Solution Manual For Economics, 14th Edition Roger A. Arnold Daniel R. Arnold David H. Arnold. Chapte by welldoneassistant

Solution Manual For Economics, 14th Edition Roger A. Arnold Daniel R. Arnold David H. Arnold Chapter 1-35

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Solution’s Manual Arnold, Economics, 14e; Chapter 1: What Economics Is About

Table of Contents Content Grid ...................................................................................................................... 5 Chapter 1: What Economics is About ................................................................................... 8 Answers to Chapter Questions and Problems ........................................................................................... 8 Answers to Problems in the Working With Numbers and Graphs Section .............................................. 16

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 1: What Economics is About Answers to Chapter Questions and Problems 1.

The United States is considered a rich country because Americans can choose from an abundance of goods and services. How can there be scarcity in a land of abundance?

Abundance does not imply unlimited resources. No one has unlimited money and time, so everyone must constantly make choices. This is the fundamental basis of scarcity. Even in a land of abundance, wants exceed the resources available to meet those wants.

Give two examples for each of the following: (a) an intangible good, (b) a tangible good, (c) a bad.

Answers will vary. a) Intangible goods are those that have no concrete existence, such as friendship or an economics lecture. b) Tangible goods are concrete goods that can be exchanged and reproduced more easily than intangible goods, such as a videotape of an economics lecture or a cell phone. c) Bads are goods that provide disutility. Examples are pollution, the noise produced by planes taking off at an airport, or the smell a skunk produces, etc.

Give an example of something that is a good for one person and a bad for someone else.

Answers will vary.

What is the difference between labor as a resource and entrepreneurship as a resource?

Labor consists of the physical and mental talents people contribute to the existing production process, while entrepreneurship refers to creatively seeking new business opportunities and new ways to organize production and developing new ways of doing things.

Can either scarcity or one of the effects of scarcity be found in a car dealership? Explain your answer.

Answers will vary. One example is that the resources used to produce a car sold in the dealership could have been used to produce a different good.

Explain the link between scarcity and each of the following: (a) choice, (b) opportunity cost, (c) the need for a rationing device, (d) competition. a) Because there is scarcity, individuals have to choose between the different goods that they have the opportunity to consume. b) In choosing between different goods, individuals face an opportunity cost. When they decide to choose one good (go to a baseball game), they give up the opportunity to consume another good (see a movie). c) Because wants exceed resources, some method for allocating scarce resources is necessary. Although there are many rationing devices, the most common one used in economic transactions is the price mechanism, which defines how much of one resource (money) an individual must give up in order to obtain another resource. d) Because resources are limited, people compete with one another both to obtain the resources they need to purchase the limited resources, and to get the resources that are available. This process is called competition.

Is it possible for a person to incur an opportunity cost without spending any money? Explain.

Yes. An opportunity cost occurs when an individual gives up any resource when making a choice. An example would be leisure time. When students study for an exam, the opportunity cost is the time they could have spent watching a movie or listening to music. Of course, not studying for the exam could also have an opportunity cost—flunking the course.

Discuss the opportunity costs of attending college for four years. Is college more or less costly than you thought it was? Explain.

Answers will vary. Students should include the cost of tuition, fees, and supplies that they purchase only because they are enrolled in college. They should also include that portion of room and board that they would not have spent had they not matriculated, remembering that, had they not enrolled in college, they would still have to eat and sleep somewhere. Finally, they should consider the opportunity cost of the time they spend in college. For example, suppose that Suzie has the following choices: she can go to college for the year, she can spend the entire year relaxing in leisure, she can take a job paying $25,000 a year as a legal secretary for a hometown law firm, or she can take a job with the Peace Corps in Africa, earning $17,000. If she decides that the best alternative use of her time would be to take a job paying $25,000 a year as a legal secretary, the opportunity cost of going to college will include the $25,000 that Susie foregoes. Once students include their opportunity costs, they find that college is considerably more expensive than they thought it was when they only considered out-of-pocket expenses.

Explain the relationship between changes in opportunity cost and changes in behavior.

To the extent that opportunity costs determine behavior by identifying those activ ities and goods that are ―worth‖ making ―sacrifices‖ for and those that aren’t, as opportunity costs

change so will a rational consumer’s assessment of various options. For example, suppose that Becky, a high school graduate, is currently working as a model and is earning $25,000 per year. In order to go to college, she would have to cut back on her modeling, reducing her annual income to $10,000. Further, suppose that tuition, books, and fees at the college of Becky’s choice total $15,000 per year. In deciding whether to quit modeling full-time and go to college, Becky is faced with balancing a present opportunity cost of $30,000, ceteris

paribus, against the future benefits of a college education. Now, suppose that Becky earns a scholarship that will reduce her tuition, books, and fees bill to $5,000 per year, thus reducing her present opportunity cost to $20,000. While this may not change Becky’s mind (she may have already decided to accept the present burden for the future benefit), such a change in opportunity cost would certainly weigh in favor of going to college.

10.

Owen says that we should eliminate all pollution in the world. William disagrees. Who is more likely to be an economist, Owen or William? Explain your answer.

William is more likely to be the economist. Owen is advocating the elimination of pollution by only considering the obvious benefits and not considering the serious costs of eliminating all pollution (such as costs incurred from finding an alternative to fossil fuels). William probably determined that the costs of eliminating all pollution are higher than the benefits from eliminating it.

11.

A friend pays for your lunch. Is this an example of a ―free lunch‖? Why or why not?

This is not an example of a free lunch, since your friend could have bought something else with the money she used to buy your lunch.

12.

A noneconomist says that a proposed government project simply costs too much and therefore shouldn’t be undertaken. How might an economist’s evaluation be different?

The noneconomicist may only be looking at the cost of the project and not considering the benefits. An economist would consider both the marginal costs and the marginal benefits of the project. For example, the interstate highway system in the United States has cost a lot of money, but it has also provided a lot of benefits. Consequently, the United States has introduced an interstate highway system because the benefits of the system exceed the costs. On the other hand, the Apollo project that sent men to the Moon was suspended after a handful of flights because many people perceived that the marginal costs of sending men to the Moon was exceeding the marginal benefits. The individual may also be making a proper economic evaluation. The project might create large benefits to society, but none to that person. So while most people might see benefits exceeding costs, to some there are only costs and no benefits.

13.

Economists say that individuals make decisions at the margin. What does this mean?

When economists say that individuals make decisions at the margin, they are referring to the fact that individuals consider the additional (marginal) benefits of their actions and the additional (marginal) costs of their actions. If the marginal benefits exceed the marginal costs, they proceed with the action. If the marginal costs are greater than the marginal benefits, then they do not carry out the action. For example, we decide whether or not to eat another piece of pizza by comparing the benefits and costs of that piece, not the benefits and costs of all the pieces we have already eaten.

14.

How would an economist define the efficient amount of time spent playing tennis?

Economists state that efficiency occurs when the marginal benefits (MB) of an activity equal the marginal costs (MC) of that activity. The efficient level of time spent playing tennis would exist where the MB of playing tennis equals the MC of playing tennis.

15.

Ivan stops studying before the point at which his marginal benefits of studying equal his marginal costs. Is Ivan forfeiting any net benefits? Explain your answer.

Ivan is forfeiting net benefits because net benefits are maximized when marginal benefits equal marginal costs.

16.

What does an economist mean if they say that there are no $10 bills on the sidewalk?

They mean that people try to maximize their net benefits.

17.

A change in X will lead to a change in Y. The predicted change is desirable, so we should change X. Do you agree or disagree? Explain.

Assuming that the relationship between X and Y had been accurately measured, and that the relationship did not change, then the change in X would be desirable; however, several caveats should be recognized. First, the relationship could have been misspecified. Important factors that also influence Y, perhaps more strongly than X, could have been ignored in the analysis. It might be more efficient to change these other factors rather than X. Some logical explanation of why the relationship between X and Y occurs should be developed before proceeding. Second, the relationship between X and Y can change over time. You don’t want to commit the fallacy of confusing correlation with causation. You can reduce the probability of this error by developing a logical explanation of why X will lead to a change in Y.

18.

Why do people enter into exchanges?

People enter into exchanges in order to make themselves better off.

19.

When two individuals enter into an exchange, you can be sure that one person benefits and the other person loses. Do you agree or disagree with this statement? Explain your answer.

Disagree. The two individuals would not have voluntarily entered into the exchange if they did not both expect to benefit from it.

20.

What is the difference between positive economics and normative economics? Between microeconomics and macroeconomics?

Positive economics addresses what is, while normative economics attempts to determine what should be. Microeconomics is the study of human behavior and choices as they relate to relatively small units, such as an individual or a firm, while macroeconomics is the study of human behavior and choices as they relate to an entire economy.

21.

Would there be a need for a rationing device if scarcity did not exist? Explain your answer.

A rationing device is a means for deciding who gets what; therefore, if there were enough resources and goods for everyone, there would not be a need for a rationing device.

22.

Jackie’s alarm clock buzzes. She reaches over to the small table next to her bed and turns it off. As she pulls the covers back up, Jackie thinks about her 8:30 American history class. Should she go to the class today or sleep a little longer? She worked late last night and really hasn’t had enough sleep. Besides, she’s fairly sure her professor will be discussing a subject she already knows well. Maybe it would be okay to miss class today. Is Jackie more likely to miss some classes than she is to miss other classes? What determines which classes Jackie will attend and which classes she won’t?

Jackie should sleep a little longer. Jackie is more likely to miss some classes than she is to miss other classes since the cost of missing class is higher on some days. Jackie will decide which classes to attend by comparing the benefit from attending with the cost of attending.

23.

If you found $10 bills on the sidewalk regularly, we might conclude that individuals don’t try to maximize net benefits. Do you agree or disagree with this statement? Explain your answer.

Disagree. We would conclude that the cost of picking up a $10 bill exceeds the benefit from picking up a $10 bill.

24.

The person who smokes cigarettes cannot possibly be thinking in terms of costs and benefits because it has been proven that cigarette smoking increases one’s chances of getting lung cancer. Do you agree or disagree with the part of the statement that reads ―the person who smokes cigarettes cannot possibly be thinking in terms of costs and benefits‖? Explain your answer.

Disagree. The person who smokes has decided that the benefits outweigh the costs of smoking (including the chances of getting lung cancer).

25.

Tamara decides to go out on a date with Liam instead of Terrance. Do you think Tamara is using some kind of rationing device to decide whom she dates? If so, what might that rationing device be?

Assuming that Tamara does not have time to date them both, she must decide which man gets the pleasure of her company. In this case she would use a rationing device to decide who gets the date. Depending on her preferences, this rationing device may be their intelligence, their looks, their earning potential, or their ability to make her laugh.

26.

A theory is an abstraction from reality. What does this statement mean?

This means that certain things are left out in order to focus on the main variables that will explain an activity or event.

Answers to Problems in the Working With Numbers and Graphs Section 1.

Suppose the marginal costs of reading are constant and the marginal benefits of reading decline (over time). Initially, the marginal benefits of reading are greater than the marginal costs. Draw the marginal-benefit (MB) curve and marginal-cost (MC) curve of reading, and identify the efficient amount of reading. Next, explain why the efficient point is the point at which the net benefits of reading are maximized.

Marginal costs, marginal benefits a4

MC C

MB 0

Quantity

In the graph shown above, the vertical axis measures the marginal costs and benefits of reading, while the horizontal axis measures quantity (i.e., the time spent on reading). The horizontal MC curve shows the constant marginal cost of reading. The downward sloping marginal benefit (MB) curve shows that the marginal benefit of reading declines over time. Initially, at point A, the marginal benefits of reading are greater than the marginal costs; MB > MC. So, there are net benefits from reading further. In the figure, the marginal benefits of studying equal the marginal costs at q2, which is the efficient length of time to read in this situation. If the time spent on reading is more than q2, the marginal costs of reading are greater than the marginal benefits, and therefore reading beyond q2 is not worthwhile. At q2, net benefits are maximized. In short, efficiency, which is consistent with MB = MC, is also consistent with maximizing net benefits.

Using the diagram you drew in question 1, lower the marginal costs of

reading and identify the new efficient amount of reading. Also, identify the additional net benefits derived as a result of the lower marginal cost of reading.

Marginal costs, marginal benefits a4

MC1 B

MC2

C MB

Quantity

With a lower cost of reading, the marginal cost curve shifts downward from MC1 to MC2. The new marginal cost curve intersects the marginal benefit (MB) curve at B. At point B, net benefit is maximized. The total net benefit derived at point A (at the higher cost of reading) is represented by the area of ∆Aa4a1, and the total net benefit derived at point B (at the lower cost of reading) is represented by ∆Ba4a2. So, the additional benefits derived as a result of the lower marginal cost of reading = the area given by (∆Ba4a2 – ∆Aa4a1) = area of the trapezium BAa1a2.

Jim could undertake activity X, but chooses not to. Draw how the marginalbenefit (MB) and marginal-cost (MC) curves look for activity X from Jim’s

perspective.

Marginal costs, marginal benefits

MB 0

Quantity

If Jim could undertake activity X but chose not to, this means that the marginal cost of undertaking a unit of activity X is higher than the marginal benefit. From Jim’s perspective, the marginal cost curve will always lie above the marginal benefit curve for all units of activity X.

Solution’s Manual Arnold, Economics, 14e; Chapter 2: Production Possibilities Frontier

Table of Contents Content Grid .....................................................................................................................21 Chapter 2: Production Possibilities Frontier ..........................................................................24 Answers to Chapter Questions and Problems ......................................................................................... 24 Answers to the Problems in the Working with Numbers and Graphs Section ........................................ 28

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 2: Production Possibilities Frontier Answers to Chapter Questions and Problems 1.

Describe how each of the following would affect the U.S. PPF: (a) a war that takes place on U.S. soil, (b) the discovery of a new oil field, (c) a decrease in the unemployment rate, and (d) a law that requires individuals to enter lines of work for which they are not suited. (a)

A war would remove individuals, capital, and potentially other resources from the

productive process; therefore, ceteris paribus, the PPF would shift inward. (b)

The discovery of a new oil field would represent an addition to the country’s

resources; therefore, the PPF would shift outward. (c)

A decrease in the unemployment rate would be represented by movement from

a point below the PPF to another point closer to or on the frontier, such as from point F to point D, in Exhibit 6. (d)

Such a law would decrease the productive efficiency of labor, thereby moving the

economy from a point on or inside the frontier to another point further inside the frontier.

Explain how the following can be represented in a PPF framework: (a) the finiteness of resources implicit in the scarcity condition, (b) choice, (c) opportunity cost, (d) productive efficiency, and (e) unemployed resources.

Scarcity is illustrated by the existence of the frontier: if there were unlimited resource availability, there would be no limit on output. Choice is illustrated by the variety of possible combinations along the frontier: there is not a single optimum or efficient combination of the two goods. Opportunity cost is represented by the slope of the frontier or can be viewed as how much we give up of one good to get one more unit of another good. Productive efficiency is

represented by points on the frontier. Unemployed resources are represented by points below the frontier.

What condition must hold for the PPF to be bowed outward (concave downward)? To be a straight line?

In order for a nation’s PPF to be bowed outward, resources must be somewhat specialized, so that the law of increasing opportunity costs holds. With specialized resources, additional units of a good can only be produced at increasing opportunity costs. In order for a nation’s PPF to be a straight line, there must be complete interchangeability of resources, with no specialization, so that the law of increasing opportunity costs does not apply.

Look back at Exhibit 4 and notice that the slope between points A and B is relatively flatter than it is between points C and D. What does the slope of a curve between two points have to do with the opportunity cost of producing additional units of a good?

The slope of the PPF represents the marginal opportunity cost of producing additional units of the good on the horizontal axis. A relatively flat slope between points A and B indicates that relatively little of Good X (5 units) must be given up to produce 10 more houses. A relatively steeper slope between points C and D indicates that relatively more of Good X (20 units) must be given up to produce 10 more houses. Therefore, as more houses are produced, the slope of the PPF becomes steeper and the marginal opportunity cost of producing houses increases.

Give an example to illustrate each of the following: (a) constant opportunity costs and (b) increasing opportunity costs.

Answers will vary. Constant opportunity costs occur when increasing output of a good does not cause society to give up more and more resources in order to produce that good. Although, at

some point increasing opportunity costs will occur, over some level of output constant opportunity costs could prevail. For example, if a college has a $20 million budget and each class costs $25,000 to offer, then the school can offer 800 classes during the year. If the college received a $500,000 grant, it could offer another 20 classes if its costs did not increase, perhaps because there were unemployed professors ready and willing to work at the going wage rate. Increasing opportunity costs occur when society has to give up more and more of one resource in order to obtain another resource. If the college received a second $500,000 grant, it might not be able to offer another 20 classes, if there were no unemployed professors ready and willing to work at the going wage rate. In order to hire more teachers, the college would have to hire individuals who had a higher opportunity cost.

Why are most PPFs for goods bowed outward (concave downward)?

Most production possibilities frontiers are concave downward because the law of increasing opportunity costs holds. This law says that as society devotes more resources to the production of a given good, the opportunity cost of producing that good will increase. The reason for this is that the most efficient resources will be used to initially produce that good. Only as those resources are used up will society employ less productive resources. Farmers will plant wheat in Kansas before they plant wheat in Alaska or Nevada.

Within a PPF framework, explain each of the following: (a) a disagreement between a person who favors more domestic welfare spending and one who favors more national defense spending, (b) an increase in the population, and (c) a technological change that makes resources less specialized. (a)

The first question deals with choices among possible output combinations along

a frontier representing total government spending. For illustrative purposes, substitute for ―Good X‖ with ―domestic welfare spending‖ and ―Houses‖ with ―national defense spending‖ in Exhibit 4. The person favoring more welfare spending would prefer point C, while the person favoring more defense spending would prefer point D.

(b)

An increase in population, ceteris paribus, will shift the PPF outward, as in Exhibit

7(a). (c)

A technological change that makes resources less specialized will lessen the

opportunity cost of switching production from one good to another. The production possibility frontier will become less bowed outward (straighter relative to the origin).

Explain how to derive a PPF. For instance, how is the extreme point on the vertical axis identified? How is the extreme point on the horizontal axis identified?

The extreme point on the vertical axis is identified by figuring out how much of the good on that axis can be produced using all of the economy’s available resources. The extreme point on the horizontal axis is identified by figuring out how much of the good on the horizontal axis can be produced using all of the economy’s available resources. Once the extreme point on the vertical axis (for example) has been identified, other points can be identified by asking how much of that good must be given up in order to increase production of the good on the horizontal axis by some discrete amount. The production possibilities frontier can be derived by identifying all the points that show the combinations of both goods that can be produced in the economy.

If the slope of the PPF is the same between any two points, what does this relationship imply about costs? Explain your answer.

A PPF slope that is the same between any two points implies that the opportunity cost of producing the two goods represented on the axes is constant.

10.

Suppose a nation’s PPF shifts inward as its population grows. What happens, on average, to the material standard of living of the people? Explain your answer.

The material standard of living would tend to decrease. The economy, as a whole, would have fewer goods and services to go around and would be distributing them to more people. Consequently, each person would get less and less.

11.

Can a technological advancement in sector X of the economy affect the number of people who work in sector Y of the economy? Explain your answer.

Yes. A technological advancement in sector X makes it possible to produce X with fewer people, freeing those people to produce other things (Y, for example). 12.

Use the PPF framework to explain something in your everyday life that was not mentioned in the chapter.

Answers will vary, but should illustrate some of the following: choice, opportunity costs, productive inefficiency, scarcity, productive efficiency, unemployed resources, and growth.

13.

What exactly allows individuals to consume more if they specialize and trade than if they don’t?

The fact that each person specializes in producing what he or she can produce at lower cost is what ―releases‖ resources to produce more goods, which then leads to greater consumption.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Illustrate constant opportunity costs in a table similar to the one in Exhibit 1(a). Next, draw a PPF that is based on the data in the table.

Answers will vary, but the PPF will be a straight line similar to the one in Exhibit 1(b). 2.

Illustrate increasing opportunity costs (for one good) in a table similar to the one in Exhibit 2(a). Next, draw a PPF based on the data in the table.

Answers will vary, but the PPF will be bowed outward similar to the one in Exhibit 2(b). 3.

Draw a PPF that represents the production possibilities for goods X and Y if there are constant opportunity costs. Next, represent an advance in technology that makes it possible to produce more of X, but not more of Y. Finally, represent an advance in technology that makes it possible to produce more of Y, but not more of X.

PPF when an advance in technology makes it possible to produce more of Y, but not more of X.

PPF when an advance in technology makes it possible to produce more of X, but not more of Y.

In the following figure, which graph depicts a technological breakthrough in the production of good X only?

Graph (3). The technological breakthrough allows more of good X to be produced, so the extreme point of the PPF on the horizontal axis shifts outward.

In the preceding figure, which graph depicts a change in the PPF that is a likely consequence of war?

Graph (2). A likely consequence of war is decreased production of all goods leading to an inward shift of the PPF. 6.

If PPF2 in the graph that follows is the relevant PPF, then which points are unattainable? Explain your answer.

J, I and H are unattainable. They are farther from the origin than PPF2, which represents maximum possible output. 7.

If PPF1 in the preceding figure is the relevant PPF, then which point(s) represent productive efficiency? Explain your answer.

Points A, B, and C represent efficiency because they are located on the frontier itself. By definition, a point on the frontier requires us to use all our existing resources and technology to their most efficient level. 8.

Tina can produce any of the following combinations of goods X and Y: (a) 100X and 0Y, (b) 50X and 25Y, and (c) 0X and 50Y. David can produce any of the following combinations of X and Y: (a) 50X and 0Y, (b) 25X and 40Y, and (c) 0X and 80Y. Who has a comparative advantage in the production of good X? Of good Y? Explain your answer.

Tina gives up 50X to produce 25Y (100 – 50 and 0 – 25). David gives up 25X to produce 40Y (50 – 25 and 0 – 40). Tina’s opportunity cost is 2X = 1Y (1X = 1/2Y), and David’s is 5/8X = 1Y (1X = 8/5Y). David can give up 50X and get 80Y, while Tina gets only 25Y for 50X. So, David has the lower opportunity cost for good Y and Tina for good X.

Using the data in Problem 8, prove that both Tina and David can be made better off through specialization and trade.

Suppose Tina produces 50X and 25Y and David produces 25X and 40Y. Together, they produce 75X and 65Y. Now, suppose Tina produces 100X and 0Y and David produces 0X and 80Y. Together, they produce 100X and 80Y. Tina could now consume (for example) 60X and 35Y, and David could consume 40X and 45Y, making both better off.

10.

Suppose there is a PPF with two goods, X and Y. Suppose the economy is located at a point on the PPF. Does this point represent some of both goods or only one good and not the other? The point may include some of both goods or it may contain only one good and not the other. Points that contain only one good and not the other may be found where the PPF intersects the horizontal and vertical axes. Points that contain some of both goods occur at all other points along the PPF.

11.

The economy is producing 100X and 200Y, but it could produce 200X and 300Y with the given resources and technology. Does it follow that when the economy

is producing 100X and 200Y that it is productive inefficient and that when it is producing 200X and 300Y it is productive efficient? Explain your answer. The economy is productive inefficient when it is producing 100X and 200Y because it is capable of producing a larger amount of both goods with the same resources and technology. However, we do not know whether the economy is capable of producing even more of both goods with the same resources and technology when it is producing 200X and 300Y. If it can produce more of both goods in that case, then it is productive inefficient. If it can produce more of one good only by reducing production of the other good, then it is productive efficient in that case.

12.

A person can produce the following combinations of goods A and B: 20A and 0B, 15A and 5B, 10A and 10B, 5A and 15B, and 0A and 20B. What is the opportunity cost of producing 1B? 1A? The marginal opportunity cost is constant in this case, and the PPF is a straight line. The opportunity cost of an additional unit of B is 1A. The opportunity cost of an additional unit of A is 1B.

Solution’s Manual Arnold, Economics, 14e; Chapter 3: Supply and Demand: Theory

Table of Contents Content Grid .....................................................................................................................34 Chapter 3: Supply and Demand: Theory .............................................................................37 Answers to Chapter Questions and Problems ......................................................................................... 37 Answers to the Problems in the Working with Numbers and Graphs Section ........................................ 43

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 3: Supply and Demand: Theory Answers to Chapter Questions and Problems 1. What is wrong with this statement? Demand refers to the willingness of buyers to purchase different quantities of a good at different prices during a specific period. Demand refers to the willingness and ability of buyers to purchase different quantities of a good at different prices during a specific period.

What is the difference between demand and quantity demanded?

Demand refers to the willingness and ability of buyers to purchase different quantities of a good at different prices during a specific time period, while quantity demanded refers to the number of units that individuals are willing and able to buy at some particular price during a specific time period.

True or false? As the price of oranges rises, the demand for oranges falls,

ceteris paribus. Explain your answer.

False. If the price of oranges rises, the quantity demanded of oranges falls, ceteris paribus. There is a big difference between the terms demand and quantity demanded. Quantity demanded refers to the amount of a good consumers are willing and able to buy at a particular price. Demand refers to the demand curve, depicting the various quantities demanded at all possible prices. While a number of factors may shift the demand curve, a good’s own price is not one of them. The only thing that a good’s own price can change is quantity demanded.

4. ―The price of a bushel of wheat, which was $3.00 last month, is $3.70 today. The demand curve for wheat must have shifted rightward between last month and today.‖ Discuss. Not necessarily; both supply and demand determine price. It is possible that price rose due to a rightward shift in the demand curve for wheat, but it is also possible that the price rose due to a leftward shift in the supply curve of wheat. A number of different combinations of supply and demand changes can raise price, and the suggested explanation is only one of them.

5. Some goods are bought largely because they have ―snob appeal.‖ For example, the residents of Beverly Hills gain prestige by buying expensive items. In fact, they won’t buy some items unless they are expensive. The law of demand, which holds that people buy more at lower prices than higher prices, obviously doesn’t hold for the residents of Beverly Hills. The following rules apply in Beverly Hills: high prices, buy; low prices, don’t buy. Discuss.

Maybe people in Beverly Hills do buy only expensive items, but this only means that they have a preference for expensive items—perhaps because there is some ―snob appeal‖ associated with the item. The law of demand does not rule out such a preference. The relevant question is whether Beverly Hills residents buy more or fewer high-priced items as the prices of these items rise even further, ceteris paribus. That is, even though they may all prefer $45,000 Lexuses to $25,000 Mazdas, will they continue to buy even more Lexuses if their price rises to $50,000? If the law of demand holds true, the answer should be ―No.‖

6. ―The price of T-shirts keeps rising and rising, and people keep buying more and more. T-shirts must have an upward-sloping demand curve.‖ Identify the error. People may observe higher prices and higher sales, but the higher prices do not cause the higher sales. In the following figure, price is higher at Point B than at Point A, as is quantity demanded. Does this mean the demand curve is upward sloping? The answer is ―no.‖ Point A is on one demand curve, and Point B is on another.

7. With respect to each of the following changes, identify whether the demand curve will shift rightward or leftward: (a) An increase in income (the good under consideration is a normal good); (b) A rise in the price of a substitute good (caused by a decline in supply); (c) A rise in expected future price; (d) A fall in the number of buyers. (a) Rightward; (b) Rightward; (c) Rightward; (d) Leftward

8. What does a sale on shirts have to do with the law of demand (as applied to shirts)? A sale on shirts allows us to see that the law of demand holds; that is, ceteris paribus, when the price of shirts falls, the quantity demanded of shirts rises.

9. What is wrong with this statement: As the price of a good falls, the supply of that good falls, ceteris paribus.

Supply usually increases when factors other than price change, while quantity supplied increases with an increase in price. According to the law of supply, as the price of a good falls, the quantity supplied of the good falls, ceteris paribus. An increase in the supply of a good means that suppliers are willing and able to produce and offer to sell more of the good at all prices.

10. In the previous chapter you learned about the law of increasing opportunity costs. What does this law have to do with an upward-sloping supply curve? The increased production of a good comes at increased opportunity costs. An upward-sloping supply curve reflects the fact that costs rise when more units of a good are produced.

11.

How might the price of corn affect the supply of wheat?

If the price of corn rises, farmers might switch their production from wheat to corn, therefore reducing the supply of wheat. A decrease in the price of corn might have the opposite effect.

12.

What is the difference between supply and quantity supplied?

Supply refers to the willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period, while quantity supplied refers to the number of units that sellers are willing and able to produce and offer to sell at some particular price during a specific time period.

13.

What is the difference between a movement factor and a shift factor?

A movement factor is a factor that causes a movement along a curve. For example, in the case of the demand curve, the price is the movement factor because a change in price causes a movement along the demand curve. A shift factor is a factor that can shift a curve when it changes. In the case of the demand curve, some shift factors include income, preferences, and the prices of related goods.

14. Compare the ratings for television shows with prices for goods. How are ratings like prices? How are ratings different from prices? (Hint: How does rising demand for a particular television show manifest itself?) Television ratings are similar to prices in that they reflect consumer demand for the product. That is, if consumers like a show, its ratings will most likely be high; if consumers do not like

the show, ratings will likely be low. Furthermore, only those who can afford to watch the show are counted in the ratings; thus, ratings reflect both the willingness and, to some extent, the ability to ―consume‖ television.

The most striking departure lies in the fact that ratings do not translate into a price to be paid by the television consumer. For instance, it doesn’t cost any more to watch ―The Simpsons‖ than it does to watch reruns of ―Friends‖ on Nick at Nite. The interesting twist is that those ratings do affect the price to advertisers of hawking their wares to the viewing public, but the viewer is not directly affected. (It might also be interesting here to consider cable television and pay-per-view events.)

Ratings are tied directly to the price of advertisements. Contracts with the network price ads based on the ratings of the television program. Therefore, the ratings are, in effect, the price of the ad to the advertiser.

15. At equilibrium in a market, the maximum price that buyers would be willing to pay for the good is equal to the minimum price that sellers need to receive before they are willing to sell the good. Do you agree or disagree with this statement? Explain your answer. Agree. Buyers and sellers trade money for goods as long as both benefit from trade. As long as the maximum price buyers would be willing to pay for the good exceeds the minimum price sellers need to receive before they are willing to sell the good, trade will take place.

16. Must consumers’ surplus equal producers’ surplus at equilibrium price? Explain your answer. Consumers’ surplus does not have to equal producers’ surplus at equilibrium price. Their relative sizes depend on the relative slopes of the demand and supply curves.

17. Many movie theaters charge a lower admission price for the first show on weekday afternoons than they do for a weeknight or weekend show. Explain why. If theater owners are rational, then it must be because they perceive a surplus of seats for early shows. There are two reasons: first, the physical number of available viewers is lower, because much of the viewing public is working or in school during the early show—thus, the number of buyers is lower than at ―prime‖ times; second, those potential viewers who are available at the early show are likely to have less money to spend, since a large portion of them would probably be either children or nonwage earners—thus, the income level of the average potential viewer is low. Both of these causes suggest that the quantity of seats supplied will greatly exceed the quantity of seats demanded at the full ticket price. Therefore, a rational theater owner faced with a surplus of seats does the only logical thing: he cuts the price.

18. A Dell computer is a substitute for an HP® computer. What happens to the demand for HP computers and the quantity demanded of Dell computers as the price of a Dell falls (as a result of a change in supply)? As the price of a Dell falls, the quantity demanded of Dells rises (that is, we move from one point on the demand curve for Dells to another point on the same curve), and the demand falls for HP computers (that is, the demand curve for HP shifts to the left).

19. Describe how each of the following will affect the demand for personal computers: (a) A rise in incomes (assuming that computers are a normal good); (b) A lower expected price for computers; (c) Cheaper software; (d) Computers that are simpler to operate. (a)

The demand for computers will rise.

(b)

The current demand for computers will fall.

(c) Software is a complement to computers; cheaper software would increase the demand for computers. (d) If computers become easier to operate, we would expect that peoples’ preferences would become more favorable toward computers and the demand for computers would rise.

20. Describe how each of the following will affect the supply of personal computers: (a) A rise in wage rates; (b) An increase in the number of sellers of computers; (c) A tax placed on the production of computers; (d) A subsidy for the production of computers. (a)

The supply of computers decreases when resource prices rise.

(b)

The supply of computers increases.

(c)

The supply of computers decreases.

(d)

The supply of computers increases.

21. The price of good X is higher in year 2 than in year 1 and people are buying more of good X in year 2 than year 1. Obviously, the law of demand does not hold. Do you agree or disagree? Explain your answer. Disagree. The law of demand assumes that shift factors are held constant. If a shift factor changes from year 1 to year 2, then the demand for good X might rise. This change will increase the equilibrium price and quantity exchanged. Because the higher price and quantity exchanged are the result of a change in a shift factor, the law of demand is not violated.

22. Use the law of diminishing marginal utility to explain why demand curves slope downward. As people consume more of a good, eventually they get less utility (satisfaction) from consuming another unit of the good. As they value each additional unit less, they will be willing to pay less for each additional unit. The lower willingness to pay equates to a demand curve that has higher quantities associated with lower prices.

23. Explain how the market moves to equilibrium in terms of shortages and surpluses and in terms of maximum buying prices and minimum selling prices. If a shortage exists, the market price is below the minimum selling price for many producers. Consumers will compete for the limited quantity of the good that is available, and they will bid up the price until the market price reaches equilibrium. If a surplus exists, the market price is above the maximum buying price of many consumers. Sellers will compete for the few consumers by lowering their prices until the market price reaches equilibrium.

24. Identify what happens to equilibrium price and quantity in each of the following cases: (a)

Demand rises and supply is constant – equilibrium price rises and quantity rises

(b)

Demand falls and supply is constant – equilibrium price falls and quantity falls

(c)

Supply rises and demand is constant – equilibrium price falls and quantity rises

(d)

Supply falls and demand is constant – equilibrium price rises and quantity falls

(e) Demand rises by the same amount that supply falls – equilibrium price rises and quantity is unchanged (f) Demand falls by the same amount that supply rises – equilibrium price falls and quantity is unchanged (g)

Demand falls less than supply rises – equilibrium price falls and quantity rises

(h)

Demand rises more than supply rises – equilibrium price rises and quantity rises

(i)

Demand rises less than supply rises – equilibrium price falls and quantity rises

(j)

Demand falls more than supply falls – equilibrium price falls and quantity falls

(k)

Demand falls less than supply falls – equilibrium price rises and quantity falls

25. Suppose the demand curve for a good is downward sloping and the supply curve is upward sloping. Now suppose demand rises. Will producers’ surplus rise or fall? Explain your answers.

In the above figure, the increase in demand causes the demand curve, D, to shift to the right, to DNEW. Producers’ surplus will rise from ABC to AFG.

26. When speeding tickets were $100, usually 500 speeders were on the roads each month in a given city; when ticket prices were raised to $250, usually 215 speeders were on the roads in the city each month. Can you find any economics in this observation? Yes. The law of demand holds for speeding.

27. What does it mean to say that ―the market‖ feeds Cleveland, Austin, Atlanta, or Indianapolis? People in Cleveland eat, just as people in New York, Los Angeles, or Topeka, Kansas eat. The market, through changes in prices, directs suppliers to produce the goods that people want to consume. To illustrate, when the demand for apples rises, the price rises, and apple growers end up producing more apples to satisfy the increased demand for apples.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Suppose the price is $10, the quantity supplied is 50 units, and the quantity demanded is 100 units. For every $1 rise in price, the quantity supplied rises by 5 units and the quantity demanded falls by 5 units. What is the equilibrium price and quantity?

At a price of $15, quantity supplied would be 75 units and quantity demanded would also be 75 units.

Using numbers, explain how a market demand curve is derived from two individual demand curves.

Answers will vary. For each price, individual quantities demanded are summed to find the quantity demanded for all buyers. When this is done for a series of prices, a market demand curve can be traced out.

Quantity Demanded Price

Anna

Bryan

Other Buyers

All Buyers

$100

100

112

$200

$300

Draw a diagram that shows a larger increase in demand than the decrease in supply.

See Exhibit 18 (g) in the text.

Draw a diagram that shows a smaller increase in supply than the increase in demand.

At equilibrium in the following figure, what area(s) represent consumers’ surplus? producers’ surplus?

Consumers’ surplus = A + B + C + D + E Producers’ surplus = F + G + H + I + J 6.

At what quantity in the preceding figure is the maximum buying price equal to the minimum selling price?

At the equilibrium quantity, 50 units, the maximum buying price equals the minimum selling price. 7.

In the figure that follows, can the movement from point 1 to point 2 be explained by a combination of an increase in the price of a substitute and a decrease in the price of nonlabor resources? Explain your answer.

Yes. Demand increases when the price of a substitute rises, and supply increases when resource prices fall. As long as the demand shift is greater than the supply shift, point 2 is possible. 8.

Suppose the demand curve is downward sloping, the supply curve is upward sloping, and the equilibrium quantity is 50 units. Show on a graph that the difference between the maximum buying price and minimum selling price is greater at 25 units than at 33 units.

At 25 units, the difference is equal to P2 – P1. At 50 units, the difference is 0. Since 33 units is between 25 and 50 units, the difference will be closer to 0 (smaller) than at 25 units.

Fill in the blanks in the following table.

This Happens… Demand rises and supply remains constant Supply declines more than demand rises Demand rises more than supply rises Demand rises by the same amount as supply rises Supply falls and demand remains constant Demand falls more than supply falls This Happens… Demand rises and supply remains constant Supply declines more than demand rises Demand rises more than supply rises Demand rises by the same amount as supply rises Supply falls and demand remains constant Demand falls more than supply falls

Does equilibrium price rise, fall, or remain unchanged? A

Does equilibrium quantity rise, fall, or remain unchanged? B

Does equilibrium price rise, fall, or remain unchanged? Rise

Does equilibrium quantity rise, fall, or remain unchanged? Rise

Rise

Fall

Rise

Unchanged

Rise

Fall

Solution’s Manual Arnold, Economics, 14e; Chapter 4: Prices: Free, Controlled, and Relative

Table of Contents Content Grid .....................................................................................................................49 Chapter 4: Prices: Free, Controlled, and Relative .................................................................52 Answers to Chapter Questions and Problems ......................................................................................... 52 Answers to Problems in the Working with Numbers and Graphs Section............................................... 54

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 4: Prices: Free, Controlled, and Relative Answers to Chapter Questions and Problems 1.

―If price were outlawed as the rationing device used in markets, there would be no need for another rationing device to take its place. We would have reached utopia.‖ Discuss.

This statement is false. As a result of scarcity, a rationing device is needed to determine who gets what of the available limited resources and goods and also to provide an incentive for the producer of a good to produce it.

What kind of information does price transmit?

Price provides information about the relative scarcity of the good.

Should grades in an economics class be ―rationed‖ according to dollar price instead of how well a student does on the exams? If they were and prospective employers learned of it, what effect might this have on the value of your college degree?

Grades should not be rationed according to dollar price because if they were, a college degree would no longer demonstrate student performance, but instead would demonstrate a willingness and ability to pay for a degree. Since employers want to hire workers who have a demonstrated ability to perform, the value of your degree would fall to $0.

Think of ticket scalpers at a rock concert, a baseball game, or an opera. Might they exist because the tickets to these events were originally sold for less than the equilibrium price? Why or why not? In what way is a ticket scalper like and unlike your retail grocer, who buys food from a wholesaler and then sells it to you?

Ticket scalpers exist because there is disequilibrium in the market for tickets (a shortage of tickets) due to the fact that the tickets were originally sold for less than the equilibrium price. If the tickets were originally sold at the equilibrium price, then there would be no arbitrage opportunities for ticket scalpers to exploit. A ticket scalper is like a retail grocer because both buy at one price and resell at a higher price. Many people recognize that the retail grocer is compensated for the value it adds to the transaction (one-stop shopping for many items, for instance), but don’t see any value added by the ticket scalper. Many people believe that if the ticket scalper had not bought the ticket, it would have been available for the ultimate consumer to buy. Others say that the scalper provides the service of waiting in line, but in today’s computerized selling systems, the wait time is negligible.

Many of the proponents of price ceilings argue that government-mandated maximum prices simply reduce producers’ profits and do not affect the quantity supplied of a good on the market. What must the supply curve look like if the price ceiling does not affect quantity supplied?

If the supply curve is vertical, then a price ceiling does not affect quantity supplied.

James lives in a rent-controlled apartment and has for the past few weeks been trying to get the supervisor to fix his shower. Why does waiting to get one’s shower fixed have to do with a rent-controlled apartment?

With a rent ceiling, the supervisor knows there is a shortage of apartments and that he could rent the apartment easily if James moved, and therefore he is less likely to be responsive to James’s request to fix the shower than he would be if the rental market were in equilibrium or surplus.

Explain why fewer exchanges are made when a disequilibrium price (below the equilibrium price) exists than when the equilibrium price exists.

There are fewer exchanges made when a disequilibrium price (below equilibrium price) exists than when equilibrium price exists because sellers are not willing and able to produce and offer to sell as many units.

Buyers always prefer lower prices to higher prices. Do you agree or disagree with this statement? Explain your answer.

Disagree. Buyers always prefer lower prices to higher prices, ceteris paribus. However, they may be willing to pay higher prices to avoid the effects of a price ceiling. 9.

What is the difference between a price ceiling and a price floor? What effect is the same for both a price ceiling and a price floor?

A price ceiling is effective if it is set below the equilibrium price, while a price floor is effective if it is set above the equilibrium price. Both lead to fewer exchanges than would occur at the equilibrium price.

10.

If the absolute price of good X is $10 and the absolute price of good Y is $14, then what is (a) the relative price of good X in terms of good Y and (b) the relative price of good Y in terms of good X? a) The relative price of good X in terms of good Y = $10/$14 = 0.714 units of good Y. b) The relative price of good Y in terms of good X = $14/$10 = 1.4 units of good X.

11.

Give a numerical example that illustrates how a tax placed on the purchase of

good X can change the relative price of good X in terms of good Y. Answers will vary, but should demonstrate that the tax placed on the purchase of X will raise the relative price of good X in terms of Y.

Answers to Problems in the Working with Numbers and Graphs Section 1.

In the diagram, what areas represent the deadweight loss due to the price ceiling (PC)?

The deadweight loss = areas 3 + 5.

In the preceding diagram, what areas represent consumers’ surplus at the equilibrium price of PE? At PC? (Keep in mind that, at PC, the equilibrium quantity is neither produced nor sold.)

Consumers’ surplus at PE = areas 1 + 2 + 3. Consumers’ surplus at PC = areas 1 + 2 + 4.

Using Exhibit 1 in the chapter, suppose the price ceiling is $13 instead of $8. Would the consequences of the price ceiling we identified in the text (such as a shortage, fewer exchanges, etc.) arise? Why or why not?

In Exhibit 1, the equilibrium price is $12. The price ceiling is $13. Since the price ceiling is above the equilibrium price, it has no effect.

Draw a market that is in equilibrium, and identify the area of consumers’ surplus and producers’ surplus. Now place a price ceiling in the market, and identify the rise and fall in consumers’ surplus. Finally, identify the decline in producers’ surplus.

In the above figure, the market is in equilibrium at price p1 and quantity q1. Consumer surplus is equal to the areas A + B + C. Producer surplus is equal to the areas D + E + F. There is no deadweight loss in the market. A price ceiling is imposed at price p2. The quantity supplied in the market falls to q2, and the quantity demanded is equal to q3, resulting in a shortage. Consumer surplus is now equal to the areas B + A + D. Producer surplus is equal to the area F. The change in consumer surplus will depend on the relative sizes of the areas C and D. The area D is transferred from producers to consumers. Producer surplus will fall as a result of the price ceiling. The areas C and E represent deadweight loss in the market.

The absolute prices of goods X, Y, and Z are $23, $42, and $56, respectively. What is the relative price of X in terms of Y? What is the relative price of Y in terms of Z? What is the relative price of Z in terms of X?

Relative price of good X in terms of good Y: X = (0.55)Y Relative price of good Y in terms of good Z: Y = (0.75)Z Relative price of good Z in terms of good X: Z = (2.43)X

There are two goods: X and Y. The absolute price of X rises, and the absolute price of Y does not change. Prove that the relative price of X rises in terms of Y.

Suppose the initial absolute prices of goods X and Y are $10 and $20, respectively. The relative price of good X in terms of good Y is X = (0.50)Y. Now assume that the absolute price of good X rises by $1, and the absolute price of good Y does not change. The relative price of good X in terms of good Y becomes X = (0.55)Y. Since 0.55 is greater than 0.50, the relative price of good X in terms of good Y has increased.

Solution’s Manual Arnold, Economics, 14e; Chapter 5: Supply, Demand, and Price: Applications

Table of Contents Content Grid .....................................................................................................................58 Chapter 5: Supply, Demand, and Price: Applications ............................................................61 Answers to the Chapter Questions and Problems ................................................................................... 61 Answers to the Problems in the Working with Numbers and Graphs Section ........................................ 64

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 5: Supply, Demand, and Price: Applications Answers to the Chapter Questions and Problems 1. Explain how lower lending standards and lower interest rates can lead to higher house prices. Lower lending standards and lower interest rates make home mortgages easier to get, raising the demand for housing. When the demand for housing rises, housing price increases follow.

2. If there were no third parties in medical care, medical care prices would be lower. Do you agree or disagree? Explain your answer. Agree. If there were no third parties in medical care, individuals would pay lower prices for medical care. This is because with third-party payers, the price for medical care falls essentially to $0, increasing the demand for medical care components and driving up the cost of those components.

3. Three prestigious universities all charge relatively high tuition. Still, each uses ACT and SAT scores as admission criteria. Are charging a relatively high tuition and using standardized test scores as admission criteria inconsistent? Explain your answer. Despite the relatively high tuition, there are more students who wish to attend these schools than seats available. The schools could raise the money price until the number who wish to attend equals exactly the available space. However, schools generally have more than one goal. They also wish to maximize the quality of their students. Thus, it makes sense that they would use a second, nonprice rationing technique that allows them to deal with the surplus of applicants and meet their second goal of having an intelligent student body. It may be in their interest to have a persistent surplus to ensure that their enrollment goals are always met. Then the ACT and SAT scores become a necessary rationing device to select students. Either way, using both prices and the test scores allow them to meet more than one goal at the same time.

4. What do the applications about freeway congestion and 10 a.m. classes have in common? They are all applications of markets with vertical supply curves and a shortage at the prevailing market price. Markets usually respond to shortages by raising the price until the shortage disappears. But in these cases, the price cannot increase automatically, leading to persistent shortages that must be resolved through nonprice rationing devices or non-money prices (e.g. time costs). All of these situations could be resolved with higher prices at the congested times.

5. Economics has been called the ―dismal science‖ because it sometimes ―tells us‖ that things are true when we would prefer them to be false. For example, although there are no free lunches, might we prefer that there were? Was there anything in this chapter that you learned was true that you would have preferred to be false? If so, identify it. Then explain why you would have preferred it to be false. Answers will vary.

6. In the discussion of health care and the right to sue your HMO, we state, ―Saying that a seller’s minimum price for providing a good or service rises is the same as saying that the seller’s supply curve has shifted upward and to the left.‖ Does it follow that, if a seller’s minimum price falls, the supply curve shifts downward and to the right? Explain your answer. Yes. This would just be the reverse of the chapter example. Reduced costs lower minimum price requirements that increases or shifts supply curves to the right. For instance, if we are allowing patients to sue HMOs and then take that legal right away, then HMO firms will perceive lowered costs (the reverse of the example in the text) and the curve would shift down and to the right back to where it was when suing was not allowed.

7. Application 6 explains that even though no one directly and explicitly pays for good weather (―Here is $100 for the good weather‖), you may pay for good weather indirectly, such as through housing prices. Identify three other things (besides good weather) that you believe people pay for indirectly. Answers will vary. Some choices would include: proximity to highly paid jobs, access to convenient roads, clean air, low crime rates and being walking distance to a college campus.

8. Suppose there exists a costless way to charge drivers on the freeway. Under this costless system, tolls on the freeway would be adjusted according to traffic conditions. For example, when traffic is usually heavy, as it is from 6:30 a.m. to 9:00 a.m. on a weekday, the toll to drive on the freeway would be higher than when traffic is light. In other words, freeway tolls would be used to equate the demand for freeway space with its supply. Would you be in favor of such a system to replace our current (largely zero price) system? Explain your answer. This answer involves student opinion, so the arguments will vary. However, any person who values his or her time would probably prefer the toll system, especially if the revenues from the collected tolls are used to offset other forms of taxes. Users of the freeway who value the money more than the time savings could use the freeway at times other than rush hour and thus pay the light toll rate.

9. Wilson walks into his economics class 10 minutes late because he couldn’t find a place to park. Because of his tardiness, he doesn’t hear the professor tell the class there will be a quiz at the next session. Consequently, Wilson is unprepared for

the quiz and ends up failing it. Might Wilson’s failing the quiz have anything to do with the price of parking? Explain your answer. Yes. The text discusses three ways to solve the parking problem: pay in parking fees, pay in time opportunity cost by leaving earlier to get to class, or pay by arriving late to class. Since the first is not an option, Wilson has chosen the last option of risking arriving late for class.

10. University A charges more for a class for which there is high demand than for a class for which there is low demand. University B charges the same for all classes. All other things being equal between the two universities, which university would you prefer to attend? Explain your answer.

This answer employs the logic of Application 3. The equilibrium price for high-demand classes will be higher than the equilibrium price for low-demand classes at both institutions. Suppose University B charges the equilibrium price for low-demand classes for all its classes. A shortage of high-demand classes will arise at University B. University B will require some method of allocating the limited number of seats. If seats are rationed on a first-come, first-served basis, then the student will need to decide between paying more for high-demand classes at University A and competing with other students in the registration process at University B. If the student is confident that he/she can wake up early to register before other students, then University B would be the better option. If the student would rather avoid the stress of competing with students in the registration process, then the student would prefer to pay more for high-demand classes at University A.

11. Suppose the equilibrium wage for a college athlete is $40,000, but, because of NCAA rules, the university can offer him only $22,000 (full tuition). How might the university administrators, coaches, or university alumni lure the college athlete to choose their school over others? Answers will vary. Some possibilities are that alumni might lure with cars, the administration with the reputation of the school.

12. Consider the theater in which a Broadway play is performed. If tickets for all seats are the same price (say, $200), what economic effect might arise? Assuming that there is greater demand for some show times than for others (e.g., evening shows versus matinees), and for some seats than for others (e.g., front row seats versus back row seats), then you might expect shortages for these high-demand types of tickets, along with all the behaviors associated with shortages.

13. What is the relationship between the probability of a person being admitted to the college of his choice and the tuition the college charges?

The lower the tuition, the larger the quantity demanded will be, giving the college a larger applicant pool to choose from, and reducing the probability of a person being admitted.

14. Aliyah is flying, from Albuquerque, New Mexico to Dallas, Texas, on a commercial airliner. She asks for an aisle seat, but only middle seats are left. Why aren’t any aisle seats left? (Hint: The airline charges the same price for an aisle seat as a middle seat). There aren’t any aisle seats left because the demand for aisle seats is greater than the demand for middle seats, leading to a shortage of aisle seats at the going price. See Application 7.

15. Speculation (on prices) leads to gains for the speculator and losses for others. Do you agree or disagree? Explain your answer. Yes. When speculators expect the price of good X to rise in the future, they buy the good in order to make profits from selling at the future expected price. But, the price of good X will rise when speculators buy it. Therefore, when speculators gain, the others lose from the higher prices.

16. Explain why subsidizing the purchase of good X could end up raising the price of good X. When a subsidy is given to buyers to purchase good X, it increases their willingness and ability to pay by the amount of the subsidy. The demand curve shifts rightward as a result. The rightward shift of the demand curve creates a shortage and pushes up the market price.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Diagrammatically show and explain why there is a shortage of classroom space for some college classes and a surplus for others.

In the above figure there is a fixed supply of space, S, for classrooms and a fixed price of P. The demand varies by time period. In period 1, demand is D1. At price P, this demand curve brings a quantity demanded of Q1, but the quantity supplied is fixed at Q2, creating a surplus of space. In period 2, demand is D2. At price P, this demand curve brings a quantity demanded of Q3, but the quantity supplied is fixed at Q2, creating a shortage of space.

Smith has been trying to sell his house for six months, but so far, he has had no buyers. Draw the market for Smith’s house.

There is a surplus for Smith’s house at price P1. Smith needs to lower his price to P2 in order to eliminate the surplus and sell his house.

Think of two types of books, A and B. Book A can be purchased new by someone and resold as a used book. Book B can only be purchased new by someone. (It cannot be resold as a used book.) All other things being equal between the two books, draw the demand curve for each book.

In the figure above, DA is the demand curve for book A and DB is the demand curve for book B. Since book A can be resold as a used book, the DA curve lies above DB because the demand for book A is greater than the demand for book B.

As price declines, quantity demanded rises but quantity supplied does not change. Draw the supply and demand curves that represent this state of affairs.

Price

Shortage

P1 D Quantity Q2 Q1 In the figure above, when the price falls from P2 to P1, quantity demanded increases from Q2 to Q1. With the supply remaining unchanged, there is a shortage equivalent to the distance between Q2 and Q1. 0

As price declines, quantity demanded rises and quantity supplied falls. Draw the supply and demand curves that represent this state of affairs.

Price

Shortage

P1 D 0

Quantity

In the figure above, when the price falls from P2 to P1, quantity demanded increases from Q2 to Q1. The quantity supplied falls from Q2 to Q3. Therefore, there is a shortage equivalent to the distance between Q3 and Q1.

Explain diagrammatically why a good whose consumption is subsidized is likely to sell for a higher price than a good whose consumption is not subsidized.

When the consumption of a good is subsidized, the willingness and ability of consumers to pay for the good increases by the amount of the subsidy. The demand curve shifts rightward and raises the equilibrium price to P2. Without the subsidy, the demand curve will not shift, and the equilibrium price will remain at P1.

Solution’s Manual Arnold, Economics, 14e; Chapter 6: Macroeconomic Measurements, Part 1: Prices and Unemployment

Table of Contents Content Grid .....................................................................................................................70 Chapter 6: Macroeconomic Measurements, Part 1: Prices and Unemployment ........................73 Answers to the Chapter Questions and Problems ................................................................................... 73 Answers to the Problems in the Working with Numbers and Graphs Section ........................................ 75

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 6: Macroeconomic Measurements, Part 1: Prices and Unemployment Answers to the Chapter Questions and Problems 1.

What does the CPI in the base year equal? Explain your answer.

The CPI in the base year always equals 100. This benchmark allows one to easily compare changes between the current year and the base year and to compare several different economic measurements that have the base year as their starting point. 2.

Show that, if the percentage rise in prices is equal to the percentage rise in nominal income, then one’s real income does not change.

Real income is defined as nominal income divided by the price index times 100. Suppose: Year 1: Nominal income = $25,000 and the CPI = 100. Real income can be calculated as follows: Real income = ($25,000/100) x 100 = $25,000 Year 2: Nominal income = $37,500 and the CPI = 150. Real income can be calculated as follows: Real income = ($37,500/150) x 100 = $25,000 The increase of 50 percent in nominal income is exactly offset by the 50 percent increase in prices, and real income is unchanged. 3.

When is the total dollar expenditure on the market basket in the base year the same as in the current year?

The total dollar expenditure on the market basket in the base year will equal the total dollar expenditure on the market basket in the current year when the current year is the base year. The equality could exist when the current year is different from the base year, but it would be a highly unlikely coincidence.

4. How does structural unemployment differ from frictional unemployment? The major difference between the two is that structurally unemployed individuals do not have transferable skills. Structural unemployment occurs when individuals are forced out of their jobs due to structural changes that eliminate those jobs. Frictional unemployment occurs because matching qualified workers with jobs takes time. 5.

What does it mean to say that the country is operating at full employment?

The country is operating at full employment when the current unemployment rate equals the natural unemployment rate and cyclical unemployment is zero.

What is ―natural‖ about natural unemployment?

The natural rate of unemployment is the rate of unemployment that will exist under full employment conditions. It consists of frictional unemployment (voluntary job changers) and structural unemployment (people for whom there are no jobs for which they are qualified). It is, therefore, the rate toward which a growing economy moves naturally.

What is the difference between the employment rate and the labor force participation rate?

The labor force participation rate includes both the number of employed persons and the number of unemployed persons in its numerator, while the employment rate only includes the number of employed persons.

If the unemployment rate is 4 percent, it does not follow that the employment rate is 96 percent. Explain why.

The unemployment rate is calculated by dividing the number of unemployed persons by the civilian labor force, but the employment rate is calculated by dividing the number of employed persons by the civilian noninstitutional population. Since they have different denominators, the sum of the fractions would not normally equal one.

What criteria must be met in order for a person to be characterized as being unemployed?

To be characterized as unemployed, one (a) must not have a job, but made specific active efforts to find a job during the reference period, and was available for work, or (b) is not working, but is waiting to be called back to a job from which he/she had been temporarily laid off.

10.

What is the difference between a job leaver and a reentrant?

A person who voluntarily quits a job is a job leaver. A reentrant is someone who has been previously employed, hasn’t worked for some time, and is now returning to the labor force.

11.

How is a discouraged worker different from an unemployed worker?

A person who is unemployed is actively seeking work, while a discouraged worker has given up looking for a job because he/she thinks there are no jobs available or there are none for which

he/she qualifies. The discouraged worker is not included in the unemployment rate, while the unemployed worker is.

12.

If the price of, say, oranges has risen, does it follow that the price level has risen too? Explain your answer.

No, because the price level includes the price of all goods. Prices of other goods may have fallen, offsetting the effect of the higher price for oranges.

13.

What is the relationship between your nominal income and the inflation rate if you are more than keeping up with inflation?

Your nominal income rises by a greater percentage than the inflation rate if you are more than keeping up with inflation.

14.

Explain how the CPI is computed.

The CPI is computed by dividing the total dollar expenditure on a particular market basket of goods in the current year by the total dollar expenditure on that same market basket in the base year and then multiplying the result by 100.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Suppose 60 million people are employed, 10 million are unemployed, and 30 million are not in the labor force. What does the civilian noninstitutional population equal? The civilian noninstitutional population includes persons who are not in the labor force and persons in the civilian labor force. This is given by: 60 + 10 + 30 = 100 million people.

Suppose 100 million people are in the civilian labor force and 90 million people are employed. How many people are unemployed? What is the unemployment rate? The number of unemployed persons equals 10 million (100 – 90), so that the unemployment rate is: 10 million divided by 100 million, which equals 10 percent.

Change the current-year prices in Exhibit 1 to $1 for pens, $28 for shirts, and $32 for a pair of shoes. Based on these prices, what is the CPI for the current year?

The new market basket value would be:

10 pens x $1 = $10 + 5 shirts x $28 = $140 + 3 shoes x $32 = $96, or a total of $246. The CPI for the current year = ($246 / $67) x 100 = 367.16

Regina earned an annual salary of $45,000 in 1986. What is this salary equivalent to in 2020 dollars? (Use Exhibit 2 to find the CPI in the years mentioned.)

The CPI for 1986 = 109.6 The CPI for 2020 = 195.3 Regina’s income in 2005 dollars = $45,000 x (258.811/109.6) = $106,263.64

A house cost $80,000 in 1986. What is this price equivalent to in 2019 dollars? (Use Exhibit 2 to find the CPI in the years mentioned.)

The CPI for 1986 = 109.6 The CPI for 2019 = 255.657 Price of the house in 2001 dollars = $80,000 x (255.657/109.6) = $186,610.95

Using the following data, compute (a) the unemployment rate, (b) the employment rate, and (c) the labor force participation rate. The civilian noninstitutional population = 200 million, number of employed persons = 126 million, and number of unemployed persons = 8 million.

The labor force = 126 + 8 = 134 million

a) The unemployment rate = 8/134 = 0.0597 = 5.97%

b) The employment rate = 126/200 = 0.63 = 63%

c) The labor force participation rate = 134/200 = 0.67 = 67%

Based on the following data, compute (a) the unemployment rate, (b) the structural unemployment rate, and (c) the cyclical unemployment rate. The frictional unemployment = 2 percent, natural unemployment rate = 5 percent, civilian labor force = 100 million, and number of employed persons = 82 million. a) The unemployment rate = (100 million – 82 million)/100 million = 18%.

b) The natural unemployment rate = frictional unemployment rate + structural unemployment rate. Therefore, structural unemployment rate = natural unemployment rate − frictional unemployment rate = 5% − 2% = 3%. c) Cyclical unemployment rate = the current unemployment rate – the natural unemployment rate = 18% – 5% = 13%.

The CPI in 1987 = 113.6; the CPI in 1992 = 140.3 Change in prices = [(140.3 – 113.6)/ 113.6] x 100 = 23.5%

The CPI in 1998 = 163; the CPI in 2009 = 214.537 Change in prices = [(214.537 – 163)/163] x 100 = 31.6%

The CPI in 2005 = 195.3; the CPI in 2017 = 245.120 Change in prices = [(245.120 – 195.3)/ 195.3] x 100 = 25.5%

Assume the market basket contains 10X, 20Y, and 45Z. The current-year prices for goods X, Y, and Z are $1, $4, and $6, respectively. The base-year prices are $1, $3, and $5, respectively. What is the CPI in the current year?

Total dollar expenditures in base year were 10(1) + 20(3) + 45(5) = $295. Total dollar expenditures in the current year are 10(1) + 20(4) + 45(6) = $360. Therefore,

CPI current year =

total dollar expenditure on market basket in current year ——————————————————————————— x 100 total dollar expenditure on market basket in base year

$360 —— $295

122.03

x 100

10. If the CPI is 150 and nominal income is $100,000, what does real income equal? Real income = ($100,000/150) x 100 = $66,666.67

Solution’s Manual Arnold, Economics, 14e; Chapter 7: Macroeconomic Measurements, Part 2: GDP and Real GDP

Table of Contents Content Grid .....................................................................................................................79 Chapter 7: Macroeconomic Measurements Part 2: GDP and Real GDP....................................82 Answers to the Chapter Questions and Problems ................................................................................... 82 Answers to the Problems in the Working with Numbers and Graphs Section ........................................ 85

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 7: Macroeconomic Measurements Part 2: GDP and Real GDP Answers to the Chapter Questions and Problems 1.

―I just heard on the news that GDP is higher this year than it was last year. This means that we’re better off this year than last year.‖ Comment.

First, the statement simply refers to GDP, not Real GDP. Perhaps the increase in nominal GDP was due to higher prices. Output may not have increased at all. In fact, it may have gone down. When Real GDP increases, our well-being could decline if bads are associated with the increased production of goods and services. Finally, we do not know what happened to the size of the population. If the population grew faster than GDP, our per-capita GDP will have fallen.

Which of the following are included in the calculation of this year’s GDP? (a) 12-year-old Logan mowing his family’s lawn; (b) Adil Naser buying a used car; (c) Kate Sabitini buying a bond issued by General Motors; (d) Ed Ferguson’s receipt of a Social Security payment; and (e) the illegal drug transaction at the corner of Elm and Fifth.

None are included in GDP. Review the section of the chapter on the exchanges that GDP omits.

Discuss the problems you see in comparing the GDPs of two countries, say, the United States and the People’s Republic of China.

One problem is that GDP does not account for population differences. A better measure would be per-capita GDP. A second problem is that if prices for similar goods are a lot higher in one country, then that country’s GDP would be higher even if it produced the same amount of output as the other country. A third problem is that GDP does not include many exchanges that take place. If one country has a significant non-market sector or a significant underground market sector, then GDP would significantly understate its production. In addition, the distribution of income may be significantly different in the two countries, a point that GDP does not make. If we want to make meaningful comparisons about economic well-being, we should not rely only on GDP measurements.

The manuscript for this book was keyed by the author. Had he hired someone to do the keying, GDP would have been higher than it was. What other activities would increase GDP if they were done differently? What activities would decrease GDP if they were done differently?

Examples will vary. In general, when we hire someone to do a job for us instead of doing it ourselves, GDP will rise. When we do something ourselves instead of paying someone else to do it, GDP will fall. When payment is received in nonmonetary form (tomatoes from a garden in

exchange for lettuce from another garden) or under the table instead of as a recorded cash transaction, GDP will fall.

Why does GDP omit the sales of used goods? Of financial transactions? Of government transfer payments?

All these transactions are omitted from GDP because they transfer existing resources from one individual to another rather than creating new goods or services for investment or consumption. Sales of used goods and financial transactions transfer ownership of existing goods. Transfer payments take tax receipts from one group of taxpayers and transfer the money to recipients of government programs.

A business firm produces a good this year that it doesn’t sell. As a result, the good is added to the firm's inventory. How does this inventory good find its way into GDP?

Gross private domestic investment, I, includes fixed investment and inventory investment. Goods that are produced in a given year but that are not sold that year show up as inventory investment in our measure of GDP.

What are the five components of national income?

The five components of national income are compensation of employees, proprietors’ income, corporate profits, rental income of persons, and net interest.

Is it true that net domestic product plus the capital consumption allowance is equal to GDP? Explain your answer.

Yes. Net domestic product (NDP) is equal to GDP minus the capital consumption allowance. If we add the capital consumption allowance to both sides of this equation, then we obtain NDP plus capital consumption allowance equals GDP.

What is the capital consumption allowance?

Also referred to as depreciation, the capital consumption allowance is the estimated amount of capital goods used up in production through natural wear, obsolescence, and accidental destruction.

10.

Economists prefer to compare Real GDP figures for different years instead of comparing GDP figures. Why?

If a country suffers from inflation, changes in GDP will reflect changes in the price level in addition to any changes in output, and so will overstate economic growth. Real GDP is GDP adjusted for price level changes, and so avoids this problem.

11.

What is the difference between a recovery and an expansion?

Both recovery and expansion refer to increases in GDP. Recovery refers to that portion of growth in which the economy increases production to the levels it had reached prior to the recession, and expansion refers to growth beyond the previous peak.

12.

Define each of the following terms: (a) Contraction; (b) Business cycle; (c) Trough; (d) Disposable income; (e) Net domestic product. a. Contraction refers to the decline in Real GDP that occurs after the economy has peaked. b. The business cycle is the up and down movements in Real GDP that occur over time. c. The trough is the low point in the business cycle, just before it begins to turn up. d. Disposable income is equal to personal income minus personal taxes. e. Net domestic product equals gross domestic product minus the capital consumption allowance (i.e., depreciation).

13.

Does the expenditure approach to computing GDP measure U.S. spending on all goods, or U.S. spending on only U.S. goods, or U.S. and foreign spending on only U.S. goods? Explain your answer.

GDP measures all expenditure in the country regardless of source. So it measures all spending, U.S. and foreign, on U.S. goods. We see that explicitly in the calculation with the inclusion of net exports.

14.

In the first quarter of the year, Real GDP was $400 billion; in the second quarter it was $398 billion; in the third quarter it was $399 billion; and in the fourth quarter it was $395 billion. Has there been a recession? Explain your answer.

The standard definition of recession is that recessions occur when Real GDP declines for two or more consecutive quarters. In this case, Real GDP falls for one quarter, rises in the next quarter, and then repeats the cycle. Therefore, no recession (based on the standard definition) has occurred.

Answers to the Problems in the Working with Numbers and Graphs Section 1. Net exports are –$114 billion and exports are $857 billion. What are imports? NX = EX – IM This implies: –$114 = $857 – IM Rearranging gives us: IM = $857 + $114 = $971 billion.

Consumption spending is $3.708 trillion, spending on nondurable goods is $1.215 trillion, and spending on services is $2.041 trillion. What does spending on durable goods equal? Consumption = spending on durable goods + spending on nondurable goods + spending on services. Therefore, $3.708 trillion = spending on durable goods + $1.215 trillion + $2.041 trillion, which implies: Spending on durable goods = $3.708 trillion – $1.215 trillion – $2.041 trillion = $0.452 trillion

Inventory investment is $62 billion and total investment is $1.122 trillion. What does fixed investment equal? Total investment = Fixed investment + Inventory investment. Therefore, $1.122 trillion = Fixed investment + $62 billion, which implies: Fixed investment = $1.122 trillion – $62 billion = $1.060 trillion.

In year 1, the prices of goods X, Y, and Z are $2, $4, and $6 per unit, respectively. In year 2, the prices of goods X, Y, and Z are $3, $4, and $7, respectively. In year 2, twice as many units of each good are produced as in year 1. In year 1, 20 units of X, 40 units of Y, and 60 units of Z are produced. If year 1 is the base year, what does Real GDP equal in year 2?

Real GDP is calculated using the base-year prices computed against the current-year quantities. Real GDP in year 1 = $2 × 20 + $4 × 40 + $6 × 60 = $560 Real GDP in year 2 = $2 × 40 + $4 × 80 + $6 × 120 = $1,120

Nondurable goods spending = $400 million, durable goods spending = $300 million, new residential housing spending = $200 million, and spending on services = $500 million. What does consumption equal?

New residential housing is a part of investment, not consumption. So, consumption is the sum of the other three items, or $1,200 million.

According to the circular flow diagram in Exhibit 4, consumption spending flows into U.S. product markets but import spending does not. But U.S. households buy imported goods in U.S. markets, don’t they? Explain.

GDP is concerned with the production of goods and services in the economy or the generation of income. Imports are produced in a foreign country and generate income for that country, not for the United States. Costs of selling the import within the United States are part of GDP, such as the salesperson’s salary at the Toyota dealership. But the good itself generated income in the home country of the company.

If personal taxes are $400 billion and disposable income is $4,000 billion, then what does personal income equal?

Personal income is equal to $4,400 billion since disposable income equals personal income minus personal taxes.

If national income is $5,000 billion, compensation of employees is $2,105 billion, proprietor’s income is $1,520 billion, corporate profits are $490 billion, and net interest is $128 billion, then what does rental income equal?

Rental income equals $757 billion because national income is the sum of all the other components.

Use the table to answer the following questions: Dollar Amount Item

(in $ billions)

Durable goods

200

Nondurable goods

400

Services

700

Fixed investment

120

Inventory investment

Government Purchases

500

Exports

100

Imports

150

Capital consumption allowance

Compensation of employees

700

Proprietors’ income

480

Corporate profits

200

Rental income

200

Income earned from the rest of the world

Income earned by the rest of the world

200

Indirect business taxes

Statistical discrepancy

Undistributed corporate profits

Social insurance taxes

Corporate profits taxes

Transfer payments

Personal taxes

100

Net interest

(a) What does the GDP equal? (b) What does the NDP equal? (c) What does the national income equal? (d) What does the personal income equal? (e) What does the disposable income equal? (f) If purchases of new capital goods are $90 billion, then what does purchases of new residential housing equal? (g) What do the net exports equal? a) GDP = C + I + G + EX  IM = ($200 + $400 + $700) + ($120 + $20) + $500 + $100  $150 = $1,890 billion b) NDP = GDP – depreciation = $1890 – $20 = $1,870 billion c) NI = Employee compensation + proprietors’ income + corporate profits + rental income + net interest = $700 + $480 + $200 + $200 + $20 = $1,600 billion d) PI = NI – undistributed corporate profits – social insurance taxes – corporate profits taxes + transfer payments = $1600 – $20 – $80 – $30 + $50 = $1,520 billion e) DI = PI – personal taxes = $1520 – $100 = $1,420 billion f) Purchases of new residential housing = fixed investment – purchases of new capital goods = $120 – $90 = $30 billion g) NX = EX – IM = $100 – $150 = $50 billion

10.

If Real GDP is $487 billion in year 1 and $498 billion in year 2, what is the economic growth rate?

Growth Rate = [($498 – $487) / $487] × 100 = 2.26% 11.

The figure that follows shows a business cycle. Identify each of the following as a phase of the business cycle: (a) Point A; (b) Between points A and B; (c) Point B; (d) Between points B and C; (e) Point D.

a) Point A: peak b) Between points A and B: contraction c) Point B: trough d) Between points B and C: recovery e) Point D: peak

Solution’s Manual Arnold, Economics, 14e; Chapter 8: Aggregate Demand and Aggregate Supply

Table of Contents Content Grid .....................................................................................................................90 Chapter 8: Aggregate Demand and Aggregate Supply ..........................................................93 Answers to the Chapter Questions and Problems ................................................................................... 93 Answers to the Problems in the Working with Numbers and Graphs Section ........................................ 97

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

Chapter 8: Aggregate Demand and Aggregate Supply Answers to the Chapter Questions and Problems 1.

Is aggregate demand a specific dollar amount? For example, is it correct to say that aggregate demand is $9 trillion this year?

Aggregate demand is not a specific dollar amount. It is a schedule that shows the Real GDP people are willing to buy at different price levels. Remember that along an AD curve there are many points, not just one.

Explain each of the following: (a) real balance effect, (b) interest rate effect, and (c) international trade effect.

The real balance effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in the value of monetary wealth. As the price level changes, the purchasing power of monetary wealth changes, causing the quantity demanded of Real GDP to change.

The interest rate effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in household and business spending that is sensitive to interest rate changes. As the price level changes, it takes a different quantity of money to purchase a fixed bundle of goods, and this leads to a change in savings (the supply of credit increases). Subsequently, the price of credit, which is the interest rate, changes, causing households and businesses to change their borrowing levels, and changing the quantity of Real GDP to change.

The international trade effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through foreign sector spending. As the price level in the U.S. changes, U.S. goods become relatively cheaper or more expensive than foreign goods. As a result, Americans and foreigners change the amounts of U.S. goods they buy, changing the quantity of Real GDP to change.

Graphically portray (a) a change in the quantity demanded of Real GDP and (b) a change in aggregate demand.

A change in the quantity demanded is illustrated in Exhibit 4(a) of the text, and a change in aggregate demand is illustrated in Exhibit 4(b).

There is a difference between a change in the interest rate that is brought about by a change in the price level and a change in the interest rate that is

brought about by a change in some factor other than the price level. The first will change the quantity demanded of Real GDP, and the second will change in the AD curve. Do you agree or disagree with this statement? Explain your answer. Agree. Since the price level is shown on the vertical axis of an AD curve, any effect of a change in the price level, such as the change in the interest rate that results from a change in purchasing power from a change in the price level, will be shown by sliding along the AD curve (which is referred to as a change in quantity demanded of Real GDP). If the interest rate changes for any other reason, however, the entire AD curve will shift.

The amount of Real GDP (real output) that households are willing and able to buy may change if there is a change in either (a) the price level, or (b) some nonprice factor, such as wealth, interest rates, and the like. Do you agree or disagree? Explain your answer.

Agree. Both a change in the price level and changes in nonprice factors could affect Real GDP. However, a change in the price level would change the quantity demanded of Real GDP (shown by movement along an existing AD curve), and a change in a nonprice factor would cause a change in aggregate demand (shown by shifting to a new AD curve).

Explain what happens to aggregate demand in each of the following cases: (a) The interest rate rises; (b) Wealth falls; (c) The dollar depreciates relative to foreign currencies; (d) Households expect lower prices in the future; (e) Business taxes rise.

In cases (a), (b), (d), and (e), the aggregate demand curve would shift to the left, causing both Real GDP and the price level to decrease in the short run. In (c), the aggregate demand curve would shift to the right, causing both Real GDP and the price level to increase in the short run.

Explain what is likely to happen to U.S. export and import spending as a result of the dollar depreciating in value.

A depreciation of the U.S. dollar makes foreign goods more expensive for Americans and American goods cheaper for foreigners. Therefore, U.S. exports are likely to rise (foreigners will buy more American goods since they are cheaper) and U.S. imports are likely to fall (Americans will buy fewer foreign goods since they are more expensive). 8.

Explain how expectations about future prices and incomes will affect consumption.

If individuals expect higher prices in the future, they increase current consumption expenditures to buy goods at the lower current prices, and vice versa. If individuals expect higher incomes in the future, they will increase their current consumption expenditures, and vice versa. 9.

Explain how expectations about future sales will affect investment.

Businesses invest because they expect to sell the goods they produce. If they expect to sell more goods in the future they will increase investment, and vice versa. 10.

How will an increase in the money supply affect aggregate demand?

An increase in the money supply will reduce interest rates, which will increase consumption and investment, therefore boosting aggregate demand.

11.

Can there be an increase in total spending in the economy without there first being an increase in the money supply?

Yes. Recall that total spending equals the money supply times the velocity of money. It is possible that the velocity of money increases even as the money supply remains unchanged. In this case, total spending will rise. 12.

Under what conditions can consumption rise without some other spending component declining?

Consumption can rise without some other spending component declining if the money supply rises and/or velocity rises.

13.

Can total spending be a greater dollar amount than the money supply? Explain your answer.

Total spending can be a greater dollar amount than the money supply as long as velocity is greater than 1. 14.

Will a direct increase in the price of U.S. goods relative to foreign goods lead to a change in the quantity demanded of Real GDP or to a change in aggregate demand? Will a change in the exchange rate that subsequently increases the price of U.S. goods relative to foreign goods lead to a change in the quantity demanded of Real GDP or to a change in aggregate demand? Explain your answers. An increase in the price of U.S. goods relative to foreign goods leads to a decrease in the quantity demanded of Real GDP, as typified by the foreign trade effect. Graphically, this would be shown by sliding up along a given AD curve. A change in the exchange rate that subsequently increases the price of U.S. goods relative to foreign goods would be a change in a nonprice factor and would therefore lead to a decrease in aggregate demand, shown by shifting the AD curve leftward.

15.

Explain how each of the following will affect short-run aggregate supply: (a) An increase in wage rates; (b) A beneficial supply shock; (c) An increase in the productivity of labor; (d) A decrease in the price of a nonlabor resource (e.g., oil).

The increase in wages in (a) will shift the short-run aggregate supply curve to the left because the higher wage rates will cause Real GDP to be produced at a higher price level than existed

before. The three remaining changes in (b), (c), and (d) would each shift the short-run aggregate supply curve to the right since, in these three cases, the same level of Real GDP could be produced at a lower price level.

16.

What is the difference between a change in the quantity supplied of Real GDP and a change in short-run aggregate supply?

A change in the quantity supplied of Real GDP is brought about by a change in the price level and is shown as a movement along the SRAS curve, while a change in short-run aggregate supply is brought about by a change in wage rates, the prices of nonlabor inputs, productivity, or supply shocks and is shown as a shift of the SRAS curve.

17.

A change in the price level affects which of the following? (a) The quantity demanded of Real GDP; (b) Aggregate demand; (c) Short-run aggregate supply; (d) The quantity supplied of Real GDP.

A change in the price level would affect the quantity demanded of Real GDP and the quantity supplied of Real GDP (both [a] and [d]), but it would not change either aggregate demand or short-run aggregate supply (either [b] or [c]).

18.

In the short run, what is the impact on the price level and Real GDP of each of the following? (a) An increase in consumption brought about by a decrease in interest rates; (b) A decrease in exports brought about by the dollar appreciating; (c) A rise in wage rates; (d) A beneficial supply shock; (e) An adverse supply shock; (f) A decline in productivity. a. A decrease in interest rates increases autonomous consumption, which shifts the AD curve rightward. The price level and Real GDP rise, ceteris paribus. b. An autonomous decrease in exports shifts the AD curve leftward. The price level and Real GDP fall, ceteris paribus. c. A rise in wage rates shifts the SRAS curve leftward. The price level rises and Real GDP falls, ceteris paribus. d. A beneficial supply shock shifts the SRAS curve rightward. The price level falls and Real GDP rises, ceteris paribus. e. An adverse supply shock shifts the SRAS curve leftward. The price level rises and Real GDP falls, ceteris paribus. f. A decline in productivity shifts the SRAS curve leftward. The price level rises and Real GDP falls, ceteris paribus.

19.

Identify the details of each of the following explanations for an upwardsloping SRAS curve: (a) Sticky-wage explanation; (b) Worker-misperception explanation. a. Firms pay nominal wages, but they often base their decision on how many workers to hire on real wages (nominal wages divided by the price level). When

the price index falls, real wages rise and firms cut back on labor. With fewer workers working, less output is produced.

b. Workers change the quantity of labor they are willing to supply when their real wage changes. If workers overestimate the drop in their real wage rate, they may reduce the quantity of labor they are willing to supply and firms will end up producing less.

20. What is the difference between short-run equilibrium and long-run equilibrium? Short-run equilibrium occurs at the intersection of SRAS and AD, while long-run equilibrium occurs at the intersection of LRAS and AD. There is no reason to assume that short-run equilibrium will occur at the full employment level in the economy. LRAS will be located at the Natural Real GDP level, or full employment equilibrium.

21.

An economist is sitting in the Oval Office of the White House, across the desk from the president of the United States. The president asks, ―How does the unemployment rate look for the next quarter?‖ The economist answers, ―It’s not good. I don’t think Real GDP is going to be as high as we initially thought. The problem seems to be foreign income; it’s just not growing at the rate we thought it was going to grow.‖ How can foreign income affect U.S. Real GDP?

If foreign income growth slows, foreigners may buy fewer exports from the U.S. If U.S. export spending declines, so does aggregate demand for U.S.-produced goods and services. A decline in aggregate demand, in turn, leads to lower Real GDP in the short run.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Suppose that at a price index of 154, the quantity demanded of U.S. Real GDP is $10.0 trillion worth of goods. Do these data represent aggregate demand or a point on an aggregate demand curve? Explain your answer.

These data represent a point on the aggregate demand curve. Aggregate demand is not a specific dollar amount. It is a schedule that shows the Real GDP people are willing to buy at different price levels. Remember that along an AD curve there are many points, not just one.

Diagrammatically represent the short-run effect of each of the following on the price level and on Real GDP: (a) An increase in wealth, (b) An increase in wage rates, and (c) An increase in labor productivity.

Panel (a) in the above figure shows the effect of an increase in wealth. Increases in wealth lead to increases in consumption. When consumption increases, aggregate demand rises and the AD curve shifts to the right. Panel (b) in the above figure shows the effect of an increase in wage rates. When wage rates become higher, a firm’s profits at a given price level decrease. Consequently, the firm reduces production and the SRAS shifts leftward.

Panel (c) in the above figure shows the effect of an increase in labor productivity. An increase in labor productivity means businesses will produce more output with the same amount of labor, causing the SRAS curve to shift rightward.

Diagrammatically represent each of the following and identify its short-run effect on Real GDP and the price level: (a) An increase in SRAS that is greater than the increase in AD; (b) A decrease in AD that is greater than the increase in SRAS; and (c) An increase in SRAS that is less than the increase in AD.

(a) An increase in SRAS that is greater than the increase in AD will lead to an increase in Real GDP and a fall in the price level. (b) A decrease in AD that is greater than the increase in SRAS will lead to a fall in both the Real GDP and the price level. (c) An increase in SRAS that is less than the increase in AD will lead to an increase in both the Real GDP and the price level.

In the following figure, which part is representative of each of the following: (a) A decrease in wage rates, (b) An increase in the price level, (c) A beneficial supply shock, and (d) An increase in the price of nonlabor inputs.

a. Panel (a)

100

b. Panel (b) c. Panel (a) d. Panel (c)

Fill in the blank spaces (A–Z) in the table that follows.

Factor and change

Shifts AD or SRAS curve? A

Curve shifts right or left? B

Business taxes fall

Dollar depreciates

Wage rate falls

Adverse supply shock

Government purchases rise

Interest rate rises

Foreign real national income falls

Income taxes decline

Velocity rises

Money supply falls

Productivity declines

Prices of nonlabor inputs rise

Shifts AD or SRAS curve? AD

Curve shifts right or left? Right

Business taxes fall

Right

Dollar depreciates

Right

Wage rate falls

SRAS

Right

Adverse supply shock

SRAS

Left

Government purchases rise

Right

Interest rate rises

Left

Foreign real national income falls

Left

Income taxes decline

Right

Wealth rises

Factor and change Wealth rises

101

Velocity rises

Right

Money supply falls

Left

Productivity declines

SRAS

Left

Prices of nonlabor inputs rise

SRAS

Left

Fill in the blank spaces (A–BB) in the table that follows. Shifts the AD or SRAS curve?

Curve shifts right or left? B

Change in price level: up or down? C

Change in Real GDP: up or down? D

Velocity falls

Expected future income rises

Wage rates rise

Business taxes fall

Beneficial supply shock

Prices of nonlabor inputs decline

Money supply rises

Factor and change

Shifts the AD or SRAS curve?

Curve shifts right or left?

Velocity falls

Left

Change in price level: up or down? Down

Change in Real GDP: up or down? Down

Expected future income rises

Right

Wage rates rise

SRAS

Left

Down

Business taxes fall

Right

Beneficial supply shock

SRAS

Right

Down

Prices of nonlabor inputs decline

SRAS

Right

Down

Money supply rises

Right

Factor and change

102

103

Solution’s Manual Arnold, Economics, 14e; Chapter 9: Classical Macroeconomics and the Self-Regulating Economy

Table of Contents Content Grid ................................................................................................................... 105 Chapter 9: Classical Macroeconomics and the Self-Regulating Economy ............................... 108 Answers to the Chapter Questions and Problems ................................................................................. 108 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 113

104

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

105

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

106

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

107

Chapter 9: Classical Macroeconomics and the Self-Regulating Economy Answers to the Chapter Questions and Problems 1.

What is the classical economics position on (a) wages, (b) prices, and (c) interest rates?

All three are considered by classical economics to be flexible upward and downward and are determined by the interaction of supply and demand in their respective markets, leading to a position of equilibrium. 2.

According to classical economists, does Say’s Law hold in a money economy? Explain your answer.

The classical position is that Say’s law holds in a money economy, since interest rate flexibility ensures that money saved will reappear in the spending stream as investment.

How do you explain why investment falls as the interest rate rises?

The interest rate is the cost of borrowing funds. The higher is the cost of borrowing funds, the lower will be the funds that firms borrow and invest.

Explain why saving rises as the interest rate rises.

The higher is the interest rate, the higher is the reward for saving (or the higher is the opportunity cost of consumption), and therefore, fewer funds are allocated to consumption and more funds are saved.

According to classical economists, does an increase in saving shift the AD curve to the left? Explain your answer.

No, because the increase in savings (and the resulting decrease in consumption) will be exactly offset by an increase in investment created when the additional savings forces interest rates down.

What does it mean to say that the economy is in a recessionary gap? In an inflationary gap? In long-run equilibrium?

In a recessionary gap, Real GDP < Natural Real GDP. In an inflationary gap, Real GDP > Natural Real GDP. When Real GDP = Natural Real GDP, the economy is said to be in long-run equilibrium.

108

What is the state of the labor market in (a) a recessionary gap, (b) an inflationary gap, (c) long-run equilibrium? a. A surplus exists in the labor market. b. A shortage exists in the labor market. c. The labor market is in equilibrium.

Describe the relationship of the (actual) unemployment rate to the natural unemployment rate in each of the following economic states: (a) a recessionary gap, (b) an inflationary gap, and (c) long-run equilibrium.

In a recessionary gap, the actual unemployment rate is greater than the natural unemployment rate; in an inflationary gap, the actual unemployment rate is less than the natural unemployment rate; and in long-run equilibrium, the actual unemployment rate equals the natural unemployment rate.

Diagrammatically represent an economy in (a) an inflationary gap, (b) a recessionary gap, and (c) long-run equilibrium.

These three situations are illustrated in the text in Exhibit 3.

10.

Explain how the economy can operate beyond its institutional PPF but not beyond its physical PPF.

The institutional PPF includes institutionally or government-imposed restrictions on economic activity, such as the minimum wage. Since the minimum wage reduces economic efficiency, it could prevent the economy from operating on its physical PPF. However, inflation could reduce the real minimum wage, allowing the economy to move closer to its physical PPF. Since the physical PPF is determined by the nation’s resource endowment and technology, the economy could not operate beyond the physical PPF.

11.

According to economists who believe in a self-regulating economy, what happens—step by step—when the economy is in a recessionary gap? What happens when the economy is in an inflationary gap?

According to economists who believe in a self-regulating economy, if the economy is in a recessionary gap, it will move back to its long-run equilibrium without any intervention by the government. In a recessionary gap, excess unemployment exists. This causes wages to fall, and the SRAS curve to shift to the right. The economy moves along the AD curve until it returns to its long-run equilibrium. In an inflationary gap, unemployment is below its natural rate, creating wage inflation. This shifts the SRAS curve to the left. The economy moves along the AD curve until it returns to its long-run equilibrium.

109

12.

If wage rates are not flexible, can the economy be self-regulating? Explain your answer.

Flexible wages are an essential assumption of the self-regulating economy. Without flexible wages, the SRAS curve would not shift in response to an inflationary gap or a recessionary gap. Without this flexibility, the economy could not move back to its long-run equilibrium, and the economy would not be self-regulating.

13.

Explain the importance of the real balance, interest rate, and international trade effects to long-run (equilibrium) adjustment in the economy.

The real balance, interest rate, and international trade effects explain the downward slope of the AD curve. Each reflects how aggregate demand responds to a change in prices. For example, an increase in prices reduces the purchasing power of consumers’ bank accounts and other cash-related assets. Consequently, an increase in prices would reduce aggregate demand. When the SRAS curve shifts, the price level will adjust upward or downward, and to keep the economy in equilibrium, the real balance, interest rate, and international trade effects allow the economy to move along the AD curve to the new equilibrium.

14.

Suppose that the economy is self-regulating, that the price level is 132, that the quantity demanded of Real GDP is $4 trillion, that the quantity supplied of Real GDP in the short run is $3.9 trillion, and that the quantity supplied of Real GDP in the long run is $4.3 trillion. Is the economy in short-run equilibrium? Will the price level in long-run equilibrium be greater than, less than, or equal to 132? Explain your answers.

An economy is in short-run equilibrium when aggregate demand equals short-run aggregate supply. In the above figure, aggregate demand ($4 trillion) is greater than short-run aggregate supply ($3.9 trillion). The economy is not in short-run equilibrium. At the short run equilibrium © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

110

(point A), a recessionary gap exists. As labor surpluses at point A drive wage rates down, the SRAS curve will shift rightward to SRAS’. In long-run equilibrium (at Point B), the price level would be less than 132.

15.

Suppose that the economy is self-regulating, that the price level is 110, that the quantity demanded of Real GDP is $4 trillion, that the quantity supplied of Real GDP in the short run is $4.9 trillion, and that the quantity supplied of Real GDP in the long run is $4.1 trillion. Is the economy in short-run equilibrium? Will the price level in long-run equilibrium be greater than, less than, or equal to 110? Explain your answers.

111

As shown in the above figure, in the short run, aggregate demand ($4 trillion) is less than short-run aggregate supply ($4.9 trillion), so the economy is not in short-run equilibrium. At the short-run equilibrium (point A), an inflationary gap exists. As labor shortages at point A drive wage rates up, the SRAS curve will shift rightward to SRAS’. In long-run equilibrium, the price level would be less than 100.

16.

Ava is telling her friend Harper that wages are rising and so is the unemployment rate. She tells Harper that she (Ava) may be the next person to be fired at her company and that she may have to move back in with her parents. What does the economy have to do with Ava possibly having to move back in with her parents?

When wages are rising and the unemployment rate is rising, too, the economy is self-regulating and removing itself from an inflationary gap. Some people will become unemployed as the economy stabilizes itself at the natural unemployment rate. If Yvonne is one of these people, she may have to move back in with her parents for a while.

17.

Leo says, ―I think it’s a little like when you have a cold or the flu. You don’t need to see a doctor. In time, your body heals itself. That’s sort of the way the economy works too. We don’t really need government coming to our rescue every time the economy gets a cold.‖ According to Leo, how does the economy work?

Leo believes the economy is self-regulating and will heal itself. The economy will move itself out of either an inflationary gap or a recessionary gap and will settle down (eventually) in long-run equilibrium at the natural unemployment rate and Natural Real GDP.

18.

Beginning with long-run equilibrium, explain what happens to the price level and Real GDP in the short run and in the long run as a result of (a) a decline in AD, (b) a rise in AD, (c) a decline in SRAS, (d) a rise in SRAS. a. The price level and Real GDP will fall in the short run; the price level will fall further in the long run while Real GDP will rise to its initial level in the long run. b. The price level and Real GDP will rise in the short run; the price level will rise further in the long run while Real GDP will fall to its initial level in the long run. c. The price level will rise and Real GDP will fall in the short run; the price level will be higher in the long run, but Real GDP will return to its initial level. d. The price level will fall and Real GDP will rise in the short run; the price level will be lower in the long run, but Real GDP will return to its initial level.

112

Answers to the Problems in the Working with Numbers and Graphs Section 1.

In the following figure, which point is representative of: (a) the economy on its LRAS curve, (b) the economy in a recessionary gap, and (c) the economy in an inflationary gap?

a. Point B b. Point D c. Point C

Which of the following figures, (a)–(c), is consistent with or representative of: (a) the economy operating at the natural unemployment rate, (b) a surplus in the labor market, (c) a recessionary gap, and (d) a cyclical unemployment rate of zero.

113

a. b. c. d.

Part (c) Part (a) Part (a) Part (c)

Represent the following situations diagrammatically: (a) An economy in which AD increases as the economy is self-regulating out of a recessionary gap, (b) An economy in which AD decreases as the economy is self-regulating out of an inflationary gap.

Economist Jones believes that there is always sufficient (aggregate) demand in the economy to buy all the goods and services supplied at full employment. Diagrammatically represent what the economy looks like for Jones.

114

The economy would always be at Natural Real GDP, where LRAS equals SRAS.

Diagrammatically show what happens when the institutional constraints in the economy become less effective.

In the figure, the institutional PPF shifts outward toward the physical PPF, in this case from PPF1 to PPF2.

Diagrammatically represent an economy in a recessionary gap. Next, identify where the economy in a recessionary gap lies in terms of both the institutional PPF and the physical PPF.

115

Physical PPF

LRAS

Price Level

All Other Goods

SRAS Institutional PPF

AD1 0

Real GDP

Recessionary Gap

Good X

(a) (b) In figure (a), the economy is producing a level of Real GDP in the short run that is less than its Natural Real GDP level. When the Real GDP that the economy is producing is less than its Natural Real GDP, the economy is said to be in a recessionary gap. In figure (b), point A, below the institutional PPF, represents an economy in a recessionary gap, where the economy is producing less than Natural Real GDP, QN.

Fill in the blank spaces (A–O) in the table that follows. In the table, Q = Real GDP and QN = Natural Real GDP.

State of the economy

Is the economy in a recessionary gap, inflationary gap, or long-run equilibrium?

Q < QN Q > QN Q = QN

A F K

State of the economy

Q < QN Q > QN Q = QN

Does equilibrium, a shortage, or a surplus exist in the labor market?

Will wages fall, rise, or remain unchanged?

Will the SRAS curve shift right, left, or remain unchanged?

Is the economy above, below, or on its institutional PPF?

Is the economy in a recessionary gap, inflationary gap, or long-run equilibrium?

Does equilibrium, a shortage, or a surplus exist in the labor market?

Will wages fall, rise, or remain unchanged?

Will the SRAS curve shift right, left, or remain unchanged?

Is the economy above, below, or on its institutional PPF?

Recessionary gap

Surplus

Fall

Right

Below

Inflationary gap

Shortage

Rise

Left

Above

Long-run equilibrium

Equilibrium

Unchanged

116

Solution’s Manual Arnold, Economics, 14e; Chapter 10: Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Table of Contents Content Grid ................................................................................................................... 118 Chapter 10: Keynesian Macroeconomics and Economic Instability: A Critique of the SelfRegulating Economy........................................................................................................ 121 Answers to the Chapter Questions and Problems ................................................................................. 121 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 125

117

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

118

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

119

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

120

Chapter 10: Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy Answers to the Chapter Questions and Problems 1.

How is Keynes’s position different from the classical position with respect to wages, prices, and Say’s law?

According to Keynes, wages and prices might not be as flexible as classical economists had assumed, so Say’s law might not hold. It could take years for the economy to adjust to a new equilibrium, leaving the economy in a recessionary gap for years before the self-regulating economy moved back to its long-run equilibrium.

Classical economists assumed that wage rates, prices, and interest rates are flexible and will adjust quickly. Consider an extreme case: Suppose classical economists believed that wage rates, prices, and interest rates would adjust instantaneously. What would the classical aggregate supply (AS) curve look like? Explain your answer.

Under this assumption, the classical aggregate supply curve would be a vertical line. Instantaneous adjustment would mean that there would never be any deviations from the natural unemployment rate or the Natural Real GDP level. Supply and demand in individual markets would quickly respond to any shifts in supply and demand, eliminating recessionary gaps and inflationary gaps very quickly. 3.

Give two reasons explaining why wage rates may not fall.

Keynes believed that employees and labor unions may resist wage cuts. New Keynesians believe that long-term contracts and efficiency reasons for firms paying higher-than-market wages might explain wage rate inflexibility. 4.

How was Keynes’s position different from the classical position with respect to saving and investment?

Keynes believed that an increase in savings might not be matched by an equal increase in investment, since both saving and investment depend on a number of factors that may be far more influential than the interest rate. The classical position was that interest rate changes would equate saving with investment.

121

According to some economists, why might business firms pay wage rates above market-clearing levels?

The efficiency wage theory says that firms may perceive benefits from paying higher-thanmarket wages, such as fewer labor negotiations and a decreased likelihood of worker strikes. 6.

Given the Keynesian consumption function, how would a cut in income tax rates affect consumption? Explain your answer.

A cut in income tax rates would increase disposable income (Yd), and with it, consumption (C), in proportion to the MPC.

Look at the Keynesian consumption function: C = C0 + (MPC × Yd). What part of it relates to autonomous consumption? What part of it relates to induced consumption? Define autonomous consumption and induced consumption.

C0 relates to autonomous consumption. (MPC)(Yd) relates to induced consumption. Induced consumption is the part of consumption that is dependent on disposable income, while autonomous consumption is the part of consumption that is independent of disposable income.

Using the Keynesian consumption function, prove numerically that, as the MPC rises, saving declines.

Since households can only consume or save, it follows that saving is the difference between disposable income and consumption: S = Yd – [C0 + (MPC)(Yd)] So choosing any two values for Yd and C0, such as $10,000 and $1,000, when the MPC rises, say from 0.7 to 0.8, savings falls (in this case from $2,000 to $1,000).

Explain the multiplier process.

The process under which an increase in an individual’s autonomous spending generates additional income for another individual, which, in turn, increases the second individual’s autonomous spending, and so on, is the multiplier process. By this process, a change in autonomous spending generates a change in Real GDP greater than itself.

10.

What is the relationship between the MPC and the multiplier?

The multiplier is equal to 1/(1 – MPC), which indicates that an increase in the MPC will increase the strength of the multiplier.

122

11.

Explain how a rise in autonomous spending can increase total spending by some multiple.

An increase in autonomous consumption (C0) will increase consumption (C) and therefore shift the AD curve to the right by an amount that depends on the multiplier.

12.

In which factors will a change lead to a change in consumption?

Consumption will increase in response to an increase in autonomous consumption (C0), disposable income (Yd), or the marginal propensity to consume (MPC).

13.

According to Keynes, can an increase in saving shift the AD curve to the left? Explain your answer.

According to Keynes, an increase in saving would result in lower consumption, which would shift the AD curve to the left. Although the additional saving would lower interest rates, Keynes believed that this would not automatically generate an increase in investment sufficient to offset the reduction in consumption.

14.

What factors will shift the AD curve in the simple Keynesian model?

Consumption, investment, and government purchases are the factors that will shift the AD curve in the simple Keynesian model.

15.

According to Keynes, an increase in saving and a decrease in consumption may lower total spending in the economy. But how could that happen if the increased saving lowers interest rates (as shown in the last chapter)? Wouldn’t a decrease in interest rates increase investment spending, thus counteracting the decrease in consumption spending?

In the Keynesian view, other variables, such as the expected rate of profit on investment, are more important than the interest rate in determining the level of investment. Business expectations can lower the investment demand at the same time that lower interest rates are increasing the quantity demanded, offsetting each other and keeping investment low.

16.

Can a person believe that wages are inflexible downward for, say, one year and also believe in a self-regulating economy? Explain your answer.

Yes, since the concept of self-regulation does not require instantaneous adjustment. To some, a one-year lag in the adjustment process would be short enough to permit them to believe in self-regulation and laissez-faire policy.

123

17.

According to Keynes, can the private sector always remove the economy from a recessionary gap? Explain your answer.

According to Keynes, the economy can get stuck in a recessionary gap, if neither consumption nor investment rise enough to shift the aggregate demand curve to a long-run equilibrium at Natural Real GDP.

18. What does the aggregate supply curve look like in the simple Keynesian model? The AS curve in the simple Keynesian model is horizontal until Natural Real GDP and vertical at Natural Real GDP.

19.

―In the simple Keynesian model, increases in AD that occur below Natural Real GDP will have no effect on the price level.‖ Do you agree or disagree with this statement? Explain your answer.

Agree. This is the case because the Keynesian model assumes the price level is constant until the economy reaches its full-employment or Natural Real GDP level.

20.

Suppose consumption rises while investment and government purchases remain constant. How will the AD curve shift in the simple Keynesian model? Under what condition will the rise in Real GDP be equal to the rise in total spending?

An initial increase in autonomous consumption leads to a much larger rightward shift of the AD curve, once the multiplier effect is factored in. If the economy is operating with idle resources, then the rise in Real GDP will equal the rise in total spending.

21.

Explain how to derive a total expenditures (TE) curve.

This is illustrated in Exhibit 12. The total expenditures curve is the vertical summation of the consumption, investment, and government purchases curves.

22.

What role do inventories play in the equilibrating process in the simple Keynesian model (as described in the TE-TP framework)?

Unexpected changes in inventories lead firms to change their production levels until TP equals TE.

23.

Identify the three states of the economy in terms of TE and TP.

The three states of the economy in terms of TE and TP include the case where TE < TP and unexpected business inventory accumulation signals firms to decrease production, the case

124

where TE > TP and unexpected business inventory depletion signals firms to increase production, and the case where TE = TP, where the economy is in equilibrium.

24. If Real GDP is $10.4 trillion in Exhibit 13, what is the state of business inventories? If Real GDP is $10.4 trillion in Exhibit 12, then TE>TP and businesses draw out of their inventories to meet the excess demand.

25.

How will a rise in government purchases change the TE curve in Exhibit 12?

A rise in government purchases will shift the TE curve upward.

Answers to the Problems in the Working with Numbers and Graphs Section Questions 1 and 2 are based on the second section of the chapter, questions 3 and 4 are based on the third section, and questions 5-8 are based on the fourth section.

Compute the multiplier in each of the following cases: (a) MPC = 0.60; (b) MPC = 0.80; (c) MPC = 0.50. a. MPC = 1/(1 – 0.60) = 2.5 b. MPC = 1/(1 – 0.80) = 5 c. MPC = 1/(1 – 0.50) = 2

Write an investment function (equation) that specifies two components: (a) Autonomous investment spending; (b) Induced investment spending.

The investment function can be written as I = I0 + i × (Yd), where I0 is the level of autonomous investment, i is the slope of the investment function, and Yd is disposable income.

Economist A believes that changes in aggregate demand affect only the price level, and economist B believes that changes in aggregate demand affect only Real GDP. What do the AD and AS curves look like for each economist?

For Economist A: AD is downward sloping; AS is vertical. For Economist B: AD is downward sloping; AS is horizontal.

Use the accompanying figure to explain the following two statements:

125

(a)

According to Keynes, aggregate demand may be insufficient to bring about the full-employment output level (or Natural Real GDP).

(b)

A decrease in consumption (due to increased saving) is not matched by an increase in investment spending.

The economy is at equilibrium at point 2 in the figure. This point, however, is below the level of Natural Real GDP. To reach Natural Real GDP, aggregate demand would have to shift to the right (increase) to AD1 from AD2. Suppose the economy was in equilibrium at point 1 where short-run AS equals AD1. When consumption falls, investment does not rise to compensate, so the AD curve will shift left to AD2, resulting in lower equilibrium GDP.

The TE curve in Exhibit 11(d) is upward-sloping because the consumption function is upward-sloping. Explain.

Consumption, investment, and government are summed to create the TE curve. We add together the levels of the three variables at each level of Real GDP and create the TE curve. If consumption (or any of the other factors as well) has an upward slope to its individual expenditure pattern, then that upward slope will be mirrored in the TE curve.

In Exhibit 11(d), what does the vertical distance between the origin and the point at which the TE curve cuts the vertical axis represent?

The vertical distance between the origin and the point where the TE curve cuts the vertical axis represents the sum of autonomous consumption, investment and government purchases.

126

In the accompanying figure, explain what happens if: (a) The economy is at Q 1; (b) The economy is at Q2.

In the above figure, at Q1, total expenditure exceeds total production in the economy. There is an unexpected decline in inventories, and businesses will expand production, moving the economy up to Q3. At Q2, total expenditure is less than total production in the economy. There is an unexpected rise in inventories, and businesses will cut production, moving the economy

In the accompanying figure, if Natural Real GDP is Q2, in what state is the economy at point A?

127

In the above figure, if Natural Real GDP is Q2, then the economy is in a recessionary gap at point A, where TE = TP. Total expenditures are not high enough to maintain an equilibrium at point B. The equilibrium level of output in this economy is Q3, which is less than Natural Real GDP.

Solution’s Manual Arnold, Economics, 14e; Chapter 11: Fiscal Policy and the Federal Budget

Table of Contents Content Grid ................................................................................................................... 129 Chapter 11: Fiscal Policy and the Federal Budget ............................................................... 132 Answers to the Chapter Questions and Problems ................................................................................. 132 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 136

128

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

129

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

130

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

131

Chapter 11: Fiscal Policy and the Federal Budget Answers to the Chapter Questions and Problems 1.

What is the difference between government expenditures and government purchases?

Government expenditures is the sum of government purchases and (government) transfer payments. Government purchases do not include transfer payments.

How much were government expenditures in 2019? How much were government tax revenues in 2019?

Government expenditures equaled $4.446 trillion in 2019. Government tax revenues equaled $3.462 trillion in 2019.

The bulk of federal government expenditures go for four programs. What are they?

Social security, Medicare, Medicaid, and national defense account for the bulk of government expenditures.

What percentage of total income did the top 10 percent of income earners earn in 2017? What percentage of federal income taxes did this group pay in 2017?

In 2017, the top 10 percent of income earners earned 47.74 percent of the total income earned and paid 70.08 percent of the total federal income taxes collected.

Is it true that, under a proportional income tax structure, a person who earns a high income will pay more in taxes than a person who earns a low income? Explain your answer.

Yes, it is true. Under a proportional income tax structure, the absolute level of taxes someone pays increases, but taxes as a proportion of income remain the same. For example, if the income tax rate were 20 percent, someone earning $20,000 would pay $4,000 in taxes, and someone earning $50,000 would pay $10,000 in taxes. The person earning $50,000 pays more in taxes, but as a proportion of income, she pays the same amount as the person earning $20,000.

132

A progressive income tax always raises more revenue than a proportional income tax does. Do you agree or disagree? Explain your answer.

Disagree. A progressive income tax can become burdensome on work effort and result in smaller tax collections than a proportional tax. For example, a 100 percent tax on all income above $100,000 would be highly progressive and drive down work effort as well.

Yuri favors progressive taxation and equal after-tax pay for equal work. Comment.

Progressive taxation is sometimes inconsistent with equal after-tax pay for equal work. To illustrate, suppose each of two persons is paid $1,000 for doing the same job. If the two individuals do not pay the same marginal tax rate, then one individual is left with less after-tax pay for doing the same job the other person does. Simply put, sometimes you have to choose between progressive taxation and equal after-tax pay for equal work.

What is the difference between a structural deficit and a cyclical deficit?

A cyclical deficit will disappear when the economy returns to full-employment, while a structural deficit will not.

What is the difference between discretionary fiscal policy and automatic fiscal policy?

When changes in government expenditures and taxes are brought about deliberately through government actions, fiscal policy is said to be discretionary. In contrast, a change in either government expenditures or taxes that occurs automatically in response to economic events is referred to as automatic fiscal policy.

10.

According to Buchanan and Wagner, why is there a political bias towards expansionary fiscal policy and not contractionary fiscal policy?

Expansionary fiscal policy is likely to be more popular among the citizens than a contractionary policy. If the political environment is such that the people do not want the government to reduce spending benefits or raise taxes, then the government is less likely to introduce these measures. Economic policies often have political dimensions and politics often trumps economics.

11.

Explain two ways crowding out may occur.

Crowding out may occur because individuals substitute government goods for private goods or because financing the deficit pushes interest rates upward causing investment to fall.

133

12.

Why is crowding out an important issue in the debate over the use of fiscal policy?

Those who advocate the use of fiscal policy believe it is capable of affecting the aggregate demand curve and therefore Real GDP. Crowding out calls the effectiveness of fiscal policy into question. For example, if an increase in government purchases causes private expenditures to fall by the same amount, then there is complete crowding out and the aggregate demand curve does not shift. Thus, there is no change in Real GDP.

13.

Some economists argue for the use of fiscal policy to solve economic problems; others argue against it. What are some of the arguments on both sides?

This answer is given with respect to demand-side fiscal policy only. Those in favor of the use of fiscal policy often argue that the economy is not always self-regulating and that sometimes it needs a push to move it in the right direction. Fiscal policy is that push. Those against the use of fiscal policy often argue that the economy is self-regulating, that the existence of lags can turn a potentially effective fiscal policy measure into the ―wrong medicine at the wrong time,‖ and that the existence of crowding out places a question mark over the effectiveness of fiscal policy. 14.

Give a numerical example to illustrate the difference between complete crowding out and incomplete crowding out.

Answers will vary. An example of complete crowding out would be if the government spends $1 million on food stamps and spending by food stamp recipients falls by $1 million. An example of incomplete crowding out would be if the government spends $1 million on food stamps and spending by food stamp recipients falls by $0.8 million.

15.

The debate over using government spending and taxing powers to stabilize the economy involves more than technical economic issues. Do you agree or disagree? Explain your answer.

Agree. Two technical issues that divide economists have to do with crowding out (Is there crowding out or not?) and the existence and importance of lags (Are there lags? To what degree do they diminish the effectiveness of fiscal policy? Are there ways to get around them?). Besides disagreeing on technical points, economists may disagree as to the ethical decision to run budget deficits, the long-run political consequences of permitting government to run continuous annual deficits, and much more. Simply put, economic debates are not always strictly limited to technical economic issues.

16.

Is crowding out equally likely under all economic conditions? Explain your answer.

No. The closer the economy is to its production possibilities frontier (i.e., full employment) and/or the steeper the SRAS curve, the greater the likelihood of significant crowding out. The

134

condition of the financial market is also important. The tighter the supply of money and/or loanable funds, the greater the likelihood of reduced private borrowing in the case of a budget deficit.

17.

Tax cuts will likely affect aggregate demand and aggregate supply. Does it matter which is affected more? Explain in terms of the AD-AS framework.

Yes. If AD and SRAS both increase, real output will increase. However, the effect on the price level depends upon the relative magnitudes of the changes in AD and SRAS. If AD increases by more than SRAS, then the price level will rise. If SRAS increases by more than AD, then the price level will fall. If AD and SRAS increase proportionally, then the price level should remain constant. 18.

Explain how, under certain conditions, expansionary fiscal policy can destabilize the economy.

The government has to know a great deal to implement fiscal policy properly, including the true state of the economy, and the values of Natural Real GDP and the MPC. If the government, for example, were to misread the state of the economy as declining when in fact it were not, the implementation of expansionary fiscal policy could turn equilibrium into an inflationary gap. 19.

Identify and explain the five lags associated with fiscal policy.

The five types of lags include the data lag (policymakers are not aware of changes in the economy as soon as they happen); the wait-and-see lag (policymakers rarely enact counteractive measures immediately); the legislative lag (it can take months for policymakers to propose a fiscal policy measure, build support for it, and get it passed); the transmission lag (fiscal policy measures take time to be put into effect); and the effectiveness lag (after a policy measure is implemented, it takes time to affect the economy).

20.

Suppose the economy is in a recessionary gap, and both Smith and Jones advocate expansionary fiscal policy. Does it follow that both Smith and Jones favor so-called big government?

Not necessarily. Expansionary fiscal policy only results in permanently larger government if the expenditure increases undertaken to shift the aggregate demand curve are left in place after the need for the policy has passed. Also, Smith may prefer more government spending (bigger government) while Jones prefers tax cuts (smaller government) when it comes to expansionary fiscal policy.

21.

Will tax cuts that the public perceives to be temporary affect the SRAS and LRAS curves differently than tax cuts that are perceived to be permanent? Explain your answer.

135

A temporary tax cut will not alter people’s work behavior because it is temporary and may not impact SRAS and should not impact LRAS at all. A permanent decrease in taxes should result in a permanent change in the behavior of people toward greater work effort, resulting in permanent rightward shifts of both the SRAS curve and the LRAS curve.

22.

What is the difference between a marginal tax rate and an average tax rate?

A marginal tax rate is the rate paid on additional income while an average tax rate is the rate paid on all income.

23.

Will tax revenue necessarily rise if tax rates are lowered? Explain your answer.

No. The answer depends on how the change in the tax rate affects the tax base. If the tax rate cut does not cause a large enough increase in the tax base, then tax revenue will fall.

24.

Gabrielle is sitting with a friend at a coffee shop, and they are talking about the new tax bill. Gabrielle thinks that cutting tax rates at this time would be wrong: ―Lower tax rates,‖ she says, ―will lead to a larger budget deficit, and the budget deficit is already plenty big.‖ Do lower tax rates mean a larger deficit? Why or why not?

Lower tax rates do not necessarily lead to a larger deficit. Lower tax rates could lead to higher tax revenues which would lead to a smaller budget deficit. What matters is whether the percentage cut in tax rates is larger or smaller than the percentage rise in the tax base.

Answers to the Problems in the Working with Numbers and Graphs Section Use the following table to answer questions 1-4:

Taxable Income

Income Taxes

$1,000-$5,000

10% of taxable income

$5,001-$10,000

$500 + 12% of everything over $5,000

$10,001-$15,000

$1,100 + 15% of everything over $10,000

If a person’s income is $6,000, how much does he pay in taxes?

He pays $500 plus 12% of $1,000 = $500 + $120 = $620.

136

If a person’s income is $14,000, how much does she pay in taxes?

She pays $1,100 plus 15% of $4,000 = $1,100 + $600 = $1,700.

What is the marginal tax rate on the 10,001st dollar? What is the marginal tax rate on the 10,000th dollar?

On the 10,000th dollar, taxes are $500 + 12% of $5,000 = $1,100 On the 10,001st dollar, taxes are $1,100 + 15% of $1 = $1,100.15 The marginal rate on the 10,001st dollar is 15%. The marginal rate on the 10,000th dollar is 12 percent.

What is the average tax rate of someone with a taxable income of $13,766?

The taxes paid are $1,100 + 15% of 3,766 = $1,664.90. That is an average tax rate of $1,664.90/$13,766 = 12.09%.

A hypothetical society has three income earners, and all three must pay income taxes. The taxable income of Ciara is $40,000, the taxable income of Jones is $100,000, and the taxable income of Isabella is $200,000. (a) How much tax revenue is raised under a proportional income tax when the tax rate is 10 percent? How much is raised if the tax rate is 15 percent? (b) A progressive tax system is installed, with a rate of 5 percent on income of $0$40,000, a rate of 8 percent on income from $40,001 to $100,000, and a rate of 15 percent on all income over $100,000. Will this system raise more or less tax revenue than a proportional tax rate of 10 percent? Explain your answer.

Total income is $340,000. a) At a 10 percent flat rate, tax payments would be $34,000; at a 15 percent flat rate, tax payments would be $51,000. b) With the progressive income tax system specified, tax payments would be $40,000.

Show graphically how fiscal policy works in the ideal case.

The two graphs that make up Exhibit 2 in the text explain this.

137

Illustrate graphically how government can use supply-side fiscal policy to get an economy out of a recessionary gap.

LRAS1

Price level

SRAS1

SRAS2

AD1

Real GDP

In the above figure, the economy is initially at Q1 in a recessionary gap. Government lowers marginal tax rates, thus increasing the incentive to engage in productive activities (such as work) and the SRAS curves shifts rightward from SRAS1 to SRAS2. At point 2, the economy is long-run equilibrium.

138

Illustrate the following graphically: (a)

Fiscal policy destabilizes the economy.

(b)

Fiscal policy eliminates an inflationary gap.

(c)

Fiscal policy only partly eliminates a recessionary gap.

a) The economy is at Q1 in a recessionary gap and government increases AD too much, resulting in an inflationary gap at Q2. b) The government shifts AD from AD1 to AD2, which moves the economy to QN. c) The government shifts AD from AD1 to AD2, which fails to move the economy completely to QN.

139

Solution’s Manual Arnold, Economics, 14e; Chapter 12: Money, Banking, and the Financial System

Table of Contents Content Grid ................................................................................................................... 141 Chapter 12: Money, Banking, and the Financial System ...................................................... 144 Answers to the Chapter Questions and Problems ................................................................................. 144 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 147

140

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

141

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

142

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

143

Chapter 12: Money, Banking, and the Financial System Answers to the Chapter Questions and Problems 1.

―How much money did you make last year?‖ What is wrong with that statement?

The most general definition of money is any good that is widely accepted for purposes of exchange (payment for goods and services) and the repayment of debt. The money that a worker earns is termed ―income.‖

Suppose the value of the dollar declines relative to other currencies. How does the decline affect the three functions of money?

Foreigners will reduce their use of the dollar in international exchange, thereby reducing its use as a medium of exchange. People will be less willing to hold dollars, thereby reducing its usefulness as a store of value. Internationally, the dollar’s use as a unit of account will be reduced over time.

Does inflation, which is an increase in the price level, affect the three functions of money? If so, how?

Money is less of a store of value when inflation makes each dollar worth less. As a medium of exchange, it will be more in demand as prices rise, because more will be required to function from day to day. As a unit of account it might fail, as rising prices make comparisons of data from one point in time not comparable to those from other times.

―People in a barter economy came up with the idea of money because they wanted to do something to make society better off.‖ Do you agree or disagree with this statement? Explain your answer.

Disagree. They came up with the idea of money to make themselves better off by reducing transactions costs.

―A barter economy would have very few comedians.‖ Do you agree or disagree with this statement? Explain your answer.

Agree. Specialization is very expensive in a barter economy.

Money makes trade easier. Would having a money supply twice as large as it currently is make trade twice as easy? Would having a money supply half its current size make trade half as easy?

144

The answer is dependent upon the current relationship between the supply of money and the demand for money for transactions. As long as there is enough money to fund all desired transactions, then doubling the money supply will have no noticeable effect on exchange. If there is a shortage of money for transactions purposes, then expanding the money supply will increase exchange. However, whether doubling the money supply would double the ease of transactions seems impossible to answer, but it is highly unlikely. Reducing the money supply will not noticeably affect exchange if the new, smaller money supply is still sufficient to cover transactions. If, however, the new money supply creates a shortage of money to fund transactions, then exchange will be hampered.

Explain why gold backing is not necessary to give paper money value.

As long as people are willing to accept money in exchange for goods and services and in payment for debts, there is no need for any commodity, gold or otherwise, to back the money supply.

―Money is a means of lowering the transaction costs of making exchanges.‖ Do you agree or disagree? Explain your answer.

Agree. Without money, we operate in a barter economy and that requires the double coincidence of wants. We must find someone who has what we want and who wants what we have. The search process is likely to be long and ineffective. In a money economy it is unnecessary because I exchange what I have for money and then exchange the money for what I want.

If you were on an island with 10 other people and there were no money, do you think that money would emerge on the scene? Why or why not?

Probably, though with 10 people it might not. In prisoner of war camps during World War II, cigarettes were used as money. People instinctively try to maximize their utility, which implies that they will try to minimize the costs of transactions, and money can aid in doing that.

10. If the component currency rises, does this affect both M1 and M2 or just M1? Explain your answer. M1 can fall as M2 rises if some other unique factor of M2 (such as savings deposits) increases by more than enough to offset the decrease in M1. M1 can rise without M2 rising, too, if some other unique factor of M2 falls by an amount equal to or larger than the increase in M1.

11.

Why isn’t a credit card money?

Credit cards simply transfer the original spending of money from the consumer to the credit card company. Eventually the credit card company will have to be paid back by the consumer. So, a credit card just delays the use of money, it does not replace it.

145

12.

Define the following: (a) Time deposit, (b) Money market mutual fund, (c) Money market deposit account, (d) Fractional reserve banking. a) A time deposit is an interest-earning deposit with a specified maturity date. b) A money market mutual fund is an interest-earning deposit at a mutual fund company, usually offering limited check-writing privileges. c) A money market deposit account is an interest-earning deposit at a bank or thrift institution, usually offering limited check-writing privileges. d) Fractional reserve banking is a banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities.

13.

Explain the process by which goldsmiths could increase the money supply.

Goldsmiths increased the money supply when they began lending out part of their customers’ gold and/or by printing receipts in excess of actual gold holdings. 14.

What is a financial system, and why would a country with a well-developed and fully functional financial system be better off than a country without it?

A financial system is a means of getting savers and borrowers together. A country with a welldeveloped and fully functional financial system is better off than a country without one because such a system leads to more lending and borrowing, which provides the financing for new businesses and the production of new products and production techniques and also because it permits individuals to enjoy the benefits of certain goods and services for a greater number of years than would be possible without lending and borrowing. 15.

Identify each of the following as either an adverse selection problem or a moral hazard problem: (a) Poor drivers apply for car insurance more than good drivers do. (b) The federal government promises to help banks that get into financial problems. (c) The federal government insures checkable deposits (promises to repay the holder of the checkable deposit if the bank fails). a) Adverse selection; b) Moral hazard; c) Moral hazard.

16.

Explain how financial intermediaries help to solve adverse selection problems and moral hazard problems when it comes to lending and borrowing.

Financial intermediaries help to solve adverse selection by collecting information on would-be borrowers and by requiring collateral, for example. They help to solve moral hazard by specifying that a loan can only be used for a particular purpose, by requiring that the borrower provide regular information on and evidence of how the borrowed funds are being used, or by giving out the loan in installments ($1,000 this month, $1,000 next month), for example.

146

17.

Explain the difference between a bank’s loans and its borrowings.

A bank’s loans are assets while its borrowings are liabilities.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

A bank’s assets are $90 million, and its liabilities are $71 million. Its assets increase by 10 percent, and its liabilities increase by 6 percent. What is the percentage change in the bank’s capital, or net worth?

Bank capital = assets – liabilities. Originally, bank capital = $90 million - $71 million = $19 million. After the changes, bank capital = $99 million - $75.26 million = $23.74 million. The percentage change in the bank’s capital is ($23.74 million - $19 million)/$19 million = 0.2494 = 25%. 2.

A bank’s assets are $100 million and its liabilities are $80 million. What is the bank’s net worth?

The bank’s net worth is the difference between its assets and liabilities, which is $100 million (assets) minus $80 million (liabilities) or $20 million. 3.

Suppose M1 is $2,000 billion, small-denomination time deposits are $4,000 billion, and retail money market mutual funds are $3,000 billion. How much does M2 equal?

M2 is equal to M1 ($2,000 billion) + small-denomination time deposits ($4,000 billion) + retail money market mutual funds ($3,000 billion), which is $9,000 billion. 4.

Currency held outside banks is $100 billion, checkable deposits are $1,000 billion, small-denomination time deposits are $300 billion and money market mutual funds are $400 billion. What does M1 equal?

M1 is equal to $1,100 billion.

Solution’s Manual Arnold, Economics, 14e; Chapter 13: The Federal Reserve System

147

Table of Contents Content Grid ................................................................................................................... 149 Chapter 13: The Federal Reserve System .......................................................................... 152 Answers to the Chapter Questions and Problems ................................................................................. 152 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 154

148

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

149

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

150

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

151

Chapter 13: The Federal Reserve System Answers to the Chapter Questions and Problems 1.

What is monetary policy?

Requires answer.

What are reserves, required reserves, and excess reserves?

Requires answer.

Questions 3–8 relate to Fed policy tools and monetary policy in the past (before October 2008). 3.

Explain how an open market purchase increases the money supply.

Suppose the Fed buys government securities from a commercial bank. At the end of the transaction, the Fed has more government securities than before, and the commercial bank has fewer. However, the commercial bank has a higher balance in its account at the Fed. Since deposits at the Fed are part of reserves (reserves = deposits at the Fed + vault cash), the reserves in the banking system have risen. Since the United States has a fractional reserve banking system, only a fraction of the increased amount of reserves has to be placed in required reserves. The remainder, or the positive excess reserves, can be used to extend more loans, create more demand deposits, and increase the money supply.

Explain how an open market sale decreases the money supply.

Suppose that the Fed sells one million dollars’ worth of its government securities to a bank. The bank pays by giving the Fed one million dollars from its reserve account at the Fed so that the bank can meet its reserve requirement. With a reduction in its Fed reserves, the bank must reduce its total outstanding loans, which then reduces checkable deposits and money in the economy.

Suppose the Fed raises the required reserve ratio, a move that is normally thought to reduce the money supply. However, banks find themselves with a reserve deficiency after the required reserve ratio is increased and are likely to react by requesting a loan from the Fed. Does this action prevent the money supply from contracting as predicted? Explain your answer.

It prevents the money supply from contracting as much and as fast as it would have contracted if the banks had not gone to the Fed for loans. However, this is only a short-run phenomenon. Once the banks repay the Fed loans (probably within the next two to four weeks), reserves will

152

leave the banking system, and the money supply will decline as predicted. The loans the Fed makes to banks create a lag between the increase in the required reserve ratio and the full contractionary effect on bank reserves and the money supply.

Suppose Bank A borrows reserves from Bank B. Now that Bank A has more reserves than previously, will the money supply increase? Explain your answer.

No, the money supply will not increase because there are no new reserves in the banking system. Though Bank A has more reserves and Bank B has fewer reserves, the banking system as a whole has the same volume of reserves.

Explain how a decrease in the required reserve ratio increases the money supply.

If the required reserve ratio decreases, then banks will have more reserves than they are required to have, which means that some formerly required reserves are now excess reserves. These excess reserves can then be used to make new loans that cause an increase in checkable deposits and hence an increase in the money supply.

In the past, how did the Fed change the federal funds rate?

Requires answer.

Questions 9–13 relate to Fed policy tools and monetary policy in the present (since October 2008). 9.

What is the IOR rate? What is the ON-RRP rate?

Requires answer.

10.

According to a statement made by the Board of Governors of the Federal Reserve System, the ―Federal Reserve conducts the nation’s monetary policy by managing the level of short-term interest rates.‖ To what end? What is the Fed trying to do by managing the level of short-term interest rates?

Requires answer.

11.

Suppose the Fed wants to raise the federal funds rate. How would it use the IOR rate and ON-RRP rate to do this?

Requires answer.

153

12.

Suppose the Fed wants to lower the federal funds rate. How would it use the IOR rate and the ON-RRP rate to do this?

Requires answer.

13.

There are three things that a bank can do with its reserves. What are they?

Requires answer.

Answers to the Problems in the Working with Numbers and Graphs Section Will these be added?

Solution’s Manual Arnold, Economics, 14e; Chapter 14: Money and the Economy

Table of Contents Content Grid ................................................................................................................... 155 Chapter 14: Money and the Economy ............................................................................... 158 Answers to the Chapter Questions and Problems ................................................................................. 158 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 162

154

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

155

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

156

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

157

Chapter 14: Money and the Economy Answers to the Chapter Questions and Problems 1.

What are the assumptions and predictions of the simple quantity theory of money? Does the simple quantity theory of money predict well? The assumptions of the simple quantity theory of money are that velocity and output are constant. If these two assumptions hold true, then there is a strictly proportional link between changes in the money supply and changes in prices. In the real world we do not always observe this strict proportionality, but we do observe a strong direct relationship between money supply growth rates and price level growth rates. 2.

Can the money supply support a GDP level greater than itself? Explain your answer.

Yes. GDP is equal to the money supply multiplied by velocity. As long as velocity is greater than 1, GDP will be larger than the money supply. 3.

In the simple quantity theory of money, the AS curve is vertical. Explain why.

One of the assumptions of the simple quantity theory of money is that output is fixed, which means that the AS curve is vertical. 4.

In the simple quantity theory of money, what will lead to an increase in aggregate demand? In monetarism, what will lead to an increase in aggregate demand?

In the simple quantity theory of money (since velocity and output are assumed to be constant), a rise in the money supply will lead to an increase in aggregate demand. In monetarism, an increase in the money supply or in velocity will lead to an increase in aggregate demand. 5.

According to the simple quantity theory of money, what will happen to Real GDP and the price level as the money supply rises? Explain your answer.

Since the SRAS curve is vertical in the simple quantity theory, an increase in the money supply (which shifts the AD curve rightward) will increase the price level but will have no effect on Real GDP.

158

In monetarism, how will each of the following affect the price level in the short run? (a) An increase in velocity; (b) A decrease in velocity; (c) An increase in the money supply; and (d) A decrease in the money supply. a) An increase in velocity will tend to increase the price level. b) A decrease in velocity will tend to decrease the price level. c) An increase in M will tend to increase the price level. d) A decrease in M will tend to decrease the price level.

According to monetarism, an increase in the money supply will lead to a rise in Real GDP in the long run. Do you agree or disagree with this statement? Explain your answer.

Disagree. An increase in the money supply will lead to a rise in Real GDP in the short run, but then adjustments to labor market imbalances will cause the economy to eventually return to its Natural Real GDP level. 8.

Suppose the objective of the Fed is to increase Real GDP. To this end, it increases the money supply. Can anything offset the increase in the money supply so that Real GDP does not rise? Explain your answer.

The simple quantity theory of money equation states that MV = PQ, where Q equals Real GDP. If velocity were to decline, it could counteract the change in M, so that Real GDP does not rise. Or the effects of the increase in the money supply could be felt as an increase in the price level, reducing the increase in Real GDP (although, in the short run, some change in Real GDP should occur). Further, interest rates might rise. If that were to occur, the AD curve might not move.

What is the difference in the long run between a one-shot increase in aggregate demand and a one-shot decrease in short-run aggregate supply?

If aggregate demand increases, the price level will be higher in the long run than it was originally. This is illustrated in Exhibit 4. If aggregate supply decreases, the price level eventually returns to its original level in the long run. This is illustrated in Exhibit 5.

10.

―One-shot inflation may be a demand-side (of the economy) or a supply-side phenomenon, but continued inflation is likely to be a demand-side phenomenon.‖ Do you agree or disagree with this statement? Explain your answer.

Agree. The reason is that it is easier to produce continuous increases in aggregate demand that increase the price level than for the economy to undergo continuous supply shocks. If the © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

159

Federal Reserve increased the money supply, this would cause an increase in aggregate demand and a one-shot increase in inflation to a higher price level. In order to cause continued inflation, the Federal Reserve would have to increase the money supply every year, which it is capable of doing. On the other hand, a supply shock (such as a crop failure) would shift the SRAS curve to the left, causing an increase in the price level. For inflation to continue, there would have to be crop failures every year without a reallocation of resources to farming to offset the decrease in supply. This is unlikely to occur.

11.

Explain how demand-induced, one-shot inflation may seem like supplyinduced, one-shot inflation.

Suppose the money supply increases, boosting aggregate demand and raising the prices that consumer-laborers must pay for goods and services, while the short-run aggregate supply curve remains unchanged. Faced with these higher prices, the consumer-laborers will demand higher wages from their employers, shifting the SRAS leftward, ceteris paribus, and raising the price level. From the producers’ perspective, the inflation was caused by higher wage demands.

12.

In recent years, economists have argued about the true value of the real interest rate at any one time and over time. Given that the Nominal interest rate = Real interest rate + Expected inflation rate, it follows that the Real interest rate = Nominal interest rate – Expected inflation rate. Why do you think that there is so much disagreement over the true value of the real interest rate?

Theoretically, it is easy to compute the real interest rate. As we said, it is equal to the nominal interest rate minus the expected inflation rate. The problem is that it is difficult, if not impossible, to observe the expected inflation rate. Consider a nominal interest rate of 15 percent. We know that this 15 percent nominal interest rate is composed of the real interest rate and the expected inflation rate. But numerous combinations of real interest rates and expected inflation rates will give us a 15 percent nominal interest rate. We could have a 10 percent real interest rate and a 5 percent expected inflation rate, or a 9 percent real interest rate and a 6 percent expected inflation rate, or a 4 percent real interest rate and an 11 percent expected inflation rate, and so on. Some economists believe the real interest rate is relatively stable over time, so changes in the nominal interest rate are due to changes in the expected inflation rate; but other economists do not agree with this, at least not to the same degree. 13.

With respect to the interest rate, (a) what is the liquidity effect? (b) what is the price-level effect? (c) what is the expectations effect? a) The change in the interest rate due to a change in the supply of loanable funds is called the liquidity effect.

160

b) The change in the interest rate due to a change in the price level is called the price-level effect. c) The change in the interest rate due to a change in the expected inflation rate is called the expectations effect. 14.

Suppose the money supply rises. Is the interest rate guaranteed to decline initially? Why or why not?

No. It would be guaranteed to fall if the only thing that an increase in the money supply did was to affect the supply of loanable funds. However, a change in the money supply changes real GDP, the price level, and the expected inflation rate, all of which also affect the interest rate. The timing and magnitude of these effects determine the change in the interest rate.

15.

To a potential borrower, which would be more important, the nominal interest rate or the real interest rate? Explain your answer.

The real interest rate. Inflation helps borrowers, who will tend to borrow more when inflation is high. Since inflation is reflected in the real interest rate, it is more important. For example, if inflation is 10 percent and interest rates are 11 percent, the real interest rate is only 1 percent. Looking at the nominal rate only is misleading.

16.

Suppose the money supply rises on Tuesday and by Thursday the interest rate has risen also. Is the rise in the interest rate more likely the result of the income effect or of the expectations effect? Explain your answer.

The expectations effect. The expectations of higher inflation caused by increases in the money supply can be established overnight, and therefore, interest rates may rise as soon as the money supply increases in anticipation of higher inflation.

17.

Suppose the money supply increased 30 days ago. Whether the nominal interest rate is higher, lower, or the same today as it was 30 days ago depends on what? Explain your answer.

The relative strengths and timing of the income, liquidity, price-level, and expectations effects will determine the nominal interest rate.

18.

What does inflation look like in a country that imposes and maintains price ceilings on goods and services?

161

Price ceilings lead to a shortage in the market. One of the consequences of using price ceilings is that non-money rationing devices, such as first-come-first-served, will be used. This will result in long lines of people waiting to buy goods. In such an economy, inflation is felt in the length of the lines of people. The longer the lines, the higher the inflation rate.

19.

In an equation-of-exchange framework, the price level is dependent upon the money supply, velocity, and Real GDP. Do you agree or disagree? Explain your answer.

Disagree. While it is true that in an equation-of-exchange framework the price level is related to the money supply, velocity, and Real GDP in the form of an identity, to argue that the price level depends on these variables, we need to switch to the Simple Quantity Theory of Money.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

How will things change in the AD-AS framework if a change in the money supply is completely offset by a change in velocity?

Things will not change. The AD curve will be affected equally in opposite directions by the two factors and remain where it started.

Graphically show each of the following: (a) Continued inflation due to supplyside factors, (b) One-shot, demand-induced inflation, (c) One-shot, supplyinduced inflation. a) See Exhibit 6(b) in the text. b) See Exhibit 4 in the text. c) See Exhibit 5 in the text.

Use the accompanying figure to answer questions a and b.

162

(a) Suppose the economy is self-regulating and is at point A when there is a one-shot demand-induced inflation. If there are no other changes in the economy, at what point will the economy settle? (b) Suppose the economy is at point A when it is faced with two adverse supply shocks. The Fed tries to counter these shocks by increasing aggregate demand. What path will the economy follow? a) Assuming that AD moves to AD2, the economy would move to point E in the short run. Then, the self-regulating economy would shift the SRAS1 curve to SRAS2 and the equilibrium position would be point B. b) If the two shocks occur first, the economy will move from A to D to F to H to C. If the shocks are spaced and the Fed acts in between them, the economy moves from A to D to B to H to C.

Starting with a position of long-run equilibrium, use the monetarist model to graphically portray what happens to the price level and Real GDP in the short run and in the long run as a result of (a) rise in the money supply and (b) a decline in velocity. a) See Exhibit 3(a). b) See Exhibit 3(d).

What does the real interest rate equal, given the following: (a) Nominal interest rate = 8 percent; expected inflation rate = 2 percent; (b) Nominal interest rate = 4 percent; expected inflation rate = -4 percent; (c) Nominal interest rate = 4 percent; expected inflation rate = 1 percent. a) The real interest rate = 8% – 2% = 6% b) The real interest rate = 4% – (-4)% = 8% c) The real interest rate = 4% – 1% = 3%

What does the nominal interest rate equal, given the following: (a) Real interest rate = 3 percent; expected inflation rate = 1 percent; (b) Real interest rate = 5 percent; expected inflation rate = -3 percent. a) The nominal interest rate = 3% + 1% = 4% b) The nominal interest rate = 5% + (-3)% = 2%

Can total expenditures ever be greater than the money supply? Explain your answer.

Yes. Total expenditures equal the money supply times the velocity of money. If the velocity of money is larger than 1, then total expenditures will be larger than the money supply by a factor greater than 1.

163

Take a look at Exhibit 6(a). If the economy starts at point 1 and then moves to point 2 as a result of an increase in aggregate demand, then how and why does the economy move from point 2 to point 3?

Because the economy is operating above the Natural Real GDP, the unemployment rate falls below the natural rate of unemployment. Wages then increase due to the shortage of labor, and the SRAS curve shifts leftward until the economy reaches its long-run equilibrium state.

Solution’s Manual Arnold, Economics, 14e; Chapter 15: Monetary Policy

Table of Contents Content Grid ................................................................................................................... 165 Chapter 15: Monetary Policy ............................................................................................ 168 Answers to the Chapter Questions and Problems ................................................................................. 168 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 172

164

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

165

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

166

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

167

Chapter 15: Monetary Policy Answers to the Chapter Questions and Problems 1.

Consider the following: Two researchers, A and B, are trying to determine whether eating fatty foods leads to heart attacks. The researchers proceed differently. Researcher A builds a model in which fatty foods may first affect X in one’s body, and if X is affected, then Y may be affected, and if Y is affected, then Z may be affected. Finally, if Z is affected, the heart is affected, and the individual has an increased probability of suffering a heart attack. Researcher B doesn’t proceed in this step-by-step fashion. She conducts an experiment to see whether people who eat many fatty foods have more, fewer, or the same number of heart attacks as people who eat few fatty foods. Which researcher’s methods have more in common with the research methodology implicit in the Keynesian transmission mechanism? Which researcher’s methods have more in common with the research methodology implicit in the monetarist transmission mechanism? Explain your answer.

Researcher A’s methods are reminiscent of the Keynesian transmission mechanism where there is an indirect link between the money market and the goods and services market. Researcher A appears to see an indirect link between fatty foods and heart attacks. Before a heart attack occurs, X, Y, and Z have to be affected. Researcher B’s methods remind us of the monetarist transmission mechanism where there is a direct link between the money market and the goods and services market. Researcher B looks at the intake of fatty foods and heart attacks and little else. The author posed this question to demonstrate that when it comes to different approaches to finding the truth, there are Keynesians and monetarists in fields other than economics, although they are not called by those names.

If bond prices fall, will individuals want to hold more or less money? Explain your answer.

They will want to hold less money. As bond prices fall, interest rates rise. As interest rates rise, the opportunity cost of holding money increases and individuals will want to hold less money.

Why is the demand curve for money downward sloping?

The price of holding money is the interest rate. When the interest rate rises, it becomes more costly to hold money and the quantity demanded of money balances falls.

Explain how it is possible to have too much money.

It is possible to have too much money relative to other things, such as food and a television set.

168

Explain how the Keynesian transmission mechanism works.

The Keynesian transmission mechanism says that a change in the money supply affects the supply of loans, which affects the interest rate, which changes investment and therefore AD, causing a change in Real GDP and the unemployment rate (the price level remains constant).

Explain how the monetarist transmission mechanism works.

The monetarist transmission mechanism says that a change in the money supply affects the amount of money consumers and businesses have, therefore affecting their spending on a wide variety of goods, shifting the AD curve and causing a change in Real GDP, the price level, and the unemployment rate.

It has been suggested that nonactivists are not concerned with the level of Real GDP and unemployment because most (if not all) nonactivist monetary proposals set stabilization of the price level as their immediate objective. Discuss.

This is a false charge since most nonactivists believe that a stable price level will lead to the desirable ends. For example, many nonactivist monetarists argue that if the price level is stabilized, the expected inflation rate will be zero and nominal interest rates will be lower and more stable. Additionally, they claim that the economic mistakes individuals naturally make when their expected inflation rate is not equal to the actual inflation rate will decrease in size and number due to the convergence of the two rates.

Suppose the combination of more accurate data and better forecasting techniques would make it easy for the Fed to predict a recession 10 to 16 months in advance. Would this state of affairs strengthen the case for activism or nonactivism? Explain your answer.

It would strengthen the case for activism. For example, one of the reasons nonactivists argue against activist monetary policy is that by the time the Fed realizes the economic problem at hand, takes action, and the policy begins to bear consequences, it is too late. The Fed policy might have been the right medicine for an earlier time, but it turns out to be the wrong medicine by the time it takes hold. If it were possible to predict events accurately far in advance, this would not be such a problem. For example, if the total lag in monetary policy is 13.3 months, and it is possible for the Fed to predict accurately, say, a recession 13.3 months in advance, then there would be less chance of its policy measures turning out to be the wrong medicine at the wrong time. The Fed would be better able to apply the right medicine at the right time.

According to the theory of patterns of specialization and sustainable trade (PSST), economic activity can decline in the face of unchanged aggregate demand. How so?

169

At any given point in time, there are certain specializations that are needed to sustain the pattern of trade as dictated by buying preferences. For example, buyers may want to buy goods X, Y, and Z in large quantities and specializations X’, Y’, and Z’ are necessary to produce these goods. If business firms are either not producing X, Y, and Z, or if labor is not skilled in specializations X’, Y’, and Z’ , then what buyers want to buy is out of sync with what business and labor are producing and have to sell. As a result, sales decline, not necessarily due to a decline in the aggregate demand in the economy, but due to the fact that businesses and labor are out of sync with what buyers want to buy.

10.

Suppose it were proved that liquidity traps do not occur and that investment is not interest insensitive. Would this be enough to disprove the claim that expansionary monetary policy is not always effective at changing Real GDP? Why or why not?

It would not be enough to disprove the claim. It is possible that something other than the liquidity trap and interest-insensitive investment spending could break the link between the money market and the goods and services market. However, it would be enough to say the Keynesians were wrong in what they believed could break the link.

11.

Both activists and nonactivists make good points for their respective positions. Do you think activists could say anything to nonactivists to convince them to accept the activist position, and vice versa? If so, what is it that they would say? If not, why not?

Probably not. The activists’ basic proposition is that the market economy is not inherently selfstabilizing, and therefore, government and/or the monetary authority has (have) a legitimate role to play in making discretionary policy moves aimed at fighting unemployment and inflation. They see activist policy as a superior alternative to rule-based policy. They favor the added flexibility that discretionary policy affords, allowing policymakers to adapt to changing conditions. On the other hand, nonactivists consider activist policy to be unreliable at best and reckless and dangerous at worst. The problems of crowding out (with fiscal policy) and time lags (with both fiscal and monetary policy), along with other factors, suggest that discretionary policy is doomed to be either ineffective or, worse, to have effects contrary to its intentions.

12.

The discussion of supply and demand in Chapter 3 noted that, if two goods are substitutes for each other, the price of one and the demand for the other are directly related. For example, if Pepsi and Coca-Cola are substitutes, an increase in the price of Pepsi will increase the demand for Coca-Cola. Suppose that bonds and stocks are substitutes for each other. We know that interest rates and bond prices are inversely related. What do you predict is the relationship between stock prices and interest rates? Explain your answer.

Assuming that stocks and bonds are substitutes, that the price of one good and the demand for its substitute are directly related, and that interest rates and bond prices are inversely related,

170

we would expect interest rates and stock prices to be inversely related as well. We know that an increase in bond prices will increase the demand for stocks. So, an increase in bond prices leads to an increase in stock prices. Now, since interest rates are inversely related to bond prices, and bond prices and stock prices move together, we should find that interest rates and stock prices are inversely related.

13.

Argue the case for and against a monetary rule.

Proponents of a monetary rule argue that (1) in modern economies, wage-price flexibility allows the economy to achieve full-employment equilibrium at a reasonable speed, without activist intervention; (2) if individuals form their expectations rationally, then anticipated monetary policy will be ineffective; and (3) time lags render activist policy destabilizing. Critics argue that (1) the economy does not always reach full-employment quickly enough without activist policy; (2) previous experience shows that activist policy works; and (3) activist policy is flexible and monetary rules are not flexible.

14.

How does average inflation targeting work?

Inflation targeting requires the Fed to manage the money supply in such a way as to keep the inflation rate near a predetermined level (if the inflation rate starts to rise above the predetermined level, for instance, the Fed would have to reduce the money supply).

15.

Monetary policy can affect relative prices. Do you agree or disagree with this statement? Explain your answer.

Agree. When the money supply is increased, some people get the new money before others get it and therefore the goods and services these people buy rise in price relative to the prices of the goods and services they do not buy.

16.

According to market monetarists, what problems might arise from a sharp decline in Nominal GDP?

If monetary policy leads to a decline in Nominal GDP, nominal income declines. As a result of a decline in nominal incomes, individuals will have a hard time paying off their debts (that were contracted at an earlier time and based on nominal incomes that were not expected to decline or to decline as much as they have). For example, a person has an income of $100,000 a year and incurs a debt that he has to pay off monthly for five years. Each month for five years he must pay $2,000. Then Nominal GDP (nominal income) declines. The income of the debtor falls, and thus he finds it harder to pay off his monthly debt of $2,000. As a result he reduces his spending in the economy, and thus his demand for goods and services declines. If a large number of debtors reduce their spending, aggregate demand in the economy declines, firms lose sales and issue layoffs, the unemployment rate rises, and so on.

171

17.

Does the monetary policy of the market monetarists take into account changes in velocity? Explain your answer.

Yes. Suppose there is a financial crisis, and as a result, people try to hold more money (spend less). This is likely to reduce velocity, and if the Fed does not offset this decline in velocity sufficiently enough, GDP will decline. For example, suppose velocity declines by 8 percent and the money supply rises by 6 percent; as a result GDP will decline by 2 percent. If the objective is to raise Nominal GDP by 5 percent, an 8 percent decline in velocity would obligate the Fed to increase the money supply by 13 percent. Anything less prompts market monetarists to argue that monetary policy is too tight.

18.

Explain how a gold standard, as monetary policy, would work.

The rate fixed by the monetary authority at which it is willing to buy and sell gold is known as the official price of gold, and the price determined in the gold market is the market price of gold. If the official price exceeds the market price of gold, then people would buy gold from the monetary authority and sell it in the market at the higher price. As the supply of gold rises in the market, its price will fall and this will continue until the price reaches the official price. People use money to buy gold from the monetary authority, and so the money supply in the economy reduces as the authority does not spend that money. When money supply declines, the price level also declines as per the exchange equation. The reverse would occur if the official price is less than the market price. So, a stabilization of gold prices can lead to a stabilization of the general price level.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Last year, Manuel bought a bond for $10,000 that promises to pay him $900 a year. This year, he can buy a bond for $10,000 that promises to pay $1,000 a year. If Manuel wants to sell his old bond, what is its price likely to be?

$1,000 a year on $10,000 is a 10 percent interest rate. $900 a year on $9,000 is a 10 percent interest rate, so we expect the bond to sell for about $9,000 to provide a 10 percent return ($900/0.1 = $9,000).

Last year, Charu bought a bond for $10,000 that promises to pay her $1,000 a year. This year, investors can buy a bond for $10,000 that promises to pay $800 a year. If Charu wants to sell her old bond, what is its price likely to be?

$1,000 a year on $10,000 is a ten percent interest rate. $800 a year on $10,000 is an 8 percent interest rate, so we expect the bond to sell for about $12,500 to provide an 8 percent return ($1000/0.08 = $12,500).

172

The annual average percentage change in Real GDP is 2.3 percent, and the annual average percentage change in velocity is 1.1 percent. Using the monetary rule discussed in the text, what percentage change in the money supply will keep prices stable (on average)?

Monetary Rule: %ΔM = (%ΔQ – % ΔV) = 2.3 percent – 1.1 percent = 1.2 percent

Show graphically that the more interest insensitive the investment demand curve is, the less likely it is that monetary policy will be effective at changing Real GDP.

In panel (a), investment demand is relatively sensitive, so the increase in interest rates caused by a change in monetary policy is relatively effective in changing the quantity demanded of I. In panel (b), the change in I resulting from the rise in interest rates is much smaller, showing insensitivity to interest rate changes. If Natural Real GDP in panel B is much higher than the level that can be achieved with I2, then it may not be possible to achieve full employment with monetary policy.

In each of parts (a)-(d), which panel in the accompanying figure best describes the situation? (a) Expansionary monetary policy that removes the economy from a recessionary gap; (b) Expansionary monetary policy that is destabilizing; (c) Contractionary monetary policy that removes the economy from an inflationary gap; and (d) Monetary policy that is ineffective at changing Real GDP.

173

a) Panel b b) Panel c c) Panel d d) Panel a 6.

Graphically portray the Keynesian transmission mechanism under the following conditions: (a) A decrease in the money supply; (b) No liquidity trap; (c) Downward-sloping investment demand.

Using Exhibit 3 in the text, the money supply would move from M2 to M1, investment would move from I2 to I1, and AD would move from AD2 to AD1. The result is higher interest rates, lower investment and lower Real GDP.

Graphically portray the monetarist transmission mechanism when the money supply declines.

Using Exhibit 6 in the text, the money supply would move from S2 to S1, and AD from AD2 to AD1. The result is lower prices and lower Real GDP.

Solution’s Manual Arnold, Economics, 14e; Chapter 16: Expectations Theory and the Economy

Table of Contents Content Grid ................................................................................................................... 175 Chapter 16: Expectations Theory and the Economy............................................................ 178 Answers to the Chapter Questions and Problems ................................................................................. 178 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 181

174

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

175

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

176

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

177

Chapter 16: Expectations Theory and the Economy Answers to the Chapter Questions and Problems 1.

What does it mean to say that the Phillips curve presents policy makers with a menu of choices?

It means that policymakers could choose to move the economy to any of the points on the Phillips curve.

According to Friedman, how do we know when the economy is in long-run equilibrium?

According to Friedman, the economy is in long-run equilibrium when the expected inflation rate is equal to the actual inflation rate.

What is a major difference between adaptive and rational expectations? Give an example of each.

With adaptive expectations, it does not matter whether a policy is anticipated or unanticipated—the effects are the same. With rational expectations, it does matter whether a policy is anticipated or unanticipated—the effects are different. This is a major difference between the two types of expectations theory. Adaptive expectations theory implicitly assumes that individuals wait to see what happens and then act. Examples will vary. Suppose individuals know that aggregate demand will increase. Adaptive expectations theory holds that individuals will wait until AD increases to see how higher AD affects the price level, and then they will revise their anticipated price level. On the other hand, rational expectations theory assumes that individuals look to the future, make an educated guess as to what is going to happen, and then act accordingly. Examples will vary. Rational expectations theory holds that if individuals anticipate that aggregate demand will increase, they will not wait to revise their inflation expectations until it has increased and the price level has risen. Simply put, adaptive expectations holds that the future will only be acted upon when it has become the present or the past; rational expectations holds that the future will be acted upon (or rather, what individuals think the future will be, will be acted upon) before it has become the present or the past.

―The policy ineffectiveness proposition (connected with new classical theory) does not eliminate policy makers’ ability to reduce unemployment through aggregate demand-increasing policies, because they can always increase aggregate demand by more than the public expects.‖ What might be the

178

weak point in this argument? The argument is implicitly based on the assumption that policy makers have an accurate idea of how much the public expects aggregate demand will increase. This would be nearly impossible to know. That is, if a policy maker says that the public thinks aggregate demand will only be increased by X amount, one might reasonably question how much faith should be put in such a statement. Additionally, one must ask how a policymaker can possibly know what the public is thinking.

Why is the new classical theory associated with the word ―classical‖? Why has it been said that classical theory failed where new classical theory succeeds—because the former could not explain the business cycle (the ups and downs of the economy), but the latter can?

The new classical theory has the word classical associated with it because when policy is (correctly) anticipated, both the new classical and the classical theories predict that Real GDP remains at its natural level. For the most part, the classical theory could not explain the business cycle because it implicitly assumed that the effects of unanticipated policy and anticipated policy were the same. The new classical theory does not make this assumption. In the new classical theory, movements away from Natural Real GDP and the natural rate of unemployment are the result of unanticipated policy or less than correctly anticipated policy.

Suppose a permanent downward-sloping Phillips curve existed and offered a menu of choices of different combinations of inflation and unemployment rates to policymakers. How do you think society would go about deciding which point on the Phillips curve it wanted to occupy?

The decision would have to be made on the basis of some normative judgment about the relative importance of low unemployment versus low inflation, taking into account public perceptions about the maximum acceptable levels of each.

Assume a current short-run tradeoff between inflation and unemployment, as well as a change in technology that permits the wider dispersion of economic policy news. How would the change affect the trade-off? Explain your answer.

A wider dispersion of economic news should have two effects. First, it may affect people’s attitudes about the acceptability of high inflation and/or unemployment. As such, it may change the slope of the short-run Phillips curve. Secondly, individuals should be able to form and adjust their inflationary expectations better and more rapidly, thus creating a world closer to the rational expectations model(s) than the simple Phillips curve.

New Keynesian theory holds that wages are not completely flexible because of such things as long-term labor contracts. New classical economists often respond that experience teaches labor leaders to develop and bargain for

179

contracts that allow for wage adjustments. Do you think that the new classical economists have a good point? Why or why not? Although many labor contracts include cost-of-living-adjustments (or COLAs) that automatically adjust wages to changes in the price level, most such devices only increase wages if prices rise; they do not decrease wages if prices fall. This seems to be a major difference between the new classical and nonclassical rational expectations models, just as it was a major difference between classical economics and Keynes. As long as wages and prices do not adjust freely both upward and downward, there is a clear argument for the nonclassical view.

What evidence can you point to which suggests that individuals form their expectations adaptively? What evidence can you point to which suggests that individuals form their expectations rationally?

Examples will vary. But, as an example, people tend to make many day-to-day purchasing decisions—such as what to buy at the grocery, whether or not to go out to dinner, etc.—on the basis of how today’s price compares to recent memory. While individuals may be aware of major market conditions, such as a widespread drought or a major boycott, they do not spend much time researching the market conditions of the avocado industry when preparing to go to the grocery store. On the other hand, individuals seek a great amount of information and advice on stock market purchases/sales, housing decisions, and the like, suggesting that they are trying to form their price expectations and make their purchasing decisions as rationally as possible.

10.

Suppose the government undertakes an expansionary fiscal policy measure that raises aggregate demand but individuals incorrectly anticipate the measure, bias upward. What will the short- and long-run changes be in the price level and Real GDP?

Assume that the economy is initially in long-run equilibrium. Since under this scenario, the rightward shift of the AD curve will be smaller than the leftward shift of the SRAS curve, in the short run the price level will rise and Real GDP will fall. Eventually the SRAS curve will shift rightward so that in the long run, the price level will fall somewhat (although it will not return to its initial level) while Real GDP will return to its long run position.

11.

Explain both the short- and long-run movements of the Friedman natural rate theory, assuming that expectations are formed adaptively.

If people form their expectations adaptively, then short-run changes in AD brought about by fiscal or monetary policy will cause a movement along a short-run Phillips curve, like PC1 in Exhibit 5. This enables the government (or the Fed) to manipulate the inflation and unemployment rates until people adapt their inflationary expectations. Over time, the natural rate hypothesis holds that people will continue to modify their expectations such that the government (or the Fed) cannot sustain its manipulation, causing the economy to tend toward full employment.

180

12.

Explain both the short- and long-run movements of the new classical theory, assuming that expectations are formed rationally and policy is unanticipated.

See Exhibit 10 and accompanying discussion.

13.

―Even if some people do not form their expectations rationally, the new classical theory is not necessarily of no value.‖ Discuss this statement.

Even if only a few people form their expectations rationally, they can have an impact on the viability of economic policy. The higher the number of economic actors who do so (or even endeavor to do so), the more important it is to understand the theory and implications of rational expectations formation.

14.

In the real business cycle theory, why can’t the change in the money supply prompted by a series of events catalyzed by an adverse supply shock be considered the cause of the business cycle?

In the real business cycle theory, decreases in consumption that result from supply shocks cause firms to cut back on their expansion plans and reduce their borrowing from banks. This, in turn, reduces the money supply and shifts the AD curve leftward. Notice that the reduction in the money supply results from the supply shock, and not vice versa. Without the supply shock, there would have been no reduction in the money supply and no shift in the AD curve. For the money supply to cause the business cycle, it would have to be the first economic factor, which changed, not the last.

15.

The expected inflation rate is 5 percent, and the actual inflation rate is 7 percent. According to Friedman, is the economy in long-term equilibrium? Explain your answer.

No. Since expectations are formed adaptively, the expected rate must equal the actual rate in equilibrium. If they do not, it means that the economy is shifting from one level to another.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Illustrate graphically what would happen in the short run and in the long run to the price level and Real GDP level if individuals hold rational expectations, prices and wages are flexible, and individuals underestimate the decrease in aggregate demand (bias downward).

181

In the above figure, if individuals underestimate the decrease in aggregate demand, their expected price level will fall to P2. The SRAS curve will shift rightward by less than the AD curve shift, moving the economy to equilibrium at point 2 (lower price level, lower level of Real GDP). Eventually, individuals come to understand that AD2 is the operational AD curve in the economy and that the long-run equilibrium consistent with AD2 is P3. They revise their expected price level, and the SRAS curve shifts rightward to SRAS3, so that the economy returns to long-run equilibrium at point 3.

Illustrate graphically what would happen in the short run and in the long run to the price level and Real GDP if individuals hold rational expectations, prices and wages are flexible, and individuals overestimate the rise in aggregate demand (bias upward).

In the following figure, if individuals overestimate the rise in aggregate demand, the AD curve looks as if it shifts rightward from AD1 to AD3. They assume the new actual price level to be 118, which is where the AD3 curve intersects the LRAS curve. Accordingly, they change their expected price level to 118, and the SRAS curve shifts leftward from SRAS1 to SRAS2. The shortrun equilibrium for the economy is at point 2. This leads to a decline in Real GDP in the short run. When individuals in the economy realize that the actual AD curve is AD2, not AD3, they adjust their expected price level to 110. Accordingly, the SRAS curve shifts rightward from SRAS2 to SRAS3. The economy is now in long-run equilibrium at point 3, and the expected price level is equal to the actual price level.

182

Price Level Pex =118

LRAS

SRAS2 SRAS3

SRAS1

2 3

Pex= Pa=110

Pex= Pa=100

AD3 (Perceived shift)

AD2 (actual shift) AD1

0 3.

Real GDP

Illustrate graphically what would happen to the price level and Real GDP level if individuals hold rational expectations, prices and wages are flexible, and individuals correctly anticipate a rise in aggregate demand.

The economy is in long-run equilibrium at point 1 in the above figure. The actual price level is equal to the expected price level which is equal to 100. The Fed increases the money supply, and this policy action is correctly anticipated by the public. The AD curve shifts rightward from AD1 to AD2. Since the policy change was anticipated correctly, individuals change their expected price level to 110. The SRAS curve will then shift leftward from SRAS1 to SRAS2. The SRAS curve shifts leftward at essentially the same time that the AD curve shifts rightward. The economy moves from point 1 to point 2 and is still at QN. Thus, if policy is correctly anticipated and if rational expectations hold, an increase in the money supply can only raise the price level; it does not change Real GDP.

183

In each of the figures (a-d) that follow, the starting point is 1. Which part (a, b, c, or d) illustrates each of the following? (a) Friedman natural rate theory (short run); (b) New classical theory (unanticipated policy, short run); (c) Real business cycle theory; (d) New classical theory (incorrectly anticipated policy, overestimating increase in aggregate demand, short run); (e) Policy ineffectiveness proposition (PIP).

a) b b) d c) c d) a e) b

Illustrate graphically what would happen in the short run and in the long run if individuals hold adaptive expectations, prices and wages are flexible, and aggregate demand decreases.

This is very similar to the process described and illustrated in Exhibit 5 (in the text), only in reverse. The decrease in aggregate demand will shift the AD curve to the left. As a result, workers revise their expected inflation rate downward in response to the lower prices brought

184

on by the decrease in aggregate demand. Wage rates begin to fall, resulting in a rightward shift of the SRAS curve. Ultimately, the new SRAS curve will intersect the new AD curve on the LRAS and the economy will return to QN.

Solution’s Manual Arnold, Economics, 14e; Chapter 17: Economic Growth: Resources, Technology, Ideas, and Institutions

Table of Contents Content Grid ................................................................................................................... 186 Chapter 17: Economic Growth: Resources, Technology, Ideas, and Institutions .................... 189 Answers to the Chapter Questions and Problems ................................................................................. 189 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 190

185

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

186

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

187

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

188

Chapter 17: Economic Growth: Resources, Technology, Ideas, and Institutions Answers to the Chapter Questions and Problems 1.

Why might per-capita real economic growth be a more useful measurement than absolute real economic growth?

Real economic growth measures changes in the output of a country but does not measure the improvement in the average standard of living for people living in that country. For example, if Real GDP increased by 5 percent, and population also increased by 5 percent, on average, individuals living in that country would see no change in their standard of living. Per-capita real economic growth measures improvements in the standard of living in a country whereas (absolute) real economic growth measures increases in output without taking into consideration changes in the population.

2. Identify how changes in L, K, and T can lead to changes in output, or Real GDP. This is shown in Exhibit 2 in the text.

What does it mean to say that ―a change in labor moves us along a given production function‖?

To say that ―a change in labor moves us along a given production function‖ means that as more labor is added to the production function, more Real GDP will be produced, and vice versa.

What do interest rates and the tax treatment of the returns to capital have to do with economic growth?

Changes in interest rates and changes in the tax treatment of the returns to capital affect capital utilization, which helps to determine the position of the LRAS curve. For example, lower interest rates and changes in the tax treatment of the returns to capital that cause decreases in taxes on the returns to capital cause an increase in capital utilization, which shifts the production function upward and thereby shifts the LRAS curve rightward (the economy grows).

What is new about new growth theory?

Neoclassical growth theory emphasized two factors: labor and capital. Technology was treated as an exogenous variable. In new growth theory, technology is treated as being endogenous. Improvements in technology depend on the amount of resources devoted to research and

189

development, not to exogenous changes over which society has no control. The new growth theory also focuses on the process of discovery and ideas that generate new technology.

How does discovering and implementing new ideas cause economic growth?

When someone has a new idea that increases labor productivity, and when that idea is implemented, then economic growth will occur.

What is the difference between business cycle macroeconomics and economic growth macroeconomics?

Business cycle macroeconomics deals with movements around a given Natural Real GDP level, while economic growth macroeconomics deals with movements to a new Natural Real GDP level.

What is an institution? Why might institutions matter to how much economic growth a country experiences?

An institution is ―the rules of the game in a society or, more formally, the humanly devised constraints that shape human interaction: the rules and regulations, laws, customs, and business practices of a country.‖ Institutions can facilitate or impede economic growth, by encouraging or dissuading individuals from producing output.

Some property rights structures provide more and stronger incentives to produce goods and services than other such structures do. Do you agree or disagree with this statement? Explain your answer.

Agree. For example, property rights structures that permit individuals to own property provide incentives for production that do not exist under property rights structures where individuals cannot own property.

10.

Why might special-interest groups favor transfer-promoting policies over growth-promoting policies?

Special-interest groups may favor transfer-promoting policies over growth-promoting policies because, for a given effort, they may get a larger return on transfer-promoting policies over growth-promoting policies.

Answers to the Problems in the Working with Numbers and Graphs Section

190

The economy of country X is currently growing at 2 percent a year. How many years will it take to double the Real GDP of country X?

The Rule of 70 can be used to find out how long it would take for the Real GDP to double. By dividing 70 by the rate of growth (70 ÷ 2 = 35), we find that it will take 35 years for Real GDP to double in country X.

Explain numerically how an advance in technology can lead to more output, or Real GDP.

Answers will vary, but should make use of the production function. When T, the technology coefficient, is increased, for given levels of L and K, Real GDP will increase.

A rise in physical capital can raise Real GDP and lead to a rightward shift in the LRAS curve. Show this relationship diagrammatically.

This is shown in Exhibit 3(c) and 3(d) for the case of an increase in the technology coefficient. A rise in physical capital causes the curves to shift in the same manner. See the parenthetical note in Exhibit 3.

A change in the labor market can change the equilibrium amount of labor employed, thus leading to a change in Real GDP and to a shift in the LRAS curve. Show this sequence of events diagrammatically.

This is shown in Exhibit 3(a) and 3(b).

Let labor be the variable shown on the horizontal axis and Real GDP on the vertical axis. Suppose there is a rise in labor. Does the rise lead to a movement along the production function or to a shift in the production function? Explain your answer. Next, draw the change in the LRAS curve that results from a rise in labor.

191

The production function is based on labor (L), capital (K), and technology (technology coefficient, T). More labor (L) leads to more Real GDP, which leads to a movement along the production function. More Real GDP shifts the LRAS curve to the right.

Again, let labor be the variable shown on the horizontal axis and Real GDP on the vertical axis. Suppose there is an increase in physical capital. Does the increase lead to a movement along the production function or to a shift in the production function? Explain your answer. Next, draw the change in the LRAS curve that results from an increase in physical capital.

The production function is based on labor (L), capital (K), and technology (technology coefficient, T). A rise in capital leads to a shift upward in the production function and an increase in Real GDP (for a given level of L and a given technology coefficient). More Real GDP leads to a rightward shift in the LRAS curve.

192

Solution’s Manual Arnold, Economics, 14e; Chapter 18: Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Table of Contents Content Grid ................................................................................................................... 194 Chapter 18: Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today ............................................................................................................................ 197 Answers to the Chapter Questions and Problems ................................................................................. 197

193

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

194

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

195

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

196

Chapter 18: Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today Answers to the Chapter Questions and Problems 1.

According to Joseph Schumpeter, where does the fundamental impulse that sets and keeps the capitalist engine in motion come from?

It comes from new consumers’ goods, the new methods of production or transportation, the new markets, and the new forms of industrial organization.

What is creative destruction?

It is a process whereby something is being created and something is being destroyed. New technologies, new kinds of products, new methods of production are being created and, at the same time, old technologies, old kinds of products, old methods of production are being destroyed, or are becoming obsolete.

Who, according to Schumpeter, plays the major role in the process of creative destruction?

The entrepreneur. It is the entrepreneur who comes up with new methods of production, new consumer goods, and in the process sometimes creates new markets.

Is the competition that Schumpeter talked about (within creative destruction) and perfect competition the same? Explain your answer.

No, the competition that Schumpeter talked about and perfect competition are not the same. Perfect competition refers to a market structure in which the seller of a good or service has no control over price. For Schumpeter, competition is a rivalrous process, where a seller comes up wit a new good, new production process, new technology; it is competition which ―commands a decisive cost or quality advantage and which strikes not at the margins of profits and the outputs of existing firms but at their foundations and their very lives.‖

One key measure of creative destruction is job flows. Explain.

When entrepreneurs come up with new consumers’ goods, and new methods of production or transportation, jobs are likely to follow. Also, the destructive part of creative destruction is likely to affect job flows too since the end of, say, of certain consumers’ goods, old methods of production, etc., are likely to come with unemployment. For example, the introduction of the automobile led to an increase in employment in the automobile industry (given that no one was

197

employed in the industry before it came into existence) and a decrease in employment in the buggy-making industry.

Give eight examples of products, technologies, or modes of transportation that can be considered part of the process of creative destruction.

Examples include the power loom, railroads, the steamship, moving assembly line, the telegraph and telephone, plastics, the incandescent bulb, engines of all sorts, film making, the automobile, the personal computer, the Internet, the microprocessor, lasers, fiber optics, satellite technologies, artificial intelligence, driverless cars, and genetic engineering.

How does education uncertainty relate to creative destruction?

With creative destruction, one is not sure which jobs creative destruction will create and which jobs it will destroy. Therefore, it places uncertainty on which jobs to train for and what education to acquire. In other words, if, with creative destruction, tomorrow’s job market is likely to look different than today’s, and one can’t be sure what it will look like, then it follows that one may be uncertain of what to study today to be ready for tomorrow.

What is the displacement effect? Give an example of it.

The displacement effect occurs when automation replaces workers in tasks that they previously performed. Examples include farm workers being displaced by harvesters and plows, travel agents and tax preparers being displaced by software.

What is the productivity effect and the reinstatement effect?

The productivity effect occurs when the cost of producing automated tasks declines, which in turn causes the economy to expand and increase the demand for labor in non-automated tasks. The reinstatement effect occurs when the creation of new tasks creates new jobs.

10.

What is crony capitalism?

It is ―a system in which government, big business, and powerful interest groups work together to further their joint interests. Government protects and subsidizes powerful corporation and in (implicit) exchange, the government uses those businesses to carry out government policies outside of the ordinary processes of government.‖ See ―Rent-Seeking, Crony Capitalism, and the Crony Constitution‖ by Todd Zywicki. Supreme Court Economic Review, Volume 23, Number 1, 2015.

198

11.

What is rent seeking?

Rent seeking consists of the actions of individuals and groups that spend resources to influence public policy in the hope of redistributing (transferring) income to themselves from others.

12.

Identify the two parts of rent seeking and explain each.

The two parts include the transfer part and the wasted-resources part. The transfer part consists of what moves from one group to another. For example, the transfer of some consumers’ surplus away from consumers to producers in the form of more producers’ surplus. The wasted-resources part consists of the resources expended to bring about the transfer.

13.

Give an example that illustrates the wasted-resources part of rent seeking.

A domestic firm expends resources to lobby government to impose tariffs on its foreign competitors who are exporting goods into the domestic economy. The resources expended are wasted (they are a loss to society as a whole) since they are used to bring about a transfer instead of being used to produce goods.

14.

What is the original meaning of the world ―monopoly’?

The original meaning of the word monopoly was the granting of a special privilege, by government, to someone or some group of persons to work in a particular trade or produce and sell a specific good.

15.

In this chapter, past and present examples of rent seeking were given. What was the effect of rent seeking on consumers in the following examples: The ferry boat company example, the taxi medallion example, the sugar example?

In the ferry boat example, the residents of the small community of Stehekin have fewer ferry boat companies to transport them back and forth from Stehekin. In the taxi medallion case, taxi rates would likely be higher than would be the case without taxi medallions. In the sugar example, sugar prices are higher than would be the case without import quotas and the loan program that effectively serves as an effective price floor on sugar.

16.

What are cargo preference laws and who are the chief beneficiaries of them?

Laws that require that a percentage of U.S. government cargo, including international food aid, must be transported by U.S.-flag vessels. The chief beneficiaries are the companies that own the U.S. flagged ships that carry the U.S. food aid.

17.

What does rent seeking have to do with lobbyists?

199

Often, rent seekers – those who are trying to obtain a transfer by way of a special privilege – will hire lobbyists to try to influence legislators to grant their special privileges.

Solution’s Manual Arnold, Economics, 14e; Chapter 19: Elasticity

Table of Contents Content Grid ................................................................................................................... 201 Chapter 19: Elasticity ...................................................................................................... 204 Answers to the Chapter Questions and Problems ................................................................................. 204 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 207

200

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

201

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

202

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

203

Chapter 19: Elasticity Answers to the Chapter Questions and Problems 1.

Explain how a seller can determine whether the demand for his or her good is inelastic, elastic, or unit elastic between two prices.

The seller can raise the price and see what happens to total revenue or analyze similar data from the recent past. If total revenue rises, demand is inelastic (between the two prices). If total revenue falls, demand is elastic. If total revenue remains constant, demand is unit elastic.

For each of the following, identify where demand is elastic, inelastic, perfectly elastic, perfectly inelastic, or unit elastic: (a) Price rises by 10 percent, and quantity demanded falls by 2 percent. (b) Price falls by 5 percent, and quantity demanded rises by 4 percent. (c) Price falls by 6 percent, and quantity demanded does not change. (d) Price rises by 2 percent and quantity demanded falls by 1 percent. a) Inelastic b) Inelastic c) Perfectly inelastic d) Inelastic

Prove that price elasticity of demand is not the same as the slope of a demand curve.

Exhibit 1 in the text is used to answer this question. To calculate the price elasticity of demand between points A and B, the percentage change in quantity demanded (between the two points) is divided by the percentage change in price (between the two points). Using the price elasticity of demand formula, the answer is 3.67. The slope of the demand curve between points A and B is the ratio of the change in the variable on the vertical axis to the change in the variable on the horizontal axis. The slope of the demand curve reflects the level of change, not the percentage change. Variable on vertical axis

-2

Slope = ————————————— = ——— = -0.04 Variable on horizontal axis

Suppose the current price of gasoline at the pump is $4 per gallon and that 1 million gallons are sold per day. A politician proposes to add a $1 tax to the

204

price of a gallon of gasoline. They say that the tax will generate $1 million in tax revenues per day. What assumption are they making? They assume that the demand for gasoline is perfectly inelastic. In other words, a higher price for gasoline does not change the quantity demanded of gasoline at all. This is not likely to be the case. We can conclude that the tax revenues will not be as high as the politician thinks they will be.

For each of the following, identify whether total revenue rises, falls, or remains constant: (a) Demand is inelastic and price falls. (b) Demand is elastic and price rises. (c) Demand is unit elastic and price rises. (d) Demand is inelastic and price rises. (e) Demand is elastic and price falls. a) Total revenue falls b) Total revenue falls c) Total revenue remains constant d) Total revenue rises e) Total revenue rises.

Suppose a straight-line, downward-sloping demand curve shifts rightward. Is the price elasticity of demand higher, lower, or the same between any two prices on the new (higher) demand curve than on the old (lower) demand curve?

It is lower. As the quantity demanded becomes larger at every price, the denominator of the fractions involving quantity becomes larger. Any absolute change in quantity is now a smaller percentage of the quantity demanded, and therefore, the numerator of the elasticity equation is always going to be lower.

Suppose a city is hit by a tornado that destroys 25 percent of the housing in the area. Would you expect the total expenditure on housing after the tornado to be greater than, less than, or equal to what it was before the tornado? Explain your answer.

The tornado shifts the supply curve of housing left, which raises the price of housing. The question is: What is the percentage change in quantity demanded compared to the percentage change in price? If the percentage change in quantity demanded is greater than the percentage change in price, total expenditure after the tornado (TEat) is less than total expenditure before the tornado (TEbt). If the percentage change in quantity demanded is less than the percentage change in price, TEat > TEbt. If the percentage change in quantity demanded is equal to the percentage change in price, TEat = TEbt.

For each of the following pairs of goods, which has the higher price elasticity of demand? (a) Airline travel in the short run or airline travel in the long run

205

(b) Television sets or Sony television sets (c) Cars or Fords (d) Cell phones or Samsung cell phones; (e) Popcorn or Orville Redenbacher’s popcorn a) Airline travel in the long run b) Sony television sets c) Fords d) Samsung cell phones e) Orville Redenbacher’s popcorn

How might you determine whether toothpaste manufacturers and mouthwash manufacturers are competitors?

Determine the cross elasticity of demand for toothpaste with respect to the price of mouthwash. If EC < 0, there is an inverse relationship between the quantity demanded of toothpaste and the price of mouthwash. This means the goods are complements. If EC > 0, there is a direct relationship between the quantity demanded of toothpaste and the price of mouthwash. The two goods are substitutes and thus are in competition with each other.

10.

Suppose that the demand for product A is perfectly inelastic and that the buyers of A get the funds to pay for it by stealing. (a) If the supply of A decreases, what happens to its price? (b) What happens to the amount of crime committed by buyers of A?

The price of A rises. Since demand is assumed to be perfectly inelastic, total expenditures on A rise. This means buyers must steal more in order to finance it.

11.

Suppose you learned that the price elasticity of demand for wheat is 0.7 between the current price for wheat and a price $2 higher per bushel. Do you think that farmers collectively would try to reduce the supply of wheat and drive the price up $2 higher per bushel? Explain your answer. Assuming that they would try to reduce supply, what problems might they have in actually doing so?

It would appear to be in the farmers’ collective best interest to raise the price by up to $2 per bushel, since doing so will increase the value of consumers’ total expenditures on wheat by more than the revenues lost due to selling less wheat. However, whether or not such a program works would depend upon a couple of factors. First, the availability of wheat from abroad may limit the farmers’ ability to raise the price by restricting domestic output. Secondly, if the price elasticity of supply is high enough, then many farmers may feel it is in their personal best interest to ―cheat‖ and increase their production as prices begin to rise (due to the general production cutbacks).

12.

In 1947, the U.S. Department of Justice brought a suit against the DuPont Company (which, at the time, sold 75 percent of all the cellophane in the United States) for monopolizing the production and sale of cellophane. In court, DuPont

206

tried to show that cellophane was only one of several goods in the market in which it was sold. The company argued that its market was not the cellophane market but the flexible-packaging materials market, which included (besides cellophane) waxed paper, aluminum foil, and other such products. DuPont pointed out that it had only 20 percent of all sales in this more broadly defined market. Using this information, discuss how the concept of cross elasticity of demand would help establish whether DuPont should have been viewed as a firm in the cellophane market or as a firm in the flexible-packaging materials market. The cross elasticity of demand (EC) between cellophane and the other products that DuPont alleges serve as suitable substitutes should be calculated. If EC > 0, then the two goods in question are substitutes for one another and DuPont has a valid case. If EC < 0, then it rules out the possibility of the two goods concerned to be complements. This is likely to weaken DuPont’s case that the relevant market includes other flexible packaging materials.

13.

―If government wishes to tax certain goods, it should tax goods that have inelastic rather than elastic demand.‖ What is the rationale for this statement?

The government can maximize tax revenue by placing the tax on goods with inelastic demand, since consumers are less likely to stop buying those goods at higher (after-tax) prices.

14.

A tax is placed on the sellers of a good. What happens to the percentage of this tax that buyers pay as the price elasticity of demand for the good decreases? Explain your answer.

The percentage of the tax that buyers pay increases. This is because as the price elasticity of demand for the good decreases, buyers become less likely to stop buying the good as its (aftertax) price rises.

Answers to the Problems in the Working Numbers and Graphs Section 1.

A college raises its annual tuition from $23,000 to $24,000, and its student enrollment falls from 4,877 to 4,705. Compute the price elasticity of demand. Is demand for the college elastic or inelastic?

Using the formula for Ed, we find: Ed = [(4,705 – 4,877)/(4,705 + 4,877)/2]/[(24,000 – 23,000)/(24,000 + 23,000)/2] = 0.84. Therefore, demand is inelastic, since Ed < 1.

207

As the price of good X rises from $10 to $12, the quantity demanded of good Y rises from 100 units to 114 units. Are X and Y substitutes or complements? What is the cross elasticity of demand?

Using the formula for Ec, we find: Ec = [(114 – 110)/(114 + 100)/2] ÷ [(12 – 10)/(12 + 10)/2] = 0.72. Therefore, X and Y are substitutes, since Ec > 0.

The quantity demanded of good X rises from 130 to 145 units as income rises from $2,000 to $2,500 a month. What is the income elasticity of demand for good X?

Using the formula for EY, we find: EY = [(145 – 130)/(145 + 130)/2] ÷ [(2,500 – 2,000)/(2,500 + 2,000)/2] = 0.491.

The quantity supplied of a good rises from 120 to 140 as price rises from $4 to $5.50. What is the price elasticity of supply of the good?

Using the formula for Es, we find: Es = [(140 – 120)/(140 + 120)/2] ÷ [(5.5 – 4)/(5.5 + 4)/2] = 0.487.

In the accompanying figure, what is the price elasticity of demand between the two prices on D1? On D2?

208

D1: Using the formula for Ed, we find Ed = [(8 – 12)/(8 + 12)/2] ÷ [(12 – $10)/(12 + 10)/2] = 2.2.

D2: Using the formula for Ed, we find Ed = [(10 – 12)/(10 + 12)/2] ÷ [(12 – $10)/(12 + 10)/2] = 1.

Solution’s Manual Arnold, Economics, 14e; Chapter 20: Consumer Choice: Maximizing Utility and Behavioral Economics

Table of Contents Content Grid ................................................................................................................... 210 Chapter 20: Consumer Choice: Maximizing Utility and Behavioral Economics ........................ 213 Answers to the Chapter Questions and Problems ................................................................................. 213 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 216

209

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

210

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

211

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

212

Chapter 20: Consumer Choice: Maximizing Utility and Behavioral Economics Answers to the Chapter Questions and Problems 1.

Give a numerical example that illustrates total utility rising as marginal utility declines.

Answers will vary. Eric gets $2 of utility from eating one Snickers Bar and $1 of utility from eating a second Snickers Bar in the same period. His total utility rises from $2 to $3 as he eats the second Snickers Bar, although his marginal utility fell from $2 to $1.

The law of diminishing marginal utility is consistent with the fact that people trade. Do you agree or disagree? Explain your answer.

Agree. If marginal utility were constant, then people would never trade. Trade only occurs when the marginal utility of consuming additional units of a good an individual already owns falls below the marginal utility of consuming units of a good that someone else owns.

―If we take $1 away from a rich person and give it to a poor person, the rich person loses less utility than the poor person gains.‖ Comment.

This statement may or may not be true. We do not know how much utility the rich person loses, nor how much utility the poor person gains.

Is it possible to get so much of a good that it turns into a bad? If so, give an example.

It is possible to get so much of a good that it turns into a bad. For example, consider hamburgers. The first hamburger a person eats usually tastes good and does a lot to satisfy his hunger. The second one tastes good, too, but not as good as the first, and does less to satisfy his hunger (since it has already largely been satisfied). The third hamburger does not taste anywhere as good as the first or second. The fourth hamburger makes the person feel somewhat nauseous. The fifth hamburger makes the person sick. A hamburger, which was once a good that gave a person utility, is now a bad, giving a person disutility.

If a person consumes fewer units of a good, will marginal utility of the good increase as total utility decreases? Why or why not?

Yes, it will, as long as the marginal utility of the units of the good no longer consumed is not negative. To illustrate, suppose the situation is as shown in Exhibit 1(a). If the consumer consumes 5 units of good X, total utility is 40 utils and marginal utility is 6 utils. If she

213

consumes one less unit of good X, or 4 units, total utility drops to 34 utils but marginal utility rises to 7 utils.

The marginal utility of good A is 4 utils, and its price is $2. The marginal utility of good B is 6 utils, and its price is $1. Is the individual consumer maximizing (total) utility if she spends a total of $3 by buying one unit of each good? If not, how can more utility be obtained?

The individual consumer is not maximizing utility. She is receiving 2 utils per dollar spent on good A and 6 utils per dollar spent on good B. She can increase her utility by purchasing more of good B (the good for which she receives more utility per dollar) and less of good A (the good for which she receives less utility per dollar).

Individuals who buy second homes usually spend less for them than they do for their first homes. Why is this the case?

The marginal utility, in terms of additional comfort, protection, etc., of the second home is not as great as that of the first. Therefore, since the marginal utility is less, so is the price that consumers are willing to pay.

Describe five everyday examples of you or someone else making an interpersonal utility comparison.

Examples will vary. Here are a few. Bob and Linda want to do different things on Sunday afternoon. Linda wants to go to the museum, while Bob wants to take a nap. Linda thinks to herself: ―I’m sure that I’d enjoy going to the museum more than Bob would enjoy getting two hours of sleep.‖ Dave and Buster are at the Pizza Hut, where they are rapidly approaching the end of a very enjoyable large pepperoni pizza. As Buster finishes his piece, he notices that only one slice is left. Rationalizing that he will enjoy it more, since he’s only eaten five slices while Dave is currently working on his sixth, Buster eats it. On the freeway, Gladys forces Marietta to move to the next lane so Gladys can get by, all the while assuming that her (Gladys’s) time and comfort are more valuable than Marietta’s. Jimmy spends his afternoons mowing lawns, trying to save money toward purchasing his first car. One day he approaches a new neighbor and asks about cutting her lawn. ―Sure,‖ says Mrs. Willis, ―we’ll be glad to pay you $10 to cut and edge our lawn.‖ Jimmy stops to think for a minute. ―Well, I guess that’s okay,‖ he says, ―but the Petersons pay me $15 for the same size lawn.‖ Ken and Debbie use teenagers for baby-sitters and pay them a fairly small amount per hour, based upon the assumption that a teenager’s time is worth less than an adult’s.

214

Is there a logical link between the law of demand and the assumption that individuals seek to maximize utility? (Hint: Think of how the condition for consumer equilibrium can be used to express the inverse relationship between price and quantity demanded.)

Yes. Individuals, seeking to maximize the utility they receive from the goods they purchase as well as the money they have to spend will buy more of a good only if the price of that good reflects their diminishing marginal utility.

10.

List five sets of two goods each (i.e., each set is composed of two goods; for example, diamonds and water make up one set) such that the good with the greater value in use has a lower value in exchange than does the good with the lower value in use.

Answers will vary. Here are a few examples. A loaf of bread and a custom T-shirt. One week’s worth of house payments and one week’s vacation in Acapulco. A Yugo and a $10,000 diamond and emerald necklace. A week’s groceries and a Nagel print.

11.

Do you think people with high IQs are in consumer equilibrium (equating marginal utilities per dollar) more often than people with low IQs? Why or why not?

If rats can figure out the optimal bundle of goods to purchase to maximize their utilities, then it should be possible for all people, regardless of intelligence. Smarter people do not necessarily do the right thing for themselves any more or less often than less smart ones.

12.

What is the endowment effect?

This is the notion that people value the things that they have at a higher value than things that they want to acquire. For example, a person wins a Ralph Lauren leather jacket that costs $600. He may prefer keeping that jacket to selling the jacket and buying a different one or keeping the cash.

13.

After each toss of the coin, one person has more money and one person has less. If the person with less money cares about relative rank and status, will he be willing to pay, say, $1 to reduce the other person’s winnings by, say, 50₵? Will he be willing to pay 25₵ to reduce the other person’s winnings by $1? Explain your answers.

In the first case no, but maybe in the second case. In the first case, the person with less money would be $1 worse off, in an absolute sense, and still be poorer than the person with more money, who would now be 50¢ poorer. With a loss in both absolute and relative wealth, there is no incentive to take that deal. In the second case, however, the person’s position, relative to the person with more money, would be improved by 75¢. So, that person may be willing to sacrifice 25¢ in absolute wealth to make this relative gain.

215

14.

How is buying a house in a good school district like sending children to a private school?

The difference in price between a house in a good school district and a similar house in a bad school district (that is, the marginal payment) can be considered a tuition payment for private (presumably good) schooling.

15.

Of two similar houses on a street, one faces the ocean and the other does not. How might we determine the price of an ocean view? Explain your answer.

The price of an ocean view is likely to be the difference in the prices of the two houses (that is, the marginal payment). If the view were not valuable, we would not expect a difference in price.

16.

What is framing and what effect can it have on the choices that individuals make?

Framing refers to the manner in which a problem is presented. The way a problem is framed can influence the choices one makes. The way a problem is framed can lead to a reversal of preferences. Even when there is no difference between options, how the options are framed matters to the outcome; framing matters to how people choose.

Answers to the Problems in the Working Numbers and Graphs Section 1.

The marginal utility for the third unit of X is 60 utils, and the marginal utility for the fourth unit of X is 45 utils. If the law of diminishing marginal utility holds, what is the minimum total utility of X?

We cannot tell for certain, except that it is greater than 105 utils. The first units consumed of the good might have lower marginal utilities than units three and four, as long as the MU’s of those units are higher than the MC of purchasing them. The law of diminishing marginal utility does not say that MU always starts high and declines, only that at some point it will decline.

Fill in blanks A-D in the following table.

216

A: 9 B: 27 C: 6 D: 2

The total utilities of the first 5 units of good X are 10, 19, 26, 33, and 40 utils, respectively. In other words, the total utility of 1 unit is 10 utils, the total utility of 2 units is 19 utils, and so on. What is the marginal utility of the third unit?

Marginal utility of the third unit = ΔTC/ΔQ = (26 utils – 19 utils)/1 = 7 utils.

Use the following table to answer questions 4 and 5: Units of Good X

Total Utility of Good X (utils)

Units of Good Y

Total Utility of Good Y (utils)

If Sam spends $5 (total) a week on good X and good Y, and if the price of each good is $1 per unit, then how many units of each good does he purchase to maximize utility?

Sam will buy the units with the highest marginal utility. He will buy unit one of good X (20 utils), then unit one of good Y (19 utils), then unit two of good X (15 utils), then unit two of

217

good Y (13 utils), and then unit three of good X (13 utils). So, he buys $3 worth of good X and $2 worth of good Y.

Given the number of units of each good that George purchases in Question 4, what is his total utility?

TU = ∑MU. So TU = 20 + 19 + 15 + 13 + 13 = 80 utils.

Draw the marginal utility curve for a good that has constant marginal utility.

In the above figure, the horizontal curve, MUx, represents the marginal utility curve for a good that has constant marginal utility.

The marginal utility curve for units 3-5 of good X is below the horizontal axis. Draw the corresponding part of the total utility curve for good X.

218

The above figure shows that the total utility (TUx) curve is rising when marginal utility falls, and TUx starts diminishing when marginal utility becomes negative.

Solution’s Manual Arnold, Economics, 14e; Chapter 21: Production and Costs

Table of Contents Content Grid ................................................................................................................... 220 Chapter 21: Production and Costs .................................................................................... 223 Answers to the Chapter Questions and Problems ................................................................................. 223 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 227

219

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

220

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

221

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

222

Chapter 21: Production and Costs Answers to the Chapter Questions and Problems 1.

Explain the difference between managerial coordination and market coordination.

Market coordination is impersonal: individuals are guided to do X instead of Y by impersonal forces, such as changes in price. Managerial coordination is personal: someone (a manager or monitor) tells someone else what to do.

Is the managerial coordination that goes on inside a business firm independent of market forces? Explain your answer.

No, it is not, as the following examples illustrate. A manager might direct employees to make 100 units of good X instead of 50 units of A and 50 units of B, but we reasonably assume that the manager of a profit-seeking business firm does not issue this directive independent of what she thinks can be sold in the marketplace. Similarly, the manager of a McDonald’s outlet might direct employees to make more fish sandwiches and fewer hamburgers for the lunch crowd, if he has reason to believe that the lunch crowd wants to buy more fish sandwiches and fewer hamburgers.

Explain why even conscientious workers will shirk more when the cost of shirking falls.

As long as shirking provides utility to a person, then a fall in the cost of shirking will cause even a hard and conscientious worker to shirk more. This is based on the idea that individuals are utility maximizers who will not turn their backs on a way to obtain more utility. Saying even hard and conscientious workers will shirk more when the cost of shirking falls is not saying that such persons are bad, immoral, or deserving of reprimand. It simply acknowledges the fact that utility-maximizing individuals respond to a change in costs relative to benefits.

Illustrate the average-marginal rule in a noncost setting.

Examples will vary. Here is one example. Suppose the average rating per TV show for a television network is 24. The network introduces a new TV show that has a rating of 28. The new show—the marginal show—pulls up the average rating. If the new show would have had a rating of 20, it would have pulled down the average rating. 5.

―A firm that earns only normal profit is not covering all its costs.‖ Do you agree or disagree? Explain your answer.

223

Disagree. Earning a normal profit is equivalent to earning zero economic profit. But a zero economic profit means that the owner generated enough revenue to cover both explicit and implicit costs. 6.

The average variable cost curve and the average total cost curve get closer to each other as output increases. What explains this convergence?

Average total cost is equal to the sum of average variable cost and average fixed cost. As output increases, average fixed cost decreases (AFC = TC/Q); therefore, as output increases, most of what makes up ATC is AVC. It follows that the ATC curve and AVC curve would get closer to each other as output increases. 7.

Explain why earning zero economic profit is not as bad as it sounds.

Earning zero economic profit—as bad as it may sound—means the owner has generated total revenue sufficient to cover total cost—that is, both explicit and implicit costs. 8.

Why does the AFC curve continually decline (and get closer and closer to the quantity axis)?

Since the formula for AFC is TFC/Q, as the quantity of output increases, AFC necessarily declines.

What is the difference between diseconomies of scale and the law of diminishing marginal returns?

The law of diminishing marginal returns applies to the short run, when at least one input is fixed, while diseconomies of scale occur when all inputs are variable, and is, therefore, a longrun concept. 10.

When would total costs equal fixed costs?

Total costs will equal fixed costs when there are no variable costs, which is another way of saying when output is zero. 11.

Is studying for an economics exam subject to the law of diminishing marginal returns? If so, what is the fixed input? What is the variable input?

Yes, at any given point in time, the fixed input is time remaining until the exam. The variable inputs are time spent studying, access to study materials, attention, and retention. 12.

Some individuals decry the decline of the small family farm and its replacement with the huge corporate megafarm. Discuss the possibility that this shift is a consequence of economies of scale.

If the minimum efficient scale for agricultural production is sufficiently high, small family farms cannot produce enough to be competitive with large, corporate farms. To the extent that the

224

replacement of family farms with corporate farms is a response to issues of scale economies, then, economically speaking, it is a good (read ―efficient‖) thing.

13.

We know that there is a link between productivity and costs. For example, recall the link between the marginal physical product of the variable input and marginal cost. With this link in mind, what link might there be between productivity and prices?

If costs are inversely related to productivity, then price should be as well, assuming that price and cost are positively related and fairly close to one another.

14.

Some people’s everyday behavior suggests that they do not hold sunk costs irrelevant to present decisions. Give some examples different from those presented in this chapter.

Examples will vary. Here are two. Rather than putting $1,000 down toward the purchase of a new car, Scott spends $1,000 on repairs to his 1979 Eldorado, figuring ―We’ve already spent so much on this car.‖ Rather than going out to a movie, Belinda stays home and watches a video on her VCR. ―Well,‖ she thinks aloud, ―I guess I’d better get my money’s worth out of this thing.‖

15.

Explain why a firm might want to produce its good even after diminishing marginal returns have set in and marginal cost is rising.

As long as the marginal benefit of producing each successive unit is greater than marginal cost, a firm will increase its total profits by increasing its production. So, even after MC begins to rise (as diminishing returns set in), producers will likely continue to produce until MC = the marginal benefit from selling the good.

16.

People often believe that large firms in an industry have cost advantages over small firms in the same industry. For example, they might think a big oil company has a cost advantage over a small oil company. For this to be true, what condition must exist? Explain your answer.

There must be economies of scale. The large firm has lower costs per unit than the small firm and thus has a cost advantage if it is operating where there are economies of scale. For example, in Exhibit 8(b), if a large company is operating at point A and a small company is operating to the left of point A, the large company has lower unit costs than the small company.

17.

The government says that firm X must pay $1,000 in taxes simply because it is in the business of producing a good. What cost curves, if any, does this tax affect?

225

The tax raises fixed costs by $1,000 so it affects TFC. Anything that affects TFC also affects TC because TC = TFC + TVC. Also, it must affect AFC because AFC = TFC/Q. Finally, it also affects ATC because ATC = AFC + AVC.

However, the tax does not affect marginal cost (MC). To see this, suppose we initially have the following data:

Quantity

TFC

TVC

$1,000

$20

$1,020

—

$1,000

$40

$1,040

$20

$1,000

$60

$1,060

$20

When the government places the tax on the firm, TFC for the firm rises to $2,000 (it was already $1,000). The new data look like this:

Quantity

TFC

TVC

$2,000

$20

$2,020

—

$2,000

$40

$2,040

$20

$2,000

$60

$2,060

$20

Notice that the TFC column and the TC column change, but that the MC column does not. Marginal cost (MC) is still $20. MC would have changed if the tax had affected TVC instead of TFC. For example, if the government had imposed a $4 tax per unit of good produced (instead of simply a lump-sum tax of $1,000), the numbers would have looked like this:

226

Quantity

TFC

TVC

$1,000

$24

$1,024

—

$1,000

$48

$1,048

$24

$1,000

$72

$1,072

$24

In this case, TVC is affected, as are TC and MC.

On the basis of your answer to question 17, does MC change if TC changes?

18.

Given that question 17 is phrased in a way that suggests a lump-sum tax, marginal cost would not change (as illustrated in the answer to question 17, above).

19.

Under what condition would a billionaire producer be rich yet earn zero economic profit?

Only under the condition that his opportunity costs were equal to the billions that he earns. Then his economic profit would be zero, since the billions would be required to keep him from changing his behavior.

Answers to the Problems in the Working Numbers and Graphs Section 1.

For each lettered space in the following table, determine the appropriate dollar amount:

(1) Quantity of Output, Q (units)

(2) Total Fixed Cost ($)

$200

200

(3) (5) Average (4) Average Fixed Total Variable Variable Cost (AFC) Cost (TVC) Cost (AVC)

(6) (7) Total Average (8) Cost Total Cost Marginal (TC) (ATC) Cost (MC) V

227

200

125

200

165

200

215

200

275

The answers are:

(1) Quantity of Output, Q (units)

(2) Total Fixed Cost ($)

(3) Average Fixed Cost (AFC)

(4) Total Variable Cost (TVC)

(5) Average Variable Cost (AVC)

(6) Total Cost (TC)

200

230

200

100

250

125

200

66.7

260

86.67

200

16.25

265

66.25

200

275

200

33.3

15.84

295

49.17

200

28.6

125

17.86

325

46.43

200

165

20.62

365

45.63

200

22.2

215

23.89

415

46.11

200

275

27.50

475

47.5

(7) Average Total (8) Cost Marginal (ATC) cost (MC)

Give a numerical example to show that as marginal physical product (MPP) rises, marginal cost (MC) falls.

Assume that each unit of input costs $100. Input

Output

MPP

100

$1.00 ($100/100)

250

150

$0.67 ($100/150)

500

250

$0.40 ($100/250)

228

Price = $20, quantity = 400 units, unit cost = $15, implicit costs = $4,000. What does economic profit equal?

Revenue = $20 × 400 = $8,000 Explicit costs = $15 × 400 = $6,000 Implicit costs = $4,000 Total costs = Implicit costs + Explicit costs = $6,000 + $4,000 = $10,000 The economic profit = $8,000 – $10,000 = -$2,000

If economic profit equals accounting profit, what do implicit costs equal?

In this case, implicit costs equal zero.

If accounting profit is $400,000 greater than economic profit, what do implicit costs equal?

In this case, implicit costs equal $400,000

If marginal physical product is continually declining, what does marginal cost look like? Explain your answer.

MC would be continuously increasing. If the additional output per unit of input is falling, the additional cost of producing one unit of output must be increasing.

If the ATC curve is continually declining, what does this imply about the MC curve? Explain your answer.

For ATC to be declining, MC must be less than ATC. So, if the ATC curve is continually declining, it must be true that the MC curve continuously lies below the ATC curve (MC need not be declining).

When will total cost equal total variable costs?

Total cost will equal total variable costs only when total fixed costs are equal to zero.

Answer the following: (a) If TVC = $80 and AVC = 4, then what does quantity (Q) equal? (b) If total cost is $40 when Q = 2 and total cost is $45 when Q = 3, then what does marginal cost equal? (c) What does average fixed cost equal at Q = 2 if total variable cost is $15 at Q = 2? (d) Why does the AFC curve get continually closer to the horizontal axis in Exhibit 6(c) as quantity of output increases?

229

a) Q = 20 units of output. Since TVC/Q = AVC, Q = TVC/AVC = 80/4 = 20. b) c) If TVC is $15 at Q = 2, then TFC must equal $25 since TFC = TC – TVC = $40 – $15 = $25. AFC then must equal $12.50 per unit since AFC = TFC/Q = 25/2 = $12.50. d) The AFC continually approaches the horizontal axis because AFC = TFC/Q, and as Q rises, the fixed TFC is spread across a larger number of units of output. Therefore, AFC falls as Q rises, but it never reaches zero since some fixed cost per unit, no matter how small, will always exist.

Solution’s Manual Arnold, Economics, 14e; Chapter 22: Perfect Competition

Table of Contents Content Grid 231 Chapter 22: Perfect Competition

234

Answers to the Chapter Questions and Problems ................................................................................. 234 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 237

230

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

231

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

232

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

233

Chapter 22: Perfect Competition Answers to the Chapter Questions and Problems 1.

―The firm’s entire marginal cost curve is its short-run supply curve.‖ Is the preceding statement true or false? Explain your answer.

The statement is false. Only that portion of the firm’s marginal cost curve that lies above the average variable cost curve is its supply curve. 2.

―In a perfectly competitive market, firms always operate at the lowest perunit cost.‖ Is the preceding statement true or false? Explain your answer.

False. A perfectly competitive firm will maximize profit (minimize losses) by producing that level of output where MR = MC. If the firm is breaking even, then P = MR = MC = SRATC. However, if P > SRATC or if P < SRATC, then P = MR = MC, which does not equal SRATC. See Exhibit 4. 3.

―Firm A, one firm in a competitive industry, faces higher costs of production. As a result, consumers end up paying higher prices.‖ Discuss.

This is not likely to be the case, or it certainly won’t be so for long. If one firm has higher costs and, as a result, must charge a higher price than its competitors, the other perfectly competitive firms will drive the less efficient firm out of the market.

Suppose all firms in a perfectly competitive market structure are in long-run equilibrium. Then demand for the firms’ product increases. Initially, price and economic profits rise. Soon afterward, the government decides to tax most (but not all) of the economic profits, arguing that the firms in the industry did not earn the profits. Rather, the profits were simply the result of an increase in demand. What effect, if any, will the tax have on market adjustment?

New firms will no longer have as great an incentive to enter the industry. Consequently, the industry supply curve will not increase by as much, and the new price will not be as low as it would have been had there been no tax. 5.

Explain why one firm sometimes appears to be earning higher profits than another but, in reality, is not.

To illustrate, suppose Fanning and Clemente each operate a single proprietorship that produces pasta. They both have identical fixed costs. Fanning, however, is much better at making pasta than Clemente and, as a result, has lower average variable and average total costs. Given that Fanning and Clemente sell their pasta at the same price, Fanning appears to have higher profits

234

than Clemente. We say ―appears‖ because Fanning’s implicit opportunity cost ought to be adjusted to reflect the higher pay he could receive (as compared to Clemente) if he were to work for someone else producing pasta. Once this is done, his variable costs will be the same as Clemente’s, and he will not be making any economic profits. This does not say that Fanning will not be making more dollars than Clemente, only that these ―more dollars‖ are not profits. They are a payment to Fanning’s superior skill at making pasta. Without this superior skill, this payment would not exist. 6.

For a perfectly competitive firm, profit maximization does not conflict with resource allocative efficiency. Do you agree? Explain your answer.

Agree. Not only does profit maximization for the perfectly competitive firm not conflict with resource allocative efficiency, it assures it. If the firm maximizes profit, it will produce the quantity of output at which MR = MC. Since P = MR for the perfectly competitive firm, it follows that the firm assures resource allocative efficiency (P = MC) by maximizing profit. 7.

The perfectly competitive firm does not increase its quantity of output without limit, even though it can sell all it wants at the going price. Why not?

Regardless of the limitless demand, the perfectly competitive firm has to take its own cost curves into account. Therefore, it will only sell up to the quantity where P = MC, because to go beyond that point, would cause the firm to lose money. 8.

You read in a business magazine that computer firms are reaping high profits. With the theory of perfect competition in mind, what do you expect to happen over time to each of the following? (a) Computer prices; (b) The profits of computer firms; (c) The number of computers on the market; (d) The number of computer firms.

Assuming that the computer industry is perfectly competitive (or at least acts as if it is), we would expect the existence of economic profits to attract new entrants into the market. This would, in turn, shift the market supply curve rightward, increasing sales, decreasing prices, and slashing profits. a) Computer prices will fall. b) The profits of computer firms will fall. c) The number of computers on the market will increase. d) The number of computer firms in the market will increase. 9.

In your own words, explain resource allocative efficiency.

We want to put our resources to the most efficient use possible. Therefore, we want to make sure that they are creating marginal benefits at least equal to the marginal cost of obtaining them.

235

10.

The term ―price taker‖ can apply to buyers as well as to sellers. A price-taking buyer is a buyer who cannot influence price by changing the amount she buys. What goods do you buy for which you are a price taker? What goods do you buy for which you are not a price taker?

Answers will vary, but in most cases, the average consumer is a price taker. The goods that consumers buy, for which they are not a price taker, such as houses and cars, often involve bargaining over price and features. 11.

Why study the theory of perfect competition if no real-world market completely satisfies all of the theory’s assumptions?

Though perfect competition may not exist in pristine form in the ―real world,‖ many markets approximate some or all of the underlying conditions for perfect competition: many buyers and sellers with no market power, homogeneous products, perfect information, and ease of entry and exit. Examples include the commodities markets, such as corn, wheat, and barley, and stock markets. In addition, even lacking perfect information or perfectly homogeneous products, a market may approximate these conditions such that it behaves ―as if‖ it were perfectly competitive. 12.

Explain why a perfectly competitive firm will shut down in the short run if price is lower than average variable cost but will continue to produce if price is below average total cost but above average variable cost.

If price is lower than average variable cost, a perfectly competitive firm will be unable to pay its variable factors of production (labor, electricity, etc.) let alone generate any money to help pay its fixed costs. If price is above average variable cost but below average total cost, each unit sold will generate some money to help pay the firm’s fixed costs. 13.

In long-run competitive equilibrium, P = MC = SRATC = LRATC. Because P = MR, we can write the preceding condition as P = MR = MC = SRATC = LRATC. The condition thus consists of four parts: (a) P = MR, (b) MR = MC, (c) P = SRATC, and (d) SRATC = LRATC. Part (b)—MR = MC—is true because the perfectly competitive firm attempts to maximize profits, and that equation represents how it does so. What are the explanations for (a), (c), and (d)? a) P = MR because, given the perfectly competitive firm’s horizontal demand curve, every unit sold yields the same price, so TR/Q is constant, just as price is constant. b) P = SRATC, because if that were not so, the market would respond. To wit, if P > SRATC, then one or more firms in the market would be making economic profit, and new firms would enter the market to absorb it; likewise, if P < SRATC, then one or more firms in the market would be experiencing losses, and if the condition persisted, they would be forced out of the market by ―leaner‖ competitors. c) If SRATC > LRATC, then firms would have an incentive to change their plant size until they achieved minimum average total cost, and once they did that, SRATC = LRATC.

236

14.

Suppose the government imposes the following production tax on one perfectly competitive firm in an industry: For each unit the firm produces, it must pay $1 to the government. Will consumers in this market end up paying higher prices because of the tax? Why or why not?

No. Since there are many producers and all producers’ products are interchangeable, if the firm’s costs are such that it is unable to pay the additional tax without raising its prices above the market price, the firm will be driven out of the market by other producers who can charge the market price and still cover costs. See answer 3 above. 15.

Why is the marginal revenue curve for a perfectly competitive firm the same as its demand curve?

The answer is that for a perfectly competitive firm, price equals marginal revenue (P = MR). A demand curve plots price and quantity, and a marginal revenue curve plots marginal revenue and quantity. If price equals marginal revenue, then both curves are plotting the same dollar amount against the same quantity. 16.

Many plumbers charge the same price for coming to your house to fix a kitchen sink. Is this because plumbers are colluding?

We do not know. Charging the same price may be the result of plumbers competing with each other or it may be that they are colluding with each other. 17.

Do firms in a perfectly competitive market exhibit productive efficiency? Why or why not?

Yes, but this is only guaranteed in long-run equilibrium. It is possible that, in the short run, a perfectly competitive firm produces its output at a unit cost higher than the lowest unit cost possible. Remember, productive efficiency exists when a firm produces its output at the lowest possible per-unit cost.

18.

Profit serves as both an incentive and a signal. Explain.

Profit serves as an incentive for individuals to produce, prompting or encouraging certain behavior. It also serves as a signal by identifying where resources are most welcome.

Answers to the Problems in the Working Numbers and Graphs Section 1.

Given the following information, state whether the perfectly competitive firm should shut down or continue to operate in the short run. a.

Q = 100; P = $10; AFC = $3; AVC = $4

Q = 70; P = $5; AFC = $2; AVC = $7

237

Q = 150; P = $7; AFC = $5; AVC = $6

a) Continue to operate since P > AVC. b) Shut down since P < AVC and ATC. c) Continue to operate since P > AVC.

If total revenue increases at a constant rate, what does this condition imply about marginal revenue?

Marginal revenue would be positive and constant. Marginal revenue is the additional revenue earned by selling one more unit. If each sale results in constant increases to revenue, then marginal revenue must be constant.

According to the accompanying table, what quantity of output should the firm produce? Explain your answer. Q

100

200

110

300

180

400

260

500

360

600

480

The firm should produce 5 units, since at that level of production MR = MC.

Is the firm in Question 3 a perfectly competitive firm? Explain your answer.

The price it charges is constant per unit sold, at $100. So, it is a perfectly competitive firm because its demand curve is horizontal.

Explain how a market supply curve is derived.

The market supply curve is the horizontal sum of all the individual firms’ supply curves.

238

Draw the relevant curves and the areas within them that show the following: (a) A perfectly competitive firm that earns profits (b) A perfectly competitive firm that incurs losses but that will continue operating in the short run (c) A perfectly competitive firm that incurs losses and that will shut down in the short run.

239

Panel (a) in the above figure shows a competitive firm that earns profit. The price (P) is above the average variable cost curve (AVC). Panel (b) shows a competitive firm that incurs losses but continues to operate since the price is below average total cost (ATC) curve but above the AVC curve. Panel (c) shows a competitive firm that incurs losses and will shut down in the short-run as the price is below the AVC and ATC.

Why is the perfectly competitive firm’s supply curve the portion of its marginal cost curve that is above its average variable cost curve?

Refer to section IIE above on this topic and Exhibit 7 in the text.

In the accompanying figure, what area(s) represent(s) the following at Q1? (a) Total cost; (b) Total variable cost; (c) Total revenue; (d) Loss (negative profit).

240

a) TC = 1 + 2 + 3 b) TVC = 1 + 2 c) TR = 1 d) Loss = 2 + 3

Why does the MC curve cut the ATC curve at the latter’s lowest point?

The average cost of a firm includes the fixed cost of production, whereas the marginal cost of a firm does not include the fixed cost. Generally, the average cost is more than the marginal cost at small quantities of production. Average cost decreases in quantity as long as the marginal cost is less than average cost. It increases in quantity when marginal cost is greater than average cost. This explains the U-shape of the average cost curve. The relationship between average cost and marginal cost implies that the marginal cost curve intersects the average cost curve at the latter’s minimum. Average cost and marginal cost come together or intersect when average cost has decreased to reach its minimum, but has not yet started increasing.

10.

Suppose all firms in a perfectly competitive market are in long-run equilibrium. Illustrate what a perfectly competitive firm will do if market demand rises.

This is illustrated in Exhibit 10 in the text.

Solution’s Manual Arnold, Economics, 14e; Chapter 23: Monopoly

Table of Contents Content Grid 243

241

Chapter 23: Monopoly 246 Answers to the Chapter Questions and Problems ................................................................................. 246 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 249

242

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

243

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

244

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

245

Chapter 23: Monopoly Answers to the Chapter Questions and Problems 1.

The perfectly competitive firm exhibits resource allocative efficiency (P = MC), but the single-price monopolist does not. What is the reason for this difference?

The reason is that the perfectly competitive firm faces a horizontal demand curve and the monopolist faces a downward-sloping demand curve. As long as the demand curve is horizontal, price will equal marginal revenue. This means that if the firm produces the quantity of output at which MR equals MC, it naturally equates P and MC. When the demand curve is downward sloping, price will be greater than marginal revenue. This means that if the firm produces the quantity of output at which MR equals MC, it cannot equate P and MC (since P and MR are not the same). In summary, the differences between a perfectly competitive firm and a monopolist firm are the result of one facing a horizontal demand curve and the other facing a downward-sloping demand curve.

Because the monopolist is a single seller of a product with no close substitutes, can it obtain any price for its good that it wants? Why or why not?

No, a monopolist cannot obtain any price for its goods that it wants. The monopolist is constrained by the demand curve it faces. It can only obtain as high a price as the demand curve warrants.

When a single-price monopolist maximizes profits, price is greater than marginal cost. In other words, buyers are willing to pay more for additional units of output than the units cost to produce. Given this situation, why doesn’t the monopolist produce more?

In order to sell additional units, the monopolist has to lower price on all previous units, thus marginal revenue (MR) will be less than price. It is MR, and not price that the monopolist compares with marginal cost (MC). It will not produce those units for which MC > MR, even if P > MC for them.

Is there a deadweight loss if a firm produces the quantity of output at which price equals marginal cost? Explain.

246

There is no deadweight loss if a firm produces the quantity of output at which price equals marginal cost. There would be no deadweight loss in perfect competition, for example. 5.

Under what condition will a monopoly firm incur losses?

Exhibit 4(b) from the text shows the condition under which a monopoly firm incurs losses. This occurs when, at the profit-maximizing level of output, ATC exceeds price.

A perfectly competitive firm will produce more output and charge a lower (perunit) price than a single-price monopoly firm. Do you agree or disagree with this statement? Explain your answer.

Agree. See Exhibit 6 in the text. In a perfectly competitive market, the demand curve is the MR curve. So, in Exhibit 6, the profit-maximizing output is QPC and buyers pay PPC per unit of the good. In monopoly, profit-maximizing output is determined by the intersection of the MR and MC curves. So, profit-maximizing output is QM (which is lower than QPC) and the price buyers pay is PM (which is higher than PPC).

Rent seeking is individually rational but socially wasteful. Explain.

Consider a monopolist whose profits (rents) are being sought after through the rent-seeking actions of persons A, B, and C. From the point of view of A, B, and C, it makes sense to go after the monopoly profits (rents); after all, profit is profit. However, from a social perspective, rent seeking does not produce any more goods. It is simply a transfer activity, not a production activity; resources that could be used to produce goods are instead used to effect a transfer of profits from one entity to another. Resources that go into lobbying, knocking on the doors of members of Congress, taking politicians out to dinner, and so on, could be used to build houses, television sets, or water slides for children.

Occasionally, students accuse their instructors, rightly or wrongly, of practicing grade discrimination. These students claim that the instructor ―charges‖ some students a higher price for a given grade than he or she charges other students (by requiring some students to do more or better work). Unlike price discrimination, grade discrimination involves no money. Discuss the similarities and differences between the two types of discrimination. Which do you prefer less or perhaps dislike more? Why?

247

If the instructor ―charges‖ more to students who are capable of ―paying‖ more—in terms of effort, time, and performance—then this would be similar to price discrimination whereby a firm charges customers what they are willing to pay. The problem is that price discrimination focuses upon willingness to pay, while grade discrimination focuses on ability to pay (regardless of willingness). For this reason, most people would find price discrimination more ―fair‖ than grade discrimination.

Make a list of real-world price discrimination practices. Do they meet the conditions posited for price discrimination?

Answers will vary, but might include variable tolls depending on the size and number of axles a vehicle has; student, employee, and senior citizen discounts (for movie tickets, for instance); and commercial versus residential electricity rates. The student must be careful to include only situations where prices vary but quality and quantity of the good or service do not. For example, different prices for different seats at a football game are not true price discrimination, whereas offering a discount to season ticket holders, students, or senior citizens would be.

10.

Make a list of market monopolies and a list of government monopolies. Which list is longer? Why do you think this is so?

Almost all of the monopolies that might come to the students’ minds are government monopolies, to the extent that the definition of government monopolies includes public franchises, as well as monopolies created by patents and licenses. The reason for this is that the government has, over most of the past 80 years, aggressively pursued and divested nongovernment monopolies such as Aluminum Corporation of America, Standard Oil, and AT&T.

11.

Fast-food stores often charge higher prices for their products in high-crime areas than they charge in low-crime areas. Is this an act of price discrimination? Why or why not?

It might be an attempt at self-insurance. Since stock lost to crime raises the unit cost of products actually sold, the firm may choose to raise prices to cover those higher costs. Also, a high incidence of crime makes it harder and more expensive to hire employees; thus, labor costs will rise, raising unit costs even higher. However, if the residents of the high-crime area are unable to leave the area to eat and since residents of low-crime areas rarely go to highcrime areas to eat, there may in fact be separate markets without the possibility of arbitrage. This means price discrimination is certainly possible. The residents of south central Los Angeles made this argument after the 1992 riots. Their anger was directed against certain shopkeepers who, it was argued, took advantage of the residents’ lack of mobility to charge higher prices.

248

12.

Coupons tend to be more common on small-ticket items than they are on bigticket items. Explain why.

Potential purchasers of big-ticket items probably differ less in their willingness to spend time to save money than do potential purchasers of small-ticket items. Almost everyone would take an extra 10 minutes to browse the ―coupons‖ to save 10 percent on a $100,000 house, whereas many people will not spend those 10 minutes browsing for a coupon to save 20 percent on a $1.00 loaf of bread. 13.

A firm maximizes its total revenue. Does it automatically maximize its profit too? Why or why not?

A firm maximizes both profits and total revenue at the same time only under the condition that it has no variable costs (so marginal costs are zero). If a firm has variable costs (which most firms do), then there is a difference between maximizing revenue and maximizing profits (MR = MC = 0). Economists assume that firms try to maximize profits, not revenues.

Answers to the Problems in the Working Numbers and Graphs Section 1.

Draw a graph that shows a monopoly firm incurring losses.

The following figure shows a monopoly firm that produces Q, sells it for P, and suffers a loss of (ATC – P) per unit.

249

A monopoly firm is currently earning positive economic profit, and the owner decides to sell it. He asks for a price that takes into account the economic profit. Explain and diagrammatically show what a price that takes into account economic profit does to the average total cost (ATC) curve of the firm.

The owner tries to convert economic profit into cost (assuming he and the buyer have the same opportunity costs). The average total cost will rise, lessening the economic profits of the new owner.

As shown in the graph, the firm is earning economic profit at ATC1, but the increase in ATC to ATC2 converts that to cost and the firm to a breakeven position.

Suppose a single-price monopolist sells its output Q1 at P1. Then it raises its price to P2, and its output falls to Q2. In terms of Ps and Qs, what does this monopolist’s marginal revenue equal?

Marginal revenue is the change in total revenue. Total revenue was P1Q1 and is now P2Q2, thus marginal revenue (MR) = P2Q2 – P1Q1.

250

Use the accompanying figure to answer questions 4, 5, and 6:

If the market is perfectly competitive, how much does profit equal?

If the market is perfectly competitive, economic profit is zero and normal profit is present.

If the market is a monopoly market, how much does profit equal?

If the market is a monopoly market, economic profit = revenue – cost = PQ – ATC(Q) = 90(50) – 50(50) = 4,500 – 2,500 = 2,000.

251

Redraw the figure and label consumers’ surplus when the market is perfectly competitive and when it is monopolized. $ 

Consumers’ surplus under monopoly = C = Consumers’ surplus under competition = A + B + C

Solution’s Manual B

Arnold, Economics, 14e; Chapter 24: Monopolistic Competition, Oligopoly, and Game Theory 50

Table of Contents Content Grid 253

MC = ATC

Q Chapter 23: Monopolistic Competition, 50 Oligopoly, and 100 Game Theory

256

Answers to the Chapter Questions and Problems ................................................................................. 256 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 258

252

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

253

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

254

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

255

Chapter 23: Monopolistic Competition, Oligopoly, and Game Theory Answers to the Chapter Questions and Problems 1.

What, if anything, do all firms in all four market structures have in common?

All firms, no matter what the market structure, produce the quantity of output at which marginal revenue equals marginal cost.

―Excess capacity is the price we pay for production differentiation.‖ Evaluate this statement in terms of monopolistic competition.

A monopolistic competitor in equilibrium produces an output smaller than the one that would minimize its costs of production, but, on the other hand, firms in a monopolistically competitive industry produce differentiated products.

Why might a producer use a designer label to differentiate her product from that of another producer?

Successful product differentiation gives a producer a better chance of becoming a monopolist.

Will there be profits in the long run in a monopolistically competitive market? Explain your answer.

Most likely, there will be no profits in the long run in a monopolistically competitive market because there are no barriers to entry for firms into the industry. Sufficient product differentiation in the minds of the buyers, however, may allow an existing firm to earn profits in the long run.

Would you expect cartel formation to be more likely in industries composed of a few firms or in those which include many firms? Explain your answer.

Cartel formation will be more likely in industries comprised of a few firms because it is easier and less costly for a few firms to get together and form a cartel than it is for many firms to do so.

Does the theory of contestable markets shed any light on oligopoly pricing theories? Explain your answer.

Yes, it does. It predicts that oligopolistic firms will price their products differently if the market they are in is contestable than if it is not. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

256

There are 60 types or varieties of product X on the market. Is product X made in a monopolistically competitive market? Explain your answer.

Product X may not necessarily be made in a monopolistically competitive market. The 60 different types of product could be made by four firms. If this is the case, it would be an oligopolistic market.

Why does the interdependence of firms play a major role in oligopoly but not in perfect competition or monopolistic competition?

The ability of the other firms in the market to lure customers away, or to match price decreases in order to preserve market share, makes anticipating ones competitors’ reactions much more important in oligopoly than in either perfect competition—where no firm has enough market power to worry—or monopolistic competition—where product differentiation insulates the firm somewhat from competitors’ actions.

Concentration ratios have often been used to note the tightness of an oligopoly market. A high concentration ratio indicates a tight oligopoly market, and a low concentration ratio indicates a loose oligopoly market. Would you expect firms in tight markets to reap higher profits, on average, than firms in loose markets? Would it matter if the markets were contestable? Explain your answers.

One would expect firms in tight markets to reap higher profits, on average, than firms in loose markets because the tighter the oligopoly the greater the likelihood of collusion. This will make the oligopoly more like a cartel and allow it to charge monopoly prices and reap monopoly profits. The presence of potential entrants will always limit monopolistic behavior.

10.

Market theories are said to have the happy consequence of getting individuals to think in more focused and analytical ways. Is this effect true for you? Give examples to illustrate.

Answers will vary.

11.

Give an example of a prisoner’s dilemma situation other than the ones mentioned in this chapter.

Answers will vary. Here is one example. Take two major league baseball owners, each of whom would like to restrain the runaway escalation of player salaries but are prevented from discussing individual players’ situations with one another. Assuming that both would also like to win their respective pennants, each will be forced to assume that the other will pay whatever it takes, and, thus, salaries will continue to rise.

257

12.

How are oligopoly and monopolistic competition alike? How are they different?

In both market structures, market power exists among some or all suppliers. In an oligopoly, it is because of the small number of suppliers; in monopolistic competition, it is because of product differentiation. As a result of the market power that exists, neither market will achieve the allocative efficiency of a perfectly competitive market. Producers in both markets may realize real economic profits. One significant difference between the two is the extent and nature of entry barriers. In oligopoly, they are typically significant. In a monopolistically competitive market, there are no barriers, per se; however, if consumers have developed brand loyalty, there may be significant de facto barriers that will make it very difficult for new competitors to take on established firms.

Answers to the Problems in the Working Numbers and Graphs Section 1.

Draw a graph that shows a monopoly firm incurring losses. Diagrammatically identify the quantity of output a monopolistic competitor produces and the price it charges.

Exhibit 1 in the text does this well, with quantity q1 and price P1.

Diagrammatically identify a monopolistic competitor that is incurring losses.

Price

ATC

D MR 0

Quantity

The above figure shows that, at the price P1, the monopolistic competitor incurs losses as price is below the average total cost curve (ATC).

258

Total industry sales are $105 million. The top four firms account for sales of $10 million, $9 million, $8 million and $5 million, respectively. What is the four-firm concentration ratio?

The four-firm concentration ratio is: CR4 = (10 + 9 + 8 + 5)/105 = 0.305

Refer to the accompanying figure. Because of a cartel agreement, a firm has been assigned a production quota of q2 units. The cartel price is P2. What do the firm’s profits equal if it adheres to the cartel agreement? What do the firm’s profits equal if it breaks the cartel agreement and produces q3?

The profits of the firm will be the rectangle P2BDC at quantity q2. If it cheats over to quantity q3, its profits will be the much larger rectangle P2AGF.

Solution’s Manual Arnold, Economics, 14e; Chapter 25: Government and Product Markets: Antitrust and Regulation

Table of Contents Content Grid 261 Chapter 25: Government and Product Markets: Antitrust and Regulation

264

Answers to the Chapter Questions and Problems ................................................................................. 264 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 267

259

260

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

261

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

262

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

263

Chapter 25: Government and Product Markets: Antitrust and Regulation Answers to the Chapter Questions and Problems 1.

Why was the Robinson-Patman Act passed? The Wheeler-Lea Act? The CellerKefauver Antimerger Act?

The Robinson-Patman Act was passed in an attempt to decrease the failure rate of small businesses by protecting them from competition from large chain stores. The Wheeler-Lea Act empowered the Federal Trade Commission (FTC) to deal with false and deceptive trade practices. The Celler-Kefauver Antimerger Act was designed to close a loophole in the Clayton Act by banning anticompetitive mergers that occurred as a result of one company acquiring the physical assets of another company.

Explain why defining a market narrowly or broadly can make a difference in how antitrust policy is implemented.

If a market is defined narrowly, there is a greater probability that a given firm will be said to be dominant in the market. Since the stated objective of antitrust policy is to promote competition and to reduce domination of a market by a single firm, the more narrowly a market is defined, the more likely antitrust action will be taken against a firm.

What is one difference between the four-firm concentration ratio and the Herfindahl index?

The four-firm concentration ratio ignores the relative concentration that exists among the four largest firms and smaller firms while the Herfindahl index attempts to measure this.

How does a vertical merger differ from a horizontal merger? Why would the government look more carefully at one than at the other?

A vertical merger occurs between firms at different stages of production, while horizontal mergers occur between firms at the same stage of production. A horizontal merger is more likely to increase concentration and reduce competition within an industry than a vertical merger, so the government looks more closely at horizontal mergers.

What is the implication of saying that regulation is likely to affect incentives?

Saying that regulation is likely to affect incentives implies that a firm’s behavior without regulation is likely to be different than it is with regulation. For example, if government were to regulate a natural monopoly by mandating that it could earn only zero economic profits—and it

264

was not allowed to earn more or less—then we would expect that the firm would have less reason to keep its costs down.

Explain price regulation, profit regulation, and output regulation.

Price regulation, profit regulation, and output regulation are all methods for regulating natural monopolies. Price regulation has the firm set price equal to marginal cost to achieve allocative efficiency; however, the firm may be unable to make a profit at this price. Profit regulation has the firm set price equal to average total cost; however, the firm loses its incentive to reduce cost when average-cost pricing is used. Output regulation mandates the quantity that the natural monopoly produces; however, the firm might lower the quality of the product as a way of increasing its profits.

Why might profit regulation lead to rising costs for the regulated firm?

Under profit regulation, the firm is allowed to use its average total costs after allowing for some return on capital. If average total costs rise, the firm is allowed to raise its price. Consequently, the firm does not have an incentive to lower its costs, and costs may rise.

What is the major difference between the capture theory of regulation and the public interest theory of regulation?

The public interest theory of regulation holds that regulators seek only to benefit the public interest with regulation. The capture theory says that no matter what the intent of the regulators (good, bad, or indifferent), those who are to be regulated will end up controlling the regulatory agency. The public interest theory of regulation holds that the public interest will be served through regulation; the capture theory holds that the interests of the regulated will be served. Thus, the two theories reach different conclusions as to the beneficiary of the regulation.

George Stigler and Claire Friedland studied both unregulated and regulated electric utilities and found no difference in the rates they charged. One could draw the conclusion that regulation is ineffective when it comes to utility rates. What ideas or hypotheses presented in this chapter might have predicted this result?

First, the chapter noted that regulators do not have complete information about the costs of the regulated firm. Consequently, the regulated firm may be able to present a cost picture (to the regulators) that is most likely to give it what it wants. Second, the capture theory of regulation would have predicted this outcome. If the regulators are ―captured‖ or controlled by the regulated firm, then regulation will likely give the regulated firm what it wants.

10.

The courts have ruled that it is a reasonable restraint of trade (and therefore permissible) for the owner of a business to sell his business and sign a

265

contract with the new owner saying that he will not compete with her within a vicinity of, say, 100 miles, for a period of, say, 5 years. If this type of contract is a reasonable restraint of trade, can you give an example of what you would consider an unreasonable restraint of trade? Explain how you decide what is a reasonable restraint of trade and what isn’t. Examples will vary but should be consistent with the idea that an unreasonable restraint of trade would reduce the overall competitiveness of the industry. For example, in the case of a single owner signing a ―no-compete‖ agreement, the negative effect on the degree of competition within the industry is likely to be negligible. On the other hand, a restraint such as an organized boycott of a group of producers and/or consumers would likely have much more effect on the overall competitiveness of the industry and will be more likely to be considered ―unreasonable.‖

11.

In your opinion, what is the best way to deal with the monopoly power problem? Do you advocate antitrust laws, regulation, or something not discussed in the chapter? Give reasons for your answer.

There is no correct answer here. The quality of the reasons given is what is important.

12.

It is usually asserted that public utilities such as electric companies and gas companies are natural monopolies, but an assertion is not proof. How would you go about trying to prove (or disprove) that electric companies and the like are (or are not) natural monopolies? (Hint: Consider comparing the average total cost of a public utility that serves many customers with the average total cost of a public utility that serves relatively few customers.)

Ideally, we would conduct an experiment that would allow one or more competing firms to enter the market and then determine whether the market is capable of sustaining them all, or whether there is, in fact, room for only one firm. In real life, such an experiment would be costly and potentially disruptive to residential and business customers. So, perhaps the best way to determine if a firm is a natural monopoly is to compare it to a similar market—where the product, number of customers, and cost structure closely approximate the market in question— and see whether that market enables more than one firm to produce at the minimum efficient scale.

13.

Discuss the advantages and disadvantages of regulation (as you see it).

The primary advantage of regulation is that it can reduce market failures such as the presence of externalities, public goods, monopoly power, and so forth. The government can subsidize positive externalities and tax negative externalities, or the government can provide these goods directly, for example, by providing free flu shots or banning the production of a lethal chemical. Because public goods are nonexcludable, private firms would be unable to collect enough revenue to provide the good, so the government must provide the good, using its power to collect taxes to fund the good. In the case of monopoly power, in the absence of public regulation, an inefficient level of the good would be produced, reducing economic welfare. The

266

government can remedy this situation either by regulating a natural monopoly or by preventing firms from merging and increasing their market power. Theory and practice often differ, and this leads to the disadvantages of regulation. The capture theory of regulation shows that government regulators may respond more readily to the demands of the regulated interest group than to the public as a whole because, relatively speaking, the interest group receives greater benefits from the government’s intervention than individual consumers are hurt. Interest groups will demand, and may receive, regulation that benefits them, without clearly considering the impact on the rest of society. There is evidence for government regulators making both choices that primarily benefit the regulators and making choices that benefit society as a whole.

14.

Explain how the lock-in effect might make it less likely for a firm that benefits from it to innovate.

A firm that benefits from a lock-in effect realizes that high switching costs keep its customers from switching to another network. Since a lock-in effect makes it less likely for customers to switch to another good, the producer has less incentive to innovate.

Answers to the Problems in the Working Numbers and Graphs Section 1.

Calculate the Herfindahl index and the four-firm concentration ratio for the following industry: Firms

Market Share (%)

The four-firm concentration ratio for this industry would be 60 percent, and the Herfindahl index would be 1,312.

267

268

Use the accompanying figure to answer questions 2, 3, and 4.

Is the firm in the figure a natural monopoly? Explain your answer.

Yes. One firm can produce all of the output required by the market, and larger firms will always be able to charge lower prices than small ones.

Will the firm in the figure earn profits if it produces Q3 and charges P3? Explain your answer.

The firm will lose money because it is pricing at marginal cost and the average total cost is higher, at that point, than price.

Which quantity in the figure is consistent with profit regulation? With price regulation? Explain your answers.

P2 is consistent with profit regulation because P = ATC at that point. Price regulation requires P = MC, which is P3.

269

Arnold, Economics, 14e; Chapter 26: Factor Markets: With Emphasis on the Labor Market

Table of Contents Content Grid 271 Chapter 26: Factor Markets: With Emphasis on the Labor Market 274 Answers to the Chapter Questions and Problems ................................................................................. 274 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 278

270

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

271

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

272

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

273

Chapter 26: Factor Markets: With Emphasis on the Labor Market Answers to the Chapter Questions and Problems 1.

What does it mean to say that the demand for a factor is a derived demand?

It means that it is the result of some other demand. The demand for factors is a derived demand because a firm hires factors to produce its output, and so, if the demand for its output changes, its demand for factors will also change.

Why is the MRP curve a firm’s factor demand curve?

The MRP curve shows the various quantities of the factor the firm is willing to buy at different prices, which is what a demand curve shows.

―VMP = MRP for a price taker but not for a price searcher.‖ Do you agree or disagree with this statement? Explain your answer.

Agree. VMP (which is P × MPP) equals MRP (which is MR × MPP) whenever P = MR. P = MR is a condition for a price taker but not for a price searcher. Therefore, VMP = MRP will hold only for a price taker.

Compare the firm’s least-cost rule with how buyers allocate their consumption dollars.

Both firms and consumers attempt to arrange their purchases in such a way that they receive equal additional benefits per dollar of expenditure.

The supply curve is horizontal for a factor price taker; however, the industry supply curve is upward-sloping. Explain why this occurs.

The firm’s supply curve is horizontal for a price taker because it can hire additional factor units and not drive up the price of the factor since it buys a relatively small portion of the factor. For the industry, however, higher factor prices must be offered in order to entice workers from other industries. The difference in the two supply curves—the firm’s and the industry’s—is basically a reflection of the different sizes of the firm and the industry.

What forces and factors determine the wage rate for a particular type of labor?

274

The best way to answer this question is to ask you to visualize a two-dimensional diagram with a downward-sloping demand curve for labor and an upward-sloping supply curve for labor. The wage rate in a competitive market is determined by the forces of supply and demand. But, these forces are what they are because of different factors. On the demand side is the price or marginal revenue of the product that labor produces. This is related to the demand for and supply of the product. Also on the demand side is the marginal physical product of labor. This, in turn, is dependent upon a number of factors: the other factors labor works with, labor, a person’s innate and learned abilities, and the degree of effort a person applies to the job. The supply of labor in a particular labor market depends upon the wage rates in other labor markets, the nonmoney or nonpecuniary aspects of a job, the number of persons who can do a job, the costs of moving across labor markets, and training costs necessary to join the particular labor market.

What is the relationship between labor productivity and wage rates?

As labor productivity increases, so do wage rates. This is due to the fact that an increase in labor productivity (MPP) causes the demand for labor to rise, by increasing the marginal revenue product (MRP). MRP = MPP × MR.

What might be one effect of government legislating wage rates?

We learned in this chapter that wage rates are determined by the demand for and supply of labor. If either the supply of or demand for a type of labor changes, and government doesn’t permit the wage rate to respond, we can expect to see either surpluses or shortages of labor in the particular labor market. Whether there is a surplus or shortage depends upon whether the legislated wage is above (surplus) or below (shortage) the equilibrium wage.

Using the theory developed in this chapter, explain the following: (a) Why a worker in Ethiopia is likely to earn much less than a worker in Japan; (b) Why the army expects recruitment to rise during economic recessions; (c) Why basketball stars earn relatively large incomes; (d) Why jobs that carry a health risk offer higher pay than jobs that do not, ceteris paribus. a) Japanese workers are considerably more productive, owing largely to superior training and better tools and production techniques; thus, their MPP is higher, which raises their MRP, which should also result in higher wages. b) During recessions, people buy fewer goods and services. As a result, labor demand falls, reducing the level of employment and increasing the level of unemployment. With a larger pool of unemployed workers looking for work and a decent wage, the armed forces have a much better chance of recruiting otherwise disinterested prospects than if the labor market were tight and the economy were booming. c) Basketball stars have natural abilities and have developed skills that make them unique. As a result, they are in short supply, and firms wishing to hire them must pay

275

exceptionally high wages in order to attract one or more. Stars also increase attendance and, therefore, revenue for their teams. d) Health risks would be considered a nonpecuniary aspect of a job. The greater the health risk, the greater the ―unpleasantness‖ of the task, and the higher the wage that must be paid (ceteris paribus) to attract a worker to take a ―risky‖ job over a less ―risky‖ one.

10.

Discuss the factors that might prevent the equalization of wage rates for identical or comparable jobs across labor markets.

Labor immobility, poor information, differing skills, varying degrees of productivity, and different supply and/or demand conditions for the products of labor may all create wage differentials for the same job across labor markets. First, if the supply of eligible workers is geographically concentrated, the wage those workers are paid, in the areas where they are in great supply, will be lower than the wage they are paid in areas where they are scarce. Second, workers and/or employers may not realize that two jobs are sufficiently identical that they should pay the same wage. Workers and/or employers may not be aware of the wages that are being paid for similar work elsewhere. Third, not all workers have the same skills and/or training. Thus, even if the job is the same, a worker with more experience, superior skills, and/or more or better training may be paid more on the assumption that he will be more productive at the same job than the average worker. Fourth, not all workers are equally productive. Since marginal productivity theory tells us that workers should be paid a wage equal to their MRP, differing levels of productivity mean differing MRPs and different wages. Fifth, and finally, if the same work is capable of producing goods with different demands and/or if the work may be done for suppliers with different degrees of market power (in the product market), then the MRP of labor will vary, even if the MPP is the same. As a result, a wage differential will also exist.

11.

Prepare a list of questions that an interviewer is likely to ask an interviewee in a job interview. Try to identify which of the questions are part of the interviewer’s screening process.

Lists will vary, but some examples of ―screening‖ questions are: ―Where did you get your degree?‖ ―What is/was your major field of study?‖ ―How much full-time work experience have you had?‖ ―What was your GPA?‖

12.

Explain why the market demand curve for labor is not simply the horizontal addition of the firms’ demand curves for labor.

See Exhibit 7. As the wage rate rises, a firm’s costs of production increase, shifting its supply curve leftward and raising the product price. As P increases, so does the MRP of labor (recall, MRP = MPP × P). Therefore, a change in the wage rate changes the MRP curve, resulting in a

276

market labor demand curve that is steeper than the labor demand curves of individual firms, as shown in Exhibit 7(c).

13.

Discuss the firm’s objective, its constraints, and how it makes choices in its role as a buyer of resources.

As a buyer of resources, the firm’s objective is to minimize cost while fully utilizing its factors. Its constraints are the price, productivity, and availability of those factors. The firm will try to achieve its objective by purchasing combinations of factors such that the ratio of marginal physical product (MPP) to price of the last unit of each input ―hired‖ will be equal. For example, in a two-input world, where L = labor and K = capital, MPPL/PL = MPPK/PK.

14.

Explain the relationship between each of the following pairs of concepts: (a) The elasticity of demand for a product and the elasticity of demand for the labor that produces the product; (b) The ratio of labor cost to total cost and the elasticity of demand for labor; (c) The number of substitutes for labor and the elasticity of demand for labor. a) If the demand for the product that labor produces is highly elastic, a small percentage increase in price will decrease quantity demanded of the product significantly, which will, in turn, decrease the quantity of labor demanded significantly. Therefore, the higher the elasticity of demand for the product, the higher the elasticity of demand for labor; and, likewise, the lower the elasticity of demand for the product, the lower the elasticity of demand for labor. b) The higher the percentage of total cost accounted for by labor, the more elastic the demand for labor, since an increase in wage rates will raise total cost more under such circumstances, increasing price and reducing quantity demanded of the product. c) The more substitutes available for any good or service, the more elastic the demand for that good or service, since a price increase can be responded to by looking to the substitutes.

15.

How might you go about determining whether a person is worth the salary he or she is paid?

A person is worth the salary he or she is paid as long as their MRP exceeds that salary. So, to determine whether someone is worth their salary you would need to compare their salary with their MRP.

16.

What do substitution and income effects have to do with the supply curve of labor?

The supply curve of labor will be upward-sloping only if the substitution effect is stronger than the income effect.

277

Answers to the Problems in the Working Numbers and Graphs Section 1.

Determine the appropriate numbers for the lettered spaces. (1) Units of Factor X

(2) Quantity of Output

0 1 2 3 4 5

(3) MPPX

(4) Product Price = Marginal Revenue

(5) Total Revenue

(6) MRPX

15 24 32 39 45 50

0 A B C D E

$8 8 8 8 8 8

F G H I J K

L M N O P Q

Units of Factor X

Quantity of Output

MPPX

Product Price = Marginal Revenue

Total Revenue

MRPX

0 1 2 3 4 5

15 24 32 39 45 50

0 9 8 7 6 5

$8 8 8 8 8 8

$120 192 256 312 360 400

$ 0 72 64 56 48 40

The answers are:

On the basis of the preceding table, if the price of a factor is constant at $48, how many units of the factor will the firm buy?

MRP = MFC at 4 units of the factor.

In one diagram, draw the VMP curve and the MRP curve for an oligopolist. Explain why the curves look the way you drew them.

Exhibit 3(b) in the text is the appropriate graph. Because P > MR in oligopoly, and VMP = P × MPP and MRP = MR × MPP, there will be two separate curves, and the VMP will be greater than the MRP.

Explain why the factor supply curve is horizontal for a factor price taker.

Exhibit 4 in the text shows and explains this answer.

278

279

Look at the two factor demand curves in the accompanying figure. Is the price of the product that labor goes to produce higher for MRP2 than for MRP1? Explain your answer.

MRP = MR × MPP. If we assume that the MPP remains constant between the two curves, then the shift must be due to a change in the marginal revenue (MR). If the MR has risen, then price has risen as well, so MRP2 must have a higher-priced product. However, if we drop the assumption of a constant MPP, it could be that price is constant and MPP is higher along MRP2.

Solution’s Manual Arnold, Economics, 14e; Chapter 27: Wages, Unions, and Labor

Table of Contents Content Grid 281 Chapter 27: Wages, Unions, and Labor

284

Answers to the Chapter Questions and Problems ................................................................................. 284 Answers to the Problems in the Working Numbers and Graphs Section .............................................. 287

280

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

281

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

282

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

283

Chapter 27: Wages, Unions, and Labor Answers to the Chapter Questions and Problems 1.

Will a union behave differently if it wants to get all of its members employed instead of maximizing the total wage bill? Explain your answer.

Most likely, yes. The total wage bill is maximized by choosing the wage-quantity combination at the point where the demand for labor is unit elastic. Assuming that the resulting quantity of workers is smaller than the total number of union members, then the wage it must bargain for to employ all members will be lower.

What does the elasticity of demand for labor have to do with the wageemployment tradeoff?

The more elastic is the demand for labor, the bigger will be the wage-employment tradeoff.

Identify one practice of labor unions that is consistent with the following: (a) Affecting the elasticity of demand for union labor; (b) Increasing the demand for union labor; (c) Decreasing the supply of labor union workers.

Answers will vary. a) Generally, though, labor unions try to affect the elasticity of demand for union labor by reducing the availability of substitute products and factors. b) They try to increase the demand for union labor by increasing demand for the product they produce, by increasing substitute factor prices, and by increasing the MPP of their members. c) They try to decrease the supply of union labor through the use of union shops.

What view is a labor union likely to hold on each of the following issues? (a) A quota on imported products; (b) Free trade; (c) A decrease in the minimum wage. a) A labor union is likely to be for a quota on imported products, especially if it applies to products similar to those produced by workers in the union. b) A labor union is likely to be against free trade for the same reason that it is in favor of quotas. c) A labor union is likely to be against decreasing the minimum wage. A decrease in the minimum wage decreases the price of a substitute factor for union labor—something that is not in the best interest of union labor.

284

Most actions or practices of labor unions are attempts to affect one of three factors. What are they?

The activities or practices of labor unions are, for the most part, attempts to affect the elasticity of demand for labor (in order to soften the wage-employment tradeoff), the demand for labor (in order to increase union wage rates), and the supply of labor (in order to increase union wage rates).

Explain why the monopsonist pays a wage rate less than labor’s marginal revenue product.

First, the supply curve of labor the monopsonist faces is the industry supply curve; thus, if it wants to hire additional labor, it must offer a higher wage rate. Second, as a result, the marginal factor cost is greater than the wage rate—that is, MFC > wage rate. Third, since the monopsonist hires the amount of labor at which MRP = MFC, it follows that the wage rate will be less than labor’s MRP.

Organizing labor unions may be easier in some industries than in others. What industry characteristics make unionization easier?

All other things held constant, the lower the elasticity of demand for the product that labor produces, the easier unionization efforts will be. This is because when there is low elasticity of demand, an increase in wage rates results in a smaller percentage fall in employment than when there is high price elasticity of demand. Since employees thinking about becoming unionized care whether they keep their jobs, they will be less likely to unionize if more jobs must be traded for any given wage rate increase.

What is the effect of labor unions on nonunion wage rates?

Labor unions decrease the wage rates of nonunion labor. If a union is successful at either collectively bargaining or decreasing the supply of their labor in order to achieve higher wage rates, fewer people will end up working in the union sector of the labor market. The excess will move to the nonunion sector, thus increasing the supply of nonunion labor and decreasing the nonunion wage rate.

Some persons argue that a monopsony firm exploits its workers if it pays them less than their marginal revenue products. Others disagree. They say that, as long as the firm pays the workers their opportunity costs (which must be the case, or else the workers would not stay with the firm), the workers are not being exploited. This view suggests that there are two definitions of exploitation: (a) Paying workers below their marginal revenue products (even if wages equal the workers’ opportunity costs); (b) Paying workers below their opportunity costs. Keeping in mind that your answer may be a subjective judgment, which definition of exploitation do you think is more descriptive of the process and why?

285

The first definition—paying workers less than their marginal revenue product—seems to be more descriptive of the exploitation that most people see occurring in monopsony situations. As stated, if the monopsonist were paying workers less than their opportunity costs, then the workers would leave. However, if the firm is a monopsonist, it can get away with paying workers less than their MRP, because the firm hires at MFC = MRP, but MFC > W; therefore, MRP > W.

10.

A discussion of labor unions usually evokes strong feelings. Some people argue vigorously against labor unions; others argue with equal vigor for them. Some people see labor unions as the reason workers in this country enjoy as high a standard of living as they do; others see labor unions as the reason the country is not so well off economically as it might be. Speculate on why the topic of labor unions generates such strong feelings and emotions— often with little analysis.

The worker-management relationship in the United States is considerably more adversarial than in most other developed economies. Unions may add to this adversarial feeling. As a result, most people take sides—supporting either labor or management—and allow the emotions of the issue to cloud their judgment and analysis. In addition, unions deal with two things that are very important to most people: their jobs and their salaries.

11.

What forces may lead to the breakup of an employer (monopsony) cartel?

The most important force would be the entry of one or more new firms into the labor market. Additionally, the existence of a labor union does not break up a monopsony, per se, but it will decrease the monopsony’s ability to choose its wage rate and level of employment.

12.

Unions can affect (a) a firm’s profits, (b) the price consumers pay for a good, and (c) the wages received by nonunion workers. Do you agree or disagree? Explain your answer.

(a) Disagree. In the short run it is possible for higher wages to come out of profits, but in the long run, as firms adjust, this is not likely to be the case. (b) Agree. The higher union wages mean higher costs for the firms that employ union labor, and higher costs affect supply curves, which in turn lead to higher prices. (c) Agree. Higher union wages lead to less labor being employed in the unionized sector. As this labor moves to the nonunion sector, wages there are driven down.

13.

Contrast the traditional (or orthodox) and new views of labor unions.

The traditional view holds that labor unions have a negative impact on productivity and efficiency. They often have unnecessary staffing requirements and disrupt production through strikes. They also drive an artificial wedge between the wages of comparable labor in the union and nonunion sectors of the labor market. The traditional view of labor unions says that they lead to a misallocation of labor. The new view, on the other hand, recognizes that unions are

286

not all bad: that they provide a collective voice that reduces quit rates and leads to happier, more productive workers. They also help to ensure that employees feel more confident, less intimidated, and more secure in their work.

Answers to the Problems in the Working Numbers and Graphs Section 1.

Determine the appropriate numbers for the lettered spaces. (1) Workers

(2) Wage Rate

(3) Total Labor Cost

(4) Marginal Factor Cost

1 2 3 4

A $12.10 12.20 B

$12.00 24.20 C D

$12.00 E F 12.60

Workers

Wage Rate

Total Labor Cost

Marginal Factor Cost

1 2 3 4

$12.00 12.10 12.20 12.30

$12.00 24.20 36.60 49.20

$12.00 12.20 12.40 12.60

The answers are:

Which demand curve for labor in the accompanying figure exhibits the most pronounced wage-employment tradeoff? Explain your answer.

D3. As the wage rises, the largest changes in employment occur on D3 (it represents the most elastic demand).

287

Diagrammatically explain how changes in supply conditions and wage rates in the unionized sector can cause changes in supply conditions and wage rates in the nonunionized sector.

Exhibit 6 in the text does this well.

Solution’s Manual Arnold, Economics, 14e; Chapter 28: The Distribution of Income and Poverty

Table of Contents Content Grid ................................................................................................................... 289 Chapter 28: The Distribution of Income and Poverty .......................................................... 292 Answers to the Chapter Questions and Problems ................................................................................. 292 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 294

288

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

289

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

290

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

291

Chapter 28: The Distribution of Income and Poverty Answers to the Chapter Questions and Problems 1.

What percentage of total money income did the lowest fifth of households receive in 2019? The fourth fifth?

The lowest fifth of households received 3.1 percent of the total money income. The fourth fifth 22.7 percent of the total money income.

―The Gini coefficient for country A is 0.35, and for country B it is 0.22. Therefore, the bottom 10 percent of income recipients in country B have a greater percentage of the total income than the bottom 10 percent of the income recipients in country A.‖ Do you agree or disagree? Why?

Disagree. The Gini coefficient gives us a measurement of the degree of income inequality overall; it does not tell us the percentage of income that is received by a specific income group. It is possible for the bottom 10 percent of income recipients in a country, with a lower Gini coefficient, to receive a lower percentage of total income than the same group receives in a country with a higher Gini coefficient.

Would you expect greater income inequality in country A, where there is a large disparity in age, or in country B, where there is a small disparity in age? Explain your answer.

All other things held constant, we would expect more income inequality in country A where there is great disparity in age. We know that most persons’ income starts off low, rises in their 20s, 30s, and 40s, takes a slight downturn in their late 40s or early 50s, and then levels off. In a country where the disparity in age is great, the income distribution will reflect the fact that many people are in different stages of their life-cycle earnings pattern (and the more ―different stages‖ there are, the greater the income inequality). In a country where there is little disparity in age, the income distribution will reflect the fact that most people are in the same stage of their life-cycle earnings pattern (and the fewer ―different stages‖ there are, the less the income inequality).

Compare the U.S. income distribution in 1967 with the income distribution in 2019. Has U.S. income inequality increased or decreased? What percentage of total money income did the top fifth of U.S. households receive in 2019?

U.S. income inequality increased from 1967 to 2019. In 2019, the top fifth of U.S. households received 51.9 percent of total money income.

292

What role might each of the following play in contributing to income inequality: (a) Risk taking, (b) Education, (c) Innate abilities and attributes?

All of the following can contribute to income inequality. (a) The more risk-takers there are, the more income inequality we can expect, as these risk-takers become wildly successful or lose their shirts. (b) The greater the variance in educational attainment, the more income inequality we can expect, since high educational attainment is associated with higher income. (c) The greater the variance in innate abilities and attributes, the more income inequality we can expect, since those with greater abilities and attributes are more likely to earn higher incomes than those with lesser abilities and attributes.

Welfare recipients would rather receive cash benefits than in-kind benefits, but much of the welfare system provides in-kind benefits. Is there any reason for not giving recipients their welfare benefits the way they want to receive them? Would it be better to move to a welfare system that provides benefits only in cash?

The notion behind in-kind benefits is that it allows the government to ―target‖ its assistance to those needs—such as housing, medical care, and nutritional requirements—that policy makers see as being the most important. If the government were to provide all benefits in cash, it would have no control over how those benefits were spent, and a number of people might still be without decent housing (etc.), despite receiving their welfare benefits. A second reason is that in-kind benefits bypass the difficult process of assessing cash value to certain basic needs. For instance, by assuring some minimum level of medical assistance, the government avoids having to calculate some ―medical budget‖ for welfare recipients in a world where health costs are constantly changing. Related to this, the government can pay for only those benefits received, so that it doesn’t provide unneeded assistance; thus, both the idea of ―targeting‖ benefits and the desire to keep costs down are somewhat appeased this way.

What is the effect of age on income distribution?

More young people are poor than other age groups. As the population ages, the distribution of income could improve because lower-income young people represent a smaller proportion of the population.

Can more people live in poverty at the same time that a smaller percentage of people live in poverty? Explain your answer.

Yes. Suppose there are 100 people in the population and 10 of them live in poverty. The poverty rate is 10 percent. Now suppose that the population rises to 250 and the number of people in poverty rises to 20. The absolute number of people living in poverty has risen to 20 (doubled), but the poverty rate has fallen to 8 percent, since 20 is 8 percent of 250.

293

How would you determine whether the wage difference between two individuals is due to wage discrimination?

We would have to eliminate other factors that are different between the two: education, experience, work history, etc., until we are left with a difference (or not) that cannot be accounted for by other factors.

10.

Define each of the following: (a) In-kind transfer payment, (b) Lorenz curve, (c) Wage discrimination. a) An in-kind transfer payment is a payment made in a specific good or service, such as medical assistance and subsidized housing, rather than in cash. b) The Lorenz curve represents the distribution of income; it is a graph that expresses the relationship between the cumulative percentage of households and the cumulative percentage of income. c) Wage discrimination occurs when individuals of equal ability and productivity (as measured by their contribution to output) are paid different wage rates.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

The lowest fifth of income earners have a 10 percent income share; the second fifth, a 17 percent income share; the third fifth, a 22 percent income share; the fourth fifth, a 24 percent income share; and the highest fifth, a 27 percent income share. Draw the Lorenz curve. Actual Perfect

The Lorenz curve shows the cumulative percentage of income earned by the cumulative percentage of households. If all households received the same percentage of total income, the Lorenz curve would be the line of perfect income equality represented by the straight dashed line in the figure. The bowed Lorenz curve shows an unequal distribution of income.

294

In Exhibit 7, using Lorenz curve 2, calculate the approximate percentage of income that goes to the second-highest 20 percent of households?

The graph shows us that 60 percent of households receive approximately 40 percent of the income and that 80 percent of households receive approximately 60 percent of the income, therefore the second highest 20 percent of households receive around 20 percent of the income. 3.

Is it possible for everyone’s real income to rise even though the income distribution in a society has become more unequal? Prove your answer with a numerical example.

Yes. Examples will vary, but here is one: There are only two people in an economy, Jones and Smith. Jones has an income of $10,000 and Smith has an income of $40,000. Smith earns 4 times more than Jones. Now suppose Jones has $20,000 and Smith has $160,000. Both Smith and Jones have more income, but now Smith has 8 times more income than Jones. The income distribution between Jones and Smith becomes more unequal even as both earn more income.

Solution’s Manual Arnold, Economics, 14e; Chapter 29: Interest, Rent, and Profit

Table of Contents Content Grid ................................................................................................................... 296 Chapter 29: Interest, Rent, and Profit ............................................................................... 299 Answers to the Chapter Questions and Problems ................................................................................. 299 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 302

295

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

296

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

297

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

298

Chapter 29: Interest, Rent, and Profit Answers to the Chapter Questions and Problems 1.

What does it mean to say that an individual has a positive rate of time preference?

An individual who has a positive rate of time preference would prefer earlier availability of goods to later availability. 2.

What does having a positive rate of time preference have to do with positive interest rates?

Consumers who have a positive rate of time preference prefer earlier availability of goods to later availability. A positive interest rate is the price consumers or borrowers pay for the earlier availability of goods.

How would the interest rate change as a result of the following? (a) A rise in the demand for consumption loans; (b) A decline in the supply of loanable funds; (c) A rise in the demand for investment loans.

The interest rate will (a) rise, (b) rise, (c) rise.

The interest rate on loan X is higher than the interest rate on loan Y. What might explain the difference in interest rates between the two loans?

Loan X might be riskier, have a longer term, or be more costly to process and administer than loan Y.

The real interest rate can remain unchanged as the nominal interest rate rises. Do you agree or disagree with this statement? Explain your answer.

Agree. When the nominal interest rate rises by an amount equal to the expected inflation rate, the real interest rate will remain unchanged.

What type of person is most willing to pay high interest rates?

We expect that individuals who have a stronger preference for present over future consumption will be the most willing to pay high interest rates. That is, persons with a higher positive rate of time preference will be more willing to pay a higher interest rate than persons with a low positive rate of time preference.

299

Some people have argued that, in a moneyless (or barter) economy, interest would not exist. Would it? Explain your answer.

This is not true because interest can be viewed as the manifestation of a positive rate of time preference. Individuals living in a moneyless or barter economy may be as inclined to a positive rate of time preference as individuals living in a money economy. Whereas individuals living in a money economy pay their interest in money, individuals living in a moneyless economy would pay their interest in terms of goods and services (two chickens next week for one chicken this week).

In what ways are a baseball star who can do nothing but play baseball and a parcel of land similar?

One might begin by saying that the opportunity cost of each is zero and, therefore, any payment is pure economic rent. However, this is only one way of looking at the question. It could also be said that the baseball star has the opportunity of playing for a team other than the one he currently plays for, and that the land can be used for something other than its present use. Looking at things this way, each would then have opportunity costs, and therefore, any payment each received would not be pure economic rent (although some economic rent may be received).

What does it mean to say that land rent is price determined, not price determining?

It means that landowners have no control over the price of land because they have no control over the demand for land. The demand for land is determined by the demand for grain prices or for living, shopping, and dining in a particular locale.

10.

What is the link between profit and uncertainty?

An investor-decision maker who is adept at making business decisions under conditions of uncertainty earns a profit.

11.

What is the overall economic function of profits?

Profits direct resources. If a good is linked to profits, there is an inclination for resources to flow into the production of that good. Negative profit, or loss, also directs resources. If a good is linked to losses, there is an inclination for resources to flow out of the production of that good.

12.

―The more economic rent a person receives in his job, the less likely he is to leave the job and the more content he will be on the job.‖ Do you agree or disagree? Explain your answer.

To the extent that one’s job satisfaction is largely determined by pay, and pay is judged relative to the opportunity cost of doing the job, this is probably a true statement. Of

300

course, many non-monetary factors should also be considered, and their importance in determining whether the worker will be content on the basis of his economic rent will depend on whether they are fully incorporated into the worker’s notions of opportunity cost.

13.

It has been said that a society with a high savings rate is a society with a high standard of living. What is the link (if any) between saving and a relatively high standard of living?

Higher savings make it possible to fund greater amounts of investment, thus increasing productive capacity and allowing the economy to grow more rapidly. Further, to the extent that greater savings may lower interest rates, consumers will be able to borrow more freely and pursue their positive rate of time preference, making them feel more well-to-do.

14.

Make an attempt to calculate the present value of your future income.

Answers will vary, depending on the student’s assessment of his/her future earning potential. The proper method is to treat future income as a stream of payments, so that we can calculate the present value for each year and then add the values.

15.

Describe the effect of each of the following events on individuals’ rate of time preference and thus on interest rates: (a) A technological advance that increases longevity; (b) An increased threat of war; (c) Growing older. a) If individuals feel that they will live longer, they may be less inclined toward current consumption, reducing their rate of time preference and their demand for consumer loans and, thus, reducing the interest rate. b) By the same logic, if individuals feel less certain about their future prospects, they will likely increase their desire for current consumption, increasing their rate of time preference and their demand for loanable funds and, thus, increasing the rate of interest. c) Same as b.

16.

―As the interest rate falls, firms are more inclined to buy capital goods.‖ Do you agree or disagree? Explain your answer.

Yes. A reduction in interest rates raises the present value of potential investments, making more of them economical. As a result, firms will increase their demand for capital goods and the loanable funds with which to purchase them.

17.

What is it that the entrepreneur does?

Entrepreneurs are the people who try to figure out where economic opportunities are available. They work toward increasing the number of trades in a market. They turn potential trades into actual trades, either by satisfying an unmet demand or by lowering transaction costs.

301

Entrepreneurs can increase the number of trades and also change the nature of trades at the same time. All entrepreneurs do something in the present that they hope will turn out well for them in the future. It follows then that all entrepreneurs bear some degree of uncertainty.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

(a)

Compute the following: (a)

The present value of $25,000 each year for 4 years at a 7 percent interest rate.

(b)

The present value of $152,000 each year for 5 years at a 6 percent interest rate.

(c)

The present value of $60,000 each year for 10 years at a 6.5 percent interest rate.

PV = ∑An/(1 + i)n PV = $25,000/(1+0.07)1 + $25,000/(1+0.07)2+$25,000/(1+0.07)3 + $25,000/(1+0.07)4 =23,364.49 + 21,835.976+20,407.45 + 19,072.38 = $84,680.28

(b)

PV = ∑ An/(1 + i)n PV = $152,000/(1+0.06)1 + $152,000/(1+0.06)2 + $152,000/(1+0.06)3 + $152,000/(1+0.06)4 + $152,000/(1+0.06)5 = 143,396.2 + 135,279.5 + 127,622.1 + 120,398.2 + 113,583.2 = $640,279.3

(c)

PV = ∑ An/(1 + i)n PV = $60,000/(1+0.065)1 + $60,000/(1+0.065)2 +$60,000/(1+0.065)3 + $60,000/(1+0.065)4 + $60,000/(1+0.065)5 + $60,000/(1+0.065)6 + $60,000/(1+0.065)7 +$60,000/(1+0.065)8 + $60,000/(1+0.065)9 + $60,000/(1+0.065)10 = 56,338.03 + 52,899.56 + 49,670.95 + 46,639.39 + 43,792.85 + 41,120.05 + 38,610.37 + 36,253.87 + 34,041.19 + 31,963.56 = $431,329.8

Rodrigo is a baseball player who earns $1 million a year playing for team X. If he weren’t playing baseball for team X, he would be playing baseball for team Y and earning $800,000 a year. If he weren’t playing baseball at all, he would be working as an accountant earning $120,000 a year. What is his economic

302

rent as a baseball player playing for team X? What is his economic rent as a baseball player? Playing for team X, his economic rent is $200,000, the difference between his team X salary and his alternative salary if he does not play for team X. His economic rent as a baseball player is $880,000, the difference between what he would earn as an accountant and what he earns playing baseball.

Diagrammatically represent pure economic rent.

Exhibit 3 in the text does this by showing the vertical supply curve for the factor of production, land in this case.

Solution’s Manual Arnold, Economics, 14e; Chapter 30: Health Economics

Table of Contents Content Grid ................................................................................................................... 304 Chapter 30: Health Economics ......................................................................................... 307 Answers to the Chapter Questions and Problems ................................................................................. 307

303

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

304

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

305

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

306

Chapter 30: Health Economics Answers to the Chapter Questions and Problems 1. Explain what makes health care markets different from other markets. Uncertainty, insurance, and negative externalities make health care markets different. Large unexpected negative financial shocks are particularly problematic and drive demand for health insurance. Negative externalities, contagious diseases being the most notable, mean that one person’s health behavior can affect someone else’s health. People generally do not internalize the social value of their health decisions, which means health falls below socially desirable levels.

2. Between 1960 and today, U.S. health care shifted from accounting for $1 out of every $20 spent to $1 out of every $5 spent. List some of the reasons why this happened. High labor costs, market power of medical providers, waste, improvements in medical technology, and a fragmented health insurance system are some of the possible reasons.

3. What are some of the dimensions along which health disparities exist? Health disparities have been identified across several dimensions including race/ethnicity, sex, education, income, sexual identity and orientation, access to health insurance, access to decent and safe housing, disability status, and geographic location (urban versus rural).

4. What are some of the causes that have been identified to explain health disparities? Education, early childhood deprivation, income, and stress have all been proposed as causes of health disparities. Each of these has gathered convincing evidence that it can at least partially explain health disparities.

5. Explain the way in which differences in education can cause differences in health. Also explain why it’s not immediately obvious that this causal pathway runs from education to health instead of from health to education. Better-educated people get more directly useful information about how they can take care of their health (e.g., health and nutrition classes). But education can also endow individuals with information or traits that indirectly benefit health. Education also determines the type of jobs that people can obtain. Highly educated people usually have less physically demanding jobs in indoor settings. These factors alone help individuals stay healthy. An example of the other

307

causal direction— that is, good health causing more education or poor health causing less education—is a child who isn’t able to attend school due to poor health.

6. Why are the prices commercial insurers pay medical providers higher than those paid by Medicare or Medicaid? The consensus is that this has to do with the market power of medical providers and insurers. To compete in the commercial insurance market, private health insurers must build attractive networks of providers. This gives ―must-have‖ hospitals, or hospitals that happen to be the only game in town, considerable leverage in price negotiations, which leads them to be able to negotiate higher prices.

7. Did COVID-19 exacerbate or lessen health disparities? What do you think caused the change? The current evidence suggests COVID-19 exacerbated health disparities. Taking race/ethnicity health disparities as an example, people of different races/ethnicities live in different areas and have different types of jobs. Minority populations generally live in denser areas and have jobs that require in-person work, both of which could lead to greater exposure to COVID-19.

8. How does the tax exclusion of employer-sponsored health insurance make it cheaper for you to obtain health insurance through your employer than by yourself? Your employer can purchase a $5,000 health insurance policy or give you $5,000 in cash. The latter would get taxed as income, so if you accept the cash, you will have less than $5,000 in cash to use in your solo quest to purchase insurance.

9. How much of U.S. health spending is estimated to be wasted spending? List the categories of waste mentioned in the chapter. More than a trillion dollars, or about 30 percent, of total health spending is estimated to be wasted spending. The six categories of waste mentioned in the chapter are administrative complexity, overtreatment, fraud and abuse, pricing failures, failures of care delivery, and failures of care coordination.

10. What was the last major health care reform in the United States, and what were the most significant changes it made to the U.S. health care system? The Affordable Care Act (ACA) of 2010 was the last major health care reform in the United States. It significantly increased the number of people in the United States with health insurance by expanding Medicaid eligibility and by offering subsidized health plans on the Healthcare Marketplace.

308

11. What’s the history behind why U.S health insurance is largely employerbased? What does the history tell you about possible unintended consequences of restricting certain practices? The United States became tied to system of employer-based health insurance after World War II. This occurred after President Roosevelt froze wages by executive order in fear of rampant inflation. Employers began trying to attract potential employees with health insurance because they entice potential employees by offering higher wages.

12. In this chapter, what were some of the problems that Dr. Robinson ran into while trying to determine the demand for her surgical services? Dr. Robinson first considered surveying her current patients. This was problematic because her current patients would likely be much more loyal to her and much less sensitive to price increases than the general population. Dr. Robinson next ran into the problem of people in the general population facing different health care prices. An overall price of $10,000 could mean an out-of-pocket price of $500 for one person and $3,000 for another, so it’s determine meaning from the answers provided by survey respondents who are asked what they would do if the price of a hip replacement were $10,000.

13. Is it the difference in the prices or the difference in quantities of health care services in the United States that explain why its health care spending per capita is higher than other countries’ health care spending? The difference in prices. Several studies have shown than the United States consumes a similar amount of health care when compared to other countries. Higher prices account for the U.S. higher health spending per capita.

14. What’s the evidence for income differences being a cause of health differences? Some of the best evidence comes from studying lottery winners. A 2005 study of Swedish lottery participants found a significant positive effect on health of winning the lottery. The study found that lottery wins that increased one’s income by at least 10 percent reduced the five-year mortality rate by 2 percentage points (from 6 percent to 4 percent).

Solution’s Manual Arnold, Economics, 14e; Chapter 31: Market Failure: Externalities, Public Goods, and Asymmetric Information

309

Table of Contents Content Grid ................................................................................................................... 311 Chapter 31: Market Failure: Externalities, Public Goods, and Asymmetric Information ........... 314 Answers to the Chapter Questions and Problems ................................................................................. 314 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 317

310

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

311

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

312

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

313

Chapter 31: Market Failure: Externalities, Public Goods, and Asymmetric Information Answers to the Chapter Questions and Problems 1.

Under what condition will MSC = MPC? When will MSB = MPB?

MSC will be equal to MPC when MEC = 0. MSB will be equal to MPB when MEB = 0.

Suppose there is a negative externality. If a tax is used to correct for the negative externality, what condition must be satisfied? What must the tax equal?

The negative externality in this case can be corrected by imposing a tax that is equal to MEC.

Explain why the shaded triangle, in Exhibit 3, is representative of a market failure.

The shaded triangle is representative of a market failure because it shows the net social benefit that is lost to society by moving from Q2 to Q1.

When will asymmetric information in a product market not cause market failure?

Asymmetric information in a product market will not cause market failure when symmetric information in the same market does not lead to a different outcome.

Give an example that illustrates the difference between private costs and social costs.

Answers will vary. One example would be as follows: A manufacturer of chemicals incurs a cost of $100,000 to produce a certain quantity of chemicals. In the process of producing the chemicals, the manufacturer emits pollution into the air that eventually results in higher medical bills for the people who live nearby. If we consider only the costs of the manufacturer—the $100,000—we are speaking of private costs. If we consider this private cost plus the cost to the persons affected by the pollution—that is, the $100,000 plus the increase in the medical bills— we would be speaking of social costs.

Consider two types of divorce laws. Law A allows either the husband or the wife to obtain a divorce without the other person’s consent. Law B permits a divorce only if both parties agree to it. Will there be more divorces under law

314

A or law B, or will there be the same number of divorces under both laws? Why? The Coase theorem tells us that there would be the same number of divorces under both laws. To see this, consider a situation where (1) the husband wants a divorce but the wife does not, and (2) the husband wants the divorce more than the wife does not want the divorce. Under law A, there will be a divorce. The wife would not be able to change her husband’s mind because he wants the divorce more than she doesn’t want the divorce. What about under law B? Will there be a divorce under law B? At first sight, most persons would say no. They would argue that since both must agree to the divorce under law B and the wife does not want the divorce, there will be no divorce. But consider, once again, that the husband wants the divorce more than the wife doesn’t want the divorce. With trivial or zero transaction costs, the husband will offer the wife more than she requires to agree to the divorce. For example, if the husband is willing to pay $5,000 to obtain a divorce, and the wife is willing to pay $3,000 to stop the divorce, then it is possible for the husband to pay the wife something more than $3,000 and less than $5,000 to win her agreement to the divorce. Under law B, there will be a divorce. We conclude that under both divorce laws a divorce will result.

People have a demand for sweaters, and the market provides sweaters. There is evidence that people also have a demand for national defense, but the market does not provide it. Why doesn’t the market provide national defense? Is it because government is providing national defense and therefore there is no need for the market to do so? Or is it because the market can’t provide it?

National defense is a public good; it is nonrivalrous in consumption and nonexcludable. Because it is a public good, it is subject to the free-rider problem; that is, its benefits can be received without making payment. Given this, rational producers won’t supply a good that no one is likely to pay for.

Identify three activities that generate negative externalities and three activities that generate positive externalities. Explain why each activity you identified generates the type of externality you specified.

Answers will vary. However, each activity that generates negative externalities will impose costs on third parties, and each activity that generates positive externalities will convey benefits to third parties.

Give an example of each of the following: (a) A good that is rivalrous in consumption and is excludable, (b) A good that is nonrivalrous in consumption and is excludable, (c) A good that is rivalrous in consumption and is nonexcludable, and (d) A good that is nonrivalrous in consumption and is nonexcludable.

Answers will vary. For example:

315

a) A hamburger b) An opera being staged in a theater c) Fish in the ocean d) National defense

10.

Some individuals argue that, with increased population growth, negative externalities will become more common and that there will be more instances of market failure and more need for government to solve externality problems. Other individuals believe that, as time passes, technological advances will be used to solve negative externality problems and that there will be fewer instances of market failure and less need for government to deal with externality problems. What do you believe will happen? Give reasons to support your position.

There is no right or wrong answer, only good or bad rationale. Basically, increased population means an increased likelihood of imposing costs on others. On the other hand, increased technology means that we may be able to reduce the extent of our externalities.

11.

Name at least five government-provided goods that are excludable public goods.

Answers will vary, but here are five: (1) education, (2) electricity generation, (3) mail service, (4) personal security, and (5) low-cost housing. 12.

There is a view that life is one big externality: Just about everything someone does affects someone else either positively or negatively. To permit government to deal with externality problems is to permit government to tamper with everything in life. No clear line divides externalities in which government should become involved from those it should not. Do you support this position? Why or why not?

This question is intended to make the student think about ―real-world‖ problems in the context of economic theory and economic analysis and involves normative judgments. Most students will probably argue for some government intervention—some externalities are bad enough or good enough to warrant action. The problem is determining which externalities are ―deserving‖ of government attention and which are not. 13.

Economists sometimes shock noneconomists by stating that they do not favor the complete elimination of pollution. Explain the rationale for this position.

At some point, the marginal cost of pollution abatement is greater than the marginal social cost of pollution. To expend otherwise productive resources to reduce pollution beyond that level would be an inefficient allocation of available resources.

316

14.

Explain how both an emission tax and tradable pollution permits system can reduce pollution.

Both emissions taxes and tradable pollution permits reduce pollution because they place a price on pollution. Since firms will have to pay to pollute in both cases, they will have an incentive to reduce pollution in an efficient manner.

15.

Identify each of the following as an adverse selection or a moral hazard problem: (a)

A person with car insurance fails to lock his car doors when he shops at a mall.

(b)

A person with a family history of cancer purchases the most complete health coverage available.

(c)

A person with health insurance takes more risks on the ski slopes of Aspen than he would without health insurance.

(d)

A college professor receives tenure (assurance of permanent employment) from her employer.

(e)

A patient pays his surgeon before she performs the surgery.

a) Moral hazard (since it occurs after the exchange takes place) b) Adverse selection (since it occurs before the exchange takes place) c) Moral hazard (since it occurs after the exchange takes place) d) Moral hazard (since it occurs after the exchange takes place) e) Moral hazard (since it occurs after the exchange takes place)

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Graphically portray the following: (a) A negative externality; (b) A positive externality. a) See Exhibit 1 in the text. b) See Exhibit 3 in the text.

Graphically represent the following: (a) A corrective tax that achieves the socially optimal output; (b) A corrective tax that moves the market output farther away from the socially optimal output than was the case before the tax was applied.

See Exhibit 4 in the text. Curve S2 represents situation (a) and curve S3 represents situation (b).

317

Using the following data, prove that pollution permits that can be bought and sold can reduce pollution from 12 tons to 6 tons at a lower cost than a regulation which specifies that each of the three firms must cut its pollution in half.

The costs of moving each firm from four to two units of pollution are: X = $900 ($500 + $400), Y = $1,700 ($900 + $800), and Z = $6,300 ($3,400 + $2,900), for a total of $8,900. Suppose now that firms can sell their pollution rights, and each begins with the right to produce two units of pollution. Firm X would agree to sell all its pollution rights for, say, $2,000 to firm Z. Firm Y pays the $1,700 it needs to spend to eliminate two units of its pollution. Only six units of pollution are being produced (0X, 2Y, and 4Z). However, the reduction was accomplished at a cost of $3,700, compared with $8,900 in

Solution’s Manual Arnold, Economics, 14e; Chapter 32: Public Choice and Special-Interest Group Politics

Table of Contents Content Grid ................................................................................................................... 319 Chapter 32: Public Choice and Special-Interest Group Politics ............................................. 322 Answers to the Chapter Questions and Problems ................................................................................. 322 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 326

318

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

319

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

320

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

321

Chapter 32: Public Choice and Special-Interest Group Politics Answers to the Chapter Questions and Problems 1.

Some observers maintain that not all politicians move toward the middle of the political spectrum in order to obtain votes. They often cite Barry Goldwater in the 1964 presidential election and George McGovern in the 1972 presidential election as examples. Goldwater was viewed as occupying the right end of the political spectrum and McGovern the left end. Would these two examples necessarily be evidence that does not support the median voter model? Are the exceptions to the theory explained in this chapter?

These are not necessarily exceptions. It is correct that Goldwater was perceived as being to the far right of middle and that McGovern was perceived as being to the far left of middle, but we do not know how the candidates perceived themselves. Possibly, both candidates thought they were gravitating toward the middle of the political spectrum, but were wrong on where the middle of the spectrum was. It is interesting to note what their respective political parties did in the next presidential election. In 1968, the Republicans, having suffered a defeat with Goldwater in 1964, chose a presidential candidate who was closer to the middle of the political spectrum than Goldwater: Richard Nixon. In 1976, the Democrats, having suffered a defeat with McGovern in 1972, chose a presidential candidate who was closer to the middle of the political spectrum than McGovern: Jimmy Carter.

The economist James Buchanan said, ―If men should cease and desist from their talk about and their search for evil men and commence to look instead at the institutions manned by ordinary people, wide avenues for genuine social reform might appear.‖ What did he mean?

He meant that people in the public sector do not behave differently from the people in the private sector because they are different types of people but because the two sectors have different institutional arrangements.

Would voters have a greater incentive to vote in an election involving only a few registered voters or in one that has many? Why? Why might a Republican label her opponent too far left and a Democrat label his opponent too far right?

Ceteris paribus, a voter would have a greater incentive to vote in an election with a smaller

number of registered voters. The reason is that the smaller the number of voters, the greater the likelihood that one’s vote will affect the outcome, while the greater the number of voters, the smaller the likelihood that one’s vote will affect the outcome. A Republican might label her opponent too far left and a Democrat might label his opponent too far right in order to paint

322

their opponents as out-of-step with the average voter’s tastes, in order to win the support of the median voter.

Many individuals learn more about the car they are thinking of buying than about the candidates running for president of the United States. Explain why.

If an individual learns about the car he is thinking of buying, this information can be extremely useful. Since the individual who buys the car has to live with his choice, he wants to make certain it is a good one. If he decides incorrectly, money has been wasted. When it comes to the presidential candidates, however, the individual knows that he will not decide the election, and that no amount of information that he has on the candidates will matter to the decision at hand.

If the model of politics and government presented in this chapter is true, what are some of the things we would expect to see?

Answers will vary. Some possibilities are as follows: First, we would expect to see a higher voter turnout in warm weather than in cold, rainy weather, ceteris paribus. The reason is that cold, rainy weather increases the costs of voting. Second, we would expect to see congressional representatives from nonfarm states voting for farm subsidies. If we didn’t see this, we would question the existence of logrolling. Third, we would expect to see government bureaus spending any excess funds before the end of the fiscal year. Excess funds cannot be divided up among the government bureaucrats themselves, so from their point of view it is better to spend the money than leave it unspent and return it to the legislature. Returning it to the legislature might result in a smaller budget the next year. Fourth, we would expect to see the programs, ideas, and policies of representatives elected by large majorities copied by other representatives. What they are copying is success. The representative who wins an election by a large majority is presenting other representatives, or other individuals running for office, with information as to where the middle of the political spectrum is in a particular voting distribution.

It has often been said that Democratic candidates are more liberal in Democratic primaries and Republican candidates are more conservative in Republican primaries than either is in the general election. Explain why.

In the party primaries, the median Democrat voter is to the left of center, and the median Republican voter is to the right of center. As a result, a rational candidate, wishing to appeal to the median voter in whatever election she is running will adjust her rhetoric and positions accordingly. Thus, since the median voter in the Democrat primary is to the left of the median voter on the presidential election, we would expect Democrat hopefuls to appear more liberal in the primaries than in the general election. Since the median voter in the Republican primary is to the right of the median voter in the presidential election, we would expect Republican hopefuls to appear more conservative in the primaries than in the general election.

323

What are some ways of reducing the cost of voting to voters?

Some simple ways would be to provide more thorough information on the candidates and their positions on issues important to voters; increase the period of time during which voters may vote; allow people to cast their votes via telephone or home computer link (assuming we can protect against computer sabotage); require employers to let employees off work, with pay, to go to vote; and provide free public transportation to voting places.

Provide a numerical example which shows that simple-majority voting may be consistent with efficiency. Next, provide a numerical example which shows that simple-majority voting may be inconsistent with efficiency.

Answers will vary. Here is an example. Assume three people have MPB for West Nile Virus spraying as follows:

Person

MPB of first gallon

MPB of second gallon MPB of third gallon

$50

$40

$20

$30

$20

$15

$10

If the marginal cost of providing a gallon of bug spray is $70, then: Case 1: If the taxes attached to the legislation to help fund this are assessed at $40 per unit for person X, $20 per unit for person Y and $10 per unit for person Z, then they will vote to have 2 gallons sprayed, which is efficient. Case 2: If the taxes needed to pay for this are assessed at $23.33 per unit provided, then people will vote to have only one gallon, which is inefficient.

John chooses not to vote in the presidential election. Does it follow that he is apathetic when it comes to presidential politics? Explain your answer.

No. John may be rationally ignorant since the cost of becoming informed on various political issues exceeds the benefits he gets from voting. 10.

Some individuals see national defense spending as benefiting special interests—in particular, the defense industry. Others see it as directly benefiting not only the defense industry but the general public as well. Does this same difference between viewpoints apply to issues other than national defense? Name a few.

324

Yes. Here are some examples. Example 1: The investment tax credit is seen by some as a ―break‖ for big business, allowing firms to get out of paying their fair share of the tax burden, while others see it as a way of promoting investment, expanding productive capacity, and enabling the economy to grow. Example 2: Many people view environmental legislation and nuclear plant bans as a threat to their jobs and their standard of living, while others see protecting the environment as essential to maintaining the well-being of every American and ensuring the integrity of the Earth’s ecosystem. Example 3: The Republicans have passed legislation to lower the capital gains tax. The rationale for this is that it will spur investment and economic growth. Assuming that many Republicans have capital gains in the stocks they own, this reduction would provide them with direct benefits by reducing their tax burden if they sell their shares.

11.

Evaluate each of the following proposals for reform in terms of the material discussed in this chapter: (a) Linking all spending programs to visible tax hikes; (b) A balanced-budget amendment stipulating that Congress cannot spend more than total tax revenues; (c) A budgetary referendum process whereby the voters actually vote on the distribution of federal dollars to the different categories of spending (x percentage to agriculture, y percentage to national defense, etc.) instead of letting elected representatives decide. a) By linking all spending programs to a visible tax hike, voters will be better able to see the cost of proposed legislation, making it less difficult for them to become informed and enabling them to make more rational choices and to hold elected officials more accountable. b) Requiring a balanced budget may restrict the tendency to vote for new spending programs simply to collect political favors (logrolling) and force politicians to consider the economics of their decisions more carefully. It could also help to reduce the growth of bureaucratic spending, or at least force any increase to be considered on its merit and not simply passed. c) Having voters decide on the distribution of funds could serve two purposes. First, it would encourage voters to become more informed about the programs government conducts, because the cost of ignorance is much higher if you have to make a decision, rather than delegating that responsibility to someone else. Second, it would likely reduce the extent of special-interest spending, since the cost to special-interest groups of effectively lobbying 200 million voters would be much greater than the cost of lobbying 535 senators and representatives.

12.

―Rent seeking may be rational from the individual’s perspective, but it is not rational from society’s perspective.‖ Do you agree or disagree? Explain your answer.

Agree. Resources are scarce and society is better off when people are employed in the production of goods and services. When individuals pursue rent seeking, they are expending

325

resources to capture transfers from others, not for production. This means that the economy is operating inside its production possibilities frontier, and further inside the PPF than it would in the absence of rent seeking.

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Suppose that three major candidates—A, B, and C—are running for president of the United States and that the distribution of voters is that shown in Exhibit 1. Two of the candidates—A and B─are currently viewed as right of the median voter, and C is viewed as left of the median voter. Is it possible to predict which candidate is the most likely to win?

Depending on exactly where to the left and right these candidates are, it may be possible to predict which candidate is most likely to win. If A and B are competing for the same group of voters and are close together, they may split the vote and allow C to win. On the other hand, they might be close to the median while C is well to the left of median, and either A or B could win. If A and B are not close together, then the one closest to the median is more likely to win or finish second behind C. In short, we can speculate, but not know for certain.

Look back at Exhibit 2. Suppose that the net benefits and net costs for each person are known a week before election day and that it is legal to buy and sell votes. Furthermore, suppose that neither buying nor selling votes has any conscience cost (i.e., one does not feel guilty buying or selling votes). Would the outcome of the election be the same? Explain your answer.

The net gains to the individuals total $132 and the net losses total $320. The potential losers could pay $200 to the potential gainers, who would then be better off and the statue is not purchased, saving the potential losers $120. So, yes, the result should be the same (not to buy the statue).

In part (a) of the accompanying figure, the distribution of voters is skewed to the left; in part (b), the distribution is skewed neither left nor right; and in part (c), it is skewed right. Assuming a two-person race for each distribution, will the candidate who wins the election in (a) hold different positions from the candidates who win the elections in (b) and (c)? Explain your answer.

326

Probably yes. Assuming that the candidates are both located relatively close to center, then the elections in part (a) and part (c) at least would yield winners with differing points of view. Of course, candidates taking extreme positions might offset the skewed nature of the distributions, or small differences in distance from the median in part (b) could throw that race in either direction.

Solution’s Manual Arnold, Economics, 14e; Chapter 33: New Frontiers in Economic Research: Causal Inference and Machine Learning

Table of Contents Content Grid ................................................................................................................... 328 Chapter 33: New Frontiers in Economic Research: Causal Inference and Machine Learning ... 331 Answers to the Chapter Questions and Problems ................................................................................. 331

327

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth

Part 5

328

Chapter 16 Expectations Theory and the Economy

Chapter 17 Economic Growth: Resources, Technology, Ideas, and Institutions

Part 6 Creative Destruction and Crony Capitalism Chapter 18 Creative Destruction and Crony Capitalism: Two Forces on the Economic Landscape Today

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

329

Chapter 32 Public Choice and Special-Interest-Group Politics Part 12 Economic Theories and Research

19 Part 7

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

330

Chapter 33: New Frontiers in Economic Research: Causal Inference and Machine Learning Answers to the Chapter Questions and Problems 1.

What does casual inference refer to?

Causal inference refers to trying to infer the cause of some effect. For example, suppose we observe that the unemployment rate has recently risen in the country. We want to know what caused this rise in unemployment. The cause may not be obvious to us, so we try to infer what the cause is. Economists use natural experiments, instrumental variables, and regression discontinuity designs to try to infer the causal effects.

What does it mean if someone says that ―correlation is not causation‖?

It means that just because there is a correlation between X and Y, it does not follow that X is the cause of Y or that Y is the cause of X. Correlation may look like causation to us, but it takes more than how something looks to us to establish causation.

The fact that European countries with more storks also tend to have higher human birth rates is an example of what type of correlation?

This is an example of a spurious correlation. It is spurious because this correlation is clearly not causal, as storks do not cause higher birth rates.

What is a controlled experiment?

It is an experiment in which we have two different groups of people, and the individuals that are in each group have been picked at random. The random selection is important here because we want the two groups to be similar. It would be as if you could interchange the persons in one group with the people in the other group and nothing would have fundamentally changed. For the treatment group, something is introduced to it that is not introduced to the control group. For example, the treatment group might be given a drug to take and the control group is given a placebo. Finally, we observe whether there is any difference (as a result of the treatment or drug) between the two groups.

In the Card–Krueger study discussed in the chapter, we referred to it as a natural experiment. Why was it a natural experiment instead of a controlled experiment?

It was a natural experiment because the control and treatment groups appeared naturally. They were not created by some researcher in the way a medical researcher might create a control

331

group and a treatment group by choosing people at random for the two groups and then deliberately giving a treatment to one group and a placebo to the other. In the Card–Krueger natural experiment, the researchers took advantage of the fact that Pennsylvania and New Jersey happened to be similar, and that New Jersey happened to increase the state-level minimum wage. They did not choose these groups or generate the variation in minimum wage, and therefore, this is not a controlled experiment.

Card and Krueger found that the increased minimum wage rate in New Jersey did not cause a decline in employment in New Jersey. Does it follow that increases in the minimum wage would therefore never and in no place cause a decline in employment? Explain your answer.

No. Just because Card and Krueger found that an increase in the minimum wage in New Jersey from $4.25 to $5.05 did not cause a decline in employment, it does not follow that a larger increase, say, from $4.25 to $8.50, would not have caused a decline in employment.

What are the details of economist Joshua Angrist’s study of the Vietnam War Draft lottery?

Each of the 366 days of the year were placed in plastic capsules, and the capsules were then scrambled. One capsule was chosen at a time, and the individuals, of a certain age range, whose birthday was the same as the date inside the capsule, were then eligible to be drafted. People whose birth dates were chosen earlier in the lottery were more likely to be drafted than those whose birth dates were chosen later in the lottery. At the end of the process, this set up two groups of individuals who were very much alike except that one group was drafted into military service and the other was not. Angrist then sought to find if there was a difference between the earnings of the two groups.

What does it mean for a defendant to ―win the judge lottery‖?

Some judges are lenient on defendants, and some judges are strict on defendants. For example, some judges are more likely to assign longer incarceration lengths than others for the same crime committed. A defendant who wins the judge lottery is assigned a lenient judge. This ―judge lottery‖ is helpful for identifying causal effects because some defendants will randomly be assigned longer incarceration lengths (due to being assigned a strict judge), whereas some will randomly be assigned shorter incarceration lengths (due to being assigned a lenient judge).

What is the essence or key characteristic of a regression discontinuity?

There is a cutoff rule.

10.

Dinardo and Lee (2004) study the effect of unions on firm employment with a regression discontinuity. What is the discontinuity in their setting?

332

If less than 50 percent of the workers vote to unionize, then the firm is not unionized. If 50 percent of the workers or more vote to unionize, the firm will become unionized. Therefore, there is a discontinuity at a 50 percent vote share. In other words, firms that have 49 percent of workers voting to unionize are probably similar to firms that have 51 percent, but the 49 percent firm is not unionized while the 51 percent firm is unionized.

11.

How is the goal of big data and machine learning different from the goal of causal inference?

The goal of big data and machine learning is primarily focused on making accurate predictions. The goal of causal inference is to identify the causal relationships.

12.

Economists use data to accomplish various goals or objectives. What are these goals or objectives?

To identify causal relationships and to make accurate predictions.

13.

In machine learning, what does the concept of ―regularization‖ refer to?

It refers to the process of eliminating variables that are only weakly related to one’s target of interest. For example, if one is interested in predicting the crime rate in a given city in a given year, regularization would be the process of eliminating those variables that are weakly related, if related at all, to predicting the crime rate in a given city in a given year.

Solution’s Manual Arnold, Economics, 14e; Chapter 34: International Trade

Table of Contents Content Grid ................................................................................................................... 334 Chapter 34: International Trade ....................................................................................... 337 Answers to the Chapter Questions and Problems ................................................................................. 337 Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 340

333

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

334

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

335

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

336

Chapter 34: International Trade Answers to the Chapter Questions and Problems 1.

Although a production possibilities frontier is usually drawn for a country, one could be drawn for the world. Picture the world’s production possibilities frontier. Is the world positioned at a point on the PPF or below it? Give a reason for your answer.

The world is positioned at a point below the frontier. We know this because we live in a world where countries impose tariffs and quotas. As the chapter explained, both tariffs and quotas result in net losses; that is, without tariffs and quotas (with free trade), there would be net gains that are not received with tariffs and quotas. In short, the countries of the world would produce and consume more if no restrictions existed. Thus, we conclude that in a world where tariffs and quotas exist, the world must be positioned at a point below its production possibilities frontier. 2.

If country A is better than country B at producing all goods, will country A still be made better off by specializing and trading? Explain your answer. (Hint: Look at Exhibit 1.)

Yes. Even if one country has an absolute advantage in the production of all goods (for simplicity, assume two goods) it still has a comparative advantage in the production of one good. Exhibit 1 illustrates the case where the U.S. has an absolute advantage over Japan in the production of both food and clothing, but Japan still has a comparative advantage in the production of clothing. Both countries are made better off by specializing in their area of comparative advantage and then trading. 3.

The desire for profit can end up pushing countries toward producing goods in which they have a comparative advantage. Do you agree or disagree? Explain your answer.

Agree. When someone notices price differences between his country and another and decides to buy goods which are cheaper in one country to sell in the other in order to make a profit, he is moving each country toward its comparative advantage. Each country ends up specializing and exporting goods in which they have a comparative advantage. 4.

Whatever can be done by a tariff can be done by a quota. Discuss.

To a large degree, this is true. For example, if a tariff raises the price of imported goods from P1 to P2, a quota can raise the price by exactly the same amount. And, if a tariff and quota both raise the price of imports by the same amount, both will reduce consumers’ surplus and increase producers’ surplus by the same amount. A difference between a tariff that produces a

337

price of P2 and a quota that produces a price of P2 is that the tariff will raise tariff (tax) revenues for the government and the quota will not. 5.

Neither free trade nor prohibited trade comes with benefits only. Both come with benefits and costs. Therefore, free trade is no better or worse than prohibited trade. Comment.

Even though both come with benefits and costs, we have proved graphically that free trade is superior to prohibited trade. As we saw in Exhibits 4 and 5, there are greater losses than gains if we move from free trade to prohibited trade. 6.

Consider two groups of domestic producers: those which compete with imports and those which export goods. Suppose the domestic producers that compete with imports convince the legislature to impose a high tariff on imports—so high, in fact, that almost all imports are eliminated. Does this policy in any way adversely affect domestic producers that export goods? If so, how?

Yes, it does. If a nation does not import goods from foreigners, foreigners will not have the purchasing power to buy that nation’s export goods. For example, suppose there are only two countries in the world, the United States and Mexico. If the United States imposes a high tariff on Mexican goods so that Americans no longer buy Mexican goods, this will drastically reduce the number of dollars Mexicans will have to buy U.S. goods. In turn, this will affect U.S. producers who produce goods for export. 7.

Suppose the U.S. government wants to curtail imports. Would it be likely to favor a tariff or a quota to accomplish its objective? Why?

It would most likely favor a tariff over a quota, since a tariff raises revenue for the government while a quota does not. (As an aside, the average U.S. tariff rate has been approximately 10 percent in the past decade.) 8.

Suppose the landmass known to you as the United States of America had been composed, since the nation’s founding, of separate countries instead of separate states. Would you expect the standard of living of the people who inhabit this landmass to be higher, lower, or equal to what it is today? Why?

Lower. The flow of goods, services, and factors across the 50 states would be substantially lessened if they were 50 separate countries, since each country would have political pressures to protect its indigenous industry and workforce. Since the flow of goods, services, and factors is reduced, the distribution of resources would be less optimal than with unrestricted trade, resulting in a lower level of real output and a lower standard of living.

338

Even though Jeremy is a better gardener and novelist than Bill, Jeremy still hires Bill as his gardener. Why?

As long as Bill can allow Jeremy to become more productive by devoting all of his time to writing novels rather than splitting his time between writing and gardening, then Jeremy is making a wise choice. It is based on the comparative advantage theory—while Jeremy has an absolute advantage in both tasks, Bill is ―less worse‖ at gardening than at novel writing and thus has a comparative advantage there that, if exploited, will allow both men to be better off than if they each acted separately and performed both the tasks. 10.

Suppose that a constitutional convention is called tomorrow and that you are chosen as one of the delegates from your state. You and the other delegates must decide whether it will be constitutional or unconstitutional for the federal government to impose tariffs and quotas or to restrict international trade in any way. What would be your position?

The answer to this question will depend on how the student weighs the economic arguments against trade restrictions against the political arguments for it. There is no ―right‖ answer but be sure that the student can support his or her answer with sound reasoning. 11.

Some economists have argued that, because domestic consumers gain more from free trade than domestic producers gain from (import) tariffs and quotas, consumers should buy out domestic producers and rid themselves of costly tariffs and quotas. For example, if consumers save $400 million from free trade (through paying lower prices) and producers gain $100 million from tariffs and quotas, consumers can pay producers something more than $100 million but less than $400 million and get producers to favor free trade too. Assuming that this scheme were feasible, what do you think of it?

In a sense, this is like the ―voluntary agreement‖ introduced in Chapter 30. As long as both parties benefit more from the agreement than they would from disagreement, then this is an economically sound policy. Consumers will gain more from free trade, even after ―paying off‖ domestic producers, than producers would gain from restricted trade; producers should also favor the proposal, for they are guaranteed a gain greater than they would get with restricted trade, when they cannot even be sure that trade would otherwise be restricted to protect them. 12.

If there is a net loss to society from tariffs, why do tariffs exist?

As we have learned throughout this course, individuals consider their own self-interest, not the well-being of society, in their decision making. If a business can make foreign competitors less competitive, thereby raising its own prices and profits, it will seek to do so, regardless of the loss that the rest of society will suffer as a consequence. Further, conventional wisdom may fear the loss of jobs from imported goods without considering the benefits of new jobs from increased exports.

339

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Using the data in the accompanying table, answer the following questions: (a) For which good does Canada have a comparative advantage? (b) For which good does Italy have a comparative advantage? (c) What might be a set of favorable terms of trade for the two countries? (d) Prove that both countries would be better off in the specialization-trade case than in the nospecialization–no-trade case.

340

Points on Production Possibilities Frontier

CANADA Good X Good Y

ITALY Good X

Good Y

150

100

120

180

a) Canada has a comparative advantage in the production of good X. In Canada, the opportunity cost of producing 1 unit of X is 1/2Y. In Italy, the opportunity cost of producing 1 unit of X is 2Y. Since Canada can produce good X at a lower opportunity cost than Italy can, Canada has a comparative advantage in the production of good X. b) Italy has a comparative advantage in the production of good Y. In Italy, the opportunity cost of producing 1 unit of Y is 1/2X. In Canada, the opportunity cost of producing 1 unit of Y is 2X. Since Italy can produce good Y at a lower opportunity cost than Canada can, Italy has a comparative advantage in the production of good Y. c) In Canada, 1X = 1/2Y, and in Italy, 1X = 2Y. A favorable set of terms of trade would be anything between these two extremes: for example, 1X = 3/4Y, or 1X = 1Y, or 1X = 1 3/4Y. To see this, pick any of these terms of trade, say, 1X = 1Y. At present, Italy has to give up 2Y to get 1X; it would prefer to give up only 1Y to get 1X. At present, Canada gives up 1X and gets only 1/2Y; it would prefer to give up 1X and get 1Y instead. d) Suppose that in the no specialization–no trade case, Canada is producing and consuming at point B on its production possibilities frontier, and Italy is producing and consuming at point C on its production possibilities frontier. This means the situation is as follows:

No Specialization–No Trade Canada

Italy

Produces 100 units of X

Produces 30 units of X

Consumes 100 units of X

Consumes 30 units of X

Produces 25 units of Y

Produces 120 units of Y

Consumes 25 units of Y

Consumes 120 units of Y

Now suppose the countries agree to the terms of trade 1X = 1Y and trade (in absolute amounts) 40X for 40Y. Canada specializes in the production of good X, Italy in the production of good Y. Now Canada is in this situation: It produces 150 units of X, trades 40 units to Italy, and receives 40 units of Y in exchange. It consumes 110 units of X (150 – 40 = 110) and 40 units of Y (received in trade). Italy is in this situation: It

341

produces 180 units of Y, trades 40 units to Canada, and receives 40 units of X in exchange. It consumes 140 units of Y (180 – 40 = 140) and 40 units of X (received in trade). Thus, both countries consume more of both goods in the specialization-trade case than in the no specialization–no trade case.

Specialization–Trade Canada

Italy

Produces 150 units of X

Produces 180 units of Y

Consumes 110 units of X Consumes 40 units of Y

Consumes 140 units of Y Consumes 40 units of X

342

In the accompanying figure, PW is the world price and PW + T is the world price plus a tariff. Identify the following: (a) The level of imports at PW; (b) The level of imports at PW + T; (c) The loss in consumers’ surplus as a result of a tariff; (d) The gain in producers' surplus as a result of a tariff; (e) The revenue received as a result of a tariff; (f) The net loss to society as a result of a tariff; (g) The net benefit to society of moving from a tariff to no tariff.

a) Imports at PW are Q2 – Q1. b) Imports at PW + T are Q4 – Q3. c) The loss in consumers’ surplus is equal to areas 3 + 4 + 5 + 6. d) The gain in producers’ surplus is equal to area 3. e) The tariff revenue is area 5. f) Net loss to society is areas 4 + 6. g) The net benefit to society of removing tariffs is areas 4 + 6.

Solution’s Manual Arnold, Economics, 14e; Chapter 35: International Finance

Table of Contents Content Grid ................................................................................................................... 345 Chapter 35: International Finance .................................................................................... 348 Answers to the Chapter Questions and Problems ................................................................................. 348

343

Answers to the Problems in the Working with Numbers and Graphs Section ...................................... 352

344

Content Grid ECONOMICS

MACRO

MICRO

Part 1

Chapter 1 What Economics Is About

Appendix A Working with Diagrams

Appendix B Should You Major in Economics?

Chapter 2 Production Possibilities Frontier

Chapter 3 Supply and Demand: Theory

Chapter 4 Prices: Free, Controlled, and Relative

Chapter 5 Supply, Demand, and Price: Applications

An Introduction to Economics Part I Economics: The Science of Scarcity

Part 2 Macroeconomic Fundamentals

Part 2

Chapter 6 Macroeconomic Measurements, Part I: Prices and Unemployment

Chapter 7 Macroeconomic Measurements, Part II: GDP and Real GDP

Part 3 Macroeconomic Stability, Instability, and Fiscal Policy

Part 3

Chapter 8 Aggregate Demand and Aggregate Supply

Chapter 9 Classical Macroeconomics and the Self-Regulating Economy

Chapter 10 Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Chapter 11 Fiscal Policy and the Federal Budget

Part 4 Money, the Economy, and Monetary Policy

Part 4

Chapter 12 Money, Banking, and the Financial System

Chapter 13 The Federal Reserve System

Chapter 14 Money and the Economy

Chapter 15 Monetary Policy

Appendix C: Bond Prices and Interest Rates

Part 5 Expectations and Growth Chapter 16 Expectations Theory and the Economy

Part 5 16

345

17 Part 6

Part 6

MICROECONOMICS

Part 2

Part 7 Microeconomic Fundamentals Chapter 19 Elasticity

Chapter 20 Consumer Choice: Maximizing Utility and Behavioral Economics

Appendix D Budget Constraint and Indifference Curve Analysis Chapter 21 Production and Costs Part 8 Product Markets and Policies

C 8 Part 3

Chapter 22 Perfect Competition

Chapter 23 Monopoly

Chapter 24 Monopolistic Competition, Oligopoly, and Game Theory

Chapter 25 Government and Product Markets: Antitrust and Regulation

Part 9 Factor Markets and Related Issues

Part 4

Chapter 26 Factor Markets: With Emphasis on the Labor Market

Chapter 27 Wages, Unions, and Labor

Chapter 28 The Distribution of Income and Poverty

Chapter 29 Interest, Rent, and Profit

Part 10 Health Economics

Part 5

Chapter 30 Health Economics

Part 11 Market Failure, Public Choice, and Special-Interest Group Politics

Part 6

Part 11 Public Choice and Special-Interest-Group Politics Chapter 31 Market Failure: Externalities, Public Goods, and Asymmetric Information

Chapter 32 Public Choice and Special-Interest-Group Politics

346

Part 12 Economic Theories and Research

Part 7

Part 8

Chapter 34 International Trade

Chapter 35 International Finance

Chapter 33 New Frontiers in Economic Research: Casual Inference and Machine Learning The Global Economy Part 13 International Trade and Finance

347

Chapter 35: International Finance Answers to the Chapter Questions and Problems 1.

Explain the link between the Mexican demand for U.S. goods and the supply of pesos. Next, explain the link between the U.S. demand for Mexican goods and the supply of dollars.

If the Mexican demand for U.S. goods increases, it leads to an increase in the demand for U.S. dollars with which to buy U.S. goods. To buy dollars, the supply of pesos will increase. Similarly, the increase in U.S. demand for Mexican goods leads to an increase in the demand for Mexican pesos, and to buy those pesos, the supply of U.S. dollars will increase.

The lower the dollar price of a peso, the higher is the quantity demanded of pesos and the lower is the quantity supplied of pesos. Do you agree or disagree? Explain.

Agree. The demand curve for pesos is downward sloping, indicating that as the dollar price per peso declines, the quantity demanded of pesos (by Americans) rises. To illustrate, if Americans have to pay 10 cents to buy a peso, they might offer to buy 100 pesos, but if Americans have to pay 8 cents to buy a peso, they might offer to buy 140 pesos. The supply curve for pesos is upward sloping, indicating that as the dollar price of a peso falls—that is, as Mexicans receive less for a peso—the quantity supplied of pesos (by Mexicans) falls. To illustrate, at 10 cents for a peso, Mexicans might offer to sell 110 pesos, but at 8 cents for a peso, they might offer to sell 60 pesos.

What does it mean to say that the U.S. dollar has depreciated in value in relation to the Mexican peso? What does it mean to say that the Mexican peso has appreciated in value relative to the U.S. dollar?

When the equilibrium exchange rate rises from say, 0.10 USD= 1 MXN to 0.12 USD = 1 MXN, Americans must now pay 12 cents instead of 10 cents to buy a peso. Hence, the dollar has depreciated in relationship to the Mexican peso. The other side of the coin, so to speak, is that it takes fewer pesos to buy a dollar; so, the peso has appreciated in relationship to the U.S. dollar. That is, at an exchange rate of 0.10 USD = 1 MXN, it takes 10 pesos (1.00/0.10 = 10) to buy $1, but at an exchange rate of 0.12 USD = 1 MXN, it takes only 8.33 pesos (1.00/0.12 = 8.33) to buy $1.

Suppose the United States and Japan have a flexible exchange rate system. Explain whether each of the following events will lead to an appreciation or depreciation of the U.S. dollar and Japanese yen. (a) U.S. real interest rates rise above Japanese real interest rates. (b) The Japanese inflation rate rises relative to the U.S. inflation rate. (c) An

348

increase in U.S. income combines with no change in Japanese income. a) If U.S. real interest rates rise above Japanese real interest rates, Japanese investors will want to buy U.S. financial assets that give a higher rate of return. This increases the demand for U.S. dollars. The U.S. dollar appreciates, and the Japanese yen depreciates. b) An increase in the Japanese inflation rate relative to the U.S. inflation rate means goods in Japan cost more relative to the U.S. Japanese buyers will want to buy more U.S. goods, increasing the demand for U.S. dollars. This also increases the supply of yen. The yen depreciates, and the U.S. dollar appreciates. c) If there is an increase in U.S. income, the overall demand for goods, both domestic and imported, will increase. Consumers in the U.S will increase their demand for Japanese goods. The demand for the yen will increase, and the supply of dollars, to buy those yen, will also increase. Assuming that the income levels in Japan remain unchanged, this will result in an appreciation of the yen and a depreciation of the dollar.

Give an example of how a change in the exchange rate alters the relative price of domestic goods in terms of foreign goods.

Answers will vary. For example, suppose the exchange rate between the U.S. dollar and the English pound is $1.50 = £1. At this exchange rate, an American good, X with a price tag of $1.50, equals one English good, Y with a price tag of £1. That is, 1X = 1Y. If the exchange rate changes to $3 = £1, an American can either buy 1X with $1.50 or 1/2Y. That is, 1X = 1/2Y. The depreciation of the dollar makes U.S. goods relatively cheaper (and makes English goods relatively more expensive).

What are the strong and weak points of the flexible exchange rate system? What are the strong and weak points of the fixed exchange rate system?

The arguments for and against flexible and fixed exchange rates are laid out in section IV of the outline, above in this Instructor’s Manual and the corresponding text sections.

Explain the details of the purchasing power parity (PPP) theory.

The PPP theory predicts that changes in the relative price levels of two countries will affect the exchange rate in such a way that 1 unit of a country’s currency will continue to buy the same amount of foreign goods as it did before the change in the relative price levels.

A country whose currency is the primary reserve currency can likely borrow at lower interest rates than it could if its currency were not the primary reserve currency. Do you agree or disagree? Explain.

Agree. One of the advantages to a country whose currency is the primary reserve currency is that it can borrow at lower interest rates. To explain, in August 2011, China held approximately $2 trillion of its $3.2 trillion in foreign exchange reserves, in dollars. Most of these ―dollar holdings‖ were in the form of U.S. government bonds. In other words, because of the dollar’s © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

349

primary reserve currency status, China was more willing (than it would have been had the dollar not been the primary reserve currency) to buy dollar-denominated U.S. government bonds. But, of course, more demand for U.S. government bonds means that the U.S. government can get a higher price when selling those bonds and, therefore, has to pay a lower interest rate on those bonds.

What does it mean to say that a currency is overvalued? undervalued?

A currency is overvalued if its price is above its equilibrium level and is undervalued if its price is below its equilibrium level. If the dollar price of pesos, for instance, is above its equilibrium level, the peso is overvalued and the dollar is undervalued.

10.

Under a flexible exchange rate system, if the equilibrium exchange rate is 0.10 USD = 1 MXN and the current exchange rate is 0.12 USD = 1 MXN, will the U.S. dollar appreciate or depreciate? Explain.

When the equilibrium exchange is 0.10 USD = 1 MXN and the current exchange rate is 0.12 USD = 1 MXN, Americans must now pay 12 cents instead of 10 cents to buy a peso. Hence, the dollar will appreciate in relationship to the Mexican peso.

11.

Under a fixed exchange rate system, setting the official price of a peso in terms of dollars automatically sets the official price of a dollar in terms of pesos. Do you agree or disagree? Explain.

Disagree. Suppose there is a surplus of pesos in the foreign exchange market, indicating that the peso is overvalued and the dollar is undervalued. Mexico and the United States could agree to reset the official price of the dollar and the peso. For example, suppose the first official price of a peso is 0.10 USD = 1 MXN or 1 USD = 10 MXN. Mexico and the United States agree to change the official price of their currencies. The second official price is 0.12 USD = 1 MXN or 1 USD = 8.33 MXN. Moving from the first official price to the second, the peso has been revalued because it takes more dollars to buy a peso (12¢ instead of 10¢). Of course, moving from the first official price to the second means the dollar has been devalued because it takes fewer pesos to buy a dollar (8.33 pesos instead of 10). One country might want to devalue its currency, but another country might not want to revalue its currency. Revaluing the dollar means Mexicans have to pay more for it; instead of paying, say, 8.33 pesos for $1, Mexicans might have to pay 10 pesos. At a revalued dollar (a higher peso price for a dollar), Mexicans will find U.S. goods more expensive and will not wish to buy as many. Americans who produce goods to sell to Mexico may see that a revalued dollar will hurt their pocketbooks, and so they will argue against it.

12.

Country X wants to lower the value of its currency on the foreign exchange market. Under a flexible exchange rate system, how can it do that?

The factors that affect the equilibrium exchange rate under a flexible exchange rate system include differences in income growth rates, differences in relative inflation rates, and differences

350

in real interest rates. Accordingly, if country X wants to lower the value of its currency on the foreign exchange market, it should try to lower inflation rates and increase the interest rates.

13.

What is an optimal currency area?

An optimal currency area is a geographic region in which exchange rates can be fixed or a common currency used without sacrificing domestic economic goals.

14.

Country 1 produces good X, and country 2 produces good Y. People in both countries begin to demand more of good X and less of good Y. Assume that there is no labor mobility between the two countries and that a flexible exchange rate system exists. What will happen to the unemployment rate in country 2? Explain.

If exchange rates are flexible, the value of country 1’s currency changes vis-à-vis country 2’s currency. If country 2 wants to buy more goods from country 1, it will have to exchange its domestic currency for country 1’s currency. The demand for country 1’s currency on the foreign exchange market increases at the same time that the supply of country 2’s currency increases. Consequently, country 1’s currency appreciates, and country 2’s currency depreciates. Therefore, country 1’s goods become relatively more expensive for country 2; so, they buy fewer of them, while country 2’s goods become relatively cheaper for country 1; so, they buy more of them. Country 2’s business firms begin to sell more goods; so, they hire more workers and the initial rise in unemployment due to fall in demand for good Y disappears.

15.

How important is labor mobility in determining whether an area is an optimal currency area?

When labor is mobile between two countries, they could have a fixed exchange rate or adopt a common currency and retain the benefits of flexible exchange rates. Then they do not have to have separate currencies that float against each other, because resources (labor) can move easily and quickly in response to changes in relative demand. When labor in countries within a geographic area is mobile enough to move easily and quickly in response to changes in relative demand, the countries are said to constitute an optimal currency area. Thus, labor mobility is very important in determining whether or not an area is an optimal currency area.

16.

If everyone in the world spoke the same language, would the world be closer to or further from being an optimal currency area? Explain.

Closer. A common language promotes labor mobility, because the number and types of jobs available to immigrants would be larger and the number of potential immigrants capable of doing any particular job would be higher.

351

Answers to the Problems in the Working with Numbers and Graphs Section 1.

Use the following information to answer (a) – (c): U.S. Dollar Equivalent Thursday Friday Russia (ruble) Brazil (real) India (rupee) (a) (b) (c)

0.0318 0.3569 0.0204

0.0317 0.3623 0.0208

Currency Per U.S. Dollar Thursday Friday 31.4190 2.8020 48.9100

31.5290 2.7601 47.8521

Between Thursday and Friday, did the U.S. dollar appreciate or depreciate against the Russian ruble? Between Thursday and Friday, did the U.S. dollar appreciate or depreciate against the Brazilian real? Between Thursday and Friday, did the U.S. dollar appreciate or depreciate against the Indian rupee?

a) Appreciated. A dollar bought 31.4190 rubles on Thursday and 31.5290 rubles on Friday, so it is worth more. Or, a ruble bought .0318 dollars on Thursday and only .0317 on Friday. So, the ruble depreciated and the dollar appreciated. b) Depreciated. c) Depreciated. 2.

If $1 equals ¥0.0093, what does ¥1 equal?

If $1 = ¥0.0093 yen, then ¥1= 1/0.0093 = $107.53.

If $1 equals 7.7 krone (Danish), what does 1 krone equal?

If $1 = 7.7 krone, then one krone = 1/7.7 dollars = $0.1299.

If $1 equals 31 rubles, what does 1 ruble equal?

If $1 equals 31 rubles, then 1 ruble = 1/31 dollars = $0.0323.

If the exchange rate is 0.08 = 1 MXN, what is the cost in dollars of a Mexican table priced at 500 pesos?

If 1 MXN = $0.08, then $1 = 1/0.08 = 12.5 MXN. Therefore, a table costing 500 pesos will cost, 500/12.5 = $40.

352

353