the Fed has supplied. Thus, people will try to buy bonds or deposit funds in an interest-bearing account. This increases the funds available for lending, pushing interest rates down. c. If the interest rate is lower than the equilibrium interest rate, the quantity of money that people want to hold is greater than the quantity that the Fed has supplied. Thus, people will try to sell bonds or withdraw funds from an interest-bearing account. This decreases the funds available for lending, pushing interest rates up. G. FYI: Interest Rates in the Long Run and the Short Run

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand 1. In an earlier chapter, we said that the interest rate adjusts to balance the supply and demand for loanable funds. 2. In this chapter, we proposed that the interest rate adjusts to balance the supply and demand for money. 3. To understand how these two statements can both be true, we must discuss the difference between the short run and the long run. 4. In the long run, the economy’s level of output, the interest rate, and the price level are determined by the following manner: a. Output is determined by the levels of resources and technology available. b. For any given level of output, the interest rate adjusts to balance the supply and demand for loanable funds. c. Given output and the interest rate, the price level adjusts to balance the supply and demand for money. Changes in the supply of money lead to proportionate changes in the price level. 5. In the short run, the economy’s level of output, the interest rate, and the price level are determined by the following manner: a. The price level is stuck at some level (based on previously formed expectations) and is unresponsive to changes in economic conditions. b. For any given price level, the interest rate adjusts to balance the supply and demand for money. c. The interest rate that balances the money market influences the quantity of goods and services demanded and thus the level of output. H. The Downward Slope of the Aggregate-Demand Curve 1. When the price level increases, the quantity of money that people need to hold becomes larger. Thus, an increase in the price level leads to an increase in the demand for money, shifting the money demand curve to the right. 2. For a fixed money supply, the interest rate must rise to balance the supply and demand for money. Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand

3. At a higher interest rate, the cost of borrowing and the return on saving both increase. Thus, consumers will choose to spend less and will be less likely to invest in new housing. Firms will be less likely to borrow funds for new equipment or structures. In short, the quantity of goods and services purchased in the economy will fall. 4. As the price level increases, the quantity of goods and services demanded falls. 5. Instruction Idea: Go through the example above in reverse as well. Make sure that students understand that a decline in the price level will lead to a drop in money demand and the interest rate and that this will cause a rise in aggregate quantity demanded. Changes in the Money Supply

Figure 3

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand

1. Example: The Fed buys government bonds in open-market operations. 2. This will increase the supply of money, shifting the money supply curve to the right. The equilibrium interest rate will fall. 3. The lower interest rate reduces the cost of borrowing and the return to saving. This encourages households to increase their consumption and desire to invest in new housing. Firms will also increase investment, building new factories and purchasing new equipment. 4. The quantity of goods and services demanded will rise at every price level, shifting the aggregate-demand curve to the right. 5. Thus, a monetary injection by the Fed increases the money supply, leading to a lower interest rate, and a larger quantity of goods and services demanded. a. Alternative Classroom Example: Suppose the Fed sells government bonds in the open market. The following would occur. a. The supply of money will decrease, shifting the money supply curve to the left. b. 2. The equilibrium interest rate will rise, raising the cost of borrowing and the return on saving. c. 3. Households will reduce consumption and firms will reduce investment. d. 4. The quantity of goods and services demanded will fall at every price level, shifting the aggregate-demand curve to the left. b. Instruction Idea: Point out the circumstances under which the Fed is likely to increase the money supply. Then, discuss the circumstances under which the Fed is likely to decrease the money supply. Discuss the short- and long-run effects of each. The Role of Interest-Rate Targets in Fed Policy 1. Instruction Idea: Show students that the Fed can target either the money supply or the interest rate, but not both. 2. In recent years, the Fed has conducted policy by setting a target for the federal funds rate (the interest rate that banks charge one another for shortterm loans). When the Fed targets the interest rate, it commits itself to adjusting the money supply in order to hit that target in the market for money. a. The target is re-evaluated every six weeks when the Federal Open Market Committee meets. b. The Fed has chosen to use this interest rate as a target in part because the money supply is difficult to measure with sufficient precision. c. Since 2008, the Fed uses the interest it pays on bank reserves to adjust the money supply. When it lowers the target for the federal funds rate, it also lowers the interest it pays on reserves causing banks to lend more of their reserves, and the money supply rises.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand

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3. Because changes in the money supply lead to changes in interest rates (and vice versa), monetary policy can be described either in terms of the money supply or in terms of the interest rate. a. Instruction Idea: Make sure that you point out to students that, while the media describes the actions of the Federal Reserve as “changing interest rates,” they instead could be described as “changing the money supply.” K. Case Study: Why the Fed Watches the Stock Market (and Vice Versa) 1. A booming stock market expands the aggregate demand for goods and services. a. When the stock market booms, households become wealthier, and this increased wealth stimulates consumer spending. b. Increases in stock prices make it attractive for firms to issue new shares of stock and this increases investment spending. 2. Because one of the Fed’s goals is to stabilize aggregate demand, the Fed may respond to a booming stock market by keeping the supply of money lower and raising interest rates. The opposite would hold true if the stock market would fall. 3. Stock market participants also keep an eye on the Fed’s policy plans. When the Fed lowers the money supply and raises interest rates, it makes stocks less attractive because alternative assets (such as bonds) pay higher interest rates. Also, higher interest rates may lower the expected profitability of firms. L. FYI: The Zero Lower Bound 1. What if the Fed’s target interest rate is already close to zero? 2. Some economists describe this situation as a liquidity trap. a. Nominal interest rates cannot fall much below zero. b. Expansionary monetary policy might not have any effect. 3. Other economists are less concerned with this situation. a. The central bank could alter inflationary expectations. b. The Fed could also purchase other financial instruments in open market operations, known as “quantitative easing.” In addition, the Fed could engage in “forward guidance” by committing to keeping interest rates low for a long period. How Fiscal Policy Influences Aggregate Demand A. Definition of fiscal policy: the setting of the levels of government spending and taxation by government policymakers. B. Changes in Government Purchases 1. When the government changes the level of its purchases, it influences aggregate demand directly. An increase in government purchases shifts the aggregate-demand curve to the right, while a decrease in government purchases shifts the aggregate-demand curve to the left. 2. There are two macroeconomic effects that cause the size of the shift in the aggregate-demand curve to be different from the change in the level of government purchases. They are called the multiplier effect and the crowding-out effect.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand C. The Multiplier Effect 1. Suppose that the government buys a product from a company. a. The immediate impact of the purchase is to raise profits and employment at that firm. b. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. c. Thus, total spending rises by more than the increase in government purchases. Figure 4

2. Definition of multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. 3. The multiplier effect continues even after the first round. a. When consumers spend part of their additional income, it provides additional income for other consumers. b. These consumers then spend some of this additional income, raising the incomes of yet another group of consumers. 4. A Formula for the Spending Multiplier a. The marginal propensity to consume (MPC) is the fraction of extra income that a household consumes rather than saves. b. Example: The government spends $20 billion on new planes. Assume that MPC = 3/4. c. Incomes will increase by $20 billion, so consumption will rise by MPC × $20 billion. The second increase in consumption will be equal to MPC × (MPC × $20 billion) or MPC2 × $20 billion. d. To find the total impact on the demand for goods and services, we add up all of these effects: Change in government purchases = $20 billion First change in consumption = MPC × $20 billion Second change in consumption = MPC2 × $20 billion Third change in consumption = MPC3 × $20 billion Total Change = (1 + MPC + MPC2 + MPC3 + . . .) × $20 billion

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand e. This means that the multiplier can be written as: Multiplier = (1 + MPC + MPC2 + MPC3 + . . .). f. Because this expression is an infinite geometric series, it also can be written as: multiplier 1/ 𝑀𝑃𝐶 g. Note that the size of the multiplier depends on the marginal propensity to consume. 5. Other Applications of the Multiplier Effect a. The multiplier effect applies to any event that alters spending on any component of GDP (consumption, investment, government purchases, or net exports). b. Examples include a reduction in net exports due to a recession in another country or a stock market boom that raises consumption. D. The Crowding-Out Effect 1. The crowding-out effect works in the opposite direction. 2. Definition of crowding-out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. 3. As we discussed earlier, when the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. 4. If consumers want to purchase more goods and services, they will need to increase their holdings of money. This shifts the demand for money to the right, pushing up the interest rate. Figure 5

5. The higher interest rate raises the cost of borrowing and the return to saving. This discourages households from spending their incomes for new

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consumption or investing in new housing. Firms will also decrease investment, choosing not to build new factories or purchase new equipment. 6. Thus, even though the increase in government purchases shifts the aggregate-demand curve to the right, this fall in consumption and investment will pull aggregate demand back toward the left. Thus, aggregate demand could increase by less than the increase in government purchases. 7. Therefore, when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on the sizes of the multiplier and crowding-out effects. a. If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise by more than $X. b. If the multiplier effect is less than the crowding-out effect, aggregate demand will rise by less than $X. E. Changes in Taxes 1. Changes in taxes affect a household’s take-home pay. a. If the government reduces taxes, households will likely spend some of this extra income, shifting the aggregate-demand curve to the right. b. If the government raises taxes, household spending will fall, shifting the aggregate-demand curve to the left. 2. The size of the shift in the aggregate-demand curve will also depend on the sizes of the multiplier and crowding-out effects. a. When the government lowers taxes and consumption increases, earnings and profits rise, which further stimulate consumer spending. This is the multiplier effect. b. Higher incomes lead to greater spending, which means a higher demand for money. Interest rates rise and investment spending falls. This is the crowding-out effect. 3. Another important determinant of the size of the shift in aggregate demand due to a change in taxes is whether people believe that the tax change is permanent or temporary. A permanent tax change will have a larger effect on aggregate demand than a temporary one. F. FYI: How Fiscal Policy Might Affect Aggregate Supply 1. Because people respond to incentives, a decrease in tax rates may cause individuals to work more, because they get to keep more of what they earn. If this occurs, the aggregate-supply curve would increase (shift to the right). The reduction in the corporate tax rate during the Trump administration was aimed at promoting capital accumulation and long-run economic growth. 2. Changes in government purchases may also affect supply. If the government increases spending on capital projects such as roads, railroads, or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right. Using Policy to Stabilize the Economy A. The Case for Active Stabilization Policy

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand 1. Example: The government raises taxes, lowering aggregate demand (shifting the curve to the left). a. The Fed can offset this government action by increasing the money supply. b. This would lower interest rates and boost spending, shifting the aggregate-demand curve back to the right. 2. Policy instruments are often used in this manner to stabilize demand. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946. a. One implication of the Employment Act is that the government should avoid being the cause of economic fluctuations. b. The second implication of the Employment Act is that the government should respond to changes in the private economy in order to stabilize aggregate demand. 3. The Employment Act occurred in response to a book by John Maynard Keynes, an economist who emphasized the important role of aggregate demand in explaining short-run fluctuations in the economy. 4. Keynes also felt strongly that the government should stimulate aggregate demand whenever necessary to keep the economy at full employment. a. Keynes argued that aggregate demand responds strongly to pessimism and optimism. When consumers are pessimistic, aggregate demand is low, output is low, and unemployment is increased. When consumers are optimistic, aggregate demand is high, output is high, and unemployment is lowered. b. It is possible for the government to adjust monetary and fiscal policy in response to optimistic or pessimistic views. This helps stabilize aggregate demand, keeping output stable at full employment. 5. Case Study: Keynesians in the White House a. In 1961, President Kennedy pushed for a tax cut to stimulate aggregate demand. Several of his economic advisers were followers of Keynes. b. In 2009, President Obama pushed for a stimulus bill that included several increases in government spending. In 2020 and 2021, Presidents Trump and Biden employed fiscal stimulus to restore aggregate demand during the coronavirus recession. 6. Ask the Experts: Economic Stimulus a. 97 percent of economic experts agree that the U.S. unemployment rate was lower at the end of 2010 than would have been without the 2009 stimulus bill. b. 75 percent of economic experts agree that the benefits will outweigh the costs of the 2009 stimulus bill, while 6 percent disagree and 19 percent are uncertain. B. The Case against Active Stabilization Policy

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand 1. Some economists believe that fiscal and monetary policy tools should only be used to help the economy achieve long-run goals, such as low inflation and robust economic growth. 2. The primary argument against active policy is that these policy tools may affect the economy with a long lag. a. With monetary policy, the change in money supply leads to a change in interest rates. This change in interest rates affects investment spending. However, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly. b. The lag in fiscal policy is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate (after going through committees in both houses). 3. By the time these policies take effect, the condition of the economy may have changed. This could lead to even larger problems. C. Automatic Stabilizers 1. Definition of automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession but that occur without policymakers having to take any deliberate action. 2. The most important automatic stabilizer is the tax system. a. When the economy falls into a recession, incomes and profits fall. b. The personal income tax depends on the level of households’ incomes and the corporate income tax depends on the level of firm profits. c. This implies that the government’s tax revenue falls during a recession. This tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn. 3. Some government spending is also an automatic stabilizer. a. More individuals become eligible for transfer payments during a recession. b. These transfer payments provide additional income to recipients, stimulating spending. c. Thus, just like the tax system, our system of transfer payments helps to reduce the size of short-run economic fluctuations. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 177. The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-demand curve slopes downward

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand because: (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus, the price level has a negative relationship with the quantity of goods and services demanded. 178. A decrease in the money supply shifts the money-supply curve to the left. The equilibrium interest rate will rise. The higher interest rate reduces consumption and investment, so aggregate demand falls. Thus, the aggregate-demand curve shifts to the left. 179. If the government spends $3 billion to buy police cars, aggregate demand might increase by more than $3 billion because of the multiplier effect on aggregate demand. Aggregate demand might increase by less than $3 billion because of the crowding-out effect on aggregate demand. 180. If pessimism sweeps the country, households reduce consumption spending and firms reduce investment, so aggregate demand falls. If the Fed wants to stabilize aggregate demand, it must increase the money supply, reducing the interest rate, which will induce households to save less and spend more and will encourage firms to invest more, both of which will increase aggregate demand. If the Fed does not increase the money supply, Congress could increase government purchases or reduce taxes to increase aggregate demand. 181. Government policies that act as automatic stabilizers include the tax system and government spending through the unemployment-benefit system. The tax system acts as an automatic stabilizer because when incomes are high, people pay more in taxes, so they cannot spend as much. When incomes are low, so are taxes; thus, people can spend more. The result is that spending is partly stabilized. Government spending through the unemployment-benefit system acts as an automatic stabilizer because in recessions the government transfers money to the unemployed so their incomes do not fall as much and thus their spending will not fall as much.

PROBLEMS AND APPLICATIONS 270. a. When the Fed’s bond traders buy bonds in open-market operations, the moneysupply curve shifts to the right from MS1 to MS2, as shown in Figure 1. The result is a decline in the interest rate.

Figure 1

Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand b. When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD1 to MD2, as shown in Figure 2. The result is a decline in the interest rate. c. When the Fed reduces the interest rate it pays on reserves, the money supply increases, so the money-supply curve shifts to the right from MS1 to MS2, as shown in Figure 1. The result is a decline in the interest rate. d. When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 3. The result is a rise in the interest rate.

Figure 3 e. When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD1 to MD2 in Figure 3. The increase in money demand increases the interest rate.

Figure 4

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand 271. a. The increase in the money supply will cause the equilibrium interest rate to decline, as shown in Figure 4. Households will increase spending and will invest in more new housing. Firms too will increase investment spending. This will cause the aggregate demand curve to shift to the right as shown in Figure 5.

Figure 5 b. As shown in Figure 5, the increase in aggregate demand will cause an increase in both output and the price level in the short run (point B). c. When the economy makes the transition from its short-run equilibrium to its new long-run equilibrium, short-run aggregate supply will decline, causing the price level to rise even further (point C). d. The increase in the price level will cause an increase in the demand for money, raising the equilibrium interest rate. e. Yes. While output initially rises because of the increase in aggregate demand, it will fall once short-run aggregate supply declines. Thus, there is no long-run effect of the increase in the money supply on real output.

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Figure 6 272. a. When fewer ATMs are available and the online payments system is disrupted, money demand is increased and the money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 6. If the Fed does not change the money supply, which is at MS1, the interest rate will rise from r1 to r2. The increase in the interest rate shifts the aggregate-demand curve to the left, as consumption and investment fall. b. If the Fed wants to stabilize aggregate demand, it should increase the money supply to MS2, so the interest rate will remain at r1 and aggregate demand will not change. c. To increase the money supply using open market operations, the Fed should buy government bonds. 273. A tax cut that is permanent will have a bigger effect on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much. 274. a. The current situation is shown in Figure 7.

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Figure 7 b. The Fed will want to stimulate aggregate demand. Thus, it will need to lower the interest rate by increasing the money supply. This could be achieved if the Fed purchases government bonds from the public.

Figure 8 c. As shown in Figure 8, the Fed's purchase of government bonds shifts the supply of money to the right, lowering the interest rate. d. The Fed's purchase of government bonds will increase aggregate demand as consumers and firms respond to lower interest rates. Output and the price level will rise as shown in Figure 9.

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Figure 9 275. a. Legislation allowing banks to pay interest on certain checking deposits increases the return to money relative to other financial assets, thus increasing money demand. b. If the money supply remained constant (at MS1), the increase in the demand for money would have raised the interest rate, as shown in Figure 10. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate demand and output. c. To maintain a constant market interest rate, the Fed would need to increase the money supply from MS 1 to MS 2. Then aggregate demand and output would be unaffected.

Figure 10 276.

a. If there is no crowding out, then the multiplier equals 1/(1 – MPC ). Because the multiplier is 3, then MPC = 2/3.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 35: The Influence of Monetary and Fiscal Policy on Aggregate Demand b. If there is crowding out, then the MPC would be larger than 2/3. An MPC that is larger than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the crowding-out effect. 277. If the marginal propensity to consume is 4/5, the spending multiplier will be 1/(1 – 4/5) = 5. Therefore, the government would have to increase spending by $400/5 = $80 billion to close the recessionary gap. 278. If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and thus a decline in aggregate demand if the Fed keeps the money supply constant. But if the Fed maintains a fixed interest rate, it will increase money supply, so aggregate demand will not decline. Thus, the effect on aggregate demand from an increase in government spending will be larger if the Fed maintains a fixed interest rate. 279. a. Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the investment accelerator is large. A large investment accelerator means that the increase in output caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because the increase in aggregate demand will raise the interest rate. b. Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the interest sensitivity of investment is small. Because fiscal policy increases aggregate demand, thus increasing money demand and the interest rate, the greater the sensitivity of investment to the interest rate the greater the decline in investment will be, which will offset the positive accelerator effect. 280. a. Y=C+I+G is the equilibrium condition for GDP in a closed economy (output equals the sum of consumption, investment, and government spending); C=100+.75(Y-T) is the equation for consumption which depends on disposable income; I=500–50r is the equation for investment which depends on the interest rate; G=125 means that government spending is fixed at 125; T=100 means that taxes are fixed at 100. b. The marginal propensity to consume is 0.75. c. When the interest rate, r, is 4 percent, Y = 100 + .75(Y – 100) + 500 – 50(4) + 125 Y = 100 + .75Y – 75 + 500 – 200 + 125 Y = 450 + .75Y .25Y = 450 Y = 1800, which is less than the full employment level. d. Assuming no change in monetary policy, an increase in government purchases of 50 (to 175) would restore full employment. Because the marginal propensity to consume is .75, the multiplier is 1/(1–.75) or 4. To increase GDP from 1800 to 2000, or by 200, government spending would need to increase by 200/4 = 50. e. Assuming no change in fiscal policy, a decrease of 1 percent (from 4 percent to 3 percent) in the interest rate would restore full employment. 2000 = 100 + .75(2000 – 100) + 500 – 50r + 125 2000 = 2150 – 50r 50r = 150 r=3

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ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run TradeOff Between Inflation and Unemployment Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter Chapter Objectives

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Complete List of Chapter Activities and Assessments Key Terms

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What's New in This Chapter 651 Chapter Outline

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Solutions to Text Problems 662 Questions for Review ................................................................................................................................................... 662 Problems and Applications ........................................................................................................................................ 663 Additional Resources670 Cengage Video Resources ........................................................................................................................................... 670

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 36 is the final chapter in a three-chapter sequence on the economy’s short-run fluctuations around its long-term trend. Chapter 34 introduced aggregate supply and aggregate demand. Chapter 35 developed how monetary and fiscal policies affect aggregate demand. Both Chapters 34 and 35 addressed the relationship between the price level and output. Chapter 36 will concentrate on a similar relationship between inflation and unemployment. The purpose of Chapter 36 is to trace the history of economists’ thinking about the relationship between inflation and unemployment. Students will see why there is a temporary trade-off between inflation and unemployment, and why there is no permanent trade-off. This result is an extension of the results produced by the model of aggregate supply and aggregate demand where a change in the price level induced by a change in aggregate demand temporarily alters output but has no permanent impact on output. Key points addressed in this chapter: 



The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate demand, policymakers can choose a point with lower inflation and higher unemployment. The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run. In the long run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips curve shifts. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives policymakers a less favorable trade-off between inflation and unemployment. That is, after an adverse supply shock, policymakers have to accept a higher rate of inflation for any given rate of unemployment, or a higher rate of unemployment for any given rate of inflation. When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve, which results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall. Some economists argue that a credible commitment to low inflation can reduce the cost of disinflation by inducing a quick adjustment of expectations.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Examine the trade-off between inflation and unemployment.



Derive the short-run Phillips curve, given a scenario on market outcomes.



Determine the effect of a change in monetary policy, given a graph of the short-run and long-run Phillips curve.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment 

Contrast the slope of the short-run Phillips curve with the slope of the long-run Phillips curve.



Explain the relationship between expectations and inflation using the Phillips curve.

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Explain why a natural rate of unemployment exists.

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Given a scenario on market outcomes, derive the long-run Phillips curve.

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Given data on the unemployment and inflation rate, determine what happened to the shortrun Phillips curve over the 20th century.

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Calculate the sacrifice ratio given a country's inflation rate and total production.

COMPLETE LIST OF CHAPTER ACTIVITIES AND ASSESSMENTS The following table organizes activities and assessments by objective, so that you can see how all this content relates to objectives and make decisions about which content you would like to emphasize in your class based on your objectives. For additional guidance, refer to the Teaching Online Guide. Activity/Assessment Active Learning 1 Ask the Experts: The Inflation of 2021–2022 A Ask the Experts: The Inflation of 2021–2022 B Ask the Experts: The Inflation of 2021–2022 C Think-Pair-Share Activity Self-Assessment Section 36-1 QuickQuiz Section 36-2 QuickQuiz Section 36-3 QuickQuiz Section 36-4 QuickQuiz Section 36-5 QuickQuiz ConceptClip: Phillips Curve Figure 2: How the Phillips Curve Is Related to the Model of Aggregate Supply Figure 4: How the Long-Run Phillips Curve Is Related to the Model of Aggregate Demand and Aggregate Supply Figure 5: How Expected Inflation Shifts the Short-Run Phillips Curve Figure 8: An Adverse Shock to Aggregate Supply

Source (i.e., PPT slide, Workbook) PPT Slide 24 PPT Slide 51

Duration

PPT Slide 53

10–15 mins.

PPT Slide 55

10–15 mins.

PPT Slide 58 PPT Slide 58 MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap Learn It Folder MindTap Learn It Folder

5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

MindTap Learn It Folder

5 mins.

5–10 mins. 10–15 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment Figure 10: Disinflationary Monetary Policy in the Short Run and Long Run Chapter 36 Problems & Applications Chapter 36 A+ Test Prep Video Quiz: The Phillips Curve Chapter 36 News Analysis: Is the Phillips Curve a Myth? Chapter 36 Homework Chapter 36 Quiz: The Short-Run Trade-Off between Inflation and Unemployment

MindTap Learn It Folder

5 mins.

MindTap Study It Folder

30–40 mins.

MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

N/A 10–15 mins. 10–15 mins.

MindTap Apply It Folder MindTap Apply It Folder

25–35 mins. 20–30 mins.

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KEY TERMS Natural-Rate Hypothesis: the claim that unemployment eventually returns to its normal, or natural rate, regardless of the rate of inflation. Phillips Curve: a curve that shows the short-run trade-off between inflation and unemployment. Rational Expectations: the theory according to which people optimally use all the knowledge they have, including information about government policies, when forecasting the future. Sacrifice Ratio: the number of percentage points of annual output lost in the process of reducing inflation by one percentage point. Supply Shock: an event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and thus the Phillips curve. [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

There is a new section on the recent history of the Phillips Curve and monetary policy, including a discussion of the economic impact of the pandemic. There are two new Ask the Experts features on inflation during the pandemic.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

The Phillips Curve a. Origins of the Phillips Curve i. In 1958, economist A. W. Phillips published an article discussing the negative correlation between inflation rates and unemployment rates in the United Kingdom. ii. American economists Paul Samuelson and Robert Solow showed a similar relationship between inflation and unemployment for the United States two years later. iii. The belief was that low unemployment is related to high aggregate demand, and high aggregate demand puts upward pressure on prices. Likewise, high unemployment is related to low aggregate demand, and low aggregate demand pulls price levels down. iv. Definition of Phillips curve: a curve that shows the short-run trade-off between inflation and unemployment. Figure 1

Samuelson and Solow believed that the Phillips curve offered policymakers a menu of possible economic outcomes. Policymakers could use monetary and fiscal policy to choose any point on the curve. b. Aggregate Demand, Aggregate Supply, and the Phillips Curve i. Instruction Idea: Show how the Phillips curve is derived from the aggregate demand/aggregate supply model step by step. This graph is different from all the other graphs that they have drawn in macroeconomics, because it is not a supply-and-demand diagram.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment ii.

iii.

iv.

Figure 2

The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve. The greater the aggregate demand for goods and services, the greater the economy’s output and the higher the price level. Greater output means lower unemployment. The higher the price level in the current year, the higher the rate of inflation. Example: The price level is 100 (measured by the Consumer Price Index) in the year 2025. There are two possible changes in the economy for the year 2026: a low level of aggregate demand or a high level of aggregate demand. 1. If the economy experiences a low level of aggregate demand, we would be at a short-run equilibrium like point A. This point also corresponds with point A on the Phillips curve. Note that when aggregate demand is low, the inflation rate is relatively low and the unemployment rate is relatively high. 2. If the economy experiences a high level of aggregate demand, we would be at a short-run equilibrium like point B. This point also corresponds with point B on the Phillips curve. Note that when aggregate demand is high, the inflation rate is relatively high and the unemployment rate is relatively low.

Because monetary and fiscal policies both shift the aggregate-demand curve, these policies can move the economy along the Phillips curve. 1. Increases in the money supply, increases in government spending, or decreases in taxes all increase aggregate demand and move the economy to a point on the Phillips curve with lower unemployment and higher inflation. 2. Decreases in the money supply, decreases in government spending, or increases in taxes all lower aggregate demand and move the

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economy to a point on the Phillips curve with higher unemployment and lower inflation. Shifts in the Phillips Curve: The Role of Expectations a. The Long-Run Phillips Curve i. In 1968, economist Milton Friedman argued that monetary policy is only able to choose a combination of unemployment and inflation for a short period of time. At the same time, economist Edmund Phelps wrote a paper suggesting the same thing. ii. In the long run, monetary growth has no real effects. This implies that it cannot affect the factors that determine the economy’s long-run unemployment rate. Figure 3

iii.

Thus, in the long run, we would not expect there to be a relationship between unemployment and inflation. This must mean that, in the long run, the Phillips curve is vertical.

Figure 4

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

iv.

The vertical Phillips curve occurs because, in the long run, the aggregate supply curve is vertical as well. Thus, increases in aggregate demand lead only to changes in the price level and have no effect on the economy’s level of output. Thus, in the long run, unemployment will not change when aggregate demand changes, but inflation will. v. The long-run aggregate-supply curve occurs at the economy’s natural level of output. This means that the long-run Phillips curve occurs at the natural rate of unemployment. vi. Instruction Idea: You may want to review what is meant by the “natural rate” of unemployment. b. The Meaning of “Natural” i. Friedman and Phelps considered the natural rate of unemployment to be the rate toward which the economy gravitates in the long run. ii. The natural rate of unemployment may not be the socially desirable rate of unemployment. iii. The natural rate of unemployment may change over time. c. Reconciling Theory and Evidence i. The conclusion of Friedman and Phelps that there is no long-run trade-off between inflation and unemployment was based on theory, while the correlation between inflation and unemployment found by Phillips, Samuelson, and Solow was based on actual evidence. ii. Friedman and Phelps believed that an inverse relationship between inflation and unemployment exists in the short run. iii. The long-run aggregate-supply curve is vertical, indicating that the price level does not influence output in the long run. iv. But, the short-run aggregate-supply curve is upward sloping because of misperceptions about relative prices, sticky wages, and sticky prices. These perceptions, wages, and prices adjust over time, so that the positive relationship between the price level and the quantity of goods and services supplied occurs only in the short run.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment v.

This same logic applies to the Phillips curve. The trade-off between inflation and unemployment holds only in the short run. vi. The expected level of inflation is an important factor in understanding the difference between the long-run and the short-run Phillips curves. Expected inflation measures how much people expect the overall price level to change. vii. The expected rate of inflation is one variable that determines the position of the short-run aggregate-supply curve. This is true because the expected price level affects the perceptions of relative prices that people form and the wages and prices that they set. viii. In the short run, price expectations are somewhat fixed. Thus, when the Fed increases the money supply, aggregate demand increases along the upward sloping short-run aggregate-supply curve. Output grows (unemployment falls) and the price level rises (inflation increases). ix. Eventually, however, people will respond by changing their expectations of the price level. Specifically, they will begin expecting a higher rate of inflation. d. The Short-Run Phillips Curve i. We can relate the actual unemployment rate to the natural rate of unemployment, the actual inflation rate, and the expected inflation rate using the following equation: unemp. rate

Figure 5

natural rate

𝑎 actual inflation

expected inflation

1. Because expected inflation is already given in the short run, higher actual inflation leads to lower unemployment. 2. How much unemployment changes in response to a change in inflation is determined by the variable “a,” which is related to the slope of the short-run aggregate-supply curve. a. Instruction Idea: Be sure to discuss why actual inflation always equals expected inflation along the long-run Phillips curve.

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ii.

If policymakers want to take advantage of the short-run trade-off between unemployment and inflation, it may lead to negative consequences. 1. Suppose the economy is at point A and policymakers wish to lower the unemployment rate. Expansionary monetary policy or fiscal policy is used to shift aggregate demand to the right. The economy moves to point B, with a lower unemployment rate and a higher rate of inflation. 2. Over time, people get used to this new level of inflation and raise their expectations of inflation. This leads to an upward (rightward) shift of the short-run Phillips curve. The economy ends up at point C, with a higher inflation rate than at point A, but the same level of unemployment. e. The Natural Experiment for the Natural-Rate Hypothesis i. Definition of the natural-rate hypothesis: the claim that unemployment eventually returns to its normal, or natural rate, regardless of the rate of inflation. Figure 6 ii. iii.

iv.

Figure 6 shows the unemployment and inflation rates from 1961 to 1968. It is easy to see the inverse relationship between these two variables. Beginning in the late 1960s, the government followed policies that increased aggregate demand. 1. Government spending rose because of the Vietnam War. 2. The Fed increased the money supply to try to keep interest rates down. As a result of these policies, the inflation rate remained fairly high. However, even though inflation remained high, unemployment did not remain low.

Figure 7

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1. Figure 7 shows the unemployment and inflation rates from 1961 to 1973. The simple inverse relationship between these two variables began to disappear around 1970. 2. Inflation expectations adjusted to the higher rate of inflation and the unemployment rate returned to its natural rate of around 5% to 6%. Shifts in the Phillips Curve: The Role of Supply Shocks a. In 1974, OPEC increased the price of oil sharply. This increased the cost of producing many goods and services and therefore resulted in higher prices. i. Definition of supply shock: an event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and thus the Phillips curve. ii. Graphically, we could represent this supply shock as a shift in the short-run aggregate-supply curve to the left. iii. The decrease in equilibrium output and the increase in the price level left the economy with stagflation, which is falling output with rising prices. Figure 8

b. Given this turn of events, policymakers are left with a less favorable short-run tradeoff between unemployment and inflation. i. If they increase aggregate demand to fight unemployment, they will raise inflation further. ii. If they lower aggregate demand to fight inflation, they will raise unemployment further. c. This less favorable trade-off between unemployment and inflation can be shown by a shift of the short-run Phillips curve. The shift may be permanent or temporary, depending on how people adjust their expectations of inflation. d. During the 1970s, the Fed decided to accommodate the supply shock by increasing the supply of money. This increased the level of expected inflation. Figure 9 shows inflation and unemployment in the United States during the late 1970s and early 1980s.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment Figure 9 LXXXV.

The Cost of Reducing Inflation a. The Sacrifice Ratio i. To reduce the inflation rate, the Fed must follow contractionary monetary policy. 1. When the Fed slows the rate of growth of the money supply, aggregate demand falls. 2. This reduces the level of output in the economy, increasing unemployment. 3. The economy moves from point A along the short-run Phillips curve to point B, which has a lower inflation rate but a higher unemployment rate. 4. Over time, people begin to adjust their inflation expectations downward and the short-run Phillips curve shifts. The economy moves from point B to point C, where inflation is lower and the unemployment rate is back to its natural rate. Figure 10

ii.

Therefore, to reduce inflation, the economy must suffer through a period of high unemployment and low output. iii. Definition of sacrifice ratio: the number of percentage points of annual output lost in the process of reducing inflation by one percentage point. iv. A typical estimate of the sacrifice ratio is five. This implies that for each percentage point inflation is decreased, output falls by 5%. b. Rational Expectations and the Possibility of Costless Disinflation i. Definition of rational expectations: the theory according to which people optimally use all the knowledge they have, including information about government policies, when forecasting the future.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment ii.

Proponents of rational expectations believe that when government policies change, people alter their expectations about inflation. iii. Therefore, if the government makes a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately. This implies that the short-run Phillips curve would shift quickly without any extended period of high unemployment. c. The Volcker Disinflation Figure 11 i. ii. iii.

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Figure 11 shows the inflation and unemployment rates that occurred while Paul Volcker worked at reducing the level of inflation during the 1980s. As inflation fell, unemployment rose. In fact, the United States experienced its deepest recession since the Great Depression. Some economists have offered this as proof that the idea of a costless disinflation suggested by rational-expectations theorists is not possible. However, there are two reasons why we might not want to reject the rational-expectations theory so quickly. 1. The cost (in terms of lost output) of the Volcker disinflation was not as large as many economists had predicted. 2. While Volcker promised that he would fight inflation, many people did not believe him. Few people thought that inflation would fall as quickly as it did; this likely kept the short-run Phillips curve from shifting quickly.

Recent History a. The Greenspan Era Figure 12 i.

ii.

iii.

iv.

vi.

Figure 12 shows the inflation and unemployment rate from 1984 to 2005, called the Greenspan era because Alan Greenspan became the chair of the Federal Reserve in 1987. In 1986, OPEC’s agreement with its members broke down and oil prices fell. The result of this favorable supply shock was a drop in both inflation and unemployment. The rest of the 1990s witnessed a period of economic prosperity due to a technological boom. Inflation gradually dropped, approaching zero by the end of the decade. Unemployment also reached a low level, leading many people to believe that the natural rate of unemployment had fallen. The economy ran into problems in 2001 due to the end of the dot-com stock market bubble, the 9-11 terrorist attacks, and corporate accounting scandals that reduced aggregate demand. Unemployment rose as the economy experienced its first recession in a decade. But a combination of expansionary monetary and fiscal policies helped end the downturn, and by early 2005, the unemployment rate was close to the estimated natural rate. In 2005, President Bush nominated Ben Bernanke as the Fed chair.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment b. The Great Recession i. In his first couple of years as Fed chair, Bernanke faced some significant economic challenges. 1. One challenge arose from problems in the housing and financial markets. 2. The resulting financial crisis led to a large drop in aggregate demand and high rates of unemployment. Figure 13

ii.

iii.

iv.

3. Figure 13 shows the implications of these events for inflation and unemployment. 4. From 2007 to 2010, as the decline in aggregate demand raised unemployment from below 5 percent to about 10 percent, it also reduced the inflation rate from about 3 percent to about 1 percent. 5. After 2010, unemployment fell back to about 5 percent and the inflation rate remained between 1 percent and 2 percent. In essence, the economy first rode down the Phillips curve and then rode back up. Janet Yellen was appointed chair in 2014 and Jerome Powell in 2018. 1. Note that expected inflation was well anchored at 2% so the position of the short-run Phillips curve was relatively stable during this period. 2. By 2018, the economy had moved up the short-run Phillips curve to a point of slightly higher inflation and unemployment below the natural rate. The Pandemic 1. In 2020, the pandemic caused a sudden reduction in both aggregate demand and aggregate supply. Aggregate demand recovered quickly due to expansionary policy. 2. Supply chain disruptions further contracted aggregate supply. The economy returned to the natural rate of unemployment but at a significantly higher inflation rate. Ask the Experts: Inflation During the Pandemic 1. When asked whether supply bottlenecks can be expected to abate without causing long-term inflation above the Fed’s target, 55 percent of economic experts agreed, 11 percent disagreed, and 34 percent were uncertain. 2. When asked whether the current combination of U.S. fiscal and monetary policy poses a serious threat of prolonged higher inflation, 53 percent of economic experts agreed, 13 percent disagreed, and 34 percent were uncertain.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW

Figure 5 13. Figure 5 shows the short-run trade-off between inflation and unemployment. The Fed can move the economy from one point on this curve to another by changing the money supply. An increase in the money supply reduces the unemployment rate and increases the inflation rate, while a decrease in the money supply increases the unemployment rate and decreases the inflation rate.

Figure 6 14. Figure 6 shows the long-run trade-off between inflation and unemployment. In the long run, there is no trade-off, as the economy must return to the natural rate of unemployment on

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment the long-run Phillips curve. In the short run, the economy can move along a short-run Phillips curve, like SRPC1 shown in the figure. But over time (as inflation expectations adjust) the short-run Phillips curve will shift to return the economy to the long-run Phillips curve, for example shifting from SRPC1 to SRPC2. 15. The natural rate of unemployment is natural because it is beyond the influence of monetary policy. The rate of unemployment will move to its natural rate in the long run, regardless of the inflation rate. The natural rate of unemployment might differ across countries because countries have varying degrees of union power, minimum-wage laws, collective-bargaining laws, unemployment insurance, job-training programs, and other factors that influence labormarket conditions. 16. If a drought destroys farm crops and drives up the price of food, the short-run aggregatesupply curve shifts to the left and the short-run Phillips curve shifts to the right, because the costs of production have increased. The higher short-run Phillips curve means the inflation rate will be higher for any given unemployment rate. 17. When the Fed decides to reduce inflation, the economy moves down along the short-run Phillips curve, as shown in Figure 7. Beginning at point A on short-run Phillips curve SRPC1, the economy moves down to point B as inflation declines. Once people's expectations adjust to the lower rate of inflation, the short-run Phillips curve shifts to SRPC2, and the economy moves to point C. The short-run costs of disinflation, which arise because the unemployment rate is temporarily above its natural rate, could be reduced if the Fed's action was credible, so that expectations would adjust more rapidly.

Figure 7

PROBLEMS AND APPLICATIONS 281. Figure 8 shows two different short-run Phillips curves depicting these four points. Points a and d are on SRPC1 because both have expected inflation of 3%. Points b and c are on SRPC2 because both have expected inflation of 5%.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

Figure 8 282. a. A rise in the natural rate of unemployment shifts both the long-run Phillips curve and the short-run Phillips curve to the right, as shown in Figure 9. The economy is initially on LRPC1 and SRPC1 at an inflation rate of 3%, which is also the expected rate of inflation. The increase in the natural rate of unemployment shifts the longrun Phillips curve to LRPC2 and the short-run Phillips curve to SRPC2, with the expected rate of inflation remaining equal to 3%.

Figure 9 b. A decline in the price of imported oil shifts the short-run Phillips curve to the left, as shown in Figure 10, from SRPC1 to SRPC2. For any given unemployment rate, the inflation rate is lower, because oil is such a significant aspect of production costs in the economy.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

Figure 10 c. A rise in government spending represents an increase in aggregate demand, so it moves the economy along the short-run Phillips curve, as shown in Figure 11. The economy moves from point A to point B, with a decline in the unemployment rate and an increase in the inflation rate.

Figure 11 d. A decline in expected inflation causes the short-run Phillips curve to shift to the left, as shown in Figure 12. The lower rate of expected inflation shifts the short-run Phillips curve from SRPC1 to SRPC2.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

Figure 12

Figure 13 283. a. Figure 13 shows how a reduction in consumer spending causes a recession in both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. In both diagrams, the economy begins at full employment at point A. The decline in consumer spending reduces aggregate demand, shifting the aggregate-demand curve to the left from AD1 to AD2. The economy initially remains on the short-run aggregate-supply curve AS1, so the new equilibrium occurs at point B. The movement of the aggregate-demand curve along the short-run aggregate-supply curve leads to a movement along short-run Phillips curve SRPC1, from point A to point B. The lower price level in the aggregate-supply/aggregate-demand diagram corresponds to the lower inflation rate in the Phillips-curve diagram. The lower

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment level of output in the aggregate-supply/aggregate-demand diagram corresponds to the higher unemployment rate in the Phillips-curve diagram. b. As expected inflation falls over time, the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the short-run Phillips curve shifts to the left from SRPC1 to SRPC2. In both diagrams, the economy eventually gets to point C, which is back on the long-run aggregate-supply curve and long-run Phillips curve. After the recession is over, the economy faces a better set of inflation-unemployment combinations.

Figure 14 284.

a. Figure 14 shows the economy in long-run equilibrium at point a, which is on both the long-run and short-run Phillips curves. b. A wave of business pessimism reduces aggregate demand, moving the economy to point b in the figure. The unemployment rate increases and the inflation rate declines. If the Fed undertakes expansionary monetary policy, it can increase aggregate demand, offsetting the pessimism and returning the economy to point a, with the initial inflation rate and unemployment rate. c. Figure 15 shows the effects on the economy if the price of imported oil rises. The higher price of imported oil shifts the short-run Phillips curve to the right from SRPC 1 to SRPC 2. The economy moves from point a to point c, with a higher inflation rate and higher unemployment rate. If the Fed engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point d, but the inflation rate will be higher. If the Fed engages in contractionary monetary policy, it can return the economy to its original inflation rate at point e, but the unemployment rate will be higher. This situation differs from that in part (b) because in part (b) the economy stayed on the same short-run Phillips curve, but in part (c) the economy moved to a higher short-run Phillips curve, which gives policymakers a less favorable trade-off between inflation and unemployment.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment

Figure 15 285. Economists who believe that expectations adjust quickly in response to changes in policy would be more likely to favor using contractionary policy to reduce inflation than economists with the opposite views. If expectations adjust quickly, the costs of reducing inflation (in terms of lost output) will be relatively small. Thus, Milton would be more in favor of following a policy to reduce inflation than would James.

Figure 16 286. If the Fed acts on its belief that the natural rate of unemployment is 4%, when the natural rate is in fact 5%, the result will be a spiraling up of the inflation rate, as shown in Figure 16. Starting from a point on the long-run Phillips curve, with an unemployment rate of 5%, the Fed will believe that the economy is in a recession, because the unemployment rate is greater than its estimate of the natural rate. Therefore, the Fed will increase the money supply, moving the economy along the short-run Phillips curve SRPC1. The inflation rate will rise and the unemployment rate will fall to 4%. As the inflation rate rises over time, expectations of inflation will rise, and the short-run Phillips curve will shift to the right to SRPC2. This process will continue, and the inflation rate will spiral upwards.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 36: The Short-Run Trade-Off Between Inflation and Unemployment The Fed may eventually realize that its estimate of the natural rate of unemployment is wrong by examining the rising trend in the inflation rate. 287. a. If wage contracts have short durations, a recession induced by contractionary monetary policy will be less severe, because wage contracts can be adjusted more rapidly to reflect the lower inflation rate. This will allow a more rapid movement of the short-run aggregate-supply curve and short-run Phillips curve to restore the economy to long-run equilibrium. b. If there is little confidence in the Fed's determination to reduce inflation, a recession induced by contractionary monetary policy will be more severe. It will take longer for people's inflation expectations to adjust downwards. c. If expectations of inflation adjust quickly to actual inflation, a recession induced by contractionary monetary policy will be less severe. In this case, people's expectations adjust quickly, so the short-run Phillips curve shifts quickly to restore the economy to long-run equilibrium at the natural rate of unemployment.

Figure 17 288. a. As shown in the left diagram of Figure 17, equilibrium output and employment will fall. However, the effects on the price level and inflation rate will be ambiguous. The fall in aggregate demand puts downward pressure on prices, while the decline in short-run aggregate supply pushes prices up. The diagram on the right side of Figure 17 assumes that the inflation rate rises. b. The Fed would have to use expansionary monetary policy to keep output and employment at their natural rates. Aggregate demand would have to shift to AD3. c. The Fed may not want to pursue this action because it will lead to a rise in the inflation rate as shown by point C.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy

ADDITIONAL RESOURCES CENGAGE VIDEO RESOURCES 

MindTap Videos: o ConceptClip: Fiscal Multiplier o Video Problem Walk-Through: Using the Theory of Liquidity Preference to Analyze a Reduction in the Reserve Requirement o Video Problem Walk-Through: Analyzing the Use of Monetary Policy to Counteract a Reduction in Aggregate Demand o Video Problem Walk-Through: Estimating the Impact of a Reduction in Government Spending on Aggregate Demand o Video Problem Walk-Through: Comparing an Increase in Government Spending with Tax Rebates to Stimulate Aggregate Demand o Equation Basics o Graphing Basics o Graphing Linear Equations o Video Quiz: Monetary Policy o Video Quiz: Fiscal Policy o Video Quiz: Tax Policy

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 672 Chapter Objectives ........................................................................................................................................... 673 Complete List of Chapter Activities and Assessments ......................................................................... 673 What's New in This Chapter .......................................................................................................................... 674 Chapter Outline ................................................................................................................................................. 674 Solutions to Text Problems ........................................................................................................................... 679 Questions for Review ................................................................................................................................................... 679 Problems and Applications ........................................................................................................................................ 680 Additional Resources ...................................................................................................................................... 682 Cengage Video Resources ........................................................................................................................................... 682

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 37 addresses six unresolved issues in macroeconomics, each of which is central to current political debates. The chapter can be studied all at once, or portions of the chapter can be studied in conjunction with prior chapters that deal with the related material. The purpose of Chapter 37 is to provide both sides of six leading debates over macroeconomic policy. It employs information and tools that students have accumulated in their study of this text. This chapter may help students take a position on the issues addressed or, at least, it may help them understand the reasoning of others who have taken a position. Key points addressed in this chapter: 



Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe that policy can manage aggregate demand in order to offset the instability. Critics of active monetary and fiscal policy emphasize that policy affects the economy with a lag and that our ability to forecast future economic conditions is poor. As a result, attempts to stabilize the economy can end up being destabilizing. Advocates of increased government spending to fight recessions argue that because the extra income from tax cuts may be saved rather than spent, direct government spending provides a greater boost to aggregate demand, which is key to promoting production and employment. Critics of spending hikes argue that tax cuts can expand both aggregate demand and aggregate supply and that hasty increases in government spending may lead to wasteful public projects. Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, abuse of power, and time inconsistency. Critics of rules for monetary policy argue that discretionary policy is more flexible in responding to changing economic circumstances. Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits. Moreover, the cost of eliminating inflation—depressed output and employment―is only temporary. Even this cost can be reduced if the central bank credibly commits to reduce inflation, thereby directly lowering inflation expectations. Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce the inflation is quite costly. The critics also point out two benefits to moderate inflation. It facilitates real-wage adjustment, and it allows real interest rates to be negative when necessary. Advocates of a balanced government budget argue that budget deficits impose an unjustifiable burden on future generations by raising their taxes and lowering their incomes. Critics of a balanced government budget argue that the deficit is only one small piece of fiscal policy. Single-minded concern about the budget deficit can obscure the many ways in which policy, including various spending programs, affects different generations. Advocates of tax incentives for saving point out that society discourages saving in many ways, such as by heavily taxing capital income and reducing benefits for those who have accumulated wealth. They endorse reforming the tax laws to encourage saving, perhaps by switching from an income tax to a consumption tax. Critics of tax incentives for saving argue that many proposed changes to stimulate saving would primarily benefit the wealthy, who

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy do not need a tax break. They also argue that such changes might have only a small effect on private saving. Raising public saving by decreasing the government’s budget deficit would provide a more direct and equitable way to increase national saving.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain the benefits and challenges of using monetary policy to address economic imbalances.



Debate the use of discretionary policy to stabilize the economy.

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Compare the effects of making monetary policy by rule rather than by discretion.

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Explain the short-run cost of the economy of reducing inflation.

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Discuss the benefits and costs of reducing the budget deficit.

Activity/Assessment

Source (i.e., PPT slide, Workbook)

Duration

Active Learning 1 Active Learning 2 Active Learning 3 Ask the Experts Think-Pair-Share Activity Self-Assessment Section 37-1 QuickQuiz Section 37-2 QuickQuiz Section 37-3 QuickQuiz Section 37-4 QuickQuiz Section 37-5 QuickQuiz Section 37-6 QuickQuiz Chapter 37 Problems & Applications Chapter 37 A+ Test Prep Chapter 37 Homework Chapter 37 Quiz: Six Debates over Macroeconomic Policy

PPT Slide 8 PPT Slide 23 PPT Slide 33 PPT Slide 35 PPT Slide 38 PPT Slide 39 MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap eBook MindTap Study It Folder MindTap Study It Folder MindTap Apply It Folder MindTap Apply It Folder

5–10 mins. 5–10 mins. 5–10 mins. 10–15 mins. 5–10 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 5 mins. 15–25 mins. N/A 20–30 mins. 20–30 mins.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy [return to top]

WHAT'S NEW IN THIS CHAPTER The following elements are improvements in this chapter from the previous edition:  

The headings on each section have been changed to better describe the arguments for and against each proposition. There is a new In the News feature: The Goals of Monetary Policy, “The Fed’s Duty Is to the Economy, Not Equity.”

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LXXXVIII.

LXXXIX.

Instruction Idea: Provide supporting facts and figures for each side of the debates. Emphasize that there are no clear right or wrong answers. Do not forget to mention the political dimensions involved with these debates. At the heart of these debates is that there is a great deal of wealth and power at stake, and these considerations often are more important than the consensus of economists. Instruction Idea: Instead of lecturing, divide the students into groups and have them present the debates discussed in the chapter. Ask them to provide facts and figures to support their positions. How Actively Should Policymakers Try to Stabilize the Economy? a. The Case for Robust Stabilization Policy i. When households and firms feel pessimistic, aggregate demand falls. This causes output to fall and unemployment to rise. ii. There is no reason for the economy to suffer through a recession when policymakers can reduce the severity of economic fluctuations. iii. Thus, policymakers should take an active role in leading the economy to stability. iv. Policymakers should “lean against the wind.” When aggregate demand is inadequate to ensure full employment, policymakers should act to boost spending in the economy. When aggregate demand is excessive and there is a risk of inflation, policymakers should act to reduce spending. v. Such policy actions put macroeconomic theory to its best use by leading to a more stable economy. b. The Case for Modest Stabilization Policy

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy i.

XC.

XCI.

There are substantial difficulties associated with running fiscal and monetary policy. One of the most important problems to remember is the time lag that often occurs with policy. ii. Economic conditions change over time. Thus, policy effects that occur with a lag may hit the economy at the wrong time, leading to a more unstable economy. iii. Therefore, policymakers should refrain from intervening in the economy unless the downturn is deep and protracted. They should be content with “doing no harm.” Should the Government Fight Recessions with Spending Hikes or Tax Cuts? a. The Case for Fighting Recessions with Spending Hikes i. Traditional Keynesian analysis indicates that increases in government spending are a more potent tool than cuts in taxes. Government spending is particularly useful when monetary policy has caused interest rates to hit the zero-lower bound. 1. Tax cuts can lead to increases in spending and saving. 2. Increases in government spending raise spending directly. ii. Estimates from the Obama administration suggest that $1 of tax cuts raises GDP by $0.99, but a $1 increase in government spending raises GDP by $1.59. b. The Case for Fighting Recessions with Tax Cuts i. Policymakers can target particular types of spending (such as investment) with the right tax incentives. ii. Tax cuts may also increase aggregate supply. 1. Reducing marginal tax rates may provide greater incentive to work. 2. Increases in aggregate supply that accompany an increase in aggregate demand will keep the price level more stable. 3. Government spending multipliers may be exaggerated because people anticipate future taxes needed to pay for it. Also, the government cannot spend money quickly and wisely. Should Monetary Policy Be Made by Rule or Discretion? a. The Case for Rule Based Monetary Policy i. Discretionary monetary policy leads to two problems. 1. It does not limit incompetence and abuse of power. For example, a central banker may choose to create a political business cycle to help out a particular candidate. 2. It may lead to a greater amount of inflation than is desirable. Policymakers often renege on the low inflation policy that they promise. If individuals do not believe that the central bank will follow a low inflation policy, the short-run Phillips curve will shift upward or right, resulting in a less favorable trade-off between inflation and unemployment. ii. One way to avoid these problems is to force the central bank to follow a monetary rule. This rule could require a fixed rate of growth or the money supply or it could be flexible enough to allow for specific policy responses to new information on the state of the economy.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy

XCII.

b. The Case for Discretionary Monetary Policy i. Discretionary monetary policy allows flexibility. This gives the Fed the ability to react to unforeseen situations quickly. ii. It is also unclear that Fed central bankers use policy to help political candidates. Often, the policy used is one that actually lowers the candidate’s popularity (such as during the Carter administration). iii. The Fed can gain the confidence of people by following through on its promises. If it promises to fight inflation and then runs policies that keep the growth of the money supply low, there is no reason why inflation expectations would be high. Thus, the economy can achieve low inflation without a policy rule. (This was shown to be the case in the United States in the 1990s.) iv. It would also be very difficult to specify a precise rule. c. FYI: Inflation Targeting i. Many central banks around the world have adopted explicit targets for inflation. ii. In 2020, the Federal Reserve announced that it targets inflation at an average of 2 percent. Should the Central Bank Aim for Inflation Near Zero? a. The Case for Near Zero Inflation i. Inflation confers no benefits on society, but it poses real costs. 1. Shoeleather costs 2. Menu costs 3. Increased variability of relative prices 4. Tax distortions 5. Confusion and inconvenience 6. Arbitrary redistributions of wealth ii. Reducing inflation usually is associated with higher unemployment in the short run. However, once individuals see that policymakers are trying to lower inflation, inflation expectations will fall, and the short-run Phillips curve will shift downward. The economy will move back to the natural rate of unemployment at a lower inflation rate. iii. Therefore, reducing inflation is a policy with temporary costs and permanent benefits. b. The Case for Living with Moderate Inflation i. The benefits of achieving near zero inflation are small relative to the costs. Estimates of the sacrifice ratio suggest that lowering inflation by one percentage point lowers one year’s output in the economy by 5%. These costs are borne by the workers with the lowest level of skills and experience who lose their jobs. ii. There is no evidence that the costs of inflation are large. Also, policymakers may be able to lower the costs of inflation (by indexing the tax system, for example) without actually lowering the inflation rate. iii. Although, in the long run, the economy will move back to the natural rate of unemployment, there is no certainty that this will occur quickly. It may take time for the central bank to gain the trust of the people.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy iv.

XCIII.

XCIV.

Moreover, recessions have permanent effects. Investment falls, lowering the future capital stock. When workers become unemployed, they lose valuable job skills. v. A small amount of inflation may actually benefit the economy by reducing real wages when nominal wages are sticky downward. c. In the News: The Goals of Monetary Policy, “The Fed’s Duty Is to the Economy, Not Equity” i. The legislated mandate for the Fed is to achieve “maximum employment, stable prices, and moderate long-term interest rates.” The Fed has great latitude and independence to choose a strategy to achieve those goals. ii. Some Federal Reserve District Banks are creating a new objective of “economic equity” for historically marginalized groups. This differs from the traditional objectives of monetary policy because it suggests that policy should be concerned with individual groups rather than the economy as a whole. iii. All monetary policy decisions unintentionally affect the welfare of particular interests. For example, low interest rates benefit borrowers and harm savers. The authors argue that if the Fed concerns itself with economic equity, monetary policy will become more politicized and will lead to a reduction in the independence of the Fed. Should the Government Balance Its Budget? a. The Case for a Balanced Budget i. Future generations of taxpayers will be burdened by the federal government’s debt. This will lower the standard of living for these future generations. ii. Budget deficits cause crowding out. Reduced national saving raises interest rates and lowers investment. A lower capital stock reduces productivity and thus leads to a smaller amount of economic growth than would have occurred in the absence of this budget deficit. iii. While it is sometimes justifiable to run budget deficits (such as in times of war or recession), recent budget deficits are not easily justified. It appears that Congress simply found it easier to borrow to pay for its spending instead of raising taxes. b. The Case Against a Balanced Budget i. The problems caused by the government debt are overstated. The future generation’s burden of debt is relatively small when compared with their lifetime incomes. ii. It is important that any change in government spending is examined for external effects. If education spending is cut, for example, this will likely lead to lower economic growth in the future. This will certainly not make future generations better off. iii. To some extent, parents who leave a bequest to their children can offset the effects of the budget deficits on future generations. Should the Tax Laws Be Reformed to Encourage Saving? a. The Case for Promoting Saving through Tax Reform

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy i.

The greater the amount of saving in an economy, the more funds there are available for investment. This increases productivity, raising the nation’s standard of living. ii. Because people respond to incentives, changing the tax laws to make saving more attractive will raise the amount of funds saved. Current laws tax the return on saving fairly heavily. Some forms of capital income (such as corporate profits) are taxed twice: first at the corporate level and then at the stockholder level. Large bequests are also taxed, limiting the incentive parents have to save for their children. iii. Tax laws are not the only government policy that discourage saving. Transfer programs such as welfare and Medicaid are reduced for those who have saved past income. College financial aid policies also are a function of income and wealth, penalizing those who have saved. iv. There are various ways to change the tax laws to encourage saving. 1. Expand the ability of households to use tax-advantaged savings accounts such as Individual Retirement Accounts. 2. Replace the current income tax system with a tax on consumption. b. The Case Against Promoting Saving through Tax Reform i. Increasing saving is not the only goal of tax policy. Policymakers are interested in using tax policy to redistribute income, making sure that the burden of taxation falls on those who can most afford it. Any tax change that encourages saving will favor high-income households as they are more likely to be saving in the first place. ii. Changes in tax rates have conflicting substitution and income effects so it is not clear that reducing taxes on saving generates additional saving. iii. Saving can be increased in other ways. For example, governments could lower budget deficits (or increase budget surpluses) to raise public saving. iv. Lowering the tax on capital income lowers the revenue of the government. This may increase the budget deficit, lower public saving, and push national saving down as well. c. Ask the Experts: Taxing Capital and Labor i. 96 percent of economic experts agree that setting lower tax rates for capital income than for labor income gives people the incentive to relabel income as capital income rather than labor income. ii. Economic experts are divided on whether permanently taxing capital income at a lower rate than labor income would result in higher average long-term prosperity than setting tax rates for capital and labor income equal while generating the same amount of tax revenue. iii. 98 percent of economic experts agree that economists disagree on tax policy because they hold differing views about choices between raising average prosperity and redistributing income [return to top]

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 289.

The lags in the effect of monetary and fiscal policy on aggregate demand are caused by the fact that many households and firms set their spending plans in advance, so it takes time for changes in interest rates or taxes to alter the aggregate demand for goods and services. In addition, the effects of fiscal policy are slowed by the political process. As a result, it is more difficult to engage in activist stabilization policy, because the economy will not respond immediately to policy changes. 290. According to traditional Keynesian analysis, a tax cut has a smaller effect than an equal rise in government spending because some of the tax cut may be saved rather than spent. However, a tax cut may also boost aggregate supply leading to a larger impact on output than a rise in government spending. 291. A central banker might be motivated to cause a political business cycle by trying to influence the outcome of elections. A central banker who is sympathetic to the incumbent knows that if the economy is doing well at election time, the incumbent is likely to be reelected. So the central banker could stimulate the economy before the election. To prevent this, it might be desirable to have monetary policy set by rules rather than discretion. 292. Credibility might affect the cost of reducing inflation because it influences how quickly the short-run Phillips curve adjusts. If the Fed announces a credible plan to reduce inflation, the short-run Phillips curve will shift down quickly and the cost of disinflation will be low. But if the plan is not credible, people will not adjust their expectations of inflation, the short-run Phillips curve will not shift down quickly, and the cost of disinflation will be high. 293. Some economists are against a target of zero inflation because they believe the costs of reaching zero inflation are large and the benefits are small. 294. Two ways in which a government budget deficit hurts a future worker are: (1) taxes on future workers are higher to pay off the government debt; and (2) because of crowding out, budget deficits lead to a reduction in the economy's capital stock, so future workers have lower incomes. 295. Two situations in which a budget deficit is justifiable are: (1) in wartime, so tax rates will not have to be increased so much that they lead to large deadweight losses; and (2) during a temporary downturn in economic activity, because balancing the budget would force the government to increase taxes and cut spending, making the downturn even worse. 296. The government can run a budget deficit forever because population and productivity continuously increase. Thus the economy's capacity to pay off its debt grows over time. As long as the government debt grows slower than the economy's income, government deficits can continue forever. 297. Income from capital is taxed twice in the case of dividends on corporate stock. The income is taxed once by the corporate income tax and a second time by the individual income tax on dividend income. 298. Tax incentives to increase saving may have the adverse effect of raising the government budget deficit, which reduces public saving. Thus, national saving may not increase even though private saving rises.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy

PROBLEMS AND APPLICATIONS 33. a. Figure 1 illustrates the short-run effect of a fall in aggregate demand. The economy

starts at point A on aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The decline in aggregate demand shifts the aggregate-demand curve from AD1 to AD2 and the economy moves to point B. Total output falls from Y1 to Y2, so income and employment fall as well. b. With no policy changes, the economy restores itself gradually over time. The recession induces declines in wages, so the cost of production declines, and the short-run aggregate-supply curve shifts to the right to AS2. The economy ends up at point C, with a lower price level, but with output back at Y1. However, this process may take years to complete. c. If policymakers are passive, the economy restores itself, but very slowly. If policymakers shift aggregate demand to the right, they can get the economy back to long-run equilibrium much more quickly. However, due to lags and imperfect information, a policy to increase aggregate demand may be destabilizing.

Figure 1

34. It is difficult for policymakers to choose the appropriate strength of their actions because of lags between when policy is changed and when it affects aggregate demand, as well as the difficulty in forecasting the economy's future condition. It is also difficult to anticipate how sensitive consumers and firms will be to the changes in policy. 35. a. If investors believe that capital taxes will remain low, then a reduction in capital taxes leads to increased investment. b. After the increase in investment has occurred, the government has an incentive to renege on its policy because it can get more tax revenue by increasing taxes on the higher income from the larger capital stock. c. Given the government's obvious incentive to renege on its promise, firms will be reluctant to increase investment when the government reduces tax rates. The government can increase the credibility of its tax change by somehow committing to

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 37: Six Debates Over Macroeconomic Policy low future tax rates. For example, it could write a law that guarantees low future tax rates for all capital income from investments made within the next year, or write a law penalizing itself if it raises future taxes. d. This situation is similar to the time-inconsistency problem facing monetary policymakers because the government's incentives change over time. In both cases, the policymaker has an incentive to tell people one thing, then to do another once people have made an economic decision. For example, in the case of monetary policy, policymakers could announce an intention to lower inflation (so firms and workers will enter labor contracts with lower nominal wages), and policymakers could increase inflation to reduce real wages and stimulate the economy. 36. Issues about whether the costs of inflation are large or small are positive statements, as is the question about the size of the costs of reducing inflation. But the question of whether the Fed should reduce inflation to zero is a normative question. 37. The benefits of reducing inflation are permanent and the costs are temporary. Figure 2 illustrates this. The economy starts at point A. To reduce inflation, the Fed uses contractionary policy to move the economy down the short-run Phillips curve SRPC1. Inflation declines and unemployment rises, so there are costs to reducing inflation. But the costs are only temporary, because the short-run Phillips curve eventually shifts to the left to SRPC2, and the economy ends up at point B. Because inflation is lower at point B than at point A, and point B is on the long-run Phillips curve, the benefits of reducing inflation are permanent. The costs of increasing inflation are permanent and the benefits are temporary for similar reasons. Again, suppose the economy starts at point A. To increase inflation, the Fed uses expansionary policy to move the economy up the short-run Phillips curve SRPC1. Inflation rises and unemployment declines, so there are benefits to increasing inflation. But the benefits are only temporary, because the short-run Phillips curve eventually shifts to the right to SRPC3, and the economy ends up at point C. Because inflation is higher at point C than at point A, and point C is on the long-run Phillips curve, the costs of increasing inflation are permanent.

Figure 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data 38. If the budget deficit is 12% of GDP and nominal GDP is rising 5% each year, the ratio of government debt to GDP will rise until it hits a fairly high level. (That level turns out to be debt/income = 12/5, because at that point, a deficit that is 12% of GDP with GDP growing 5% maintains the debt/income ratio at exactly 12/5. To be sustainable, debt and GDP must grow at the same rate, 5% each year. If the deficit is 12% of GDP, which is growing 5% each year, the ratio of debt to GDP must be 12/5, so that the deficit can be both 12% of GDP and maintain a constant ratio of debt to GDP.) Such a high debt level is likely to require a big tax increase on future generations. To keep future generations from having to pay such high taxes, you could increase your savings today and leave a bequest to them. 39. a. An increase in the budget deficit redistributes income from young to old, because future generations will have to pay higher taxes and will have a lower capital stock. b. More generous subsidies for education loans redistribute income from old to young, because future generations benefit from having higher human capital. c. Greater investments in highways and bridges redistribute income from old to young, because future generations benefit from having a higher level of public capital than otherwise. d. An increase in Social Security benefits redistributes income from young to old, because current workers fund the benefits of those retired. 40. The fundamental trade-off that society faces if it chooses to save more is that it will have to reduce its consumption. Thus, society can consume less today and save more if it wants higher future income and consumption. The choice is really one of consumption today versus consumption in the future. The government can increase national saving by revising tax laws or by reducing its budget deficit.

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Instructor Manual Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data Prepared by David R. Hakes, University of Northern Iowa

TABLE OF CONTENTS Purpose and Perspective of the Chapter .................................................................................................. 684 Chapter Objectives ........................................................................................................................................... 684 Complete List of Chapter Activities and Assessments ......................................................................... 685

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data Key Terms ........................................................................................................................................................... 685 What's New in This Chapter .......................................................................................................................... 686 Chapter Outline ................................................................................................................................................. 686 Solutions to Text Problems ........................................................................................................................... 693 Questions for Review ................................................................................................................................................... 693 Problems and Applications ........................................................................................................................................ 694 Additional Resources ...................................................................................................................................... 694 Cengage Video Resources ........................................................................................................................................... 694

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data

PURPOSE AND PERSPECTIVE OF THE CHAPTER Chapter 38 is the last chapter in the text. It is included as an appendix. The purpose of Chapter 38 is to introduce students to how economists use data. The chapter explains the different types of data economists use, what economists do with data, and the statistical methods economists use to analyze data. Students are introduced to linear regression, ordinary least squares, and multiple regression. Key points addressed in this chapter/appendix: 



  



Economists use two kinds of data to study how the world works: experimental data obtained from randomized controlled trials and observational data obtained from surveys and administrative records. Interpreting observational data requires extra care due to the problems of confounding variables and reverse causality. There are three types of data. Cross-sectional data present information about multiple subjects (such as people, firms, or nations) at a given point in time. Time-series data present information about a single subject over time. Panel data present information about multiple subjects over time. Economists usually have one of four goals when using data: describing the economy, quantifying relationships among variables, testing hypotheses, or predicting the future. To quantify relationships, statistical methods are used to find parameter estimates that best fit the data. One such method is ordinary least squares. Statistical methods not only estimate parameters but also determine the uncertainty associated with those estimates that arises from sampling variation. An estimate’s standard error is a measure of that uncertainty. Data analysts can be led astray if a confounding variable is correlated with the independent variable and omitted from the statistical model. One approach to dealing with this problem is to add the confounding variable to the model and use multiple regression to estimate the true effect of the independent variable of interest. To estimate the causal effect of one variable on another, data analysts need to be careful about confounding variables and reverse causality. One approach is to look for natural experiments.

CHAPTER OBJECTIVES The following objectives are addressed in this chapter: 

Explain the difference between experimental data and observational data.



Describe the two problems associated with observational data.



Explain the difference between cross-sectional data, time-series data, and panel data.



Identify the parameters in a linear regression model.



Explain how ordinary least squares (OLS) generates the best fitting line through a scatter plot.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data 

Explain why a researcher might need to use multiple regression rather than linear regression.



Understand the advantages of a natural experiment.

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5–10 mins. 5–10 mins. 5–10 mins. 5 mins. 5 mins. 5 mins.

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KEY TERMS Confounding Variable: an omitted variable that can mislead the researcher because it is related to the variables of interest. Cross-sectional Data: data that present information about multiple subjects (such as a people, firms, or nations) at a given time. Data: factual information, often quantitative, that provides the basis for reasoning and discussion. Econometrics: the subfield of economics that develops tools to analyze data. Experimental Data: data that comes from a researcher running a randomized controlled trial. Linear Regression: a statistical model in which the dependent variable is linearly related to one or more independent variables plus a random residual. Multiple Regression: a linear regression model with more than one independent variable.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data Natural Experiment: a chance event that causes variation in the data similar to that generated by a randomized controlled trial. Observational Data: data that come from a researcher observing the world as it presents itself. Ordinary Least Squares: a statistical method for estimating parameter values by minimizing the sum of squared residuals. Panel Data: data that present information about multiple subjects (such as people, firms, or nations) at various times. Parameter: the numerical values that govern the strength of the relationships among variables in a model. Randomized Controlled Trial: an experiment in which a researcher randomly divides subjects into groups, treats the groups differently, and compares their outcomes. Reserve Causality: a situation in which a researcher confuses the direction of influence between two variables. Standard Error: a measure of the uncertainty associated with a parameter estimate that results from sampling variation. Time-series Data: data that present information about a single subject (such as a person, firm, or nation) at various times. [return to top]

WHAT'S NEW IN THIS CHAPTER In the past, this chapter was an optional “module” available in the digital version of the text. It is now included as an appendix in both the digital and hard copy versions of the text. In addition, this chapter now includes Quick Quizzes, Questions for Review, and Problems and Applications. [return to top]

IX.

Economists use data to support or refute theories. A. Definition of data: factual information, often quantitative, that provides the basis for reasoning and discussion. B. Definition of econometrics: the subfield of economics that develops tools to analyze data. The Data that Economists Gather and Study A. Experimental Data

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data 1. Data can be generated by a randomized controlled trial. 2. Definition of randomized controlled trial: an experiment in which a researcher randomly divides subjects into groups, treats the groups differently, and compares their outcomes. 3. In a controlled trial, the researcher randomly assigns a treatment group that gets the treatment, and a control group that does not receive the treatment. The treatment could be a new drug being tested for safety and effectiveness. 4. Definition of experimental data: data that comes from a researcher running a randomized controlled trial. 5. In economics, experiments are not often used because experiments are expensive and policymakers may consider it unfair to treat people differently. 6. Instruction Idea: Students may have some difficulty with understanding why economists don’t often use randomized controlled trials when these experiments generate the best data. This is a good place to demonstrate the unfairness of treating people differently just to get good data. Government could provide unemployment benefits to one group and not to another to see how benefits affect the intensity of job search. Government could provide free food to some students and not to others to see how a better diet affects learning, and so on. There are many more examples that demonstrate why it is sometimes too unfair to run a randomized controlled trial. Another reason economists rarely use randomized controlled trials is that the economic cost may be too high. Government could raise taxes to measure the impact of taxes on economic growth, but the damage to the economy would be higher than the value of the data. 7. Case Study: The Moving to Opportunity Program a. The U.S. Department of Housing and Urban Development created experimental data to study the effects of living in high-poverty neighborhoods. b. Randomly, some families were given vouchers that could be used to move to more affluent neighborhoods. Other families did not receive the vouchers. c. Living in more affluent areas didn’t change outcomes for adults or older children, but children under 13 had higher rates of college attendance, lower rates of single motherhood, and higher incomes as adults. B. Observational Data 1. Definition of observational data: data that come from a researcher observing the world as it presents itself. 2. This type of data can come from surveys, administrative records, tax returns, etc. It is more easily obtained but it presents two problems: confounding variables and reverse causality. a. Definition of confounding variable: an omitted variable that can mislead the researcher because it is related to the variables of interest.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data

b. Suppose that we want to know if smaller class size improves student learning. If less experienced teachers are assigned to smaller classes, we will underestimate the impact of small classes on student learning. If teacher experience is ignored, it is a confounding variable. c. Definition of reserve causality: a situation in which a researcher confuses the direction of influence between two variables. d. If people with a high body mass index (BMI) consume a lot of diet soda, it would be a mistake to conclude that drinking diet soda causes obesity. It is much more likely that people trying to lose weight drink diet soda. 3. Instruction Idea: This is a good place to involve students by letting students create examples of reverse causality. For example: a. When people carry umbrellas, it tends to rain. It would be a mistake to argue that umbrellas cause rain. It is much more likely that the expectation of rain causes people to carry umbrellas. b. Student’s IQ and years of schooling tend to be positively related. But it would be a mistake to argue that schooling increases IQ when it is much more likely that having a high IQ makes it easier to accumulate more years of schooling. C. Three Types of Data 1. Both experimental and observational data can come in three types. 2. Definition of cross-sectional data: data that present information about multiple subjects (such as a people, firms, or nations) at a given time. 3. Definition of time-series data: data that present information about a single subject (such as a person, firm, or nation) at various times. 4. Definition of panel data: data that present information about multiple subjects (such as people, firms, or nations) at various times. 5. Instruction Idea: This is a good time to let students create examples of each type of data. It is not difficult, and it allows them to gain some confidence with data before they move to harder topics. What Economists Do with Data A. Describing the Economy 1. Data adds precision to our observations. 2. We know that people in the United States earn more income than people in Mexico. Data allows us to state that average income in the Unites States is three times as that in Mexico. B. Quantifying Relationships 1. When variables are related, data allows us to know the magnitude of the relationship. 2. Definition of parameter: the numerical values that govern the strength of the relationships among variables in a model. 3. Data allows economists to measure the responsiveness of the quantity demanded of a good to a change in the price of that good. C. Testing Hypotheses 1. Economic theory suggests many hypotheses.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data

XI.

2. Data allows economists to confirm or refute a hypothesis. 3. Often an economic debate cannot be settled with theory. It requires empirical investigation. D. Predicting the Future 1. To make reliable predictions, economists create models which are mathematical representations of the forces at work in a given situation. 2. Economists quantify the relationships within a model by estimating the parameters in the model. 3. To forecast the starting wage of college graduates, economists would estimate the magnitude of the relationship between a graduates starting wage, major, grade point average, past internships, etc. E. Case Study: The FRB/US Model 1. An important model is the Federal Reserve Board’s model of the U.S. economy, abbreviated as FRB/US. 2. It includes hundreds of equations that describe the relationships among key variables. Some of the equations explain household’s consumption decisions and firm’s investment decisions. 3. The computer estimations of the model are used for two purposes. a. Forecasting: The model projects the most likely outcome for the future if current policy is not changed. b. Policy analysis: The model projects what would happen to key economic variables if the Fed were to tighten or loosen monetary policy. The members of the FOMC use this as a guide for choosing a policy. Methods of Data Analysis A. Finding the Best Estimate 1. Example: To answer the question, “How much does an extra year of schooling increase a worker’s wage?” use the survey data in Table 1. Table 1 Worker Wage ($/hour) Years of Schooling Andy 20 12 Brooke 30 12 Chloe 30 16 Diego 40 14 Emma 40 18 Flynn 50 16 Gina 50 18 Table 1 Data on Wages and Education 2. The data in Table 1 is graphed in Figure 1. The scatterplot of the data shows a positive relationship between years of schooling and wages, but the relationship is not perfect. Figure 1

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data 3. To determine how much each year of schooling increases a worker’s wage, economists create a statistical model. WAGEi = B0 + B1 x SCHOOLi + ei where B0 and B1 are parameters that measure how the variables are related. Person i’s WAGE is the dependent variable, the variable being explained, and SCHOOL is the independent variable, the variable taken as given. The term ei is the residual. This model is a linear regression. 4. Definition of linear regression: a statistical model in which the dependent variable is linearly related to one or more independent variables plus a random residual. Figure 2 5. To estimate the best fitting line in Figure 2, economists estimate the parameters with ordinary least squares. This method minimizes the distance from the data points to the estimated line.

Figure 2 Estimating the Best-Fitting Line 6. Definition of ordinary least squares: a statistical method for estimating parameter values by minimizing the sum of squared residuals. 7. Keep in Mind: Students often have difficulty understanding why minimizing the sum of squared residuals generates the best fitting line. By squaring the residuals, the signs from negative deviations from the estimated line are removed so positive and negative deviations are equally weighted.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data 8. When OLS is applied to the data points, the estimate of B1 is 3.16, which means that each year of schooling increases a worker’s wage by $3.16. B. Gauging Uncertainty 1. Economists also want to know how precise or reliable parameter estimates are. 2. A simple example: Measuring the average (mean) height of the residents of NY City. Suppose we get data on the height of a random sample of 100 New Yorkers. There is now some uncertainty known as sampling variation (different random samples will provide slightly different estimates of the mean height. 3. Compute the average height of the sample of 100. Calculate the standard deviation (the square root of the average squared deviation from the mean) of the sample. In a normal distribution, about 95% of observations fall within two standard deviations of the mean. 4. Using this information, we can calculate a measure of the estimate’s reliability known as the standard error. The standard error of the sample mean as an estimate of the population mean is the standard deviation divided by the square root of the sample size. 5. Definition of standard error: a measure of the uncertainty associated with a parameter estimate that results from sampling variation. 6. The true value of a parameter lies within two standard errors of the estimated value about 95% of the time. 7. Calculating the standard errors of the parameters in a regression model is more complex, and is not calculated in the text. In our model of how SCHOOL affects WAGE, the estimate of B1 was 3.16. The standard error of that estimate (which is given in the text) is 1.35. Two standard errors is 2 x 1.35 = 2.70. Thus, we are 95% confident that the true wage benefit of a year of schooling is between $0.46 and $5.86, which is a large range. C. Accounting for Confounding Variables 1. Sometimes the dependent variable (WAGE) depends on more than one independent variable (SCHOOL). For example, suppose WAGE also depends on cognitive ability as measured by a worker’s IQ, but IQ is not included in the model. 2. If SCHOOL and IQ are uncorrelated, then the error term is uncorrelated with SCHOOL, and B1 is unbiased. 3. If it is easier for high IQ people to gain more years of SCHOOL, then SCHOOL and IQ are correlated and our OLS estimate of B1 would be biased upward. In this case, B1 includes both the effect of SCHOOL and IQ. We would attribute too great of an impact of SCHOOL on WAGE. OLS confounds the effects of SCHOOL and IQ. 4. One solution is to include IQ as an independent variable in the model in addition to SCHOOL. WAGEi = B0 + B1 x SCHOOLi + B2 x IQi + ei Table 2

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data 5. Definition of multiple regression: a linear regression model with more than one independent variable. a. Instruction Idea: Let students list other variables that belong in a multiple regression explaining WAGE. If the additional right-handside variable is uncorrelated with SCHOOL, then B1 was unbiased prior to the addition of the variable. If the additional RHS variable is correlated with SCHOOL, then B1 was biased prior to the addition of the new RHS variable. 6. Estimating the expanded model using the data from Table 2 generates an estimate of B1 of 1.86. When IQ is included in the model, the new estimate of the impact of an additional year of SCHOOL on WAGE is only $1.86, not $3.16. 7. Alternative Classroom Example: The examples in the text show a positive relationship between the independent variable and the dependent variable. That is, B1 is positive. Here are a couple of examples that show a negative relationship. a. COURSE GRADE = B0 + B1 x NUMBER OF CLASSES SKIPPED + e Suppose B1 = -0.25. This would suggest that skipping four classes reduces a student’s grade by one grade point. b. MILES PER GALLON = B0 + B1 x AVERAGE SPEED + e Again, B1 would be negative because the faster one drives, the lower the gas mileage. D. Establishing Causal Effects 1. The estimation of causal effects using observational data is difficult due to both the potential omission of confounding variables and the possibility of reverse causality. 2. Sometimes these problems can be addressed by exploiting a natural experiment. 3. Definition of natural experiment: a chance event that causes variation in the data similar to that generated by a randomized controlled trial. 4. Example: Suppose a philanthropist offers to pay for four years of college for students that graduate from a particular high school. By comparing the wages of the students from the high school that received the treatment (free college) to the wages of students from a similar high school without free college (control group), we can measure the causal effect of extra schooling. 5. The example above employs the instrumental variables method. The instrument is a random variable that meets two conditions. a. The instrument is correlated with the independent variable. b. The instrument does not affect the dependent variable other than through its effect on the independent variable. c. The philanthropist’s generosity qualifies as an instrument. 6. Case Study: How Military Service Affects Civilian Earnings

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data a. The U.S. government provided a natural experiment when it employed a draft lottery, based on a man’s birthdate, during the Vietnam War. b. Evidence from this natural experiment suggests that veterans earn 15 percent less that nonveterans. [return to top]

SOLUTIONS TO TEXT PROBLEMS The following are solutions to the problems within the text.

QUESTIONS FOR REVIEW 182. Experimental data comes from a randomized controlled trial, an experiment in which a researcher randomly divides subjects into groups, treats the groups differently, and then compares the outcomes. Observational data are data that come from simply observing the world as it is. Observational data can come from surveys, tax returns, and so on. 183. Sometimes generating experimental data is unfeasible. Running an experiment can be too costly. The high cost could be monetary or the economic cost to the economy for a macro experiment. Also, because a randomize controlled experiment requires that groups receive different treatments, policymakers may object to the unfairness of treating people differently. 184. The two problems presented by observational data are confounding variables and reverse causality. Confounding variables occurs when a variable that has been omitted is related to the variables of interest. Reverse causality occurs when a researcher believes that one variable influences a second variable when in fact it is the second variable that influences the first. 185. Cross-sectional data show the characteristics of multiple subjects (people, firms, or nations) at a given time. A data set consisting of the weight of each person in your class is cross-sectional data. Time-series data show the characteristics of a single subject at various times. A data set consisting of your weight every year of your life is time-series data. 186. OLS generates the values of the parameters in a statistical model by minimizing the sum of the squared residuals. The residuals are the distances from the actual data points and the estimated line. 187. Standard error is a measure of the uncertainty associated with a parameter estimate that results from sampling variation. The true value of the parameter lies within two standard errors of its estimated value about 95 percent of the time. The smaller the standard error, the more reliable the estimate. 188. A confounding variable is an omitted variable that is that is related to the variables of interest in the model. One solution is to estimate a multiple regression which allows the researcher to include the confounding variable as an additional independent variable in the model. Another solution is to exploit a natural experiment, which is a chance event that causes variation in the data similar to that generated by a randomized controlled trial. A natural experiment may provide an instrumental variable that is correlated with the independent variable and does not affect the dependent variable other than through its effect on the independent variable.

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Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 38: Appendix: How Economists Use Data

PROBLEMS AND APPLICATIONS 299. a. b. c. d. e. f. g. h. i. j.

cross-sectional ordinary least squares standard error observational randomized controlled trial confounding variables multiple regression reverse causality natural experiment instrumental variables

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